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When The Cycle Turns: Spanish Consumer Goods Companies See Tougher Times Ahead

Increased costs, intense competition, and several strategical missteps. That was the year 2018 for two big Spanish consumer companies that S&P Global Ratings covers, DIA (CCC+/Negative/--) and Deoleo S.A. (CCC+/Stable/--), which triggered falling credit metrics and then negative ratings actions.

On Oct. 15, DIA announced a profit warning after suffering margin erosion due to stiff price competition in the Spanish market, especially from the No. 1 retailer Mercadona. What's more, strategic slip-ups, high restructuring costs, and financial missteps resulted in weak top-line performance and dented overall creditworthiness. Meanwhile, Spanish olive oil bottler Deoleo faced tough competition in the U.S. where its premiumization strategy is facing hurdles because of the company's inability to lure customers. Furthermore, Deoleo's margins have been narrowing in response to new highs for volatile olive oil prices since 2017.

Although some of these challenges are unique to DIA and Deoleo, especially the strategic missteps, we believe the Spanish consumer goods sector overall will face more difficult operating conditions in 2019 and 2020, namely, weaker economic growth and rapidly changing consumer preferences. We expect Spanish consumer confidence will decline in coming years and push manufacturers to focus much more closely on price cliffs while rapidly changing consumer tastes in the country--toward convenience, experiences, and healthier options--will likely test logistics, and pricing and product differentiation. Due to their exposure to economic cycles, Spanish companies in the consumer goods sector in our view will have to build sufficient buffers to maintain or improve their current creditworthiness in 2019 and 2020 as the economy slows. Yet, some opportunities are likely to surface for Spanish consumer goods companies that can offer a broader range of price points for their products and with geographically diversified operations.

Solid economic growth is set to soften in upcoming years

Following three years of strong economic recovery, signs of a deceleration are starting to surface that are likely to mean weaker conditions for Spanish consumer goods companies. We expect economic growth in Spain to slow further in coming years as slack diminishes and GDP converges to its potential growth rate. Lower employment growth, offset by stronger wage growth, and somewhat higher inflation of 1.9% annually (according to our forecasts) will translate into slower gains in Spanish consumer purchasing power.

This slowdown is set to translate almost one to one into less dynamic consumer spending as they are likely to start to save more; the savings rate has consistently dropped since the financial crisis to just below 6% of disposable income in 2017, well below its historical average of 9.5%. In the short to medium term, households are likely to seek higher purchasing power through consumer credit, as they have done since 2016. However, the Spanish government has included a measure in the budget to boost the minimum wage to €900, which if approved, could help purchasing power. Indeed, banks continue to report an easing in credit and rising demand for consumer loans other than for the purchase of a house. That said, an increase in the cost of funding due to the normalization of the European Central Bank's monetary policy from the end of 2019 should prevent consumer credit from rising at the same pace as in the past three years. Overall, we expect the Spanish economy to grow by an average annual 2.2% from 2018 to 2021, at rates above the eurozone average, a testament to the strength of underlying economic growth fundamentals.

Chart 1


Purchasing power could weaken further if job creation slows more than we currently expect. If unemployment levels remain at their current level, this could lead to more subdued wage growth and limit gains in household disposable income. Spanish unemployment remains very high at 15.3% in the second quarter of 2018, the second highest in the EU after Greece, and especially among youth (15-25 years old) at 36.8%. If purchasing power increases only marginally, growth prospects could be slim for premium innovative products. That said, discounters could benefit from an uplift in sales if consumers trade down to lower-priced products to preserve their spending power.

Chart 2


Tighter financing conditions are likely to soften consumer credit growth and increase refinancing risk for Spanish consumer goods companies

Consumer credit has helped support the recovery in Spanish domestic consumption since 2016. Just in 2017, credit to Spanish consumer grew by 14.7%, double the rate observed in the eurozone. This buoyant growth can be explained by:

  • Accommodative financing conditions that allowed many Spanish households to increase their access to credit since 2014, despite facing a higher cost of funding versus the eurozone average. Spanish households have seen average interest rates on consumer credit fall to 8.7% in 2018 from about 10% in 2012.
  • First and foremost, strong economic and employment growth experienced by Spain in recent years.

Now, with decreasing growth prospects and monetary easing coming to an end, we expect growth in consumer credit to revert back to more moderate levels. Given a low savings rate, Spanish consumers are also more likely to favor savings instead of consumption.

Chart 3


Similarly, tighter financing conditions could also lead to rising refinancing risk among Spain's highly leveraged consumer goods companies. Currently, access to credit remains good in light of still low interest rates. Spanish companies have been able to tap the markets and refinance debt in the consumer goods sector in recent years. However, the tightening of refinancing standards that should come with ECB rate hikes from the third quarter of 2019 may mean that the cost of refinancing will rise gradually for Spanish corporates. Hence, investment decisions are crucial now since debt-financed acquisitions and capital expenditures plans will be more expensive from the end of 2019.

Finally, global trade tensions and increasingly protectionist policies remain as major threats to the outlook for Spanish consumer goods companies, given that many of them are heavily export-oriented. Brexit risk remains a major source of concern because the U.K is Spain's fifth-biggest export destination. Any imposition of tariffs or nontariffs barriers on trade may disrupt the well-established supply chain and distribution channels of Spanish consumer goods companies with the U.K. In the consumer goods space, we expect Spanish agribusiness firms to feel the brunt due to its exposure to the U.K. For instance, exports to Britain from this sector amounted to just over €3.3 billion and represented about 17% of total exports from Spain to the British territory in 2017, only second to the automobile industry. Please refer to "Countdown to Brexit: No Deal Moving Into Sight," published on Oct. 30, 2018.

