(The following statement was released by the rating agency)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 thecompany's total debt.
-- We believe DFA's near-term operating performance may suffer undercurrent market conditions, including increases in raw milk prices resulting inpart from the ongoing drought in the U.S. The company also faces litigationuncertainties.
-- We are affirming our 'BBB+' corporate credit rating on DFA andrevising the outlook to negative from stable.
-- The negative outlook reflects our opinion that market challenges mayresult in weaker operating performance which, combined with some increase indebt, may lead to a leverage increase over the near term.
Rating ActionOn Oct. 9, 2012, Standard & Poor's Ratings Services revised its rating outlookon Dairy Farmers of America Inc. (DFA) to negative from stable. At the sametime, we affirmed all of our DFA ratings, including the 'BBB+' corporatecredit rating.
DFA had about $815 million of total debt outstanding at June 30, 2012.
The ratings on DFA reflect Standard & Poor's view that the company's financialrisk profile is "intermediate" and business risk profile is "satisfactory."
Key credit factors in our assessment of DFA's business risk profile includethe company's strong market position, diverse portfolio of products and brandnames, and limited geographical diversification. We also consider DFA'sexposure to U.S. dairy industry conditions, characterized by reduced fluidmilk consumption, near-term reduction in raw milk production volumes, excessprocessing capacity in some regions, and volatile raw milk and dairy productprices.
DFA is the leading dairy cooperative in the U.S., marketing about 30% of totaldomestic fluid milk production. The company benefits from its significanteconomies of scale and extensive distribution capabilities. DFA has strongrelationships with a national network of regional milk bottlers, including itsown plants and through its affiliate network, and has long-term milk supplyagreements with regional and national dairy processors, including Dean FoodsCo., the largest national dairy processor and distributor. While milkmarketing represents the majority of DFA's sales, the company's commercialoperations are a very significant and growing portion of its overall business,and include dairy products processing under DFA's brands, contractmanufacturing, and joint ventures. We believe DFA is exposed to customerconcentration risk as its top 10 customers represent over 50% of sales,reflecting the consolidating trends in this mature industry and withretailers. DFA also has limited geographic diversity, with less than 10% ofits sales outside of the U.S.
The domestic dairy business is mature and is subject to significant commodityexposure, including the volatility of raw milk prices. The sector is alsohighly fragmented and susceptible to overcapacity on a regional basis. Whilethe demand characteristics of fluid milk are relatively stable, the industrytrend for fluid milk consumption is gradually declining. The federalgovernment, through dairy support programs and marketing orders, regulates theindustry.
Despite several periods of weak farmer profitability in the industry over thelast few years (reflecting higher input costs relative to milk prices),aggregate milk production levels did not decline significantly. However, theUSDA forecasts U.S. milk production to decline slightly during the remainderof 2012 and into 2013, with total annual milk production of 199.9 billion and198.9 billion pounds, respectively. This reflects, in part, the ongoingdrought conditions and recent reductions in cow numbers and expected milkoutput per cow due to rising feed prices and high temperatures, although themedium- to longer-term impact on milk production from this year's droughtremains unclear. The average all-milk price (based on various dairy productprices) 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 isabout $17.90 per cwt, with declines in milk prices during the first half ofthis year reversing somewhat in the second half.
DFA's business mix, which includes low margin commodity raw milk marketing andhigher margin value-added dairy products processing, had supported more stableoperating performance during the recent period of volatile milk pricing,compared to some of its dairy processor competitors. While DFA's producercooperative members benefit from increased milk prices, and its milk marketingoperations largely passes through rising milk costs, DFA's dairy processingoperations' margins, including its affiliates, are more susceptible toincreases in the cost of raw milk. As with many other dairy processors,margins were pressured as raw milk input costs increased throughout most of2011 while the ability to pass through these higher costs in wholesale andretail prices was limited. DFA's sales level is heavily influenced by milkprice levels and trends, as reflected in a 7.5% decrease in total sales in thefirst half of 2012 and a 32.0% increase during full year 2011, relative to thecomparable prior year periods. DFA's gross margin on a last-12-month basis was3.0% in the second quarter of 2012, above the 2.0% level of the second quarterof 2011, reflecting in part the decline in average milk prices beginning inthe latter part of 2011.
