Dairy Industry Outlook

This week's episode is a recap of a recent webinar we hosted on Horizon's Dairy Industry Outlook. Each year, a team of Horizon employees compile a document, which includes an analysis of global, national, and local dairy trends, a price forecast for the current year, and recommended best practices for Pennsylvania dairy producers.

In today's episode, we'll hear from Mike Hosterman and Heather Weeks, who are Horizon Ag Business Consultants, with extensive dairy backgrounds, who together authored The Dairy Outlook document. They'll share highlights from the report, to help us better understand factors impacting the dairy industry. To kick off the discussion, Mike will share the team's projections on 2022 Pennsylvania milk prices and costs.

Mike: 2021 is going to come in roughly at an average year. If you look at Class III and Class IV prices, they're at record highs; so, we're probably going to see a record high milk price in 2022. We are anticipating that the 2022 milk price, the gross milk price for our PA producers, will be $6 to $6.50 higher than it was in 2021. If you look at an EBITDA (earnings before interest, taxes, and depreciation) per cow, this is a way a lot of lenders will make projections without getting into the weeds on feed price or labor prices. EBITDA per cow will be higher than it was in 2021. What we are saying for the EBITDA is to project about $100 per cow higher in 2022 than it was on our five-year average.

Mike: It won't be a record year from a profit standpoint. It will be good profit for most producers when you look at net income per cow or net income per hundredweight. It's probably not going to be like 2018, where we had really high prices, because cost of production is up. When you really think about what's going on there with inflation, shortages of fertilizer, chemicals, and seeds, we are seeing a higher cost of production. We are anticipating that the cost of production, which will cover net worth, equity, and maintaining our balance sheet, will be somewhere around $22 per hundredweight. This will be up significantly from our prior years of $19-$20, up $2-$3 a hundredweight. At the same time, our break-even costs will also be going up to almost $23, based on what debt has done.

Next, Mike and Heather will tag team some areas of focus for Pennsylvania dairy producers this year.
Mike: In the Northeast, when you think about areas for us to focus on, we have an infrastructure that may be somewhat limited. We haven't seen a lot of reinvestment in it. We have typically produced fluid milk with not a lot of other products to go with it, which makes it difficult on us when fluid consumption is down. Dairy consumption is up. It's just not in what products we produce here in the Northeast.

Mike: When you think about being at record high Class III and Class IV prices, a lot of us out there keep hearing this term risk management. Producers have to do risk management. 2022 has some record high prices. Our input costs are up, but there's a lot of opportunities out there, if we focus on a few things.

Mike: One of the things they tell us to focus on is making sure every producer is enrolled in DMC which is cheap insurance for producers to do some risk management. I would say from the producer standpoint, they need to focus on components. We tend to look at Pennsylvania as being lower in milk ship per cow, but if you dig into that deeper, even on an energy corrected milk basis, we ship less components than other producers around the US do. We need to focus on that. We need to increase our percentages of butter fat and protein along with production levels. The more components we can ship and the less water we ship, the more potential there is for profits. We're not paying to haul that water down the driveway to the processing plant.

Mike: They really need to focus on some component levels here in the Northeast to try and improve it. Top herds across the US tend to be greater than six, more around six and a half. There are producers out there shooting for seven pounds of components per cow per day, or even higher levels than that. Again, for me, one of the focus areas that we should be working with Pennsylvania producers on are our component levels and increasing how many pounds of components are we shipping per cow per day.

Mike: With record high prices producers should consider contracting. Producers should consider taking the risk off the table and contracting at these high prices. One of the things I hear from producers all the time, "If I contract, and prices go higher, I left money on the table. I'm losing money." I would argue they aren't losing money. In fact, I tell all the producers I would work with, "The best thing that can happen to you if you contract, especially when you go to the co-op with that contract, is to see a negative on the milk check for those contracts." That means your market prices are higher.

Mike: In theory, we are still making more money, even though we left an opportunity cost on the table with that contract. These prices are at record highs. Our costs are going to be up, but with these record high prices, you can lock in a profit. Producers should be trying to focus on locking in those prices before you see the market turn and then start coming back down.

