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Our Stress Test To Protein Processors' Margins May Not Cut Into Ratings, But The Sector's Lean Leverage Could Fatten

Key Takeaways

  • Most of the protein companies we rate are very likely to face much lower margins and higher leverage over the next year because of tight livestock supplies and less pricing power, particularly in the U.S.
  • Although most of these companies have significant cushion in their ratios or have sufficient geographic and product diversification to withstand a short-lived downturn, a more pronounced downturn could negatively impact ratings.
  • Other risks, such as growing recession odds, an increased regulatory burden, litigation risk, and the recent outbreak of avian flu appear well contained, but heighted credit surveillance of the sector is required.

Industry Outlook… A Bumpy Road Ahead

After consecutive years of record margins for conventional, animal protein processors across the globe (particularly beef packers in North America), the strong margin cycle is correcting as rising livestock input costs because of smaller herds and normalizing production capacity are squeezing beef cut-out margins. At the same time, a combination of seasonally high inventories and higher feed costs point to weak U.S. poultry and pork processing profits in the coming quarters. However, the negative ratings impact the sector experienced during prior bust cycles is not likely to be as severe (several single protein processors suffered multi-notch downgrades in the last cycle back in 2012 as many companies in the sector have kept leverage low while generating above-average margins (see charts 1 and 2). Moreover, many players have prudently expanded their product portfolios over time to reduce earnings volatility, while global consolidation has diversified geographic footprints as global demand continues to grow, leaving many participants better fortified for an industry downturn. Still, many will face significant margin pressure and higher leverage so negative ratings actions are not completely off the table.

Chart 1


Chart 2


Margin pain in the U.S. is widespread across the major proteins, albeit possibly short-lived for chicken margins

Companies are already facing U.S. beef processing margin contraction. Leading U.S. beef packers like JBS S.A., Tyson Foods, and National Beef (owned by Marfrig S.A.) have all faced operating income margin declines of well over 500 basis points year-over-year in their most recent reporting quarters. Industry wide cut-out margins face significant pressure from higher cattle costs (see chart 3) that companies can't fully pass on to wholesalers in part because of price competition from other proteins such as chicken where pricing has softened significantly. They also can't do so because higher inflation is affecting consumers' pocketbooks. Moreover, processors face negative operating leverage from lower processing volumes while drought conditions in much of the U.S. have led to accelerated on-pasture herd culling. With the USDA projecting U.S. cattle production to decline 7.5% year-over-year in 2023 as herds rebuild, we expect tight cattle supplies to keep beef processing margins pressured for the remainder of calendar 2023 and likely into 2024 and beyond.

Chart 3


We expect poultry margins to be pressured in the fourth quarter and into the start of 2023 as feed costs remain high and chicken cold storage inventories are elevated following an industry ramp-up in production in response to very tight supply conditions at the start of 2022 because of weak hatch rates. In fact, U.S. broiler meat in cold storage was up almost 28% year-over-year as of November 2022 month-end (see chart 4). Moreover, as hatch rates rebounded, the ramp-up in production took hold during the seasonally low fourth quarter when grilling demand is weakest and holiday demand favors other meats like ham and turkey further pressuring chicken prices. As a result, the USDA estimated whole bird chicken prices declined about 25% by year-end 2022 from the June highs. The bloated inventories are more pronounced for breast meat and will likely hurt demand for large bird processors (such as Walnut-Sycamore) for foodservice compared with companies with a more balanced mix toward small bird and more processed retail offerings, such as Pilgrim's Pride Corp. and Tyson Foods. Still, we expect U.S. poultry producers to face significant margin pressure in the coming quarters. A key risk to our full-year 2023 margin outlook for U.S. chicken processors is whether inventories will be right-sized ahead of the key summer grilling season. We are cautiously optimistic that margins will rebound into the second half of the year as inventories sell-down in the coming quarters, breeders slow production, and demand possibly rebounds as pork and beef substitutes remain less affordable.

