Fitch: U.S. Packaged Foods Industry to Benefit from Value-Focused Consumers in 2010

Fitch Ratings expects consumers to remain value conscious when making food purchase decisions in 2010, which will support the stable outlook for U.S. packaged foods companies. Although the economy has started to recover, unemployment has reached 10 percent and is expected to remain high, which will weigh heavily on consumer spending. This value focus provides both pros and cons for packaged foods companies, which benefit from consumers' propensity to eat at home more often, but face weaker operating performance in their food service businesses when consumers restrict restaurant spending.

A combination of factors has contributed to the ongoing shift from branded to private label/store brand products:

--The proliferation of higher quality private label food choices available;

--Consumers' desire for value;

--The price increases packaged food companies implemented when input cost inflation soared in 2007 and 2008.

'Looking ahead at 2010, the outlook for the packaged foods companies remains stable as we expect positive free cash flow (cash flow from operations less capital expenditures and dividends), conservative capital structures and ample liquidity,' said Judi Rossetti, Director at Fitch. 'Moderate input cost inflation, cost savings from productivity initiatives and pruning of low margin products should allow investment grade packaged food companies to expand margins in 2010.'

Credit Outlook - Companies Still Cautious with Liquidity, But Those on Solid Financial Footing May Expand Share Repurchases or Acquisitions:

Fitch analyzes packaged food companies' trends in internally generated sales growth, consisting of changes due to pricing actions, volume and product mix. Higher pricing, carried over from pricing actions implemented in 2008, contributed significantly to sales growth, particularly in early 2009. Internally generated sales growth has slowed due to less impact from the price increases as the companies lap when those increases took place. Companies implemented higher prices to offset elevated input costs; however, they have lowered prices in heavily commodity-based categories, such as cheese and bottled oils, when prices fell. Price elasticity has led to volume declines or deceleration for packaged food companies during the past several quarters. The volume declines were attributed to the impact from higher pricing, as well as select stock-keeping unit (SKU) reductions and the decision to exit low profit or unprofitable businesses. Looking across the packaged food sector, General Mills has generated the highest internal sales growth (price/volume/mix), but along with the sector, sales and volume growth have decelerated in recent quarters.

Sales growth should generally be in the low single-digit range in 2010, driven mainly by volume. Fitch anticipates a slight rebound of volumes, which had turned negative in many cases, back to low single digit positive territory. Volumes should improve as higher pricing abates, SKU rationalization slows and volume comparisons from the prior year get easier. However, if volume growth is slow to return, sales growth may hover near zero. Fitch expects foodservice volumes to remain lackluster due to adverse restaurant industry trends; however, comparisons should also become easier in this area. Companies are expected to continue cutting costs and eliminating less profitable SKUs in foodservice to help preserve margins and profitability. Moderate inflation and continued cost cutting should have a positive impact on margins and operating earnings. Higher pricing is not anticipated, except in select circumstances where it could be justified, such as the expected rise in cheese costs in 2010. Any foreign currency impact would be felt more by companies with the most exposure overseas, which include Kellogg Company (Kellogg), Kraft Foods Inc. (Kraft), Sara Lee Corporation (Sara Lee) and H.J. Heinz Company (Heinz).

Positive free cash flow will mainly be utilized for small bolt-on acquisitions and/or share repurchases. Debt reduction is not likely to be a high priority. In 2009 free cash flow was constrained by higher pension contributions due to poor market performance for pension plans in 2008. If pension contributions are not as large in 2010 due to better financial market performance in 2009, it will positively affect free cash flow. Preservation of liquidity may take a lesser priority as the economy recovers. Investment grade packaged food companies have ample access to credit and may shift to a less restrained attitude toward share repurchases and merger/acquisition (M&A) activity. However, if companies engage in significant M&A activity, such as Kraft Foods potential acquisition of Cadbury plc, share repurchases will need to be put on hold until leverage is more appropriate for the rating level.

Since packaged food companies tend to be very stable and mature, most are likely to struggle to generate impressive sales and earnings growth organically. Therefore, large acquisitions, such as Kraft's quest for Cadbury and its growth in developing markets, may be just the beginning of an M&A boom for the sector. However, large acquisitions with significant debt financing would likely lead to ratings downgrades upon initially higher debt burdens. If a definitive agreement is reached with Cadbury that places Kraft's pro-forma total debt/EBITDA in the 4 times (x) range, a one-notch downgrade to the lowest investment grade rating is likely. Except for the higher rated packaged food companies such as Campbell's, Kellogg and General Mills, large debt-financed acquisitions would be constrained by efforts to remain investment grade.

