Fitch: U.S. Food & Restaurant Industries Outlook is Stable, But Cost Pressures are Looming.

CHICAGO -- With the exception of the protein processors, whose demand and production cycles have been destabilized by the market impact of animal diseases, the operating performance of the food and restaurant industries was generally Stable throughout 2006 for Fitch's rating universe. Many firms absorbed higher energy and packaging costs, which moderated during the latter half of the year, but still remain relatively high and are expected to stay in that range in the near-term. Although several of the packaged food companies are undergoing restructurings, the benefits from either revenue enhancements or cost savings for the most part have only partially flowed through to the bottom line. Fitch expects higher ingredient costs, due to elevated agricultural commodities prices, to also pressure margins in 2007 for the food and restaurant companies.

As management continues to focus on enhancing shareholder returns through heightened share repurchases and dividends, strong cash flow generation and overall stable credit profiles provide ready access to capital markets. This market access is essential given the approximately $6 billion of debt maturing 2007 for Fitch rated companies in these sectors. While there continues to be moderate acquisition and divestiture activity, leveraged transactions have been limited to the protein processors and restaurant companies. However, the elements of leveraged buy-out (LBO) risk are still alive and very real for bondholders and they are afforded limited, if any, protection by debt covenants.

Packaged Foods Sector:

Fitch expects many of the packaged food companies to continue their commitment to enhance shareholder returns in 2007, primarily via share repurchases. Higher levels of liquidity concurrent with limited growth opportunities are driving the share repurchase activity.

For the second year in a row, Fitch does not anticipate meaningful debt reduction in 2007 for most companies in the sector. Thus, credit ratings next year will have a bias toward stability or downward revisions, depending on the magnitude of shareholder friendly activities and whether they are funded with internally generated cash or financed with debt.

Volume growth is likely to be in the 1-2% range for most of the sector, with sales growth in the low single digits and operating earnings growth in the mid single digits. Continuing with the prior year's trend, consumer brand building has become an increasingly important way to grow earnings and market share.

Several companies in the sector, such as Sara Lee Corporation (Sara Lee), ConAgra Foods, Inc. (ConAgra), and H.J. Heinz Company (Heinz) engaged in considerable pruning of their product portfolios in 2006. They are entering 2007 with much more focus and leaner cost structures. Nonetheless, more cost cutting could be necessary for some of these companies to bolster their margins to levels closer to the leading packaged food companies. The focus on core brands will continue. There may be additional non-core divestitures, but not likely to the same extent seen in the past year.

Kraft Foods Inc. (Kraft) is continuing its multi-year restructuring. Altria Group, Inc. (Altria) plans to outline the timing and details of the spin-off of Kraft at the end of January, which coincides with Kraft's new CEO's announcement in February 2007 of her ongoing strategy to accelerate Kraft's growth. While Fitch does not expect any major change to Kraft's capital structure or financial strategy, the ratings may be reviewed if it occurs. Post spin, Kraft's rating will be de-linked from Altria's.

Fitch expects to see higher commodity input costs for corn, wheat and soy-based ingredients, based on their recent price escalation. Substantial high fructose corn syrup (HFCS) increases are also expected for 2007. Protein prices will also likely be higher, as rising feed costs are passed along. Effective hedging strategies may minimize some of the impact of higher costs. While there may be some ability to pass on soaring costs via price increases, success with price increases in the past has been limited. Moderation in fuel and energy costs may offset some of the other higher costs. However, if price increases are not successful, some margin pressure could occur across the food sector.

Competition remains intense among branded packaged food companies. Competition from retailer's private label products is also growing. Innovation is the best way to differentiate branded products from each other and from private labels. Food product innovation in 2007 is likely to follow trends started in the past year or two, such as portion control packaging, convenience, health and wellness, ethnic foods and organic products.

Agricultural Commodities Sector: 2006 Credit Review:

Negative rating actions and/or Outlook changes were prevalent in the agribusiness sector in 2006. Negative Outlooks for Tyson Foods Inc. (Tyson) and Bunge Limited (Bunge) reflect both companies severe earnings weakness for several quarters that led to rapid increases in leverage. Most of the difficulties Bunge incurred in Brazil in 2005 and 2006 appear to be behind the company, as it generated stronger earnings in its most recent quarter. Tyson also showed slight signs of improvement in its most recent earnings, though the earnings recovery should be much more apparent in fiscal 2007. Cargill's ratings were downgraded one notch as a result of its steadily growing capital expenditures and its gradual increase in leverage. Cargill's growth strategy will likely preclude any debt reduction in the near term.