Chart 4


Pork processing margins were pressured throughout 2022 (see chart 5) as smaller herds and higher feed costs kept input costs high, but wholesale prices remained low. Despite strong domestic pork demand in response to tight turkey supplies which were hurt by the avian flu, wholesale prices struggled with lower-than-expected export demand, due in part to a strengthening U.S. dollar. Moreover, the domestic production capacity expansion destined for exports that came online in 2020 is eating in to cut-out margins given continued decline in pork production, which is projected to fall for the second consecutive year in 2022. The USDA is projecting only a modest 1% year-over-year production rebound in 2023, which could keep cut-out margins depressed in 2023, especially as cold-storage chicken supplies are currently elevated.

Chart 5


Strong export demand to Asia-Pacific supports the outlook in other geographies, namely Brazil

South America exports about 50%-60% of beef and poultry products to Asia, and export prices remain fairly supportive despite China's volatile orders, which fell in fourth-quarter 2022 with COVID-19 restrictions preventing stronger volumes mainly for beef. Demand for beef from China is expected to increase 2%-3% next year, which should benefit Latin American exports amid a declining herd in the U.S. Depreciated currencies in Latin America should further boost exports supporting better margins in 2023 and 2024. This is particularly evident for Brazilian and Paraguayan operators. Following several years of calf retention in those regions, cattle availability is now much higher. This has led to cattle costs declining about 15% since mid-2022. Given our expectation for about a 5% further decline in prices, cattle costs should remain contained. Healthy cattle supplies should last until 2024 before a potential cost rebound. Conditions in neighboring regions also support strong export prices. Slaughter rates in Argentina are falling in response to export restrictions in that country and continued weak local macroeconomic conditions. As such, we expect healthy EBITDA margins for most South American beef operators to range from 7%-11%, compared with the weaker margins closer to 5% in the past two years. These conditions should help offset weaker margins in the U.S. for South American-based beef packers with a large U.S. footprint such as Marfrig and JBS.

For poultry and pork, still high but stable feed costs following a large 2022 corn harvest should keep margins stable, despite growing export demand for corn and soybean meal from Asia as pork herds rebuild and chicken flocks expand. Moreover, operators continue to increase their mix toward higher-margin more processed offerings while taking additional domestic price increases to boost profitability. Additional tailwinds to margins include further currency devaluations and possibly steeper declines in cattle prices. Still, exports can be volatile particularly to China, and a key risk to this outlook is a weaker economic environment in China that again reduces export volumes and prices and causes a supply glut in domestic markets that pressure margins.

Economic headwinds could weaken foodservice demand and keep a lid on pricing

Supply demand imbalances in the protein supply chain and feed costs are more relevant for protein processors' margins than are economic cycles. Nonetheless, the increased likelihood of recession in the U.S. and other economies is a headwind on pricing and mix, which are important levers for offsetting weak commodity processing margins. Foodservice demand typically declines during recessions which affects pricing and mix as companies typically generate higher margins on foodservice contracts compared with more competitive retail pricing for their more commoditized fresh tray-pack and other refrigerated offerings. Therefore, given our outlook for slowing economic growth, reduced volumes for more premium-priced offerings are less likely to offset the industry's current margin headwinds.

Margin Stress Test Assumptions and Issuer Severity Heat Map

We applied three margin stress scenarios to all rated issuers that have commodity protein processing operations

Industry consolidation has resulted in a global rated universe of several players across regions with large U.S. operations, where margin pressure is currently expected to be most severe. Therefore, we have included all our global issuers with commodity protein processing operations in this stress test study instead of limiting our margin stress to U.S. companies. Moreover, companies in other geographies are not immune from margin volatility and weak earnings cycles in line with the magnitudes of our simulated margin stresses for this study. Still, margin pressure over the next year may vary by company depending on both geographic and product diversity, as operating outlooks across regions differ while certain protein inputs may face more severe margin pressure than others given different local market conditions. To capture the range of possible margin contraction that any one company may face over the next 12 months, we applied three margins stress scenarios of 250, 500, and 750 basis points (bps) declines to each company's most recent trailing-12-month EBITDA. We then applied the impact of each company's stressed EBITDA to its debt to EBITDA ratio. We then compared each company's respective stressed leverage ratio to its downgrade trigger.

