The Consumer Price Index (CPI) rose 8.5% year-over-year in March, buoyed by extraordinary energy and food costs, supply constraints, and strong consumer demand. The Russia-Ukraine conflict, along with renewed lockdowns in China due to a COVID surge, only add to the pressure. Packaged food companies, which fared well during the height of the pandemic, have seen moderating demand along with high inflation eat away at profits. Public company guidance for inflation range from low-single- to mid-double-digit ranges, depending on their commodity baskets and product mix. Many companies had already started raising prices in the back half of 2021 and have continued apace, averaging high-single-digits, showing up in CPI increases. S&P Global Ratings expects additional rounds of pricing actions to reflect expectations for continued high inflation through the remainder of calendar 2022 into at least the first half of 2023.

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The Russia-Ukraine conflict fueled further cost pressures on energy, wheat, sunflower oil, barley, and oil-based packaging inputs (see "Russia-Ukraine Conflict Will Test Agribusiness Supply Chain Efficiencies And Consumers' Appetite For More Food Inflation," March 18, 2022). These are key inputs into many packaged foods. We expect further price increases or other mitigating actions to partially offset these cost increases.

Along with pricing, many companies will likely substitute inputs to the extent they can and utilize tools such as trade optimization, reducing package sizes, taking volume out of products, reformulating products, changing product mix, and adjusting their promotional strategies. With unemployment just around 3.6% in March 2022, we expect labor costs to remain high. Also, high energy costs along with labor shortages will keep freight costs high.

Our Base-Case Assumptions

For most packaged food companies in calendar 2022, we expect price increases in the high-single- to low-double-digits range, while volumes decline mid- to high-single digits due to lapping elevated demand and higher price elasticity of demand in the second half of the year. Still, we assume volumes will remain higher than pre-pandemic levels, but below 2020 and 2021 levels. We assume hybrid work will remain, increasing breakfast and lunch consumption at home for at least 2-3 days per week. The combination of price increases and volume declines results in low- to mid-single-digit percent organic revenue growth on average for the sector. We assume promotions are another lever that companies will pull to either execute higher prices or to stimulate demand, depending on the category and supply availability. Because of the broad base inflation, we assume at least 200-300 basis points (bps) gross margin decline for the industry. We assume selling, general, and administrative (SGA) dollars are flat, but as a percentage of revenues they are likely down as companies pull back on marketing. Based on these assumptions, we forecast EBITDA margin decline of at least 200-300 bps as well. In 2023, we assume still-elevated inflation into at least the first half of the year and macroeconomic and geopolitical factors will impact the remainder of the year.

A possible recession poses only a limited risk to the sector overall.

Historically, packaged food companies fare well during a recession, consumers eat at home more and trade down to private label, and we expect that trend to continue if we enter a recession. We assess the risk of a recession in the next 12 months as about 1-in-4 and less likely before 2023, as successive rate hikes take effect.

During the pandemic, private label did not see the outsized benefits that branded players saw and lost unit market share on average to branded players because consumers were financially strong with high savings, low unemployment, boosted by high government stimulus. Additionally, the large, branded players were supply-chain-advantaged and able to get more products on shelves because of their stronger distribution networks, lower cost base, and large manufacturing networks. Conversely, private label struggled with distribution and manufacturing because of their smaller scale, higher stock keeping unit (SKU) counts, small batch runs, and reliance on their retail customers to merchandise the products.

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However, we believe that as consumers (especially lower-income consumers) feel the extraordinary inflationary pressures that reduce buying power and drain savings, they will trade down, which could result in a benefit for struggling private label manufactures such as TreeHouse Foods Inc. and Shearer's Foods LLC. Real average hourly earnings are well below CPI and nominal average hourly earnings, supporting our belief that the consumer is feeling the inflationary pressures.

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As for the branded players, we believe the companies that operate in categories with the historically highest level of private label penetration (over 20% of dollar category share versus industry average of about 16%, per Euromonitor) such as processed fruit and vegetables, chilled ready meals, cheese, nuts, tomato pastes and purees, rice, pasta, and noodles, will experience the most private label competitive threat. These companies include Conagra Brands Inc., Del Monte Foods Inc., and B&G Foods Inc.

