Dean Foods Imminent Margin Contraction Spawns Asymmetric Short Opportunity

Dean Foods: Imminent Margin Contraction
Spawns Asymmetric Short Opportunity
|Must Read Apr. 26, 2016 3:39 PM ET3 comments
by: Lester Goh
Summary
• Dean Foods has traded range-bound since 2014. The bull case appears to
be predicated on margin expansion being sustainable and raw milk prices
continuing to fall.
• The drivers of gross margin expansion are largely temporary (low milk
prices, cheap oil/natural gas) and are likely to experience mean reversion
over the next couple of quarters.
• In the medium term (next few years), milk prices should rise by a significant
amount due to increased feed costs making raw milk production
incrementally less economic, pressuring gross margins further.
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• The drivers of opex contraction have largely reached their limits, and thus
investors should not expect significant opex reduction in the future to prop
up margins.
• ~50% downside from current levels. Upside risks are limited.
Thesis
Shares of Dean Foods (NYSE:DF) ("Dean", "DF", or the "Company") have traded
range-bound since 2014. The bull case seems to be based largely on two key pillars
- recent margin expansion being sustainable and raw milk prices continuing to fall.
I disagree on both counts and believe that the recent margin expansion - especially
on the gross margin side - is mostly unsustainable, and thus arrive at the conclusion
that Dean is a compelling short.

Why now? In my view, margins have likely peaked and should mean-revert over the
next few quarters. The catalysts for this margin contraction are lower margin-over-
milk and higher oil/natural gas prices on the gross margin side, and increased per-
unit selling & distribution costs on the opex side.
Over the next few years, milk prices are likely to be materially higher than current
prices due to increased feed costs making raw milk production incrementally less
economic, which should pressure DF's gross margins further. Moreover, retailer
pressure (especially from Wal-Mart (NYSE:WMT)) could result in Dean needing to
make incrementally greater working capital investments, reducing free cash flows.
Assuming the top-line experiences a slight decline, gross margins mean-reverts
modestly, opex is flat, and the EV/EBITDA multiple to 8x, shares of Dean see ~50%
downside from current levels.
Quick Background
As a quick reminder, Dean is the largest milk processor in the U.S. with ~35%
market share. Essentially, Dean purchases raw milk (mostly Class I mover) from
farmers' cooperatives, processes it, and then sells the finished product to its
customers - who are largely retailers. Dean then hopes to earn a gross profit over
the costs of raw milk - i.e. a margin-over-milk.
Broadly, Dean sells its processed milk under private labels (~52% of 2015 sales)
and Company brands (~48% of 2015 sales). The Company tends to charge a
premium over the private label price for its branded milk. The mix has improved
slightly in the past few years, from ~56%/~44% private label/branded in 2009 to its
current mix.
Milk in general has been experiencing industry-wide volume declines in recent
years. This is largely due to consumers substituting dairy products with other non-
dairy products. Another major contributor to volume declines has been due to
consumers shifting away from cereal, evident from the sustained declines in cereal
sales seen at Post Holdings (NYSE:POST), Kellogg (NYSE:K), and General Mills
(NYSE:GIS); consumers tend to consume milk alongside cereal.

Dean operates in a largely commoditized industry, thus resulting in low margins and
high competition. Management has been focused on closing plants to rationalize
operations and remove excess capacity from the industry. Rationalizing of
operations to reduce costs have worked out quite well so far and have likely resulted
in Dean possessing the lowest-cost position in the industry.
The Bull Case
Dean's gross margins expanding ~700 bps from 2014 to 2015 coincided with raw
milk prices peaking in October 2014. The drivers for gross margin expansion are
lower Class I mover prices and cheaper oil/natural gas - resin, which requires crude
oil and natural gas to manufacture, is used by Dean to make plastic bottles to hold
their products.
Source: 4Q 2015 Earnings Call Presentation

