Fitch Rates Dairy Farmers of America Preferred Stock 'BBB-'
KEY RATING DRIVERS
Ratings Reflect Unique Financial Flexibility
DFA's ratings reflect the unique financial flexibility associated with its by-laws that expressly subordinates farmer payments for milk (i. e. cost of goods sold), which enables the company to generate material cash flows with relatively small milk payment reductions distributed across its member base. Fitch views this flexibility as a substantial credit positive. The willingness in the past by DFA to adjust milk payments at both the national and regional level to protect their financial profile demonstrates this flexibility.
In addition to payment subordination, DFA's cooperative capital plan provides further ratings support. The cooperative capital plan objectives specifically target the maintenance of an investment grade rating to ensure DFA has adequate access to capital at competitive rates. Thus, DFA has flexibility, if needed, to increase its member equity target, which is currently at $1.75 per hundredweight of milk. This option would require board of director approval. Additionally, DFA has recently lengthened the time period recommended for equity retirement revolvements from 10 to 12 years to reduce cash payments.
These structural protection mechanisms materially differentiate DFA from other agricultural cooperatives and corporations by providing cash flow resiliency in either challenging operational environments or when addressing regional supply/demand imbalances. Consequently, Fitch believes these characteristics provide four notches of support to the ratings and offset the fact that leverage (debt/EBITDA) is high for the ratings. Proforma LTM leverage for the preferred stock issuance at the end of the second quarter 2016 was approximately 5.5x.
Leverage is Expected to Increase Before Moderating in 2018
As a result of the increased strategic investments to expand dairy processing capabilities including Southwest Kansas, New York and other potential projects, Fitch anticipates leverage will increase to above 6x in 2017 before moderating back to the mid 5x range in 2018. Stable to modestly improving core operations and increased earnings generation from the new capital investments projects are key to improving credit metrics back in-line with Fitch's expectations.
DFA utilizes partnerships and alliances with other companies, farmers and cooperatives to lower required investment and reduce capital risk. Asset sale proceeds from closed facilities could provide additional financial flexibility if DFA can reach an agreement with willing buyers. Fitch also believes DFA will continue to explore opportunities for modest bolt-on acquisitions to increase operating income growth.
Healthy Farmer Profitability
A key aspect in assessing DFA's ability to subordinate a portion of its milk payments is the extent DFA farmers can absorb a reduced pay-out. DFA generally pays its farmers a premium over the federal milk price and distributes patronage earnings based on the profitability of its valued-added processing businesses. Farmer profitability has been relatively healthy on average over the past 10 years with margin over feed averaging $6 to $8 per hundredweight. Farmer margin is calculated by milk price per hundredweight less feed costs.
As such, Fitch believes DFA has the ability, if required, to nationally flex the milk payment to farmers in the 3% - 5% range (roughly $225 million to $400 million on an annualized basis depending on total milk payments) to mitigate potential negative effects of a stress scenario. DFA farmers are typically second or third generation owners with a long-term view and are generally willing to accept shorter-term reduced payments due to changing industry or operational conditions. However, over an extended period of holdbacks, farmer's relations could become strained, particularly if other cooperatives are not reducing their milk payments to farmers.
Farmer service programs offered by DFA and the daily logistics of milk production improve farmer profitability and create additional membership stickiness. Fitch also views DFA's regional structure as a risk mitigant that also protects farmers in other regions from supply and demand imbalances that can lead to regional milk payment adjustments.
National Scale and Leading Market Position
DFA's ratings reflect the substantial scale as the largest U. S. dairy cooperative and its integral market position in the dairy supply chain based on DFA's expansive logistics, distribution and commercial processing capabilities that connect key customers and farmers. Since DFA is vertically integrated with well-known regional brands along with various strategic alliances, the company generates additional returns from valued-added manufacturing of dairy products for its members.
DFA's 8,000 plus member farms produce approximately 46 billion pounds of milk annually representing more than 20% of the total U. S. milk production. DFA marketed approximately 30% of total U. S. milk production in 2015 which constituted approximately three-quarters of DFA's total revenues. DFA is well positioned to service key regional and national customers including Dean Foods ('BB-'/Outlook Stable), Leprino Foods, Southwest Cheese, PepsiCo ('A'/Outlook Stable), Kroger ('BBB'/Outlook Stable) and CHOBANI. However, the cooperative's exposure to fluid milk which has been in long-term structural decline is materially less versus other dairy processors including Dean Foods at approximately 70%.
