Sector Overview

Recent protein plant closures in the U.S., if temporary, are not likely to lead to shortages, but a more sustained shutdown would.   The production cuts announced so far are not insignificant, with companies like Smithfield Foods Inc. temporarily closing its Sioux City, S.D., plant, and Tyson Foods Inc. temporarily shutting down its Waterloo, Iowa, facility. The announced pork plant closures to date account for more than 15% of production (Smithfield's shuttered plant alone constitutes 4%-5% of total U.S. pork production). The closures are not just limited to pork facilities. JBS USA Food Co. shuttered a beef packing plant in Greeley, Colo., for about two weeks and another in Souderton, Pa., while Cargill Inc. closed its Hazleton, Pa., beef processing plant for cleaning.

S&P Global Ratings currently expects the shutdowns to be temporary, albeit likely to continue in fits and starts as processing plants become future "hot spots" for COVID-19. In our opinion, there is significant political support to keep production open given the importance of food to the population, and to support the economic wellbeing of key constituents; for instance, farmers would face significant losses if they could not sell their livestock, which remains plentiful in supply. Still, supporting the food supply and farmer wellbeing should be balanced against the health of plant employees; a prolonged shutdown due to employee shortages would hurt operating performance and cause significant meat inflation, which is already starting to take hold at the wholesale level, particularly for beef. Based on total industry production forecasts by the U.S. Department of Agriculture (USDA) and existing inventories in cold storage, we estimate material shortages could occur if 10% of the USDA's projected domestic production were to shut down for four to six weeks straight.

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COVID-19 disruptions are not just limited to the U.S.; plants in Brazil (a key global protein exporter) also face shutdowns, but strong export markets and comparatively less foodservice exposure continue to support the sector in that region.  The plant closures in Brazil and other South American economies have been limited to proactive two- to three-week stoppages, placing workers on paid leave while companies increase security and sanitation at their facilities, and adjust production away from foodservice volumes. Ten beef plants in Brazil have been temporarily closed so far. However, the possibility of material shortages is not as severe as in the U.S., where some of the beef and poultry production facilities are large complexes with significant scale. The production facilities in South America are smaller and the manufacturing footprint is more fragmented across the region, which may mute the impact of the pandemic.

Processors in South America are relatively less exposed to foodservice, too. The beef segment in Brazil is not excessively exposed to restaurants (likely less than 15% of volumes), and will benefit from recovering export volumes and pricing in China, which should offset still weak domestic consumption, especially for premium cuts. Restaurant demand for premium cuts fell by more than 50% in the past month, and only part of that volume was absorbed by retail or exports. A more balanced supply and demand outlook for cattle is improving margins, and a depreciated foreign exchange (FX) is further boosting export values in domestic currency. The temporary shutdowns have considerably increased cattle availability, causing prices to decline by about 10%-15% from record highs in December 2019 due to much higher export demand resulting from the Asian swine flu (ASF) outbreak. Domestically, more consumption of processed meat should offset margins for fresh meat in the first and second quarters as well. Overall, the outlook out of South America remains modestly positive due to lower cattle costs, continued strong export demand, and a favorable FX outlook.

Most rated companies have a broad manufacturing footprint and good channel, product, and geographic diversification to mitigate production and sales shortfalls in the near term.   The vast majority of our rated animal protein processors operate numerous processing facilities in key livestock growing regions, making sourcing affordable while reducing manufacturing concentration. Product diversification across proteins and into branded prepared foods also benefits several rated industry leaders. For example, JBS and Tyson are well diversified across all three core animal proteins and in JBS' case there is a strong geographic footprint globally, further mitigating concentration risk. Companies such as Hormel Foods Corp. and to a lesser degree BRF S.A. or even Smithfield Foods Inc., have expanded their branded packaged food presence to complement their more commodity-based protein portfolios. Even companies that are concentrated in one particular protein such as Smithfield Foods, Pilgrim's Pride Corp., or Marfrig (in pork, chicken, and beef respectively) have a large manufacturing footprint (well over 20 facilities each) and have expanded their geographic presence through acquisitions.

