Stay-at-home orders and social distancing in response to the COVID-19 pandemic have hit several sectors of the U.S. economy hard. Within the food and beverage industry, restaurants, bars, travel, leisure, schools, and to a lesser degree convenience stores and gas stations face significant losses in customer traffic and sales volumes. The abrupt falloff in these channels in turn is impairing a handful of key consumer products subsectors, starting with the food service distributors we rate.

The food service industry's woes, as well as those for delicatessens and family-owned convenience stores, are having a knock-on effect on several additional subsectors. Those include alcoholic and nonalcoholic beverage (NAB) companies as traffic at convenience stores and gas stations is down, and increased volatility in cigarette volumes. While each company's exposure varies depending on product, channel, and geographic mix, we have taken numerous negative rating actions on issuers in some of these subsectors, and there could be more depending on the severity and duration of the COVID-19 pandemic.

Here we discuss our outlook for U.S. food service distributors, alcoholic and nonalcoholic beverages, and tobacco given the changing economic landscape because of COVID-19, the key risks and opportunities each sector faces, and a summary of rated issuers and their liquidity positions.

Credit Risk Assessment

Food service distributors face an unprecedented demand shock with an uncertain rebound as social distancing may last and disposable incomes fall. 

Sales in the hard-hit $300 billion U.S. food service distribution sector are likely to decline up to 50% in the second quarter of 2020. It is also likely to rebound slower than the overall economy because of the discretionary nature of away-from-home spending on food and continued isolation/social distancing even after shelter-at-home requirements are lifted. People may be hesitant to spend on away-from-home food service amid meaningfully higher unemployment that could persist into 2021 and depress disposable income. Sector recovery prospects will be dampened with fewer people going into offices, either voluntarily working from home or because of unemployment, which will reduce spending on food service.

While we expect many people, including the young and healthy, will enthusiastically return to normal food service consumption, we expect varying degrees of hesitation by people who are older, have one or more chronic illnesses, or are less economically confident. Additionally, the trajectory of the pandemic is a risk factor. It seems likely that shelter-at-home measures have flattened the curve of infection rates, though outbreaks could return this year after these measures are relaxed over the next few weeks and months.

We believe restaurants constitute at least 60% of food service distribution sales. Other large customer segments include education, travel and leisure, health care, and business and industry. A meaningful portion of smaller independent restaurant operators may not reopen once shelter-at-home orders are lifted. It is difficult to say what the impact will be given continued coronavirus uncertainty and potential positive effects of the recent small business relief act; restaurant pickup and delivery services will probably provide modest uplift. It is also possible food service demand from education clients (which we believe accounts for about 10% of industry sales) could weaken, possibly permanently, if increased use of online learning replaces large lecture halls.

To partly offset the sales deterioration, food service distributors are looking for alternate revenue sources. About 50% of consumer food dollars are spent away from home, though we believe away-from-home volumes are meaningfully lower, perhaps 30% of total food volumes, depending on the retail markup. A sizable portion of away-from-home sales will at least temporarily shift to grocery. Most food service distributors we rate are pursuing opportunities to serve the retail grocery sector. It seems likely the away-from-home distribution sector will win some grocery business, though the amount will partly depend on excess capacity within the grocery distribution network.

We believe retail grocery margins are on balance well below typical average foodservice distribution margins (perhaps half the level). We believe the profit benefit from picking up some grocery business will be modest. Food service distributors are also cutting spending, including furloughs, job cuts, salary reductions, reducing capex closer to maintenance levels, and eliminating share buybacks. Nevertheless, once the environment returns to near pre-coronavirus levels, large food service distributors could command higher market shares since smaller rivals with less access to capital will fail.

Alcoholic beverage companies can only partially offset lost on-premise sales at bars and restaurants. The flatter and longer the "U" in our economic forecast, the higher the risk of a negative mix shift to lower–margin, less-premium offerings. 

These companies also will face a sales decline because of less on-premise volumes at bars and restaurants. That will be partially offset by higher off-premise sales, particularly in the short run as consumers restock pantries. In fact, based on Nielsen data, spirits sales in the U.S. increased well over 30% year over year in March, and beer posted similar growth. Still, we expect these trends to taper off and not fully offset lost on-premise sales as people tend to consume more per occasion in social settings and events than at home. The magnitude of decline also will depend on the severity, duration, and shape of the rebound once economies reopen. We expect a slow rebound for the U.S. on-premise consumption in the second half of 2020 as social distancing and less discretionary income will likely preclude a return to normal.