Severity heat map indicates the likelihood of each stress scenario occurring to each company over the next 12 months

Because of different geographic and portfolio compositions, including business lines that may not be directly correlated to protein processing, we have provided a color-coded severity heat map to indicate the degree of likelihood of each margin's stress occurring to each respective issuer. Green reflects low likelihood, yellow medium, and red high (please see table 1 below for our heat map and please refer to table 2 for comments on each company).


Regulatory And Other Emerging Risks Appear Contained

Export restrictions

The recent Avian flu outbreak, the most pronounced near-term threat to trade flow disruptions, has so far not disrupted the sector on a large scale. Avian flu cases rose sharply in 2022, wreaking havoc in some poultry producing regions of North America, Europe,and Asia. Millions of birds were culled, affecting the global poultry supply, particularly for egg layers. Many countries, such as the U.S. and most of Europe, have expertise in dealing with the virus, and have done a better job isolating cases, preventing unnecessary culling, and thus softening the impact. However, even in the U.S., the turkey and egg industries found it difficult to contain the virus, which caused a surge in prices. The U.S. chicken market, which had elevated cold storage inventories, were not less affected. However, it remains an ongoing risk, particularly given China's (a large importer of dark meat, including parts not generally consumed in the U.S.) temporary ban on exports from regions where cases have been identified. In South America, the Avian flu has been detected in Peru, Chile, Colombia, Venezuela, and Ecuador--some of those countries border Brazil, the second-largest global poultry producer. So far, no cases have been reported in the country, but contagion continues to be closely monitored.

Export restriction for sanitary breeches out of Brazil have subsided but deforestation-free trade policies may lead to future restrictions in Europe. Protein processors and livestock farmers need to meet strict sanitary standards to avoid import bans that governments regularly levy against specific countries, states, or operating plants that fail to meet regulatory standards or that are found to harbor disease. Historically, there have been several export bans on Brazilian companies for sanitary reasons. A recent example was China's ban on Brazilian beef imports that lasted about six months in 2021, significantly hurting domestic margins as roughly 50% of Brazilian beef exports are destined to China. Prior to that, Europe banned Brazilian chicken exports due to safety protocol breeches, and China banned several chicken plants last year. Another emerging regulatory risk is the recent European parliament discussion of a potential ban on meat imports from countries that are exposed to cattle supply in deforestation areas, which is the case for the major Brazilian players with suppliers that graze cattle in the Amazon and Cerrado biomes. While Europe represents only about 10% of meat exports from Brazil, increased export restrictions would make that country even more reliant on Asia, and in the Middle East for trade, and could increase to other regions such North America where the landscape has improved after the U.S. lifted beef export restrictions from Brazil.

Animal welfare regulation

In the U.S., California's Proposition 12 may put pressure on the pork industry. Also known as the Prevention of Cruelty to Farm Animals Act, Prop 12 is a ballot initiative set to ban the sale of pork, veal, and eggs from farms that do meet established minimum space criteria for its farm animals. It was initially passed in November 2018, but enforcement has been delayed. The Supreme Court agreed to hear a legal challenge from the National Pork Producers Council (NPPC) and we expect it will make a ruling in the first half of 2023. Because of the nature of the pork supply chain, the NPCC claims that essentially all hog farmers nationally would be required to comply with Prop 12 to continue selling to California (which represents a material percentage of all U.S. consumption), costing the industry hundreds of millions of dollars. While some of these added costs would likely be passed on to consumers, pork producers margins could tighten because of difficulty raising prices in the currently weak macroeconomic environment. Margins could be more severely hurt if the initiative materially reduces hog supply, leading to further pressure on pork cutout values.


