Solid earnings recovery at Dean Foods

by Josh Sosland
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DALLAS — A 21% jump in third-quarter operating income at its DSD Dairy segment paced a dramatic increase in quarterly profits at Dean Foods Co.

Net income at the company in the third quarter ended Sept. 30 was $37,752,000, equal to 25c per share on the common stock, up 482% from $6,482,000, or 5c per share, in the third quarter last year. Net sales were $3,149,669,000, up 2.5%.

Adjusted net income from continuing operations in the third quarter was $43.5 million, up 133% from $18.7 million in the third quarter last year.

In addition to stronger results from DSD Dairy, profits were boosted by lower interest expense.

"The third-quarter results demonstrate the clear progress the business has made over the last year," said Gregg Engles, chairman and chief executive officer. "Third-quarter adjusted operating income for the DSD Dairy segment is 21% higher than the very difficult third quarter of last year while fluid milk volumes were over 3% higher this quarter than the third quarter of 2007.

"At WhiteWave-Morningstar, sales continue to grow at a strong pace, while profitability was challenged in the quarter by increasing commodity costs at Morningstar and the continued effects of higher organic milk costs on WhiteWave’s Horizon Organic brand. Overall, it was a very encouraging quarter and positions us well to finish out the year strong."

Operating income of DSD Dairy was $140,444,000 in the third quarter, up from $116,543,000.

Net sales of the DSD Dairy business were $2,523,357,000, up 1% from $2,498,634,000 in the same period last year. Higher volumes were partly offset by the effects of lower overall dairy commodity costs. The lower costs were a significant contributor to higher operating profits for the division as were increased proceeds from excess cream sales and cost control efforts. Energy costs and packaging costs were countervailing forces.

In a Nov. 4 conference call, Jack Callahan, executive vice-president and chief financial officer, expanded on results of the DSD Dairy business.

"DSD Dairy fluid milk volumes outpaced the overall market, increasing 3.2% over year-ago levels, including a significant contribution from our acquisitions this year," Mr. Callahan said. "This compares favorably to a fluid milk category that we estimated increased volumes slightly more than 1% in the quarter, based on U.S.D.A. and federal milk marketing order data."

While the division performed well in the third quarter, market conditions remained highly volatile, Mr. Callahan said. He elaborated on a number of market challenges the company faced.

"July was perhaps the most challenging month of 2008, with Class 1 milk back near $21 per cwt, and diesel, electricity, natural gas and resin prices at or near all-time highs," he said. "Our costs for these four energy-related inputs alone moved up over $13 million from Q2 to Q3.

"Conditions did begin to improve month by month as we moved through the quarter, with the Class 1 mover declining in August and September to average $18.97 (per cwt) for the quarter. Similarly, other commodity costs, like diesel, natural gas, and resin, also began to recede from their highs in August and September. As a result, DSD Dairy’s results improved sequentially each month in the quarter, including a particularly strong September.

"Keep in mind that, with the exception of Class 1 milk prices, we have no forward visibility into these input prices and therefore experienced them in our P.&L. as they occur. We price for them in arrears, and our price mechanism to recover non-milk commodity cost increases is less robust than for Class 1 milk."

WhiteWave-Morningstar operating income in the third quarter was $41,321,000, down 4% from $43,062,000. Net sales were $3,194,669,000, up 9%.

Operating margins in the segment narrowed to 6.2% in the quarter from 7% in the same period last year. Increasing dairy costs at Morningstar, specifically higher butter prices, pressured results.

"Higher raw organic milk costs also continued to challenge the Horizon Organic brand in the WhiteWave portfolio, offsetting efficiency gains and improving profitability across the rest of the branded portfolio," the company said.

Horizon Organic milk net sales were up 20% from the third quarter last year because of higher prices. Silk sales also chalked up double-digit gains. The company credited distribution expansion and "integrated marketing that featured both print and television advertising highlighting the heart health benefits of the Silk product line."

During the conference call, Mr. Callahan said further difficulties in the organic milk market are likely in the months ahead. Because of the higher costs, organic milk prices are about as high as possible in the present environment, he said.

