Fitch US Foods Outlook: Weaker Credit Profiles Due to Higher Costs, Shareholder Initiatives in 2006.

CHICAGO -- During the past few years, many U.S. packaged food companies reduced the level of financial risk within their capital structure through debt reduction. For the most part credit profiles have improved despite cost challenges. Credit ratings throughout that period were supported in part by continued debt reduction and the maintenance of conservative financial strategies with regard to acquisitions, dividends, and share repurchases. However, 2005 marked the end of such restraint for many packaged food companies.

Changes in financial strategy, such as diverting discretionary cash flow from debt reduction towards acquisitions and shares repurchases and heightened cost pressures resulted in the downgrades of Sara Lee Corporation (Sara Lee) and H.J. Heinz Company (Heinz). More importantly, Fitch has observed that many firms within the packaged food industry are managing their capital structure more aggressively, and as a result credit ratings are gravitating towards the 'BBB' investment-grade level. While several companies have indicated that debt reduction is still a goal, they have also demonstrated a renewed commitment to enhancing shareholders returns. As a result, Fitch does not anticipate meaningful debt reduction in 2006.

The packaged food industry continues to restructure, which creates incremental execution risk that has historically reduced financial visibility and created short-term variability in operating earnings. Several firms are engaged in sizable restructurings, such as Sara Lee -- which is divesting of businesses that represent approximately 40% of its revenues and ConAgra -- which is in the midst of revamping its information technology infrastructure and engaged in a major SKU rationalization effort. ConAgra has had several major divestitures over the past several years to exit its commodities businesses. Heinz continues to trim its operations, announcing a plan in September 2005 to divest of several European product lines after selling a number of businesses to Del Monte Foods Company (Del Monte) in 2002. A positive from these noncore divestitures have or will be a high generation of cash proceeds. Kraft Foods Inc. (Kraft), the largest U.S. packaged food company, is approximately two-thirds of the way through its $1.2 billion (pretax charge) restructuring plan, which was announced in January 2004. The restructuring plan, aimed at reducing Kraft's cost structure and asset base, has a cash cost of approximately $600 million, and the annual pretax cost savings are estimated to grow to $400 million annually by 2006.

Fitch believes that the following factors may negatively affect the credit profile of the packaged food industry in 2006:

--Margin pressure due to higher energy and packaging costs;

--Continued lack of material top-line growth due to sluggish volume;

--Lack of incremental pricing;

--Industry consolidation or leverage buyouts;

--Diversion of cash flow to share repurchases from debt reduction.

The ability to generate strong levels of discretionary cash flow remains a positive for the industry. A few sector standouts, from a bond investor perspective, have been the success that companies, such as Kellogg Company (Kellogg) and Campbell Soup Company (Campbell's), have had in maintaining a conservative financial strategy and consistently reducing debt. Kellogg's has also been highly successful at growing revenues and increasing profit margins, and as a result, is one of the strongest packaged food companies within Fitch's portfolio and has a Positive Outlook. There is currently room in both of these companies' ratings to accommodate their current share repurchase plans.

Profit Margins Erosion Continues

For the packaged food industry, changing dietary trends, increased agricultural commodities costs, and greater pension costs have been the major culprits for the lack of top-line revenue growth and declining profitability since early 2000. Now the industry is being challenged by heightened energy, packaging, and benefit costs, which have negatively affected profitability in 2005 and are expected to continue throughout 2006. There were several downward earnings revisions during 2005 due to unanticipated increases in these costs. The most insidious of which are energy costs that pervade the entire industrial complex from the procurement of ingredients to the production, packaging, and distribution of finished goods. Coupling these cost elements with the industry's historical lack of pricing flexibility will create a recipe for flat to lower operating earnings in 2006. Of the major packaged food companies Kellogg has been the only one to consistently increase its operating margins over the past five years, while operating margins of Campbell's, General Mills, Inc. (General Mills), and Kraft have declined 400-500 basis points. In a best case scenario, the industry may be able to recover a portion of the heightened packaging costs and energy costs through price increases and productivity savings.

Volume Growth Remains Challenging

With few exceptions, volume growth for the industry is limited, which is not unexpected considering the packaged food industry's maturity. Nevertheless, given higher inflation trends and increased energy costs, which may increase the propensity of consumers to trade down to lower price points, aggressively shop for discounts, and evaluate private labels, industry volume growth is likely to be under further pressure.

