Fitch Outlook: U.S. Consumer Products Sectors Have Diverging Outlooks in 2007.
Many companies within the consumer universe have instituted restructurings, improved productivity and have stressed innovation in order to meet changing market dynamics, deal with sustained high commodity costs and limit earnings and cash flow declines from potentially slower growth. Price increases combined with more centralization, less SKU's (stock keeping units), and improved sourcing are all being used to offset continuing high commodity costs even though these are expected to moderate.
While several large acquisitions closed in 2006, including Whirlpool's $2.6 billion purchase of Maytag and Fortune Brands $630 million purchase of SBR, Inc. and its Simonton vinyl window unit, the outlook is for less sizable ones (less than $500 million) in 2007. The wherewithal for consumer companies to complete niche acquisitions without a material effect on financial strength is due to their solid cash positions, improved credit metrics, strong cash flow and generally high debt capacity. Despite the expectation of slowing economic growth, at least in the first half of 2007, earnings and cash flow are expected to remain robust, though some sub-sectors may be flat or have marginal increases.
Overall, ratings are not anticipated to change meaningfully as we enter 2007 as most companies have Stable Outlooks and the ones with Negative Outlooks relate primarily to margin pressure, which is expected to lessen in 2007 as commodity cost pressures moderate. Debt maturities are relatively low for the group, thus debt issuance is not expected to be material in 2007. In addition, many companies have pre-funded upcoming maturities and others are in a debt repayment mode. Reflecting the expectation that consumer companies will maintain reasonably strong credit positions and solid free cash flow, Fitch anticipates most companies to continue to repurchase common stock and pay rising dividends without rating implications. Excessive stock repurchases, significant dividend increases or special large dividends are not anticipated.
It was a relatively quiet year for the industry as several large 2005 acquisitions were digested during the year and other acquisition/divestiture activity was smaller and related to those that made the core business stronger. Thus, 2006 proved to be the year that managements maintained a focus on competition and escalating commodity costs though LBO event risk has crept into the landscape. Further, a torrent of price increases, stepped-up restructuring activity, and ongoing productivity initiatives, were sometimes not enough to offset rising input costs which compressed margins. In the Household Products and Personal Care segment, a medium term trend of declining margins led to Negative Outlooks for several names. The durable sector of the industry had a strong year but near the end has begun to downshift in response to the housing environment. Nevertheless, the companies in the sector remain highly liquid with low leverage and high debt capacity despite commodity based headwinds, higher interest rates and the recent decline in the housing market.
The key trends for 2007 are the commodity outlook, housing's impact, and event risk.
Commodity Outlook: Fitch's view is that except for some base metals, commodity costs while still high, appear to be moderating. Nevertheless, Fitch is cognizant that energy remains a 'wild card' and could provide some volatility to margins as it ripples through the supply chain.
Global oil prices fell 22% between August and October this year. Fitch expects global oil prices to continue drifting downwards over 2007, though at a much slower pace than in the recent past. In addition, the slowdown in GDP growth should ease broader capacity pressures. Pulp is expected to rise slightly but remain relatively flat through 2007 as additional capacity develops in Latin America. Moderate decreases in resin prices are also expected. Zinc, which is used in general purpose batteries, and copper are expected to remain high through 2008 given supply constraints. The battery industry has responded with a price increase to begin in January 2007.
Housing: Housing is in the midst of a fairly severe, probable multi-year contraction. Fitch estimates new home sales and existing home sales for 2006 will decline 18.8% and 8.6%, respectively. A further decline of approximately 7% for both new and existing home sales is anticipated in 2007. For the moment, issues of affordability, excess supply and poor buyer psychology dominate. The economy, for now, is generating reasonable growth, but excess home inventory is troubling. In addition, consumer expectation is that home prices have peaked and buying would be a mistake. This psychology applies to most types of purchasers but especially applies to trade up and second home buyers. Further troubling consumers is the potential for slight to moderate declines in national housing prices over the coming months. Consequently, Fitch expects housing weakness to persist into 2007, which will impact consumer spending on items related to housing turnover, particularly appliances, hard goods and other durable items.