Source: NASDAQ

Source: NASDAQ
A combination of the above has led to higher margin-over-milk, allowing the
Company to substantially improve its financial performance from 2014 to 2015.
Gross profit jumped ~18% from ~$1.6b to $1.9b and operating income grew more
than 10x from ~$8.5m to $93.4m. Adj. diluted EPS turned significantly positive, and
free cash flow exploded. The aforementioned improvement in Dean's profitability
metrics has also allowed the Company to de-lever from ~4.5x net debt/EBITDA in
2014 to ~1.9x in 2015.
Unsurprisingly, shares appreciated by a respectable amount (if we take October
2014 as the starting point). Shares have retreated slightly in recent months due to a
Wal-Mart initiative, which I will address in the subsequent section.
Higher Margin-Over-Milk Is Likely Temporary

I believe that higher margin-over-milk is temporary and should mean-revert over the
next few quarters.
One major tenet of the bull case appears to hinge on the hypothesis that margin-
over-milk should stabilize. While margin-over-milk has historically gone through
mean-reversion after spiking temporarily when milk prices collapse, longs argue that
this time is different. Bulls cite the Company's significant efforts to reduce excess
capacity dating back to 2009 as a major factor that should strengthen its negotiating
position.
The difference between the cost of milk from suppliers and the retail price of
processed milk (whether private label or branded) is a margin that is shared
between wholesalers like Dean and retailers like Wal-Mart. Who keeps more of
said margin depends on their relative bargaining positions. Bulls think that
Dean's negotiating position is vastly superior as compared to the past and thus
reason that Dean should be able to keep more of the margin to itself when milk
prices collapse.
Unfortunately for longs, it appears that Dean's negotiating position has yet to
improve. One can plausibly make an argument that it has weakened. Despite
substantial efforts by Dean to rationalize its capacity, capacity utilization still remains
fairly low - clocking in at ~60% according to GuruFocus - suggesting significant
excess capacity still exists. It is difficult to argue for a strong bargaining position if
your counterparty knows you have excess capacity. A large reason for the lack of
improvement in the capacity situation can be attributed to continued decline in
industry volumes, as discussed.
To make matters worse, Dean's primary customers - retailers - have improved their
negotiating position materially in recent years, largely due to consolidation. This is
cited by Dean many times over the years in the risk factors of its 10-Ks. Greater
concentration in the retail space would increase retailers' clout over their suppliers
(i.e. Dean). Unlike companies such as Kraft Heinz (NASDAQ:KHC) that own
extremely strong brands allowing them some leeway to push back on retailers,
Dean is not so fortunate.
Moreover, Dean's negotiating position is set to worsen even further. Wal-Mart
recently announced an initiative to in-source processed milk manufacturing. As
noted earlier, the announcement led to a ~12% drop in Dean's stock price.

To be fair, Dean responded to the announcement and clarified that the Wal-Mart
initiative should have minimal impact on the Company, as the initiative was rolled
out in states where DF did not have significant exposure. However, this is beside
the point.
Considering that Wal-Mart is known to be extremely skilled at managing its cost
position, it seems fair to assert that the retailer only made this move after having
figured out that it would lower its overall costs. Basically, it appears likely that Wal-
Mart would probably roll out the initiative to more states over time, as the economics
of in-sourcing prove themselves out in the first few states.
Longer term, this would be hugely detrimental to milk processors as demand from
their largest customer (Wal-Mart) would plummet, negatively affecting milk
processor sales. As an alternative to losing Wal-Mart as a customer, companies like
Dean would likely be compelled to match the benefit the retailer would derive from
in-sourcing, pressuring milk processor margins.
Although Wal-Mart does purchase both private label and branded products from
Dean, it is difficult to make the argument that consumers would reject WMT's in-
house milk given that consumers do not seem particularly attached to branded milk.
This is evident if we consider the price gap between private label and branded milk -
in its 4Q '15 earnings presentation, Dean reported that the price gap of branded vs.
private label was down 10% to 1Q. If consumers were attached to Dean's branded
milk, we would see more price stability.
Couple substantial excess capacity, a worsening negotiating position with respect to
Dean, and an improving negotiating position at retailers with continued industry-wide
volume declines, it seems nigh impossible to argue that Dean would be able to
maintain its margin-over-milk. This is already beginning to show up in its financials,
as seen below (red emphasis).