DFA's "intermediate" financial risk profile reflects the company's moderatefinancial policies, including the subordination of member payments to debtservice payments (including both principal and interest). The company'sleverage, as measured by an adjusted debt-to-EBITDA ratio of about 1.6x forthe 12 months ended June 30, 2012, is stronger than the indicative ratios of2x-3x for an intermediate financial risk profile. But cash flow coveragemeasures are somewhat weaker than indicative ratios for the profile, withfunds from operations (FFO) to total debt of about 14% for the 12 months endedJune 30, 2012, as compared to indicative ratios of 30%-45%. We believe thecompany has significant discretion over the timing of its member milk paymentsto manage its cash flow generation. However, we estimate that the company'sproposed new debt financings and increase in debt levels will result in anadjusted leverage ratio near or above 2.0x.
DFA's capital structure includes several series of trust-originated preferredstock that have debt- and equity-like characteristics. Although weanalytically treat this type of preferred stock as 50% debt and 50% equity,and the dividends as 50% interest and 50% dividends, in calculating creditmeasures, the preferred stock's equity-like characteristics provide DFA withsome additional financial flexibility. The cooperative's balance sheet ishighly liquid, indicative of the perishable product that DFA handles. Thesubordination of cooperative member payments to operating expenses and debtservice also provides a high degree of financial flexibility, therebysupporting an intermediate financial risk assessment despite the weaker cashflow coverage measures relative to indicative ratios for the intermediatecategory.
Key assumptions in our 2012 forecast for DFA include:
-- Continued volatility in milk prices and commodity input costs. We useUSDA forecasts of total milk production and the all-milk price in ourassumptions.
-- Total sales declining by about 10%, reflecting in part lower milkprices relative to 2011.
-- Gross margin near 3% and improving earnings from affiliates.
-- Capital expenditures near $50 million.
(DFA is a private company and does not publish financial statements.)
Our short-term rating on DFA is 'A-2', and we believe the company has adequateliquidity in the near term, with sources of cash likely to exceed cash usesfor the next 12 months. Cash sources include nominal excess cash (as acooperative, the company redistributes a significant portion of its cash toits member owners); a $500 million commercial paper program, backed by a $500million revolving credit facility, which the company recently refinanced; andpositive cash flow from operations. At June 30, 2012, we estimate DFA hadabout $20 million of cash on its balance sheet, about $214 million ofavailable borrowing capacity under its commercial paper program, and about$482 million available to borrow under its revolving credit facility (afterdeducting $18 million of letters of credit). The company retired $42 millionof debt in October 2012 and upcoming debt maturities include $155 million ofsenior unsecured notes maturing in 2013. Other potential uses of cash relateto outstanding litigation issues, capital expenditures, or relatively smallacquisitions.
The company's financial covenants include maximum leverage (debt to totalcapital) and minimum fixed charge coverage tests. These covenants weremodified as part of the company's September 2012 credit facility refinancingand we now believe they provide an expected greater-than-15% projectedcovenant cushion.
Our assessment of DFA's liquidity profile also incorporates the followingexpectations, assumptions and factors:
-- We expect cash flow sources will cover uses in excess of 1.2x for thenext 12 months.
-- We estimate that liquidity sources would continue to exceed uses evenif EBITDA were to decline by 15% from forecasted levels.
-- With its cash balances, availability under its revolving creditfacility, and flexibility in making certain cash member payments, we believethe company could absorb (without refinancing) high-impact, low-probabilityevents.
-- In our view, the company has well-established relationships with banksand a satisfactory standing in the credit markets.
Our rating outlook on DFA is negative. We expect credit measures could weakensomewhat over the near term with leverage potentially increasing to over 2.0xfollowing completion of the company's proposed new financings. We couldconsider a lower rating if, as a result of total debt levels increasing oroperating performance deteriorating significantly, leverage increases to wellabove 2.0x. We could consider revising the outlook back to stable if thecompany successfully resolves its litigation issues and sustains leveragebelow 2.0x while maintaining adequate liquidity and sufficient covenantcushion.
Related Criteria And Research
-- Business Risk/Financial Risk Matrix Expanded, Sept. 18, 2012
-- Methodology And Assumptions: Liquidity Descriptors For GlobalCorporate Issuers, Sept. 28, 2011
-- Key Credit Factors: Criteria For Rating The Global Branded NondurableConsumer Products Industry, April 28, 2011
-- 2008 Corporate Criteria: Our Rating Process, April 15, 2008
Ratings ListRating Affirmed; Outlook RevisedTo FromDairy Farmers of America Inc.Corporate credit rating BBB+/Negative/A-2 BBB+/Stable/A-2Ratings AffirmedDairy Farmers of America Inc.Commercial paper A-2Preferred stock BBB-
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