Event Risk: The rated companies in this sector for the most part are investment grade with average equity market capital exceeding $10 billion. Typically, acquisition activity in the upper end of the market has been strategic in nature such as Whirlpool's purchase of Maytag. However, the growing importance and size of private-equity mega funds combined with the buying power of consortiums has made it possible for them to bid for much larger companies historically considered too large for an LBO. Consumer names such as Avon with approximately $15 billion in equity capital and Kimberly Clark with $34 billion have recently been bandied in the business press as candidates for an LBO. Certainly the liquidity is in the private equity market providing the capacity to execute, but event risk is not predictable and would depend on the ability of the investor to get more value out of the firm than the current management team balanced against the share performance at a price that would generate the required rate of return. Nonetheless, it is noted that investment grade names tend to have few covenants that protect current bondholders from additional leverage and/or being pushed down the capital structure.
Household Products and Personal Care
Fitch anticipates that this mature industry will continue seeing low to mid single digit organic volume growth. Much of the price increases of late 2005 and the first half of 2006 will anniversary next year. However, top line growth should be bolstered by positive mix effects from a successful trade-up strategy and by a spattering of late 2006 and early 2007 price increases related to continued escalations in metals, particularly zinc, and in categories with dominant shares. Of note, while higher pricing had a positive effect on the top line for many companies, it also caused spot volume declines in certain products or markets during 2006 for Clorox, Kimberly-Clark and Spectrum Brands. Participants expect that consumers will return after the 'sticker shock' wears off and pantries are de-loaded. If history proves correct, companies such as Clorox, which experienced declining volume growth vis a vis historical levels, should see a rebound in this key measure. Stellar growth levels outside the 3%-6% range will depend on further international market penetration or acquisitions. Large strategic acquisitions are not expected except for P&G which expects to derive at least 4% of its 9%-11% revenue growth rate from acquisitions in 2007.
With a moderating commodity environment, margins and cash flow should improve. In fact, P&G recently raised its outlook for the bottom line based on a better commodity and energy cost environment for the balance of its fiscal year with fiscal 2007 operating margins expected to improve by 100bps with less commodity cost increases. Absent event risk, companies such as Clorox and Kimberly Clark which have tended to be more heavily exposed than their peers to resins, pulp and energy and who are in the midst of cost control programs, should see an improvement in their credit metrics.
Key concerns in a moderating commodity environment that may apply to the latter half of 2007 are whether improved cash flow will lead to increased shareholder friendly activities, larger investments in brand support activity particularly in light of competitor responses, or a potential for price rollbacks if retailers see marked expansions in margins. All or any of these activities initially dampens cash flow.
Despite the expected moderation, commodity costs remain high and are volatile. There will not be a direct flow to margins due to the lag effect caused by contractual buying or hedging arrangements. Thus, while there should be less pressure on margins large improvements are not expected to the extent that might attract retailer attention and thus calls for price-rollbacks.
The competitive arena, particularly private label, should also serve to keep the price gap and thus margins in check. There is most likely to be a step up in competitive activity in the form of advertising or trade support. Each competitor will have to determine how much price disparity or erosion of share they will allow. It has been noted that Clorox's competitors in the trash bag space, in anticipation of resin price decreases, are increasing their trade support such that the price gap between Glad and Hefty has widened. Clorox will defend its brand.
Dividend and net share buybacks for the rated companies in this space has grown at a four-year CAGR of 6.6%. Totaling $5 billion through the last twelve months ended September 30, 2006, it is expected that the amount will remain high and continue growing in the mid to high single digits due to the industry's significant and stable cash flows. As in the past, Fitch expects that the participants will continue to exhibit sound financial policies to maintain their investment grade rating. For this sector we do not expect marked changes in current ratings.
The industry has a number of negative dynamics such as low barriers to entry, increasing seasonality particularly in profitability and fashion risk. Traditional toys have also been in a slow decline for a number of years, as age compression shrinks the size of the domestic market for these toys. However, it is important to note that the two largest industry participants have been able to achieve growth through international market penetration which is a significant part of total revenues. The key to long term survival and success in this industry are a broad and diverse product portfolio, strong R&D and brand support and a very clean balance sheet with strong liquidity. We expect that Mattel and Hasbro's product portfolio and strong balance sheet with high cash balances will serve to insulate them from current industry dynamics.
