CHICAGO — Many packaged food companies are likely to struggle to generate sales growth above low single digits without the benefit of higher pricing, while competition should remain intense as the economy improves, according to “U.S. Packaged Foods: Improved Credit Metrics Despite Lackluster Top-Line Growth,” a new report published May 20 by Fitch Ratings.

“Very low input cost inflation, cost savings from productivity initiatives, and pruning of low-margin products have recently allowed packaged food companies to expand margins and improve credit metrics,” Fitch said. “Margins have also benefited from higher pricing taken in 2008 and its carryover impact in 2009. However, volume growth has been challenged by continued low-margin stock-keeping unit (s.k.u.) rationalization, the elasticity impact from higher pricing taking in prior periods and competition from store brands.”

Fitch noted recent improvement in credit metrics may not be sustainable if companies step up acquisition and share repurchase activity. For example, while Kraft Foods Inc.’s combination with Cadbury P.L.C. may be just the beginning of merger and acquisition activity for the sector, the ratings agency cautioned that large acquisitions such as Kraft/Cadbury with significant debt financing would likely lead to ratings downgrades upon initially higher debt burdens. As a result, companies such as ConAgra Foods, Inc., General Mills, Inc. and Kellogg Co. are more likely to eye bolt-on acquisitions, Fitch said.

Beyond acquisitions, Fitch said productivity initiatives are expected to become increasingly important for driving earnings growth.

“Restructuring projects have become part of routine business for packaged food companies, as cost savings from these programs are necessary to help offset modest cost inflation and generate margin expansion,” Fitch said. “Now that higher pricing is not currently a lever the packaged food companies can use unless it can be justified in specific circumstances, generating cost savings from productivity initiatives is increasingly important for driving earnings growth. However, there is a risk that too much cost-cutting could adversely affect product quality.”

Another area to watch in 2010 is consumers’ continued focus on value, which Fitch said provides both pros and cons for packaged foods companies.

“The companies benefit from consumers’ propensity to eat at home more often, but face weaker operating performance in their food service businesses when consumers restrict restaurant spending,” Fitch said.

That said, Fitch said it expects food service volumes to pick up slowly as the economy improves in the second half of 2010. The ratings agency said companies have cut costs and eliminated less profitable s.k.u.s in food service, which has contributed to improving margins and profitability.

While private label products will continue to provide viable competition for branded products, the competitive pressure should ease as the economy improves, Fitch said.

“Food retailers continue to invest in their store brands, improving the quality and variety of items offered,” Fitch said. “However, branded products still drive the vast majority of sales in the U.S., and retailers must balance the importance of these brands with their desire to expand store brand sales.”

The ratings agency indicated while the risk remains for U.S. packaged food companies that the shift to private label food products will continue, it is likely to do so at a moderate pace as the economy improves. The private label penetration also is unlikely to reach the same level in the United States that it has in Western Europe, Fitch said.

“Competition is expected to remain intense,” Fitch said. “No. 1 brands with high market shares, and to a lesser extent strong No. 2 brands, are a distinct advantage for packaged food companies because those are perceived as ‘must have’ brands by both retailers and customers. Food retailers need strong brands and innovative new products to draw customers to the stores and drive category growth. Packaged food companies that own these brands can command more pricing power and have lower risk that their brands will be subject to reduced shelf space.

“Companies with high margins for the sector, including General Mills, Kellogg, Campbell, Heinz, and Mead Johnson, have greater resources to invest in their brands to preserve or gain market share relative to competitors. However, lower margin companies Sara Lee, ConAgra, and Del Monte Foods Co. have made notable improvement recently in profitability and cash flow, allowing them to allocate more resources toward advertising and promotions.

“Packaged food companies have shifted more brand-building resources to in-store promotions to support new products and keep the value of existing products at the forefront of consumers’ minds.”