May 19, 2017 / 3:19 PM / 9 months ago

Fitch Affirms Land O' Lakes, Inc.'s 'BBB-' Ratings

(The following statement was released by the rating agency) CHICAGO, May 19 (Fitch) Fitch Ratings has affirmed the Long-Term Issuer Default Rating (IDR) of Land O' Lakes, Inc. (LOL). The Rating Outlook is Stable. A full list of ratings is provided at the end of this release. KEY RATING DRIVERS Significant Scale, Strong Brands LOL's ratings reflect its significant scale as the second largest U.S. agricultural cooperative (co-op) and leading market shares within the categories in which it competes. LOL, with sales of approximately $13 billion, has expanded both organically and through mergers, acquisitions and joint ventures. The co-op's lengthy history since 1921, long-term relationships with its grower/owners, as well as strong brands including Land O' Lakes, Purina Animal Nutrition, and WinField Solutions, support the ratings. Dairy members supply LOL's Dairy segment with milk, cream, cheese and butter. Ag Services members purchase agricultural products, primarily feed, seed and crop protection products. Diversified Operations LOL's operations are more diversified versus its agricultural peers. In 2015, LOL acquired United Suppliers Inc. (United) in a two-step merger process that has increased LOL's scale and exposure to the more profitable Crop Inputs segment. After merging United's seed and crop protection business in October 2015, the second phase merges United's remaining crop nutrient operations and is expected to complete in October 2017. For 2016, Dairy Foods, Feed, and Crop Inputs accounted for 27%, 27% and 45% of EBITDA respectively. Additionally, EBIT margins were 1.8%, 2.4% and 3.9% for the respective segments. Fitch expects once United's crop nutrients business is merged, the Crop Inputs segment will generate close to 50% of LOL's overall EBITDA for 2018. Low-Margin Business LOL's competitive market positioning is balanced against its exposure to volatile commodity products with low single-digit EBITDA margins. Consolidated EBITDA margin was 4.3% in 2016 compared to 3.8% in 2015 driven by margin increases in the Dairy and Feed segments. Fitch's forecast has margins increasing modestly in 2017 from improved mix and cost initiatives. LOL generated in excess of $50 million in synergy benefits from the United Suppliers merger with the majority of the savings reinvested back into the business. LOL expects to realize an additional $50 million in synergy cost savings phased in over the next two years related to supply chain and back office initiatives. Retained Earnings, Board Policies Provide Flexibility Co-ops generally distribute the majority of their earnings back to members, which can constrain financial flexibility resulting in low free cash flow (FCF) generation. LOL's board has a current cash target for distribution of 60% of prior year's net earnings with the remainder retained by the company as either permanent or member equity. The 60% target was adopted by LOL's board in 2005 to more adequately align the total cash revolvements for members to operating performance in earnings. However, LOL has multiple levers it can pull to retain additional earnings by adjusting co-op policies that provide flexibility to acquire and maintain adequate capital with which to fund strategic business initiatives. LOL retains permanent equity through both its non-member business earnings (i.e. Eggland's Best) and LOL's by-laws that allow the company to retain up to 25% of earnings from its member business with no revolvement requirements. The current holdback percentages for the dairy and the agriculture business are both 10%. The holdback percentage and cash target for distribution is subject to annual board review. LOL could also reduce the cash pay-out target to less than 60% although Fitch believes this would be a less likely option. Lastly, LOL can increase the amount of equity a member must retain in either the dairy or agricultural services co-op. This is evidenced by LOL's plan to increase the equity target investment rate for the dairy operations to $3.75 per hundred pounds of milk in 2018 from $2.75 to increase equity for future dairy M&A investment initiatives. Thus, Fitch believes this 60% target affords LOL sufficient flexibility to maintain adequate capital to finance its business and maintain sufficient permanent equity. Fitch treats the cash patronage pay-out as a dividend in its analysis. On an annual basis, the board of directors, at their discretion, will establish the total allowable payments for the current year cash to members, including cash patronage, age and estate payments, and equity revolvements for both the Dairy Foods and Ag Services members. Credit Enhancements Exist LOL's debt agreements contain credit enhancing restrictions that subordinate the majority of patronage payments to debt payments with an allowed 20% cash patronage distribution to preserve the co-op's tax status. LOL's effective income tax rate is substantially lower than the statutory federal and state income tax rates as a result of the tax deductibility of qualified patronage distributions made from net income. Relatively Stable Credit Metrics Expected For 2016, LOL's leverage (total debt/EBITDA) was 2.5x, total adjusted debt/EBITDAR was 3.1x and operating EBITDA/gross interest expense was 8.1x. Leverage increased to approximately 3.5x at the end of the first quarter 2017 due primarily to working-capital build and the $94 million acquisition of Vermont Creamery. For 2017, Fitch expects total debt/EBITDA will increase modestly from 2016 levels to the range of 2.7x to 2.8x. Over the longer term, Fitch expects LOL's leverage to be relatively stable in the mid-2x range. LOL's rent expense is significant, approximately $125 million annually. However, more than 40% consists of inventory storage fees for its dairy and crop inputs business that are very short-term and cancellable at any time. Thus, Fitch views the storage expense as a variable operating cost and adjusts lease expense accordingly. Fitch expects LOL will continue to explore value-added bolt-on M&A opportunities similar in size to the Vermont Creamery acquisition. