Fitch Ratings expects that the rating outlook for the U.S. Packaged Foods sector will remain stable in 2011, despite the challenges of rising input costs, aggressive competition, and value-conscious consumers. Although the U.S. economy has shown signs of recovery, it has been a slow process that has been hampered by weak labor and housing markets. These factors have prompted consumers to remain cautious regarding spending and seek out the best deals when making food purchase decisions.
Private-label food products are likely to continue to grow in 2011 and will provide formidable competition for branded packaged foods. Growth in private label will be driven by consumers’ desire for value, the proliferation of higher quality private-label food choices, and the price increases that packaged food companies are likely to implement in 2011 to help offset rising commodity input costs.
Packaged food companies with higher exposure to emerging markets, such as Kraft Foods Inc. and H.J. Heinz Co., are likely to generate more robust sales and earnings growth in 2011 and over the long term. Food companies continue to seek acquisitions and organic growth in the BRIC countries (Brazil, Russia, India, and China), where Fitch forecasts GDP growth of 7.3% in 2011, to boost their overall earnings growth. In comparison, Fitch forecasts 2011 GDP growth in mature markets at 2.5% in the United States and 1.7% in the Euro area.
Rising Food Cost Inflation
The input cost inflation environment has changed dramatically since mid-2010. Earlier this year, the packaged food companies were facing very modest input cost inflation. However, shortfalls in wheat crops in Russia and surrounding areas due to drought reduced harvest expectations and Russia’s subsequent ban on wheat exports led to a surge in wheat prices. Other key commodities such as corn and soybeans joined in the new wave of rising prices, which was exacerbated when U.S. corn yields were reduced in October. Separately, other commodities such as world sugar and coffee have seen spot prices rise 40–50% year over year due to reduced crops in key growing regions.
Packaged food companies are raising prices in response to the heightened input costs. However, they risk losing customers to other branded competitors or private label if they lead prices increases and competitors do not follow. Kraft, General Mills, and Sara Lee have recently taken prices increases and may implement additional price hikes. Packaged food companies typically hedge a portion of their costs for the next few quarters. However, swiftly rising input costs have put them in a situation where margins are squeezed because it will take time for their price increases to catch up with the commodity cost inflation they are already incurring. The food companies are also likely to increase cost savings initiatives to help offset the high input cost inflation.
In addition, with the weak economic environment, consumers are not likely to be as receptive to the higher prices as they were prior to the recession. Thus, volumes will be negatively affected and switching to private-label products is expected to be prevalent in this rising price environment. Highly commoditized products and those with the widest price gaps versus private label are most at risk to this trade-down phenomenon. In addition, promotional spending is likely to offset at least a portion of the pricing actions that packaged food companies will implement, and higher advertising expense to maintain consumer loyalty will make it difficult to increase margins or operating earnings in 2011. However, flat to slightly lower margins are not anticipated to affect company ratings.
Judi M. Rossetti
Director, Corporate Finance
Fitch Ratings Ltd.