Protein participants have all been subject to various class action lawsuits in the U.S. recent years. Among others, these include broiler antitrust cases first filed in 2016, pork antitrust cases first filed in 2018, and beef antitrust litigation filed in 2019. The companies we rated in the sector have accrued legal expenses and settled some cases, but others remain outstanding. We assume future legal payments will be manageable and not be material to our ratings but continue to monitor ongoing developments.

Moderate Margin Contraction Is Likely For Almost All--But Pressure On Leverage Varies


Our stress test shows a moderate downgrade risk to the sector in aggregate as the companies facing the most risk to large margin declines next year have built up significant leverage cushion to their downside triggers during the strong operating cycle of the past years. Moreover, issuers by in large demonstrated prudent financial stewardship during the recent boom cycle by not pursuing large M&A and not increasing leverage for shareholder returns from sizable cash generation. In addition, the majority of issuers not facing a likely risk of margin compression over their outlook horizons have diverse product portfolios and operate in more than one geography, including where operations are recovering from very weak performance. These offsetting factors mitigate the risk of downside margin pressure for many of our issuers.

Although we expect more than half of our rated issuers to face a high likelihood of at least a 250-basis-point margin contraction in 2023 and close to half to face a medium risk of a 500-basis-point margin contraction, only three of these more at-risk issuers have less than a turn of cushion on their leverage ratios, while the rest have more than 1.5 turns of cushion. One of the issuers with less than a turn of cushion, Frigorifico Concepcion, recently had its issuer credit rating outlook revised from positive to stable, because of acquisitions and weaker EBITDA that postponed its deleverage expectations. The other two issuers with less than turn of cushion, JBS and Marfrig, have significant geographic offsets outside of the U.S. where the operating outlook is more favorable such that they could manage leverage below respective downgrade triggers depending on how their discretionary investment outlays, working capital management and shareholder returns policies. Additionally, these two issuers have already suffered several hundred bps of margin compression in the past two quarters while still not breeching their downgrade triggers.

Moreover, because we factor cyclicality in our ratio analysis, we typically view downgrade risk as contained when leverage is only temporarily elevated but still below an issuer's downgrade trigger during trough industry cycle conditions as is currently the base case. Still, we do have geographically concentrated issuers in the US with more narrow product portfolios that will necessitate heightened surveillance over the next years to monitor the severity of the anticipated industry downturn on profitability and credit quality.

Individual Company Summaries


BRF's margins are likely to remain flat after falling to 8.5% mainly due to its Brazilian domestic market business, which was squeezed by lackluster demand in the country amid cost inflation (mainly feed costs). Stronger Halal division results offset domestic market results. Direct exports (including Asia) also benefited from record prices after the conflict in Ukraine and a depreciated real, which should support margins of about 8%-9% in 2023. Therefore, a 250-basis-point decrease over those already low levels would only have a medium probability of materializing and would require depressed poultry international prices and a further surge in feed costs, which we do not view as likely. This scenario would pressure our ratings on BRF as leverage would reach over 6.0x in 2023, even if the company further curtails capital spending. We believe more severe margin declines of 500 or 750 basis points are unlikely, given that the company is already operating with very low margins and its domestic and international market outlooks are more favorable than the U.S. outlook where the cycle has turned.

Cargill Inc.

Although Cargill has very good geographic and product diversity across several businesses outside protein processing, its recent EBITDA growth reflects the robust beef operating performance which started to turn in the first quarter of its current fiscal year. Therefore, a margin contraction of at least 250 basis points is very likely over the next year, but this degree of margin compression is well-mitigated by a more favorable outlook for the company's other businesses which constitute more than two-thirds of EBITDA during normal protein cycles. Oilseed processing in particular has a strong operating outlook, with crush margins benefitting from growing global biofuel demand and tight industrywide capacity. With trailing-12-month debt to EBITDA of 0.7x as of Nov. 30, 2022, the company has significant balance sheet cushion to weather a downturn in beef packing margins while increasing growth capex and M&A, which we expect to materially increase to about $3 billion in the current fiscal year compared to the bolt-on acquisitions of less than $500 million in recent years. Still, Cargill should maintain more than a turn of cushion on its 2.5x debt to EBITDA downgrade trigger despite facing weaker beef processing margins concurrent with higher capex and M&A.

