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U.S. Packaged Food Companies Could Fail Additional Inflationary Stresses

The Consumer Price Index (CPI) rose 8.5% year-over-year in March, buoyed by extraordinary energy and food costs, supply constraints, and strong consumer demand. The Russia-Ukraine conflict, along with renewed lockdowns in China due to a COVID surge, only add to the pressure. Packaged food companies, which fared well during the height of the pandemic, have seen moderating demand along with high inflation eat away at profits. Public company guidance for inflation range from low-single- to mid-double-digit ranges, depending on their commodity baskets and product mix. Many companies had already started raising prices in the back half of 2021 and have continued apace, averaging high-single-digits, showing up in CPI increases. S&P Global Ratings expects additional rounds of pricing actions to reflect expectations for continued high inflation through the remainder of calendar 2022 into at least the first half of 2023.

Chart 1

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The Russia-Ukraine conflict fueled further cost pressures on energy, wheat, sunflower oil, barley, and oil-based packaging inputs (see "Russia-Ukraine Conflict Will Test Agribusiness Supply Chain Efficiencies And Consumers' Appetite For More Food Inflation," March 18, 2022). These are key inputs into many packaged foods. We expect further price increases or other mitigating actions to partially offset these cost increases.

Along with pricing, many companies will likely substitute inputs to the extent they can and utilize tools such as trade optimization, reducing package sizes, taking volume out of products, reformulating products, changing product mix, and adjusting their promotional strategies. With unemployment just around 3.6% in March 2022, we expect labor costs to remain high. Also, high energy costs along with labor shortages will keep freight costs high.

Our Base-Case Assumptions

For most packaged food companies in calendar 2022, we expect price increases in the high-single- to low-double-digits range, while volumes decline mid- to high-single digits due to lapping elevated demand and higher price elasticity of demand in the second half of the year. Still, we assume volumes will remain higher than pre-pandemic levels, but below 2020 and 2021 levels. We assume hybrid work will remain, increasing breakfast and lunch consumption at home for at least 2-3 days per week. The combination of price increases and volume declines results in low- to mid-single-digit percent organic revenue growth on average for the sector. We assume promotions are another lever that companies will pull to either execute higher prices or to stimulate demand, depending on the category and supply availability. Because of the broad base inflation, we assume at least 200-300 basis points (bps) gross margin decline for the industry. We assume selling, general, and administrative (SGA) dollars are flat, but as a percentage of revenues they are likely down as companies pull back on marketing. Based on these assumptions, we forecast EBITDA margin decline of at least 200-300 bps as well. In 2023, we assume still-elevated inflation into at least the first half of the year and macroeconomic and geopolitical factors will impact the remainder of the year.

A possible recession poses only a limited risk to the sector overall.

Historically, packaged food companies fare well during a recession, consumers eat at home more and trade down to private label, and we expect that trend to continue if we enter a recession. We assess the risk of a recession in the next 12 months as about 1-in-4 and less likely before 2023, as successive rate hikes take effect.

During the pandemic, private label did not see the outsized benefits that branded players saw and lost unit market share on average to branded players because consumers were financially strong with high savings, low unemployment, boosted by high government stimulus. Additionally, the large, branded players were supply-chain-advantaged and able to get more products on shelves because of their stronger distribution networks, lower cost base, and large manufacturing networks. Conversely, private label struggled with distribution and manufacturing because of their smaller scale, higher stock keeping unit (SKU) counts, small batch runs, and reliance on their retail customers to merchandise the products.

Chart 2

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However, we believe that as consumers (especially lower-income consumers) feel the extraordinary inflationary pressures that reduce buying power and drain savings, they will trade down, which could result in a benefit for struggling private label manufactures such as TreeHouse Foods Inc. and Shearer's Foods LLC. Real average hourly earnings are well below CPI and nominal average hourly earnings, supporting our belief that the consumer is feeling the inflationary pressures.

Chart 3

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As for the branded players, we believe the companies that operate in categories with the historically highest level of private label penetration (over 20% of dollar category share versus industry average of about 16%, per Euromonitor) such as processed fruit and vegetables, chilled ready meals, cheese, nuts, tomato pastes and purees, rice, pasta, and noodles, will experience the most private label competitive threat. These companies include Conagra Brands Inc., Del Monte Foods Inc., and B&G Foods Inc.

Chart 4

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Inflationary Stress Test Assumptions

Similar to the approach of our previous stress test, we designed a hypothetical scenario that consisted of a simple broad-based assumption of 500 bps in additional gross margin degradation for one year for the rated U.S. packaged food companies. 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.

We designed the stress test 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 included 36 U.S. packaged food issuers in our stress test. We rate 12 investment grade and 24 speculative grade. We included three companies with negative outlooks or on CreditWatch negative. We have TreeHouse Foods with a developing outlook pending its strategic review outcomes.

