S&P affirms BBB corporate credit and senior unsecured debt ratings on Sara Lee, removes senior unsecured debt ratings from CreditWatch; outlook stable

Nevin Barich

NEW YORK , June 18, 2012 (press release) – Overview

-- Sara Lee Corp. will spin off its coffee and tea business, D.E Master Blenders 1753 B.V. (BBB/Stable/A-2), on June 28, 2012

-- After the spin-off Sara Lee will be renamed The Hillshire Brands Co., and will primarily be a provider of branded package meats and bakery products to retailers and foodservice customers.

-- We are affirming our 'BBB' corporate credit and senior unsecured debt ratings on Sara Lee, while removing the senior unsecured debt ratings from CreditWatch.

-- The outlook remains stable, reflecting our opinion that the new company will maintain debt-to-EBITDA near or below 2.5x and a funds from operations to total debt ratio approaching 30%.

Rating Action

On June 18, 2012, Standard & Poor's Ratings Services affirmed its ratings on Downers Grove, Ill.-based Sara Lee Corp., including the 'BBB' corporate credit and senior unsecured debt ratings. The outlook is stable. At the same time, we removed the senior unsecured debt ratings from CreditWatch, where they were placed with negative implications on Jan. 28, 2011, reflecting our concern that this debt may be structurally subordinated to obligations at the operating company.

Rationale

We affirmed the senior unsecured debt ratings based on our belief that Sara Lee will continue to directly own the majority of its operating assets, and therefore its debt obligations will not be structurally subordinated to any operating subsidiary priority obligations. Sara Lee will have about $942 million in outstanding debt after the spin-off, when $650 million in private
placement notes recently issued at Sara Lee become the obligation of D.E Master Blenders 1753.

We do not currently consolidate this debt for analytical purposes because it will not be an obligation of Sara Lee post-spin-off. Moreover, all regulatory hurdles to complete the spin-off have been met, so we see very little risk of the spin-off not occurring and this debt remaining an obligation of Sara Lee. Lastly, if a spin-off were not to occur, Sara Lee would continue to be a consolidated entity with a large EBITDA base. The company would have significant cash balances, totaling at least $1.8 billion, given that the announced $3 per share dividend to be paid by D.E Master Blenders 1753 would not occur, thus affording it sufficient funds to repay the private placement notes if it opted to under a call option in the bond agreements.

We affirmed our Sara Lee corporate credit rating to reflect our opinion that the remaining company would continue to have a "satisfactory" business risk profile and an "intermediate" financial risk profile. Key credit factors in our business risk assessment include Sara Lee's leading market positions within its product categories, and brand strength. These are somewhat tempered by Sara Lee's narrower geographic diversification following the spin-off, and exposure to volatile commodity costs. The intermediate financial risk profile reflects the company's intention to maintain moderate leverage while adopting prudent financial policies, including a pro forma ratio of debt to EBITDA of about 2.7x improving to below 2.5x by fiscal year end 2013, a moderate dividend policy, and no current intentions to repurchase shares.

In our opinion, the remaining Sara Lee meats and bakery products business, although more narrowly focused, has good brand recognition, including a portfolio of four core national brands (Jimmy Dean, Hillshire Farms, Ball Park, and State Fair), and two core artisanal brands (Gallo and Aidells). The company's brands have the number one market position in all but two categories (hot dogs and lunch meats, where it ranks behind Oscar Meyer with respective number two and three market share positions). Moreover, these brands are in categories with generally good household penetration rates and benefit from limited private label penetration (currently less than 10% private label penetration in aggregate). Despite these strengths, we believe Sara Lee's post-spin-off business profile is moderately weaker than the current consolidated business risk profile, reflecting narrower geographic diversification (sales are largely U.S.-based with a small Australian bakery business). Additionally, Sara Lee will have lower pro forma EBITDA margins of closer to 11% with continued exposure to volatile protein-based and other raw material costs, which constitute about 60% of the company's cost of sales.