Frigorifico Concepcion S.A.

Frigorifico benefits from ample cattle availability in Paraguay and Bolivia and most of its production is destined to the export markets which remain healthy. Despite the favorable pricing environment during 2022, the company's margin was hurt by the consolidation and ramp up of four beef and two pork processing plants recently acquired in Brazil that did not run at full capacity for the entire year. Additionally, margins were pressured by cost inflation, particularly cattle prices and transportation costs. Still, we expect the company to report EBITDA margin around 9% in 2022 and a similar figure in 2023 as prices moderate from last year offset by better operating leverage. A 250-basis-point decrease over that margin has a medium probability of materializing and would require depressed international prices and a further surge in cattle costs, which we do not view as likely. This scenario would pressure our ratings on Frigorifico as leverage would reach over 5.0x in 2023, above our 4.0x downside trigger. Moreover, we believe the company has little room to reduce capex because the new plants require further investment to fully ramp up. In addition, working capital requirements will remain elevated as the new plants increase slaughter volumes. We believe more severe margin declines of 500 or 750 basis points are even less likely, given its higher anticipated volumes and margin improvement at its recently acquired facilities.

Goncalves & Tortola S.A.

GT Foods is a pure poultry player with limited scale and geographically concentrated, so it is usually more exposed to cyclical downturns affecting metrics and cash flows. However, we believe that the probability of a steeper decline of 250 basis points in margins is low because the expected stable input costs points to a rebound in margins and should benefit from easy year-over-year comparisons as it starts to lap last year's weaker margin quarters. The company emerged from bankruptcy in mid-2019 with a much lower debt burden enabling it to gradually increase production volumes and improve operations. After starting 2022 with weak profitability because of lower egg volumes because of genetic issues, bird supplies have further stabilized concurrent with easing grain costs, following the larger Brazilian corn harvest last year. We estimate margins will approach 10% in the end of 2022 reflecting less inflationary grain costs and good export pricing. Therefore, a 250-basis-point decline from 2021 is difficult to materialize, but would nonetheless pressure ratings given the company's small scale.


After abnormally high margins in the U.S. beef segment and weak profitability in South America due to low availability of cattle in the past two years, margins across this company's segments continued to normalize closer to long-term historical averages as of the second and third quarters of 2022. A 250-basis-point contraction over the next year highly likely because our 2022 consolidated margin expectations already consider the company's recent margin contraction and assumes a decline of almost 750 basis points in the second half of 2022 in the U.S. beef sector compared with one year ago. However, this is offset by a 300-basis-point rebound in Latin America's operations. We also view the possibility of a margin compression of 500 basis point as medium to high, because of the very quick deterioration in U.S. conditions. JBS' broad geographic and product diversification across all proteins with a large further processed portfolio should help mitigate margin compression to reach 750 basis points. Still a 500-basis-point stress could materialize because of a still subdued U.S. pork, poultry and in particular beef margin outlook and the large contribution of these subsegments to consolidated EBITDA. Therefore, debt to EBITDA could exceed our downside trigger of above 3x on a sustained basis, but only temporarily as JBS would likely pare back share repurchases and not increase its dividend payout while reducing capital spending closer to maintenance levels.

Hormel Foods Corp.

Hormel's exposure to commodity proteins is lower than most of its peers given its focus on shifting its portfolio mix to high-value-added branded products through innovation and M&A (e.g., Planters), while reducing its commodity pork exposure. As such, we believe the company is better positioned to absorb protein cycle volatility compared with most of its peers. We place a medium probability of a 250-basis-point margin contraction stemming mainly from depressed poultry processing in its Turkey operations, high feed costs, and labor challenges that constrain the company's ability to fully capture volumes of its higher-margin products. We view the probability of further margin deterioration as low given the company's product diversity and better pricing discretion on its branded product portfolio. Given Hormel's elevated leverage since its acquisition of Planters, a 250-basis-point contraction could result in a ratings downgrade. However, this would primarily reflect the company's recently more aggressive financial policies rather than its business risk exposure to protein margin volatility.