Higher rated entities are best positioned to withstand additional inflationary shocks.

In general, we believe large, branded players retain the most pricing power and would fare best during the stress periods, especially if they are the leader in categories with a lower degree of private label penetration. Companies with less pricing power are those with portfolios of lower tier brands or a high degree of private label penetration in their categories. We believe contract manufacturers are the next-best positioned given they generally have pass-through pricing mechanisms and contracts that protect them during inflationary periods. Contract manufacturers include H-Food Holdings LLC, Aspire Bakeries Holdings LLC, CHG PPC Intermediate II LLC, KNEL Acquisition LLC, Monogram Food Solutions LLC, and JHW Alphia Holdings Inc. We believe private label is least advantaged given their supply chain limitations, limited brand strength, and reliance on retailers to merchandise the products. However, they could benefit from higher demand with consumer trade-down, which could partially mitigate some of the negative impacts. Private label manufacturers include TreeHouse Foods, Shearer's Foods, and 8th Avenue Food & Provisions Inc.

The stress test resulted in potential negative rating actions for approximately 86% of our sample of 36 companies. This highlights the stress that we are already factoring into our base case forecast (200-300 bps). An additional 500 bps hit to gross margin would result in at least 700-800 bps on margin degradation to our base case for many companies, leaving little cushion for further pressure. Twenty would face downgrades, seven would face outlook revisions to negative, and four would face outlooks back to stable from positive. Only five would not experience any negative rating actions. These unaffected entities include Mars Inc., The J.M. Smucker Co., Hostess Brands Inc., The Simply Good Foods Co., and Sovos Brands Inc. Of these, only Mars and Smucker are investment grade. The common theme among these companies is their relatively low leverage for their ratings. Their peers had debt leverage near or just below their downgrade thresholds.

While we believe the investment-grade issuers retain greater pricing power and have more levers to pull to restore credit measures, such as larger cost reduction actions, reducing share repurchases, or halting acquisitions, near-term credit measures could deteriorate substantially in a hyper-inflationary environment. Therefore, for the large, investment-grade issuers, we would likely revise the outlook to negative for most versus an immediate downgrade, despite near-term deterioration in credit measures.

Most of the downgrades were of speculative-grade ratings, which could face unsustainable capital structures or liquidity crunches because of their already highly leveraged capital structures, pushing many 'B-' issuers into the 'CCC' category.

The table below ranks the companies from best to worst positioned in our view in the event of an additional 500 bps gross margin inflationary shock.

Table 1

U.S. Packaged Food Inflation Stress Test Results Summary
Company Current Rating Downgrade or Outlook Revision Threshold Potential Rating Actions Base Inflation Assumptions Publicly Announced and In Base Case Comments

Mars Inc.

A/Stable/-- >3x debt to EBITDA None N/A The company has ample cushion against its downside because of continued strong performance within the pet segments.

J.M. Smucker Co. (The)

BBB/Stable/A-2 >4x debt to EBITDA None Low-double-digit Leverage would rise to just under 4x. Given the company's low leverage relative to its ratings, the company has more cushion to withstand added pressure.

Simply Good Foods Co. (The)

B+/Stable/-- >5x debt to EBITDA None Expected gross margin erosion of 250 bps for fiscal 2022 Leverage currently is below 3x. There is ample cushion at this rating level for additional leverage in a stress scenario, absent a leveraging acquisition.

Hostess Brands Inc.

B+/Stable/-- >5x debt to EBITDA None Double-digit Strong recent performance and deleveraging to around 4x gives the company good headroom for potential margin degradation.

Sovos Brands Inc.

B/Stable/-- >6.5x debt to EBITDA None High-single-digit Sovos is now operating with leverage below 5x after its IPO but the rating is constrained because it is still financial sponsor controlled and we believe it could remain acquisitive. Given where it is operating today, there is significant headroom to our 6.5x downgrade trigger under the stress scenario.

Hershey Co. (The)

A/Stable/A-1 >Low-2x debt to EBITDA Outlook revision to negative Mid- to high-single-digit Given recent acquisitions, leverage increased modestly and the company has less cushion against further deterioration. We believe a downgrade is less likely but the negative outlook highlights the fact that the company would be above our downgrade threshold.

Mondelez International Inc.

BBB/Stable/A-2 >4x debt to EBITDA Outlook revision to negative High-single-digit Leverage could rise to over 5x, but we expect the company to take pricing actions within 24 months. The company also has sufficient liquidity in equity investments it could sell to reduce debt.

Flowers Foods Inc.

BBB/Stable/-- >3x debt to EBITDA Outlook revision to negative High-single-digit We would likely revise the outlook to negative given the company's high flour and wheat exposure. We expect it to be able to pass along price increases and we do not expect the company to breach its covenants.

