Dean Foods finds focus

by Josh Sosland
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In his vision of Dean Foods Co. as a company with a growth rate on par with the food and beverage industry’s leaders, Gregg L. Engles has faced no shortage of obstacles.

As chairman and chief executive officer of the nation’s largest dairy company, Mr. Engles sits atop a food industry segment that could be portrayed as the precise opposite of what has popularly become known as an "advantaged category." With a core business in liquid milk, Dean’s products have faced a long-term trend of declining consumption. Hardly a consolidated segment with just a few large players, the dairy market is extraordinarily fragmented, and margins are tight. National brands in milk are utterly lacking and the industry’s flagship products attract no impulse buying (Not many shoppers walking through a supermarket suddenly think, "Ooh, I know I shouldn’t, but I just can’t resist buying that gallon of 2%!").

Notwithstanding these handicaps, Mr. Engles is hard at work shaping Dallas-based Dean into a dairy company that consistently will deliver earnings growth in an 8% to 10% per year range. And he won’t be running from the company’s heritage dairy business to achieve its growth.

"Broadly described, Dean Foods’ strategy is to focus on its core businesses — the fluid dairy business, particularly in North America and its branded business, particularly in the dairy case," Mr. Engles said in August after announcing the company’s second-quarter financial results.

Dean has made progress toward his objectives, both in shaping the business and in the company’s earnings targets.

Dean earnings were up 14% in fiscal year 2003 (year ended Dec. 31) from 2002 and up 9% in fiscal 2004. At the high end of its current forecasts, Dean would achieve earnings growth of 16% in 2005. The results exclude the effects of facility closing costs, discontinued operations and one-time items.

To achieve the company’s objectives of earnings growth and greater portfolio focus, Dean Foods is looking to build its rapidly growing branded foods segment — organic dairy, soy milk and creamer businesses. In the August conference call, Mr. Engles celebrated progress toward Dean Foods long-term objective to "build a branded business in the dairy case" as well as the company’s "ongoing efforts to clarify and improve" its business.

The success Dean has achieved has made the company’s shares a hit on Wall Street. From the beginning of 2003 through the end of September, Dean shares jumped 85%, a far better performance than achieved by most major food companies and easily outpacing a 46% gain in the S.&P. 500 index.

In fact, Dean has in certain respects been a victim of its own success. During the second quarter ended June 30, the company took a $3.9 million charge against earnings in connection with stock units granted in January 2003. Under terms of the company’s executive compensation plan, the grants vested early because of appreciation in Dean Foods common stock.

Additionally, Dean Foods shares declined last week after downgrades by analysts from Credit Suisse First Boston and Prudential Securities. Shares fell $1.23, or 3%, to $38.22, after the two rated Dean a neutral because their price target of $39 had been surpassed. At the same time, C.S.F.B.’s David Nelson acknowledged that Dean’s "fundamentals remain solid, and full upside has yet to be captured in the branded business."

Silk, Horizon Organic keys to growth
At the heart of the branded strategy has been the acquisition of the Silk and Horizon Organic brands. Beginning last year, the company began to formally combine the acquired business with Dean Foods existing brands. WhiteWave Foods has been formed to house the branded businesses.

"We are beginning to see the benefit of our efforts with second-quarter operating income at WhiteWave up 160% and operating margins up 574 basis points," Mr. Engles said.

Still, growth potential alone has not been the sole criterion pursued as Dean reshapes its portfolio. The company has disposed of or is selling a number of business lines that may have greater growth potential than the company’s core dairy business.

For example, during the second quarter Dean completed the spinoff of its Treehouse Foods business (see related story ???) and, more recently, sold its Marie’s dressings and Dean’s dips businesses.

"Our continuing drive for focus will result in continued scrutiny of our activities within WhiteWave Foods as we emphasize our most profitable and rapidly growing lines within our strategic brands and deemphasize activities where we do not have a competitive advantage or that will not produce significant long-term value," Mr. Engles said.

Just as he said the Treehouse businesses were not core to Dean Foods, Mr. Engles offered a similar assessment of the dip and dressing brands, which were sold to Ventura Foods. His comments shed light on the considerations Dean Foods is using in determining what kinds of products belong in its portfolio.

Dressings, dips don’t fit
"While Marie’s and Dean’s dips are strong, profitable businesses, we made the decision to divest them because they’re very distinct from our core dairy and branded businesses with little if any synergies," he said. "The manufacturing processes are unique to these products and the sales and distribution channels are separate from our core product lines. Based on a definitive agreement, we will receive what we believe is a very favorable price for the businesses and expect this sale to close in the third quarter. This initiative will allow us to further focus our efforts and resources on our core dairy operations and on the growth at WhiteWave Foods."

The changes will leave Dean Foods with a unique balance of businesses within the food industry. Speaking in Boston at the Prudential Equity Group’s Back to School Consumer Conference, Mr. Engles said the Dean Dairy Group, with $8.6 billion in annual sales, offers stable and predictable earnings, volume growth and strong cash flow. WhiteWave Foods, with $1.2 billion in sales, offers significant growth potential in large, growing categories, strong national brands and value-added margins.

Largest dairy company, by far
In its core Dairy Group, Dean has worked to capitalize on its scale to meet the needs of a consolidating supermarket industry. While the dairy business may still be fragmented, Dean is the clear volume leader, about four times the size of its nearest competitor. The company has estimated its market share at 30% to 35%.

The Dairy Group operates 105 plants sprinkled across the country. Its direct-store delivery system covers virtually the entire mainland United States plus Hawaii. Other than Alaska, Washington and Oregon are the only states in which Dean does not currently have a D.S.D. presence.

Not only is Dean the largest dairy company, it has been gaining market share steadily in recent periods.

