Dean Foods continues to have to deal with operational challenges and is also facing some potential strategic and financial questions. The exit of chief operating officer Joseph Scalzo emphasises the air of uncertainty around the US dairy company, writes Dean Best.

The latest executive departure from US dairy giant Dean Foods adds to the questions already being asked of the company’s direction.

On Tuesday (1 March), Dean Foods said COO and president Joseph Scalzo had left the company, becoming the third top official to leave the dairy processor in the past four months.

In November, CFO Jack Callahan departed and his exit came only a month after Harrald Kroeker, the head of Dean Foods’ fresh-dairy operations, left the business amid a wider rejig of the company’s management team.

These departures come as Dean Foods continues to battle tough trading conditions and face concerns from analysts about its balance sheet. Throughout 2010, Dean Foods warned repeatedly of fierce competition from private label in its key fluid milk business, with competitors aggressively bidding for business and retailers discounting its own-label lines to attract shoppers.

Last month, Dean Foods posted a slump in profits for the fourth quarter of 2010 and, looking ahead to the coming financial year, issued an earnings per share target that missed analyst estimates.

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On the day the results were announced, chairman and CEO Gregg Engles admitted he thought the first half of 2011 would remain difficult but he was cautiously optimistic about the rest of the year. “Results are expected to strengthen in the back half,” Engles told analysts.

Dean Foods is taking capacity out of its system in a bid to contribute to cutting the overcapacity in the whole milk market and the company believes there should be some positive movement in prices. In fact, the business insists there is some evidence that competitors are making similar moves to rationalise production.

However, Engles admitted that the majority of Dean Foods’ customer base – large-format grocery stores – had seen milk volumes drop in the last three months of the year.

“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.”

Of course, for all Dean Foods’ efforts on cost and capacity, the company, like many food manufacturers has faced higher input costs and there remains some uncertainty about whether it can successfully get its retail customers to up prices. Engles said retailers have been trying to raise prices and added that the gap between its milk brands and private label was “stabilising”. However, price increases are likely to be needed to significantly improve margins and profits, especially with volumes under pressure.

Scalzo’s departure, then, comes against the backdrop of continuing tough trading conditions. The executive was also seen as central to Dean Foods’ cost-cutting efforts, according to Morningstar analyst Erin Lash. She sees those efforts to lower costs as an “opportunity” in the face of “intense” competition and rising input costs, although both these factors, she says, will “limit meaningful margin expansion over the longer term”.

However, Lash questions the decision to have Engles take on Scalzo’s responsibilities and not replace him with another executive. In the wake of Scalzo’s departure, apparently to lead an unnamed consumer packaged goods company, Engles said Dean Foods wanted to create a new structure to move decisively and quickly to execute our strategy, while maintaining an extremely tight strategy”.

Lash wrote: “CEO and chairman Gregg Engles will assume [Scalzo’s] responsibilities, including those related to the firm’s current cost-reduction efforts. We would prefer Dean to have appointed someone to replace Scalzo beyond Engles, who was part of the management group that unwisely chose to leverage up Dean’s balance sheet to pay a special dividend.”

Dean Foods’ balance sheet remains a concern for Wall Street. Analysts have questioned cautioned that Dean Foods may be at risk of tripping its debt convenants later this year and questioned whether the company could sell parts of its business to shore up its balance sheet.

At the CAGNY investment conference in Florida last week, Dean Foods indicated that it could consider spinning off its WhiteWave-Alpro as a way to improve value for shareholders. Engles said the problems in Dean Foods’ milk business was affecting its share price, which, he said “did not adequately reflect the value of WhiteWave”. He cautioned, however, that a spin off could be prevented by the leverage that would be put on the milk business.

“We believe that we need to be able to put meaningfully less leverage on the milk business as a stand-alone entity than on the combined companies because it won’t have the predictable and relatively robust levels of cash-flow from WhiteWave to support it in a spun or separated context,” Engles said.

As such, Scalzo’s departure – on the back of Callahan’s exit in November – also comes with Dean Foods facing some strategic and financial challenges, as well as the issues in the milk market. And Engles seemingly adding to his responsibilities could concern some, not least those at Morningstar, which, in a commentary of Dean Foods’ management points to the decision to pay a special dividend in 2007.

“In our opinion, management’s decision to leverage up the balance sheet in order to pay out a special dividend to shareholders was not a prudent use of capital. Overall, it appears that management could have done a better job of allocating shareholders capital, as Dean’s returns have exceeded our cost of capital only three times in the past five years,” Morningstar writes.

Elsewhere in Wall Street, some are highlighting the difference in styles and capabilities between Engles and Scalzo. Alexia Howard at Sanford Bernstein acknowledged that Dean Foods wanted to eliminate the role of COO to, she said, quoting the company’s announcement on Tuesday, “move decisively and quickly”.

However, she added: “We wonder if Mr. Scalzo’s departure will leave somewhat of a void, as Mr. Scalzo’s reputation is as an operator given his background in the consumer products industry at Minute Maid, Coca Cola and Gillette before joining Dean Foods in 2005, while Mr. Engles is considered more of a dealmaker given his role in consolidating the fragmented dairy industry since the early 1990s.”

Scalzo’s departure, Howard argued, did “not bode too well” for Dean Foods’ performance over the year ahead. She noted the company has indicated it expects to see some improvement in the second quarter but warned: “If the turnaround is not seen shortly, then the company may need to refinance for the third time in a year in order to avoid tripping looming debt covenants.”

Much to ponder then for Dean Foods and what is left of its senior management team.