Source: 4Q 2015 Earnings Call Presentation, emphasis mine
The reason for the lag between the changes of raw milk prices and margin-over-milk
is due to the fact that Dean adjusts its prices on a monthly basis. In a perfect world
where there is no pass-through friction and equal negotiating positions between
Dean and retailers, raw milk prices would move in tandem with margin-over-milk.
This lag results in short-term spikes in margin-over-milk (green emphasis above),
which allows Dean to temporarily make outsized profits.

However, as adjustments kick in, margin-over-milk should contract significantly.
Lower margin-over-milk also makes it difficult to hold on to branded margins - the
gap between branded and private label has contracted, as noted above.
Finally, crude oil and natural gas have recently bounced off their lows, making it
unlikely that Dean would obtain any benefit here; higher input costs is far more
likely. Over the next few years, prices of the aforementioned commodities should
normalize, thanks to continued supply rationalization over the past two years.
Longer-Term, Milk Prices Should Rise, Pressuring Gross Margins Further
The apparent bright spot is that Dean expects that Class I prices will fall sequentially
by ~11% in 1Q '16, according to the 10-K. The Company has also spent the last few
years rationalizing its operations by closing plants around the country.
Thus, it seems that the other major tenet of the bull case is predicated on milk prices
continuing to fall - thus resulting in higher margin-over-milk - and Dean being able to
capitalize on lower excess capacity - hence allowing the Company to retain a
greater portion of the higher margin-over-milk for itself - which should improve gross
profits.
However, I am not convinced. As discussed, the latter argument not only has holes
in it, but it has not played out. Margin-over-milk continues to contract, suggesting
that at best, Dean's negotiating position is no better than before. The former
argument which relates to the prediction of raw milk prices continuing to fall is
suspect as well.
The Company acknowledges in its 10-K that the commodity environment can be
hugely volatile. Hence, one should take the ~11% projected sequential decline with
a grain of salt.
Milk is derived from cows. Cows are fed with feed that comprise primarily of
soybean and corn (i.e. grain-fed). Both are used interchangeably (and at fairly
similar amounts - 47% and 60% of soy and corn produced in the US is consumed by
livestock) by farmers as an alternative to grass (hence grass-fed vs. grain-fed). As
they are used interchangeably, the decisive factor tends to be price. However, both
commodities have correlated pretty well in the past, suggesting that the net demand
change over time will likely be minimal.
Dean Foods: Imminent Margin Contraction Spawns Asymmetric Short Opportunity -… Page 10 of 25

Grain-fed cattle tends to be preferred for two reasons - 1) as the end-product is far
more consistent compared to grass-fed (amount and mix can be scientifically
determined) and 2) there are significant government subsidies provided to grain
farmers, which lowers the price of grain significantly. The prices of both soybean
and corn have fallen substantially in recent years, as seen below:
Source: NASDAQ

Source: NASDAQ
Given Dean's cautious comments on commodity price volatility, it appears extremely
likely that Dean based its projection on commodity price action in recent years,
extrapolating the recent past into the future. However, soybean and corn prices
have bounced off their lows in recent months, as seen below:

Source: NASDAQ

Source: NASDAQ
It seems fair to assert that cow farmers would likely cut back on raw milk production
- thus potentially leading to a rise in raw milk prices - as their economics become
incrementally unfavorable; rising COGS (feed) and lower revenues (raw milk) is not
a pretty equation.
While I do not proclaim to be a particularly astute macro-timer, there are reasons to
believe that the prices of crop-based commodities in general could be experiencing
a cyclical upturn. This assertion is supported by the fact that agrochemical
companies such as Dow Chemical (NYSE:DOW), Syngenta (NYSE:SYT), and
Monsanto (NYSE:MON), which manufacture insecticides, pesticides, herbicides,
and fungicides, have identified high crop protection inventories as early as 2014.

