Morgan Stanley Downgrades Dean Foods, Sees 'Limited Upside' And Macro Pressure

In a report published Wednesday, Morgan Stanley analyst Matthew Grainger downgraded the rating on Dean Foods Co DF from Overweight to Equal-weight, with a $19 price target, following the recent outperformance of the stock.

"While we are constructive on DF's near-term outlook given a benign input cost environment, we view this as appropriately reflected in valuation, and see continued pressures for the fluid milk industry," Grainger explained.

Although milk prices fell significantly, it now appears to be recovering from the trough levels. The analyst had expected Dean Foods to benefit from a significant decline in Class I milk prices during 1H15, which was the case with prices falling more than 30 percent. The prices are expected to continue at depressed levels during 2H15 as well, driven by higher global production, moderating export demand and increase in domestic dairy inventories.

However, both the analyst and the company expect milk prices to rise gradually to reach the low end of the "normalized" prices by the end of 2015.

While Dean Foods benefited from the high price gap between private label and branded milk and stronger than expected branded volumes during Q1, the analyst believe that the Q1 gross margins are unlikely to be sustainable.

"Going forward, as industry operating conditions normalize, we believe the need to bring price gaps back to historical levels should result in gross profit per gallon moderating through the balance of the year, limiting the potential for significant upside to overall EBIT per gallon," the Morgan Stanley report stated.

The company is expected to deliver a meaningful improvement in profitability in 2015. The analyst also expects the recently launched DairyPure brand and opportunities to monetize the DSD network to drive upside potential for Dean Foods in the longer term. "However, we expect DF's longer-term prospects for margin improvement and profit growth to still be limited," Grainger added.