- Industry fundamentals in the current cycle remain healthy but 2021 performance could be difficult compared with last year's strong performance
- The pandemic has heightened some ESG components like workplace safety social risks, while long-term sustainability goals increasingly require more attention
- Lower leverage for most companies provides cushion to pursue M&A, which will likely be smaller and more targeted
- Upgrades outpaced downgrades since the pandemic's onset and the trend will likely continue in some regions
Agribusiness performed surprisingly well last year as the pandemic deflated commodity input costs while customer pricing remained firm. Despite the possibility of additional industry consolidation through mergers and acquisitions (M&A), and pandemic-related hurdles (including key emerging social risks affecting workplace safety) still impeding some segments, many companies have sustained lower leverage. These and other favorable credit characteristics led S&P Global Ratings to upgrade some agribusiness companies or at least revise outlooks to stable last year. We believe this momentum will continue into 2021. Here, we discuss the risks and opportunities influencing the agribusiness sector, and subsequently, our ratings.
Ratings Trends Are Stable To Positive
Agribusiness companies have been demonstrating good operating discipline, allowing them to navigate supply chain disruptions and commodity price volatility. These achievements resulted in mostly positive rating actions and outlook revisions this past year. Since the onset of the pandemic in the Western Hemisphere, we've upgraded three companies in the sector with no downgrades. During this period, we've also revised about a quarter of our rating outlooks favorably, mostly to stable from negative. These actions reflect our expectation for generally favorable industry trends in 2021, albeit with a difficult comparison to 2020 (see charts 1, 2, and 3).
Some Sector Outlooks Bode Well For 2021
Grain originators face a difficult comparison to 2020 despite a positive outlook for global oilseeds and feed once global economic activity rebounds The thawing of the U.S.-China trade war, a strong U.S. dollar, and a large South American harvest enabled grain originators and processors to generate significant EBITDA growth in 2020. Companies like Archer Daniels Midland Co. and Bunge Ltd. posted double-digit EBITDA growth in 2020 and we expect similar growth rates for peers like Cargill Inc. and Louis Dreyfus Co. B.V. Although global demand for oilseed and animal feed remains strong while demand for other grains like corn used for packaging remains healthy, commodity costs will be higher in 2021, likely pressuring origination and processing margins. Corn prices for the 2020 crop spiked above $5.00 and soybean prices increased by double digits with strong Chinese oilseed demand (see chart 5), notwithstanding the growing likelihood of a bumper Brazilian soybean harvest. The higher grain and oilseed prices will likely result in lower U.S. crush margins compared with last year (see chart 4). In addition, higher corn-feedstock costs for ethanol and biofuels will keep margins tight while renewed lockdowns in Western Europe will delay a rebound in biofuel demand. Adding to the commodity inflation, are recent supply chain disruptions, including recent transportation dislocation from cold weather in the US and a shortage of shipping containers as China's exports volumes rebound.
Protein processors will likely benefit from strong global protein demand, particularly from China, while lower COVID-related costs and strong pricing should offset margin pressure from higher feed and livestock costs in some regions. The outlook for global protein exports remains strong and will continue to support healthy pricing and trade, particularly out of South America where our ratings outlook is modestly positive. China has been rebuilding its hog herd following the African Swine Fever (ASF) pandemic in 2018, and the high hog prices in there continue to require large capital expenditures (capex) to restore capacity, partly financed by debt. A strong hog herd recovery may enable China's hog production to reach pre-ASF levels over the next 12 to 18 months (see chart 6). This could lead to hog-price normalization, including a possible 30%-40% drop in hog prices by late 2021 or early 2022 from an elevated US$5.00 per kilogram as of December 2020. We estimate such a decline would only return prices to the peak levels reached prior to the 2018 ASF onset. Leading hog producers like Wens Foodstuff Group Co. Ltd. are likely to sustain low leverage thanks to protein diversification and volume growth offsetting any near term hog price decline. The current price correction could create a liquidity crunch for many smaller, overexpanded domestic producers in the still fragmented Chinese hog industry, but global trade would likely offset any disruption in domestic production.
Input cost inflation for meat processors will be somewhat challenging next year because China's demand increased livestock prices as well as feed costs, particularly corn and soybean meal, which increased by 20% and 40%, respectively, since the 2020 U.S. harvest (see chart 7). Higher cattle and pork prices in South America shifted consumer demand to poultry where wholesale pricing is strong and the produce mix is more skewed to higher-margin processed offerings. These benefits will partially offset higher feed costs.
