NEW YORK — In projecting a stable ratings environment for packaged foods companies in 2012, Fitch Ratings said prospective gross margin improvements could prove an offset to “significant challenges,” including a difficult consumer environment.

“Many of the food companies faced their peak commodity cost inflation levels during the most recent quarter, and Fitch expects this cost pressure to begin to ease sequentially,” the agency said. “Correspondingly, gross margins should recoup some lost ground as the prolonged margin squeeze that food companies faced for most of 2011 begins to dissipate.”

The analysis was part of “2012 Outlook: U.S. Packaged Foods,” published by a team of Fitch analysts led by Judi. M. Rossetti. Fitch currently has stable outlooks for 67 packaged foods companies, negative outlooks for 22 and positive for 11.

Other key elements included in the Fitch outlook include projections for the completion of major corporate spinoffs in the sector and continued focus on emerging markets.

A factor identified by Fitch that could worsen the outlook would be a substantial increase in leverage across the sector, either through more aggressive financial strategies or material earnings declines.

A revision to a more positive outlook would be possible if several companies choose to become significantly more cautious in their financial policies, Fitch said. Foregoing share repurchases in favor of debt reduction or limiting growth strategies were examples offered by Fitch of how companies may seek to keep leverage “well below current rating levels.”

During the upcoming year, positive free cash flow generated by packaged foods companies is expected to be substantial, Fitch said, allowing companies to maintain ample liquidity and facilitating anticipated priorities such as bolt-on acquisitions and share repurchases.

“Acquisitions are likely to be in core categories and to grow internationally, particularly in faster growth emerging markets,” Fitch said.

While acknowledging debt-financed share repurchases will be “tempting” in the current low interest rate environment, the ratings agency expressed doubt food companies will pursue “material leverage increases for share repurchases.”

Larger plunges into leverage in 2012 are likely only for what were termed “must have” larger acquisitions.
“ConAgra Foods Inc. would be the most likely to push the limit of investment-grade ratings since it already demonstrated this willingness with its rejected proposal to acquire Ralcorp for approximately $7.6 billion in cash,” Fitch said. “ConAgra’s leverage is currently low in the rating level and allows the company flexibility to pursue acquisitions in private label, core adjacencies or outside the United States.”

Fitch also mentioned Campbell Soup as a company that may be aggressive in the acquisition sphere, with a likely focus on expanding its international presence.

By contrast, a number of companies are likely to move to reduce debt burdens in 2012 with certain industry players having already committed to doing so.

In particular, Fitch said General Mills, Inc. has pledged to reduce share repurchases in the new year after having spent $1.2 billion, partly financed by debt, to acquire interest in Yoplait.

“Debt reduction will also be a priority for each of the companies in the midst of spinoffs,” Fitch said. “Kraft, Sara Lee and Ralcorp will need to significantly reduce debt at their remaining businesses to maintain ratings as smaller, less diverse companies.”

Expanding on inflationary prospects, Fitch said the industry was plagued in 2011 by inflation that led companies to raise prices, sometimes multiple times.

“Fitch anticipates that input cost inflation for companies with 2012 calendar year ends will be modestly below these levels (high single digit or low double digit – ranges expected in 2011 or for companies with fiscal years ending in 2012) since the highest inflation period appears to be behind them,” Fitch said.

The agency said the risks of further inflationary spikes have not been eliminated but noted a Bureau of Labor Statistics forecast of “moderation in food price inflation” with a forecast of 3% to 4% inflation in 2012, versus 4% to 5% in 2011.

Emblematic of challenges facing the U.S. food industry is the recent track record of Kraft, Fitch said.

“One of the best performing food companies has been Kraft, which generated sequentially higher sales growth this year and achieved high single-digit organic sales growth in the third quarter of 2011 while maintaining slightly positive volume/mix,” Fitch said. “However, when broken down by geography, strong volume/mix in developing markets has outweighed a slight volume decline in North America. These divergent growth trends are likely to continue.”

Fitch cited Campbell Soup and Kellogg as companies either struggling to grow or facing challenges ahead.
“Campbell’s and Kellogg will both have rebuilding years in 2012 as they invest in their businesses for long-term growth,” Fitch said.