Dear Mr. Market:
Normally we write you a series of letters about the stock market or the economy. As we wrap up 2016, however, we decided to share an article that was recently published on Seeking Alpha. The proverbial ‘Santa Claus rally’ seems to perhaps have taken place before Christmas this year but what opportunities might there be going into 2017?
This interview reviews questions around a stock we’re interested in adding to some portfolios; Dean Foods (DF). Enjoy!
- Despite trading at 52-week highs (and ~30% gain over the last three months), DF is still undervalued relative to peers.
- As the clear market leader in fluid dairy, DF enjoys significant economies of scale – a critical advantage in a commodity-related business.
- “Skating to wear the puck is going” with leading position in healthy dairy products such as TruMoo.
- Friendly’s ice cream acquisition was immediately accretive, highly complementary, and further cemented its growing position in branded ice cream.
- Takeover rumors that surfaced in October provide a floor for the stock.
What is one of your highest conviction ideas right now?
As plain and simple as a glass of milk might sound, we really like Dean Foods (NYSE:DF) right now. With a new year upon us and investors scouring for names that might benefit with a new administration, sometimes the best answer is to look at leading companies that are not in the spotlight but right in your fridge!
Can you provide a brief overview of what the company does?
Dean Foods is a leading U.S. processor and distributor of milk and other dairy products. The company has been around since 1925 and is headquartered in Dallas, TX. DF is surprisingly much larger than its next closest competitor but if you ask most investors to name any companies in this space they may not have a grasp of the landscape. Several of DF’s products are sold under licensed brand names and they have over 50 private-label brands in grocery stores nationwide. DF delivers their products via one of the most extensive direct store delivery (DSD) systems in the U.S.
What led you to take a position?
We actually owned DF several years ago and then sold the position. The catalyst for the sale was the divestiture of WhiteWave Foods Co. (NYSE:WWAV) in July of 2013. From a fundamental standpoint some of the same pricing concerns, intense competition, and inflationary concerns were swirling around the company as they are now. Ironically enough, talks of another potential acquisition also recently surfaced with a report in October of Hongsheng Beverage being potentially interested in buying DF.
Your investment decision-making process involves being value or growth agnostic – what value and growth qualities does DF have?
In our opinion, the greatest advantage of being style agnostic is that it allows you to scan the entire universe for companies and also avoid any preconceived biases. Albeit possibly warranting an entire discussion on its own…the value versus growth debate will always remain, but in general we believe value stocks will outperform over longer periods of time. There is of course always a reversion to the mean but 2016 has clearly seen value trounce growth.
DF just released its third quarter earnings and from a growth perspective it continues to perform well. The company actually has a healthy long-term earnings growth rate of 12%. From a valuation perspective, we believe this is where DF should attract some attention. We believe the company was extremely undervalued in August and early September and even after about a 31% bump since then, we think the stock has much more upside. S&P Capital IQ currently has a fair value calculation of $26 for DF.
How is DF positioned competitively?
Although there are potential headwinds in the form of rising commodity costs and increased milk pricing due to industry supplies, we actually believe DF retains a competitive advantage relative to the competition. Based on net sales, DF is the largest company in the fluid dairy industry. DF has superior management that has guided them through challenging environments with incredible success. Cost control measures and improvements in logistical efficiencies continue to give DF an advantage over the competition. By far and away though, DF leads the industry with over 50 private-labeled brands, which provides a competitive advantage and also reinforces its customer base.
What’s your outlook for the core dairy business? What impact does the recent decline in milk prices have on DF?
Over the most recent third quarter results, raw milk costs actually increased 12% versus Q2 2016 although the quarterly average cost of raw milk for the third quarter declined 8% year-over-year. Total U.S production looks strong with about a 2.1% growth increase year-over-year. DF expects this past October to have been the peak month for raw milk costs and now sees much more stability going into 2017. Management is confident that they will continue to be able to mitigate any sequential increase in milk prices through cost productivity and pricing management.
The trend towards “better for you” food/drinks appears to be secular as opposed to cyclical in nature – can you discuss how DF is positioned to benefit, especially with products such as TruMoo?
It’s hard to argue that the market for healthier food and drink options will continue to change but ultimately demand is the driver. With TruMoo, DF once again relies on its multifaceted brand strength as opposed being a one trick pony and just relying on volume with white milk sales. TruMoo not only has the brand strength but also differentiates itself from other chocolate milk formulas by being the healthiest option out there. The TruMoo brand is produced with no growth hormones and also does not contain any high fructose corn syrup.
