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Who Benefits from Rising Milk Prices?

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

We just drove the DeLorean with Marty McFly to the not-too-distant future.  It is the year 2015 and after many struggles by Congress the last few years to address a new farm bill with not merely extensions, but one that is long-term and fair for all involved parties, milk prices are now over $5 a gallon and slowly rising.  This is less than what was predicted back in 2012 when milk was expected to double from about $3.50 a gallon to the $7-8 range, but this increase still is significant and impacts everyone.  As we look around at the market in 2015, while Marty discovers his family is in ruins, we find out who has benefited from the rising milk prices.


Milk pricing is historically complicated but here is a quick breakdown minus the fat:

  1. Prices for storable manufactured dairy products like butter, cheese, whey, and nonfat dry milk are market determined by supply and demand.
  2. However, minimum prices for liquid milk to cover dairy farmers’ product costs are based on supply and demand conditions for manufactured dairy products and set by federal and state milk marketing orders for Grade A milk (99% of all U.S. milk).
  3. If the market price drops below minimum prices for liquid milk, the government buys dairy products from farmers to reduce supply and increase demand, and this raises the market prices to reasonable levels.
  4. The so-called 1949 rules would go into effect without a new bill that is renewed every five years would cause inflation because they were put into place when mules and other labor by hand were calculated, which ultimately went into the cost of producing milk. 
  5. Farmers sell to government instead of customers (market price now below the now high minimum prices under 1949 rules) while shortage ultimately occurs at grocery stores, creating higher prices for customers at the back end.
  6. The higher costs to produce milk today, ethanol use in gasoline indirectly raising feed costs for cows that produce milk, widespread droughts, higher electricity costs, and economic conditions are all making it even harder for dairy farmers to even break even.

Dean Foods

Publicly traded dairy stocks are few and far between, and dispersed globally.  Dean Foods Company’s (NYSE: DF) Fresh Dairy Direct line of business is the largest processor and distributor of milk and other dairy in the United States, with net sales to external customers of $6.7 billion in the nine months ended through September 30, 2012.  Its product line includes milk, ice cream, cultured dairy products (yogurt), creamers, ice cream mix, and other dairy varieties.  They admit they are exposed to commodity price fluctuations and, in particular, milk.  Although Dean Foods utilizes forward purchase contracts and other financial instruments to mitigate the risks related to commodity price changes, these strategies do not fully protect the company’s bottom line.

Dean Food’s other two lines of business are WhiteWave-Alpro (19% of total net sales) and Morningstar (11% of total net sales).  Earlier this month, however, Dean Food’s completed the sale of its Morningstar division to Canada’s Saputo Inc. for $1.45 billion, which will result in net proceeds of $887 million.  WhiteWave is in mid-spin-off mode, with Dean Food’s owning approximately 86.7% economic interest in the now publicly traded company under ticker WWAV.  Regardless of future interest in the WhiteWave segment, a growing majority of Dean Food’s net sales will come from its Fresh Dairy Direct line of business.

This is where the problem lays in this potential future of rising milk prices.  While it might be nice short-term for Dean Foods to sell milk products at prices higher than they are today, the demand for milk would eventually drop.  End users in the business line that include restaurant chains using milk byproducts would stop buying milk domestically and look for alternatives.  If and when prices stabilize and return to lower levels, the lag that is produced by Dean Food’s business model would have a negative impact on profitability.  With profit margins that have averaged -1.28% quarterly for the past five years, Dean Food’s would be hit hardest in the end.

<img src="http://media.ycharts.com/charts/10b728cab46303a25a3b33c689afd626.png" />

DF Total Return Price data by YCharts

Vitamin Shoppe

In 2011, U.S. exports of whey proteins were 993 million pounds (55% of production) with China, Russia, and Southeast Asia leading the way.  Unlike liquid milk, whey is driven by the market.  Since the popularity of whey protein is now spreading throughout the world, the whey and nonfat dry milk that account for about 20% of nonfat solids usage is at an all-time premium.  However, I believe this only helps supplement retailers like Vitamin Shoppe (NYSE: VSI) who would continue to thrive even without milk price increases.

If milk were to go up in price in this not-too-distant future, whey protein supplements would inevitably go higher.  They have been going higher the past several years anyways, but this hasn’t stopped the increasing demand for the muscle builder.  For a company like Vitamin Shoppe this results in increased net sales, better margins, and higher stock price.  Net sales last quarter increased 14.4% to $239 million year-over-year and profit margins have been increasing annually.  In their recent earnings report, Vitamin Shoppe cites that their sports nutrition and weight management categories continue to be their fastest growing segment categories.  The majority of these products contain whey protein of some kind.

Where lag hurts a direct milk supplier like Dean Foods, it can help a retailer of milk’s byproducts like Vitamin Shoppe.  If whey protein supplements go higher, people aren’t necessarily going to stop using them.  They may buy more in anticipation for even higher prices.  This includes buying in bulk quantities or during promotions.  In the end, whey protein is still a far more economical option over milk and whole food products in order to get protein intake.  If the cost of milk were to drop and consequently the price of whey, there is no governing rule that retailers like Vitamin Shoppe need to drop prices back down.  They can use the lag and maximize margins and slowly drop prices to meet demand or maintain the higher prices as the new standard.

<img src="http://media.ycharts.com/charts/fd6b04046b2737cf47965c10a0f662ec.png" />

VSI Total Return Price data by YCharts

Domino’s Pizza

In the past five years, Domino’s Pizza (NYSE: DPZ) has gone up over 307% in share price including reinvested dividends.  In that same time their quarterly profit margins have been slowly increasing while milk has been steadily increasing.  Recently, a spokesman for the $2.5 billion market cap pizza chain stated that cheese is about 40% of the cost of Domino’s pizza.  The company actually uses about 200 million pounds a year on the pizzas alone.  So why do I think a milk price surge would be a positive for Domino’s?

Yes operating margins traditionally are positively impacted by a decrease in overall commodity prices like cheese.  However, I’m looking at it from a long-term approach that isn’t as straightforward.  Domino’s is the second-largest pizza chain in the United States behind Pizza Hut, which is actually part of Yum Brands.  If you want to invest in strictly pizza, then you could say Domino’s is the largest pizza chain in the United States and the world.  Located in all 50 states and more than 70 international markets, they have recently opened their 10,000th store to attack the $32.4 billion pizza market.  What will happen is that cheese will increase not just for Domino’s but for everyone.  This includes all those random local pizza joints, those mom & pop pizza restaurants, and everyone in between.  Who has the capital and competitive advantage to outlast the competition during a milk price surge?  I would place my money on Domino’s.  By the time the milk prices drop, and inevitably cheese prices, the competition that couldn’t afford to stay in business would be eaten up.

<img src="http://media.ycharts.com/charts/09ca14aae5859998476f7036ec5a8f0e.png" />

DPZ Total Return Price data by YCharts

Back to the Present

Back here in 2013, milk prices should remain steady after the recent 9-month extension Congress granted.  Despite this temporary fix, the world is just starting to capture the benefits of milk and its byproducts.  Exports will continue and growing populations like China will continue to drink it up.  If U.S. per capita consumption trends are any indication of the future, liquid milk will continue to drop as it has the past 30 years (dropping over 20% since 1975) while cheeses and whey go up.  As a consequence, milk producers suffer while those that capitalize on products from milk succeed.

Next earnings announcements for Dean Foods and Domino’s Pizza are set for Feb. 11 and Feb. 25.   Vitamin Shoppe future earnings announcements are not set yet.

mikecart1 has no position in any stocks mentioned. The Motley Fool owns shares of Dean Foods Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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