Equally important is companies' exposure to on-premise sales and the degree to which more off-premise consumption moves the mix to lower-priced offerings. Companies with larger international portfolios will be hit harder by lost on-premise demand, which is typically higher outside the U.S. The on-premise channel typically constitutes 20%-25% of sales in the U.S.; in Western Europe the mix is closer to 30%-35%. Although the exposure in emerging Latin American economies is closer to that of Western Europe, it's materially higher in emerging Asian economies such as China, where on-premise drinking is estimated to be above 50%.

Spirits companies typically have a more global presence than brewers. They also sell into the travel retail channel, which has ground to a halt, so sales are likely to be affected more heavily. Exposure varies widely company to company, depending on portfolio composition.

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We believe the longer it takes the off-premise channel to return, the larger the mix shift to lower less profitable sales. There is not a material difference in wholesale selling price between on– and off-premise sales in the U.S. because manufacturers are precluded from distribution and retailing. Regulations require them to sell products destined for both on- and off-premise to distributors, which is typically done off one list price. So a material negative mix impact is not likely in the near term, particularly considering the recent spike in off-premise sales that remains skewed toward premium products.

Still, an open on-premise channel is important for premium pricing in two ways:

• Closed bars and restaurants suggest higher unemployment or underemployment and lower discretionary income, which eventually leads to a consumer shift to value-priced products.
• The on-premise channel serves as a platform to launch and promote recent innovations, typically premium offerings, the engine behind organic growth of higher-margin products.

Therefore, we believe the longer bars and restaurants stay closed, the higher the risk of lower margins as premium product launches fall off and consumers eventually trade down for at-home consumption.

A final important rating factor is how leveraged companies' balance sheets were heading into the pandemic. Several companies had elevated leverage for M&A before the onset of the pandemic. Given the prospect of a significant falloff in demand for much of the industry, we took several company-specific negative rating actions given their already tight credit measures for the respective ratings. (See "International Brewer Anheuser-Busch InBev 'A-' Rating Placed On CreditWatch Negative; 'A-2' Rating Affirmed", published March 26, 2020; "Molson Coors Beverage Co. Outlook Revised To Negative From Stable; Ratings Affirmed", published March 27, 2020; "Constellation Brands Inc. Outlook Revised To Negative From Stable; Ratings Affirmed", published March 30, 2020; "Bacardi Ltd. Ratings Affirmed On Expectation Of Cut Costs And Covenant Relief; Outlook Stable", published April 6, 2020; and "Heineken Outlook Revised To Negative On COVID-19 Related Business Disruption; Affirmed At 'BBB+/A-2'", published April 27, 2020). With the exception of two isolated niche speculative-grade cases facing refinancing risk, our rating actions so far are limited to negative outlook revisions or negative CreditWatch placements. That's in part because companies have cost-cutting levers they can pull, including lower advertising and promotional spending, and possibly other corporate overhead costs.

Cash flow conversion for the sector also remains strong, as companies on average convert just more than half their EBITDA to free operating cash flow, which enables fairly quick deleveraging. Lastly, if EBITDA remains under pressure, possibly into the second half of 2020, shareholder returns or asset sales may be a final move, which select companies may make.

The portfolio compositions of NAB companies will largely shape their sales outlook, but margins are likely to be pressured by lost fountain sales at restaurants and fewer single-serve sales at delis and convenience stores. 

NAB companies' sales are somewhat less affected given the sector's high household penetration (well over 80%), a more balanced channel mix, and broad portfolios that benefit from a combination of high-velocity soft drink sales volumes (albeit not necessarily growing) and several faster rising categories. Similar to the alcoholic beverage sector, pantry reloading has accelerated sales growth in March to well over 30% year over year, based on recent Nielsen data. In addition, with the exception of players with a large fountain presence at restaurants, the sector is not as reliant on off-premise sales.