Sales of agrochemicals have been pressured in the past few years - this is clear
when one examines the aforementioned companies' financial results, as the channel
continued working off inventories. As a result, it does not seem like a stretch to
assert that crop farmers will continue to pare back on crop plantings until prices
recover significantly. This should result in crop prices (especially soybean and corn,
which are most relevant to raw milk production) continuing to see upward pressure
from here on out.
In short, raw milk prices are likely to appreciate significantly in the medium term, a
development that would be disastrous for Dean. This is because when raw milk
prices rise, although the retail price of processed milk does rise, there is a ceiling.
The ceiling exists because as retail prices rise, there eventually comes a point when
consumers would balk at the high prices and substitute processed milk for other
alternatives (search "demand destruction" in the 10-K). Thus, the margin that is
shared between milk processors and retailers compresses. Due to Dean's poor
negotiating position relative to retailers as discussed, retailers are able to take a
larger portion of the diminishing margin, hence resulting in a collapse in margin-
over-milk, as seen below:

Source: 4Q 2015 Earnings Call Presentation, emphasis mine
Thus, while net sales in 2014 increased ~5% largely due to higher pricing, gross
profits actually contracted by ~300bps due to a ~9% jump in COGS thanks to higher
input costs.
Drivers Of Opex Reduction Have Largely Reached Their Limits

In response to the 2008 crisis, Dean has embarked on a huge initiative to rationalize
its operations. This rationalization has largely comprised of closing plants around
the country. According to the 2009 10-K, Dean had 106 manufacturing facilities
(Fresh Dairy Direct + WhiteWave/Morningstar).
Fast-forward to 2015, the Company has nearly halved its manufacturing capacity;
the current number of manufacturing sites sits at 67. As a result of this
rationalization in operations, opex has declined from ~$2.5b in 2009 to ~$1.9b in
2015. Despite eradicating ~$600m in opex, operating income has declined
substantially from ~$600m in 2009 to the current ~$93m, largely as a result of the
top-line contracting from ~$11b to ~$8b over the same period.
While the top-line contraction appears to be slowing - largely due to strong category
performance in fluid milk (~71% of 2015 sales), it is still up for debate whether this
would be sufficient to reverse the decline in revenues going forward. The Company
has ramped up spending on national brands - particularly DairyPure, spending
~$45m on advertising in 2015, suggesting that there is potential for a surprise to the
upside if said advertising gains traction.
However, judging by the continued multi-year industry-wide volume declines, a
reversal in the top-line is not something I would bet on. While ice cream sales
appear to be gaining some steam (due to ~4% volume growth, they largely offset
the declines in non-fluid milk products), at ~12% of 2015 sales, it would be years
before ice cream sales would be able to offset the downward pressures in fluid milk.
In the Company's 10-K, Dean continues to emphasize on rationalizing its
operations, suggesting that it could potentially continue closing more plants around
the country in future years. The 2013-2015 period was cited by the Company to be
an acceleration of plant closures on its part. Management expects to return to more
normal levels of plant closures going forward, suggesting that annual facility
rationalization and related costs should normalize around ~$15m. However, the
benefits of this should be mostly limited due to a thinner network.
In microeconomics, one of the very first concepts taught is that of long-run average
costs.

As the firm increases the quantity sold, average costs decline, until a certain point
(A to C). Dean is experiencing the opposite. From 2009 to 2014, it appears that
Dean has travelled from point D to B, evident from its declining revenues and
smaller manufacturing base.
Starting in 2015 however, it appears that the Company is beginning to travel from
point B to A. This is clear when we consider that opex has jumped from 17.5% of
sales to ~23% from 2014 to 2015; whereas from 2013 to 2014 it decreased from
~19% to 17.5%.
One explanation is the decline in revenue. G&A played a small role, rising from 3%
of sales to ~4.3%. G&A is likely to increase going forward, given continued spending
by the Company on its national brands and higher incentive-based comp. Selling &
distribution expenses played a larger role, increasing from ~14.3% of sales to 17%.
Selling & distribution expenses likely increased as a percentage of sales due to the
fact that as Dean continued closing plants, its network consequently thinned, thus
resulting in transportation costs being spread over a smaller revenue base. The
thinning of its network is apparent when we consider the Company's smaller
presence as compared to 2009 (39 plants were closed over the 2009-2015 period).
Therefore, it appears fair to contend that any future benefit from plant closures is
likely to be limited - any benefit from a reduction in G&A is likely to be offset by
transportation costs growing on a per-unit basis.

