• E-mail
• Print
• Comment
• Font Size
• Digg
• del.icio.us
• Discuss article

Fitch: Limited Earnings Growth, More Consolidation for U.S. Packaged Foods in 2008

Posted on: Thursday, 6 December 2007, 09:00 CST

Fitch Ratings expects most credit ratings for the U.S. packaged foods companies to remain stable in 2008 despite mounting input cost pressure. Packaged food companies faced high input cost inflation in 2007 and several have given even higher preliminary input cost inflation guidance for 2008.

According to the U.S. Department of Agriculture (USDA), elevated commodity prices are anticipated to remain in 2008. Average prices for wheat, corn, soybeans, soybean meal and soybean oil are all expected to be well above their 10-year averages in 2007-08, and also above the already elevated prices incurred during 2006-07. Solid domestic and global demand for dairy products combined with tight global supplies has propped up dairy prices in 2007 and will keep them relatively high in 2008. High diesel prices are also impacting the packaged food companies.

Pricing actions and a mix shift toward higher margin products are crucial in the coming year, since the industry is subject to cost pressure that is difficult to completely offset with productivity initiatives. If pricing actions cannot be achieved to the extent desired by the packaged food companies, they are likely to see margin deterioration in 2008. However, margin erosion is not expected to affect credit ratings unless the companies' ratings are already weak for the rating category.

The major packaged food companies have diversified product portfolios and relatively stable consumption patterns for their products. Despite high input cost inflation, a weak housing market and a slowing economy, packaged food is non-discretionary. Thus, these companies tend to exhibit stable operating earnings and cash flow, as well as excess free cash flow.

CREDIT AND OPERATING PROFILES:

Many firms in the industry have become comfortable operating with more leverage in their capital structures. Over the past several years, credit ratings for several companies in this sector have migrated down toward the mid-to-high-BBB level. Companies at the 'BBB' level may plan their financial strategies more conservatively so as not to edge closer to the bottom level of investment grade ratings and lose Tier 2 commercial paper ratings. However, a few companies, such as Campbell Soup Company (Campbell's) and Kellogg Company (Kellogg's), are maintaining more conservative capital structures and stronger credit measures.

Limited growth opportunities have led to an increase in activities to increase shareholder returns. As in 2007, Fitch again anticipates many of the packaged food companies will enhance shareholder returns by repurchasing shares and raising dividends. For the third year in a row, debt reduction is not expected to be a priority for most packaged food companies. Margin erosion combined with more aggressive financial policies such as debt financed share repurchases or acquisitions, could lead to rating downgrades.

The companies covered in this report have ample liquidity for their operations and financing needs. Upcoming debt maturities are likely to be refinanced. Significant 2008 maturities include $1.25 billion for General Mills, based on the put rights of the holders. With a portion of the net proceeds from its debt issuance yesterday, Kraft will partially refinance its EUR5.3 billion interim bridge facility for the Groupe Danone global biscuits acquisition with longer term debt.

EARNINGS:

Low to mid-single digit revenue growth is expected for most companies in this sector. Price and mix will play a prevalent role and will be necessary to help offset high input costs. While volume is expected to be positive, products where demand is more elastic could be negatively impacted by price increases.

Although the basket of commodity inputs varies by company, most are facing higher costs for corn, wheat, soybeans, vegetable oils, dairy and corn sweeteners. Del Monte Foods Company (Del Monte) also faces high fish cost for its tuna business and high input costs for pet food. It will be difficult to maintain or grow operating margins amid higher costs. However, some companies such as Kraft and Sara Lee are aiming for higher margins in 2008 as the benefits of significant savings from their restructuring unfold.

Competition is expected to remain intense. Companies with higher margins such as General Mills, Kellogg, Campbell's and H.J. Heinz Co. (Heinz) have greater ability to invest in their brands to preserve market shares relative to competitors. Innovation is likely to continue in the areas of perceived health and wellness, convenience, and ethnic products. For example, recent product launches have included reduced sodium soups, dairy products with probiotics, and Asian dinner kits. Portion control packaging such as 100-calorie packs has proliferated as consumers look for simple ways to manage their weight.

Significant spending on consumer marketing is also likely to continue in 2008. This spending is necessary to support core categories as well as new products. Many packaged food companies are planning to invest in consumer marketing at a faster rate than sales growth in an effort to preserve and expand market share. Furthermore, the industry is aiming for more focused trade spending. Several companies have implemented systems to better track the effectiveness of trade spending, which over time should result in lower trade spending costs.