Marfrig Global Foods S.A.

Although Marfrig subsidiary National Beef's margins in 2020 and 2021 reached over 20% due to the booming beef cycle in the U.S., it began to recede in 2022, reaching low double digits in the third quarter. However, Marfrig's South American margins are rising due a rebounding cattle cycle in Brazil amid the lifting of the Chinese ban on Brazilian beef exports in December 2021, bringing margins in that segment to high-single-digits enabling consolidated margins for the 12-months ended Sept. 30, 2022, to reach 12.7%. We nonetheless expect profitability to continue receding in the upcoming quarters as U.S. beef margins normalize. Therefore, an overall 250-basis-point margin decrease is highly likely, while a 500-basis-point decrease would have a medium probability of materializing should U.S. beef margins fall below our estimated 7-8% base-case scenario for 2023, while South American margins remain at high-single-digit levels. As such, a 250-basis-point margin stress would cause leverage to increase slightly above our 3.0x downgrade but only temporarily as we believe the company would curtail dividends and capex; particularly if margin declines were to approach 500 basis points or worse. (Our stress result includes proportional consolidation of BRF into Marfrig's financials).

Minerva S.A.

Minerva has historically demonstrated more stable margins compared with rated peers, despite being a primarily a beef player (with some recent diversification into lamb) because of its geographic diversification across several countries in Latin America and its good operating track record. It can quicky manage its production mix to optimize export or domestic market volumes depending on market conditions. This flexibility enables it to maximize overall pricing while keeping margin volatility in check. Although a 250-basis-point margin faces a medium likelihood of occurring, our base-case projection assumes margin expansion because of the improving cattle cycle in Brazil and Paraguay coupled with favorable export demand and prices. As such, the company will likely maintain a turn of cushion on its 4x downside trigger if it faces a 250-basis-point margin decline which would require export restrictions to China to unexpectedly return. A more pronounced margin contraction is much less likely given improving domestic cattle supplies.

Pilgrim's Pride Corp.

Pilgrim's Pride Corp.'s (PPC) S&P Global Ratings-adjusted EBITDA margins improved to 11.6% for the trailing-12-months ended Sept. 30, 2022, from 8.7% from the same prior-year period, driven almost entirely by strong operating performance in the U.S., which accounted for nearly all the company's operating profits in the first nine months of the year. Based on a softening U.S. poultry market, we believe a 500-basis-point margin contraction is highly likely. While the company is a significant player in the commodity big bird market, we believe its presence outside of the U.S. (non-domestic sales represented close to 40% of total sales for the nine months ended Sept. 30, 2022) and a more balanced mix toward small bird and further processed products help mitigate the risk of more severe margin deterioration. Still, we believe there is a medium risk of a 750-basis-point contraction given currently elevated levels of cold storage inventories. We expect leverage will weaken to the low-3x area in 2023, in line with its parent JBS. We likely would only take a negative rating action on PPC if we took a negative action on its JBS or if we no longer viewed PPC as core holding of JBS.

Sigma Alimentos S.A. de C.V.