Note that the absolute increase (as compared to the percentage of sales increase
discussed above) was due to ~$24m of advertising costs incurred to support the
Company's national brands.
While the Company continues to tout its extensive "direct-to-store delivery" system
and its focus on filling trucks and optimizing deliveries, these seem less compelling
in light of the recent per-unit increase in selling & distribution expenses.
Retailer Pressure Could Result In Incrementally Higher Working Capital
Investment, Pressuring Free Cash Flows
Retailers have been facing pressure with respect to their bottom-lines recently,
largely as a result of currency headwinds, anemic growth, higher wages, and
decreased traffic. This is especially prominent at Wal-Mart, which recently
disappointed investors by taking out-year earnings guidance down substantially.
In an effort to reinvigorate earnings growth, Wal-Mart has vowed to right-size
working capital by reducing inventories, stretching payables to match inventory
turnover, and pushing suppliers such as Dean for better pricing at its annual
meeting. Recent commentary from the retailer suggests that these initiatives are
gaining traction. Dean's compressing margin-over-milk in the last few months further
supports this.
While difficult to quantify, the impact of these initiatives by retailers such as Wal-
Mart on Dean will be directionally negative. From Dean's point of view, retailer
actions such as reducing inventories means less sales, stretching payables means
less cash, and the push for better pricing means lower ASPs.
These effects could be particularly pronounced at Dean as Wal-Mart comprises
~16% of net sales. Moreover, considering the Company's declining volumes, it is
unlikely that Dean would be able to come out ahead in negotiations. Declining
volumes could also turn into a vicious cycle where retailers assign less shelf-space
to Dean's products.
Valuation - Modest Mean-Reversion In Gross Margins Implies ~50% Downside

Source: Company filings, author's estimates/calculations
I am modeling a low single-digit top-line decline, a contraction in gross margins to
22%, flat selling & distribution expenses, G&A, and D&A.
The top-line assumption seems fair given that the Company itself is expecting low-
single-digit declines. A gross margin reversion to ~22% (from the current ~24%) is
quite conceivable - considering that gross margins were ~20% in 2013, and is
arguably highly generous - as 2013 margin-over-milk was >$0.10 greater than the
current number.

Assuming flat selling & distribution expenses seems kind considering my prior
comments regarding a thinner network, and actual G&A could be greater than the
2015 number due to the Company's ramping up on advertising spending on its
national brands and higher incentive-based comp. To be conservative, I assumed
zero facility rationalization costs going forward - there would likely be more given
management's comments.
Note that since net income is negative, and free cash flow is in the red as well (due
to negative net income, incremental working capital investment exacerbated by Wal-
Mart's actions, offset somewhat by D&A exceeding 2016 CapEx guidance slightly), I
used EV/EBITDA for valuation purposes.
According to YCharts, Dean's EV/EBITDA averaged ~8x in 2013. Using this
multiple, EV should clock in at $1.58b. Subtracting net debt of ~$780m, the
implied equity value is ~$800m or ~$7.80 per share, suggesting ~50%
downside from current levels. Notably, my EBITDA estimates also imply net
debt/EBITDA rising to ~3.9x, which acts as additional support for the multiple
contraction I am expecting.
In the event where milk prices rise substantially (i.e. a repeat of 2014), gross
margins could plausibly fall to the ~17.5% range, as they did that year. Downside
would be much greater in this case, further exacerbated by EV/EBITDA multiple
contraction (a ~4x multiple in this case is quite plausible, as such a multiple was
assigned to the stock in 2014).
Risks to the upside should be limited given the multi-year declines in the top-line
suggesting minimal opportunities for growth, the strong negotiating positions of
retailers preventing sustained gross margin expansion at Dean, and a meagre cash
balance exposing the balance sheet to significant risks.
With limited cash, debt repayment would have to stem from cash generation from
the Company's assets; as discussed, cash generation ability is likely to contract.
Moreover, gross margins are already near their five-year peak - in '12/'10, gross
margins were ~25.3% and 25.5% respectively, suggesting limited opportunities for
further expansion (more so if one considers the negative gross margin leverage
stemming from declining volumes), even if one assumes they can expand going
forward.

