Thursday, May 27, 2010

Credit Rating

Morningstar is initiating credit coverage of Dean Foods DF with a BB rating, reflecting the company's narrow economic moat and leading position as the largest processor and distributor of milk and related dairy products in the U.S. Offsetting these strengths, Dean Foods' Cash Flow Cushion is rated poor on the basis of the significant amount of term loan amortizations and repayments due over the course of next five years. In addition, we forecast that Dean Foods will need to tap the capital markets to refinance debt as it matures. Our Solvency Score is also poor because of the company's high balance sheet leverage and low interest coverage ratio.
As the largest dairy company in the U.S., Dean Foods' portfolio includes more than 50 local and regional brands, as well as private-label offerings, which are sold through retailers, food-service outlets, and educational facilities. With sales about 5 times greater than its closest competitor, Dean Foods dominates the highly fragmented dairy category. Acquisitions have contributed significantly to growth, as the firm has completed more than 40 acquisitions since 1994 and has increased revenue 37% compounded annually, from $150 million in 1994 to $11 billion in 2009. Most recently, Dean acquired Alpro, a leading European player in the branded soy-based beverage and food product market, in order to expand its scale and to extend its product portfolio.

The firm is working to improve its cost structure by eliminating redundancies, closing facilities, and streamlining distribution and production. Initial results from its efforts to improve routing technologies and sales standards are positive, as Dean has already eliminated more than 250 delivery routes and reduced the gallons of fuel used by more than 5% despite increasing the total gallons of product delivered. The firm should benefit from these efforts to streamline its cost structure, but we aren't convinced these actions will be enough to offset intense competitive pressures and continued volatility in input costs.

While Dean Foods has raised equity twice ($400 million in February 2008 and $410 million in May 2009) to repay debt, management's ill-timed decision to saddle the firm with debt to pay a $1.9 billion special dividend to shareholders in 2007 has only increased the volatility inherent in Dean's results. Beyond the risks associated with its significant leverage, consumer spending remains tight, and we are concerned that consumers who traded down to private-label dairy offerings may not trade back up to branded products when the economy improves. In addition, Dean is under significant pressure from major retailers (which are pushing their private-label offerings) and competitors (which are taking aggressive pricing actions).

Dean Foods reported total sales of $11.2 billion and EBITDA of $907 million for fiscal 2009, resulting in interest coverage of 3.6 times, a debt/cap ratio of 0.76, and leverage of 4.8 times. We forecast fiscal 2010 sales will increase 3.7% to $11.6 billion and EBITDA will increase 6.5% to $966 million. As a result, we project interest coverage of 3.2 times, a debt/cap ratio decrease to 0.72, and leverage declining to 4.3 times. On the basis of Dean's current cash balance of $48 million and our five-year cash flow generation forecast of $2.4 billion, the company will not cover total cash commitments of $4.8 billion and will need to refinance indebtedness as it matures.

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