Fitch: U.S. Consumer Products Industry Outlook - Limited Upside in 2006.

NEW YORK -- In 2006, Fitch Ratings expects the stronger companies within the U.S. consumer products industry will be in the household products and personal care segments. These companies have well-supported, strong brands and an ability to produce well-conceived, new products that can command premium pricing in sectors with less cyclicality or narrowing markets. The toy sector and those companies exposed to the fortunes of the housing industry are expected to face more difficult conditions.

Against the backdrop of continuing high levels of competition in 2006 are a number of intensifying old events and new concerns. Among them are: raw material cost escalations, which was exacerbated by hurricanes, rising interest rates and a potential slowdown of the housing market, gross debt increases to take advantage of the American Job Creation Act (AJCA), shareholder-friendly activities, and increasing levels of customer concentration. In addition, increasing brand/media support requirements, the need for growth in developing markets (but often at lower margins), and faster pace of new product introductions and the investment needed to keep ahead of the competition, all affected 2005 and have ramifications for 2006. Restructuring/reorganization to meet these challenges without unduly increasing leverage and pressuring credit metrics will make 2006 an interesting year.

A myriad of events dominated the landscape in 2005 for consumer products companies. Among them, two highlights stand out:

--The continuation of raw material cost escalations - particularly those that were oil-based, followed by acceleration in price increase announcements;

--Significant mid-to-late year mergers or pending mergers: Fortune Brands acquisition of a number of spirit and wine brands, Procter & Gambles' (P&G) acquisition of Gillette, and Whirlpool's pending acquisition of Maytag - whose scale may change the dynamics of the industry.

Other noteworthy occurrences included several restructurings undertaken to reduce costs to enable companies to defend their market positions, increased common-share repurchase activity, senior management changes, and event risk, as managements face difficult decisions regarding ongoing operations. In general, price increases and productivity improvements have been able to mitigate rising material costs, but not offset them. Rating activity was moderately negative in 2005, reflecting an inability to meet these rising costs and sustain market positions, acquisitions, and a severe decline in financial strength at one company.

While the industry and participants are global in scope, except for a handful of companies, such as Colgate and Avon, many depend on the U.S. for the majority of operating profits. Good news was reported on Nov. 29 as falling gasoline prices and an improving job outlook resulted in a sharp rise in consumer confidence. The Conference Board reported that its index of consumer confidence for November improved to a reading of 98.9 from October's revised 85.2. In addition, the Commerce Department reported that sales of single-family homes increased 13% to a seasonally adjusted annual rate of 1.424 million. Some offsetting news was recently reported on Dec. 7 as the National Association of Realtors stated its index of pending home sales, based on contracts singed in October, declined 3.2% from September. The index was also down 3.3% from a year earlier. Putting it all together, Fitch expects softness in overall revenue growth rates and net profitability for the industry in 2006 for most participants based on the following:

--World growth has slowed from last year's near-record 4% to a more sustainable 3% pace during 2005. In the U.S., despite 12 consecutive quarter-point increases in the federal funds rate, interest rates remain below normal and real GDP growth has continued a little above trend at 3.7% over the last four quarters. Business spending has wavered after last year's rapid growth, but consumer spending has, until recently, been sustained by a continuing strong housing market. That is likely to reverse at some stage, easing GDP growth to 3% or below next year. Sectors such as appliances and other consumer durables that have some level of dependence on the housing market will be negatively affected by these cyclical forces.

--Disposable income of low- and middle-income buyers is being pressured, not only by sustained high gas and heating oil prices and high consumer debt levels, but also by many large employers downsizing their labor force in restructurings. In light of this, the ability to make price rises stick if the prices between brands and private label widens is questionable. Fitch's expectation is for some level of trade-down within product portfolios as mix and potential volume losses play out during 2006. Thus, the high level of volume growth experienced recently for branded consumer product companies could decline.

--The outlook is for a stronger dollar against major currencies, which will mute revenue gains in 2006.

--Growth in profitability will be hampered by gross margin pressure, restructuring charges, strong levels of brand support at the SG&A level, and higher effective interest rates.

--Intense competition will continue and scale will become more of an issue particularly for those who compete against P&G. The sheer size of the company, even prior to its merger with Gillette, has prompted several restructuring announcements as companies free up funds for brand support.

Rating activity should be stable to slightly negative in 2006. This reflects, in part, the expectations that: leverage and cash flow will be pressured with additional debt from AJCA repatriation activities, share repurchase activity will increase, and profit margins will be constrained due to the raw material environment and increasing brand support activities. As a result, financial metrics, which have weakened somewhat recently, may continue to slide.

Household Products and Personal Care

While oil prices have retreated since hurricanes Katrina and Rita, energy and oil-derivative material prices have been challenging for a number of years and will remain so during 2006. Resin and natural gas prices continue to escalate. Sector gross margins which, for the most part, have trended upward in the past five years stalled in 2004 and started declining in 2005. Many companies have had cost reduction programs in place, which helped but couldn't offset raw material cost escalations; price increases were the next step. The onset of price increases, a trickle in 2004, became a torrent in 2005 and some products have had multiple price increases. Clorox, for example, with the announcement of a new round of price increases effective January 2006, will not only cumulatively increase prices across 50% of its product portfolio, but will have raised prices on Glad trash bags three times since October 2003.