Furthermore, '12/'10 results include the previously-owned WhiteWave and
Morningstar business units, both of which generally carry higher margins than the
Company's current business. As discussed, avenues to drive incremental opex
reduction are likely to be sparse. The aforementioned factors make it difficult to
argue for multiple expansion driving any upside.
Catalysts
• Gross margin contraction - likely as a result of lower margin-over-milk as
retailers push for better pricing and less inventories. This should also eradicate
any bullish belief that the Company's negotiating position has improved through
its reduction in manufacturing capacity in recent years.
• Possible fair value impairments - although the Company states in its 10-K that
the fair value of its reporting units exceed its carrying values by ~16%, Dean has
had a history of frequent and large impairments. In 2015 alone, the Company
took a ~$110m impairment charge, greater than the ~$20m and ~$43m it
incurred in 2014 and 2013 respectively. The largest impairment charge it took
was in 2011, where the amount clocked in at a massive ~$2.07b. This history
suggests that management might be overly optimistic with its assumptions to
arrive at fair value. With industry-wide volumes continuing to decline, and gross
margin potentially set to contract, further impairments appear likely.
• Equity issuance to de-lever - Assuming my thesis plays out, the Company
would have limited cash generation and a highly-elevated net debt/EBITDA
ratio. The Company is subject to a maximum senior secured net leverage ratio
of 2.5x. Against $700m in senior notes and ~$60m in cash, the Company would
trip its senior secured net leverage covenant in the event that consolidated
EBITDA (i.e. EBITDA + a bunch of add-backs) falls below ~$304m ($760m/2.5).
My model calls for ~$200m in 2016 EBITDA in the event gross margins revert to
22%. Management will likely try to de-lever via equity issuance before this
scenario occurs, thus allowing shorts to get paid. Alternatively, Dean could draw
on its liquidity lines (specifically, the recently-modified $550m receivables
facility), but the market would likely balk at the increased leverage and re-rate
the stock downwards, like it did in 2014. Note that borrowings on its receivables
facility are excluded from the senior secured net leverage calculation.

• Adverse IRS tax ruling on the WhiteWave spin-off - While unrelated to my
thesis, this is also a potential path to get paid as a short. In 2013, the Company
received a private letter ruling from the IRS that the WhiteWave spin-off would
be tax-free. However, Dean may not be able to rely on the IRS private letter if
there were factual misrepresentations. In the event that the IRS rules against
Dean, the Company could be on the hook for a substantial tax bill - DF classifies
this as a risk factor in its 10-K.
Risks
• Although dubious given the relative negotiating positions of Dean and its
customers, if gross margins are maintained over periods longer than a year
(which suggests a stronger negotiating position at DF), then the short thesis
would be largely invalid.
• While highly unlikely, if industry-wide milk volumes experience a reversal and
begin to grow over a time period greater than a year (which should exclude one-
time spikes coinciding with a promotional environment), then one tenet of the
short thesis would be impaired.
Conclusion
Dean is an attractive short exhibiting the following attributes - 1) overvaluation
relative to its poor growth profile; 2) significant potential for margin contraction due
to a weak negotiating position vis-a-vis customers, rising oil and natural gas prices,
and the potential for material appreciation in raw milk prices over the next few years;
3) limited room for incremental opex reduction; and 4) well-defined catalysts to set
off a sell-off in shares. Over the next few quarters, these factors should become
evident and could potentially lead to ~50% downside from current levels.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate
any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving
compensation for it (other than from Seeking Alpha). I have no business relationship
with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The author's reports contain factual statements
and opinions. He derives factual statements from sources which he believes are
accurate, but neither they nor the author represent that the facts presented are
accurate or complete. Opinions are those of the the author and are subject to
change without notice. His reports are for informational purposes only and do not
offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester")
accepts no liability whatsoever for any direct or consequential loss or damage
arising from any use of his reports or their content. Lester advises readers to
conduct their own due diligence before investing in any companies covered by him.
He does not know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.

Dean Foods Imminent Margin Contraction Spawns Asymmetric Short Opportunity

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Dean Foods Imminent Margin Contraction Spawns Asymmetric Short Opportunity