The tendency of global food producers to spend first and deleverage second, rather than accumulate some slack in the capital structure until M&A targets materialise, may require readjustment in the current economic slowdown, says a report titled "Can Global Branded Food Producers Keep Up M&A And Shareholder Returns In A Downturn?," published recently by Standard & Poor's Ratings Services.

"Against the background of a weak macroeconomic outlook for the world's largest developed economies, the creditworthiness of branded food manufacturers appears robust thanks to their noncyclical demand and sustainable profitability," said Standard & Poor's credit analyst Anna Overton. "Nevertheless, the processed food industry is not immune to shifts in demand and input price inflation, and companies may have to slow down the absorption of free operating cash flows to cushion margin pressure.

"From a ratings standpoint, our main concern is a potential disconnect between the need for such adjustments and firms' continuing pursuit of acquisitions and shareholder returns."

Branded food manufacturers enjoy the combined benefit of good visibility of earnings and high conversion of profits into cash, which affords them business risk profiles designated as 'strong' or 'excellent'. These benefits also drive their financial policies, which aim to continuously absorb discretionary cash flows from operations into either acquisitions or returns to shareholders. M&A activity is an essential part of business development in this industry, as the intangible value of brands and well-developed sales and distribution franchises generally far exceed the value of the physical plant and equipment. In addition, consolidation delivers significant economies of scale in manufacturing and distribution, helping to improve margins in specific geographic markets.

Looking ahead, we expect strong brands to underpin sales volume for food manufacturers, other factors such as economies of scale being strongly dependent on healthy top-line expansion. Operating scale, meanwhile, remains critical for continuing profitable growth: Firms' global spread can incur high overhead costs, and manufacturing and
distribution efficiencies are essential to offset rising marketing and raw material costs.

As the report points out, we believe that commodity price inflation is here to stay for the next three to five years and can be reasonably accommodated by most diversified producers, so long as it's gradual. A price spike or severe interruption in supply, however, could prove more difficult to absorb and adversely affect companies' credit quality.

Although we expect investment-grade credits in the global food industry to maintain adequate liquidity provision, a marginal increase in their financial costs is likely. Such an increase would be of particular significance when assessing additional debt capacity in conjunction with M&A and share buybacks.