Highly leveraged food and beverage companies face tough decisions on how to grow sales while reducing debt amid a fast changing consumer landscape.
Companies in the sector are weighing two different avenues for growth: acquisitions or organic sales through existing brands.
Both strategies require investment – but food and beverage names are at risk of being downgraded to junk if they spend too heavily in their reach for growth, having failed to meet their deleveraging targets from the last bout of M&A in 2018.
It is a classic build versus buy debate.
"What do they do for growth going forward?" asked Meredith Contente, high-grade credit strategist at Amherst Pierpont Securities.
"Acquisitions are obviously a growth vehicle, and if they look to acquisitions before they've hit their leverage targets they would be levering up on already somewhat higher leverage."
Many food and beverage companies levered up in 2018 to fund splashy M&A deals that were supposed to help them adapt to consumer trends in healthy eating.
For example, that year Slim Jim-maker Conagra Brands issued a US$7.025bn bond to pay for the acquisition of Pinnacle Foods, Cheerios producer General Mills issued a US$6.05bn bond to fund its acquisition of Blue Buffalo Pet Products and Campbell Soup priced a US$5.3bn bond for its purchase of Snyder's Lance.
Leverage spiked as high as 5.5 times net debt to Ebitda on those deals, but rating agencies gave the companies until 2021 – a year more than usual – to meet deleveraging targets, Contente said.
And yet nearly two years into those deals, companies are not seeing the sales growth they had hoped for.
Earlier this month one of the most highly leveraged names, Conagra Brands, revised its organic sales to flat or just 0.5% growth in the fiscal year, which is a reduction from its already paltry 1%-1.5% earlier forecast.
"We've just found that the execution wasn't there [across the sector]," said Jon Duensing, director of investment-grade corporates at Amundi Pioneer.
Growing sales by simply hiking prices has not worked, either.
Kraft Heinz, which was downgraded to junk earlier this month, saw US organic net sales decline by 2.7% in the most recent quarter after it attempted to raise revenues through a 3.1% price hike, according to a Barclays report.
"Prices increase and then lower volumes offset that increase, so you're seeing flat to slightly negative organic sales growth," Contente said. "That's telling me that there might be a problem with growth moving forward if they can't get price hikes through."
Kraft had hoped that asset sales would have taken some of the financial pressure off, but these ultimately proved a tough sell.
The company was in discussions to sell a number of its brands including Breakstone's butter and sour cream, Plasmon baby food, Maxwell House coffee and Oscar Mayer processed meats. The sales were shelved amid tepid private equity interest in the brands that were said to require significant investment, according to reports in summer 2019.
"What they failed to do is invest in the brand," said Michael Cho, an investment grade portfolio manager at Aviva Investors.
Ultimately, Kraft decided to halt planned asset sales and belatedly reinvest in those flagship brands, while also maintaining a dividend to appease shareholders.
The moves resulted in downgrades by Fitch and S&P to BB+ and angered some bond investors who participated in Kraft's 2019 liability management exercise on the assumption the company would fight harder to maintain its investment-grade ratings, IFR previously reported.
BIGGER AND BOLDER
The Kraft example highlights the tightrope that food and beverage companies are walking as they try to grow sales as well as firming up their balance sheet.
Kraft hopes to improve sales by boosting its media spending by 30% this year and to drive marketing efficiencies through a shift to support "fewer, bigger and bolder initiatives", said Dave Novosel, high-grade bond analyst at GimmeCredit.
Other companies such as Conagra have strengthened their language around using asset sales as a means of hitting their financial targets.
But the shift in language was too little too late for S&P, as rating agencies show signs of becoming less lenient on missed targets.
Although S&P affirmed a stable outlook for Conagra's BBB– rating in January, a month later it revised the outlook to negative after the company guided for lower organic sales. Conagra still holds stable Baa3 and BBB– ratings at Moody's and Fitch, respectively.
"The outlook revision feels a little bit like Conagra paying for the sins of Kraft Heinz," CreditSights wrote in a report.
"That the agencies are suddenly holding Conagra immediately accountable feels indicative of a more stern approach following years of leniency, and following the Kraft Heinz downgrade."
This tougher approach creates a challenging sector for companies and their bondholders at a time when consumer behaviour is changing rapidly, said Jason Shoup, head of global credit strategy at Legal & General Investment Management America.
"It's a time that is really tricky to navigate," he said. "There are winners and losers as a result of that."