The channel mix for NAB is more skewed toward retailers, including convenience stores, drug stores, and supermarkets, which remain open and should benefit from relatively higher foot traffic than food service, albeit not at historical levels. In addition, sales are not as likely to fall off as much as alcoholic beverage sales after the initial bout of pantry reloading. Most NABs are consumed at much higher rates (multiple occasions per day) than alcoholic beverages. Demand should hold up for several faster expanding categories, including water, energy, and coffee. Single-serve coffee, and pods in particular, may expand more as consumers likely shy away from their preferred coffee shops given a higher percentage of the population working from home and continued social distancing.

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Still, the sector may face margin pressure from lower-margin, large-package formats and higher production and delivery costs. It will not likely recover from a product mix shift away from higher-margin, impulse, single-serve purchases at convenience stores and gas stations until 2021, given seasonally higher summer purchases that won't occur at typical levels. Fountain sales at restaurants too are much higher, although the negative mix impact to fountain sales is more concentrated to The Coca-Cola Co. rather than the entire NAB sector. In addition to negative mix, production costs are likely to be a problem, as social distancing measures and absenteeism at plants will reduce efficiencies and could increase delivery hourly rates.

Recent M&A has led to weaker credit measures for many of the larger NAB players, including Keurig Dr Pepper Inc., PepsiCo Inc., and Coca-Cola. Nonetheless, cash flows remain strong and should lead to steady deleveraging at least by 2021. In fact we only have one negative outlook related to higher leverage for M&A for the sector (see "The Coca-Cola Co. Outlook Revised To Negative From Stable On Potential Coronavirus Fallout; Ratings Affirmed", published April 6, 2020), as deleveraging from debt repayment is anticipated despite COVID-19.

Tobacco sales over the first half of 2020 are expected to hold up fairly well despite being lumpy.  

Nevertheless, sales trends could deteriorate if there is a protracted economic downturn or change in consumer behavior stemming from health concerns around smoking and vulnerability to coronavirus. Over the short term, we believe tobacco product sales will remain firm as consumers stock up because of shelter-in-place requirements. Users can typically still purchase tobacco products at essential retailers, although traffic at some formats (particularly convenience stores) is down substantially. Despite some lumpiness, overall consistent near-term tobacco sales are likely because consumers will increasingly be at home instead of public work settings, where there are likely smoking restrictions. Moreover, tobacco use may increase to reduce stress and alleviate boredom.

Nevertheless, sales could eventually weaken if tobacco users' disposable incomes fall because of a protracted downturn accompanied by high unemployment. In such a scenario, tobacco users--many of whom are older and/or in lower income brackets--could reduce consumption or trade down to cheaper products. We also cannot rule out that the secular decline in cigarette volumes could accelerate beyond our pre-coronavirus annual assumption of 4%-4.5% because of the belief that smoking makes them more vulnerable to the coronavirus (via smoking's effect on the lungs or increased touching of the mouth and face). There is not enough information at this point to say whether nicotine can actually help the body fight the coronavirus, as some researchers in France have hypothesized.

Base-Case Forecasts

Our forecasts are highly uncertain since we do not know the long-term impact of the virus on peoples' behavior (social distancing and isolation), the duration of existing or future lockdowns, and the potential for the economic shock to have longer-lasting ramifications on consumer spending habits. Many issuers have withdrawn earnings guidance for 2020. We do not try to assess if or when medical breakthroughs (vaccines) may foster an eventual return to normal, though it is clearly possible.

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Food service distributors

We expect up to a 50% sales drop in the second quarter of calendar 2020, followed by gradually better sales trends during the second half of 2020, but notably lower year over year. In 2021, we assume a low-double-digit percent rebound, but sales are still materially below 2020 levels. A moderate-sized customer sales base likely exists among health care providers, institutional customers (to the extent cafeterias are open), certain geographies less affected by the coronavirus, quick-service restaurants with drive-through windows, and restaurants offering delivery/takeout. However, sit-down restaurants and bars reopening with at least the potential by 2022 to approach pre-coronavirus demand is important for the sector to restore credit metrics and maintain the overall sector business risk assessment.

Based on S&P Global Ratings economists' forecast, we assume food cost inflation will accelerate by 2021, though at manageable rates. A higher rate is nevertheless possible given the meaningful increase in the money supply and the potential for large protein processing facilities (beef or pork) to be temporarily idled. Most food service issuers we rate are not anchored to one food category (contrasted to, for example, steak or chicken restaurant operators). This should lessen the potential impact of specific food category inflation. In addition, a portion of distributors contracts are cost-plus, though it often takes several months to pass along underlying food cost increases. We also believe labor cost inflation will be manageable given prospects for higher unemployment. Nevertheless, a large increase in food costs generally could constrain gross profit margins.

