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Fitch Affirms Kellogg Company IDR at 'BBB'; Outlook Stable
April 7, 2017 / 5:53 PM / 8 months ago

Fitch Affirms Kellogg Company IDR at 'BBB'; Outlook Stable

(The following statement was released by the rating agency) CHICAGO, April 07 (Fitch) Fitch Ratings has affirmed Kellogg Company's (Kellogg) Long-Term Issuer Default Rating (IDR) at 'BBB' and Short-Term IDR at 'F2'. The Rating Outlook is Stable. The ratings apply to approximately $7.8 billion of total outstanding debt. A full list of rating actions follows at the end of this release. KEY RATING DRIVERS Revenue Pressure Amidst Changing Consumer Preferences Kellogg's ratings reflect Fitch's expectations that organic volume will remain modestly negative over the medium term given the Kellogg portfolio's exposure to mature developed markets that account for about 87% of total sales and a nascent natural/organic offering. Revenue declined an average of 4% over the past three years. Currency translation was responsible for most of the decline, followed by volume - which declined approximately 1%/year. Offsetting this weakness, price/mix has been positive for each of the past three years. These positive price/mix results are driven by a mix shift towards higher-growth categories and Kellogg's efforts to expand its gross margin. Changing consumer preferences have had a negative impact on Kellogg's performance. The cereal category has seen steady declines in sales since peaking in 2011. Kellogg's cereal sales have declined at a CAGR of 3.5% since 2011 to $5.4 billion as of 2016. Cereal had accounted for 51% of company net sales in 2011, but fell to 42% of sales by 2016, a function of sales declines and portfolio restructuring moves, such as the 2012 purchase of Pringles. In comparison, snacks grew to account for 51% of sales in 2016 vs 37% in 2011. Sales in the U.S. Snacks business, although trending right, have been slightly negative over the past three years, with growth ranging from -1.1% to -2.9%. Positive growth in some brands, such as Pringles with nearly $2 billion in revenues and approximately 14% of sales, has been offset by negative organic growth trends in other brands. While Kellogg's exposure to developing markets remains low, at just under 15%, the company is investing in the emerging economies. Fitch views these investments as a long-term positive despite the near-term weakness seen in China, Russia and Latin America that has been exacerbated by the strong U.S. dollar. In the fourth quarter of 2016, Kellogg closed an acquisition of a Brazilian snack company, Parati Group. At the February 2017 Consumer Analyst Group of New York (CAGNY) conference, Kellogg reiterated its portfolio strategy as 1) stabilizing its core developed markets breakfast strategy, 2) growing its emerging markets business and 3) investing for growth in its snack business. Fitch expects Kellogg's cereal business growth to continue to be slightly negative, tracking industry growth, but sees opportunity in the snack business as investments in crackers and wholesome snacks take hold. Restructuring Efforts In November 2013, Kellogg announced Project K, a global restructuring program with savings expected to reach an annual run rate of $425 million to $475 million by 2018. The program was expanded in early 2017 to include exiting direct store delivery (DSD) for all of Kellogg's U.S. Snacks business in favor of a warehouse delivery system. As a result estimated annual savings from Project K increased to $600 million to $700 million and the program was extended to 2019. As of the end of 2016, $300 million of annual savings had been realized. Some of the savings will be reinvested in the business with the aim of increasing margins and strengthening marketing and sales capabilities. In addition to Project K, Kellogg implemented zero-based budgeting (ZBB) in 2015 in North America and internationally in 2016. Cumulative savings from ZBB is expected to total $450 million to $500 million by the end of 2018, and is focused on selling, general and administrative expenses. Kellogg's restructuring programs are one of the more aggressive in the industry when evaluated on the basis of savings as a percent of EBITDA at approximately 25% of 2016 EBITDA versus an average of 17%-20% among the major U.S. packaged food companies excluding Kraft Heinz. The cash restructuring costs from the programs are expected to approximate $1.1 billion after-tax ($1.5 billion to $1.6 billion pre-tax). As of 2016, $725 million had been spent. Initial costs had largely been offset by working capital improvements. At this stage, realized costs savings outweigh the current expenses. Kellogg is targeting an EBIT margin of 18% by 2018. Due to lingering costs of the DSD switchover, as well as revenue pressure, Fitch is projecting EBIT margins of mid-16% in 2018 from 15.9% in 2016 (adding back non-cash stock-based compensation expense), gradually improving throughout the forecast period. DSD to Warehouse Delivery Changeover In February 2017 Kellogg announced that it would be transitioning from a direct store delivery (DSD) for all of Kellogg's U.S. Snacks business to a warehouse delivery system. A DSD system is fixed-cost and volume-dependent. Given that Kellogg was shipping only approximately 25% of U.S. sales through its DSD network, the Kellogg system was generally acknowledged to be relatively expensive. The change is expected to save nearly $300 million a year, some of which Kellogg envisions investing back in brand-building and marketing support. The change will occur in the second and third quarter 2017 and it is anticipated that there may be some