Finding Opportunity in the Milk Trade

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Despite milk’s omni-presence in the majority of Americans' refrigerators, the industry has been a tough place to do business with volatile commodity prices and low margins due to food retailers’ negotiating power.  According to the USDA, per capita consumption of milk products continued to fall in 2012, although the organic and premium dairy segments enjoyed volume growth.  The creamer category also enjoyed a pickup in sales, as caffeine-addicted consumers increasingly add non-dairy flavor supplements to their favorite beverages.  So, in the current environment, which companies are worth a look?

The empire parts ways

Dean Foods (NYSE: DF) built a dairy empire over a twenty-year period that culminated in the completion of 40 acquisitions and an annual sales run rate of roughly $11 billion.  The company’s size allowed it to create an efficient national production network and an unparalleled direct store distribution system.  However, the acquisitions also led to significant debt and interest charges, which didn’t correlate well to an industry with volatile pricing and relatively low profitability.

In 2012, Dean Foods strategically reformulated the company’s business mix, with a partial spinoff of its organic WhiteWave Foods (NYSE: WWAV) unit in October, as well as a sale of its Morningstar distribution unit in late December for $1.5 billion.  The transactions allowed it to pay down debt and focus on improving operating performance in its core dairy business.  The company’s financial performance was also aided by lower average commodity costs for milk, down approximately 9% for the period, which improved its pricing versus food retailers’ private label products.

In its latest fiscal year, Dean Foods’ core dairy unit reported mixed financial results, with a 4.5% decline in segment revenues but an 18% increase in segment operating income.  While product volumes and prices both declined at low single-digit rates, the company’s cost savings initiatives led to a much improved operating margin.  Looking ahead, management sees the potential to further reduce its plant capacity by 10 to 15%, which should improve profitability while maintaining an efficient distribution system.

The rise of organic

WhiteWave Foods’ ownership by Dean Foods since 2002 allowed it to use the parent company’s contacts and distribution network to build a leading position in the organic segment.  WhiteWave’s Silk and Horizon Organic product lines are currently the market leaders in the plant-based and premium dairy categories, respectively, far surpassing rivals’ market share.  The company also has a strong position in the creamer market with its Land O’ Lakes and International Delight brands, capitalizing on a segment that is estimated to have grown roughly 9% over the past four years.

In its latest fiscal year, WhiteWave reported solid top-line growth, up 13% for the period.  Its results gained from both higher volumes and prices, as consumers exhibited a continued willingness to pay up for the health benefits associated with organic products.  While WhiteWave’s operating margin was impacted by one-time offering charges, its gross margin reached a five-year high due to lower commodity costs and its greater geographic scale of operations.  With plant-based beverages only being consumed by 25% of the domestic population, according to data provider IRI, the company should continue to see gains in the future as it converts more people to its product lines.

Another idea in dairy

Investors looking for value in the sector, off the beaten path, might also want to consider Lifeway Foods (NASDAQ: LWAY), a leading producer of dairy beverages made from kefir, a drinkable yogurt-like substance with strong nutritional properties.  France-based food giant Danone Group saw value in the company way back in 1999 and currently holds a 21% in Lifeway.  Starting from its small base in the Chicago metro area, the company has taken its distribution network national-wide, with a presence in major organic supermarket chains like Whole Foods Market and Trader Joe’s.

In its latest fiscal year, Lifeway posted strong financial results, with increases in revenues and operating income of 16.3% and 74.3%, respectively, versus the prior year.  Like Dean Foods and WhiteWave Foods, Lifeway benefited from lower commodity costs during the period, as well as more efficient use of its company-owned transportation fleet.  With Danone in its corner and new products, including cheeses and spreads, all signs point to more growth for this small-cap dairy company.

The bottom line

While the milk trade will never be a high growth industry, there are pockets of strength in non-traditional segments like organic dairy products and creamers.  WhiteWave Foods and Lifeway Foods are valued at above-market P/E multiples, but they are focusing on the right product segments, making them stocks to watch.

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Robert Hanley owns shares of WhiteWave Foods. The Motley Fool owns shares of Dean Foods Company and WhiteWave Foods. 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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