By Patrick Barwin, CFA, Credit Research Analyst, & Denise Langhoff, Credit Research Analyst
Fundamental headwinds in the packaged food industry have crystalized over the last year as secular pressure on revenue growth has been compounded by a cyclical step-up in inflation. Unable to pass on the inflation through higher pricing, company profits and margins have weakened. This has led to an aggressive pursuit of M&A within the industry, introducing execution risk, higher leverage and lower discretionary free cash flow into many credit profiles. With some packaged food issuers now trading at historically wide spread levels, is this an opportunity for credit investors or does it signal the start of a longer-term fundamental inflection and downward rating migration?
Not new, but different
Over the last 10 years, consumers have pivoted from the grocery store center aisles to the perimeter in search of fresh, less-processed products such as meat and produce. While packaged food managers offset the revenue stagnation in recent years through extensive cost savings programs during a benign inflationary environment, the wringing of profits from cost containment has largely reached its limit. The sector is now in the cross-hairs of a number of fundamental challenges, including:
- Volume headwinds, as the shift from packaged to fresh food is expected to continue;
- Reduced pricing power, as retailers have gained negotiating leverage through consolidation;
- Increased private label competition, as retailers look to expand margins with in-house brands;
- Rising commodity costs, including freight inflation (Exhibit 1); and
- Increased investment needs to support new product innovation and reinvigorate legacy brands.
Exhibit 1: Increase in truckload transportation rates, year over year
Source: Bloomberg. As of June 7, 2018.
Some manufacturers have responded by focusing on internal investment initiatives and tuck-in acquisitions. Many others have opted for large-scale M&A to capture growth, often with a new CEO at the helm (16 new CEOs in packaged food in the last two years). The slew of recent deals have been expensive with an average enterprise value multiple of 20.1x for the five most recent transactions (Exhibit 2). These deals have driven leverage into what was typically viewed as high yield territory. The issuers, which have placed $24 billion in new investment grade debt in the last year to fund M&A—in addition to more than $100 billion in new supply in 2016/17 to fund other M&A in consumer staples—are left with relatively minimal discretionary free cash flow (FCF) to de-lever. Thus, while headwinds in packaged food volumes and cyclical inflation pressures are not new, the levered nature of many balance sheets means this cycle could be different. An extended period of deteriorating profits could result in downward ratings migration, potentially into high yield.
Exhibit 2: Recent deal activity completed at high multiples (last five deals as of June 30, 2018)
1. FCF = Funds from operations (FFO) less capex less dividends/net debt
Source: Aegon AM US estimates and company filings.
Outlook and opportunities
The lack of discretionary free cash flow that can be used to reduce debt implies EBITDA growth will be needed to de-lever in a timely manner. In addition to the synergies expected from the acquisitions, companies must generate organic EBITDA growth to meet their stated delevering targets. With many packaged food companies reporting EBITDA declines in the first quarter of 2018 due to inflationary pressures, confidence that some issuers can grow EBITDA organically in the current environment has been reduced. In the event margins continue to weaken, many issuers could remain materially above the rating agency leverage targets.
While treating the packaged food space with caution is warranted, especially the recent M&A issuers, this may represent an opportune time for bottom-up investors to identify manufacturers that maintain above-average fundamentals but whose spreads have moved wider. There may also be an opportunity with the levered issuers if companies show a commitment to de-levering through actions, not simply words, such as an openness to cut the dividend. Viewing the opportunities through a disciplined lens may provide an opening to gain exposure to fundamentally sound companies within a defensive sector at attractive levels, while a lack of discipline could leave investors with investment grade paper bound for high yield.
This material is to be used for institutional investors and not for any other purpose. The enclosed information has been developed internally and/or obtained from sources believed to be reliable. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US Form ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate.
The information presented is for illustrative purposes only. Individual accounts may vary based on restrictions, substitutions, cash flows and other factors.
Specific sectors mentioned to not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable. References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell, or hold such securities. Aegon AM US products and strategies may or may not include the securities referenced and if such securities are included, there is no representation that such securities will continue to be included.
Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.
There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.
This document contains "forward-looking statements" which are based on change to the firm's beliefs, as well as on a number of assumptions concerning future events based on information currently available. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein. In addition, this material contains information regarding market outlook, rates of return, market indicators and other statistical information that is not intended and should not be considered an indication of the results of any Aegon AM US-managed portfolio.
Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.
Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon Asset Management US, 4333 Edgewood Rd NE, Cedar Rapids, IA 52499. ©2018 Aegon Asset Management US. Adtrax Code: 2168082.1 Exp Date: 7/31/19.