Continuing Challenges

Competition and cost containment add stress to an otherwise robust dairy industry.
Chief executives of some of the nation’s top dairy processors offered their input for a brief Q&A on a few key industry issues:
• Gregg Engles, chairman and chief executive officer, Dean Foods Co.
• Larry Jensen, president, Leprino Foods Co.
• Marty Margherio, president and CEO, Farmland Dairies LLC
• Gary Wells, CEO, Wells’ Dairy Inc.
Dairy Field: The past two years have seen raw costs go from record highs to record lows. How has that impacted your business?
Engles: Net sales increased slightly due to strong volume growth that was largely offset by the pass-through of lower dairy commodity costs. Consistent with the trend of the last several years, the Dairy Group continues to gain market share.
Jensen: Volatility is an increasing challenge in the cheese business. High prices, such as we experienced in 2004 and 2005, dampen demand, both short term and long term. Low prices, such as we are currently experiencing, stress the production side. Like it or not, however, volatility is probably something we have to deal with over the long term.  We’ve seen increasing demand for risk-management solutions and we expect this will continue. One of the serious weaknesses we have with current risk-management tools is “length.” We find an increasing demand for fixed-price quotes in excess of 12 months. As an industry, I don’t think we’re doing enough to generate liquidity in futures contracts out at least 24 months.
Margherio: Because the bulk of our business is Class 1, we have been able to handle the moves in our pricing. It does impact our cream costs, and there we see swings from month to month. We are also looking at new product introductions that are value-added in nature, aiming for higher margins and offsetting the potential negative impact of raw costs. The additional value-added products we mentioned include extensions to our number-one-rated Skim Plus lines (Lactose Free and several other products nearing an official launch). We need to move the business toward the products that provide us a larger margin to offset certain costs that are beyond our control. It is also very important to study the demographics of the areas in which we service so we can anticipate the consumers needs and quickly respond. One example is the growth we are experiencing in the Hispanic and Asian markets, in which we are launching some new fresh and aseptic products.
DF: While raw costs have dropped, energy costs have soared. Likewise, how has this impacted your business, and how have you attempted to ease the burden on your own operations as well as your customers?
Engles: Partially offsetting the benefit of lower dairy commodity costs was diesel fuel, resin, natural gas and electricity costs that remain at historically high levels. We spent $16 million more on these commodities in the first quarter of 2006 than we did in the previous year. We’re in the first phase of a broad restructuring of our Dairy Group intended to streamline our back-office operations and allow us to purchase more effectively. … These programs support our commitment to leading the industry in low-cost production, superior customer service and return on invested capital.
Jensen: Our energy costs are up over 25 percent in the past two years, which has had a severe negative impact on our margins. We would like to see the impact of higher energy costs addressed in pending regulatory proceedings regarding cheese make allowances.  We believe adjustments are well justified. Naturally, we have a major focus on energy conservation. The justification for energy-savings projects is much easier today than it was several years ago. We are constantly vigilant for opportunities. Fuel prices and transportation availability have also had a major impact for all sectors of the industry.  Efficient traffic management is increasingly important for all of us.
Margherio: We have begun to contract for energy to cap it where we can. This will help both the company and the customers as we will know how high our electric costs can go, and price accordingly. To offset the high costs of fuel, we have instituted a delivery charge which customers have accepted. Everyone is faced with this challenge. In addition, we are actively implementing conservation practices and programs wherever we can. Some of the new capital projects not only provide us with productivity improvements but are also more energy efficient. We are currently very involved in a full review of our distribution area to possibly consolidate routes to increase efficiency and at the same time aggressively seek other profitable customers to fill these routes to capacity.
Wells: The high cost of materials is definitely hurting our business. Going to record lows helps, but as you know, oil and sugar and other commodities have offset a lot of that. 
DF: What capital projects do you have coming on line this year?
Engles: In addition to our purchasing and back-office initiatives, we’re also beginning to roll out a common IT platform across all of our dairy facilities. This multi-year project aims to increase the timeliness and utility of the financial and operating metrics available to our Dairy Group management team. … We believe the combination of these two initiatives will lead to a significantly more efficient and profitable dairy business model over time.
Jensen: We have several major capital projects involving product line extensions and operating efficiencies in the works. We are constantly reinvesting in our business to remain competitive. Our outlook on that issue has not changed, in spite of the current climate. We remain bullish on our business prospects in the long term.
Margherio: Capital projects include maintenance projects such as heating and cooling infrastructure upgrades, as well as efficiency enhancements such as robotics for automatic palletizing, and growth projects that include new ESL processors. We are also adding several new box packers, three new boilers and new trucks.
DF: What is your outlook for the dairy industry for the coming year?
Engles: For the second quarter and the balance of the year, energy costs remain a concern across all of our operations. In the Dairy Group, inflation and packaging and energy should be more than offset by a favorable dairy commodity cost environment, which on balance leads us to expect upside to our previous estimates of growth. … In the near term, however, we are facing significant inflationary pressure from raw organic milk and sugar costs.
Jensen: I think it is likely to be a fairly challenging year in the cheese business. Prices are likely to remain low by historic standards. Relative to the cheese price and manufactur­ing costs, milk prices are quite a bit higher than they should be (in spite of the precipitous drop from the past two years). We think demand will be relatively good, and we see 2006 as a year of opportunity for those with a long-term focus. Nonetheless, there will be a fair amount of financial stress in the industry.
Margherio: Costs will have a direct impact on all decisions as they continue to rise and impact profit margins. Health and wellness will be a major issue, with heightened awareness of organic and rBST-free products. We have already mentioned our plan to align ourselves with the health industry; our recent focus group of physicians, nutritionists and dietitians have given us some insight into where this growing trend of “health awareness and practices” is headed, and we want to be out in front with consumer demand. However, it is important to keep in mind that the consumer is not only looking for healthy, but also a product that tastes good, and we feel with our Skim Plus line we have exceeded their expectations.
Wells: If you look at the market, Unilever and Nestlé continue to “buy” market share from regional brands with record-low retail prices. The ice cream market is a tough place to be these days. The only thing we can do at this point is to try and continuously cut costs and innovate, innovate, innovate. My outlook for the dairy industry is, despite low commodity prices, it is very competitive out there.
Jensen, Margherio and Wells responded directly to our questions by e-mail; Engles’ staff provided a transcript of a recent corporate Webcast that addressed these issues.
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