Standard & Poor's affirms BBB+ corporate credit rating for Kellogg,

Nevin Barich

NEW YORK , April 13, 2012 (press release) – Overview

-- U.S.-based Kellogg Co. is acquiring Pringles from Procter & Gamble (AA-/Stable/A-1+) for about $2.7 billion.

-- Given our expectation that Kellogg will reduce leverage to below 3x by 2014, we are affirming our ratings, including the 'BBB+' corporate credit rating.

-- The outlook is negative. We could lower the ratings if Kellogg is unable to improve credit protection measures during the next 24 months, including reducing and sustaining lease- and pension-adjusted leverage to below 3x and improving funds from operations (FFO) to total debt approaching 30% by 2014.

Rating Action

On April 13, 2012, Standard & Poor's Ratings Services affirmed all its ratings, including its 'BBB+' corporate credit rating, on Battle Creek, Mich.-based Kellogg Co. and removed the ratings from CreditWatch, where they had been placed with negative implications on Feb. 15, 2012, following the company's announcement that it was acquiring Pringles for roughly $2.7
billion, funded with approximately $2.3 million in additional debt and $450 million of international cash. The company's 'A-2' short-term and commercial paper (CP) ratings remain unchanged.

While we affirmed the issue-level ratings at 'BBB+', the same level as the corporate credit rating, we estimate that the company's pro forma ratio of priority obligations to adjusted assets is on the weaker end of our threshold for notching down for investment-grade issues, despite including some benefit from our estimates for the brand value of Kellogg. If the company made an additional sizable acquisition, we would consider reviewing the issue-level ratings for a possible downgrade by one notch.

The ratings affirmation reflects our expectation that Kellogg will apply excess cash flow to debt reduction during the next two years through the maintenance of an EBITDA margin of at least mid- to high-teens, positive working capital from Pringles, capital expenditures not exceeding 5% of sales, and curtailment of its share repurchases. We estimate that pro forma for the Pringles acquisition, leverage would increase to about 3.4x and FFO to total debt would weaken to about 21% for the year ended Dec. 31, 2011 as compared with about 2.8x and 25%, respectively, actual at year-end.

The outlook is negative. This reflects our belief that we could lower the ratings if Kellogg is unable to reduce and sustain leverage below 3x by 2014. We estimate this could occur if it were to use excess cash for share repurchases instead of debt reduction and is unable to attain at least 2% revenue growth and maintain EBITDA margin in the mid- to high-teens area
through organic growth by 2014. Pro forma for the additional debt related to the Pringles acquisition, we estimate the company will have about $8.3 billion in reported debt outstanding. Including our adjustments for operating leases and pension obligations, we estimate that Kellogg will have roughly $9.3 billion in adjusted debt outstanding after the transaction.

Rationale

The ratings on Battle Creek, Mich.-based Kellogg Co. reflect its 'strong' business risk profile. Key credit factors considered in assessing Kellogg's business risk profile include its well-recognized brands, leading market positions in the ready-to-eat (RTE) cereal and snack food industries, and product and geographic diversity. These factors are partially offset by the
company's exposure to volatile commodity costs and participation in the highly competitive cereal market, which has experienced slower growth in the U.S. Standard & Poor's believes Kellogg has a 'significant' financial risk profile, marked by the company's increased debt levels following the acquisition, which have resulted in credit measures weakening to those more in line with indicative ratios for a significant financial risk profile.

Kellogg is the largest global producer of RTE cereal (about 51% of total 2011 sales), and a large producer of snack foods (39% of sales), including cookies, crackers, toaster pastries, cereal bars, fruit-flavored snacks, as well as frozen/other items (10% of sales) including waffles and veggie foods. The company's strong portfolio of brands, including Special K, Frosted Flakes, Cheez-It, Eggo, Pop-Tarts, and Keebler, is supported by high levels of advertising (about 9% of sales). We believe reinvestment in brands, through advertising, promotion, and product innovation, helps keep private-label share in Kellogg's categories below average levels in grocery. In our opinion, Kellogg has good geographic diversity, with about 33% of sales generated outside the U.S. in 2011, although most of its international sales are currently concentrated within cereal.

We believe that Pringles will somewhat improve the company's diversity and add operating scale to its international snack segment. We estimate that the company's international snack division will nearly triple in sales following the acquisition and international sales will increase to about 36% of combined company sales. Pringles will also provide the company with channel diversification through broader distribution at mass retailers and convenience stores.

Performance has begun to improve after weak financial performance in 2010 that resulted from supply chain problems, lack of product innovation, deflation in core cereal categories, and other issues. After volume declines in 2010, the U.S. cereal category began to show improving trends in 2011. Over the long term, we believe the category can grow in the low-single-digits (similar to historical rates) from areas such as health and wellness trends, product innovation, brand building, increasing consumption beyond breakfast, affordability, and demographic trends. Kellogg's reported sales in fiscal 2011 grew 6.5%, or 4.5% organically driven by pricing and mix. We estimate pension- and lease-adjusted EBITDA declined by about 1% and EBITDA margins weakened to 18.8% for the year, about a 140 basis point decline from the prior year, largely due to commodity cost inflation of about 7%. We expect margins to
remain pressured in 2012 from higher commodity costs, reinstatement of incentive compensation, and Pringles integration costs. To partially offset this inflation, Kellogg has raised prices, focused on productivity initiatives, and hedged over 70% of its commodities for 2012. Upon the completion of a three-year productivity program, Kellogg believes it will realize more than $1 billion of annual cost savings beginning in 2012. As part of that initiative, the company implemented its K-LEAN (Kellogg's lean, efficient, agile network) program to optimize its global manufacturing network, reduce waste, and develop global best practices. Following the completion of the program, Kellogg believes it can achieve 3% to 4% productivity savings.