General Mills Inc.

BBB/Stable/A-2 >4x debt to EBITDA Outlook revision to negative 8% to 9% We would revise the outlook to negative because the stress would result in leverage exceeding 4x. We expect General Mills to be able to implement price increases and productivity measures to restore margins. The company could also reduce share repurchases and acquisitions.

Kellogg Co.

BBB/Stable/A-2 >4x debt to EBITDA Outlook revision to negative Double-digit Credit metrics would be pressured and we would likely revise the outlook to negative. We believe Kellogg could largely offset incremental inflation with additional price increases and productivity measures. The company could also reduce share buybacks and pay down debt to reduce leverage.

McCormick & Co. Inc.

BBB/Stable/A-2 >4x debt to EBITDA Outlook revision to negative Mid-to-high teens Leverage would rise above 4x, but demand remains strong and the company has pricing power, so we believe they could deleverage back to below 4x. We would also expect reduced share repurchases and acquisitions to reduce leverage.

Kraft Heinz Co. (The)

BBB-/Positive/A-3 >4x debt to EBITDA Outlook revision to stable Low-teens Potential rating action assumes the company will eventually recoup margin deterioration; also there is a $500 million share repurchase in base/stress model, which could be dialed back.

Campbell Soup Co.

BBB-/Positive/A-3 > Mid-3x debt to EBITDA Outlook revision to negative Low-double-digit We would likely revise the outlook to negative to reflect downside risk given leverage would rise above 4x.

Hormel Foods Corp.

A/Negative/-- >1.5x debt to EBITDA Downgrade Did not provide Given Hormel is already operating above our 1.5x downgrade trigger and still deleveraging after its acquisition of Planters, we would likely lower the rating and assign a negative outlook under this stress scenario.

Conagra Brands Inc.

BBB-/Negative/A-3 >4.0x debt to EBITDA Downgrade Approximately 16% for fiscal 2022 About 75% of Conagra's adjusted leverage improvement seen in pandemic has reversed; further sustained EBITDA declines per this stress test would lead to lower rating.

Post Holdings Inc.

B+/Stable/-- >6.5x debt to EBITDA Downgrade Mid- to high-single-digit Post is still recovering from the pandemic in its foodservice segment. With ongoing inflation and pressure from the Avian flu, we believe margin recovery will take longer. Therefore, a downgrade is likely, despite recent debt reduction from BellRing sale proceeds.

Wells Enterprises Inc.

B+/Stable/-- >5x debt to EBITDA Downgrade N/A After gross margins already compressed 500 bps last year primarily due to labor shortages another hit to margins could result in a multi notch downgrade signaling the risk that the company’s capital structure could become unsustainable absent an EBITDA margin rebound to historical levels of closer to 10%. Still the company’s nearest debt maturity is 2025 and the company has significant revolving credit facility availability with a covenant light package.

BellRing Brands Inc.

B/Positive/-- >4.5x debt to EBITDA Outlook revision to stable High-single-digit Performance has been strong. However, we would revise the outlook back to stable in a stress scenario because leverage would rise above our upgrade threshold.

Del Monte Foods Inc.

B/Positive/-- >5x debt to EBITDA Outlook revision to stable N/A Del Monte recently refinanced its existing high-coupon notes. However, the spike in leverage we observe from the stress scenario would be well above our threshold for an upgrade.

Whole Earth Brands Inc.

B/Positive/-- >5x debt to EBITDA Outlook revision to stable Mid-single-digit The company would likely need to seek lender relief of its leverage covenant of 5.5x. The revolver is also subject to a minimum fixed-charge coverage ratio of 1.25x.

TreeHouse Foods Inc.

B/Developing/-- >7x debt to EBITDA Downgrade Mid-to-high teens Assuming no asset sale proceeds, we likely would lower the rating because leverage would rise above 7x. The company would likely need to seek lender relief of its leverage covenant of 4.5x.

Utz Brands Inc.

B/Stable/-- >7x debt to EBITDA Downgrade Low-double-digit A downgrade is possible and the company could be borrowing on its revolver at the stress leverage and may run into liquidity constraints. The ABL is subject to a springing fixed-charge coverage ratio of 1.0x that is tested when its excess availability is less than the greater of 10% of the facility's commitment or $7 million.

B&G Foods Inc.

B/Stable/-- >7x debt to EBITDA Downgrade Double-digit We would likely lower the ratings. The company would likely need to seek lender relief of its leverage covenant of 7x.

CHG PPC Intermediate II LLC

B/Stable/-- >7x debt to EBITDA Downgrade N/A Given the company's high leverage, we could view the capital structure as unsustainable. The covenant is only tested when 35% of the revolver is drawn.

