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Some U.S. Consumer Products Companies Could Fail The Inflation Stress Test

Just as the pandemic seemed to be subsiding and the U.S. consumer products industry expected some return to normalcy, new challenges emerged or intensified including supply chain constraints, labor shortages, the delta variant, and rising commodity prices. Fortunately, so far, S&P Global Ratings doesn't think the delta variant has had much of an effect on consumer behavior--at least not enough to damage the sector's credit quality. Higher labor, freight, and materials costs, on the other hand, are pressuring margins for many issuers and we don't expect much relief in the coming year. Much of the pricing pressure is being passed to the consumer (see chart 1).

Chart 1

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Our ratings reflect significant inflationary pressure at least for the next several quarters and then a gradual abatement as supply and demand return closer to historical levels. However, we're watching closely for signals that suggest inflation will become entrenched because we believe this would threaten credit quality for many consumer products companies. Here, we examine the impact of potentially greater inflation on the ratings of select consumer products issuers.

Inflationary Stress Test Assumptions

To stress test issuers that could be exposed to higher inflation, we designed a hypothetical scenario that consisted of a simple broad-based assumption of 500 basis points in additional costs for one year for a select group of issuers. We then considered two offsets that companies would likely be able to implement: reducing costs elsewhere in their operations and raising prices. On a case-by-case basis, we estimated the portion of the additional inflation each issuer would be able to offset, from either cost offsets or passthroughs. In cases where we believed passing on costs could hurt volumes, we adjusted revenues accordingly. We then compared the resulting credit metrics to the respective downgrade or outlook revision threshold to determine if a negative rating action would be likely, holding all else equal, for the issuer.

The stress test was designed to be a simple "what if" scenario that communicates our view of the vulnerability of select issuer ratings to additional inflation. For this reason, we limited the offsetting actions to operational strategies. If a similar spike in inflation became reality, we would expect many companies to pull additional levers to protect their balance sheets and cash flow; for instance, by optimizing inventory, reducing investments and capital expenditures, and pausing share buybacks.

We intentionally chose issuers that we believe could face a downgrade or negative outlook revision. For instance, issuers who are already facing high inflation, or issuers whose credit metrics are approaching our downgrade threshold. Of the 21 issuers, we rate 12 investment grade and nine speculative grade. We included six companies with negative outlooks. The sample represents most subsectors of consumer products: packaged foods, household products and personal care, apparel, durables, and one each in beverage and commodity foods and ingredients.

Stress Test Results Vary

The stress test resulted in potential negative rating actions for slightly more than half of our sample of 21 companies: seven could face a downgrade and we could revise the outlook on four to negative from stable or to stable from positive. Ratings and outlooks on 10 companies were unaffected under our stress test scenario (see table 1). Most of the hypothetical downgrades were of speculative-grade ratings. Two thirds of the issuers whose ratings and outlooks remained the same were investment grade. Of the six companies with negative outlooks, four were potentially downgraded. Of the three with positive rating outlooks, two were potentially revised to stable or negative.

Table 1

Inflation Stress Test Results Summary
Company Subsector Rating as of Sept. 24, 2021 Downgrade or outlook revision threshold Potential rating action Comments

Campbell Soup Co.

Packaged foods BBB-/Positive/A-3 high 3x Revise outlook to negative Although we believe Campbells could offset part of the inflationary pressures, the impact would likely lead to a lower probability of achieving metrics appropriate for a higher rating within the next two years.

Clorox Co.

Household products & personal care A-/Stable/A-2 >2.5x Downgrade Clorox is already facing headwinds of cost increases to the tune of a 400 basis point hit to its gross margin. We believe this leaves the company vulnerable to additional inflationary pressure which could result in a lower rating barring other actions that preserve credit metrics such as pausing share buybacks.

Conagra Brands Inc.

Packaged foods BBB-/Stable/A-3 4.5x Revise outlook to negative Conagra already faces extraordinary inflation, about half of which it expects to offset with efficiencies and passthroughs. We believe it may be able to pull more levers in these areas but not enough to prevent credit metrics from rising to a level that would pose risk to the rating.

Crocs Inc.

Apparel BB-/Stable >3x debt/EBITDA None Even if Crocs were unable to offset the impact of the additional inflation, its credit measures would remain within an appropriate range for the rating.

Edgewell Personal Care Co.

Household products & personal care BB/Stable 4x Revise outlook to negative We believe Edgewell could take modest pricing action and cost savings initiatives to partially offset higher commodity, labor and transportation costs that would result in leverage rising temporarily to above 4x, posing risk to its rating.

General Mills Inc.

Packaged foods BBB/Stable/A-2 4x None General Mills is already facing extraordinary inflation. We expect the company to be able to offset 700-800 basis points of cost increases with cost reductions in the coming fiscal year. If additional pressures materialized, we believe leverage could approach 4x temporarily before additional savings and price increases take effect. We would also expect the company to take actions that reflect its financial policy, such as reducing share buybacks.

Hanesbrands Inc.

