Shares in Dean Foods rallied yesterday (16 February) after the US dairy group posted expectation-beating earnings and insisted that its prospects would pick up in the back half of 2011. However, Katy Humphries suggests, a number of challenges could hamper the group’s performance over the next 12 months.

Looking at Dean Foods’ share price, which rose by around 10% on higher trading volumes yesterday (16 February), one might have been surprised to learn that the company posted plummeting fourth-quarter profits, margins that failed to hit expectations and earnings per share guidance for the first quarter of 2011 that was well below market expectations earlier that morning.

In its 2010 full-year earnings update, Dean Foods said that fourth-quarter adjusted EPS came in at US$0.15 a share, one cent above market expectations.

However, the news from Dallas was far from rosy. Net income for the fiscal year plummeted, dropping to $91m from $240m in the previous year. Gross margin fell to 24% from 26.8%, missing analyst expectations of a little over 25%. And, looking to the coming 12 months, management issued EPS guidance of $0.55-0.65 versus consensus estimates of $0.78.

“Today’s results and guidance underscore our continued concerns with Dean Foods’ fundamental outlook given the new industry dynamics,” Bernstein analysts write in a note to investors.

So why the positive movement in the company’s share price?

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By GlobalData

Speaking to analysts during a conference call, management at the US’s largest dairy processor appeared cautiously optimistic on the company’s outlook.

“We expect the first half of 2011 to be particularly difficult but results are expected to strengthen in the back half,” chairman and CEO Gregg Engles predicted.

Could further cost cuts, price hikes and volume gains all really be just over the horizon?

Certainly, the company has made some impressive strides in offsetting the well-documented spike in commodity prices through its cost-cutting programme. And, with a focus on projects that will reap more immediate gains with a minimum capital requirement, Dean Foods is predicting productivity savings in the region of $125m this year.

As part of this productivity drive, the group is taking excess capacity out of its systems: a move that, management hopes, will contribute to combating the issue of overcapacity in the market as a whole.

“We closed four plants in ’09; we closed one facility last year; we’ve already announced the closure of one milk facility in Q1 this year. We are taking capacity out of our business. We are all over it. To the extent where we are spending capital to consolidate multiple facilities. We are going to right-size our network around our volume for which we can make an adequate return,” Engles insisted.

Dean Foods believes that the removal of excess supply from the market through capacity reduction should result in some positive movement in prices. Management adds that there is evidence that competitors are talking similar actions to rationalise production.

The need to reduce capacity is made all the more pertinent as the company grapples with declining volumes and rising raw material costs, notably in fluid milk.

Dean Foods says it expects new business to contribute “a meaningful amount of volume” in the coming year, offsetting recent soft volumes by the third quarter.

However, Engles acknowledges that volume remains a “risk” for the business, given the majority of its customer base – large-format grocery stores – saw volumes drop 2.5% in the fourth quarter.

“Large format grocery is one of the softest overall channels out there,” Engles said. “We have a customer portfolio today that is under performing its historical performance and peer group… we need that customer set to perform reasonably well in 2011. We need to see less erosion of volume from our customer set.”

Given the environment of weakening demand and inflationary input costs, Engles acknowledged that a crucial issue will be whether Dean Foods can push through price increases.

“We have a great deal of confidence in our ability to take costs out of the system. The issue is our ability to price for inflation as we come into a more inflationary environment… we are going to have to be able to recapture that in price because we are not going to be able to offset that with cost reductions alone,” he said.

Though no mean feat, management believes that the need to increase prices is far from a lost cause.

US dairy products – in particular, liquid milk – are trading at historic lows as retailers look to drive footfall by selling own-label liquid milk at rock-bottom prices and competition among dairy suppliers remains aggressive. However, Dean Foods argues that this situation is simply unsustainable.

“There is a level of exhaustion in the industry… you in fact see in the business companies walking away from business at current price levels,” Engles told analysts. “There doesn’t appear to be much more capacity to take price down in this industry. We feel we are hitting a bottom.”

While on the one hand Dean Foods’ competitors are finding themselves unable to take further pricing hits, the company also suggests that retailers could ease the pressure to slash prices as they look to garner some profitability from the dairy aisle.

“Retailers are trying to take prices up off the bottom as it doesn’t appear that this deep discounting strategy is moving share around,” Engles says. “We see the pricing between us and our private-label customers stabilising.”

However, it is worth noting that this “stabilisation” remains quite some way from the price increases that Dean Foods’ will need to realise if its performance is to see any meaningful turnaround over the next 12 months.

While Dean Foods has some cause for optimism, the road to recovery is likely to be long as input costs continue to rise, margins remain thin and volumes are yet to recover from the depths of recession.