Rating Action Overview
- U.S.-based H-Food Holdings LLC (operating as Hearthside Foods Solutions LLC) reported declining profitability for the past couple of quarters, resulting in very high S&P adjusted leverage of 13.2x for the latest 12 month (LTM) period ended March 31, 2022.
- Rising wage costs, labor instability, and supply chain challenges contributed to lower profitability.
- We revised our outlook on Hearthside to negative from stable and affirmed our 'B-' issuer credit rating to reflect our expectation for very high leverage, negative free operating cash flow, and the continuing difficult operating environment in 2022.
- The negative outlook reflects that we could lower the ratings within the next 12 months if the company's profitability deteriorates further leading to constrained liquidity or we view the capital structure to be unsustainable.
Rating Action Rationale
The outlook revision to negative reflects Hearthside's elevated leverage as a result of weak profitability and underperformance from the recently acquired Interbake business. We expect S&P Global Ratings-adjusted pro forma leverage to remain elevated above 10x throughout 2022, before improving to around 8x in 2023. Hearthside's organic revenue grew 8% sequentially in the first quarter of 2022, largely as a result of increased volume from new capital projects and price increases to offset higher input costs for raw materials and packaging. The company has mostly pass-through pricing contracts in place with customers for commodities and raw materials at the legacy Hearthside business; however, the recently acquired Interbake business has more private-label exposure and does not benefit from direct pass-through pricing of commodity costs. The inflationary environment has led to underperformance from Interbake, with our expectations for profitability to remain depressed into the second half of 2022 until price increases take effect. In addition, higher labor costs and operating inefficiencies are pressuring margins at the legacy Hearthside business, with some lag time for labor-related price increases to be passed on to customers. The company has experienced high startup costs from new capital projects as well, and elevated levels of capex have not produced the expected return on investment because high employee turnover is resulting in lower throughput, and higher-than-normal scrap rates and training costs.
As a result of the above-mentioned factors, Hearthside experienced gross margin contraction of nearly 400 basis points (bps) in the first quarter. We expect gross margins will remain pressured throughout 2022, with some improvement in the second half of the year as price increases are fully realized. We forecast profitability to improve in 2023 as the company gradually realizes cost-savings and efficiency improvements, in addition to some of the roughly $30 million in capacity synergies related to the Interbake acquisition.
We forecast Hearthside will experience steep cash flow deficits in 2022 as it continues to fund higher-than-historical levels of capital expenditures (capex). We expect capex levels of at least $100 million to continue over the next 12-24 months. Additionally, we forecast the company will require roughly $15 million-$25 million in cash usage for working capital purposes in 2022, related to higher receivables, the recently acquired Interbake business, and increased safety stock for inventories. Given the higher-than-normal levels of capex, buildup of inventory safety stock, and growing receivables, we forecast roughly $100 million in cash flow deficits in 2022. We expect free operating cash flow (FOCF) to improve to negative $10 million-$20 million in 2023, as a result of cost savings and expense reductions from identified projects, before turning positive in 2024 due to increased capacity from the Interbake acquisition and recent investments in capital projects. The company continues to make investments in customer-driven projects, which began in 2020, as well as building out new production lines related to the Interbake acquisition, which should result in increased capacity and volumes for the business. Plant inefficiencies, labor instability, and supply chain disruption have led to lower-than-expected volumes from these new capital projects to date.
The company has experienced supply chain challenges, which we expect to continue into the latter half of 2022. The company is attempting to diversify its suppliers and increase its safety stock to prevent against additional supply chain disruptions; however, we expect volumes will continue to be strained for a while, mostly as a result of packaging issues, label shortages, and the inability to source labor. Trucking availability has also been an issue for Hearthside leading to some disruption in deliveries. Hearthside's baking segment was particularly hurt by labor shortages because it requires a higher level of skilled workers, which has contributed to increased scrap rates and plant inefficiencies. However, the company continues to see strong demand overall, particularly from the baking segment, which supports our long-term revenue growth expectations for the business in the mid-single-digit percentages.
Outlook
The negative outlook reflects that we could lower the ratings within the next 12 months if the company's profitability deteriorates further resulting in additional revolver borrowings and weakening liquidity, or we view the capital structure to be unsustainable.
Downside scenario
We could lower our ratings on Hearthside any time within the next 12 months if:
- Profitability deteriorates due to operational inefficiencies, labor instability, or supply chain disruptions further pressure liquidity.
- Interest coverage fails to improve to greater than 1.5x; or Additional capital projects are added without realizing the benefits of previous projects; or
- Prolonged free cash flow deficits.
Upside scenario
We could revise the outlook to stable if the company:
- Improves profitability from its previous capital projects;
- Realizes capacity synergies from the Interbake acquisition on time and on budget;
- Realizes cost savings, operating improvements, and expense reductions from identified projects;
- Successfully implements price increases to offset inflation; and
- Generates sustained positive free cash flow.