Conversely, Archer Daniels Midland Company (ADM) and Corn Products International, Inc. (Corn Products) maintained their ratings and Stable Outlooks as their earnings and credit metrics improved. Both companies benefited from double digit increases in high fructose corn syrup (HFCS) pricing in 2006 and solid increases are expected again in 2007. The improvement in HFCS pricing is driven by tight corn supplies. ADM is also benefiting from its leading position in biofuels.

Agribusiness Sector Outlook:

While the current year's corn production is down slightly from the past two record large crops, it is still very large. Nonetheless, corn prices have shot up due to booming demand from the ethanol industry. There is currently uncertainty as to where corn prices will stabilize.

Soybean prices have also seen a substantial run-up despite the record large 2006/07 soybean supply. Soybean prices have been propelled by higher wheat and corn prices. The large corn and soybean crops should be positive for the major agribusiness companies, whose earnings are bolstered by transporting and storing these large crops. However, the high prices will reverberate throughout the protein industry due to higher feed costs.

Protein Processors:

On the poultry side, as Tyson and Pilgrim's Pride enter 2007 the prognosis is mixed. In the first quarter of fiscal 2007 Tyson expects all of its businesses to strengthen and earnings to rebound. However, poultry prices have seen some weakness lately and feed costs are rapidly rising. Higher feed costs and seasonal weakness are expected to reduce Tyson's fiscal second quarter earnings. Tyson is counting on passing through higher prices and generating a solid second half of fiscal 2007. However, poultry processors' margins could get squeezed later in 2007 if they are unable to pass through higher pricing.

All protein processors will need to adjust to the higher feed cost environment, which may linger through the intermediate term. The poultry industry needs to exhibit discipline and cut back production. The effectiveness of these measures will determine how profitable these sectors are in 2007. If discipline is not exercised, the excess supply could lead to a period of prolonged weak pricing and earnings.

A few quarters of solid earnings for Tyson will be necessary for the company to return to credit metrics that are more appropriate for the rating level. If the recovery fails to materialize or is short-lived, Tyson's ratings will be downgraded.

Beef processors Tyson, Cargill and Smithfield should begin to benefit from larger cattle supplies, better capacity utilization and the resumption of trade to some key export markets. However, the recovery from steep losses in beef processing is likely to be slow and operating margins could be at or near breakeven for most of 2007. As beef exports regain traction, there may be some pull-back in pork exports, which had strengthened when the beef export bans were in place.

The risk of intermittent animal disease outbreaks is the most unpredictable factor for the protein processors. High Pathogenic Avian Influenza (HPAI) outbreaks in certain overseas markets had a devastating impact on export demand for leg quarters early in 2006. Cold storage inventories ballooned and prices fell until the inventories could be cleared. The impact of any re-surfacing of HPAI in 2007 will be monitored closely for its impact on poultry processors, and ratings outlook changes or downgrades are possible depending on the severity and length of the outbreak.

Biofuels Producers:

Biofuels are driving growth across agribusiness with ethanol expected to consume nearly 20% of the corn crop this year. That is up more than 30% from the amount used for ethanol in the previous year. The Renewable Fuels Standard (RFS) mandates the use of 7.5 billion gallons of renewable fuels by 2012. If ethanol production grows to 10% of the gasoline supply, production could reach about 14 billion gallons. As ethanol production continues to grow, there could be a battle for corn use in food versus fuel. This dilemma has recently driven up corn prices substantially, with cash prices approximately double from year-ago levels.

According to the Renewable Fuels Association, there are currently 107 ethanol bio-refineries with 5.1 billion gallons of capacity. An additional 56 projects under construction will add another 3.8 billion gallons of new ethanol production capacity over the next 18 months. Despite thriving industry growth, there is substantial risk to the profitability of the ethanol industry with rising corn costs and moderating fuel prices. Ultimately, different sources of feedstocks for ethanol production will need to be developed to reduce the need for corn. Cellulosic ethanol, which uses plant material and agricultural wastes, such as corn stalks, switchgrass and wood chips to produce ethanol, appears to be a longer term solution that is just in its infancy.

