As Milk Prices Keep Rising, Should You Stay Away From Dairy Companies?

Despite the increase in U.S. output for the fifth consecutive year, milk prices are not dropping. Class III milk futures, which is the variety used to make cheese, are up 23% this year. What is going on?

Although it's true that domestic milk production is growing, exports have also been increasing -- and at a greater rate. In fact, according to the U.S. Dairy Export Council, they now account for 15.5% of sales, compared with 5% a decade ago. Prices are also on the rise, as U.S. January dairy exports' value rose 35% year over year, holding a quantity increase of 19%.

Futures traders might explain the rise in milk prices as a "tough commodity inflation environment," but basically, there is one global driver pushing prices up: demand.

The growing middle classes in Asia and South America are boosting demand for dairy products in general, and these include cheese and processed foods containing milk, such as ice cream for example. The Chinese example is clear, as dairy producers in the country have been unable to keep pace with rising demand, and as a consequence, China increased its dairy imports dramatically.

The interesting thing here is that demand for dairy in the U.S. is shrinking. According to the USDA, domestic per-capita consumption of fluid milk has decreased 25% since 1975, after a non-stop drop for the past four decades.

What's the impact on dairy companies
Certainly, it is tough times for the largest dairy processor and distributor in the U.S., Dean Foods , as the higher prices are eroding its profit margins. The company's CEO, Gregg Tanner, stated in the latest earnings call that these unusually high raw-milk prices are "an undeniable headwind for their business." In fact, the company's costs may rise by as much as $600 million this year, and transferring these costs to retail prices carries the risk of adding pressure to local demand. U.S. consumers might just reduce their milk consumption.

The case for Nestle is a bit different, since the company is not 100% reliant on dairy prices. Nonetheless, things are not in an optimal state. According to the company, 2014 will be "challenging," in line with its 2013 performance, when it recorded the slowest organic growth rate in four years, at 4.6%. Unfortunately, Nestle CEO Paul Bulcke does not expect much growth in U.S. consumer confidence, and he does not foresee strong growth back in Europe, either. He is a bit more optimistic about the emerging markets, as he reckons they will continue to grow, but at a slower pace. The company continues to grow in these markets; in fact, it showed 8.8% organic growth in the first nine months of 2013, versus a 1.1% rate in the developed markets.

For France-based Groupe Danone in particular, this year should be more promising. This has to do with the major impact of a recall that affected several of the company's infant formula products in Asia last year. Fortunately, this issue is over, and inventories are back to normal levels. In fact, the company expects this year's like-for-like sales to grow in the range of 4.5%-5.5%, maintaining an operating margin variability of 0.2%.

The recovery in European dairy is gathering momentum for Danone, and if things march on as planned, the company should return to profitability in mid-2014. Despite the growth in dairy prices, overall margins are recomposing from the damage caused by the recall in Asia, which affected the company's operating profit margin by 26 basis points.

Final foolish thoughts
Don't get confused: The rise in milk prices is good for farmers and milk producers, but not for dairy processors and distributors, simply because it represents a rise in costs that is not easily transferred to retail prices. This just plainly reduces company margins, and makes investors stay away from their stocks.

Dean Foods will probably continue correcting until mid-2014, when prices find more stability and the company manages to restore volume growth. Reducing costs to improve profitability will not be easy with the current price scenario.

Regarding Nestle, the company's milk products and ice cream category accounted for 19% of total nine-month sales in 2013. So, the impact on its cost structure could be significant, especially if prices continue to rise. Watch out, as almost 20% of the company's sales are related to dairy.

Danone is even more exposed, since it is the world's largest yogurt maker and dairy products account for 60% of the groups' sales. Hence, although the company's situation will improve compared to last year, mostly thanks to the resolution of its recall in Asia, it will be tough to grow if higher raw milk costs persist.

The main issue here is that for processed milk products like the ones Nestle and Danone produce, transferring the rise in raw milk costs to final retail product pricing is complicated because of intense competition in the retail sector.

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