Company Description
Formed in 2009, Hearthside Foods Solutions LLC increased its sales to more than $3.4 billion in 2021 from about $145 million in 2009 by acquiring various plants, co-manufacturers, and contract packagers and expanding to 37 manufacturing facilities and 23 warehouses across the U.S. and Europe. The company supplies a wide range of bakery products, nutrition bars, frozen packaged products, meal kits, snacks, and customized packing solutions to customers such as General Mills Inc., Tyson Foods Inc., Mondelez International Inc., PepsiCo Inc., Kraft Heinz Foods Co., and Kellogg Co.
Our Base-Case Scenario
- U.S. real GDP increases by 2.4% in 2022 and 2.0% in 2023;
- Revenue rises by roughly 25% in 2022, primarily due to contributions from the Interbake acquisition, price increases, and recently completed customer-driven capital projects, and in the high-single-digit percentage area in 2023; we expect 10%-12% organic revenue growth in 2022.
- S&P Global Ratings-adjusted EBITDA margin in the low-6% area in 2022, down from the low-7% area in 2021 because of labor inflation and turnover, supply chain disruption, and high scrap rates. We expect margins to improve by roughly 160 bps in 2023 as the company benefits from its recent productivity initiatives, operational efficiencies, and realizes capacity synergies related to the Interbake acquisition. We expect the company to pass on any increases in its raw material costs in the legacy Hearthside business to its customers to help offset inflationary pressures;
- Total capex of at least $100 million in 2022 as the company builds out new capacity lines and continues new customer projects. We expect capex to increase modestly in 2023 and remain higher than the company's historical average;
- FOCF deficits of roughly $100 million in 2022 and modest FOCF deficits of $10 million-$20 million in 2023;
- Annual term-loan amortization of $20.75 million;
- No sizable acquisitions, although we expect the company to pursue bolt-on purchases; and
- No shareholder dividends.
Based on these assumptions, we arrive at the following credit metrics:
- Adjusted debt to EBITDA in the mid-10x area in fiscal 2022 and in the 8x area in 2023;
- Funds from operations (FFO) to debt of about 2.6% in fiscal 2022 and 6% in 2023; and
- EBITDA to interest of 1.4x in fiscal 2022 and 1.9x in 2023.
Liquidity
We assess the company's liquidity as adequate. Specifically, we expect Hearthside's liquidity sources to be at least 1.4x its uses over the next 12 months and anticipate that its sources will remain positive even if its EBITDA declines by 30%. We believe the company has sound banking relationships and a satisfactory standing in the credit markets given its ability to secure financing at market rates and its ownership by well-known financial sponsors with good banking relationships. Despite meeting our quantitative benchmarks for a higher assessment, we do not believe the company fulfills certain qualitative factors. These include its inability to absorb high-impact, low-probability events (such as the loss of a major customer) without needing to refinance due to its high leverage and material customer concentration.
Due to the company's high capex and need to rebuild its inventory, the company borrowed $20 million on its revolving credit facility during the second quarter and an additional $20 million related to a customer invoicing issue. We expect the company will begin repaying borrowings on the revolver in the third and fourth quarters. However, if the company continues to fund its operations utilizing its revolver it could weigh negatively on our liquidity analysis.
Principal liquidity sources include:
- Balance sheet cash of $76.9 million as of March 31, 2022;
- Availability of about $145.7 million under its $202.5 million revolving credit facility due November 2024 as of March 31, 2022; and
- Positive cash funds from operations of more than $75 million over the next 12 months.
Principal liquidity uses include:
- Annual term loan amortization of $20.75 million;
- Capex of at least $100 million over the next 12 months to support its growth projects and capacity expansion; and
- Peak seasonal working-capital requirements of about $30 million.
Covenants
The revolver is subject to a 7.75x springing maximum first-lien net leverage ratio when the company draws on at least 35% of the facility's commitment. If the facility is tested, we expect Hearthside to maintain at least 20% covenant cushion given our forecast and the permissible EBITDA addbacks under its credit agreements.
Issue Ratings - Recovery Analysis
The company's capital structure comprises:
- $202.5 million revolving credit facility due in 2024;
- $2.02 billion first-lien secured term loan due in 2025;
- $300 million second-lien term loan due in 2026; and
- $350 million of senior unsecured notes due in 2026.
Key analytical factors
- The borrower under the revolver and term loans is H-Food Holdings LLC. Dutch operating subsidiary Hearthside Bidco B.V. is a co-borrower on the term loan that supports the company's international operations. The guarantors of the facility are H-Food Holdings LLC and all of its direct and indirect wholly owned material domestic and Dutch subsidiaries. The term loan facilities are secured by a first-priority lien on substantially all of the assets and stock of the borrowers and H-Food Holdings' domestic and Dutch subsidiaries. The second-lien term loan is secured on a secondary basis to the collateral mentioned above. The notes are senior unsecured obligations and are subordinated to the first- and second-lien senior secured credit facilities.