After facing significant margin pressure in the first nine months of 2022 due to widespread input cost inflation, including labor, transportation, energy, and commodity food inputs, mostly for pork and poultry, Sigma's key input costs have recently started to stabilize or even soften in some cases, after peaking during the summer. The company continues to take proactive actions to mitigate the impact on its margins amid still uncertain business conditions, including implementing pricing increases across all geographies and categories, accelerating cost-savings, and actively hedging gas prices in Europe and its U.S. dollar needs. Sigma has also managed its product mix to maximize the production mix of its most profitable stock-keeping units thereby maximizing capacity utilization rates, while also restructuring its supply chain, diversifying its sales channels, and exporting higher-value-added products to other markets. Given so many operating initiatives that are still being implemented, we believe a 250-basis-point EBITDA margin stress has a medium probability of occurring, while a 500-basis-point margin compression has a low probability of materializing. Although a 250-basis-point stress would result in an adjusted leverage slightly above our 3.0x stand-alone credit profile downside trigger, it would likely be temporary given the company's track record of reducing capex, bolt-on acquisition, and dividends, if necessary, to protect its credit protection measures. All thing else being equal, a 500-basis-point contraction in margin would temporarily raise adjusted leverage above 5x, although we see this scenario much less probable given the operating efficiencies implemented by the company.

Simmons Foods Inc.

Simmons had a very strong first nine months of 2022, reflecting strong poultry pricing that more than offset higher feed costs and the benefits of being a net seller of commodity chicken cuts when market prices were high. The poultry segment profits contributed to over half the company's year-to-date profits despite portfolio diversification into pet food and animal nutrition. Because of the steep decline in poultry prices in the second half of 2022, we expect the company will begin to report much less favorable results in its chicken segment. Therefore, we believe a 250-basis-point margin contraction is very likely, particularly as feed costs remain high. However, the company's private-label wet pet food and animal nutrition businesses should partly offset the weakening profitability in its poultry segment mitigating the risk of a margin stress beyond 250 basis points. In addition, Simmons has made investments to bring new value-added further processing capacity online in 2023, which should reduce its exposure to the commodity market and provide downside protection to falling commodity bird prices. Giving that Simmons has about a turn-and-a-half of cushion to our 6.5x downgrade trigger as of Sept. 30, 2022, we believe the company could absorb the high likelihood of a 250-basis-point contraction and sustain leverage below 6x given its portfolio diversification. We would likely lower the rating if margins weakened by 500 basis points, which has a medium probability of occurring as the chicken segment remains the largest profit contributor for the company.

Smithfield Foods Inc.

Smithfield has leveraged its vertically integrated business model to effectively offset the impact of rising costs. The company was able to sustain trailing-12-month S&P global Ratings-adjusted EBITDA margins in the 9% area largely on the strength of its North America packaged meats business, which was able to raise prices that more than offset higher costs. Having its own farming operations has also helped soften the impact of rising hog costs. However, we believe the branded packaged meats segment's pricing power began to weaken in the second half of 2022 as consumer spending came under pressure. We expect the company will continue to face this challenge in 2023 with more consumers trading down to lower-priced private label or alternative proteins (chicken). Absent a decline in hog prices and input costs (feed and energy), this will likely squeeze the company's margins. The potential for additional costs to comply with California's Proposition 12, if upheld by the Supreme Court, could further pressure profits. As such, we believe the company is at high risk of a 250-basis-point margin contraction and moderate risk of a 500-basis-point one. Importantly, our ratings on Smithfield are supported by those on its parent, WH Group, because we view it as highly strategic to WH Group. A 250-basis-point margin contraction would likely not be material to our ratings. However, we could lower our ratings on Smithfield if margins weakened by the less likely to occur 500-basis-point stress. This magnitude of margin contraction would cause leverage to increase to well above 4x and possibly lead us to unfavorably reassess the group's credit profile depending on WH Group's consolidated performance, which we currently believe is well insulated from a material decline in margins.

Tyson Foods Inc.

Tyson's S&P Global Ratings-adjusted EBITDA margins declined to 10.5% for the fiscal year ended Oct. 1, 2022 (from 12.3% the prior year) largely because of rapidly weakening beef margins. This was partly offset by improved performance in its chicken segment, which benefited from higher productivity rates and enhanced pricing initiatives. We believe Tyson's beef margins will continue to weaken in fiscal 2023, while its pork segment will also remain under pressure (in part due to rising hog costs combined with limited export demand for pork due to foreign currency headwinds). Combined with the risk of higher feed costs, we believe the company is at high risk of a further 500-basis-point margin contraction. However, its diversification across multiple protein categories should help mitigate the risk of further margin deterioration.