Cutout margins in mature markets like the U.S. aren't likely to be as strong this year as last, when there was a glut of livestock on farms, depressing animal costs. The oversupply stemmed from temporary plant shutdowns designed to contain COVID-19 outbreaks in the labor force. Still, livestock supplies (particularly cattle) remain plentiful and we can expect fewer one-time COVID-related operating expenses and processing disruptions this year compared to last, which combine to support a favorable margin outlook. Meat packers like Smithfield Foods Inc., Pilgrim's Pride Corp., Simmons Foods Inc., and Tyson Foods Inc. incurred unprecedented one-time COVID-related costs in 2020 (more than $800 million and $500 million in Smithfield's and Tyson's cases), the bulk of which were employee bonuses. Manufacturers also had to shift production from foodservice to retail offerings, which caused margin pressure from repurposing production for the product mix shift toward retail. While personal protection equipment (PPE) will remain an ongoing expense, COVID-related costs in 2021 are likely to drop by more than 20%. This will likely benefit beef and pork processors more than chicken processors, because vertically integrated operations face higher feed costs with the run up in corn and soybean meal prices considering last year's U.S. corn crop shortfalls and a rebound in Chinese soybean imports (see chart 8).
The outlook for sugar and ethanol processing varies by region, with Europe still downsizing but Brazilian producers are enjoying record high prices in local currency and a smaller Brazilian harvest is further brightening the outlook.
Europe. We don't see a sharp increase in earnings for European sugar producers in 2021 because of still subdued volume demand in away-from-home and foodservice channels through at least the first half of the year. We're also cautious about prospects for a good harvest after several summer droughts and a devastating pest attack (due to the ban on insecticides like neonicotinoids) diminished beet yields last year. Ongoing profitability pressures will likely lead to more industry consolidation with less efficient factories closing down.
Brazil. The ratings outlook for the sugar sector in Brazil is more favorable. A strong Brazilian sugar harvest in the central south region coupled with weak Indian sugar production last year and a strong U.S. dollar enabled Brazilian sugar mills to produce sugar profitability in 2020 and offset the impact of pronounced weak ethanol demand from mobility restrictions (see chart 9). Profitability should further improve into 2021 because we expect the 2021-2022 sugarcane harvest to decline more than 5% while supply chain restrictions have kept Indian and Thai sugar trade depressed. Moreover, domestic ethanol margins will likely rebound as mobility restrictions are lifted, boosting pricing and enabling companies to increase already positive free operating cash flow.
After revising the rating outlook on many Brazilian issuers to stable from negative in the beginning of the pandemic, we've taken additional positive rating actions. Ratings may continue to benefit from renewed equity investor appetite in the sector that could allow companies to reduce leverage through equity offerings. For example, Brazilian organic sugar producer Jalles Machado S.A. just completed a BRL590 million equity offering on the Sao Paulo stock exchange, which led to an upgrade amid bolstered liquidity and lower leverage.
Dairy markets in mature markets may need more time to heal, but good demand in Asia has propped up prices.
North America. Dairy market dynamics remain quite regional in mature markets such as North America and the Eurozone. In North America the industry is undergoing consolidation as fluid milk consumption continues to lose share to other nondairy alternatives, such as plant-based beverages, despite strong growth in other dairy categories, particularly cheese and energy beverages. To that end, the U.S.'s largest milk processor Dean Foods Co. remains in bankruptcy, but most of its asset have already been acquired by Dairy Farmers of America Inc. The company will likely face limited integration challenges and should leverage those assets at a lower cost base post bankruptcy to restore EBITDA and deleverage.
Europe. The European industry had been lapping the impacts of deregulation that led to a supply glut. It then faced additional pricing weakness because of less import demand from China. Nevertheless, global competition for exports to China continues to weigh on Eurozone dairy companies such as Koninklijke FrieslandCampina N.V., whose prospects for improved export volumes are, in part, tied to the pandemic's end. Powder pricing is trending higher because the industry has kept production levels down from their 2018 highs when the Eurozone deregulated. Increased dairy pricing should lead to improved performance, albeit at a slow pace, given still depressed food service demand will take time to rebound. As such, we continue to have a modestly negative ratings bias for companies in the dairy segment in Europe and the North America.
Asia-Pacific. China's aggregate demand for dairy products continues to grow, spurred by rising health awareness while the pandemic has pushed up local raw milk prices as well as international powdered milk prices since the second half of 2020 (see chart 10). Despite expected declining birth rates for the next several years, imported powdered milk still serves as a useful cost-control tool for local Chinese dairy producers. As such, we expect rising local raw milk prices to drive import of international powdered milk given the ongoing milk undersupply in China.
Workplace safety is a key social risk that came to the forefront for protein processors at the onset of the pandemic and could become more substantial if regulatory scrutiny increases. Food processors, primarily pork and beef packers in North America and Brazil, faced significant disruption and social scrutiny for workplace conditions at the start of the pandemic. Several plants across the world were plagued by workforce COVID-19 outbreaks and were forced to temporarily halt production to prevent spread and to properly sanitize their plants against the virus. Although the shutdowns proved temporary as maintaining a stable food supply for consumers remained a societal priority, the margin impact was substantial for many. Companies in the U.S., for example, saw plant-operating costs skyrocket by double digits. Moreover, reputation risk and litigation for labor malpractice is now elevated. For now, litigation appears to be well mitigated as several players have settled recent cases with manageable payouts while not admitting guilt. Although the monetary damage has been limited to a mostly temporary spike in manufacturing costs, longer-term repercussions could weigh on the industry, particularly if government and regulatory bodies take a more aggressive posture toward safety, regulation, and penalties for food and employee safety breaches.
