2023-10-23 16:52:06 ET
Summary
- International Flavors & Fragrances has seen its share price fall by 28% over the past year, underperforming the broad market.
- However, those headwinds may be temporary and the stock could see a rebound next year as customer orders normalize and its new product pipeline comes online.
- IFF's dividend is expected to remain safe and the share price is well under my fair value estimate.
It’s easy to be bearish on a company when a stock is down by a significant amount. However, this is sometimes when the best investment opportunities are found, so long as the headwinds facing the company are temporary in nature.
Having a contrarian mindset lets the investor employ time arbitrage. This is best described by Warren Buffett, who has remarked in the past that the stock market is a means for transferring wealth from the impatient to the patient.
This brings me to International Flavors & Fragrances ( IFF ), which has seen its share price fall by 28% over the past 12 months, as shown below. In this article, I discuss why value and income investors may want to look into IFF at present levels, so let’s get started!
Why IFF?
International Flavors & Fragrances may not be a household name, but its products are common ingredients for the food, beverage, health, household goods, personal care, and pharmaceutical industries. IFF isn’t known for being an exciting company, as reflected by its steady revenue growth for much of the past 20 years. However, it did make a substantial acquisition for DuPont’s Nutrition & Biosciences business, which gave it a significant revenue ramp to $11.9 billion over the trailing 12 months, as shown below.
Of course, IFF wouldn’t fall like it has over the past year without a fair share of headwinds, most of which stems from a tough macroeconomic environment resulting in lower order volumes. This is reflected by disappointing top-line and bottom-line results this year, with currency neutral sales declining by 4% YoY and adjusted operating EBITDA declining by 18% YoY due to lower volumes resulting in higher inventory and manufacturing absorption costs during the second quarter.
The near term isn’t looking too bright either, as management is guiding for full year 2023 sales and adjusted EBITDA declines of 7% and 18%, respectively, due to customer destocking. As reflected above, lower customer orders results in higher manufacturing absorption costs for the company.
Many IFF investors are likely into the stock for the dividend. At present, IFF yields 4.9% and the dividend comes with an 80% payout ratio and 20 years of consecutive growth. As shown below, IFF’s yield now sits at its highest level in at least 20 years.
One of the biggest risks for dividend-focused investors is the risk of a cut due to the potential for IFF to hit its debt covenants. IFF took on $7.0 billion in additional debt during 2021 to pay for acquiring the Nutritional & Biosciences unit from DuPont and has since reduced its long-term debt balance by $1.56 billion. While this is encouraging, recent challenges to the bottom-line due to the aforementioned reasons have pressured IFF’s debt metrics, including its net debt to TTM EBITDA ratio which stands at 5.75x.
During the last earnings call, an analyst speculated that IFF may move above its debt covenant in the second half of this year. However, management responded that they have multiple levers to pull and do not anticipate having issues with its covenant and do not anticipate a change to its dividend. Furthermore, a Morningstar analyst expects that IFF could achieve breathing room from renegotiation of covenants and a future sale of its Lucas Meyer Cosmetics business, as noted during last month’s analyst report :
For now, IFF's dividend should be safe over at least the next year. Following the second-quarter earnings, we assumed IFF would have to renegotiate its covenants but thought the company would have to give up its dividend in exchange for covenant relief. However, if the company is able to divest the Lucas Meyer cosmetics business at a reasonable valuation and sees a slight rebound in profits in its businesses, which we expect will occur, the company should not run up against its new covenants through at least 2024.
Looking ahead to Q3 results and beyond, I would expect to see continued pressures on the business for the balance of the year, considering that a ‘higher for longer’ interest rate environment hasn’t exactly instilled confidence amongst CEOs and consumers. Plus, IFF has work to do in its Functional Ingredients within the Nourish segment, which represents about a quarter of the total business. This segment has underperformed industry peers while the remainder of IFF’s businesses have performed broadly in-line with industry peers. The underperformance is due in part to declining customer demand for alternative plant-based proteins.
While this underperformance is expected to continue in the near-term, other products in the pipeline could provide an offset. This includes the following pipeline in the Nourish segment as discussed during the last conference call:
In Nourish, increased opportunities across regions and categories, has led to a greater than 60% pipeline inflow versus last year. Our recent notable win included Xylitol, which is a sweetener used in bars, cereals and other confectionery goods. In sense, our compounds pipeline opportunity continues to be healthy and strong. Included in this was a significant win for our Boost Powder Detergent, a 100% active powder laundry detergent that is effective and safe to use unwatchable fabrics.
Turning to valuation, I see plenty of risks as already having been baked into the stock at the current price of $65.64, and while the forward PE of 20.2 may seem high, that’s more of a function of the earnings downturn this year. As shown below, analysts expect a fairly solid earnings rebound next year and beyond, as customer work down their inventory, resulting in a potential normalization of order volumes.
Performing the following NPV analysis, I arrive at a fair value of $83.71, which sits 28% above where the share price is trading now. This assumes next year’s EPS estimate as a starting point, as that reflects a more normal demand environment. It also assumes a conservative annual EPS growth of just 5%, which is below the forward analysts' growth estimates shown above, and a 2.5% discount rate, which sits higher than the 2% long-term inflation target by the Federal reserve.
Investor Takeaway
International Flavors & Fragrances has underperformed the broader market this year and is currently facing near-term headwinds. However, I believe that these challenges are already priced in at current levels and there is potential for a rebound in earnings next year as inventory levels normalize and new products come to fruition. As such, value and income investors seeking a bargain may want to look into IFF at present levels for potential material upside over the long run.
For further details see:
International Flavors & Fragrances: Calling All Contrarians