"We experienced strong growth in fluid milk volumes in the second quarter, up 4.1% over the same period a year ago due to solid execution in all channels," Mr. Engles said.

Noting that U.S. Department of Agriculture data showed total milk consumption up 1.6% during the first two months of the company’s second quarter, he said that "Consistent with recent trends, we believe we’re continuing to gain market share in the fluid milk category."

In 2004, fluid dairy products accounted for 76% of Dean Foods sales, with the balance divided between ice cream (10%), cultured products (7%) and other products (4%).

In addition to building its business through volume growth, the company has steadily and deliberately tried to reduce costs in its network of dairy plants.

"There is a lot of excess capacity in the dairy industry, said Barry Sievert, senior director of investor relations at Dean. "In many cases we have been able to consolidate our processing operations within a given region that maybe was being serviced by three or four plants down to two or three facilities which operated much more efficiently. Depending on acquisitions, we expect to close approximately two or three facilities per year for the foreseeable future. Two are slated for closure this year."

Responding to what the company called an "extraordinarily difficult dairy commodity market" in 2004, Dean shuttered eight facilities last year alone. The moves have paid off as measured both by sales and operating income growth. The plant closings and other cost reduction initiatives bolstered profitability, and operating margins in the second quarter gained 90 basis points, Mr. Engles said.

Commenting on the operating environment in the dairy market, Mr. Engles noted that last year’s higher prices encouraged increased milk output, with milk production in 2005 very strong.

"We’re currently operating in a more benign dairy commodity environment than last year," he said.

Operating income of the Dairy Group was $173 million in the second quarter, up 11% from the same period last year. While noting a $4.5 million benefit from the settlement of a high fructose corn syrup lawsuit, Mr. Engles pointed out that higher resin and fuel costs were a drag on profitability, with increases of $6.5 million and $7.6 million, respectively.

WhiteWave profits more than double
The most dramatic improvement in second-quarter profitability took place in the Dean Foods WhiteWave Foods segment. The branded business had operating income of $28.7 million, up 160% from the second quarter last year. Sales were up 12%, to $284 million.

"We’re beginning to integrate and internalize the manufacturing and distribution of our branded products and therefore lower our costs," Mr. Engles said.

Also a major factor in the improved profitability has been reduced marketing spending.

"We’re managing our advertising and promotional activities better than in the past, and they are therefore more efficient and effective," Mr. Engles said.

Both of the central brands of WhiteWave Foods — Horizon Organic and Silk soy milk — enjoyed impressive results in the second quarter.

At Horizon, second-quarter sales were up 57% from the same period last year, reflecting continued growth in consumer demand for organic products. The rate of growth could create short-term demand squeezed from time to time, Mr. Engles warned.

"We now regularly source raw organic mil from approximately 300 separate farms, the majority of which are small family-owned operations," he said. "We continue an active program to convert conventional farms to our network of organic suppliers to keep pace with the rapidly growing demand for our organic dairy products. We currently believe that we will be able to procure a sufficient supply of raw organic mil to meet the long-term demands of our customers. However, the relatively long lead times inherent in the conversion process to organic farming, combined with continued unprecedented growth in demand, could cause short-term imbalances in any given period. That said, we remain extremely excited about the long-term prospects for this brand."

While not as eye popping as the Horizon sales jump, Silk product sales were up 17% from the second quarter last year. The line remains the category leader, capturing about 80% of total dollar sales in all categories, the company said. Recently introduced Silk Light products "have enjoyed early success," generating incremental sales, Mr. Engles said.

The cut in marketing spending could be characterized as giving the company a moment to catch its breath, he said.

"Consistent with our plan, marketing spending for the Silk brand was lower in the second quarter of this year as compared with the same period last year when we launched our first ever TV campaign for silk with heavy introductory spending," he said. "Our plans call for marketing expenditures for the brand in the back half of 2005 to be at levels consistent with second half of last year. With the support of this investment, we expect the brand to continue to exhibit strong growth in sales and profitability."

The other leading brands in WhiteWave focus on the creamer market — International Delight and Land O’ Lakes. International Delight, a non-dairy creamer brand, enjoyed 10% year-over-year sales growth in the second quarter, despite a slowdown in category sales growth.

"The brand's strongest growth is coming in the away-from-home market where innovative packaging is increasing demand for the product through new points of distribution in the convenience and food service markets," Mr. Engles said.

The company is introducing a trans fat-free formulation across its entire line in the second half.

Land O’ Lakes as platform for growth
Growth was far slower for Land O’ Lakes, with a 1% gain versus the second quarter last year. First-half growth was 6%.

"Land O' Lakes presently operates in more mature dairy categories," Mr. Engles said. "However, as one of the most widely recognized and trusted brands in the dairy case, we see this brand as a platform for growth in coming years as we work to bring more value-added milk products to the marketplace. In the back half of this year, we intend to introduce new packaging and graphics to deliver a more consistent, recognizable presentation across our entire Land O’ Lakes product line."

Dean Foods has been building its portfolio of branded products for nearly a decade, beginning with the 1997 purchase of Morningstar. The company entered into a licensing agreement with Land O’ Lakes in 2002. That same year, the company acquired White Wave, the maker of Silk soy milk. Horizon Organic was acquired in 2004.

While its branded WhiteWave Foods segment is growing rapidly, it still accounts for a small part of the overall Dean Foods business. With $1.2 billion in sales expected in 2005, the division would account for just about 10% of overall corporate sales.

The company’s ultimate objective is a company with a "focused portfolio of premium brands," a fully integrated supply chain and an organization that is brand centric and attracts top food industry executive talent.

Growth potential is central in the brands Dean sees in its portfolio in the future. The Silk, Horizon, Land O’ Lakes and International Delight brands the company owns have a five-year compounded annual sales growth rate of 29%.

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