Environmental risks are becoming increasingly important for the sector with land and water use management being critical for sustainable harvests. Key environmental factors for agribusiness are underpinned by land and water use concerns, which will become bigger risks to sustainable production over the next 10 years compared to the past. Historically, ample land and water availability coupled with technological advancement in farming (including seed and fertilizer innovation, farm equipment automation, and use of satellite technology for more efficient agronomy) have enabled increases in harvest yields. These benefits may start having diminishing returns, particularly as countries look to curb deforestation and more closely scrutinize water use (see chart 11). Although we currently factor volatility into our ratings, and don't anticipate an increase in rating risk due to heightened volatility over the next three to five years (apart from the typical periodic regional supply shocks the industry faces), land and water scarcity are becoming more of a 10- to 20-year concern rather than a 50-year one. The Amazon's ongoing deforestation, for example, is a significant land-use risk that we can't ignore, while aquafers that supply key Midwestern U.S. farm regions too are showing signs of strain. As such, companies are becoming more specific about their sustainability goals to meet growing demand without undue cost increases because of resource scarcity or more frequent occurrences of supply disruptions. Marfrig Global Foods S.A. and JBS S.A., for example, announced a full monitoring of its supply chain over the next five to 10 years to avoid cattle sourcing from the Amazon biome. Well-defined sustainability goals will also be important to ensure a viable competitive position in the market both from a consumer awareness and regulatory standpoint.
Some Consolidation Expected
Moderate leverage and a focus on core operations suggests M&A activity likely will be modest and not pressure ratings. M&A was mostly muted last year as companies prioritized consolidating and improving core competencies, including accelerating divestitures, which may continue for companies that have had subpar operating performance in categories where they don't have a competitive advantage. Otherwise, a generally good operating year has reduced leverage for many issuers, affording companies dry power to invest in growth without much pressure on credit measures (see chart 12).
We expect M&A to pick up somewhat this year, but it will remain largely regional. In Europe, we see potential for some M&A deals with stronger or low levered companies buying the good assets of weaker companies. For example, diversified French cooperative Invivo (not rated) is in talks to buy French barley processor Soufflet (not rated). Some sectors, such as grain origination and processors, appear ripe for a consolidation wave but aren't likely to turn to transformation consolidations for their growth; not least of which because of antitrust hurdles. An exception could be the Brazilian sugarcane sector. After many years of anticipated consolidation being thwarted by weak industry performance, consolidation in this very fragmented industry is finally taking hold. Raízen S.A. (not rated) just announced the acquisition of Biosev S.A. (the third in capacity), Jalles will use the IPO to acquire a small mill, and Bunge and BP PLC formed a joint venture one year ago that became the third largest in crushing capacity. We also anticipate rising M&A risks in the Chinese dairy sector as consolidation of upstream dairy producers continues.
The rest of the sector is more likely to continue looking for internal capex projects (e.g., to modernize or expand critical infrastructure to source or distribute commodities) and smaller more targeted M&A to tap into growth areas such as plant-based protein for grain and ingredient manufacturers and geographic expansion into still fragmented Asian economies in protein. Most of these opportunities would be fairly small in size and pursued primarily by larger competitors, which tend to be investment grade. The deals would likely only cause a temporary increase in leverage, from which they would be able to quickly deleverage back to long-term targets within a year. In short, to the extent the pandemic comes under control sometime in 2021, most companies will probably resume a combination of growth capex and modest size strategic M&A into faster-growing areas, which isn't likely to materially change many leverage profiles in our rated universe.
S&P Global Ratings believes there remains high, albeit moderating, uncertainty about the evolution of the coronavirus pandemic and its economic effects. Vaccine production is ramping up and rollouts are gathering pace around the world. Widespread immunization, which will help pave the way for a return to more normal levels of social and economic activity, looks to be achievable by most developed economies by the end of the third quarter. However, some emerging markets may only be able to achieve widespread immunization by year-end or later. We use these assumptions about vaccine timing in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
This report does not constitute a rating action.
|Primary Credit Analyst:||Chris Johnson, CFA, New York + 1 (212) 438 1433;|
|Secondary Contacts:||Flavia M Bedran, Sao Paulo + 55 11 3039 9758;|
|Maxime Puget, Paris + 33(0)140752577;|
|Flora Chang, Hong Kong + 852 2533 3545;|
|Maurice Bryson, Dublin;|
|Shannon Slough, New York + 1 (212) 438-0971;|
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