Dean Foods Company (DF)

The P/E of 20x management’s guidance is above the company’s five-year average of 17.5x.

The P/E of 20x management’s guidance is above the company’s five-year average of 17.5x.

The consensus five-year growth rate of 11.5% also seems incredibly optimistic, given that the same analysts are expecting a 5% sales increase this year to be followed by a modest decline next year.

The consensus five-year growth rate of 11.5% also seems incredibly optimistic, given that the same analysts are expecting a 5% sales increase this year to be followed by a modest decline next year.

If there is a bright side to Dean’s horrible earnings outlook, it is that the quality of earnings remains relatively sound. The accrual ratio, which represents the difference between cash earnings and accounting earnings, should ideally hover around zero. That is more or less what Dean’s has done.

So, with the earnings quality indicating that the lousy earnings are at least trustworthy, I have to ask whether the current “50% off” share price reflects all the bad news. Unfortunately, no matter how I look at it it’s hard for me to think that it does.

Dean is experiencing both oversupply (in organic milk) and high commodity prices in traditional fluid milk - a situation that appears on its face to contradict the law of supply and demand.

Dean has managed to get itself on the wrong side of every dairy-related position (so much for Peter Lynch’s invest in what you know theory.) For example, the company describes the current dairy environment in its latest 10Q: “As a consequence of higher raw milk costs, we have seen a related increase in shrink costs and reduced profits from excess cream sales. At the same time, sales volumes in the Dairy Group have softened as consumers react to the higher retail prices. We are also seeing a shift from our branded fluid milk products to private label products resulting in reduced gross profit. In our White Wave segment, results continue to be negatively impacted by the oversupply of organic milk.”

High commodity costs during a period of oversupply? It is as if the law of supply and demand has been overturned. And Dean doesn’t expect to see much improvement. “As we look beyond the first quarter, we find it difficult to have much confidence in current dairy commodity forecasts given these unprecedented levels of dairy commodity market instability,” management warned.

As a result of this lack of confidence, the consensus earnings estimate for 2008 has dropped from $1.45 to $1.33 over the last month. The Zacks rank, a measure of earnings momentum, has fallen two points to the worst level of five. That rank puts Dean among the worst 5% of companies followed on the basis of earnings momentum. Yet still the estimates are well above management’s own guidance for “at least $1.20 per share.”