Chart 4


The risks and opportunities coming of the changes to come

It's losing some steam, but Spain remains the fastest-growing economy in the eurozone, which should continue to support overall credit conditions. We note that a few sectors are holding up well. For example, we expect the increasing activity and investment volumes in the Spanish real estate sector to spark higher sales in home appliances, furniture, and kitchen products. And, activities related to tourism, which is trending up, should continue to benefit, including lodging and restaurants, and as result, food and beverages, which in turn would support soft drink companies like Coca-Cola European Partners PLC (BBB+/Stable/A-2). Furthermore, and despite being a Mediterranean country, we see beer consumption in Spain continuing to grow above that of wine as younger Spanish consumers shift away from traditional alcoholic drinks toward craft and premium beer products.

Still, we note that Spanish consumer goods companies will have to cope with big changes as consumers are becoming increasingly drawn to healthier alternatives, environmental issues, and digital shopping, for instance. In our view, these changes creates risks and opportunities for players in the market. In packaged food and personal and home care, the main risk for local companies comes from huge investments that multinationals are making in innovation to refresh their products, also thanks to the acquisition of local brands. When it comes to "local" preferences, we believe that Spanish companies can have a natural advantage if they can meet the need for innovation when it comes to natural products and plant-based alternatives, for example.

We also see risks and opportunities in digitalization. Thanks to the digitalization of sales and distribution, the barriers to entry for new brands are significantly lower, but at the same time the number of competitors is potentially higher. Traditional brick and mortar retailers are reducing their average shop size and dedicating the space only to successful products that increase traffic. In line with the rest of Europe, we also expect the share of private-label food penetration to increase in Spain in years to come, opening up opportunities for companies willing to work with retailers but at the same time increasing the competition for branded players. Finally, we believe that Spanish agribusiness corporates are likely to face higher operating costs due to worsening weather conditions in the coming years, exacerbating scarce water resources. Spain is to be one of the countries most affected by climate change, according to European Environment Agency.

Internationalization as a route to success

In light of the expected deceleration of the Spanish economy and softening of domestic household consumption, we believe Spanish consumer goods companies could benefit from expanding international operations. Following the 2008 financial crisis, many Spanish corporates, including the ones in the consumer goods sector, found growth opportunities abroad, as shown by solid growth in Spanish exports over the last five years, which represented more than 30% of Spain's GDP each year.

In our view, internationalization would not only bring higher long-term volume growth, but also diversification of customers and markets for a more balanced business model. Similarly, by further expanding their customer base, we think Spanish consumer goods companies could reduce their reliance on consumer credit growth in Spain for increasing demand. For instance, Planasa (Placin Sarl, B/Stable) is a producer of berry plants, with a focus on breeding and nursery activities. The company is based in Spain, but has production facilities in Morocco, the U.S., Mexico, and its customers (berry growers) are based all over Europe and North America. The diversified geographic exposure helps the company to mitigate the risks associated with operating in a business affected by weather conditions and agronomic cycles, as well as limit its dependence on the Spanish market. In a very different segment, we note that Pronovias, the bridal wear designer, aims to grow more in the U.S., the world's largest bridal market, by selectively opening new stores. Earlier this year Pronovias acquired an Italian bridal company to strengthen its international position.

Chart 5


We have also monitored other major unrated Spanish consumer goods groups and found a similar internalization trend. Mahou San Miguel, one of the biggest players in the Spanish beer sector, in 2017 acquired a 33% stake in U.S. craft beer brand Avery Brewery and in 2016 signed an agreement with C&C Group to produce and distribute beer in India. Furthermore, Mahou San Miguel is currently preparing to re-enter the Chinese market with its brands Mahou and Alhambra, because of the expansion of the country's premium beer market. Ebro foods, the leading Spanish food company in revenue, which generates more than 90% of its turnover outside of Spain, partly through stakes in Bertagni (70%) and Geovita (52%), continues to increase its investment in its Tennessee plant in the U.S. given the popularity of its microwaveable rice product offering among U.S. consumers. Finally, Calidad Pascual, Spain´s largest dairy manufacturer, reached an agreement with Alibaba Group to introduce its yogurt products into China and continues to build alliances with international partners to reinforce its supply chain.

Market dynamics are pointing toward internationalization as a global strategy, conquering emerging markets and confirming historical positioning in developed markets. In our view, the strategies of Spanish companies are no exception to those of European companies, which are introducing value brands in emerging markets and premium products, mostly plant-based and healthier alternatives, in more developed markets.

No time to rest on your laurels

Spanish consumer goods companies will have to adapt to what seems to be a changing domestic economic cycle. Credit conditions are likely to tighten and the strong consumer demand of the last five years is set to soften. This, coupled with international trade tensions and continued tensions between the Spanish central government and Catalonia, adds up to tougher operating conditions for Spanish corporates in the consumer goods sector. In addition, changes in Spanish consumption trends towards convenient, trendy, and healthy food options will mean that companies will have to be responsive to maintain their competitive edge. What's more, we believe Spanish consumer goods companies will need to build buffers and continue their internationalization efforts to successfully deal with potential domestic shocks of the future.

This report does not constitute a rating action.

Primary Credit Analyst:Manuel Vela Monserrate, Madrid + 34 914 233 194;
Secondary Credit Analysts:Barbara Castellano, Milan (39) 02-72111-253;
Maxime Puget, Paris (44) 20-7176-7239;
Economist:Marion Amiot, London + 44 20 7176 0128;

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