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Inflationary Stress Test Assumptions

Similar to the approach of our previous stress test, we designed a hypothetical scenario that consisted of a simple broad-based assumption of 500 bps in additional gross margin degradation for one year for the rated U.S. packaged food companies. We then compared the resulting credit metrics to the respective downgrade or outlook revision threshold to determine if a negative rating action would be likely, holding all else equal, for the issuer.

We designed the stress test to be a simple "what if" scenario that communicates our view of the vulnerability of select issuer ratings to additional inflation. For this reason, we limited the offsetting actions to operational strategies. If a similar spike in inflation became reality, we would expect many companies to pull additional levers to protect their balance sheets and cash flow; for instance, by optimizing inventory, reducing investments and capital expenditures, and pausing share buybacks.

We included 36 U.S. packaged food issuers in our stress test. We rate 12 investment grade and 24 speculative grade. We included three companies with negative outlooks or on CreditWatch negative. We have TreeHouse Foods with a developing outlook pending its strategic review outcomes.

Higher rated entities are best positioned to withstand additional inflationary shocks.

In general, we believe large, branded players retain the most pricing power and would fare best during the stress periods, especially if they are the leader in categories with a lower degree of private label penetration. Companies with less pricing power are those with portfolios of lower tier brands or a high degree of private label penetration in their categories. We believe contract manufacturers are the next-best positioned given they generally have pass-through pricing mechanisms and contracts that protect them during inflationary periods. Contract manufacturers include H-Food Holdings LLC, Aspire Bakeries Holdings LLC, CHG PPC Intermediate II LLC, KNEL Acquisition LLC, Monogram Food Solutions LLC, and JHW Alphia Holdings Inc. We believe private label is least advantaged given their supply chain limitations, limited brand strength, and reliance on retailers to merchandise the products. However, they could benefit from higher demand with consumer trade-down, which could partially mitigate some of the negative impacts. Private label manufacturers include TreeHouse Foods, Shearer's Foods, and 8th Avenue Food & Provisions Inc.

The stress test resulted in potential negative rating actions for approximately 86% of our sample of 36 companies. This highlights the stress that we are already factoring into our base case forecast (200-300 bps). An additional 500 bps hit to gross margin would result in at least 700-800 bps on margin degradation to our base case for many companies, leaving little cushion for further pressure. Twenty would face downgrades, seven would face outlook revisions to negative, and four would face outlooks back to stable from positive. Only five would not experience any negative rating actions. These unaffected entities include Mars Inc., The J.M. Smucker Co., Hostess Brands Inc., The Simply Good Foods Co., and Sovos Brands Inc. Of these, only Mars and Smucker are investment grade. The common theme among these companies is their relatively low leverage for their ratings. Their peers had debt leverage near or just below their downgrade thresholds.

While we believe the investment-grade issuers retain greater pricing power and have more levers to pull to restore credit measures, such as larger cost reduction actions, reducing share repurchases, or halting acquisitions, near-term credit measures could deteriorate substantially in a hyper-inflationary environment. Therefore, for the large, investment-grade issuers, we would likely revise the outlook to negative for most versus an immediate downgrade, despite near-term deterioration in credit measures.

Most of the downgrades were of speculative-grade ratings, which could face unsustainable capital structures or liquidity crunches because of their already highly leveraged capital structures, pushing many 'B-' issuers into the 'CCC' category.

The table below ranks the companies from best to worst positioned in our view in the event of an additional 500 bps gross margin inflationary shock.

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Related Research

• Economic Outlook U.S. Q2 2022: Spring Chills, March 29, 2022
• Russia-Ukraine Conflict Will Test Agribusiness Supply Chain Efficiencies And Consumers' Appetite For More Food Inflation, March 18, 2022
• Some U.S. Consumer Products Companies Could Fail The Inflation Stress Test, Sept. 28, 2021