TEXT-S&P revises Dairy Farmers of America outlook to negative
Overview -- We expect Kansas City, Mo.-based Dairy Farmers of America Inc.'s (DFA's) proposed new financing initiatives to result in an increase in the company's total debt. -- We believe DFA's near-term operating performance may suffer under current market conditions, including increases in raw milk prices resulting in part from the ongoing drought in the U.S. The company also faces litigation uncertainties. -- We are affirming our 'BBB+' corporate credit rating on DFA and revising the outlook to negative from stable. -- The negative outlook reflects our opinion that market challenges may result in weaker operating performance which, combined with some increase in debt, may lead to a leverage increase over the near term. Rating Action On Oct. 9, 2012, Standard & Poor's Ratings Services revised its rating outlook on Dairy Farmers of America Inc. (DFA) to negative from stable. At the same time, we affirmed all of our DFA ratings, including the 'BBB+' corporate credit rating. DFA had about $815 million of total debt outstanding at June 30, 2012. Rationale The ratings on DFA reflect Standard & Poor's view that the company's financial risk profile is "intermediate" and business risk profile is "satisfactory." Key credit factors in our assessment of DFA's business risk profile include the company's strong market position, diverse portfolio of products and brand names, and limited geographical diversification. We also consider DFA's exposure to U.S. dairy industry conditions, characterized by reduced fluid milk consumption, near-term reduction in raw milk production volumes, excess processing capacity in some regions, and volatile raw milk and dairy product prices. DFA is the leading dairy cooperative in the U.S., marketing about 30% of total domestic fluid milk production. The company benefits from its significant economies of scale and extensive distribution capabilities. DFA has strong relationships with a national network of regional milk bottlers, including its own plants and through its affiliate network, and has long-term milk supply agreements with regional and national dairy processors, including Dean Foods Co., the largest national dairy processor and distributor. While milk marketing represents the majority of DFA's sales, the company's commercial operations are a very significant and growing portion of its overall business, and include dairy products processing under DFA's brands, contract manufacturing, and joint ventures. We believe DFA is exposed to customer concentration risk as its top 10 customers represent over 50% of sales, reflecting the consolidating trends in this mature industry and with retailers. DFA also has limited geographic diversity, with less than 10% of its sales outside of the U.S. The domestic dairy business is mature and is subject to significant commodity exposure, including the volatility of raw milk prices. The sector is also highly fragmented and susceptible to overcapacity on a regional basis. While the demand characteristics of fluid milk are relatively stable, the industry trend for fluid milk consumption is gradually declining. The federal government, through dairy support programs and marketing orders, regulates the industry. Despite several periods of weak farmer profitability in the industry over the last few years (reflecting higher input costs relative to milk prices), aggregate milk production levels did not decline significantly. However, the USDA forecasts U.S. milk production to decline slightly during the remainder of 2012 and into 2013, with total annual milk production of 199.9 billion and 198.9 billion pounds, respectively. This reflects, in part, the ongoing drought conditions and recent reductions in cow numbers and expected milk output per cow due to rising feed prices and high temperatures, although the medium- to longer-term impact on milk production from this year's drought remains unclear. The average all-milk price (based on various dairy product prices) has been volatile at $20.14 per hundredweight (cwt) in 2011, following $16.29 per cwt in 2010, $12.82 per cwt in 2009, and $18.41 per cwt in 2008. The USDA's Sept. 18, 2012, forecast for the average all-milk price in 2012 is about $17.90 per cwt, with declines in milk prices during the first half of this year reversing somewhat in the second half. DFA's business mix, which includes low margin commodity raw milk marketing and higher margin value-added dairy products processing, had supported more stable operating performance during the recent period of volatile milk pricing, compared to some of its dairy processor competitors. While DFA's producer cooperative members benefit from increased milk prices, and its milk marketing operations largely passes through rising milk costs, DFA's dairy processing operations' margins, including its affiliates, are more susceptible to increases in the cost of raw milk. As with many other dairy processors, margins were pressured as raw milk input costs increased throughout most of 2011 while the ability to pass through these higher costs in wholesale and retail prices was limited. DFA's sales level is heavily influenced by milk price levels and trends, as reflected in a 7.5% decrease in total sales in the first half of 2012 and a 32.0% increase during full year 2011, relative to the comparable prior year periods. DFA's gross margin on a last-12-month basis was 3.0% in the second