We believe the company's strategy to invest more heavily in product innovation and marketing, advertising, and promotional (MAP) spending may have some success. However, we also recognize the very competitive nature of its end markets, and believe the high degree of demand elasticity (as recently experienced in response to higher pricing) is a critical risk factor that
could limit top-line growth to low-single-digit rates compared with the company's long-term targets of mid-single digit rates. Still, we believe the company will achieve a portion of its identified cost saving opportunities, which should allow it to moderately improve adjusted EBITDA margins over time, despite facing about $70 million of corporate costs, including $20 million of "stranded costs" (prior cost commitments).

Our base case projections for fiscal 2013 (ending June 30, 2013) and beyond include the following:

-- Low-single-digit sales growth in both the retail and foodservice business segments, primarily reflecting a volume rebound after the company raised prices to offset raw material inflation, and to a lesser degree from improved product mix.

-- An improvement in adjusted EBITDA margin to closer to 13% reflecting improved gross margin from better volumes and lower raw material costs, which offset higher corporate costs and increased MAP spending.

-- Free operating cash flows of more than $100 million, approaching $150 million by fiscal year-end 2014, which should allow the company to repay about $115 million in zero coupon bonds and other debt, the majority of which matures by June 30, 2014.

Our intermediate financial risk profile assessment incorporates an expected 30%-35% dividend payout ratio that is lower than industry peers; no current plans for share repurchases; and a targeted capital structure consistent with management's desire to utilize the commercial paper markets for short-term borrowing needs. In addition, we believe our base case assumptions will allow the company to improve debt-to-EBITDA to below 2.5x and improve the ratio of funds from operations (FFO) to total debt to closer to 30% over our outlook
period (compared with pro forma post-spin-off leverage of about 2.7x and FFO to debt of about 28%). We expect the company's debt to EBITDA ratio to improve to the lower end of the indicative ratio range of 2x-3x for an intermediate financial risk profile by fiscal year-end 2013., and moderately improve thereafter absent other uses of cash (like share repurchases or a higher dividend payout ratio). We expect the FFO to debt ratio to decline modestly in 2013, reflecting lower operating cash flows from one-time corporate costs, and to improve to the weak end of the 30%-45% indicative ratio range for an intermediate financial risk profile by 2014.

Liquidity

We believe the Sara Lee will have "adequate" liquidity to meet its needs over the next year. Our view of liquidity incorporates the following expectations:-- We expect liquidity sources (including cash, discretionary cash flow, and revolving credit availability) will exceed uses by 1.2x over the next year.

-- We expect liquidity sources will continue to exceed uses, even if EBITDA were to decline by 15%-20%.

-- In our view, compliance with interest coverage and leverage financial covenants likely would survive more than a 20% drop in EBITDA.

-- In our assessment the company has sound relationships with banks and a satisfactory standing in the credit markets.

In our sources-to-uses analysis we assume the company will have about $700 million of availability on its $750 million revolving credit facility that matures in 2017, and FFO of at least $300 million. We believe this would adequately cover stressed working capital requirements of $200 million annually, capital expenditures of about $190 million, cash dividends of close
to $80 million, and about $115 million in debt maturities, the vast majority of which would mature June 30, 2014.

Outlook

The outlook is stable. We expect Sara Lee to achieve and maintain credit measures within indicative ratio ranges for an "intermediate" financial risk profile, including reducing total debt-to-EBITDA near or below 2.5x by 2013 and achieving FFO-to-total debt of 30% or more by 2014. We could lower the ratings if the company is not able to improve FFO-to-total debt to about 30% by 2014 and if leverage approaches 3x. We believe this could occur if the company is not able to expand its adjusted EBITDA margins as currently projected to closer to 13%, either because sales volumes decline or raw material inflation of more than 5% per year returns.

We do not currently contemplate a higher rating because of the company's limited track record operating as a stand-alone meats and bakery business, and given our current expectations for credit measures over the outlook period. 

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