Apparel BB/Negative >4x Downgrade Although we believe Hanesbrands could reduce operating expenses and raise prices modestly, it has limited room at the current rating for underperformance.

Herman Miller Inc.

Durables BB+/Stable 3x Downgrade Herman Miller has limited hedging in place and relies on pricing to pass on inflation, which we believe would only cover part of the inflation in our hypothetical stress scenario. We would likely downgrade unless the company could preserve its credit measures by pulling other levers such as finding additional Knoll merger synergies or delaying capital expenditures.

Hormel Foods Corp.

Packaged foods A/Negative >1.5x Downgrade In our view, Hormel wound be challenged to offset higher input cost inflation, such as for pork, and would breech downgrade trigger given its current limited leverage headroom after its recent acquisition of Planter's.

International Flavors & Fragrances Inc.

Commodity Foods BBB/Negative/A-2 >4x Downgrade We believe IFF would be able to pass on about one third of the incremental inflation through higher pricing but that the net impact to margins would cause leverage to rise and the company would be challenged to return leverage below 4x in a timeframe appropriate for the rating.

The J.M. Smucker Co.

Packaged foods BBB/Stable/A-2 4x None Despite already facing mid-single digit inflationary headwinds, JM Smuckers will implement price increases such as in its pass-through categories like coffee and peanut butter. We believe the company will be able to offset the majority of the hypothetical inflation envisioned in this scenario, and leverage would remain comfortably within the range appropriate for the rating.

Kellogg Co.

Packaged foods BBB/Stable/A-2 4x None We believe Kellogg could largely offset incremental inflation through additional price increases and productivity initiatives. However, if the company is not able to offset the majority of the hypothetical inflation envisioned in this scenario, the company could be at risk of a downgrade if it does not employ other tools to maintain leverage in a range appropriate for the rating, such as significantly reducing share buybacks.

Kimberly-Clark Worldwide Inc.

Household products & personal care A/Stable/A-1 > low 2x None Kimberly-Clark already faces challenges in commodity headwinds and difficult comps in its tissue products. The incremental inflation could probably be somewhat offset with productivity gains and pricing, but volumes would likely decline as consumers shift to private label. The company has demonstrated its commitment to a financial policy that supports the rating, for instance, by pausing share repurchases for the remainder of 2021. If necessary, we believe the company would institute further measures to reduce the likelihood of leverage increasing beyond the low 2x area for a sustained period.

The Kraft Heinz Co.

Packaged foods BB+/Stable High 4x None Kraft Heinz has significant room for underperformance at the current rating. Additionally, actual share repurchases could come in well below the level assumed in our model, especially if inflation continues to increase. We believe the company would recoup a portion of commodity inflation through price increases and still maintain about a turn of leverage cushion.

Molson Coors Beverage Co.

Beverage BBB-/Negative/A-3 >4x None We believe Molson could pass on a portion of the inflation with pricing and would use raw material hedging to further offset the higher input costs. We would likely maintain the negative outlook because of the elevated risk of leverage rising to above 4x for a significant period of time.

Newell Brands Inc.

Household products & personal care BB+/Positive/B mid 3x Revise outlook to stable The additional inflation could delay Newell Brands' ability to delever given they are facing very high input cost inflation already. We believe price increases and productivity savings would largely offset the rising costs but with a lag. Although leverage would rise above 4x, we believe this would be temporary until price increases would take effect.

PVH Corp.

Apparel BBB-/Stable/A-3 >4x None PVH has the capacity to selectively increase price and manage expenses to offset input cost increases, as demonstrated in the shutdown of 2020.Recent earnings and gross margin exceeded our base case despite incremental raw material and freight costs. We believe the company has additional capacity to cut costs if needed.

Reynolds Consumer Products Inc.

Household products & personal care BB+/Stable 3x Downgrade In our stress case, we assume Reynolds could recover the bulk of the inflation because of productivity gains and the effect of price increases, though these would have a time lag. Revenues would be slightly higher as price increases would be offset by lower volumes. We would expect leverage to rise above 3x for more than a year, barring other actions the company could take.

Samsonite International S.A.

Durables B/Negative >9x Downgrade We assume Samsonite would undertake price increases, product modifications and supplier negotiations to absorb most of the cost inflation. The company has been significantly reducing costs over the last 18 months to offset volume declines caused due to the pandemic. Still, leverage would likely increase to levels that could lead us to believe its capital structure is unsustainable.

Steelcase Inc.

Durables BBB-/Negative >3x None We believe Steelcase would implement price increases and cost savings measures to offset inflationary pressures. However, the company's low leverage affords it room for underperformance. The likelihood of a downgrade could increase if we believe the inflation exposes higher risk in its competitive position than we have accounted for.

Tempur Sealy International Inc.

Durables BB+/Stable >3x None Though such a substantial cost increase would be difficult to fully offset, the mattress industry has history of offsetting inflation through pricing and innovation. We assume inflationary pressure is modestly offset through pricing that in turn results in weaker volumes, netting out at the topline.
Source: S&P Global Ratings.