DF just closed on the Friendly’s ice cream acquisition – how do you see Friendly’s complementing the existing dairy product portfolio?
Once again DF management made another wise and strategic acquisition by picking up the Friendly’s brand. Prior to the acquisition, DF was already the third largest branded ice cream company in the U.S. but with the purchase of this iconic brand, it establishes itself as the clear leader in the country. Not only does it bring an immediate $0.06 per share to DF’s earnings, but adding Friendly’s to the DF brand line-up is an ideal complement to other heritage brands across the U.S. and it fills a manufacturing and retail gap for their overall ice cream footprint
How is DF valued currently compared to your estimate of intrinsic value or price target? What are the catalysts that will result in a re-pricing?
We touched on DF’s valuation earlier but to dig a bit deeper there are two metrics that have caught our eye. First off, DF has a forward P/E ratio of about 13 which is much lower than the industry average of almost 19 times forward earnings.
Secondly, another metric that may not be looked at as often is the price to forward sales (P/S) ratio. This ratio is also called the “sales multiple” or “revenue multiple” and is most useful to get an ‘apples to apples’ comparison for companies in the same industry. DF has a much lower P/S ratio of 0.23 indicating a substantial undervaluation compared to the industry average of 1.22. These two metrics coupled with the $26 fair value that we referenced earlier demonstrates that there is still some upside from where the stock currently trades (roughly around $21.43 as of today).
Even with the recent rally in DF’s stock price, we believe there is more upside. Although management was careful to not allow more discussion or speculation talk about a takeover on their recent earnings call…it’s clear that the company is an appealing target. The stock was overly punished after missing earnings estimates in August but once news that Hongsheng Beverage, a subsidiary of Chinese beverage company Hangzhou Wahaha Group, was approaching Hong Kong banks for financing, there was an immediate 11% jump in price.
Although there is of course the very real risk of no deal materializing, we believe the stock still has upside into the mid $20 range over the course of the next year. Ultimately though, we think the dairy space will see continued consolidation with companies looking for improved scale in a very low margin industry. All that said, DF is easily the most attractive company in the space and could be especially so to a foreign buyer. We believe that if a buyout occurs, shareholders will likely see the $26 fair valuation become a reality. Without such a transaction taking place we still have a $24 price target on the stock by 2017 year-end.
Can you discuss any potential headwinds such as pricing pressure, commodity price volatility, etc?
Earlier we addressed the ever present issues when dealing with any company that is connected to commodities. DF management, however, has consistently proven that they’ve been able to navigate headwinds like these before. Additionally, the pricing challenges inherent to the dairy industry may not present as much of a threat to DF as it will to most of its competitors. DF has developed a new analytical model over the past two years that brings a much more disciplined approach to its retail pricing.
Wal-Mart is its largest customer at ~15% of revenue – is this exposure a concern? How stable has this relationship been?
Last year Wal-Mart accounted for about 16% of overall revenue. While this has been DF’s largest customer, there was some concern over Wal-Mart’s plan to open a major dairy processing facility. Even though this could impact DF with reduced volume of over 100 million gallons of milk, management does not see this negatively impacting them in 2017. DF management maintains that there is not only plenty of lead time to manage this shift in very low margin milk sales, but the relationship with Wal-Mart is still as strong as ever
You stress the importance of having a sell discipline and constantly monitoring your investments – what are some of the factors that would cause you to reevaluate your thesis or sell entirely?
We’ve always maintained the premise that it’s easy to buy a stock but extremely difficult to sell one. It’s human nature to go into a new investment idea with optimistic thoughts and hopes that it will thrive. While this approach should hold true with almost any disciplined investment idea, we believe it’s even more the case with a stock like DF. In other words, this type of stock falls into the proverbial “boring bucket”. Investing in a dairy company is not as sexy as some high growth tech stock might be. What you’re looking at when buying a stock like DF is not to day trade it but rather hold it until there is either more material news on a takeover or it reaches our target price. While you exercise some patience you’ll be rewarded with what is currently a $0.09 cent dividend (about 1.67% yield) and a stock that sits in a historically less volatile position than many other companies.
Some may ask if we would suggest selling DF if news of the Chinese suitor falls through; to that question the answer might be just the opposite of what they would expect! Assuming nothing negative or company specific is being divulged, this would likely provide a dip and an additional buying opportunity. Until then, consider buying this industry leading company and add to it on broad market pullbacks.