Mike: If you compare it to corn or soybean producers in the US, usually when you go into a crop season, you aren't pricing the crop, you’re getting ready to plant. We're actually looking to contract or price the crop that's a year away, the following year. In 2022, they'd be marketing the 2023 crop before the 2022 crop is in the ground. This is because the Chicago Board presents a lot of opportunity. The same is true in milk. Producers need to try to focus on where they can lock in these prices at.

Mike: Another cheap way to do that is the DRP insurances. I say cheap, because it is somewhat subsidized by USDA. They are at a higher cost today than what DRP was a few years back when it first came out because of volatility. Again, if you want to look at ways to focus on securing profitability or securing these reasonable prices, there are tools out there that producers should be focusing on.

Heather: Mike talked about prices. When you take your milk price and you subtract your feed costs, you get milk margin. Milk margin is one of those things that we really believe that farms need to monitor this year. Some consultants or people might call it income over feed costs. They are one in the same. There are a few different vocabulary words to talk about them. Farms need to monitor that margin and that cost of production as they are making decisions on their farm. If you are working with farms to help them, try and analyze their business.

Heather: I have had a lot of producers ask me, "Will 2022 be profitable?" Farms are ignoring that amazing milk price, and they are focusing on the cost of inputs and high feed cost. While we are projecting a marginally profitable year this year, I think it's important to recognize that every single farm is different. One thing I love about working with dairy farms is that they are not cookie cutter. Every farm has different inputs and different focuses on their operation. Without analyzing your specific business, we really don't know what your cost of production is and how to incorporate the different input costs that we have.

Heather: A lot of farms have in some ways contracted for certain inputs this year. We do know that there were opportunities to lock in fertilizer, nitrogen, and chemicals, earlier in the fall. There are some opportunities to contract some feed here, going back. These are all things we have to take into account when we're looking at how we're budgeting out for 2022.

Heather: I have had a few people say, "Well, I'm just going to cut costs and put as little crop inputs as I can out. That way I will minimize my costs as much as possible." I think that's a really dangerous thing to do without truly looking at the budget that we have. It's very possible that you can afford to continue with a fairly normal cropping plan, knowing that we do have some of these income factors locked in, especially if you've taken Mike's advice from the first couple slides and contracted some milk, are using DRP, or have DMC locked in. We know that we're fairly confident in our milk price. We can then budget on the input side and know essentially what we have to spend to know that we're getting some quality forages off of our fields.

Heather: I do really caution that if we are taking some shortcuts on the cropping side, we might end up purchasing expensive grain substitutes if we don't get the yields we think we're going to have. If we cut corners on the feed side, it might result in lower components and lower production overall. That really is going to undercut the whole goal, which is to save us money in the long run. We're really just going to cut off that income driver to start out with.

Heather: To really make strong decisions there, especially when we are dealing with so many things that are uncertain, we need to have good numbers and good data to back up the decisions that we're making. We're not asking you to do it alone. There are a lot of people out there that are comfortable helping you work through some of these numbers, whether it's your agronomist, your nutritionist, folks at Horizon, or at Penn State Extension.

Mike: Heather is right. Don't cut costs; try to control your cost. Every time I've worked with producers, and they say, "We're going to cut costs." They end up cutting their costs, but they've also tended to cut their production. The bottom line is, if you don't cut your cost enough and maintain the production, your cost actually goes up. Overall, it works against them.

Mike: I think we have to control our cost. One of the ways you can do that is through what you buy. You can buy in bulk. Again, I know for some of our smaller farms, buying in bulk is not easy and they might come in larger quantities than a single producer needs. Maybe you can collaborate with a neighbor to partner up to buy things together. Heather and I have been involved with a group in Chambersburg that did that on their seeds. There were savings they could get by going in together to buy their seeds.

Mike: Another thing to think about is that whether you have excess heifers or excess crops to sell, make sure they are the highest quality. If you have extra space and you are feeding out a few steers, that can drive the income side of the equation.

