2023-03-13 23:03:22 ET
Summary
- International Flavors & Fragrances could face weak demand in 2023 as a result of lower spending by end consumers and customer destocking.
- IFF's profitability has been declining for the past 5 years, and it is not clear if recent product portfolio optimization will be sufficient to correct the issue.
- IFF's valuation is still somewhat elevated relative to the historical average, particularly when considering the level of interest rates and IFF's profitability issues.
International Flavors & Fragrances ( IFF ) has faced significant inflationary pressures over the past few years, which the company has largely been able to pass on to customers with higher prices. End market demand now appears to be stalling, which raises questions about growth going forward. While lower input costs and further integration of recent acquisitions should be supportive of margins, Ingredion's valuation is still relatively high. Weak demand or the failure of the company to execute on its strategy could present significant downside risk.
Market
IFF has a broad portfolio of products that target end-markets like F&B, fragrances, nutrition and pharma. While the company has generally been able to achieve solid growth in recent years, they are currently facing a number of headwinds in their core markets, including:
- Weak consumer demand
- High inflation
- Supply chain volatility
- Customer destocking
While raw materials and energy inflation should be less of a concern in 2023, weakening consumer demand along with high customer inventory levels could be setting the industry up for a weak year.
Figure 1: Headwinds Facing IFF (source: IFF)
DuPont Merger
The current state of IFF’s business is somewhat complicated by their merger with DuPont ( DD ) Nutrition & Biosciences in 2021. The combination was expected to deliver 300 million USD in annual cost synergies and 400 million USD in annual revenue synergies. Even if these synergies eventuate, it is likely that complete integration of the two companies is still ongoing.
Prior to the merger, IFF was the number 2 player in the flavors and fragrances market. DuPont N&B was strong in the active food & beverage segments and a leader in probiotics. From DuPont’s perspective, the strategy was reportedly to support the unlocking of shareholder value, but it may also have been an effort to divest assets that were performing poorly. IFF may have been trying to increase their scale and improve their capabilities in biotechnology. This has been a common theme across companies like Givaudan ( OTCPK:GVDBF ), DSM ( OTCPK:KDSKF ) and Ingredion ( INGR ) in recent years. The merger should also have increased IFF's ability to reach customers globally.
Figure 2: Rationale for Merger (source: IFF)
Figure 3: DuPont N&B Business Overview (source: IFF)
Figure 4: IFF Business Overview (source: IFF)
The merger gave IFF a control over a broad portfolio of potentially complementary solutions that can be leveraged by expertise at the product formulation stage.
Figure 5: Portfolio of Combined Company (source: IFF)
Improving capabilities in product creation and customer insights is another common theme in the market, with most peers viewing these competencies as an essential part of creating a competitive advantage.
Figure 6: Customer Value Proposition (source: IFF)
Market turmoil over the past few years makes assessing the merger somewhat difficult at this point. Management has suggested that the N&B business and the F&F business have similar pricing power, although some ingredients are more commoditized in nature. As a result, the N&B portfolio may have weighed on IFF’s performance over the past 12 months.
Table 1: DuPont N&B and IFF 2020 Financials (source: Created by author using data from IFF)
IFF
IFF are a leading ingredients supplier to a range of end-markets, holding the number 1 or 2 position in many attractive categories. The company has around 24,000 employees, over 340 production sites and reaches in excess of 50,000 customers, making scale an important competitive advantage.
IFF’s strategy seeks to maximize their competitive advantage and improve efficiency by focusing on areas of their business that will provide profitable growth. IFF are also investing in R&D to improve their products and get projects to market more efficiently. While this sounds good on paper, it largely mirrors the action of peers, and hence may not yield significant results without superior execution.
It should also be noted that some of IFF’s recent actions are likely in response to poor performance. Analysts have suggested that IFF's volume growth has consistently trailed peers in recent years, potentially indicating underlying problems. Management believe that volume growth within the Scent business is comparable to peers, and there are some cases where they are gaining share (e.g. fine fragrances). Food and culture enzymes are performing well within Health and Biosciences, and management believes they are competitive within Home and Personal Care. The Health business appears to be an area of relative weakness though. Volume growth also appears to have trailed in the ingredients business, as IFF is capacity constrained in some cases. They have also been aggressive on pricing to preserve margins, which has likely contributed to share loss, particularly in Protein Solutions.
Portfolio optimization is set to be a large part of IFF's efforts to improve performance going forward, which could mean further acquisitions to increase exposure to growth areas and divestments of poorly performing businesses. Health and biosciences and pharma offer better margins, which is likely why they are focus areas.
Figure 7: IFF Portfolio Optimization (source: IFF)
IFF is focused on three core end-markets, and are reorganizing their business around these end-markets:
- Food and Beverage
- Home and Personal Care
- Health
Figure 8: IFF Restructuring (source: IFF)
Alternative Proteins
The market for alternative proteins is expected to reach 140-150 billion EUR by 2025, with demand growing by double-digits annually. This is a focus area for IFF, and they believe their capabilities in proteins, food ingredients, flavors, maskers and functional ingredients will lead to success.
IFF is trying to improve the sensory experience for consumers without impacting cost or health, which they believe will lead to broader adoption. As part of this, IFF have been investing heavily in high moisture extrusion capabilities, which is what gives plant-based meat its texture.