While the poultry category is currently under pressure, Tyson is less exposed to the commodity big bird market than some of its peers, and it remains committed to being a net buyer of chicken parts for its processing needs, which limits margin declines in deflationary chicken price cycles. The prepared foods segment should also provide additional margin protection. As such, we view a 750-basis-point margin contraction as unlikely. Moreover, Tyson has significant leverage cushion. Debt to EBITDA of 1.5x at the end of fiscal 2022 was well below our 3x downgrade trigger. We estimate leverage would remain just under our 3x downgrade trigger if margins contracted 500 basis points. We also believe the company has levers it could pull to maintain headroom to our trigger, including reducing share repurchase or moderating capital investments.

Walnut Sycamore Holdings LLC

The merger of Wayne Farms and Sanderson Farms (resulting in the third-largest provider in the U.S.) was completed on July 22, 2022. We estimate pro forma leverage for the newly formed entity, Walnut Sycamore (d/b/a Wayne Sanderson Farms), was in the low-1x area, with trailing-12-month margins in excess of 20%. This was much more favorable than we initially anticipated because of stronger-than-expected commodity poultry pricing through the summer of 2022. Still, the company is more indexed to commodity whole bird offerings in the U.S. compared with its rated peers, and we believe it is subject to more significant earnings and cash flow volatility. We therefore expect severe profit and cash flow deterioration in the coming quarters given the significant declines in commodity whole chicken pricing and view a margin contraction exceeding 750 basis points as highly likely. However, our ratings consider the company's earnings volatility, and we expect it would still have sufficient headroom to our downgrade trigger (3.5x during weak earnings cycles) if margins contracted 750 basis points. Given the strong margins through September 2022, our current forecast assumes margins weaken below 15% in fiscal year ending March 2023, and further decline into fiscal 2024. We assume some recovery in pricing later in fiscal 2024 as supply tightens and consumers shift spending toward the relatively more affordable chicken offerings in a challenging economic environment. We estimate this will result in leverage in the mid-2x area in fiscal 2023 and 3x area in fiscal 2024, still within our downgrade trigger.

WH Group Ltd.

WH Group focuses more on packaged pork products although it has a small hog production and slaughtering through operation its China subsidiary Henan Shuanghui Investment & Development Co. Ltd. (Shuanghui) and U.S. subsidiary Smithfield Foods Inc. (Smithfield). Over 90% of the group's profitability comes from packaged meat, and its profitability could be squeezed by high hog prices given their concentration on pork products. We believe the probability for an overall 250-basis-point margin contraction to 7.6% is low for WH, unless hog prices in both China and the U.S. significantly increase. This is also supported by WH Group's EBITDA margin decline of 190 basis points to 8.9% in 2020 from 10.8% in 2019 when hog price recorded historically high in 2020 due to African swine fever. The group's EBITDA margin should improve to about 10% in 2022 with lower input costs amid low hog price and hog supply recovery in China in the first half of 2022, together with Smithfield's decent pricing power in the U.S. to pass on some raw material costs. We expect a slight hog price improvement in China in 2023, driven by slower supply recovery post loss period in 2022. As such, WH's margin could contract by 60 basis points in 2023. Notwithstanding the currently strong US dollar, the group can import frozen pork from the U.S. when input costs in China are high, which helps keep EBITDA margins stable. Its EBITDA margin stayed largely stable during the past six years, ranging from 8.3%-10.8%.

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;
Brennan Clark, Chicago + 1 (312) 233 7086;
Bruno Matelli, Sao Paulo + 55 11 3039 9762;
Manqi Xie, CFA, Hong Kong 852-2532-8001;
Alexandre P Michel, Mexico City + 52 55 5081 4520;
Research Contributor:Akanksha Bijalwan, GURGAON HARYANA;

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