Recent Investor Discussions: U.S.

Consumer Products Ratings Should Remain Stable In 2014 Amid Improved Consumer Spending
Primary Credit Analysts: Diane M Shand, New York (1) 212-438-7860; [email protected] Peter Kelly, New York (1) 212-438-7698; [email protected] Secondary Credit Analysts: Jeffrey A Burian, CFA, New York (1) 212-438-3508; [email protected] Bea Y Chiem, San Francisco (1) 415-371-5070; [email protected] Jacqueline Hui, New York (1) 212-438-1960; [email protected] Chris Johnson, CFA, New York (1) 212-438-1433; [email protected] Rick R Joy, New York (1) 212-438-1310; [email protected] Gerald T Phelan, CFA, Chicago (1) 312-233-7031; [email protected] Jean C Stout, New York (1) 212-438-7865; [email protected]

Table Of Contents
Questions And Answers

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Recent Investor Discussions: U.S. Consumer Products Ratings Should Remain Stable In 2014 Amid Improved Consumer Spending
The Standard & Poor's Ratings Services consumer products team recently met with investors in California to discuss our ratings and forecasts for the sector. We and many investors believe that overall economic indicators are pointing to improvement, but that cautious consumer spending--a lingering result of slow income growth and still high unemployment--is weighing on the sector. In this report, we summarize the key points of our discussions.

Questions And Answers

What is the credit outlook for the consumer products sector for 2014?
We expect the economic improvement to continue, and our outlook for the entire consumer products industry is stable, with 82% of our credits with stable outlooks. Many issuers within the consumer products industry continue to generate good cash flows and maintain adequate liquidity through cost reductions and operating efficiencies. We expect modestly improved consumer spending boosted by a stronger jobs market and healthier balance sheets. However, real disposable income growth will remain fairly weak, which could hurt companies that cater to the lowand mid-tier income levels.

What is your outlook for the protein sector?

Our outlook for the U.S. poultry sector remains favorable in 2014, given the lower grain inflation outlook, while pricing and industry margin management have been more disciplined. Still, lower grain prices may boost production levels, which may test the industry's recent discipline on pricing. The outlook for profit margins for beef packers has stabilized as industry production capacity has been reduced. However, with tighter aggregate U.S beef supplies and higher beef prices, we believe packaged food companies with a concentration in beef products will face lower operating margins, with possible rating implications for speculative-grade issuers (issuers to which we have assigned 'BB+' corporate credit ratings or lower) that have less room for shortfalls in profitability. Margins may also become pressured for pork processors, given the current PED virus affecting much of the U.S pork supply. Although most pork companies appear to be managing their pricing and sourcing strategies well enough, there could be negative rating implications for pork processors if industry conditions deteriorate, particularly for speculative-grade issuers.

What is your outlook for dairy prices for 2014?

Dairy prices have reached new highs this year, with the USDA's reported all-milk price rising to a record $24.60 per hundredweight (cwt) average level during the first quarter of 2014. The USDA's latest forecast for full-year 2014 projects a 13.9% increase over 2013 to about $22.80 per cwt, with prices peaking during the first half of the year and declining in the second half, when milk production is projected to increase.

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Recent Investor Discussions: U.S. Consumer Products Ratings Should Remain Stable In 2014 Amid Improved Consumer Spending

Global milk supply and demand conditions involve such major participants as China on the demand side and New Zealand on the supply side. These conditions play an increasing role in domestic market pricing, and current U.S. milk prices reflect strong domestic and foreign demand. Lower feed costs and higher milk prices reflect a rising milk-feed price ratio that has reached levels not seen in over five years. Domestic milk production is projected to increase 2.4% during 2014 as dairy farmers increase the number of cows to take advantage of these conditions. Rising dairy prices benefit milk producers, and the milk marketing operations of cooperatives such as Dairy Farmers of America Inc. are largely able to pass through to their customers price changes for raw milk. However, dairy processors such as Dean Foods Co. or Wells Enterprises Inc. often face greater challenges in doing so because their customers may be more resistant to the timing or extent of price pass-through. Non-dairy companies for which dairy ingredients represent a major input cost, such as Mead Johnson Nutrition Co. or Milk Specialties Company, are also susceptible to margin shrinkage related to rising dairy prices. We believe issuers in this sector will continue to experience overall high dairy input prices for the remainder of 2014, with some easing during the second half of the year, in part because we expect milk production levels to improve during the year.