Alcoholic beverage companies

We believe the sector's organic growth in the U.S. will decline in the mid- to high-single–digit percentages this year as higher at-home consumption will not offset the on-premise sales decline. Our sales decline expectation by issuer will vary depending on their product portfolios and geographic mix. Companies with better expanding portfolios such as Constellation Brands Inc. should outperform our base case for the sector, but those with larger international sales such as Bacardi Ltd. and to a lesser degree Brown-Forman Corp. may face closer to double–digit percentage declines. We expect a slow rebound in the second half of 2020. In 2021, we assume a high-single-digit percentage rebound with sales higher than 2020 and returning closer to 2019 levels.

Nonalcoholic beverage companies

We expect low-single-digit percentage year-over-year top-line growth as pantry reloading and increased at-home consumption more than offsets the sector's comparatively lower exposure to on-premise sales. This outlook assumes a modest 10%-15% exposure to the food service channel for the sector as a whole. It will not benefit as much as other consumer sectors from increased sales like packaged food and personal care because of a negative mix shift and lost on-premise sales. Still certain portfolios with more on-premise sales will underperform while others will generate higher growth than our sector base case. For example, companies with portfolios in faster-expanding categories such as single-serve coffee should outperform the broader sector. We expect a modest negative year-over-year comparison in 2021 given very high sales growth anticipated for the first half of 2020.

Tobacco

We projected tobacco sales in 2020 will be about flat compared to 2019. This incorporates our assumption that unit volumes will vary as cigarette smokers stock up and subsequently draw down their supply of tobacco products. Ultimately, continued low- to mid-single–digit percentage secular volume declines will be offset by pricing, while free cash flow generation should remain solid. We do not anticipate much runway for e-cigarettes given the potential for lingering consumer doubts following the occurrence of lung illness and--at least for smaller competitors--the May 2020 U.S. Food and Drug Administration deadline to submit product applications to stay on the market. We also believe Altria Group Inc./Philip Morris International Inc.'s new iQOS heat-not-burn cigarette will face near-term growth hurdles given lower foot traffic and the likely difficulty holding face-to-face demonstrations to use the new product.

Liquidity Overview

Covenant compliance

As detailed in the issuer list (Table 1), we estimated each company's ability to comply with its maintenance or springing financial covenants, and categorized each issuer as high, medium, or low.

High:  There are no financial covenants (including no springing covenants), or we expect over 50% cushion (e.g., issuer's EBITDA will not deteriorate over the next 6-12 months and covenant cushion exceeds 50% with no major steps).

Medium:   Even with likely EBITDA contraction, a violation seems improbable over the next 12 months. This also includes issuers with springing covenants, where springing utilization noncompliance risk is low.

Low:   Below 15% cushion and EBITDA contraction probable.

Across the group of 25 issuers, 11 are investment-grade and 14 are speculative-grade. We estimate over 90% of investment-grade issuers have medium to high covenant headroom, with Ocean Spray Cranberries Inc. the only one with low headroom. Speculative-grade issuers have considerably less financial covenant flexibility, with 36% considered low and only 7% (one issuer, Vector Group Ltd.) considered high. However, we note its bilateral bank facility (which has a loose minimum EBITDA covenant) is relatively small at $60 million.

Our overall expected corporate default rate of around 10% lines up reasonably well with our assessment that 36% of speculative-grade issuers have low covenant cushion (20% of the issuers in this report). Covenant defaults could precede larger restructuring events, including a distressed exchange or bankruptcy filing.

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Access to capital markets

We also assessed each issuer's likely ability to access capital markets under difficult conditions. We apply a high, medium, or low assessment to each issuer as defined below.

High to medium:   Large, stable investment-grade issuers.

Medium:   Midsize speculative-grade issuers that are reasonably capitalized, have adequate liquidity, and are not extremely sensitive to the COVID-19 pandemic or the economy.

Low:   Typically less than adequate or weak liquidity, or doubts about survival over the near to medium term.