The agribusiness companies continue to expand in biodiesel in Europe and have begun to also build biodiesel plants in the U.S. These actions are leading to tighter global oilseeds supplies.

Agri-business Sector Credit Outlook:

All of the expansion in biofuels has propelled capital expenditures higher in 2006 and Fitch expects this trend to continue as opportunities abound over the next couple of years. Capital expenditures have ramped up for most companies in the sector, most notably ADM and Cargill.

In 2007 Fitch expects to see higher working capital as the agribusiness companies finance their higher priced inventories. Thus, a large portion of funds from operations could go to support working capital needs. High working capital usage has already occurred. This partially relates to normal seasonal buildup of inventories and is partially due to the recent run-up in grain costs, making inventory purchases more expensive. Fitch does not tend to penalize the agribusiness companies for higher working capital usage related to commodity price increases because the effects tend to reverse over time. The inventories are highly liquid and hedged against price risk.

While most of the agribusiness companies focused on internal expansion projects in 2006, the protein processors engaged in significant M&A activity. Smithfield Foods was extremely active on the acquisition front, snapping up ConAgra's Cook's Ham and its refrigerated meats division as well as Sara Lee's European meats business. Smithfield is still awaiting regulatory approval for the acquisition of Premium Standard Farms. In the poultry sector, Pilgrim's Pride and Gold Kist Inc. announced a definitive merger agreement in December. Additional M&A activity may occur in the poultry sector if low poultry pricing lingers and corn costs remain high or trend even higher. Small, pure commodity processors may consolidate so they are better able to survive a prolonged period of weak earnings.

In 2007, most agribusiness sector acquisitions are expected to be of modest size and in key international markets such as South America or China. Dividends are likely to grow with earnings. Share repurchases and debt reduction are not expected to be high priorities. Since growth opportunities are plentiful, Fitch expects the agribusiness companies to focus their resources on capital expenditures.

LBOs have not really crept into the agribusiness sector, nor are they likely to in 2007. The low margins, high earnings and cash flow volatility and uncertain exit strategies for this sector may not be attractive to private equity firms.

LBO and Other Event Risk-Food and Restaurants:

Leveraged buy-outs and investor pressure to increase shareholder returns via debt financed share repurchases and increased dividends are events that weaken credit profiles and hurt bond market returns. LBO activity was slow to materialize in the food industry over the past couple of years but has been more common for restaurants.

High profile leveraged private-equity acquisitions include the pending OSI Restaurant Partners acquisitions, Dunkin' Brands in early 2006 and Burger King in late 2002. Restaurants pressured by hedge fund investors include Applebee's International in 2006, Wendy's International in 2005 and Arby's in 2002. The garnering of board seats by activist group Trian Fund Management at Heinz in 2006 increases the probability of debt-financed share repurchases and other adverse behavior to increase shareholder returns at the expense of bondholders.

In 2007, Fitch expects LBO and other types of event risk to remain high in the restaurant industry, particularly among smaller less competitive high-yield companies, but to occur more selectively among food companies. Within Fitch's universe, a high probability of event risk is anticipated for Sara Lee, Heinz, ConAgra and to a lesser extent Brinker International (Brinker).

Food and restaurant companies are attractive merger and acquisition candidates because the companies produce stable operating cash flow and excess free cash flow. Large scale strategic acquisitions could occur among less competitive food and restaurant companies. Accretive deals, however, are likely to be harder to find.

In recent years, internally generated cash flow has been supplemented by divestitures of non-core businesses. As mentioned earlier, many companies have been involved in multi-year restructuring programs which incorporated asset sales. Companies with poor long term performance, additional assets to sell and large amounts of cash on hand may therefore be subject to investor pressures.