What role will financial policy play in credit quality in 2014?

Financial policy will continue to play a critical role in credit quality, and we do not foresee significant financial policy changes from global consumer products companies. For the investment grade, financial policy decisions are typically the main force behind changes in ratings. Specifically, decisions with respect to how a company manages its cash flow to support or enhance shareholder returns (including dividends and share repurchases) and fund growth initiatives (including acquisitions). When these decisions result in sustained higher debt levels, which weaken credit measures beyond the scope of the company's financial risk profile, we could take a negative rating action. Given that a few investment-grade companies have activist investors within their shareholder base, and that interest rates will probably remain relatively low in the intermediate term, some companies are likely to tap the debt markets to fund shareholder or growth initiatives, share repurchases, or acquisitions. But overall, we believe financial policies will remain unchanged for most investment-grade consumer goods companies and that companies will fund share repurchases and dividends out of cash flow. Financial policy decisions may also affect the ratings on speculative-grade issuers. However, liquidity is typically the driver of rating actions, especially for issuers on the lower end of the ratings category that generally have less cash flow and smaller cushion under their maintenance financial covenants. Some equity sponsor-owned speculative-grade companies could also pursue leveraged shareholder distribution transactions, given still low interest rates. This, combined with a limited ability to raise prices amid lingering weak macroeconomic conditions, could prompt a negative rating action.

What is the biggest surprise this year for each consumer products subsector?
In packaged food, volume trends have not recovered to historical trend levels, and remain weak. This no doubt is due to changes in consumer buying habits, including less stocking of the pantry ("pantry loading") and shopping in different store formats, and changes in consumer preferences, including greater emphasis on health and wellness. Regarding the timing of merger and acquisition (M&A) activity, there was a surprising slowdown year-to-date in agribusiness. The pace seems to be now picking up, as it is for consumer goods overall. In consumer durables, we had expected demand for big ticket items (i.e., household appliances) to pick up last year

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Recent Investor Discussions: U.S. Consumer Products Ratings Should Remain Stable In 2014 Amid Improved Consumer Spending

with a rebound in housing, including new and existing home sales. Pent-up demand will likely lead to an uptick in volume this year. In personal care we were surprised that commodity costs have remained high and overall volume remained weak, given high penetration of private label offerings and changes in consumer buying habits (as noted above).

Are you seeing increased competition from private label?

On the packaged food front, private label competition remains a threat in certain categories more than others. The degree of private label penetration by category still varies, and price gaps still drive the consumer purchasing decision. As the competitive environment becomes more promotional, it becomes more difficult for branded products to maintain the price gaps with private label. Still, we expect private label to continue to grow, as consumers continue to seek value and private label quality has grown. We believe branded companies will continue to have the resources and innovation capabilities to compete effectively with private label and retain their share positions. We expect that the large private label consolidators, such as TreeHouse Foods Inc., will continue to grow through acquisitions, given the fragmented industry. On the personal care front, most products are branded and so we do not forecast meaningful market share changes in the U.S. Competition from private label in the household product segment is more intense, but branded producers continue making competitive moves against lower cost rivals. One recent example is Procter & Gamble Co.'s release of Tide Simply Clean & Fresh, a less expensive version of the flagship Tide brand intended to compete against Church & Dwight Co. Inc.'s less costly Arm & Hammer detergent and, to a lesser extent, private label competitors. Tide Simply Clean & Fresh looks similar to, and Procter & Gamble intends for it to be placed alongside of, Arm & Hammer detergent. The ability to reinvest in the product--branded or private label--remains important in this competitive environment. For example, The Sun Products Corp. has a portfolio of both branded and private label personal care and household products, but its weak operating performance and significant debt burden will continue constrain its ability to invest in its brands.