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The investment grade issuers included in this report have generally good access to capital markets, with almost 75% considered high. Issuers viewed as having high access are the large investment-grade beverage firms and Altria. Only Ocean Spray is considered low among investment-grade issuers. Most speculative-grade issuers in this report would face significant challenges accessing capital markets in tough times, with none having high access, 64% low, and 36% medium. The majority with medium access include very large food service issuers that have ample cash/liquidity, good prospects for survival, and market share gains assuming an eventual return to near normal business within the next few years, and midsize tobacco issuers. In fact, several of these very large speculative-grade food service issuers recently issued capital to shore up liquidity, including Aramark, US Foods Inc., and Performance Food Group Co.

Sector Liquidity Overviews

Food service distributors

Now that Sysco Corp., US Foods, Performance Food Group, and Aramark have recently issued capital (albeit in some cases at very high rates, including Sysco's 525 basis points spread over treasuries), sector liquidity has improved. The majority of speculative-grade food service distributors we rate have sufficient liquidity because of the predominance of asset-based lending revolvers that contain springing fixed-charge coverage covenants that are not a material constraint and high cash balances, pro forma for recent issuances.

Alcoholic beverage companies

Liquidity depends on the rating category. Investment-grade liquidity is adequate as companies have strong banking relationships, a history of stable cash flow generation, and a demonstrated commitment to repaying debt to restore credit measure despite recent M&A in the sector. Because of recent M&A, many investment-grade issuers' bank credit agreements continue to have financial covenants, and certain companies have sought amendments to relax covenants during this period of stress. Given companies' strong business and cash flows, we do not believe companies will face pushback on any near-term requirements for covenant relief.

Still, the niche highly speculative-grade issuers we rate face significant refinancing and default risk. Speculative-grade alcoholic beverage issuers Blue Ribbon LLC and Winebow Holdings Inc. are rated 'CCC', in part because their revolving credit facilities are already current and the rest of their capital structures will soon come current. Given the significant operating hurdles they face, we believe default within the next six months is highly likely (see "Blue Ribbon Intermediate Holdings LLC Downgraded To 'CCC' On Refinancing Risks; Outlook Negative", published March 18, 2020, and "Winebow Group LLC Downgraded To 'CCC' As Debt Maturities Approach Amid Economic And Market Uncertainty", published March 25, 2020).

Nonalcoholic beverage companies

Liquidity is adequate for this largely investment-grade universe as companies have strong banking relationships and industry leaders such as Coca-Cola and PepsiCo are very active in the 'A-1' segment of the commercial paper markets.

Still, because of recent M&A and shareholder returns, commercial paper programs and other working capital facilities such as receivables securitization facilities are actively used. In response to recent albeit improving dislocations in the credit markets, companies are issuing long-term debt to term out short-term borrowings and boost cash positions and short-term borrowing availability. We view this as prudent in the current environment and not leveraging. Underpinning this view is our opinion that any such debt raise is not a change in financial policy akin to targeting a higher leverage ratio and don't anticipate proceeds will be used for shareholder returns. Moreover, since we net cash against debt, these transactions are typically leverage neutral.

Tobacco

Sector liquidity is adequate because of consistent cash flow generation and low capex, though dividends are high. We believe tobacco issuers will be reluctant to reduce dividends absent very negative demand or operational disruptions.

Outlook And Conclusions

The impact of the coronavirus and economic shock has affected the food service, beverage, and tobacco sectors in different ways. We believe--absent meaningful downside scenarios--very large food service companies will survive and could even have better relative industry positions as smaller rivals fail. However, overall industry fundamentals could be impaired for a long time, potentially resulting in downgrades because of lower business risks and reduced cash flows to service debt.

Alcoholic beverage issuer ratings face more downside risk than NAB ratings because of their higher exposure to the on-premise channel and elevated leverage from recent M&A for roughly half the issuers we rate. The entire sector is likely to face margin pressure as consumers trade down to lower-priced products and economy-size offerings, and as manufacturing becomes less efficient due to production downtime and absenteeism. Still, the outlook varies by company depending on portfolio composition and their commitment to current ratings through proactive cost-cutting initiatives and other cash flow levers such as capex reduction and changes to dividend payouts.

We expect tobacco companies that generate very high cash flow and pay high dividends to continue to navigate the secular decline in volumes by taking price. However, at some point, to maintain ratings, financial policies may need to become more conservative if volume declines accelerate due to coronavirus-related health concerns or cash strapped smokers.

Table 1