Packaged food companies typically use commodity risk management to reduce earnings volatility and increase earnings predictability. Medium-to-large packaged food companies have diversified product portfolios and relatively steady consumption patterns for their products. These companies have maintained adequate liquidity and access to capital during the current instability in the credit markets. They are expected to exhibit growth in operating earnings and cash flow, as well as discretionary free cash flow. Therefore, ratings and outlooks for most companies in this sector are likely to remain stable in 2009.

CROP OUTLOOKS: PRICES BECOME MORE REFLECTIVE OF SUPPLY/DEMAND FUNDAMENTALS

The U.S. Department of Agriculture (USDA) is expecting a third consecutive year of farm prices for wheat, corn, soybeans, soybean meal and oil to be above their 10-year averages. Both 2007/08 and 2008/09 prices are substantially above the averages. While these commodities spiked up through mid-2008 driven by strong demand, rising oil prices, speculation, and adverse weather, prices have fallen dramatically since mid-year.

Expectations for large crop production and plummeting oil prices have contributed to the price declines. The USDA forecasts U.S. corn production at 12 billion bushels, 8% below last year. Both corn production and yields are currently forecast to be the second highest on record. Soybean production, at 2.92 billion bushels, is forecast to be up 9% from last year for the fourth largest production on record. U.S. wheat production is forecast at 2.5 billion bushels. With lower U.S. wheat exports due to record global wheat production, ending stocks are expected to be replenished and prices have moderated.

FOOD PRICE INFLATION: MODERATION SEEN FROM 2008 LEVELS

According to the USDA's Economic Research Service (ERS), the Consumer Price Index (CPI) for all food is forecast to rise 4.0-5.0% in 2009. Both 'Food away from home' and 'Food at home' are forecast to rise at this same pace in 2009. These above-average changes in food price indices are on top of a forecast CPI increase of 5.5%-6.5% for 'Food at home' in 2008 and a final 2007 increase of 4.2%. The highest price increases for 2008 are for eggs, fats and oils, cereals and bakery products, and dairy products. Beef, pork and poultry prices are expected to see the greatest prices increases in 2009, ranging from 5%-7%. While feed costs rose dramatically through the first half of 2008, it has taken time for the feed cost increases to materialize in the form of higher protein prices at retail. Prices for the categories that rose fastest in 2008 are expected to moderate somewhat in 2009 with the recent drops in commodity prices.

CONSUMER IMPACT: PACKAGED FOOD COMPANIES BENEFIT FROM SHIFT IN SPENDING PATTERNS

Back-to-back years of soaring food price inflation, along with high oil prices that had an impact on transportation, manufacturing, and packaging costs, have led the packaged food companies to take several rounds of price increases. Although food is a non-discretionary purchase, consumers have choices about where to spend their food dollars and how much to pull back on total food spending. Consumers have reduced spending at restaurants, particularly casual diners, and are re-allocating that spending to food eaten at home. Packaged food companies have benefited, and are expected to continue to benefit, from this shift in spending patterns. Even with the price increases that have been taken by packaged food companies, there is a much lower cost to packaged foods bought at retail versus similar foods bought at a full-service restaurant.

The greatest risk for packaged food companies in the near term is that consumers, particularly at lower income levels, may accelerate purchases of private-label substitutes. This shift is likely to be more pronounced for commodity-like, less differentiated products, such as cheese. However, all packaged food products run the risk of private-label trade-down if they do not effectively manage price gaps or have enough perceived brand value. Most packaged food companies have stepped-up their consumer spending in recent years to increase the importance of their products to consumers. Having #1 brands with high market shares, and to a lesser extent strong #2 brands, is a distinct advantage in this environment. These are perceived as 'must have' brands by both retailers and customers. Companies that own these brands can command more pricing power.

INDUSTRY OUTLOOK: HIGHER PRICING HARDER TO PASS THROUGH TO CONSUMERS IN 2009

Packaged food companies are gearing up for a third year of significant input cost inflation. Despite recent drops in commodity and oil prices, Fitch does not expect input cost pressure to subside materially for at least several months. The reason for the lag is that these companies typically try to lock in a portion of their costs for the coming year, either by using exchange traded-derivatives to hedge their costs and/or by entering into contracts with their suppliers. For competitive reasons packaged food companies do not publicly disclose details about their contracts or hedged positions. Most packaged food companies with fiscal years ending mid-2009 have provided guidance for higher year-over-year cost inflation. While many packaged food companies have done a good job with achieving higher pricing recently, there is still more pricing to come in 2009. The magnitude of pricing actions consumers are willing to accept when they are already being squeezed by the shaky economy is a delicate balance. If a packaged food company's volume turns negative, it is a sign that consumers feel that the higher pricing is too much. The consumers may switch to another brand with higher perceived value or to a private label substitute. Nonetheless, most packaged food companies have plans to offset input cost inflation in 2009 with a combination of pricing actions and productivity initiatives. Fully offsetting incremental cost inflation in 2009 will be difficult to achieve because of the magnitude of pricing actions already taken in 2008, pushback from retailers about further increases, and consumers' increased desire to switch to private label products to reduce their grocery bill. Since consumers have already seen news of lower commodity and energy prices, they may be less willing to pay for further price increases. Packaged food companies need to maintain higher levels of brand building to support new products and keep the value of existing products at the forefront of consumers' minds. Increasing the efficiency and effectiveness of trade spending will be another continued focus for packaged food companies.

