COVID-19 Industry Brief
EFFECTS OF THE CORONAVIRUS ON THE Dairy INDUSTRY Updated May 13, 2020
- COVID-19 Market Impacts: Consistent with all food producers, the dairy industry has been considered essential critical infrastructure since the onset of the pandemic. Despite this, dairy farmers are facing a collapse in milk prices due to reduced institutional and food service demand. The U.S. Department of Agriculture’s April 2020 dairy outlook, the first forecast to incorporate market impacts of the COVID-19 pandemic, projects a much lower 2020 average milk price than it had just a month earlier. The April estimate is $14.35 per hundredweight, which is almost $4.00 below its March estimate of $18.25 per hundredweight. While many food companies have seen significant demand for their products, agriculture executives note that the surge may not represent a fundamental shift in consumers’ overall food purchasing, but rather an increase in consumption at home due to forced restaurant closures.
- Weakness in the Milk Sector: The dairy industry, and in particular the milk sector, has been under pressure in the last few years due to declining per-capita milk consumption, and the pandemic has not changed the direction of that trend. Milk production increased in the period from December 2019 to February 2020 by 2.4 percent compared to the prior year. Initial commercial consumption of milk fats and skim in the months of January and February 2020, prior to the pandemic’s impact on the U.S. marketplace, were off due to continuing consumer preferences for alternative milks and weaker dairy milk consumption nationally. The pandemic has exacerbated this trend primarily due to the closure of schools, as well as restaurant closures, which has reduced demand for milk-based products including ice cream, coffee additives, and others.
- Pricing Weakness: Despite strong grocery sales, milk prices have dropped to unprofitable levels with dairy farmers concerns about processing plants closing or cutting production forcing them to dump milk. As a result, cheese prices, which are linked to milk prices, have dropped just under $0.60 per pound, from $1.76 per pound as of March 2, 2020, to $1.17 per pound as of May 2, 2020, for Grade-A cheese block. Butter prices have similarly dropped from $1.86 to $1.12 per pound for AA butter.
- Exports Trends: U.S. dairy exports during March 2020 were valued at $582.2 million, a 10 percent increase from the prior year and the highest monthly value for dairy exports since August 2014, according the U.S. Department of Agriculture’s Foreign Agricultural Service. The biggest increases came from Canada (+1 percent) and Mexico (+11 percent), with exports to China down 2 percent.
- Dean Foods: Despite the volatility in the marketplace, the ongoing Dean Foods bankruptcy auction sale was completed on March 31, 2020, with the sale of a large portion of its plants to Dairy Farmers of America and two other buyers. An anti-trust investigation of the transaction by the U.S. Department of Justice concluded in early May 2020 resulted in a settlement requiring some divestitures of certain plants.
- Stimulus Actions: On May 11, 2020, the U.S. Secretary of Agriculture announced a plan for $470 million in Section 32 food purchases to occur in the third quarter of fiscal year 2020, in addition to purchases previously announced. Of this total spend, the agency plans to buy $120 million in dairy products. Purchases are determined by industry requests, market analysis, and food bank needs. Similarly, on May 12, 2020, Canadian Prime Minister Justin Trudeau announced several measures and an investment of more than $252 million to support farmers, food businesses, and food processors in Canada.
- Valuation Outlook: From an inventory perspective, in the short term for processors of dairy products, lower prices will make raw milk cheaper and should allow some opportunity for additional gross margin to be captured in value-added products. In the longer term, lower prices will reduce overall gross margin dollars and put pressure on the industry. For cheese processors, the market drop may impact any existing on-hand inventory. On a mark-to-market basis, Gordon Brothers would expect inventory values to hold firm. From an equipment perspective, lower milk prices will negatively impact dairy equipment especially milking-related equipment. The market was already soft due to ongoing challenges in the dairy market throughout 2019 and into early 2020, and Gordon Brothers’ outlook has not improved with the onset of the pandemic.
Date November 2019
- Dean Foods, the largest milk producer in the U.S., filed for bankruptcy in November 2019 amid ongoing challenges in the dairy industry.
- U.S. milk prices have been trending upwards in 2019 due to a reduction in supply as the dairy herd has been declining.
- Butter and cheese stocks held in cold storage are lower than this time last year, resulting in reduced supply, which has aided in increasing prices for those commodities.
- U.S. exports of dairy products to China have dropped significantly stemming from retaliatory tariffs.
Approximate Net Recovery on Cost
Major bankruptcy shakes the industry: The consumer trend away from fluid milk consumption has been evolving for several years. A confluence of factors including the move toward non-dairy and healthier, vegan dietary preferences, the rise of plant-based milk alternatives, and a shift toward private label milk offerings have reshaped the industry in recent years. All of these factors proved to be too much for Dean Foods which, after reporting net sales losses for seven of its last eight quarters, filed for bankruptcy on November 12, 2019. Based on initial reporting, the Dallas-based company, which is the largest milk producer in the U.S., plans to use the Chapter 11 process to keep running the business while addressing its debt and unfunded debt obligations as it looks to sell the company. The implications of the filing will have ripple effects across the industry. A senior vice president of communications for the National Milk Producers Federation recently noted that “a number of member cooperatives provide milk to Dean Foods and could be impacted by today’s bankruptcy filing.”
USDA data shows total per capita dairy consumption was effectively flat from 2017 to 2018; however, fluid milk consumption was down 2.7 percent for the same period. Similarly, total fluid milk sales (across all types) decreased 2.0 percent from 2017 to 2018 and have decreased almost 9.0 percent since 2013. While insolvency for Dean Foods was driven in part by cultural and dietary trends, additional factors including Walmart’s decision to begin processing its own milk in 2017, and the grocery chain Food Lion cutting ties with the company in 2018, compounded the company’s struggle to compete in an evolving marketplace. Dean Foods is just the latest hit in a string of industry challenges, including ongoing Chinese and European Union (EU) tariffs on U.S dairy imports. However, there is positive news in that milk pricing has been trending up for 2019. The Producer Price Index for raw milk was up 3.4 points year-over-year for October 2019 indicating that milk demand, and pricing, has improved for farmers in the last 12 months. How industry challenges may impact recovery rates for dairy products remains to be seen, but lenders should continue to maintain diligent monitoring of product gross margins and other key metrics for collateral in the dairy space.
New tariffs on European Union dairy: The World Trade Organization authorized the Trump administration to impose a 25 percent tariff on the import of dairy products from the European Union (EU) beginning on October 18, 2019. The tariff will affect approximately 107,000 metric tons of EU dairy products, most notably on European specialty cheeses and butter. It is expected that, while the tariffs may not have a significant impact on EU imports in the short-term, the long-term impacts will likely result in consumers shifting away from EU products in favor of lower-priced domestically sourced cheeses and butter.
As a result, domestically sourced products will likely see an increase in prices, as consumer preference shifts towards these lower-priced products. On the heels of the tariff announcement, importers have been scrambling to import specialty cheese from EU suppliers and have begun to stockpile the affected products. Industry experts predict that imports of EU cheese could decline by as much as 30 percent or $1.5 billion in 2020.
Regulatory uncertainty: The United States-Mexico-Canada Agreement (USMCA), which is slated to replace the North American Free Trade Agreement, has yet to be ratified by all three countries, which continues to bring uncertainty to markets. One key change under USMCA that would affect dairy products is that Canada would eliminate its pricing scheme for what are known as Class 7 dairy products, allowing for more dairy products to be exported to Canada including milk protein concentrate, skim milk powder, and infant formula. Prior to these re-negotiations, the Canadian government restricted how much dairy could be produced in the country and how much foreign dairy could enter in order to keep milk prices high; it maintained strict import quotas and applied steep tariffs on imported dairy products that exceeded those quotas, with tariffs ranging from 200 to 300 percent.
Under the new agreement, which still needs to be approved by the U.S. Congress, Canada has agreed to drop restrictions, allowing U.S. producers to supply up to 3.6 percent of Canada’s dairy market. In 2018, exports were equivalent to 15.8 percent of U.S. milk production on a total milk solids basis, the highest figure ever, with Mexico being the largest trade destination at $1.4 billion. For the month of August 2019 dairy exports to Canada were down 6 percent over 2018, while exports to Mexico were up slightly at 1 percent for the same period. The dairy industry continues to lobby Congress to ratify the USMCA, as dairy farmers would be optimistic going forward that Canadian and Mexican export markets would exist. This would allow dairy farmers to plan for the future, make capital investments, increase heard headcounts, and invest in new processing equipment.
China tariffs remain: Exports of U.S. dairy products to China have decreased significantly as a result of escalating tariffs as part of the ongoing trade war. China announced additional tariffs on more than $60 billion of U.S. goods, including many dairy products that went into effect on June 1, 2019. Total applied tariffs on dairy products to China now range from 30 to 45 percent, including 30 percent for infant formula, 31 percent on whey and modified whey, 37 percent for ice cream products, 35 percent for casein, and 45 percent on all products consisting of natural milk constituents and buttermilk.
For August 2019, U.S. dairy exports to China were down 23 percent over last year. The timing of the downturn is particularly difficult for U.S. farmers as it corresponds to a time when the Chinese are consuming more dairy products than in the past. A trade specialist at the Peterson Institute for International Economics recently noted that potential growth in China could be in jeopardy the longer the trade war drags on. He further added, “the concern for American dairy farmers is, if they lose access to the Chinese market and Chinese consumers start to buy this stuff from New Zealand or Canada instead, they might like it. And they might stick with them even if the trade war is ever resolved.” It remains to be seen how difficult it may be for American farmers to bring their domestic export business back when customers have sourced elsewhere. In the meantime, Americans can expect more taxpayer-funded subsidies to shore up the farm industry as trade talks continue with no resolution.
Butter may warrant special analysis: Butter is a seasonal product. Prices almost always go up in the fall and winter, related to holiday cooking and baking. While sales volumes may be moderately impacted, rising market prices for butter can more greatly impact sales dollars. A lot of creameries will start building supply in anticipation of fall demand. Lenders should discuss with appraisers whether a high-low analysis to account for seasonality makes sense for companies in this sector.
Private label products may warrant modifications to exit strategies: Many dairy products are manufactured under a private label. Lenders should be aware that manufacturers may not be permitted to sell private-label products unless they are repackaged. While in certain instances, repackaging may be possible, it will incur extra time and expense in a liquidation.
Perishability: Due to the perishability of dairy products, the age and integrity of the goods is critical to recovery value. Product that is at or near its sell-by date will have a lower gross recovery value than fresher product. Most customers seek delivery of fresh products to stores or distribution centers within days of packaging, maximizing salability. The short shelf life of fresh product necessitates rapid turnover in finished inventory levels as part of the normal course of business to avoid losses.
For those who lend against milk as an asset, it is important to pay close attention to how an appraiser modifies the exit strategy to accommodate perishability. Depending on the product, there may be a couple of weeks or possibly just days to sell. It is also important to be aware of the strict regulations governing the sale, pricing, and production of milk.