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

Business Wire, Dec 6, 2006

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.