Fitch Ratings assigns BBB+ ratings to Kellogg Canada's long-term issue default, senior unsecured notes ratings; outlook negative

Nevin Barich

NEW YORK , May 16, 2012 (press release) – Fitch Ratings has assigned a 'BBB+' long-term Issuer Default Rating (IDR) to Kellogg Canada Inc. (Kellogg Canada) and a 'BBB+' senior unsecured notes rating to Kellogg Canada's proposed Cdn$300 million senior unsecured notes due 2014. Kellogg Canada is a wholly owned subsidiary of Kellogg Company (Kellogg) that produces and markets Kellogg products in Canada. Kellogg Canada intends to use the net proceeds from this debt issuance for general corporate purposes which may include the repayment of intercompany debt. The privately placed notes will be fully and unconditionally guaranteed by Kellogg, and will rank on parity with Kellogg's other unsecured and unsubordinated debt. The Rating Outlook is Negative.

The proposed notes contain a Change of Control Repurchase Event provision. Upon the occurrence of both a Change of Control and rating downgrades below investment grade, unless Kellogg exercises its right to redeem the notes, the company will be required to make an offer to purchase the notes at a price equal to 101% of the aggregate principal amount plus accrued and unpaid interest. The notes will be issued under a new indenture, which contains limitations on liens and sale-leasebacks but does not contain financial covenants.

Kellogg's ratings incorporate its #1 and #2 market share positions, strong brand equities, and ample liquidity. The company is diversified geographically, with nearly 40% of 2011 sales generated outside of the United States. However, Kellogg has significant exposure to slow-growing, mature markets and modest exposure to faster growing emerging markets.

The ratings also reflect Fitch's view that operating earnings growth beyond 2012, combined with significant debt reduction from free cash flow, could restore leverage near the level prior to Kellogg's approximately $2.7 billion acquisition of the Pringles business from Procter & Gamble within two years of the acquisition's mid-2012 closing. Kellogg has committed to reduce debt by refraining from share repurchases beyond offsetting the dilution from stock option exercise, in order to focus on debt reduction.

The Negative Outlook for Kellogg and its subsidiaries reflects that near-term consolidated leverage (total debt to operating EBITDA) of slightly more than 3.0 times (x) will be high for the rating level and a significant increase from 2.5x for the latest 12 months ended March 31, 2012. Leverage will increase due to the acquisition. Pringles will add about six months of sales to Kellogg but little if any operating earnings in 2012 due to one-time costs to achieve synergies and Kellogg's planned investment in this business for future growth. The Outlook also considers that Kellogg's debt reduction plans may be impeded by current operational challenges, significant reinvestment in its supply chain and the Pringles integration. These factors are compounded by persistently high commodity inflation, with 7% inflation anticipated in 2012, macroeconomic uncertainty, and some consumer resistance to recent food price increases.

A one notch downgrade could occur if Kellogg's operating performance, which factors in the company's recently lowered guidance, substantially deteriorates from current expectations, or if debt reduction is slower than anticipated, resulting in leverage that is likely to be at or near 3.0x in mid-2014. A downgrade could also occur if Kellogg becomes more aggressive with share repurchases or acquisitions. Conversely, Fitch could revise the Outlook to Stable if Kellogg's operating earnings trends show sustainable improvement, or if debt reduction occurs at a faster rate than anticipated so that leverage appears likely to be sustainable in the mid-2x range by mid-2014.

Kellogg recently revised its top line and earnings expectations downward for 2012, reflecting weakness in its core ready-to-eat cereal business in Europe and the U.S., primarily due to recently implemented price increases that are receiving a tepid response from consumers. Kellogg currently anticipates internal operating earnings (excluding currency and acquisitions/divestitures) to fall 2% to 4% in 2012, after a 3% decline in 2011 and flat results in 2010. Kellogg's guidance also incorporates approximately $100 million permanently higher level of investment in its supply chain after it had cut back too far in previous years.

The company's ample free cash flow (FCF; cash flow from operations less capital expenditures and dividends) has averaged almost $400 million annually during the past five years. Excluding pension and postretirement contributions, which have been substantial, FCF has averaged almost $700 million annually for the same period. Fitch anticipates that Kellogg can return to this level of FCF in 2014 or 2015, but in the near-to intermediate term heightened capital expenditures, earnings pressure, reinvestment in Pringles and cash costs to achieve synergies will reduce cash flow significantly.

Kellogg's sizeable liquidity includes $2 billion available on its unutilized revolving bank facility expiring in March 2015 and $404 million of cash and cash equivalents. Kellogg plans to utilize a substantial amount of its cash for the Pringles acquisition. On March 16, 2012, Kellogg also entered into an unsecured 364-day term loan agreement which will allow the company to borrow up to $1 billion to partially fund the acquisition and to pay related fees and expenses. Kellogg's total debt at March 31, 2012 was $5.8 billion. Pro forma for the transaction Kellogg's debt will be approximately $8 billion.

Kellogg's upcoming debt maturities include $750 million 5.125% notes due Dec. 3, 2012 and $750 million 4.25% notes due March 6, 2013. Debt reduction over the next two years could include a portion of these maturities and debt that will be issued for the Pringles deal.

Fitch rates Kellogg and its subsidiaries' as follows:

Kellogg

--Long-term Issuer Default Rating (IDR) at 'BBB+';

--Senior unsecured debt at 'BBB+';

--Bank credit facility at 'BBB+';

--Short-term IDR at 'F2';

--Commercial paper (CP) at 'F2'.

Kellogg Europe Company Limited

--Long-term IDR at 'BBB+';

--Short-term IDR at 'F2';

--CP at 'F2'.

Kellogg Holding Company Limited

--Long-term IDR at 'BBB+';

--Short-term IDR at 'F2';

--CP at 'F2'.

The Rating Outlook is Negative.

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