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer over the 2017 to 2018 timeframe include: --Revenue growth in the mid-single digits in 2017, increasing to the low double-digit teens in 2018 due to the United Suppliers acquisition closing in late 2017 and volume growth across core categories; --EBITDA increasing over the forecast period in 2017 to the $625 million range and the low-$700 million range in 2018 supported by M&A, mix, and margin improvements; --Capital spending in the mid-$300 million range; --Fitch assumes roughly $100 million in annual M&A transactions; --FCF moderately negative in 2017 before turning modestly positive in 2018; --Total cash payments to members is expected to be in excess of $200 million for revolvement, cash patronage, and estates and age retirements in 2017, declining materially in 2018; --Total debt/EBITDA relatively stable over forecast period in the mid-2x range. For 2017, Fitch expects leverage of approximately 2.7x to 2.8x. RATING SENSITIVITIES Negative: Future developments that may, individually or collectively, lead to a negative action include: --Sustained weakness or operating profit declines in at least one of LOL's key business segments; --Leverage (total debt/EBITDA) sustained in excess of 3x; --FCF (cash flow from operations less capex and dividends) after patronage dividends remains negative for multiple years; --A Board commitment to a higher cash patronage payout that creates a sustained FCF deficit. Positive: Fitch does not expect a positive rating action in the near term due to the low growth and low-margin structure of its business segments. However, future developments that may, individually or collectively, lead to a positive action include: --LOL diversifies its portfolio towards higher growth and higher-margin categories; --Leverage is sustained below 2x; --LOL consistently generates positive FCF. Liquidity and Capital Structure LOL's liquidity is sufficient at approximately $492 million as of March 31, 2017. Liquidity includes $51 million cash and cash equivalents, which varies seasonally, $381 million available on its $575 million senior unsecured revolver, and $60 million available on its $700 million receivables facility. Net proceeds from the recent offering of $250 million preferred stock was used to pay down outstanding balances under LOL's revolving credit facility, receivables securitization facility, and for working capital and general corporate purposes. Seasonal working capital needs are highest during the first and early fourth quarters and trough-to-peak liquidity can vary in the range of approximately $600 million to $800 million with timing of payments also affecting working capital swings. Consequently, FCF can be volatlile given the commodity-oriented nature of its business. Fitch forecasts a moderately negative FCF deficit for 2017 driven in part by working capital usage from inventories. Total cash payments to members are expected to be in excess of $200 million for revolvement, cash patronage, and estates and age retirements. LOL's capital structure consists of a $575 million unsecured credit facility due March 2020, $150 million senior unsecured term loan due August 2021, $170 million in senior unsecured private placement notes due 2018 through 2021, $300 million unsecured notes due August 2022, $200 million term loan due 2027 and a $700 million receivables securitization facility due March 2020. There are also $200 million junior subordinated capital securities due in March 2028 at Land O' Lakes Capital Trust I and $565 million of preferred stock at LOL. The preferred stock ranks junior to the senior debt and capital securities. Fitch grants 50% equity credit to LOL's preferred shares after considering the junior ranking, perpetuity, the option to defer dividends, and the cumulative coupon deferral. On or after April 4, 2027, the preferred stock will be redeemable at the option of the company. The term loans, revolving credit facility and private placement notes become secured on a pari passu basis in the event LOL does not maintain an investment-grade rating. In October 2015, LOL requested and was granted a release of security of substantially all of the material assets of LOL and its wholly owned domestic subsidiaries for the revolving credit facility, term loans and private placement notes. The release of security is conditional based on maintaining investment-grade ratings from two nationally recognized rating agencies. FULL LIST OF RATING ACTIONS Fitch affirms the ratings for LOL and its subsidiary, Land O'Lakes Capital Trust as follows: LOL -- Long-Term Issuer Default Rating (IDR) at 'BBB-'; -- Senior unsecured credit facility at 'BBB-'; -- Senior unsecured term loan at 'BBB-'; -- Senior unsecured private placement notes at 'BBB-'; -- Senior unsecured notes at 'BBB-'; -- Preferred stock at 'BB-'. Land O' Lakes Capital Trust I -- Jr. subordinated capital securities at 'BB+.' Contact: Primary Analyst William Densmore Senior Director +1-312-368-3125 Fitch Ratings, Inc. 70 W. Madison Street Chicago, IL 60602 Secondary Analyst Carla Norfleet Taylor, CFA Senior Director +1-312-368-3195 Committee Chairperson Ellen Itskovitz, CFA Senior Director +1-312-368-3118 Media Relations: Alyssa Castelli, New York, Tel: +1 (212) 908 0540, Email: Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below: -- Cash distribution received from affiliated companies is reflected in leverage metrics; -- Operating lease adjustment for costs that are more akin to a variable operating cost rather than a long-term financial commitment; -- Cash patronage is treated as a dividend. 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