Potential for Acquisitions in Core Categories That Lead to Expansion or Strengthening of Geographies:

Acquisitions in the sector are likely to be in core categories and lead to expansion or strengthening of geographies. Emerging markets are attractive for acquisitions because of their faster growth rates and large areas for expansion, particularly in Russia, India and China. Internal growth is also focused on those key emerging markets, exemplified by Campbell Soup Company's expansion in Russia and China. Kraft's potential acquisition of Cadbury would give it access to Cadbury's higher growth emerging markets. In addition to the desire for faster emerging markets growth, packaged food companies with similar input costs or product categories may consider business combinations to gain synergies and bolster margins.

Proceeds from non-core divestitures are not anticipated to be very material, except for Sara Lee, which is in the process of disbanding and divesting its Household and Body Care (HBC) segment. Sara Lee announced a $1 billion share repurchase program concurrently with its partial HBC divestiture. There is uncertainty regarding what Sara Lee's ultimate capital structure will look like at the conclusion of its divestitures. A large acquisition in one of its remaining core areas of global coffee or North American retail could be in its future since it has divested so much of its historical business. ConAgra also sold a large part of its legacy business to focus on core packaged food categories. With heightened near-term capital expenditures to expand its sweet potato business, it may not be looking for large external opportunities in the near-term, but further out a margin enhancing acquisition is conceivable.

Despite the completion of significant restructuring programs, margin improvement for many of the packaged food companies has been scarce in recent years. Margins are just beginning to recover with recent moderation in input costs. Restructuring projects have become part of routine business for packaged food companies, as cost savings from these programs are necessary to help offset cost inflation and generate margin expansion. Now that higher pricing is no longer a lever the packaged food companies can draw upon, generating cost savings from productivity initiatives will be increasingly important for driving earnings growth; however, there is a risk that too much cost cutting could adversely affect the quality of their products.

Several food companies took advantage of improving credit markets in 2009 to stay ahead of upcoming maturities and/or refinance high coupon debt. Kraft's $750 million notes that matured Nov. 12, 2009 were funded with cash from operations or commercial paper. Long-term debt maturities in 2010 are light for the packaged food sector, at slightly over $1 billion. Last month Kellogg announced a tender offer for up to $500 million of its $1.4 billion 6.6% notes maturing in April 2011. Kellogg just completed a debt offering earlier this week at very favorable rates to fund the tender offer. Fitch expects other companies in the sector to proactively address the relatively heavy load of 2011 and 2012 maturities in the near-term. In addition to Kellogg, Campbell, Heinz, Kraft and Sara Lee also have large debt maturities in 2011.

Kraft plans to renegotiate its five-year $4.4 billion revolving credit facility prior to its maturity in April 2010. In addition, Kraft also just entered into a GBP5.5 billion bridge credit agreement last week to finance the potential acquisition of Cadbury. Heinz and General Mills also have a portion of their credit facilities maturing in 2010. Campbell, ConAgra, Kellogg and Sara Lee have credit facilities that mature during 2011. Recent credit facility renewals have had shorter terms and higher costs.

CPI for Food Rises Modestly from 2009, But Remains below Heightened Levels of 2007 and 2008:

According to the United States Department of Agriculture's (USDA) Economic Research Service (ERS), the Consumer Price Index (CPI) for all food is forecast to increase 3%-4% in 2010. 'Food at home' is forecast to grow 2.5%-3.5%, which is slower than the 3.5%-4.5% growth anticipated for 'Food Away from Home'. 'Food at Home' inflation grew 4.2% and 6.4% in 2007 and 2008, respectively, which is well above long-term averages. In 2009 'Food at Home' inflation has moderated significantly to only 1%-2%. However, most packaged food companies incurred significant cost inflation in the early part of this year because they typically lock in their costs with suppliers or hedge their costs using exchange-traded derivatives several quarters in advance. This gives them a good indication of their upcoming costs. Therefore, a significant portion of their costs for 2009 were locked in when prices were still elevated in 2008.

Due to the lag in when input cost inflation hits earnings, some of this very low inflation, and in some cases deflation, is currently being reflected in packaged food companies' earnings. Companies that have seen significant price deflation, such as Kraft for cheese and ConAgra for bottled oils, have reduced prices. Sara Lee has mentioned that it will reduce prices for its bakery business. These heavily commodity based items lack differentiation and are very susceptible to other branded and private label competition. Therefore, they need to pass through commodity cost changes to consumers. Expectations for lower milk production in 2010, combined with an improving outlook for dairy exports, are supporting higher prices for cheese in the coming year. Inflation for meat products is expected to be modest, with the food CPI for beef, pork and poultry forecast to increase only 1%-2% in 2010.

