Kraft Foods Group exposed to significant commodity cost volatility, including exposure to key ingredients such as dairy products, coffee beans, meat products, wheat, corn, oils, nuts and sweeteners, S&P says

Nevin Barich

NEW YORK , May 25, 2012 (press release) – Overview

-- U.S.-based Kraft Foods Inc. plans to spin off its North American grocery business, Kraft Foods Group Inc. (KFG), through a distribution of KFG's stock to Kraft Foods' shareholders.
-- We are assigning our preliminary 'BBB' long-term and 'A-2' short-term corporate credit ratings to Kraft Foods Group Inc.
-- The rating outlook is negative, reflecting our concerns that key credit measures for KFG may not strengthen to levels that support the ratings within the next 12-18 months.

Rating Action

On May 24, 2012, Standard & Poor's Ratings Services assigned its preliminary 'BBB' long-term and 'A-2' short-term corporate credit ratings to Northfield, Ill.-based packaged food company Kraft Foods Group. The rating outlook is negative.

Rationale

Kraft Foods Group Inc. (KFG) is currently a subsidiary of Kraft Foods Inc. (BBB/Stable/A-2) and currently includes its snack foods and grocery businesses. Kraft Foods is spinning off the North American grocery business, which will retain the Kraft Foods name through a distribution of its common stock to its shareholders, in a transaction it expects to complete before 2012
year-end. Kraft Foods recently received a favorable private letter ruling from the U.S. Internal Revenue Service confirming the tax-free status of the planned spin-off.

Our rating on the newly formed grocery business, KFG, assumes the spin-off will occur in accordance with the plans disclosed by Kraft Foods, including in its Form 10 filing. The rating reflects our assessment of the company's business risk profile as "strong" and financial risk profile as "significant." Key credit factors in our assessment include the company's well-recognized brands and product diversification, within the mature and low-growth packaged food markets of North America, yet narrow geographic focus and exposure to volatile commodity input costs. Our view of the company's financial risk profile as significant reflects financial policies we consider aggressive, including an expected very high dividend payout rate, adequate liquidity, and key credit measures that we believe will strengthen and remain consistent with indicative ratios for a significant financial risk profile.

We view KFG's business risk profile as strong. Following the spin-off, KFG will be a North American packaged food and beverage company, with estimated net revenues of about $18.7 billion in 2011. The business will consist of the U.S. and Canadian grocery, beverage, cheese, convenient meals businesses; the Planters and Corn Nuts businesses (which were previously part of U.S. snacks); related foodservice operations; the grocery business in Puerto Rico; and the current export operations related to the grocery business lines in the U.S.
and Canada, which are currently part of Kraft Foods. KFG's diverse product portfolio will include three brands that each generate more than $1 billion in revenues including Kraft (cheeses, dinners, and dressings), Oscar Mayer meats, and Maxwell House coffee, although more than 40% of its segment operating income is derived from its U.S. grocery segment as per its Form 10 filed with the SEC. Its brand portfolio will also include 20 brands, each generating annual revenues of more than $100 million that are spread across beverages, cheese, convenient meals, and grocery segments including Jell-O, Philadelphia, Capri Sun, and Miracle Whip. KFG believes it holds leading share positions in the majority of its 50 product categories.

Although KFG will be one of the largest branded packaged food companies in North America, it participates in a highly competitive industry, characterized by a need for significant spending on advertising, trade promotion, and product innovation, amid competition with other large players such as Nestle S.A. (AA/Stable/A-1+) and Unilever PLC (A+/Stable/A-1), as well as private-label or house-branded products. Geographic diversification will be limited to North America, with substantially all of its cash flow generated in the U.S., and we anticipate that international expansion will be constrained following the separation based on disclosures in the Form 10. We believe that KFG is exposed to significant commodity cost volatility, including exposure to key ingredients such as dairy products, coffee beans, meat products, wheat, corn, oils, nuts, and sweeteners, all of which have fluctuated substantially over the past few years. The company has taken significant price increases to offset input cost increases during 2011, and we expect that KFG will continue to take pricing actions as necessary to offset fluctuations in input costs. The company estimates that the savings associated with its previously announced restructuring program will more than offset the expected overhead dis-synergies resulting from its becoming an independent company.