Mattel has experienced negative operating trends for the past three years due to a change in product mix as the more profitable Barbie line has declined along with escalating commodity costs. Both Hasbro and Mattel should be solid performers in 2007. Mattel should benefit from some recent stability in the Barbie line and improving margins as commodities, particularly resin moderate. Hasbro's top line upside is due to a slate of four entertainment releases in 2007 one of which, Transformers, is their own property and which requires no royalty payments. Both companies have very strong credit metrics relative to their rating. However, tempered by industry dynamics with some level of top line variability, we look at these companies with a long term view which smoothes out volatility particularly those related to movie releases, thus little change is expected in the ratings during 2007.
Appliances and Home and Hardware:
2007 will begin on a difficult note with the lower growth prospects of the U.S. economy weighting negatively on potential results. GDP growth has slowed and is expected to remain below trend, particularly in the first half. This is driven in large part by residential construction, which is down in 2006 and expected to fall further in 2007. In addition, the housing market correction, where new home sales and existing home sales are forecasted to decrease approximately 19% and 8.5% in 2006 and fall another 7% respectively, in 2007, will affect sales of housing-related materials including hardware and tools. The growth rate for residential alterations and repairs will slow considerably but still remain in positive territory.
For the companies in this sector, repair/remodeling spending is more important to overall results than residential construction. While slowing residential construction and housing turnover will negatively impact demand, modest growth in spending is still expected for alterations and repairs and non-residential spending is anticipated to remain fairly strong. This should provide a buffer to expected weakening in revenue for the industry. Nonetheless, volumes are expected to be flat to down for most of 2007, particularly for appliances. Pricing actions taken to mollify commodity inflation should deflect the impact from declining volumes lessening the hit to the top line.
High commodity costs have had a significant effect on profits causing price increases throughout 2006. These have not generally been sufficient to cover increased material and energy costs. In 2007, moderating commodity costs, price increases, productivity improvements and product innovation should offset lingering higher raw material costs.
While the housing slowdown will affect top and bottom line results, Fitch does not expect excessive pressure on earnings and cash flow. Whirlpool (WHR), in the midst of integrating Maytag, is expected to achieve substantial savings in 2007 from the integration, benefit from price increases and continue to successfully introduce innovative new products. Fortune Brands (FO) should benefit from its business diversification, targeted price increases and the fact that its faucets and cabinets that rely on new home construction are used late in the construction cycle. Commercial building activity, higher prices, and productivity enhancements are expected to mitigate the impact from the housing market for Black & Decker (BDK).
Limited rating actions are anticipated in 2007. Companies within this sector have stable or positive rating outlooks other than Jacuzzi Brands, which is on rating watch negative due to its pending sale. Operating performance in the face of a continuing challenging environment and slowing economic growth will be critical to ongoing rating assessments. Fitch expects credit fundamentals to remain fairly strong despite pressure on the top line and on profitability. Sizable acquisitions and/or material stock repurchase activity are not anticipated. Both WHR and FO are paying down debt. BDK has spent significantly to repurchase stock in 2006. It is expected that its management will remain prudent in the face of current challenges. Debt issuance should be minor in 2007 as FO and WHR put in place long-term financing in 2006 and BDK recently issued $300 million of long-term notes.
Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs) in the U.S. consumer sector.
Household Products and Personal Care:
--Alberto-Culver ('A-'; Outlook Stable);
--Avon Products, Inc ('A'; Outlook Negative);
--The Clorox Company ('A-'; Outlook Negative);
--Colgate-Palmolive Co. ('AA-'; Outlook Stable);
--Kimberly-Clark Corp. ('AA'; Outlook Negative);
--Newell Rubbermaid Inc. ('BBB'; Outlook Stable);
--S.C. Johnson & Son, Inc. ('A-'; Outlook Stable);
--Spectrum Brands, Inc. ('CCC'; Outlook Stable).
--Hasbro, Inc. ('BBB'; Outlook Stable);
--Mattel, Inc. ('BBB'; Outlook Stable).
Appliances and Hardware:
--The Black & Decker Corp. ('BBB'; Outlook Positive);
--Fortune Brands, Inc. ('BBB+'; Outlook Stable);
--Jacuzzi Brands, Inc. ('B+'; Rating Watch Negative);
--Whirlpool Corp. ('BBB'; Outlook Stable)
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|Date:||Dec 6, 2006|
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