photo credit: Zesmerelda
This article is a reprint of my February 25, 2008 RealMoney column
What is wrong with Dean Foods (DF)? After all with everyone from Starbucks (SBUX) to Hershey’s (HSY) getting hurt by rising milk costs, I would expect the “largest processor and distributor of milk and various other dairy products in the United States” to be living in the land of milk and honey.
Yet somehow, Dean has managed to get itself on the wrong side of every dairy-related position (so much for Peter Lynch’s invest in what you know theory.) For example, the company describes the current dairy environment in its latest 10Q: “As a consequence of higher raw milk costs, we have seen a related increase in shrink costs and reduced profits from excess cream sales. At the same time, sales volumes in the Dairy Group have softened as consumers react to the higher retail prices. We are also seeing a shift from our branded fluid milk products to private label products resulting in reduced gross profit. In our White Wave segment, results continue to be negatively impacted by the oversupply of organic milk.”
High commodity costs during a period of oversupply? It is as if the law of supply and demand has been overturned. And Dean doesn’t expect to see much improvement. “As we look beyond the first quarter, we find it difficult to have much confidence in current dairy commodity forecasts given these unprecedented levels of dairy commodity market instability,” management warned.
As a result of this lack of confidence, the consensus earnings estimate for 2008 has dropped from $1.45 to $1.33 over the last month. The Zacks rank, a measure of earnings momentum, has fallen two points to the worst level of five. That rank puts Dean among the worst 5% of companies followed on the basis of earnings momentum. Yet still the estimates are well above management’s own guidance for “at least $1.20 per share.”
If there is a bright side to Dean’s horrible earnings outlook, it is that the quality of earnings remains relatively sound. The accrual ratio, which represents the difference between cash earnings and accounting earnings, should ideally hover around zero. That is more or less what Dean’s has done.
<!--[if gte vml 1]><v :shapetype id="_x0000_t75" coordsize="21600,21600" o:spt="75" o:preferrelative="t" path="m@4@5l@4@11@9@11@9@5xe" filled="f" stroked="f"> <v :stroke joinstyle="miter"/> </v><v :formulas> <v :f eqn="if lineDrawn pixelLineWidth 0"/> <v :f eqn="sum @0 1 0"/> <v :f eqn="sum 0 0 @1"/> <v :f eqn="prod @2 1 2"/> <v :f eqn="prod @3 21600 pixelWidth"/> <v :f eqn="prod @3 21600 pixelHeight"/> <v :f eqn="sum @0 0 1"/> <v :f eqn="prod @6 1 2"/> <v :f eqn="prod @7 21600 pixelWidth"/> <v :f eqn="sum @8 21600 0"/> <v :f eqn="prod @7 21600 pixelHeight"/> <v :f eqn="sum @10 21600 0"/> </v> <v :path o:extrusionok="f" gradientshapeok="t" o:connecttype="rect"/> <o :lock v:ext="edit" aspectratio="t"/> <v :shape id="_x0000_i1025" type="#_x0000_t75" style='width:6in; height:268.5pt'> <v :imagedata src="file:///C:\DOCUME~1\WILLIA~1\LOCALS~1\Temp\msohtml1\01\clip_image001.emz" o:title=""/> </v>< ![endif]--><!--[if !vml]-->
<!--[endif]-->
Source: Zacks Research Wizard, compiled by William Trent
So, with the earnings quality indicating that the lousy earnings are at least trustworthy, I have to ask whether the current “50% off” share price reflects all the bad news. Unfortunately, no matter how I look at it it’s hard for me to think that it does.
The P/E of 20x management’s guidance is above the company’s five-year average of 17.5x. And even being willing to look way ahead, assuming the current consensus estimate of $1.76 for 2009 doesn’t get cut and that investors are willing to pay the average multiple for them, the target price would be about $30. The potential 25% gain over 1-2 years curdles when it has to be based on so many assumptions.
The consensus five-year growth rate of 11.5% also seems incredibly optimistic, given that the same analysts are expecting a 5% sales increase this year to be followed by a modest decline next year. And even assuming the 11.5% growth occurs due to margin expansion, I’d expect much of it to be eroded by a contracting valuation given Dean’s outlandish 63x price/book ratio. Considering that total return is a function of growth and the change in valuation, I think the two would offset each other in this case, perhaps resulting in annual total return in the mid single digits.
Finally, my favorite measure is the free cash flow yield, and Dean looks far from attractive on this basis. On either a free cash flow to equity or a free cash flow to enterprise basis, the yield comes to about 4%. True, it is better than the current yield on 5-year Treasuries. But given the risks involved, I think there are many more attractive opportunities.
In fact, either of the other two victims of milk pricing look far better to me. Starbucks could have a 6% free cash flow yield based on its plans to slow expansion (and related expenditures) while Hershey’s is already at a 6.7% free cash flow yield.
Long story short, I think Dean’s chairman is on the right track by selling shares.
Disclosures: William Trent owns shares of Starbucks (SBUX)
Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.
$22.11 (03/03/08)