We believe that as a stand-alone company, KFG will have a significant financial risk profile. In 2011 the company's net sales increased 4.8%, primarily from higher pricing as well from the additional 53rd week, partially offset by unfavorable volume and mix, and the loss of Starbuck's business. Following a review of its Form 10 disclosures, we estimate that EBITDA margin
declined roughly 100 basis points in 2011 to about 18%, from 19% in 2010 on a constant basis, although EBITDA was steady at about $3.3 billion. Furthermore, we estimate pro forma for $10 billion of planned debt issuance at KFG and including pension and other postretirement obligations to be transferred to KFG as part of the spin-off, leverage, as measured by the ratio of total debt to EBITDA, was about 4x and funds from operations to total debt was 16% at year-end 2011. This leverage ratio is on the weak end of the indicative leverage ratios for a significant financial risk profile, which includes debt to EBITDA of 3.0x-4.0x. Cash flow coverage is more consistent with indicative ratios for an aggressive financial risk profile, including FFO to total debt between 12%-20%.

Based on our forecasts, we estimate that pro forma leverage (at the time of the transaction expected prior to the end of 2012), will be about 3.8x and funds from operations (FFO) to total debt will be about 17%, but will improve to levels more consistent with a significant financial profile by the end of 2013, including leverage of about 3.5x and FFO to debt of almost 20% as the company realizes the increasing benefits from its restructuring efforts.

Our 2012 base-case scenario assumes the following:

-- KFG's reported revenues will decline about 1% in 2012 reflecting the loss of the Starbucks business in the beverage segment and excluding the 53rd week that will more than offset higher pricing as we expect it will result in continued pressure to volumes.
-- Our adjusted EBITDA margin improves beyond KFG's Form 10 reported fiscal 2011 margin of about 18%, reflecting our expected realization of productivity and cost savings.
-- Our free cash flow estimate for 2012 of at least $1.2 billion and capital expenditures in the 2.5%-3.0% of revenues range.
-- KFG has indicated it expects to pay the equivalent of $0.64 per share, which is over 50% of Kraft Foods Inc.'s current dividend. Given that we expect the company to fund this with annual free cash flow, we have not forecasted debt reduction.
-- We expect share repurchases, if any, will be limited to only offset option dilution.
-- No acquisitions or increase in pension funding requirements.

Liquidity

We believe KFG's liquidity following the spin-off will be "adequate" under our criteria, meaning that we believe liquidity sources will exceed uses by at least 1.2x over the next 12 months. Our view of the company's liquidity profile incorporates the following expectations.

-- We expect liquidity sources (including discretionary cash flow and availability under its $7 billion revolving credit facilities (unrated), of which $4 billion matures in March 2013) for general corporate purposes to exceed uses by 1.2x over the next 12 months.
-- We expect liquidity sources to continue to exceed uses, even if EBITDA were to decline by 15%, and without breaching the company's financial covenant test, as we expect it will have sufficient cushion.
-- The company's $3 billion revolving credit facility will be subject to a minimum net worth covenant, on which we expect the company to maintain ample cushion.
-- We believe KFG has solid relationships with its banks and will have a generally satisfactory standing in the credit markets.
-- We expect the company's debt maturity schedule will be staggered and near-term maturities will be modest.

Outlook

Our rating outlook on KFG is negative. Although we expect some improvement over the next year, credit measures pro forma for the spin-off are on the weaker end of indicative ratios for a significant financial risk profile. We could lower the ratings if the company's leverage fails to decline to less than 4x and FFO to total debt remains below 20% within the next 12-18 months.
We believe this could occur if the company experiences operating difficulties as an independent entity including the inability to sufficiently cover rising commodity costs or continued volume declines, and fails to realize its expected cost savings, or if KFG were to demonstrate a more aggressive financial policy such as debt-financed share repurchases. On the other hand, we could consider an outlook revision to stable if the company improves and sustains key credit ratios in line with a significant financial risk profile, specifically reducing leverage to 3.5x and improving FFO to total debt above 20%. We estimate this could occur if revenues increase in the low single digits and EBITDA margin is greater than 19%

Related Criteria And Research

-- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011
-- Key Credit Factors: Criteria For Rating The Global Branded Nondurable Consumer Products Industry, April 28, 2011
-- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- Corporate Criteria: Analytical Methodology, April 15, 2008

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