Food, Freight, And Labor Inflation Will Not Fade Away Easily For All

We believe the historically high inflation in the economy, in general, and food sector, specifically, reflects supply chain constraints including labor shortages, highly accommodative monetary and fiscal policy, a spike in agricultural commodities, and consumers' pent-up demand for goods and services they eschewed during the height of the pandemic. We believe many of these pressures will ease over time as demand gradually normalizes, supply catches up to sustainable demand levels, and labor imbalances decline due to the expiration of supplemental federal unemployment benefits. The unprecedented combination of shocks that have hit the economy and food supply chain at the same time are likely to continue to disrupt the consumer products industry well into 2022 and then gradually subside.

Food inflation doesn't appear to be widespread, and will likely be offset through price increases.   Key economic indicators that reflect the inflationary climate include the price of food and commodities, which have a direct impact on packaged and commodity food producers. Food inflation is primarily concentrated in meats, which is very volatile and subject to over-production and deflationary price cycles. The pandemic caused dislocations and plant closures that exacerbated volatility by combining limited meat supply with consumers' elevated demand as they pivoted to meals at home rather than at restaurants. We expect higher input costs for protein processors in feed, freight, and labor to remain high over the next year, and when coupled with still strong export demand could continue to heighten meat inflation, particularly in the away-from-home channel. Typically, packaged food companies can eventually pass along costs. They don't have to raise prices explicitly. Instead, they can reduce package sizes, change product compositions, or promote less. Additionally, because of the supply chain constraints, retailers are still heavily reliant on brands to keep shelves fully stocked. Still, packaged food companies have to be cognizant of the price gap between branded items and private label: if it increases significantly, consumers are likely to trade down. Consumers' financial condition is another risk to passing cost inflation on to buyers. With the expiration of government transfers, consumers may not have the financial flexibility to purchase the branded product.

The Bureau of Labor Statistics (BLS) expects inflation for meats to decline (see chart 2). Increased demand at restaurants and supply chain disruptions have also pushed up wholesale prices for meat. However, BLS predicts normalization across supply chains and consumer behavior should ease inflation in 2022 and beyond (see chart 3).

Chart 2

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Chart 3

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In most years over the past decade, price increases of food away from home have outpaced those for food at home. Last year was the first year since 2011 that price increases of food at home were greater than for food away from home because of the dramatic demand shift to grocers away from restaurants. We expect food-at-home inflation to ease modestly over the next year as consumers' demand for food at home continues to shift back to food away from home.

Chart 4

image

The consumer products and packaged food sectors are absorbing high costs in commodities, labor, and freight. We believe they'll be able to pass on a significant portion of these costs to the retailers and in turn consumers, especially while consumers are in good financial health, which we expect will extend well into 2022. However, raising prices beyond low- to mid-single digits could result in lower demand due to substituting for lower cost items or trading down to retailers' private label and consumers' return to dining out.

Chart 5

image

Freight inflation should ease, but not for several more quarters as port congestion and container availability remains tight.   Freight costs are also limiting consumer products companies' margins. Container dislocation, port congestion, and labor shortages are constraining the normal movement of goods from manufacturing facilities to the retailer or end consumer. According to Drewry, a provider of shipping industry research, a composite of container freight rates on major routes between the U.S., Europe, and Asia in September was more than three times higher than the same period in 2020. High port throughput (e.g., the North American ports throughput index in June was 11% higher than in 2019, according to Drewry) is causing congestion and delays. Issuers that ship product from overseas are resorting to alternative ports and shipping routes, more costly air freight, or entering contracts to charter entire container ships. All of these workarounds are appearing in margins. Eventually, the imbalance between supply and demand in freight will reverse, but we expect most of these pressures to continue in 2022.

Wage inflation may continue for longer given the current labor shortage, which coupled with ongoing supply chain constraints could trigger ratings actions.   Companies are competing for employees by making the application process easier, lowering requirements, and offering signing bonuses, retention bonuses, and other perks. The pressure on wages became evident in the 4.3% year-over-year increase reported in the U.S. Labor Department's August jobs report, up from 3.7% in July. Our macroeconomic base case assumes the labor shortage will ease beginning in September when supplemental unemployment benefits cease, which should in turn take pressure off wages and avoid triggering an inflationary spiral. Excluding transportation costs and commodity foods, consumer products companies aren't labor-intensive but that doesn't mean they wouldn't be exposed to an inflation spiral, as illustrated in this stress test.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Sarah E Wyeth, New York + 1 (212) 438 5658;
sarah.wyeth@spglobal.com
Secondary Contacts:Bea Y Chiem, San Francisco + 1 (415) 371 5070;
bea.chiem@spglobal.com
Chris Johnson, CFA, New York + 1 (212) 438 1433;
chris.johnson@spglobal.com
Amanda C O'Neill, New York + (212) 438-5450;
amanda.oneill@spglobal.com
Gerald T Phelan, CFA, Chicago + 1 (312) 233 7031;
gerald.phelan@spglobal.com

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