Following the Pringles acquisition, we believe that credit protection measures will weaken and have revised our financial risk profile to 'significant' from 'intermediate.' We estimate that pro forma for the Pringles acquisition, leverage would increase to about 3.4x and FFO to total debt would weaken to about 21% for the year ended Dec. 31, 2011 as compared with about 2.8x and 25%, respectively, at actual year-end. These pro forma credit statistics are more in line with our 'significant' indicative ratios of leverage between 3x and 4x and FFO to total debt of between 20% and 30%.

On April 23, 2010, Kellogg's board authorized a $2.5 billion, three-year share repurchase program for 2010 through 2012. About $650 million remains available for repurchase as of Dec. 31, 2011. The company maintains a dividend payout between 40% and 50% of reported net earnings. We expect the company to reduce share repurchases during the next two years to apply excess cash flow toward debt reduction.

We expect Kellogg to improve its financial profile by reducing leverage to below 3x and FFO to total debt to approach 30% by 2014 to maintain the current 'BBB+' corporate credit rating. Our base case scenario assumptions that we estimate will enable Kellogg to reach these levels include:

-- Pro forma revenue growth of about 4% annually driven primarily by pricing and favorable mix, partially offset by weaker volumes in North America and Europe in the near term and greater growth in Latin America and Asia Pacific.

-- EBITDA margin in the mid-double-digits reflecting continued high commodity costs and stable operating costs that decline modestly over time with the realization of productivity savings and cost synergies. Management targeted annual run rate cost synergies from the acquisition of roughly $50 million and $75 million by 2014.

-- Continued strong free operating cash flow generation of at least $1 billion and capital expenditures maintained at below 5% of net revenues.

-- Positive working capital reflecting the benefit of the Pringles acquisition.

-- Debt reduced by the paydown of CP borrowings and excess cash and the curtailment of share repurchases. We expect the company to pay down at least $850 million of gross debt by 2014 in order to improve credit protection measures.

-- We estimate that the company will continue to pay dividends in line with historical payout rates and will limit its share repurchases to only offset option dilution through 2014.

Our forecast and ratings have not incorporated any potential increased liability or higher contributions to the company's multiemployer pension plans. During 2011, Kellogg's total contributions to multiemployer pension plans were $12.6 million as compared with $11.6 million in 2010. As of Dec. 31, 2011, Kellogg disclosed that it participates in six major plans, including Bakery and Confectionary Union and Industry International Pension Fund. We understand that Hostess Brands, which filed for Chapter 11 bankruptcy in January 2012, is a significant contributor to this fund. It is currently unclear what effect Hostess Brands' labor modification agreements will have on Kellogg's future contributions.

Short-term credit factors

We believe Kellogg has 'adequate' liquidity (as defined in our criteria), and we expect sources of cash are likely to be in excess of uses for the next 12 months. Our view of the company's liquidity profile incorporates the following expectations:

-- We expect liquidity sources (including cash, discretionary cash flow, and significant availability under its $2 billion revolving credit facility) will exceed uses by 1.2x during the next 12 months.

-- We expect liquidity sources to continue exceeding uses, even if EBITDA declines by 15%.

-- With its cash balance and significant availability under its revolving credit facility, we believe the company could absorb, with limited need for refinancing, high-impact, low-probability events. Liquidity is supplemented by the perceived flexibility to lower capital spending or sell assets, among other actions.

Cash sources include cash balances of $460 million at Dec. 31, 2011, and cash flow (reported FFO totaled about $1.5 billion for the year ended December 2011). Kellogg has an unused, $2 billion four-year credit facility that matures in March 2015. The facility is available to support the company's CP program and short-term borrowings from financial institutions, including a
$750 million (or its equivalent in alternative currencies) euro CP program. About $216 million of CP was outstanding at Dec. 31, 2011. We estimate that the company will draw on its facilities as part of the transaction, still leaving enough capacity for working capital needs. The facility has a 4x interest coverage ratio covenant, with which Kellogg is well in compliance.

We expect cash uses in 2012 to include less than $100 million of share repurchases and ongoing dividend payments. We expect about $200 million of share repurchases in fiscal 2013. We also expect annual capital spending to total about 4% to 5% of net sales in 2012 and 2013 (compared with the company's long-term target of 3% to 4% of sales) for investment in
manufacturing capacity and information technology infrastructure, including the reimplementation and upgrade of the company's SAP system.

Outlook

The negative outlook reflects the potential that we could lower the ratings if Kellogg is unable to improve its credit protection measures within the next 24 months to levels that support the ratings. We believe this could occur if the company does not achieve at least 2% revenue growth, does not maintain an EBITDA margin in the mid- to high-teens, and does not reduce debt with excess cash. We could consider lowering the ratings if operating performance does not improve, leverage does not decline below 3x, and FFO to total debt does not approach 30% by 2014. In addition, we could lower the ratings in the event the company pursues a more aggressive financial policy such as large share repurchases and/or dividends that we believe would also impact Kellogg's ability to improve credit measures. Alternatively, we could consider revising the outlook to stable if the company continues to improve profitability, reduces and sustains leverage to below 3x, and improves FFO to total debt near 30% within the next 24 months, and maintains adequate liquidity. We believe this could occur if the company reduces debt by at least $850 million from post-transaction levels, revenues grow by at least low-single-digits, and EBITDA margin is maintained at least in the mid-teens.

Related Criteria And Research

-- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011

-- Corporate Criteria: Analytical Methodology, April 15, 2008

-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011

-- Business Risk/Financial Risk Matrix Expanded, May 27, 2009

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