CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the following ratings of Dean Foods Co. (Dean; NYSE: DF) and Dean Holding Co.:
Dean Foods Company (Parent)
--Long-term Issuer Default Rating (IDR) at 'BB-';
--Secured bank credit facility at 'BB+';
--Senior unsecured notes at 'BB-'.
Dean Holding Company (Operating Subsidiary)
--Long-term IDR at 'BB-';
--Senior unsecured notes at 'BB-'.
The Rating Outlook is revised to Negative from Stable.
KEY RATING DRIVERS:
Negative Outlook Reflects High Near Term Leverage and Negative FCF: The Negative Outlook reflects Dean's recently elevated leverage and expectations that it will continue to rise in the near term, based on the company's need for further covenant relief discussed below. In addition, Fitch estimates that free cash flow (FCF; cash flow from operations less capital expenditures and dividends) could be negative for the year due to severe earnings pressure. The timing and magnitude of earnings and FCF improvement will be key to determining if Dean can return to sustainable leverage appropriate for the current ratings. Currently, Fitch's view is that Dean can return to moderate leverage and positive FCF after 2014, as long as milk input costs moderate. Total debt to EBITDA was 3.9x for the latest 12 months ended June 30, 2014, funds from operations (FFO) adjusted leverage was 7.0x, and operating EBITDA to gross interest expense was 3.1x. Due to Dean's high level of operating leases as a stand-alone company, total adjusted debt to operating EBITDAR is also an important leverage metric, which was 5.2x for the latest 12 months. Leases are primarily for machinery, equipment and vehicles, including Dean's distribution fleet.
Further Amending Leverage Covenants: In June 2014, Dean amended its secured credit facility and accounts receivables securitization facility to raise its maximum consolidated net leverage ratio to 4.00x for the four quarters ending in the second and third quarter of 2014 before reverting to 3.50x in the fourth quarter of 2014 and thereafter. While Dean's leverage for the covenant is in this range for the second quarter at 3.61x, the company is expecting higher leverage in the near term. Later this month Dean plans to amend the total leverage ratio in both facilities significantly upward to 5.25x for the third and fourth quarter of 2014, 5.00x for the first quarter of 2015, 4.50x for the second quarter of 2015, and 4.00x in the third quarter of 2015 and thereafter. The net leverage covenant cushion could be somewhat tight in 2014 before reaching a more comfortable cushion in 2015. This amendment also adds a maximum senior secured net leverage ratio of 2.50x, which Fitch believes will have ample cushion.
Limited Diversification, Earnings Volatility, Low Margins: Dean has limited diversification following the spinoff of its higher margin and faster growing WhiteWave (WWAV) and divestiture of Morningstar in 2012 and 2013. The company's remaining operations largely consist of processing and marketing fresh fluid milk, which represented 73% of Dean's product mix during 2013. Dean also produces ice cream, cultured dairy products, juices, and teas. Dean's current ratings incorporate Fitch's view that the company's normalized EBITDA margin is in the low to mid-single-digit range, and earnings and cash flow exhibit volatility. Ratings also consider the fundamental challenges faced by the fluid milk industry, which has significant excess capacity, volume declines, and high levels of competition. The dairy industry also remains highly sensitive to volatile raw milk prices. Fitch factors Dean's historical success at reducing costs into the ratings, and views the continued rationalization of processing operations as necessary given excess capacity and declining demand.
Class I Milk Prices Remain Stubbornly High: Dean's near-term challenges include category volume declines that have accelerated recently to approximately the 4% level from 2% historically, record and near-record high milk prices and elevated per unit costs due to capacity reductions lagging lower volumes. In addition, rising butterfat cost has exacerbated Dean's margin pressure across Class II products such as ice cream. Prices for conventional raw milk increased during the back half of 2013 and, on average, were approximately 8% higher during 2013 compared to 2012. Prices continued to rise to record levels during the first half of 2014, reaching $24.47 per hundredweight (cwt) for Class I milk in May 2014. Class I prices have remained high, and are $23.87/cwt in August, which is the second highest price on record and 26% above the year ago level. Earlier this year, strong global demand for whole milk powder, particularly in the Chinese market, along with production shortfalls in key regions, were drivers of the elevated global milk prices. The dairy commodity environment continues to be very difficult. Recently, rising butterfat costs have kept Class I milk prices stubbornly high. Dean and Fitch had anticipated that Class I prices would have fallen by now, given that international milk production has improved and international dairy prices have fallen. Also, the U.S. Department of Agriculture forecasts about 3% supply growth in 2014. However, the break that Dean is seeking from record high milk prices now appears to be pushed off until late 2014 or 2015, and even that timing is uncertain given that input prices have not reacted to the increased production.
EBITDA Declines, Near Term FCF Dissipates: Fitch has brought down its EBITDA expectations for Dean but still anticipates Dean can generate more than $300 million EBITDA during most years. Clearly, 2014 EBITDA will be well below this level due to high input costs that are passed through on a lagged basis and will not be fully passed on due to volume declines and Dean's concerns about not exceeding certain retail price points. The company withdrew its earnings guidance for 2014 given the lack of earnings visibility beyond the very near term. Dean's FCF was negative $491.8 million in 2013 primarily due to cash taxes related to the divestiture of Morningstar and other one-time items. Given lower cash interest expense and reduced capital expenditures, partially offset by the company's new $26 million annual dividend, Fitch believes Dean can generate annual FCF of at least $50 million to $100 million in a normal environment. However, Fitch believes Dean will be unlikely to generate positive FCF in 2014 even with reduced capital expenditures guidance at the low end of $150 million to $175 million. This compares with the company's initial guidance of approximately $125 million FCF in 2014.
Good Liquidity: Dean's liquidity is supported by $59.8 million cash and $736.2 million available on the company's credit facilities, which include a $750 million secured revolver expiring July 2, 2018 and a $550 million accounts-receivable securitization facility through June 12, 2017. Included in the availability above, at June 30, 2014 there was $698.5 million available under the revolver and $37.7 million remaining available borrowing capacity under the receivables backed facility. Dean's next significant debt maturity is $476 million of 7% notes due June 1, 2016.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Total debt-to-operating EBITDA sustained above the 3.5x range, which equates to total adjusted debt to operating EBITDAR above the 4.5x range, due to a material increase in debt and/or EBITDA decline for a prolonged period, potentially related to sustained high Class I milk prices and the inability to effectively pass through high raw milk prices in a timely manner;
--Expectations for multiple years of minimal or negative FCF generation due to weak operating earnings and sustained acceleration of volume declines due to a contraction in milk consumption and/or loss a major customer could also support negative rating actions.
Future developments that may, individually or collectively, lead to a positive rating action include:
--A positive rating action is not anticipated in the near-to intermediate term, and any positive rating action is likely to be limited to within the 'BB' category;
--Total debt-to-operating EBITDA consistently in the low 2.0x range, which equates to total adjusted debt to operating EBITDAR consistently in the low 3.0x range, due to materially higher EBITDA and/or stable-to-declining debt levels could lead to a positive rating action;
--Sustainable annual FCF of approximately $100 million or greater, elimination of additional fixed costs, absence of significant volume declines and the maintenance of market share would also be required for further upgrades;
--Further diversification could also be positive for the ratings.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (August 2013).
Applicable Criteria and Related Research:
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage