The Milk Racket

Featuring Lutts’ Logic:

The Milk Racket

Milking the Taxpayer

A Milk Investment

Today I’m going to wade into a subject that is deep and wide, and about which most of us know very little–the economics of the milk industry in the U.S.
My interest in this topic was piqued some time ago by photographs of farmers dumping milk.  I’m sure you’ve seen the pictures, but I’ll bet, like most Americans, you can’t explain the issues behind the farmers’ protests.

I was curious, so I investigated, and here’s what I learned.

Of course, the federal government is involved (I knew that).

But before we get into that, here are a few tidbits.

There are more than 60,000 dairy farms in the U.S., and the vast majority (both large and small) are family-owned.  Ninety percent of the dairy cows they milk are Holsteins.

These cows produce milk every day of the year, but are most productive in the spring and fall.  Demand by people, meanwhile, remains fairly steady, though we do consume more butter and cheese in the fall and winter.  To smooth out the bumps between supply and demand, there are cooperatives (representing the interests of the farmers) and there are processors (the biggest is Dean Foods), who turn some of the milk into other products, and then sell it all to consumers … or the government.

The government’s large-scale involvement in the milk industry began after people cut back on buying milk in the Great Depression.  The Agricultural Adjustment Act of 1933 authorized the Secretary of Agriculture to establish price supports for many agricultural commodities, including milk.

In World War II, the situation was reversed.  As demand boomed, the government began subsidizing the processors, to protect them from the high market prices charged by the producers.

After the war, it was back to price supports for the producers, and that’s where we’ve been since, with the government guaranteeing farmers a minimum price for milk, and filling the gap whenever market demand (and prices) dipped.

Interestingly, because we have 50 states (and because of politics) there are regional variations in this price support structure.  Since 1937 there have been Federal Milk Marketing Orders, which spell out the terms of the government’s support.  After all, it wouldn’t be “fair” to make the farmers of cold and hilly Vermont (the 15th-largest milk producer) compete with the more fortunate farmers of California and Wisconsin (numbers 1 and 2).

Coming into the 1990s, there were 31 different Federal Milk Marketing Orders, but in the growth environment of the 1980s and 1990s, demand (and prices) stayed high, so price supports were seldom needed.

The 1996 Farm Act actually called for price supports to be terminated at the end of 1999, while creating a new public pricing institution, the Northeast Interstate Dairy Compact, designed to protect Northeast farmers.  The result in the years that followed was a roughly 25 cent per gallon increase in the price of milk for consumers in the Northeast.

And the price support program didn’t end; it lives on today.  What did die was the Northeast Interstate Dairy Compact.

As the world enjoyed increased prosperity, more people drank milk and ate cheese and ice cream, and the price of milk remained high.  Many producers expanded their herds.  U.S. dairy exports rose to $3.8 billion, or 11% of all milk production, in 2008.  (The biggest milk exporters in the world are the European Union, New Zealand and the U.S.)

But today, the Great Recession has caused demand to plummet; the price of a gallon of milk is now 24% less than a year ago.

So the producers are hurting (some have even killed off their milk cows and sold them for beef).  The National Milk Producers Federation recently urged Congress to spend $350 million to buy cheese and donate it to the poor.

And it’s more complicated than that, because there are other countries involved.

Artificially high prices of American milk tempt other countries to export milk to the U.S.  To control that, the U.S. has had milk import quotas in place since 1951.  Today those quotas keep foreigners, especially Europe, from driving down the price of the United States’ milk, butter and cheese.

Providing further support to the industry–and keeping prices high–is the Dairy Export Incentive Program, a major surplus-removal program that uses funds from the USDA’s Commodity Credit Corporation to subsidize exports of targeted dairy products to targeted overseas markets.  (The Europeans do the same.)
And it’s all the result of having too many cows and too many producers.

In effect, our taxes are being used to keep milk prices high and artificially perpetuate the existence of uncompetitive dairy farms.

Now, I know it’s tough being a farmer.  I sympathize with those hard-working people who from time to time are blindsided by Mother Nature.  But I know that allowing markets to work is best for all of us in the long run, and if the U.S. government would just get out of the way, the most efficient producers would gain market share, and the price of milk would fall.

Yes, prices would become more volatile, but that’s what futures markets are for.  The Chicago Mercantile Exchange conducts trading in futures now for milk, cheese and other dairy products, but it’s not a very exciting market because of the government price supports.
And here’s the kicker.  In response to the recent hard times in the industry, Dairy Farmers Working Together, the Holstein Association USA, and the California-based Milk Producers Council are cooperating to create legislation that would penalize producers who boost production from one year to the next.

That’s just plain un-American!

One more milk item:

When supermarkets buy milk, they pay less for skim than 2% and less for 2% than whole, a practice that makes perfect sense. But many of these supermarkets then turn around and price all their milk the same, removing an incentive that would drive consumers to lower-fat milk.  And who pays the price for this folly?  We all do, as obesity becomes an increasingly costly problem for our country.

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Now that you understand the milk business better, are you ready for a milk investment?

It’s in Russia, a country where milk consumption is growing as the standard of living improves, and its name is Wimm Bill Dann Foods (WBD).

The company was founded in 1992, it’s headquartered in Russia, and it has annual revenues of $2.4 billion.  It has 34% of the dairy market in Russia and 20% of the fruit drink market.  Additionally, 7% of revenues come from outside Russia.

Most important is that the company is well managed by Russian and non-Russian managers, who know how to grow a business by simple acquisition.  Since 2000, the company has grown revenues every year.  2008 growth was 16%.

This year, as business was hit by both the global recession and the devaluation of the ruble, sales were down 29% in the first quarter and 27% in the second.  But the company cut costs and as a result, second quarter earnings grew 48% from the year before, while the after-tax profit margin soared to an unheard-of (for a milk company) 9.4%.

Finally, the stock has been strong, suggesting that investors who are looking beyond the present see continued growth for the company.  In fact, third quarter earnings will be released tomorrow morning, November 24, before the market opens.  If the market likes the numbers and the stock trades up on good volume, I think you can buy it.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Editor’s note: Cabot China & Emerging Markets Report bought WBD at a split-adjusted price of 15 in January 2007 and sold it in August 2007 at 24 for a 55% profit.  After dropping as low as 3 last November, WBD has made a powerful recovery, although a four-for-one split just last week might signal a short-term high.  For continuing, timely coverage of the volatile world of emerging market stocks, a no-risk trial subscription to the Cabot China & Emerging Markets Report (the #1 investment advisory for the last five years, according to Hulbert Financial Digest) can give you the inside track.


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