Historic Drought Could Devastate This Stock by 37%

The Midwest is currently experiencing one of the worst droughts in over 50 years, and it could have a catastrophic effect on the food supply system. The U.S. Department of Agriculture expects food prices could rise 3% to 4% over the coming year. In particular, dairy products are estimated to go up as much as 4.5% from current levels. This is bad news for Dean Foods (NYSE: DF), the biggest dairy processor and distributor in the United States.

Dean Foods has already been affected by volatile commodity costs. During the past year and a half, the stock has see-sawed, between a low near $7 and a high above $17. Currently, shares are looking technically vulnerable, breaking an intermediate uptrend line and testing important support near $12.

DF hit a two-year high of $17.25 on July 3, and remained in an intermediate uptrend until the week of July 16, when that uptrend was broken on higher-than-average volume. The stock tumbled after investment firm Goldman Sachs (NYSE: GS) downgraded the company, citing how inclement weather could cause corn prices to rise, leading to inflated dairy prices because corn is a main source of cattle feed. Since then, shares have been on a steep, accelerated downtrend, falling over 15% in two weeks.

As I mentioned, shares are currently hovering near support at $12. The rising 50-week moving average, which represents additional support, intersects nearby at around $11.64. However, if that level is breached, the next meaningful support level is near $11. Once below $11, shares could easily drop to support in the $7 range, as we saw happen in December 2010 and August 2011.

RSI -- which is an overbought/oversold indicator -- is below the key 50 juncture. This is a bearish sign. In addition, the RSI intermediate uptrend line has broken, supporting the bearish interpretation of the underlying price chart.

MACD -- a buy/sell indicator -- is flashing a "sell" signal, as marked by the black line crossing below the red line on the chart above. The MACD histogram is in negative territory.

The bearish technical outlook is supported by weak fundamentals.

On Aug. 8, the company will report second-quarter results. Analysts project revenue for the quarter will decrease 2.4% to $3.2 billion, from $3.3 billion in the comparable year-ago period. For the full 2012 year, revenue is expected to drop 0.2% to $13 billion, from $13.06 billion a year earlier.

The earnings outlook is more optimistic. Due to an aggressive restructuring program in which the company is undertaking organizational changes to reduce operating costs and improve gross margins, net income is projected to rise. Analysts expect earnings per share will increase to 31 cents in the upcoming second quarter, from 18 cents in the year-ago period. For the full 2012 year, analysts expect earnings will be $1.16 versus 77 cents in 2011. However, by 2013, earnings growth is estimated to decelerate, rising only 13%.

Given my bearish outlook, I plan to short Dean Foods if it falls to $11.53. I will set my stop-loss at $13.96, just above current resistance, marked by the intersection of the falling 200-day moving average. My target is $7.23, near the two-year low hit in December 2010, for a potential profit of 37%. The risk/reward ratio is approximately 1.8:1.

Risks to consider: A sudden shift in weather conditions could alleviate the drought situation. In that case, corn prices could reverse and dairy input costs could fall.