Fitch Ratings affirms BBB ratings for Flower Foods' issuer default rating, revolving credit facility and term loan A, says company's credit protection measures very strong; outlook stable

Nevin Barich

NEW YORK , March 29, 2012 (press release) – Fitch Ratings has affirmed the ratings of Flowers Foods Inc. (Flowers; NYSE: FLO) as follows:

--Issuer Default Rating (IDR) at 'BBB';

--Revolving Credit Facility at 'BBB'

--Term Loan A at 'BBB'.

The Rating Outlook is Stable.

At the end of 2011, Flowers had approximately $315 million of rated debt in the form of a $90 million term loan A and $225 million borrowed under the revolving credit facility.

Rating Rationale:

Flowers' ratings reflect its leading position in baked goods in the U.S. and its No.1 market share in the southern U.S. - the primary market in which it competes. The company's credit protection measures are very strong. Leverage (debt/EBITDAR) has been less than 2.5 times (x) in each of the past five years. Flowers' has a fair amount of rental expense given that it leases a substantial portion of its distribution facilities, thrift store locations and equipment to grow its business. As a result, rents add more than one turn to leverage and thus the focus on EBITDAR as a primary measure of leverage. Interest coverage has been considerable with Funds Flow from Operations (FFO) interest coverage at more than 16x in each of the past five years as well. The company has ample liquidity with $260 million in revolver availability at Dec. 31, 2011 and modest debt maturities throughout the medium term.

The Stable Outlook is supported by Fitch's expectation that management will be prudent in managing its credit protection measures while executing its growth strategy. Further, there is room within the rating and enough liquidity to manage moderate acquisitions and short term pressure on free cash flow due to volatile commodity costs as discussed below.

Potential Rating Pressure:

Debt Financed Acquisitions: There is currently significant cushion within the rating but it is likely to dissipate. The bakery industry is consolidating and large national participants have declined from approximately eight in 2000 to four today including Hostess Brands which recently filed for bankruptcy. Flowers' intends to participate in the consolidation in a meaningful way. The company is accelerating its growth strategy to serve 75% of the U.S. population by 2016 from 61% at the end of 2011, with annual revenue growth targets in the 5% - 10% range. Organic growth is expected to be 3% - 5% annually and merger and acquisition activity will provide the remaining 2% - 5%. Acquisitions are likely to be funded with debt and leverage could increase materially from the current level of 2.4x.

Volatile FCF due to Hedging Related Activities: The company enters into forward purchase agreements and other derivative financial instruments qualifying for hedge accounting to manage the impact of volatility in raw material prices such as wheat and oils used in the baking process. Hedging has resulted in relatively stable operating margins despite the high level of volatility in commodity costs in 2008 and 2011. Flowers' operating margins has averaged 8% with less than 80bps of movement in either direction.

However, the effect of changes in the balance sheet related to hedging when commodities are highly volatile such as in 2008 and 2011 contributed to negative FCF in those years. Negative FCF could necessitate additional borrowings and increase leverage at a time when the company is already contemplating additional debt for acquisitions.

FCF was negative $24 million in 2011 as the average price of wheat declined approximately 13% between the first and second half of the year, for example. The company expects input costs to increase 6% to 9% from a year ago. Nonetheless, Fitch expects FCF to be materially better than last year as long as input costs remain relatively stable within these higher levels. Fitchnotes that 2008's FCF was negative $45 million but was at record levels in the following two years.

Catalysts for Rating Movements:

There would be downward pressure on the rating if leverage increased materially and did not revert to below the 3 times within 12 to 18 months. At this level the company is able to execute moderate debt financed acquisitions and endure some periods of negative FCF without impacting its ratings. Accretive acquisitions would provide the flexibility to increase debt beyond this level. Upgrades are not anticipated in the near-term due to the company's growth plans for the next 5 years which will include acquisitions and additional leverage.

Fitch notes that management is committed to maintaining an investment grade credit profile and should remain prudent in balancing growth opportunities against credit protection measures. Fitch would expect the company to pull back on discretionary activities and or issue equity, if required, to remain in line with their commitment.

Financial Performance:

For the fiscal year 2011, revenues increased 8% to $2.8 billion with added sales from the Tasty Baking Company acquisition (5%), price/mix (3%) and volume declines of .9%. Operating profit declined 8% to $203 million hampered modestly by increased ingredient and packaging costs as well as $6 million in acquisition related costs. With an EBITDA margin of 10.7%, the company fell just short of their public goal of 11%. EBITDA of $297MM was essentially flat with the prior year.

Flowers' is relatively un-levered - at present. Near-term maturities of less than $55 million are modest over the next four years. Fitch expects there to be ample liquidity for on-going operations from the $500 million revolver that expires in May 2016. Any future acquisitions in the $200 million or higher range will most likely need additional financing outside of the revolver.

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