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Stock Strategist

Competitive Advantages Sour at Dean Foods

Dairy king's edge erodes because of structural shifts.

From our perspective, the competitive landscape within the milk aisle has changed considerably during the last several years. But more importantly, it now appears that the competitive advantages we once believed  Dean Foods  possessed (namely as a low-cost operator with significant scale in a highly fragmented industry) seem to have eroded away as a result of the structural shift in what is essentially a commodity market. Here, we discuss our reasoning for recently removing Dean Foods' narrow economic moat rating.

The Industry's Leading Player Must Possess Sustainable Advantages, Right?
With $5 billion in annual sales (about 5 times greater than its closest competitor), Dean Foods is the top firm in the dairy aisle, maintaining about a 38% dollar share of the United States fluid milk market (which is up from 35% in 2003). Dean's scale is particularly evident in the fact that it is the only firm in the industry with a nationwide fluid dairy processing footprint. The company operates a large refrigerated direct store delivery network with more than 5,800 routes serving in excess of 160,000 locations.

Acquisitions have enabled Dean Foods to build out its footprint and also have contributed significantly to growth, as the company has completed more than 40 acquisitions since 1993, increasing revenue around 30% compounded annually, from $150 million in 1994 to $12 billion in 2010. Because of its impressive scale and low-cost operating platform, we had held the opinion that Dean would be better able to withstand impending headwinds than its smaller peers and, for these reasons, we previously assigned Dean Foods a narrow economic moat rating. However, in light of the challenging economic environment that has plagued the dairy industry during the last few years, it now appears to us that due to a structural shift in the industry Dean's competitive advantages no longer hold water.

Scale Advantages Aren't Enough in This Commodified Industry
Despite operating as the leading player in the domestic dairy aisle, Dean Foods' cost structure and the prices it is able to charge for its offerings are highly sensitive to changes in commodity costs. For instance in the first quarter of fiscal 2011, operating income continued its descent, slipping 14% from last year's quarter (which marks the sixth consecutive quarterly decline, following a 26% drop in the fourth quarter and the 35% decline in the third quarter), and the adjusted operating margin contracted 70 basis points to 3.5%. With significant exposure to erratic changes in commodity costs and a limited ability to differentiate most of its product lines, material margin expansion will be tough to come by for the firm, in our opinion.

Intense Competition Is Unlikely to Subside
Competitive pressures (from other branded firms as well as private-label offerings) abound in the dairy aisle and have proved to be a major hurdle for Dean Foods as of late. There are no meaningful switching costs between various milk products, as consumers have the choice of multiple offerings. Given that Dean competes in a highly competitive category and its offerings have failed to garner much if any brand equity, consumers are more likely to make purchase decisions strictly based on price rather than brand, which also limits profitability. This is the case in the fluid milk segment, where Dean derives approximately 85% of its sales and operating profits. From our perspective, Dean's lack of pricing power is particularly evident in the fact that its operating margins already pale in comparison to the mid- to high-teens margins generated by its better positioned packaged food peers, as shown below. We believe this supports our take that Dean's competitive advantages have soured.

The U.S. dairy industry has faced a barrage of headwinds, including a consolidating retailer base (which accounts for around three quarters of national retail fluid milk sales) and slowing industry volume (which grew at just a 0.1% compound annual growth rate between 1975 and 2009). While dairy processors have fought to offset this pressure by driving further consolidation in the milk arena (as shown in the charts below), sales volumes within the industry have come under pressure since the recent recession, as consumers have shown the willingness to trade down to lower-priced private-label alternatives. According to management, Dean's fluid milk volume fell 2.4% in the first quarter 2011, double the industry's volume decline, and in line with our take that competitive pressures in the space remain highly aggressive. We believe this further supports our claim that Dean's competitive advantages have eroded. The quality of private-label products has improved dramatically as supermarket chains have invested heavily in their brands (like  Safeway's  O Organics brands), many of which rival branded offerings in terms of quality. Private label now accounts for 56% of Dean's total fluid milk sales (up from 48% in 2008). We contend that a lack of meaningful differentiation between private label and branded milk could mean that consumers who traded down to value offerings may not trade back up to branded products when the economy improves and lower-margin private-label sales will become an increasing portion of the firm's sales mix.

Retailers Have Added to Dean's Headache
Consolidation among retailers has shifted power away from packaged-food firms during the last several years--i.e. the rise of  Wal-Mart (WMT) and other discounters like warehouse clubs and dollar stores. In addition, retailers have become more adept marketers to consumers. To expand the distribution of their products, it is essential that packaged food companies adapt their offerings to retailer requests or risk losing distribution through these key outlets--even if this might mean accepting a lower margin in the process.

Dean Foods has been particularly challenged by retailers flexing their muscles during the last year. Specifically, major retailers have been using private-label milk offerings as loss leaders to drive traffic in their stores. In contrast to the past, Dean has been challenged to pass through these higher costs, as retailers seek to tout value offerings for its customers. In an environment where both fuel and food prices are trending higher (as it is now), we think there is a greater risk that U.S. consumers will once again be motivated by low prices, which ultimately could mean that retailers use milk as a loss leader. While this situation is unlikely to persist over the long term, as retailers seek to garner some profitability from the dairy aisle, we doubt profit will bounce back to historical levels. We believe this represents a strategic shift in the industry.

Recent Management Turnover Makes Us Even More Wary
We are paying particular attention to turnover in Dean's management. CFO Jack Callahan left the dairy processor in November and was followed by COO Joseph Scalzo in February. We had believed that Scalzo was instrumental in driving Dean's current cost-reduction efforts, and as a result, we're disappointed by this departure. As a result, now that Scalzo has left the company, the potential to capture these cost savings could be delayed in the best case. Further, the news that CEO Gregg Engles will assume Scalzo's responsibilities doesn't sit well with us. Engles was part of the management group that decided to add leverage to the balance sheet in order to pay a special dividend to shareholders, which ultimately proved to be an imprudent use of capital as the firm's significant debt load continues to plague its progress.

Overall, it appears that management could have done a better job allocating shareholders' capital, as returns on invested capital have barely met or only marginally exceeded our cost of capital estimate four times in the last five years, and free cash flow averaged less than 3% of sales during the last five years (see below). We forecast that returns on invested capital (including goodwill) will average less than 7% during the next five years, below our 9.2% cost of capital estimate--a classic sign of a no-moat company.

What Does This Mean for the Shares?
We've been saying for some time that while we aren't cheerleaders for the commodity dairy industry, we thought the elevated level of competition from private labels would subside somewhat over time. A slightly more optimistic outlook from Dean in its first quarter indicated that industry fundamentals may be improving, and the shares popped 25% on the news. This caps a 40% rally during the last month, and brings the market price very close to our fair value. Dean appears to be moving in the right direction, but we aren't convinced that it is out of the woods yet. Dean's massive debt load and the possibility of bumping up against covenants in its bank credit facility remain concerns, but these risks are incorporated into our B+ issuer credit rating. We do not believe that Dean is at risk of bankruptcy in the near term, but we will reassess our rating if leverage continues to rise.

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