- H-Food is a U.S.-based corporation headquartered in Downers Grove, Ill. In the event of insolvency proceedings, we anticipate the company would file for bankruptcy protection under the auspices of the U.S. federal bankruptcy court system and would not involve other jurisdictions.
- We believe its creditors would receive the maximum recovery in a payment default scenario if the company was reorganized rather than liquidated. Therefore, in evaluating the recovery prospects for its debtholders, we assume Hearthside continues as a going concern and arrive at our emergence enterprise value by applying a multiple to our assumed emergence EBITDA.
Simulated default assumptions
- Default year: 2024
- Debt service: $221 million (default year interest plus amortization)
- Minimum capex: $62 million
- Emergence EBITDA: $283 million
Simplified waterfall
- Emergence EBITDA: $283 million
- Multiple: 6x
- Gross recovery value: $1.7 billion
- Net recovery value for waterfall after administrative expenses (5%): $1.61 billion
- Obligor/nonobligor valuation split: 91%/9%
- Priority claims on securitization: $79.5 million
- Estimated first-lien claims: $2.2 billion
- Value available for first-lien claims: $1.48 billion
- --Recovery expectations: 50%-70% (rounded estimate: 65%)
- Estimated second-lien claims: $314 million (unrated)
- Value available for second-lien claims: $0
- Estimated unsecured claims: $1.4 billion
- Value available for unsecured claims: $51 million
- --Recovery expectations: 0%-10% (rounded estimate: 0%)
Note: Debt amounts include six months of accrued interest that we assume will be owed at default.
Ratings Score Snapshot
Issuer credit rating: B-/Negative/--
Business risk: Fair
- Country risk: Very low
- Industry risk: Low
- Competitive position: Fair
Financial risk: Highly leveraged
- Cash flow/leverage: Highly leveraged
Anchor: b
Modifiers
- Diversification/portfolio effect: Neutral (no impact)
- Capital structure: Neutral (no impact)
- Financial policy: FS-6 (no additional impact)
- Liquidity: Adequate (no impact)
- Management and governance: Fair (no impact)
- Comparable rating analysis: Negative (-1 notch)
ESG Credit Indicators: E-2 S-2 G-3
Related Criteria
- General Criteria: Environmental, Social, And Governance Principles In Credit Ratings, Oct. 10, 2021
- General Criteria: Group Rating Methodology, July 1, 2019
- Criteria | Corporates | General: Corporate Methodology: Ratios And Adjustments, April 1, 2019
- Criteria | Corporates | General: Recovery Rating Criteria For Speculative-Grade Corporate Issuers, Dec. 7, 2016
- Criteria | Corporates | General: Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Dec. 16, 2014
- General Criteria: Methodology: Industry Risk, Nov. 19, 2013
- General Criteria: Country Risk Assessment Methodology And Assumptions, Nov. 19, 2013
- Criteria | Corporates | General: Corporate Methodology, Nov. 19, 2013
- General Criteria: Methodology: Management And Governance Credit Factors For Corporate Entities, Nov. 13, 2012
- General Criteria: Principles Of Credit Ratings, Feb. 16, 2011
Ratings List
Ratings Affirmed; Outlook Action | ||
---|---|---|
To | From | |
H-Food Holdings LLC |
||
Issuer Credit Rating | B-/Negative/-- | B-/Stable/-- |
Issue-Level Ratings Affirmed; Recovery Ratings Unchanged | ||
H-Food Holdings LLC |
||
Hearthside Bidco B.V. |
||
Senior Secured | B- | |
Recovery Rating | 3(65%) | |
Issue-Level Ratings Affirmed; Recovery Ratings Unchanged | ||
H-Food Holdings LLC |
||
Senior Unsecured | CCC | |
Recovery Rating | 6(0%) |
Certain terms used in this report, particularly certain adjectives used to express our view on rating relevant factors, have specific meanings ascribed to them in our criteria, and should therefore be read in conjunction with such criteria. Please see Ratings Criteria at www.standardandpoors.com for further information. Complete ratings information is available to subscribers of RatingsDirect at www.capitaliq.com. All ratings affected by this rating action can be found on S&P Global Ratings' public website at www.standardandpoors.com. Use the Ratings search box located in the left column.
Primary Credit Analyst: | Adam Lynn, New York + 1 (212) 438 2637; adam.lynn@spglobal.com |
Secondary Contact: | Bea Y Chiem, San Francisco + 1 (415) 371 5070; bea.chiem@spglobal.com |
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