KNEL Acquisition LLC

B/Stable/-- >6.5x debt to EBITDA Downgrade N/A A downgrade is likely and the company would likely need to seek lender relief of its leverage covenant of 7.5x.

Monogram Food Solutions LLC

B/Stable/-- >7x debt to EBITDA Downgrade N/A The company already has tight margins and is highly leveraged following its June 2021 acquisition of QFP. Sustained margin deterioration would push capital structure to unsustainable levels.

H-Food Holdings LLC

B-/Stable/-- Free operating cash flow deteriorates, unsustainable capital structure Downgrade N/A A downgrade is likely because of an unsustainable capital structure; however, there are enough liquidity sources to remain solvent beyond 12 months. Revolver borrowings would be limited to 35% of the facility's commitment.

BCPE North Star Holdings L.P.

B-/Stable/-- Free operating cash flow deteriorates, unsustainable capital structure Downgrade N/A A downgrade is likely because of an unsustainable capital structure; however, there are enough liquidity sources to remain solvent beyond 12 months. Revolver borrowings would be limited to 35% of the facility's commitment.

Woof Intermediate Inc.

B-/Stable/-- > Mid-7x debt to EBITDA Downgrade N/A Unsustainable capital structure but enough liquidity sources to remain solvent beyond 12 months. The ABL is subject to a springing fixed-charge coverage ratio test of 1.0x when excess availability is less than $10 million and 10% of the loan cap

Shearer's Foods LLC

B-/Stable/-- < 1.2x EBITDA cash interest coverage, constrained liquidity, weak operating cash flow Downgrade N/A A downgrade is likely because of an unsustainable capital structure; however, there are enough liquidity sources to remain solvent beyond 12 months. The ABL facility is subject to a springing minimum fixed-charge coverage ratio if excess availability falls below 10%.

Aspire Bakeries Holdings LLC

B-/Stable/-- >6x debt to EBITDA, negative cash flow Downgrade N/A Possible unsustainable capital structure if inflation persists and pricing actions don't offset inflation. The company would then exhaust all liquidity sources. Revolver borrowings would be limited to 35% of the facility's commitment.

Balrog Acquisition Inc.

B-/Stable/-- >9x DEBT/EBITDA and EBITDA cash interest coverage <= 1.5x Downgrade N/A A downgrade is likely because of an unsustainable capital structure; however, there are enough liquidity sources to remain solvent beyond 12 months. The $100 million ABL is subject to springing fixed-charge coverage ratio when excess availability is less than the greater of $7.5 million and 10% of the line cap.

Chobani Global Holdings LLC

B-/Stable/-- <1.5x FFO to cash interest Downgrade N/A A downgrade is likely. The company has a cash interest coverage trigger of 1.5x for a downgrade. Therefore, the capital structure would become unsustainable. Revolver borrowings would be limited to 35% of the facility's commitment.

KC Culinarte Holdings LP

CCC+/Positive/-- Outlook back to stable or downgrade if operating performance and liquidity don't improve Downgrade N/A A downgrade is likely and the company would likely need to seek lender relief of its leverage covenant of 7.4x. Liquidity would also be pressured and a near-term default is possible if the company is unable to renew its revolver maturity.

8th Avenue Food & Provisions Inc.

CCC+/Negative/-- Deterioration in liquidity, unable to offset inflationary pressure and operate plants effectively Downgrade N/A A downgrade is likely because there is a high likelihood of default in this scenario as the company would exhaust all liquidity sources within six months. Company would likely need to seek lender relief of its leverage covenant of 7.25x when 35% of the revolver is drawn. We expect the company will spring the covenant in the near term to fund its working capital needs.

JHW Alphia Holdings Inc.

CCC+/CW Negative/-- If the company is unable to file 2021 audit and improve liquidity Downgrade N/A A downgrade is likely and default probability is higher. The company would need to seek additional lender relief on covenants and extend the existing financial covenant suspension period. Another liquidity injection would likely also be required.
N/A--not available because the company has private financials. ABL--Asset-backed lending facility. bps--basis points.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Bea Y Chiem, San Francisco + 1 (415) 371 5070;
bea.chiem@spglobal.com
Sarah E Wyeth, New York + 1 (212) 438 5658;
sarah.wyeth@spglobal.com
Gerald T Phelan, CFA, Chicago + 1 (312) 233 7031;
gerald.phelan@spglobal.com
Chris Johnson, CFA, New York + 1 (212) 438 1433;
chris.johnson@spglobal.com
Secondary Contacts:Adam Lynn, New York + 1 (212) 438 2637;
adam.lynn@spglobal.com
Luis Medal, San Francisco;
luis.medal@spglobal.com
Brennan Clark, Chicago + 1 (312) 233 7086;
brennan.clark@spglobal.com
Research Assistant:Abu Rahid, Toronto

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