Positive pricing became an impetus for revenue growth in the latter half of 2005 after many years of no or negative contribution. The full impact of 2005 pricing announcements will be seen in 2006. The issue, however, is consumer and private label reaction and the potential negative effect on volumes and mix. While private label manufacturers face the same raw material impact as branded manufacturers and have thinner margins, their price increases in several key categories, based on IRI data, has been more muted -- and consumers, especially low and middle income who are pressured and will continue to be so particularly during what is expected to be an expensive winter heating season, have begun to trade down. Branded manufacturers must manage the spread between themselves and private label and offer the discerning consumer good value. Just recently, P&G announced that it would roll back some of the price increases on several diaper brands as private label became more competitive.

While all companies have long been focused on cost reduction, brand support and new product programs have not been uniformly robust. In addition, the level of industry competition for consumer attention in the form of advertising, which has been highly influenced by P&G in 2005, has ratcheted upward. Thus, very late in 2004 and during 2005 several companies, such as Colgate, Kimberly-Clark and Avon, announced substantial restructuring programs with a strong brand-building component.

Despite the strong headwinds, the sector enters 2006 with a strong financial profile -- leverage for the group as a whole has come down since 2000 and substantial cash flow has been generated to fund increasing levels of shareholder-friendly activities. The companies that should continue to fare well from a rating perspective are those with: strong momentum from earlier and successful restructuring actions whose cost savings are ramping up quickly, relatively less exposure to specific raw materials as a meaningful percentage of cost of goods sold, and balance sheet flexibility. Given the variety of issues facing the sector and barring major acquisition or substantial shareholder-friendly activity, the number of Fitch-rated companies that clearly meet the requirements previously mentioned is surprisingly small, only Colgate and Alberto-Culver. The remaining participants such as P&G have scale and a strongly diversified product portfolio, or other strong individual attributes that should allow them to remain solidly in the investment-grade category during 2006.

Toys

The toy industry has been in a slow decline for a number of years, as age compression is shrinking the size of the market for traditional toys and children turn to electronic and digital products, computers, and video games at a younger age. The industry has also become increasingly seasonal, particularly as major discounters have increased their market share of toy sales. Further, a very large customer, Toy's 'R Us is in transition and is ultimately expected to shut many of its stores in 2006. The number of closings and the disruption it will cause are unknown. Despite these significantly negative factors, the two largest players, Mattel and Hasbro, have fared relatively well because of their strong operational control over the business, reduced leverage, and significant cash balances and cash flow. Thus, Fitch expects that the overall ratings within this category will be relatively stable to slightly positive in 2006. Currently, Fitch's Rating Outlook for Hasbro is Positive.

Appliances/Hardware

Companies within this sector have, and will continue to face, higher material prices and intense foreign competition. The more successful ones have restructured, moved manufacturing to low-cost locations, and increased foreign sourcing. Productivity improvement remains critical to operations as price increases remain difficult to sustain, competition intensifies, particularly from imports and foreign companies entering the market, and retailers maintain or strengthen their position vis-a-vis manufacturers. As the distribution channel shift continues toward the home centers, manufacturers need to be focused on this outlet for consumer purchases, remain innovative, and maintain strong brands.

While demand for appliances can vary from year to year depending on a number of factors, including replacement demand, housing starts, consumer confidence, and general economic activity, the most direct drivers are:

--Replacement demand - which is mostly driven by existing home sales and accounts for about 75% of all appliance purchases; and

--New construction - which is monitored through single-family housing starts and accounts for about 25% of all appliance purchases.

Volume growth in the U.S., which has been running about 1%-2% in 2005, is expected to be maintained at about the same level in 2006. While rising interest rates and a slowing housing market could negatively impact growth, appliances generally lag the economy. Given the considerable build-up over the past couple of years from home sales and renovation projects, the sector should sustain its modest growth level during 2006.

Hardware companies are also influenced by many of the same macroeconomic factors, although commercial construction adds to demand for tools. The home repair/remodeling market is also critical to tool demand. Fitch is also concerned about recent rising interest rates and their effect on housing wealth. Home equity loans and mortgage refinancing have been instrumental in driving demand in the segment over the past few years.

Rating activity will be driven by M&A activity, specifically for Whirlpool and Maytag, stock repurchase activity, and operating performance in the face of a continuing challenging environment and expected slowing economic growth. Fitch expects credit fundamentals to remain fairly strong despite some pressure on the top line and on profitability. Barring sizable acquisition and/or stock repurchase activity, leverage should be stable except for those companies incurring debt to repatriate foreign earnings. Debt incurred for repatriation is expected to be short-term and reduced quickly.

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