What trends are you seeing in the cereal category?

U.S. breakfast cereal volumes have been contracting over the past few years as the category faces increasing competition from other breakfast alternatives and changing consumer tastes. However, Kellogg Co. and General Mills Inc. have remained committed to the category and stated their intentions to invest in innovation and brand support. We believe the category remains attractive because of its high household penetration rates and margins. The largest challenges will be to restore growth and come up with offerings that resonate better with the consumer.

How soon could FDA regulatory actions with respect to menthol cigarettes have an impact on industry players, and what prompted your upgrade of Altria?
Tobacco manufacturers continue to improve profitability through price increases, master settlement agreement (MSA) credits, and growth in demand for non-cigarette tobacco products, despite continue cigarette volume declines. With respect to regulation, the environment continues to evolve. The Food and Drug Administration (FDA), which has broad authority to regulate the industry, could damage industry profits by enacting regulations that lead to sizable declines in tobacco consumption, constrain the industry's ability to develop new products, and raise costs. We think

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Recent Investor Discussions: U.S. Consumer Products Ratings Should Remain Stable In 2014 Amid Improved Consumer Spending

the FDA will continue to move slowly on many issues. Nevertheless, we believe the FDA will likely propose regulations on the use of menthol in cigarettes in the next one to three years--although we view the potential for an outright ban as low. In addition, if the FDA proposes menthol regulations, which could weaken cigarette manufacturer profitability, we believe it is likely large menthol cigarette manufacturers would use legal means to contest such a proposal, potentially resulting in litigation lasting for a long time. On March 12, 2014, we upgraded Altria Group Inc. to 'BBB+' from 'BBB', reflecting our view that the company has substantial financial flexibility from its approximately 27% ownership interest in SABMiller, which currently has a pretax market value of about $20 billion. The action also incorporated our expectation that the group's key brands will sustain high market shares and, with respect to Marlboro (and, to a lesser extent, Copenhagen and Skoal), meaningful pricing power; and its strong management team, which has profitably grown key brands while navigating difficult litigation and evolving regulatory environments. We expect ratings on the other tobacco companies to remain stable as solid profitability and good liquidity provide financial flexibility, which we believe is important given the uncertainty surrounding litigation and regulatory risk. (Subsequent to our meetings we published a comment of the FDA's recent proposals on e-cigarettes. Please see "Early Thoughts On The FDA's Move To Regulate E-Cigs," published April 24, 2014, on RatingsDirect.

What is your outlook for durables companies, such as manufacturers of appliances and bedding?
We expect ratings for the majority of our consumer durables issuers to remain stable in 2014, as we see industrywide revenue and profits increasing at a faster pace relative to 2013. We expect the sector to benefit from continued growth in the U.S. economy, helped by a stronger jobs market and continued housing rebound. We see consumer spending for major appliances, such as washers, dryers, and refrigerators, benefiting from increasing new home construction, growth in renovation spending, and strengthening replacement demand in North America. Within the bedding and home furnishings industry, demand is likely to remain uneven, as growth in the upper- and lower-tier furnishings segments modestly outweighs sluggish demand for mid-tier products. However, low interest rates should continue to help the housing recovery and discretionary spending on housing-related items. We expect the bedding industry will also benefit from increased replacement demand as consumers that deferred purchases during this past recession look to replace worn-out mattresses.

How do we factor in regulatory risk in the food sector?

Regulatory risk is generally not a prevalent factor in our rating analysis for the food sector, and is primarily an event risk; for example, when a company has a major product recall. In such circumstances we evaluate the materiality of the event to determine if there is a rating impact. Certain subsectors may have a more explicit regulatory risk factored into our rating rationale, but represent a minority of our rated consumer products issuers. As an example, American Crystal Sugar Co. benefits from U.S. import tariff-rate quotas and sugar price protection under the USDA sugar loan program.

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