TEXT-S&P revises Dairy Farmers of America outlook to negative

Tue Oct 9, 2012 5:36pm EDT

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.
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