Competition is expected to remain intense. Companies with higher margins such as General Mills, Inc., Kellogg Company, Campbell Soup Company, and H.J. Heinz Company have greater financial flexibility to invest in their brands to preserve or gain market share relative to competitors. Innovation is likely to continue to focus on perceived health and wellness and convenience. However, convenience will be a tougher sell in this environment. Portion control packaging has been a blockbuster invention in recent years. However, it will be more difficult to get consumers to buy these more expensive calorie-controlled packs in this weak economic environment when consumers can easily divide their own snack portions. Health is still a significant attribute, and new products such as Campbell's Select Harvest soups with easy to understand ingredients, heart-healthy sodium levels and no monosodium glutamate (MSG) are on target with consumers.

CREDIT OUTLOOK: LARGER LIQUIDITY CUSHIONS LIKELY DURING CREDIT CRUNCH

Mid-single-digit sales and operating earning growth can be expected for many packaged food companies in 2009. Sales growth will still benefit from incremental pricing coming through from recent and upcoming pricing actions. Volumes should stay positive except where a large amount of pricing actions are taken in a short period and brand value is not perceived to be high enough. Also, volumes at the foodservice businesses of packaged food companies are expected to remain weak due to restaurant industry trends, particularly in casual dining. Quick service restaurants (QSRs) are holding up better in this environment because consumers perceive them to be a good value. A positive impact from currency is unlikely in 2009 with the recently strengthening dollar. This will temper sales growth for companies with a large portion of their earnings overseas, particularly in Western Europe. Heinz, Sara Lee, Kraft, Kellogg's and Campbell's all generate at least 30% of their sales outside the U.S. Most packaged food companies have been focusing on achieving higher gross margin dollars to invest back into their businesses. This focus on margin dollars is likely to continue in 2009.

The packaged food companies covered in this report are expected to have sufficient cash flow from operations to cover their capital expenditures and dividends. Free cash flow (after capital expenditures and dividends) is likely to be used for bolt-on acquisitions and/or share repurchases. However, Fitch expects preservation of liquidity to be important during this environment of instability in the credit markets. Companies are likely to be cautious about executing share repurchases until market conditions improve. However, low stock prices may entice food companies to resume share repurchases. Earlier this month Sara Lee announced the resumption of share repurchases just one day after announcing their curtailment.

Bolt-on acquisitions are likely to be in core categories either in the United States or abroad. Non-core divestitures may continue in 2009, although much of the 'low hanging fruit' has already been shed. Proceeds from non-core divestitures may be used for share repurchases or debt reduction. Fitch does not expect large acquisitions to occur until credit markets improve substantially. However, when markets do improve, the food sector may be one of the first to engage in significant merger and acquisition (M&A) activity due to the sector's stability. There may be pent-up demand for larger M&A activity once the credit markets improve. Several large restructuring programs that have been executed over the past few years, such as Kraft's and Sara Lee's, are winding down. However, escalating input costs have muted the benefits of the cost reductions. Therefore, smaller restructuring programs, such as Sara Lee's recently announced 'Project Accelerate', are likely to be announced to help further trim costs. Packaged food companies with similar input costs or product categories may consider business combinations to gain synergies and bolster margins. The last major round of consolidation was in the early 2000s and cost savings from those deals have been exhausted.

Material debt reduction is not expected to be a high priority in 2009. While many of the packaged food companies' ratings have migrated to the mid-'BBB' level over the past few years, companies still report that they have adequate commercial paper (CP) access at the tier 2 level. However, rates have certainly been higher during this credit crunch than they had been historically. Companies at the tier 1 CP level, such as Campbell's, have found it to be an advantage with lower rates and greater liquidity during this tumultuous period in the credit markets. Debt maturities in 2009 are light for the packaged food sector in comparison to the prior year. The largest maturity is Kraft's $750 million notes due November 2009. Kraft has not committed to debt reduction and instead plans to grow earnings to improve its credit metrics, which are weak for the rating level. There is very little financing activity remaining in 2008. Several packaged food companies took advantage of better credit markets and issued long-term debt earlier in the year. However, Heinz has $800 million of debt securities with a remarketing scheduled Dec. 1, 2008. If the securities are not remarketed, Heinz is required to repurchase them. Heinz also has a $2 billion credit facility that expires in August 2009. Sara Lee has a EUR250 million term loan due December 2008. Fitch expects investment grade packaged food companies to maintain conservative capital structures in this credit environment. However, materially weaker earnings, debt-financed share repurchases or acquisitions could lead to negative rating actions or Outlook changes.

Following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs):

--Campbell Soup Co. ('A'; Outlook Stable);

--ConAgra Foods, Inc. ('BBB'; Outlook Stable);

--Flowers Foods, Inc. ('BBB'; Outlook Stable);

--General Mills, Inc. ('BBB+'; Outlook Stable);

--H.J. Heinz Co. ('BBB'; Outlook Stable);

--Kellogg Company ('A-'; Outlook Stable);

--Kraft Foods, Inc. ('BBB'; Outlook Stable);

--Sara Lee Corp. ('BBB'; Outlook Stable);

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.