DFA's ratings are somewhat limited by the commodity-oriented characteristics within the dairy industry and sensitivity to volatility in raw milk prices which can affect earnings. However, DFA has positioned its businesses to realize profitability in both high and low milk price environments that when combined with internal hedging strategy has reduced earnings volatility. DFA also has significantly less risk than other agricultural cooperatives that are dependent on a single harvest due to its geographical diversity and the daily nature of milk production.
Good Track Record of Performance
Fitch views DFA's good operating performance in its commercial operations, consistent positive membership trends, and the effective resolution of past legacy legal and regulatory overhangs favorably. Fitch believes the strong operational execution and focus on the farmer has strengthened the long-term alignment of interests between DFA and its members thus improving the stability within its operations.
Favorable Industry Demand Fundamentals
The overall dairy demand in the U. S. is positive and supported by long-term growth expectations in the low-single-digits as milk use has gradually shifted from fluid to manufactured dairy products. The increasing demand for dairy in the U. S. is underpinned by the positive trends in yogurt, cheese and butter consumption that mitigates the long-term structural decline in fluid milk.
In the past several years, the increased popularity of Greek yogurt, which uses three times the amount of milk, has supported increased dairy demand. These trends should continue due to Greek yogurt's lower sugar and higher protein attributes that addresses consumers' health, convenience and taste preferences. Export markets for dry milk powder have also increasingly become a more important trade avenue the past 10 years as domestic milk production has slightly exceeded domestic demand.
Fitch's key assumptions within our rating case for the issuer include:
--Gross margins improving modestly over forecast period to 4%;
--EBITDA margins over the forecast period in the mid 1% range;
--Capital spending peaking in 2016 above 2% of revenues due primarily to Western Kansas plant, then declining to base rate of less than 0.5% of revenues beyond 2017;
--Operating cash deficit in excess of $300 million in 2016 and improving to modest level of free cash flow (FCF) in 2017;
--Leverage in the mid 5x range for 2016. For 2017, leverage increases to above 6x due to investments in growth related projects before decreasing to mid 5x range in 2018.
Future developments that may, individually or collectively, lead to a positive rating action include:
Positive rating actions are not anticipated in the intermediate term given DFA's current level of profitability and cash generation which constrains the ratings in a commodity oriented business. Over the longer term, a positive rating action would be based on continued positive dairy industry fundamentals combined with:
--Change with business mix into higher margin, value-added businesses that drive increased margins and scale in EBITDA;
--Leverage sustained below 4x;
--Improvement in DFA's underlying credit profile (without consideration for milk payment subordination) to a 'BBB-' rating.
Future developments that may, individually or collectively, lead to a negative rating action include:
--Change in bylaws by removing subordination of milk payments or commitment to maintaining investment grade rating;
--Material EBITDA margin erosion or weakness in parts of core business driven by operational or industry structural challenges;
--A sustained period of national adjustments to milk payments driven by company specific issues;
--Total debt-to-EBITDA sustained above mid 5x range;
--Multiple periods of operating deficits leading to increased debt borrowings.
DFA's liquidity is supported by the scale in its operations, which generates substantial cash flow, and the ability to subordinate milk payments. Co-ops, like DFA, generally distribute the majority of their earnings back to members resulting in lower FCF generation that can also be additionally affected by the timing of member payments. DFA does generate non-patronage income that does not have any patronage distribution requirements providing the company with some additional flexibility.
As of June 30, 2016, DFA had not drawn on its $650 million five-year unsecured credit facility that matures in October 2019. The credit facility provides for two one-year extensions and has a $150 million accordion feature. The credit facility serves as a backstop to support the company's commercial paper (CP) program that had $238 million outstanding at the end of the second quarter 2016. Availability under the credit facility is also reduced by $19 million for outstanding letters of credit.
The credit facility includes minimum fixed charge-coverage covenant and leverage financial maintenance (total funded debt to capitalization) covenant that steps down at the end of 2016. Based on the expected increase in leverage to fund strategic investments and covenant step down, Fitch anticipates DFA may seek amendments to provide sufficient cushion related to its leverage covenant. DFA maintains a very manageable maturity profile with $150 million due in 2018.
FULL LIST OF RATINGS
Fitch rates the following:
--Long-Term Issuer Default Rating (IDR) 'BBB+';
--Short-Term IDR 'F2';
--Commercial paper 'F2';
--Senior unsecured notes 'BBB+';
--Senior unsecured credit facility 'BBB+';
--Perpetual preferred stock 'BBB-'.
The Rating Outlook is Stable.