Grain Related Input Costs Moderate, But Cocoa and Sugar Are Elevated:

The USDA expects farm prices for wheat, corn and soybeans to remain above their long-term averages. However, they are likely to be lower than the highly elevated prices in 2007/08 and 2008/09 when prices were driven by strong demand, rising oil prices, speculation, and adverse weather conditions. Large North American crops this year have helped to bring prices down closer to their long-term averages, although they are still elevated in comparison to historical stocks/use ratios. A very late, wet harvest period has led to recent price volatility for corn and soybeans and fears that prices could go higher if the quality of unharvested crops deteriorates. With 2010 futures prices at the upper end or above the USDA's current ranges, USDA projected prices could potentially be revised upward, signaling greater food price inflation may be ahead. However, the large crops that are being planted in South America could help mitigate supply concerns and alleviate price pressure by their harvest time in spring 2010 as long as they remain in good condition. The biggest rise in costs recently for the packaged food companies is for cocoa and sugar. While most global food commodity prices are down significantly since their mid-2008 peak, global and U.S. sugar prices have risen. Although the U.S. sugar market is not integrated with global markets due to import restrictions, the rise in global sugar prices and tight U.S. supplies are expected to support U.S. prices in 2010.

Industry Outlook - Private Label Provides Formidable Competition for Branded Packaged Foods, Even as Economy Recovers:

According to Information Resources, Inc. (IRI) in October 2009, U.S. private label spending in consumer products categories increased almost one point versus the prior year to 18 percent of dollars spent. While growing, this level remains well below most European countries. The Private Label Manufacturers Association shows private label shares above 30 percent in key markets of the United Kingdom (UK), Germany, Spain and France. The UK is near 50 percent private label share and Spain and Germany are near 40 percent. The risk remains for U.S. packaged food companies that the shift to private label food products will continue, although it is likely to be at a moderate pace. Food retailers continue to invest in their store brands, improving the quality and variety of items offered. The private label shift tends to be more pronounced for commodity-like, less differentiated products. However, all packaged food products run the risk of private-label trade-down if they do not effectively manage price gaps or have enough perceived brand value. Branded packaged food companies must manage the price gaps versus other branded products and private label carefully or risk losing market share, which is typically difficult to regain. It is likely that consumers will retain a significant portion of their private label purchase patterns when the economy recovers. However, Fitch does not expect private label penetration to reach the same level as it has in Europe in the near-term. According to IRI, categories with above average and increasing private label share during 2006 to 2009 include shortening/oil, natural cheese, tomato products and frozen potatoes. Companies that have significant sales in these areas include ConAgra, Kraft and Heinz. In contrast, products with below average and declining private label share over the same time period include yogurt, which has benefited General Mills.

Competition is expected to remain intense. Number one brands with high market shares, and to a lesser extent strong number two brands, are a distinct advantage for packaged food companies because those are perceived as 'must have' brands by both retailers and customers. Food retailers need strong brands and innovative new products to draw customers to the stores and generate category growth. Packaged food companies that own these brands can command more pricing power and have lower risk that their brands will be subject to reduced shelf space. Companies with high margins for the sector, including General Mills, Kellogg, Campbell, and Heinz, have greater resources to invest in their brands to preserve or gain market share relative to competitors. Lower margin companies Sara Lee and ConAgra have significantly pared their portfolios in recent years and are starting to make progress to improve profitability in their U.S. retail businesses. Packaged food companies have shifted more brand-building resources to in-store promotions to support new products and keep the value of existing products at the forefront of consumers' minds. Fitch expects packaged food companies to continue to favor temporary in-store promotions and coupons to entice value-conscious consumers, rather than lower list prices. Innovation is likely to continue to focus on perceived health, wellness and convenience. However, convenient products are harder for consumers to justify purchasing during the weak economic environment due to their typically higher cost per serving. Perceived health benefits are still highly valued attributes to consumers, as evidenced by the continued proliferation of products with higher fiber, added probiotics or reduced sodium.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs):

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

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

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

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

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

--Kellogg Company ('A-'; Outlook Stable);

--Kraft Foods, Inc. ('BBB'; Rating Watch Negative);

--Sara Lee Corp. ('BBB'; Outlook Stable).

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