U.S. grocery retailers and distributors, after posting stellar operating performance in 2020-2021 amid COVID-19 pandemic stay-at-home trends, could face steep margin and profit pressure in 2022. S&P Global Ratings anticipates grocery will be one of the hardest hit subsectors of U.S. retail--an especially affected corporate sector--after a string of upgrades the past two years.

Grocery chief executives, including those at Kroger Co. and Albertsons Cos. Inc., commented last year that businesses like theirs have done well when food inflation is 3%-4%. Grocers can pass that on in prices at stores and increase their top lines. However, according to the U.S. Bureau of Labor Statistics (BLS), the Consumer Price Index was up 8.3% in the 12 months ended in April, among the highest in more than 40 years. And specifically, food inflation ramped up for an 11th straight month to 9.4%, the highest reading since April 1981, according to the BLS. S&P Global Ratings (and the U.S. Federal Reserve) believe the situation is not fully transitory. Although supermarkets benefited at the expense of restaurants during pandemic lockdowns, inflation is now eating away at all food sellers as the costs of meat, eggs, dairy, oils, and sugar are expected to continue to soar in 2022 (charts 1 and 2).

Chart 1

Chart 2

As a result, we are very cautious about prospects for the grocery industry this year and believe negative rating actions are possible if cost pressures are not offset. We believe raising prices has diminishing returns over time and that some traffic into groceries with pharmacies because of COVID-19 vaccination distribution will fade. We also think demand is likely to falter, and grocers will need to absorb cost increases into their already thin margins. We understand that after years of investing in e-commerce, there is little cushion for groceries and distributors to pass through all these macroeconomic effects this year. Potential recessionary trends, high gas prices, and elevated labor and other supply chain costs only add further risk. So do declining consumer confidence and reduced purchasing power because of rising interest rates, as well as elevated prices for certain commodities given the Russia-Ukraine conflict.

We expect elevated saving and wage rates in the U.S. should help consumers absorb some higher grocery prices, though less so for the lower-income shopper. We forecast shoppers of all incomes will trade down to smaller packages or cheaper brands. We also expect some market share gains and traffic retention from the pandemic to persist with grocers because restaurant (food-away-from-home) prices are rising too, up 7.2% between April 2021 and April 2022, according to the BLS.

Additionally, we believe customers will consolidate trips to save on gas, for higher basket size and lower grocery traffic this year. Both conventional grocers such as Kroger and Albertsons and more broadly diversified peers including Walmart Inc. will face operating pressure. Walmart, the nation's largest grocer, is already affected. Grocery was a challenged category in earnings for its fiscal year ended April 29, 2022. The discounter must balance low prices and profit preservation, as hard-hit customers look for value. It must also consider that a shift toward lower-margin food and away from higher-margin items such as apparel will dent earnings this year. CEO Doug McMillon said Walmart especially pays attention to "opening price-point food items" that low-income households must buy to feed their families, such as loaves of bread, gallons of milk, cans of tuna, and macaroni and cheese.

Gross margin compression offset top-line strength for midsize grocers in the first part of the year. Ingles Markets Inc. noted that for the first half of fiscal 2022, net sales increased 16.6% compared with the first half of 2021. But gross margins declined about 100 basis points (bps) to 25.3% as inflationary product costs and freight expenses were partially offset with store and labor efficiencies. Comparable club sales increased roughly 4% for BJ's Wholesale Club Holdings Inc. excluding gasoline revenue. Meanwhile merchandise gross margins, which excludes gasoline sales and membership fee income decreased 30 bps in the quarter ended April 30, 2022.

In 2021, food-at-home prices increased 3.5% and food-away-from-home prices increased 4.5%. The CPI for all food increased an average of 3.9% in 2021, according to the U.S. Department of Agriculture and BLS (chart 3).

Chart 3

While the food inflation that we expect this year will likely be credit negative, a certain level of other inflation can help grocers. With private sector wages and salaries up 5% in the first quarter of 2022 relative to a year earlier, according to the U.S. Department of Labor, there is some chance customers can accept higher prices than we have anticipated in previous inflationary environments. And discount grocers could expect traffic gains in the coming year.

Inflationary Stress Test Assumptions

To assess the impact of inflation on the 19 U.S. grocery and food distribution companies that we publicly rate, we designed a hypothetical stress test to sensitize gross margin and understand how much it would take to trigger a downgrade of each issuer. We designed the test as a simple "what if" scenario that indicates our view of the vulnerability of select issues to additional inflation. Therefore, we did not include offsetting actions such as optimizing inventory or labor, reducing capital expenditures, or pausing share buybacks. We included all of our publicly rated grocery and grocery distributor companies. Of the 19, seven are investment-grade and 12 are speculative-grade.

Our takeaways:

• A 100 bps decline in gross margin would result in 35% of the portfolio being downgraded.
• A 200 bps decline in gross margin would result in 65% of the portfolio being downgraded.
• Investment-grade companies can withstand 80 bps of gross margin compression before being downgraded.
• Speculative-grade companies can withstand 17 bps of gross margin compression before being downgraded.

Table 1 summarizes the companies from best- to worst-positioned in our view for a 150 bps gross margin inflationary shock. We also highlight the minimum gross margin pressure they could absorb before triggering a negative rating action.

Table 1

Of the selected 19 companies, we believe about 58% (11 companies) would qualify for a rating action with just 150 bps of inflation stress. Two of the 11 are investment-grade and the rest are speculative-grade. We note that while high-rated Costco Wholesale Corp. can absorb more than 500 bps of gross margin hit, smaller low-margin grocery distributors such as KeHE Distributors Holdings LLC only need 18 bps to hit negative rating action leverage thresholds. We believe dollar stores or lower-price retailers will benefit as the demand for their products increases during the inflationary environment.

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

Most of the negative rating action potential was for speculative-grade issuers. Many would need to approach or exceed this leverage amount on a sustained basis to see a downgrade. Others could face unsustainable capital structures or liquidity crunches because of already high leverage, pushing many 'B-' issuers into the 'CCC' category.