RESTRUCTURING, M&A AND ACTIVIST INVESTORS:

Periodic restructuring programs are common for the industry. Several companies within the packaged foods sector have engaged in significant restructuring programs over the past several years, which are winding down. However, Fitch envisions further restructuring may be necessary given the high cost environment.

Non-core divestitures were prevalent over the past few years, as exemplified by Sara Lee and ConAgra Foods, Inc. (ConAgra). To a lesser extent, the divestiture of non-core assets is likely to continue as companies focus on growing their core categories. Small bolt-on acquisitions are also anticipated, most likely in higher margin categories, in health and wellness, or in faster growing markets outside the United States.

Fitch anticipates an increased likelihood of consolidation within the industry in 2008. The last major round of consolidation was in the early 2000's. As input cost inflation cuts into margins, certain companies may plan to further cut costs by combining or streamlining operations. Since leveraged buyout (LBO) activity subsided earlier this year, merger and acquisition (M&A) activity will more likely be conducted by strategic buyers. Risk of unwanted M&A activity is minimized for companies with dual class share structures with supervoting rights. Similarly, significant foundation, trust and/or family ownership provides a strong deterrent to an unwanted transaction.

Activist investor Nelson Peltz has acquired equity stakes in both Heinz and Kraft through his investment vehicle Trian Fund Management, L.P. (Trian Partners). Activist investors aim to effect change and increase shareholder returns. Mr. Peltz and another ally were elected to Heinz's Board of Directors last year after a long proxy battle. While Heinz has continued its Superior Value and Growth Strategy rather than following Peltz's more aggressive strategy, there is risk to bondholders that at the completion of the current plan at the end of this fiscal year a new more aggressive strategy may be launched. In November 2007 Kraft appointed two new Directors to its Board, selected by the company and supported for nomination by Trian Partners. While it is unclear whether Mr. Peltz influenced Kraft's decision to divest Post cereals, there may be more non-core divestitures as the company continues to focus on core categories. As long as activist investors maintain their equity stakes, Fitch believes there is a heightened risk for higher leverage for these companies.

ECONOMIC AND COST PRESSURES:

With the weak housing market and its negative ramifications on consumer spending, there will be tightening of discretionary spending. However, due to the non-discretionary nature of packaged foods, there should be little negative impact overall. In fact, there may be some positive benefit if consumers eat out at restaurants less and instead cook more meals at home. The most convenient, pre-packaged meals will benefit the most. However, it is likely that cost sensitive consumers, particular those with lower incomes, will trade down more often to private label products from branded food items. This trading down will be more prevalent for more commodity based and less differentiated foods that have close private label substitutes.

As discussed throughout this report, input cost pressure is anticipated across the sector in 2008. Some packaged food companies already have stated that they expect the fourth quarter of 2007 to have the highest cost increases so far this year. Fitch expects this trend to continue at least for the first half of 2008. Then, as planting expectations are established for U.S. crops and the growing season progresses, prices for agricultural commodities may moderate if it looks like the harvests will be large. However, if plantings are below expectations or weather negatively impacts the growing season, commodity prices may continue to rise and put even more pressure on input costs for packaged food companies.

There is typically several months lag between commodity price changes and when they impact the financial results of the packaged food companies. Each company will be impacted differently based on its product portfolio, its hedging strategies and purchase contract structures.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. Food sector.

-- Campbell Soup Co. ('A'; Outlook Stable);

-- ConAgra Foods, Inc. ('BBB'; Outlook Stable);

-- Del Monte Foods Company ('BB'; Outlook Stable);

-- Dole Food Company Inc. ('B-'; Outlook Negative);

-- Flowers Foods, Inc. ('BBB'; Outlook Stable);

-- General Mills, Inc. ('BBB+'; Outlook Negative);

-- H.J. Heinz Co. ('BBB'; Outlook Stable);

-- Hormel Foods Corp. ('A'; Outlook Stable);

-- Kellogg Company ('BBB+'; Outlook Positive);

-- Kraft Foods, Inc. ('BBB'; Outlook Stable);

-- Sara Lee Corp. ('BBB+'; Outlook Negative);

-- Tyson Foods, Inc. ('BBB-'; Outlook Negative).

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Source: Business Wire

More News in this Category