Alternative Growth Markets
Alternative sweeteners and Human Milk Oligosaccharides (HMOs) could also be growth areas for IFF. The market for high-intensity sweeteners produced by fermentation is expected to exceed 3 billion USD by 2025. So far this does not appear to be a market that IFF is pursuing though. The market for HMOs is expected to reach 1 billion USD by 2030. IFF's merger with DuPont N&B gives them some exposure to this market.
R&D
IFF believes that R&D is one of their core capabilities and a potential source of competitive advantage. The company has significant capabilities across areas like biotech, process engineering, chemical synthesis, material science and data science, which they hope to leverage in the development of new products.
Figure 9: IFF Innovation Platform (source: IFF)
IFF wants to become the leading provider of probiotics, live biotherapeutics and skin care markets. R&D efforts are focused on 5 therapeutic areas:
- Gut
- Brain
- Metabolic
- Immuno-Modulation
- Maternal / Infant Health
Figure 10: IFF Biotechnology Capabilities (source: IFF)
IFF has approximately 3,000 engineers and scientists and invest significantly more in R&D than most peers, but it is questionable whether these R&D efforts are generating sufficient returns.
Figure 11: 2021 Annual R&D Investment (source: IFF)
Divestments
IFF recently announced the sale of their Savory Solutions business, the funds from which are being used to improve their capital structure. IFF have also sold their Microbial Control business. These two transactions will result in more than 2 billion USD in gross proceeds. In February 2023 IFF announced the sale of its Flavor Specialty Ingredients ((FSI)) business to a private equity company. The FSI business produces synthetic and natural base aroma chemicals used in the flavor market. FSI generated over 100 million USD revenue in 2022 and was sold for approximately 220 million USD.
IFF is continuing to explore additional divestitures so that they can further reduce debt and focus on their core businesses. IFF expected to announce 3 non-core divestitures by the end of the first quarter of 2023, with proceeds of approximately 1.2 billion USD .
Financial Analysis
IFF faced significant inflationary pressures in 2022, but were largely able to offset these through pricing actions and productivity initiatives. IFF attributed over 1 billion USD in revenue to strategic price increases in 2022, and efficiency improvements and supply chain optimization reduced costs by nearly 150 million USD. It should be noted that without these pricing and productivity improvements, IFF’s revenues would have declined in 2022, and they would have struggled to break even .
Figure 12: IFF Revenue (source: Created by author using data from IFF)
While revenue growth was fairly broad based across divisions and markets, the Nourish business performed particularly well. Nourish achieved currency-neutral sales growth of 11% compared to the previous year, with 6.8 billion USD in net sales. The Health and Biosciences business achieved 4% currency-neutral sales growth in 2022, although this was on the back of price increases with declining volumes. Culture and food enzymes and animal nutrition performed particularly well. The Scent business reported 8% currency neutral growth with total net sales totaling 2.3 billion USD. The Fine Fragrances and Ingredients and Consumer segments were areas of particular strength. Pharma Solutions achieved 15% currency-neutral growth.
Performance appeared to deteriorate towards the end of the year though, with volumes declining in December, which IFF attributed to customer destocking and softer consumer demand. IFF estimates that roughly 75% of the drop in volume in Q4 was related to destocking, with the balance coming from softer consumer demand. The Health and Bioscience segment experienced a revenue decline in the fourth quarter of 2022, due in part to a difficult comparable period in 2021.
Figure 13: IFF Comparison of 2022 and 2021 Revenue (source: IFF)
Table 2: IFF Performance by Segment 2022 (source: Created by author using data from IFF)
IFF’s margins have been steadily declining since around 2017, which is likely largely responsible for the company’s recent strategic moves. Some of the recent margin compression is due to input price inflation, but IFF clearly has problems which extend beyond this.
IFF is expecting roughly 6% inflation in 2023 , with around 70% coming from raw materials and the remaining from energy. IFF should largely be protected from this though, as most of their pricing is now locked-in for the year. Contract pricing often resets at the beginning of the year based on price indices. Management has stated that they are seeing signs of deflation on the raw materials side, but prices of some commodities continue to increase. Raw material price deflation is expected to be more likely in the second half of 2023.
IFF is targeting savings of 350-400 million USD between 2023 and 2025, coming largely from procurement and supply chain improvements and a lowering of the burden of overhead expenses. At the mid-point, this would improve IFF’s margins by around 3%. Exiting low margin businesses and improving growth in higher margin businesses may be the best way for IFF to improve profitability.
Figure 14: IFF Profit Margins (source: Created by author using data from IFF)
Figure 15: IFF Efficiency (source: Created by author using data from IFF)
Figure 16: IFF Job Openings (source: Revealera.com)
IFF is targeting modest revenue growth and margin improvements over the next few years. While the company is planning on generating substantial free cash flows, in the near-term much of this may be directed towards reducing leverage.
Table 3: IFF Average Performance Goals 2024-2026 (source: Created by author using data from IFF)
Valuation
IFF’s valuation has drifted higher since the global financial crisis, although it is not really clear why. IFF's performance has deteriorated significantly over the past 5 years and this has not been reflected in the company’s valuation. This may be due to an expectation that the company’s strategy will lead to a significant improvement in performance, but given that competitors are all engaged in broadly the same efforts, this seems unlikely.
It also seems likely that investors are willing to pay a premium for specialty chemical companies at the moment, with an expectation that ongoing inflation along with strong pricing power will lead to solid performance. While IFF’s share price has corrected significantly over the past 18 months, it may still have further to fall if margin compression continues.
Figure 17: IFF EV/S Multiple (source: Seeking Alpha)
For further details see:
International Flavors & Fragrances: Margin Compression Is A Concern