Restaurants are attractive because of significant real estate ownership. During certain economic cycles, the value of real estate is often underestimated by equity markets. Increased shareholder friendly activity, however, could help mitigate the occurrence of LBO and other event risk in the industry. A number of restaurants including Brinker, Wendy's, Cracker Barrel and Jack-in-the-Box, implemented large Dutch Tender Offers in 2006. Better performing restaurant companies such as McDonalds and Darden have increased dividends by 50% or more. Fitch anticipates that stronger competitors will be more resilient against hedge fund pressures while weaker competitors such as Applebee's may be more at risk.

Limited bondholder protection also increases the likelihood of heightened event risk. Weak change of control and leverage limitations, particularly for the debt of investment grade companies, leave bondholders vulnerable to LBOs and aggressive shareholders. The lack of material restrictions on sale-leaseback transactions and the absence of imbedded put options in the event of a change of control could result in unsecured bondholders becoming subordinated to any additional debt incurred. Fitch believes bondholders in the food and restaurant industries have recognized this risk. During 2006, credit default (CDS) spreads for many companies in these industries have widened.

Despite recent efforts to appease shareholders with share repurchases and dividends, Fitch believes event risk remains elevated for the food and restaurant industries. Companies most attractive will be those with low returns on equity (ROE), excess cash, additional assets to be monetized, weak corporate governance and less restrictive bond covenants.

Restaurant Industry Sector Outlook; Divergence in Operating Results:

Recent sales and operating income trends in the restaurant industry have varied. Despite this variance, credit metrics across Fitch's restaurant universe were relatively stable in 2006. Quick service restaurants (QSR), which are generally less economically sensitive than casual diners, experienced low to mid-single digit same restaurant sales (SRS) growth. Casual diners, on the other hand, experienced low-single digit declines in SRS. In general, food and beverage inflation has been offset with price and mix. Wage pressure also existed in 2006 but was partially offset with higher productivity. In most cases, operating margins only exhibited slight deterioration.

In 2007, Fitch expects increased debt levels and a continued divergence in operating performance to result in credit deterioration. There is an additional willingness among restaurants to increase the amount of debt in their capital structures. For example, many of the Dutch Tender Offers that occurred in 2006 were debt financed. Rapid unit growth will support revenue growth for less mature restaurant concepts like Brinker. SRS growth for casual diners is expected to remain slow despite recent declines in fuel prices as competition increases from lower price-point QSR and fast-casual concepts. The increase in premium offerings while maintaining diverse value items has made these restaurants more competitive. Many are also focusing on improving the dining experience. SRS for QSR's with easier prior year comparisons, such as Burger King and Wendy's, are likely to be more robust than those experiencing record performance over the past couple of years.

Fitch expects labor costs pressures to increase due to tighter labor markets and state-level governments implementing minimum wage increases. Although many companies have articulated expectations of benign food costs, Fitch also expects the restaurant industry to begin absorbing protein and other ingredient cost increases as 2007 progresses. Margin maintenance is likely to be more of a challenge in 2007.

A plethora of healthier menu changes are also expected in 2007. Fitch expects increased competitive pressure to result in further reductions in items with high trans-fatty (trans fat) acids content. In 2006, YUM, Arby's, Wendy's and McDonald's all made food preparation announcements regarding the reduction or even elimination of trans-fat. The fall 2006 release of Fast Food Nation, the movie that criticizes food quality in the hamburger industry, could also pressure restaurant companies to increase marketing dedicated to healthier menu items. Heightened competition for the higher margin breakfast and coffee business is also anticipated due to the expansion of these menu items.

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

Agribusiness:

-- Archer Daniels Midland Company ('A+'; Outlook Stable)

-- Bunge Limited ('BBB'; Outlook Negative)

-- Cargill, Incorporated ('A'; Outlook Stable)

-- Corn Products International, Inc. ('BBB'; Outlook Stable)

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

Packaged Foods:

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

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

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

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

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

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

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

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

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

-- Del Monte Foods Co. ('BB'; Outlook Negative)

-- Dole Food Co. ('B-'; Outlook Negative)

Restaurants:

-- McDonalds's Corp. ('A'; Outlook Stable)

-- Darden Restaurants, Inc. ('BBB+'; Outlook Stable)

-- Brinker International, Inc. ('BBB'; Outlook Negative)

-- YUM! Brands, Inc ('BBB'; Outlook Stable)

-- Burger King Corp. ('B+'; Outlook Positive)

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.