Mike: I have found through my career that it’s better to encourage producers to work on the income level, rather than cutting expenses. You can control the costs by focusing on those other enterprises you have. You also need to find efficiencies. If you have employees, can you empower them so that you don't need to watch over their shoulder all the time? This will ensure that they're doing their job well at a lower cost to you. Maybe they will even perform at a higher level. Sometimes giving them the authority to do things so you're not having to supervise as much or watch over their shoulder makes a difference. Overall make sure you stay efficient and that the labor pool is doing the right things that you want. It really is about trying to control the cost and maximize the output.

Heather: One of our areas of focus is to use some of those earnings really wisely to build some cash reserves. That way you can pay down the line of credit where possible. To illustrate that, these are some of the things that we look for on our farms when we are analyzing a farms balance sheet: we look at current ratio and working capital. These show how well the farm is doing at holding onto their cash and how liquid they are. Our estimates go back to where we feel that 2021 has ended up. We don't have the final numbers yet. Current ratio and working capital have been fairly strong for the last couple of years. They do meet our goals; our goals are based on industry recommendations.

Heather: I do want to caution that some of these numbers can be clouded by where those values are hidden. Is it all in inventories or is there some actually in cash? We may need to tease that out by going a little bit deeper. If you are building cash reserves, one of the easiest ways to do that is to pay down the credit line. Some farms think that getting a couple of notes off of their payment schedule sounds really great. If they can get rid of a piece of equipment in order to drop that payment, they think that that sounds like a really great idea. It may only save them a few hundred dollars a month on debt payments, whereas paying down that line of credit really gives a lot more flexibility to the farm. If they are able to get a line of credit paid down, it's still available to draw back out if something happens and they need that cash available.

Heather: Those are some areas we really want to work on. Mike has touched on the debt question a few times here. Even with a strong couple of years from 2019 through 2021, we really haven't seen a lot of movement on that debt level. When we look at debt to EBITA, we're looking at how many dollars of debt the farm has to every dollar of earnings. We really want to see that number below that $5 mark; really under $4 would be great. We just really haven't seen it improve a whole lot at this point. Farms really are re-borrowing. We touched on that capital purchases number that is staying strong whether we have a positive net income year or not. This is something we want to watch and be cognizant of.

Heather: When you're looking at percent equity, how can you really focus on getting that farm in position to make some improvements that are going to position their farms to have that presence and that competitive nature with the rest of the dairy industry? What is the relationship between percent equity, which is the overall health of your balance sheet, and that debt to EBITDA ratio? We want to see that percent to equity looking fairly strong. We want to make sure that our farms are utilizing debt smartly and understand where that debt is going. Is it all in equipment debt? Is it operating debt? Where are they focusing on that, and how can we really get them to address some of these questions that really puts them in a strong position to take advantage of opportunities when they see them? We've got a strong milk price here, so how can we use it as a good opportunity, rather than just looking at some of the challenges that we see in front of us today?

Heather: What's driving all of these numbers is that debt coverage ratio at the bottom line of cash flows. How are we driving the income to be able to cover some of these things and to pay down debt? It looks like we have had a few years of more positive debt coverage opportunities. We have had the cash to be able to cover these debt payments. If you look at that five-year average number, we've pretty much been breaking even. We need to be taking advantage of every option possible to get our balance sheet in a position to where we have the options long-term to be successful in dairy.

Mike: The bottom line to me can be summarized by the 2022 milk prices looking good at $6 higher than last year. We're going to be profitable. We're going to have a positive cash flow. We need to focus on those areas that Heather and I have discussed: build that balance sheet, control your costs, focus on production. If you do that, there are opportunities out there. Again, there is going to be a profitable year here. Talk with advisors, neighbors, and mentors about how you can take advantage of those opportunities, how you control your cost, or how you do risk management.

Mike: If you had to sum it up in a few words, make a budget, monitor it, and adjust it regularly. When I say regularly, do this on a quarterly basis. Again, 2022 is looking to be a good year. It may not be record profits, but it will be a good year where we can rebuild our balance sheet and continue to do some improvements. More importantly, if you are a business owner out there, or you're employed, have fun with what you do. I tend to always want to conclude by telling you to have fun; because if you're not enjoying what you do, you may want to rethink your business plan.