disruption. Fitch believes the decline in 2017 revenue as a result of the transition may be greater than the 2% that Kellogg has called out. Kellogg will be running dual systems over the transfer period, which may also lead to higher expenses than expected during the changeover. In summary, Kellogg will be taking resources away from delivery and in-store personnel and putting resources into price reduction for retail, reflecting the transfer of in-store activity, and into brand building and marketing. Fitch finds the rationale behind this change reasonable but believes there could be near-term execution risk. Leverage Expected to Trend Toward Low 3x Fitch expects leverage (adjusted debt to EBITDA) to trend towards the low-3x range over the next three years, with EBITDA expected to remain in the $2.5 billion range annually over the next 24-36 months and debt essentially flat. The 3.5x leverage at the end of 2016 reflects the adjustment to debt to account for the sale of $854 million of receivables to third-party financial institutions. Fitch estimates that FCF (after dividends and cash restructuring costs) will gradually increase from approximately $400 million in 2016 to approximately $600 million in the forecast period as cash costs related to the restructuring program abate. Fitch expects FCF to be either used for tuck-in acquisitions or share buybacks. KEY ASSUMPTIONS Fitch's expectations are based on the agency's internally produced, conservative rating case forecasts. They do not represent the forecasts of rated issuers individually or in aggregate. Key Fitch forecast assumptions include: --Revenues decline by low single-digits in 2017 due to weak organic growth and volume disruption as the company exits its Direct Store Delivery (DSD) business model for its snack business in the U.S. Beyond 2017, top line is expected to be essentially flat with volume declines in the 1% range being offset by modest price increases. --EBIT margin dips in 2017 to 15.5% due to DSD exit costs but gradually and continuously improves thereafter to 16+% through 2019. --EBITDA is expected to decline to just below $2.5 billion in 2017, again due to DSD exit costs, and then grow in the low-single-digit range thereafter. --FCF (after dividends and cash restructuring costs) gradually increases from approximately $400 million in 2016 to approximately $600 million in the forecast period as cash costs related to the restructuring program abate. Fitch assumes working capital is neutral. Fitch expects FCF to be either used for tuck-in acquisitions or share buybacks. --Leverage (gross debt to EBITDA) remains in the low- to mid-3x range. RATING SENSITIVITIES Positive Sensitivities: Future developments that may, individually or collectively, lead to a positive rating action include: --A positive rating action could occur with sustained low- to mid-single-digit organic growth with volume trends turning positive and with overall market shares stable or improving. In addition, Kellogg would have to maintain leverage consistently below 3x. Negative Sensitivities: Future developments that may, individually or collectively, lead to a negative rating action include: --If Kellogg's organic growth rate is negative in the low single-digit range. Consistently negative trends would signal that the company's renovation and brand support efforts are not effective and/or that emerging markets performance is worse than expected. --Leverage moving toward mid-3.0x as a result of either poor performance or material debt-financed share buybacks or acquisitions. LIQUIDITY As of December 2016, Kellogg reported $280 million of cash, $240 million of which was held overseas. The company maintains an unsecured $2 billion revolving bank facility maturing in 2019 that was undrawn as of December 2017. This facility backs up the company's commercial paper (CP) borrowings which stood at $386 million at the end of 2016. In addition, on Jan. 30, 2017, Kellogg entered into an additional revolver - an unsecured 364-day facility for $800 million. This revolver backs Kellogg's account receivable sale program (program executed in 2016 that allows for certain account receivables to be sold to third party financial institutions). Debt Maturities: As of Dec. 31, 2016, Kellogg had total debt of $7.8 billion, including $386 million CP outstanding, and $7.4 billion senior unsecured debt. Senior unsecured notes due in 2017 include a USD$400 million 1.75% note due May 17 and a CAD$300 million 2.05% note due in May 23. Fitch assumes both these notes will be refinanced. FULL LIST OF RATING ACTIONS Fitch has affirmed Kellogg's ratings as follows: --Long-Term Issuer Default Rating (IDR) at 'BBB'; --Short-Term IDR at 'F2'; --Commercial paper at (CP) 'F2'. --Senior unsecured debt at 'BBB'; --Bank credit facility at 'BBB'; 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'. Kellogg Canada, Inc. --Long-Term IDR at 'BBB'; --Senior unsecured debt at 'BBB'. The Rating Outlook is Stable. Contact: Primary Analyst Ellen Itskovitz, CFA Senior Director +1-312-368-3118 Fitch Ratings, Inc. 70 West Madison St. Chicago, IL 60602 Secondary Analyst Monica Aggarwal, CFA Managing Director +1-212-908-0282 Committee Chairperson Phil Zahn Senior Director +1-312-606-3226 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: alyssa.castelli@fitchratings.com. Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: --Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and restructuring / acquisition related costs. For example, Fitch added back $63 million in non-cash stock-based compensation and $608 million restructuring related costs in 2016. 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