For companies whose manufacturing base is more regionally concentrated like Minerva S.A., a strong export market presence mitigates their sourcing concentration, albeit subjecting their earnings to currency risk and geopolitical risk if export restrictions are imposed. In other cases, regional players have expanded into other industries to reduce concentration risk; for instance, U.S.-based Simmons Foods Inc., a regional family-owned operator diversified into pet food to reduce exposure to its chicken business. Although it remains over 50% exposed to the foodservice channel, its sales are mostly to national quick serve where drive-through sales remain fairly steady. Still, being limited to a narrow production footprint or having a product mix heavily skewed to the foodservice sales channel is a significant risk in the current environment. This risk is more material for companies in the low 'BB' and 'B' rating categories, where geographic and customer concentration risk are more pronounced.

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The U.S. dairy sector faces disruption from lost foodservice and school demand; increased retail demand for all dairy products and still ample dairy orders by food manufacturers will help soften the blow.   The challenges to the U.S. dairy sector are primarily centered on losing key foodservice markets for their milk, and are more regional given the fragmented nature of the U.S. dairy farmer, particularly in the Midwest and Northeast, where dairy farms are smaller. Losing a key customer such as a regional school district has forced some farmers to dump their unsold milk. The decline in foodservice demand is causing milk prices to fall, with the USDA currently forecasting a 20% decline in all milk price for 2020. This may hurt farmers, but not necessarily processors and manufacturers as lower input costs will be a tailwind, albeit somewhat muted by hedges and any lost production volume. Another mitigating factor for the larger national dairy processors we rate is the relatively lower exposure to the currently closed educational channel, where a significant amount of fluid milk (roughly 10% by USDA estimates) is sold to grade school and other dairy products to on-campus dining.

Although lost restaurant volumes are significant, the menu item that uses the most cheese--pizza--is comparatively better off than meat-based menu items as pick-up and deliveries for pizza largely remain open. In addition, fluid milk volumes have benefited from more meals at home. In fact, dairy products across the board at retail are up well over 50% in March based on IRI data. Although this will taper off, at-home consumption will continue to be a larger part of food demand in the coming quarters, supporting continued healthy demand for dairy at retail, which should benefit our rated universe. In short, although dairy demand will fall in aggregate, the portfolio composition for the companies we rate is fairly well insulated from the underperforming channels in dairy given their exposures to more branded retail products like butter, creamers, cheese, yogurt, and ice cream; while dairy-based ingredients produced for other food manufacturers are benefiting from strong retail demand because of less away-from-home dining.

Downgrade risk so far appears contained as there are no COVID-19-related negative outlooks and most issuers' credit ratios remain below their downgrade triggers.   Our rating actions taken in response to COVID-19 so far have been limited to outlook revisions to stable from positive (Minerva and BRF, for example); the global pork shortage following the ASF contagion that decimated nearly half of China's pork supply has been offset by COVID-19 disruptions.

With the exception of issuers with still-to-close acquisitions, we currently have a stable outlook for the sector as most companies have only modestly leveraged balance sheets and continue to generate good free cash flow. Because severely depressed earnings cycles have plagued meat processors in the past, most issuers have more conservative financial policies and target fairly prudent leverage levels, typically below 3x debt to EBITDA. These financial policy targets are providing most companies in the sector with enough balance sheet protection to weather this downturn, which we expect will be less severe than past cyclical downturns since supply is plentiful and higher wholesale pricing improves processing margins.

Still, about a quarter of our rated protein producers in the U.S. and Latin America have stretched credit measures (debt to EBITDA within a half-turn of our published downgrade trigger). The reason is primarily acquisition-related, including Dairy Farmers of America Inc., which is on CreditWatch with negative implications as its acquisition of most of Dean Foods Co.'s production footprint is pending regulatory review. Based on our base-case expectations for only flat to -modestly down EBITDA depending on geography, we expect cash flow generation to hold up, which should enable our issuers with somewhat elevated leverage to continue their current quarterly sequential trend of debt and leverage reduction back to targeted levels.

