Diary of a Financier

Incredible Value: Dean Foods

In Capital Markets on Mon 10 Jan 2011 at 10:09
  • DF crossed my radar after David Tepper’s regulatory filing.
  • I tend to avoid other peoples’ recommendations, but after scrutiny, DF proves a high-probability investment.

My investment decisions come from the Market itself: a technical reading backed by fundamentals.  I open trades when the Market tells me to, not when an analysts, pundits, or any other opinion persuades me.  That being said, I did catch a note about David Tepper taking a stake in Dean Foods (DF) over at Business Insider:

What’s gone wrong for the company? Basically it can be summarized in one chart, the price of a retail gallon of milk minus raw milk costs. Margins have been crushed thanks to high commodity costs, and the inability to pass them along to retail customers.

So what’s Tepper’s thinking here?

It might be something like this: If the economy starts to strengthen, then end demand and pricing power will finally begin to catch up to raw material costs.

If the economy weakens, then raw material commodity costs will drop, margins will widen again, and Dean Foods will benefit from the inherent defensiveness of the product (milk).

Only in the status quo scenario (increasing commodity costs, no end improvement) does the bet not work, though even still he’s getting the stock at historically cheap levels.

More often than not, I avoid a security when my thinking has been clouded by another person’s argument, but I gave Dean Foods a appraisal through a negatively-biased lens, and it comes out clean.

DF’s trend is still negative, but the shorter-term daily chart has turned up after flashing bullish confirmation this past Friday when Mr. Tepper disclosed his 7.35% stake:

DF daily chart- indicators turn bullish, price breaks resistance.

This daily chart is working hard to pull longer-term trends higher.  The weekly chart is turning up as a consequence, dare I say it’s on the brink of confirming a new long-term bull trend!?  DF is in a low-risk range, having hammered out a definitive bottom and even filled the gap left on its chart in November 2010.

As a result of that November gap and another gap in May 2010, DF now has a balance sheet that’s degenerated into overleveraged territory.  The Price/Book Value around 1.20 is cheap for even a value stock like this, and flush with assets, I don’t see solvency as a threat.  DF acquired its way to the top, and now that its ROA sits around 1.84% versus a 5-year average of 3.1%, I trust that certain assets are already on the table for deleveraging’s sake.

Charges related to an antitrust class action settlement have been administered during this nightmarish 4q10.  They slashed EPS guidance thereafter, which also accounted for the aforementioned margin squeeze.  So the stock price crater was largely due to retrospective issues.

Beyond technical, beyond fundamental, I do have to agree with the theoretical argument here.  Margins have been squeezed to a point where either higher input costs will be passed onto consumers, or lower input costs will alleviate the bottom line stress.  It’s a matter of critical importance in today’s economy.  From Reuters:

…price pressures are building in commodities despite the ample U.S. economic slack, thanks in large part to demand from emerging markets. The Reuters Jefferies CRB index (.CRB) of commodities is up 28 percent since July.

The pressures are concentrated in food and energy, the two categories the Federal Reserve prefers to ignore when it examines current data to get a sense of future U.S. inflation trends. The central bank’s reasoning is that those items are too volatile to provide a reliable guide.

That doesn’t help businesses faced with the margin-bruising prospect of paying more for raw materials while customers expect discounts in a still-weak economy…

…with PPI expected to show an increase of 3.8 percent while CPI is up just 1.3 percent… Companies may not be willing to eat the higher costs forever, particularly with the economy showing some signs of picking up speed and consumer spending strengthening.

DF’s gross margins clock in around 25.5% for the trailing 12 months.  That lags its five year average of 27.2%, and it sorely lags comparable companies like Lifeway (LWAY).  All of DF’s competitors lack their pricing power and their economies of scale.  While those competitors can maneuver nimbly in their pricing adjustments (especially those local companies), DF can engender paradigm shifts to suit itself.

I expect to scale into a long position in DF throughout this month.

–Romeo

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  1. March 14 (Bloomberg) — The milk rally that sent prices up 48 percent this year, more than any agricultural commodity, may be ending as farmers respond with record production and the costliest cheese in a quarter century curbs demand.

    http://www.businessweek.com/news/2011-03-14/milk-sliding-14-on-output-boost-cheese-jump-to-1984-high.html?amp

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