GVDBF - International Flavors & Fragrances: Only Attractive At First Glance

2023-07-18 17:51:23 ET

Summary

• At first glance, IFF seems to be in deep value territory and attracts investors with a historically high dividend yield.
• Especially compared to Givaudan, IFF looks like a real bargain.
• While management appears committed to the dividend, I would always put the emphasis on the actual figures and less on promises.
• There are some signs that the company is improving margins and inventory in particular.
• As things stand, however, I don't see the stock as a buy. However, I think the 2Q figures could justify a revaluation.

International Flavors & Fragrances ( IFF ) had been on my watchlist for years. At some point, I lost sight of the shares. By chance, I stumbled across the company a few weeks ago. Given the disastrous share price performance and disappointing operational performance, I wondered why I would ever want to invest in the company.

Yet the share price performance up to 2021 was excellent. From 2009 to 2021, the share price rose by about 15 percent a year. Since then, however, the stock has been in a downward spiral and has lost almost 45 percent of its value. The dividend yield is at a record level of over 4 percent. This is enormous for IFF. For example, the average value of the dividend yield over the last 12 months is 3.4 percent, 2.9 percent over the last two years, 2.5 percent over the last five years, and 2.14 percent over the last ten years. The world's largest manufacturer of ingredients for the food, beverage, health, household goods, personal care, and pharmaceutical industries is thus more interesting than ever for shareholders from a dividend perspective.

No growth momentum since 2021

I believe the company has not yet created value from the merger with the Nutrition & Biosciences division with DuPont from 2020/2021. Sales growth has been weak in recent years. For example, IFF will most likely only be able to increase sales from $11.6 billion since 2021 to just over $12 billion in the current 2023 financial year. This corresponds to a growth of just six percent. Most recently , IFF lowered its forecast from $12.5 billion to $12.3 billion. According to the management:

This change is largely related to energy and raw material pass-through price adjustments. In addition, we have a modest increase in unfavorable impact from foreign exchange.

The outlook is, therefore, cautious. The management expects challenging times ahead. Given that material and labor costs increased by $300 million from $7.5 billion in 2021 to $7.8 billion in 2022, it is unclear how demand and cost increases due to inflation will develop.

Inventory is a concern

Another concern is the increase in inventory since the merger with DuPont's Nutrition & Biosciences business. The inventory value is now $3.1 billion.

The company seems aware of the problem and is trying to reduce the inventory. The reduction of $200 million in 1Q 2023 is a start, but it is a drop in the ocean at this level. Investors should watch out for 2Q 2023, as management has announced its intention to achieve more inventory reduction.

Do we see a turnaround in the margin?

IFF's margins have continued to decline since 2015. Gross margin fell from 44.36 percent in 2015 to 26.6 percent in 1Q 2023. In the same period, the operating margin fell from 19.86 percent to 8.18 percent, a halving in less than ten years. These are very disappointing figures for a company that is not really cyclical. Swiss competitor Givaudan ( GVDBF ) has shown that it can keep margins largely stable in recent years. For example, Givaudan's gross margin has only fallen by just under six percentage points since 2025, from 42.8 percent to 37 percent. The operating and net margins have mainly remained stable since 2018.

The question is whether IFF will manage to stop this trend and increase margins somewhat again.

One factor could be deflationary developments. Most recently, inflation has indeed declined in the US and Europe. However, what the next quarters will bring is highly uncertain. Management also believes it may be too early to assume margin improvements due to deflationary developments.

In general, we are seeing positive deflationary trends not only in energy, but in logistics as well as in certain raw materials. But I would caution we're in the early days of deflation. So I think it's a little early to declare sort of significant margin capture relative to improvements in raw material and other costs as well. Thanks for the question.

Overall, however, CEO Frank Clyburn confirmed an improvement in the coming quarters in the Q1 earnings call :

Margins will improve, Lauren, over this year and over time. Remember that Nourish based on the first quarter, a lot of the manufacturing absorption impacted the Nourish division in Q1. There'll be some impact, as we've highlighted in Q2. And then things will improve...

In this respect, we could have seen the bottom in margins in Q1 2023. However, I would like to wait for Q2 to be able to speak of a trend reversal.

IFF is in value territory, but is it worth the buy?

One argument for buying IFF shares is undoubtedly the fundamental valuation.

On the one hand, IFF is favorably valued from a dividend perspective.

The average dividend over the last ten years was 2.14 percent. Today it is almost twice as high at 4.1 percent due to the share price losses. Based on the expected development for FY 2023, the dividend of $3.28 is also covered by the expected FCF of around $3.4 per share. Nonetheless, this is a very close call. In 1Q, the dividend paid of $206 million was almost $80 million above cash flow from operations. Overall, IFF was cash flow negative to minus $48 million. In my view, the dividend is therefore not safe at the moment. Nevertheless, management remains committed:

And regarding cutting the dividend, that is not on the table at all.

As an investor, however, I would always emphasize the actual figures and less on the management's promises. Another reality is the mountain of debt IFF is sitting on. The debt ratio, measured in terms of interest-bearing debt, is currently 32 percent. This is only acceptable if sufficient FCF is generated simultaneously to service debt and interest. However, this is currently not the case.

Accordingly, I do not think much of looking at the earnings multiples in isolation. It is true, based on earnings multiples, investors are now getting IFF shares at a discount. The current adjusted PE ratio of 16.8 is far below the historical multiple of 21. Considering a forward PE ratio for 2024 of only 14, the upside potential would be 50 percent. Nevertheless, the market has not revalued the IFF share for nothing. I certainly do not consider a current PE ratio of 16.8 cheap for a company with negative FCF and no growth momentum.

Conclusion

At first glance, IFF seems to be in deep value territory and attracts investors with a historically high dividend yield. Especially compared to Givaudan, IFF looks like a real bargain. Givaudan's adjusted P/E ratio is currently 30.5, but there is a reason why the market values Givaudan so high and IFF so low. Givaudan has a better operating performance. On the other hand, IFF seems to have some cash flow problems and is apparently still focused on digesting the 2019 merger. There are some signs that the company is moving away somewhat and improving margins and inventory in particular. As things stand, however, I don't see the stock as a buy, but rather as a bet with a not-really promising risk/reward ratio. However, the 2Q figures could justify a revaluation in my view.

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