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Forecast and Sector Outlook

Repurposing production toward retail products and temporary shutdowns pressure fixed-cost absorption, while a mix shift to retail will be largely margin neutral with lower input costs and better pricing helping to restore margins by year end.  The cost of temporary plant shutdowns, implementing social distancing guidelines on production lines, less fixed-cost absorption from lost foodservice volume, bonus pay to soften absenteeism, and upfront investments to convert production to retail all point to margin headwinds in the near term. Still, with commodity input cost inflation in check, and strong albeit changed demand for at-home food consumption we do not anticipate a material reduction in operating margins for the duration of the year. Lower livestock costs are already evident with cattle and hogs futures on the CME down about 15% and 30% respectively since the coronavirus was first reported in the U.S. Moreover, tightening wholesale supply because of production downtime will likely firm pricing. In addition, we do not anticipate a material mix impact to margins as sales are diverted to the retail channel, but it depends on portfolio mix. Companies with a larger branded presence should benefit more, particularly those with less need to invest in advertising and promotion, while those more exposed to fresh commodity cuts or a much larger foodservice mix will face margin headwinds.

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In South America, we expect margin volatility in the upcoming quarters, but higher export volumes should offset lost foodservice demand and conversion costs from switching production volumes toward retail offerings. For example, key end customers markets such as the foodservice demand in Europe has evaporated in the past couple of months, with volumes only expected to gradually improve in second half of the year; but this only represents about 5% of our rated universe's revenues and increased exports to China should more than make up for the losses. Lower cattle and grain prices, along with a strong U.S. dollar should benefit margins, albeit while adding volatility to cash flows and credit metrics as several South American issuers have a component of their capital structure in dollar-denominated debt. Still, we believe the long-term fundamentals are favorable for protein prices and demand, with growing Chinese consumption supporting exports and increasing health awareness for frozen packaged protein supporting domestic demand.

U.S. protein operating assumptions:

• Limited production cuts with restored production by the summer.
• Foodservice demand falls by well over 50% in the coming quarters and slowly rebounds in the second half of 2020, but not enough to avoid double-digit-percent industrywide declines.
• Adjusted EBITDA for most companies will decline by low- to mid-single-digit percents year-over-year as increased retail demand and better wholesale pricing partially offset higher unit production costs from less fixed-cost absorption, production downtime, and higher labor costs.

South America:

• We estimate meat demand in the foodservice might face volumes decline of around 20% in the year, but will be partially offset as companies adjust product mix and volumes toward retail.
• Our margin outlook includes the benefits of a strong U.S. Dollar, which has appreciated more than 20% against the Brazilian real since December 2019.
• We are reducing our EBITDA margin forecast for beef margins to a range of 6%-9% compared to our pre-COVID-19 range of 9%-11%.

Dairy

• The all-milk price declines more than 30% from 2019 year-end levels of just under $19/cwt in the coming quarters and slowly rebounds to the mid-$14/cwt range by year-end, consistent with USDA forecasts.
• Lost foodservice demand and the negative mix impact of higher fluid milk sales will likely lead to double-digit-percent industrywide sales declines.
• Still, margins for companies we rate should hold up as lower dairy input costs and strong ingredient demand from food manufacturers keep production volumes steady.

Liquidity Overview

Liquidity so far has not been a concern for most of the sector, as the majority of issuers have ample revolver capacity, no material covenant pressure, and have been able to access the debt capital markets for issuance. For instance, Cargill just issued $1.5 billion in senior unsecured debt at rates inside of 3%. Brazilian-based protein players have consistently accessed capital markets to extend maturities and lower interest payments and were able to alleviate any short-term refinancing pressures. BRF was facing large maturities last year, but it used asset sales proceeds to significantly improve its debt maturity profile.

Limited borrowing availability and tight financial covenants are only affecting a small minority of speculative grade issuers in the sector. The majority of companies currently have revolver access with good availability, but those with triggering covenants may not have full access if operating conditions further deteriorate to the extent a material drawdown causes a breach of an availability based covenant trigger.

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Outlook and Conclusions

Based on our current assumptions that production shutdowns will be temporary, production shortfalls and the negative impact that could have on profitability and cash flow is not likely to be material. Broad manufacturing footprints, sales channel diversity, and generally modest leverage levels are important credit factors that mitigate the risk of production shortfalls for the majority of the protein processors we rate. Still, manufacturing concentration is more prevalent for our lower-rated entities, and if a more material and prolonged manufacturing disruption were to impact those companies, ratings could be pressured. Downgrade risk may also become more pronounced for a minority of companies still de-leveraging from recent acquisitions, but currently that risk is limited to one issuer with ratings on CreditWatch with negative implications. The outlook for the rest of our issuers in the sector remains stable.