(By
Erin Lash, CFA) From
our perspective, the competitive landscape within the milk aisle has
changed considerably during the last several years. But more
importantly, it now appears that the competitive advantages we once
believed Dean Foods (DF)
possessed (namely as a low-cost operator with significant scale in a
highly fragmented industry) seem to have eroded away as a result of the
structural shift in what is essentially a commodity market. Here, we
discuss our reasoning for recently removing Dean Foods' narrow economic
moat rating.
The Industry's Leading Player Must Possess Sustainable Advantages, Right?
With
$5 billion in annual sales (about 5 times greater than its closest
competitor), Dean Foods is the top firm in the dairy aisle, maintaining
about a 38% dollar share of the United States fluid milk market (which
is up from 35% in 2003). Dean's scale is particularly evident in the
fact that it is the only firm in the industry with a nationwide fluid
dairy processing footprint. The company operates a large refrigerated
direct store delivery network with more than 5,800 routes serving in
excess of 160,000 locations.
Acquisitions have enabled Dean Foods to build out its footprint and
also have contributed significantly to growth, as the company has
completed more than 40 acquisitions since 1993, increasing revenue
around 30% compounded annually, from $150 million in 1994 to $12 billion
in 2010. Because of its impressive scale and low-cost operating
platform, we had held the opinion that Dean would be better able to
withstand impending headwinds than its smaller peers and, for these
reasons, we previously assigned Dean Foods a narrow economic moat
rating. However, in light of the challenging economic environment that
has plagued the dairy industry during the last few years, it now appears
to us that due to a structural shift in the industry Dean's competitive
advantages no longer hold water.
Scale Advantages Aren't Enough in This Commodified Industry
Despite
operating as the leading player in the domestic dairy aisle, Dean
Foods' cost structure and the prices it is able to charge for its
offerings are highly sensitive to changes in commodity costs. For
instance in the first quarter of fiscal 2011, operating income continued
its descent, slipping 14% from last year's quarter (which marks the
sixth consecutive quarterly decline, following a 26% drop in the fourth
quarter and the 35% decline in the third quarter), and the adjusted
operating margin contracted 70 basis points to 3.5%. With significant
exposure to erratic changes in commodity costs and a limited ability to
differentiate most of its product lines, material margin expansion will
be tough to come by for the firm, in our opinion.
Intense Competition Is Unlikely to Subside
Competitive
pressures (from other branded firms as well as private-label offerings)
abound in the dairy aisle and have proved to be a major hurdle for Dean
Foods as of late. There are no meaningful switching costs between
various milk products, as consumers have the choice of multiple
offerings.