quarter of 2012, above the 2.0% level of the second quarter of 2011, reflecting in part the decline in average milk prices beginning in the latter part of 2011. DFA's "intermediate" financial risk profile reflects the company's moderate financial policies, including the subordination of member payments to debt service payments (including both principal and interest). The company's leverage, as measured by an adjusted debt-to-EBITDA ratio of about 1.6x for the 12 months ended June 30, 2012, is stronger than the indicative ratios of 2x-3x for an intermediate financial risk profile. But cash flow coverage measures are somewhat weaker than indicative ratios for the profile, with funds from operations (FFO) to total debt of about 14% for the 12 months ended June 30, 2012, as compared to indicative ratios of 30%-45%. We believe the company has significant discretion over the timing of its member milk payments to manage its cash flow generation. However, we estimate that the company's proposed new debt financings and increase in debt levels will result in an adjusted leverage ratio near or above 2.0x. DFA's capital structure includes several series of trust-originated preferred stock that have debt- and equity-like characteristics. Although we analytically treat this type of preferred stock as 50% debt and 50% equity, and the dividends as 50% interest and 50% dividends, in calculating credit measures, the preferred stock's equity-like characteristics provide DFA with some additional financial flexibility. The cooperative's balance sheet is highly liquid, indicative of the perishable product that DFA handles. The subordination of cooperative member payments to operating expenses and debt service also provides a high degree of financial flexibility, thereby supporting an intermediate financial risk assessment despite the weaker cash flow coverage measures relative to indicative ratios for the intermediate category. Key assumptions in our 2012 forecast for DFA include: -- Continued volatility in milk prices and commodity input costs. We use USDA forecasts of total milk production and the all-milk price in our assumptions. -- Total sales declining by about 10%, reflecting in part lower milk prices relative to 2011. -- Gross margin near 3% and improving earnings from affiliates. -- Capital expenditures near $50 million. Liquidity Our short-term rating on DFA is 'A-2', and we believe the company has adequate liquidity in the near term, with sources of cash likely to exceed cash uses for the next 12 months. Cash sources include nominal excess cash (as a cooperative, the company redistributes a significant portion of its cash to its member owners); a $500 million commercial paper program, backed by a $500 million revolving credit facility, which the company recently refinanced; and positive cash flow from operations. At June 30, 2012, we estimate DFA had about $20 million of cash on its balance sheet, about $214 million of available borrowing capacity under its commercial paper program, and about $482 million available to borrow under its revolving credit facility (after deducting $18 million of letters of credit). The company retired $42 million of debt in October 2012 and upcoming debt maturities include $155 million of senior unsecured notes maturing in 2013. Other potential uses of cash relate to outstanding litigation issues, capital expenditures, or relatively small acquisitions. The company's financial covenants include maximum leverage (debt to total capital) and minimum fixed charge coverage tests. These covenants were modified as part of the company's September 2012 credit facility refinancing and we now believe they provide an expected greater-than-15% projected covenant cushion. Our assessment of DFA's liquidity profile also incorporates the following expectations, assumptions and factors: -- We expect cash flow sources will cover uses in excess of 1.2x for the next 12 months. -- We estimate that liquidity sources would continue to exceed uses even if EBITDA were to decline by 15% from forecasted levels. -- With its cash balances, availability under its revolving credit facility, and flexibility in making certain cash member payments, we believe the company could absorb (without refinancing) high-impact, low-probability events. -- In our view, the company has well-established relationships with banks and a satisfactory standing in the credit markets. Outlook Our rating outlook on DFA is negative. We expect credit measures could weaken somewhat over the near term with leverage potentially increasing to over 2.0x following completion of the company's proposed new financings. We could consider a lower rating if, as a result of total debt levels increasing or operating performance deteriorating significantly, leverage increases to well above 2.0x. We could consider revising the outlook back to stable if the company successfully resolves its litigation issues and sustains leverage below 2.0x while maintaining adequate liquidity and sufficient covenant cushion. Related Criteria And Research -- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011 -- 2008 Corporate Criteria: Our Rating Process, April 15, 2008 Ratings List Rating Affirmed; Outlook Revised To From Dairy Farmers of America Inc. Corporate credit rating BBB+/Negative/A-2 BBB+/Stable/A-2 Ratings Affirmed Dairy Farmers of America Inc. Commercial paper A-2 Preferred stock BBB- Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.