Description

Dean Foods is a well-known dairy processor and distributor.  The business has been unfairly scarred for extreme volatility in the 2010/11 period where an unfavorable contract and business environment weakened the company considerably.  I believe this event was a one-off event and that Dean Foods is an aggregation of defensible and indispensable businesses.  Further, the story is now ripe with hard catalysts.  Thus, I am recommending a long position in the Dean Foods stub consisting of Fresh Dairy Direct and Morningstar.  The stub price equates to 4.54 now or a base case 23.3% free cash flow yield and an entity levered 3.8x.  With the likely sale of Morningstar at the low end of the range of 1bn to 1.5bn and an estimated but undisclosed cost basis of ~300mm, the entity delevers to 3.3x (~2.6x if the high end of the range is met).  The true FDD stub then trades at a 17.2% levered free cash flow yield in my base case.  Further, through management conversations a 2 handle for leverage sounds like it would be there target leverage, therefore, excess cash distributions should pass to the equity at that point

The key drivers to the trade:

-          The stub requires less capex than depreciation by our estimate to the tune of nearly 50mm a year or .27 cents a share

-          Though fluid milk is a shrinking market (volumes down about 20% in 30 years and expected decline of ~1% annually), FDD has continued to grow share creating volumes to be down ~.5% annually

-          FDD currently has about 80 facilities which should each cover a 300mi radius efficiently; implying about 20 facilities are excess (management guided to low teens).  This will create efficiency opportunities to the tune of ~100mm a year for the foreseeable future.  A number that I believe will ultimately benefit customers vs. the company on a 50/50 split.  Further, with Tanner the ex-head of Supply Chain at the helm, I believe this will be his forte.

-          Price pass through mechanism for FDD is nearly perfect for Private Label fluid milk (50% of business), good for branded fluid milk (25% of business), and imperfect for 25% of the business or Class 2 products.  Then there is 5% of the fluid milk business that has annual resets for school contracts.  This means that about 30% of the business has weak pass throughs – a fact that gets distorted by contract negotiations particularly with Walmart (about a 20% customer)

-          FDD is a dollar margin business which faces margin contraction during continuous upward directional moves in input prices or extremely high prices where demand destruction occurs due to 30% of the business with inefficient pass throughs (and vice versa on lower moves) – Level prices are not inherently bad for FDD

Incremental Upside:

-          The actual cash interest expense (including swaps at FDD post Morningstar sale) is approximately 135mm or 8.8% effective cost of debt.  An enterprise with this market share should more likely have a 5.5% blended cost of debt or a pick-up of 30mm after tax or .16 cents a share.  Due to the terms of the senior debt, FDD would be left with primarily with high cost bonds.  The nearest call point is late 2014 on the 9.75% 2018’s.  Earlier calls are T+50 make wholes.  With that said, there is an earnings management story to taking them out.

-          Very significant underutilized cold chain logistics system at approximately 70% utilization.  Assuming that you can do 3^rd party distribution for a 1-2% fee, FDD creates about .07 cents of after tax earnings for every 10% increase in utilization through 3^rd party contracts. This assumes that about 1.3bn of products can flow through the distribution system for every 10% pick up in utilization.

-          Reform to the Federal Milk Market Order program is in the works.  Through several consultants – the farm bill is unlikely to pass this year.  However, the Senate version of the bill contains reform to FMMO program.  This program is antiquated and by design actually now creates significant volatility in the minimum raw milk prices.  The removal of this volatility would add much more dollar margin stability to the 30% of FDD which has inefficient pass-throughs.

Risks:

-          Another poor corn harvest causing dairy herd downsizing and input cost volatility into next year

-          Walmart contract negotiations – while both companies do not have many alternatives and certainly need each other, the negotiations will likely be tough.  Currently, it looks like FDD accounts for 70 to 75% of Walmart’s milk supplies

-          The new CEO has not been at the helm of a public company before

-          Once WWAV shares are distributed in mid-2013 there will likely be selling pressure as the stub mkt cap will only be ~800mm

Some other business characteristics:

-          Fresh Dairy Direct – 9bn of revenue

• 40% market share in the US which is a multiple of the nearest competitor (about 50% private label / 50% branded/other from a revenue perspective)
• Fluid milk is a shrinking market ~1% decline in gallons annually; however, FDD has continuously grown market share to help counter the decline ~.5% annually
• Utilization in the one of the US’ largest cold chain logistics systems is only 70% providing a future revenue opportunity
• Currently 80 plants exceed that can operate in a 300 mile radius; thus, nearly 20 plants can be removed from the system (management speaks to a number in the low teens)
• The acquisition hungry Greg Engles is going with the WhiteWave spin leaving the head of the supply chain management department in charge
• This business has an uncharacteristic struggle in 2010/11 due to a 2 yr contract with Walmart (a 20% customer) which sacrificed margin in FDD to help WWAV.  Walmart used this contract to make milk a permanent traffic driving loss leader due to missteps in their SKU rationalization

Ultimately, I believe an appropriately levered FDD stub should trade at a 10% free cash flow yield off of my base case 2013 numbers.  Based on the profitability lows (gross margin dollars), I believe the downside is capped around 3.25 a share for the stub which trades at 4.54 a share vs. upside to nearly 8.00 a share.  This represents nearly a double or a reward to risk 2.8x.

Please note that the below financials for FDD are on a prorata interest allocation with Morningstar.  Meanwhile the sensitivity is proforma for standalone FDD.  Also, I have excluded my WWAV sensitivity as it is less of a focus for this aspect of the trade

Catalyst