Although the interest in many popular dietary regimens waned in 2005, consumers and health policymakers are still concerned about weight and obesity, particularly in children. Several school districts have eliminated or reduced the number of snack foods available to students. The 2005 revision in the dietary guidelines for Americans, which recommended, among other things, consuming fewer calories and eating more fruits and vegetables, whole grains, and fat free or low-fat milk products. These recommendations, including those to reduce fats and cholesterol, have resulted in hundreds of new products and formulation changes. General Mills currently produces its entire line of cereals from whole grains, and many food producers have instituted portion control packaging. In addition, trans-fatty acid (trans-fat) has been reduced or removed from many food products in advance of the FDA's labeling deadline. Fitch believes products that have health and wellness attributes and attractive taste profiles will be in high demand by consumers, and may be the industry's only means of combating negative volume trends.

Increased Pricing Is Illusive 

The packaged food industry's lack of pricing flexibility -- i.e. the inability to raise prices without negatively affecting volume -- stems from several factors, 'every day low prices' market strategy at the retail level, greater buying concentration of the retail trade, and competition from private labels and store brands, which all tend to place a lid on food prices. While most of the packaged food producers face the same cost frontier, branded participants must be ever vigilant in managing the gap in price between their products and private labels or they risk losing market share. The continued growth and strengthening of nontraditional food channels such as supercenters, wholesaler clubs, mass merchandisers, and dollar stores, which all stress low prices, also contribute to the lack of pricing flexibility. These formats have increased their share of food expenditures and taken market share away from traditional grocery stores. Wal-Mart, a major catalyst in retail consolidation, is the largest food retailer in the U.S. and emphasizes 'every day low prices.' Retail consolidation has resulted in greater buyer concentration, which leads Fitch to believe that the retail trade will have a stronger bargaining position over price, marketing support, merchandising, and promotional dollars, and that such power is exercised at the detriment of the packaged food producers.

M&A, Heightened Leverage Buyout Risks

Historically, mergers and acquisitions have unexpected pitfalls, and some acquirers had been challenged to realize cost savings and revenue enhancement forecasts. While credit profiles have gradually improved, packaged food firms have not restored their credit measures to pre-2000 levels following the last round of consolidation. Additional debt-financed M&A activity would significantly weaken the industry's financial profile. Higher leverage due to debt-financed acquisitions not only increases a firm's financial risk but also its business risk by increasing the variability in operating earnings resulting from activities to secure cost savings and assimilate the acquired operations.

Changing Financial Strategies and Weakening Credit Profiles

Fitch downgraded Sara Lee two notches to 'BBB+' from 'A' on Aug. 4, 2005 and downgraded Heinz one notch to 'A-' from 'A' and revised Heinz's Outlook to Negative on June 22, 2005. These downgrades were primarily the result of implicit or explicit changes in the companies' capital structure toward more leverage in the near term. Throughout 2005, companies such as Sara Lee and Campbell's announced plans that will result in increased leverage to optimize their capital structure; concurrently, these firms would spend a substantial portion of their discretionary cash flow on higher share repurchases. However, Sara Lee's leverage is likely to increase near term, while it is executing a sizable share repurchase program. Other firms, such as General Mills, indicated that they have reached their debt reduction goal and therefore would focus on share repurchases. Heinz has indicated that they plan to use a portion of expected restructuring proceeds to increase share repurchases. With debt reduction no longer a priority, credit statistics will weaken -- given pressure on margins, operating earnings, and commitments to repurchase shares. Campbell's has made significant improvements in its credit profile over the past four years, and planned share repurchases are expected to be executed in a disciplined manner and do not have rating implications.

Although ConAgra's credit profile has shown gradual improvement over the past year, Fitch remains concerned about weakness in operating fundamentals and that cash flow from operations at times is inadequate to support capital expenditures and dividends.

The credit profiles of Del Monte and Hormel's Food Corp. continue to improve. However, positive ratings actions for these firms will continue to depend on the evolution of their financial strategies and capital structures with regard to share repurchases, acquisitions, and debt reduction. Fitch believes that longer term both company's credit measures will improve.

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.