Milk is a tough business. Pricing is cutthroat, and it requires rigid perishables management. The last few years have been especially tough, amid an industry-wide slowdown in volumes. Now, milk producers are battling a persistently inflationary environment. Be careful when investing in milk stocks, even if you love dairy.

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Got a Tough Milk Outlook
One company, Dean Foods Company (NYSE:DF), dominates the milk industry. You are probably very familiar with Dean Foods; popular brands include Mayfield Dairy, Borden and Land O'Lakes. Despite milk being a household staple, Dean Foods isn't insulated from input price increases. Higher commodity costs ate away at Dean's margins last quarter, as the Dallas-based food and beverage company swung to a $1.54 billion loss. That compares with a $24.3 million gain in the same quarter of 2010. Dean took a giant $1.6 billion non-cash charge, net of tax, on the Fresh Dairy Direct unit. Expect there to be further fallout in the following quarter, as industry-wide volume declines, and price erosion continues to be an obstacle. (To know more about inflation, read: What You Should Know About Inflation.)

High milk prices and lower cereal volumes, from the likes of Kellogg Company (NYSE:K) and General Mills (NYSE:GIS), contributed to a 0.9% drop in fluid milk volumes during the third quarter. Milk prices have come off historic highs in the last few weeks, but input costs remain elevated. Dean Foods' Chairman and CEO, Gregg Engles, expects the decline in milk prices to stall in December. This effect will be pronounced, if the dollar depreciates to strengthen exports.

Milk producers like Dean, and other private label brands, really need prices to cool down. Lower costs are beneficial in a number of ways to milk producers. There's a regular amount of product loss in the manufacturing process, and from natural spoiling. When the cost of making milk is lower, the loss from normal production operations costs less. Additionally, Dean, and other milk producers, have a lot of fixed contract prices. Lower costs improve margins on those contracts, while higher costs can result in a squeeze. Higher input costs seem unavoidable at this point. West Texas Intermediate crude prices, that had softened, are now within a striking distance of $100 per barrel, and the North Sea Brent Crude has remained sticky.

On top of pricing pressure, Dean Foods is highly leveraged. That's part of the reason the company is aggressively promoting a cost reduction agenda. Dean Foods has made progress cleaning up the balance sheet, but capital expenditures (CAPEX) still rose sharply last quarter. Expect spillover into the fourth quarter from costs of constructing the WhiteWave manufacturing facility. CAPEX won't ease markedly until 2012.

The Bottom Line
The lack of a dividend is a major drawback as well, particularly in the food and beverage space where several more prominent companies pay solid yields. PepsiCo (NYSE:PEP) has a yield of about 3.2%. H.J. Heinz Company (NYSE:HNZ), Campbell Soup Company (NYSE:CPB) and ConAgra Foods (NYSE:CAG) all offer yields well over 3% as well. High yields are protecting these stock prices as volatility has increased dramatically over the past several months. (To know more about dividend, read: Why Dividend Matter.)

After flat lining through the early portion of 2011, Dean Foods soared to a 52-week high, just below $14 in late May. The stock plunged to the year-to-date low in August, and has since clawed back more than 20%, to trade just under $10. The recent rally reflects a rebound off oversold levels and lower costs. With reduced dairy input prices baked into the stock already, oil prices surging toward dangerous levels and the lack of dividend protection, it might be best to avoid Dean Foods.

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At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.

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