"Horizon retail price gaps versus average private label prices have expanded a bit to almost 20%, which is at the high end of the acceptable range," he said. "We continue to monitor our position in this category. Looking forward, with unfavorable organic dairy economics for farmers, driven predominantly by high input costs, we expect industry supply growth to decline significantly over the next six months. Consequently, we expect increasing retail pricing to balance demand with slowing supply growth.

"However, it remains unclear when our pricing actions and the rest of the competitions’ will catch up with the cost of organic milk. For now, Horizon Organic remains unprofitable."

In the first nine months of 2008, Dean Foods net income was $117,409,000, or 80c per share, up 19% from $98,718,000, or 75c per share. Net sales were $9,374,188,000, up 9%.

Looking forward, Mr. Engles said the DSD Dairy segment would benefit from commodity deflation and that prospects were good for Dean Foods’ other businesses, except Horizon Organic.

Company-wide, Dean is projecting earnings per share of $1.40 per share in 2009, representing percentage growth in the mid-teens from $1.20 currently expected this year.

While a significant recovery from $1.20 in 2008 and $1.01 in 2007, the earnings would still be well below the $1.68 earned in 2006 and $2.10 in 2005.

Mr. Engles identified a number of forces that will curb profits in the year ahead, beginning with investments in the plant startup and the initial marketing support behind its Fruit Today initiative (see related story on Page 10 of this issue of Food Business News).

Other factors he cited included "selective" reinvestment in supply chain, research and development and distribution technology, competitive pressures and an incremental pension expense of 3c per share.

Competitive pressures have been exacerbated by the economic downturn, the credit crisis and shifting consumer behavior, Mr. Engles said.

"We are seeing increased signs of stress in the industry," he said. "The first manifestation of that stress is that our pipeline of potential acquisitions remains robust, despite having completed four acquisitions so far this year."

Additionally, as Dean Foods has gained market share, Mr. Engles said the company increasingly is encountering "aggressive and, we believe, ultimately uneconomic competitive behavior."

He continued, "To offset their volume losses, some competitors are aggressively price-discounting in an effort to take incremental business from Dean and other industry players, driving down marketplace profitability. We are actively working to defend our business during this unsettled period in the market and believe some of the recent marketplace activity is not sustainable

Engles: Focusing on the long term

DALLAS — In addition to offering insights about financial results so far in 2008 and the outlook for the balance of the year and 2009, Gregg Engles, chairman and chief executive officer of Dean Foods Co., described plans to build the company’s dairy business longer term.

In a Nov. 4 conference call with securities analysts, Mr. Engles said he has "never been more optimistic about our business."

"The work being accomplished this year in building our strategic growth plan has convinced me that the next three to five years offer tremendous opportunity for value creation at Dean," he said.

Mr. Engles said a first phase for the company will be a "focus on achieving clear cost leadership in the fluid milk industry." This objective is achievable because of the company’s scale and through investing in technology he said his competitors would be unable to match.

Toward the objective of cost leadership, the company will focus its efforts on four areas, Mr. Engles said:

• Product standardization and sourcing. "Our nationwide system, built primarily through acquisitions, gives us significant opportunities to aggregate manufacturing volumes where we can invest for efficiency, optimize and standardize our product formulations and packaging and source with scale and lower cost," Mr. Engles said.

• Network optimization. He said Dean already has begun an effort to ensure the company’s network of facilities is as efficient as possible with locations at appropriate distance from customers.

• Continuous improvement. The focus here is through the propagation of best practices, Mr. Engles said. Again noting the role of acquisitions in the makeup of Dean Foods today, he said the company’s operations were "continuing to operate through multiple different structures with different processes, standards, capabilities and efficiencies, largely unsupported from the center." The objective will be to identify and codify best practices and remove obstacles that limit productivity and increase costs, he said.

• Lowering distribution costs. "We’re in the process of rolling out a G.P.S. (global positioning satellite system) enabled tool across our direct-store delivery system that allows us to monitor driver and truck efficiency, quickly identifying areas of improvement that can be addressed," Mr. Engles said. "At the same time, we are implementing tools to manage minimum drop sizes and drop frequency."

These efforts will require stepped-up investment in supply chain, distribution technology and research and development, Mr. Engles said.

This article can also be found in the digital edition of Dairy Business News, November 2008, starting on Page 1. Click here to search that archive.

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