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Dean Foods: Imminent Margin Contraction Spawns Asymmetric Short Opportunity

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.

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.


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.

Dean Foods Logo

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.

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...