2023-08-09 07:15:01 ET
Summary
- IFF's stock price dropped after Q2 earnings missed expectations and guidance for 2023 was reduced.
- Market headwinds, including customer destocking and soft end market demand, are contributing to IFF's difficulties.
- In particular, the Functional Ingredients business is underperforming, which has been attributed to low demand for plant-based protein products and customer destocking.
IFF's (IFF) stock price dropped to decade lows after second quarter earnings came in below expectations and FY2023 sales and adjusted EBITDA guidance were reduced by 7% and 18%, respectively. While there are aspects of IFF's business that are attractive, the stock is still not particularly cheap, and there is a high probability that its current situation gets worse before it gets better.
Market Headwinds
IFF is attributing to most of its current difficulties to macroeconomic conditions, with many customers destocking and soft end market demand. IFF believes that its performance is broadly in line with peers, excluding its Functional Ingredients business. While, food demand volumes are reportedly beginning to stabilize, customer destocking is expected to persist into the second half of the year . Estimates of when destocking will end range from Q3 2023 through to 2024, dependent on end market demand.
Figure 1: Market Conditions Impacting Performance (source: IFF)
Functional Ingredients
IFF has suggested that Functional Ingredients is the one area of its business that is underperforming the market. The Functional Ingredients business is responsible for around 25% of IFF's revenue , and currently has negative growth and depressed margins. Functional Ingredients volumes are down roughly 20% in the first half of 2023 relative to a year earlier.
Weakness has been attributed to soft alternative protein consumption, including low demand for plant-based products. Customers are also aggressively managing inventory, which has contributed to a decline in demand. This is not really surprising if the recent performance of Beyond Meat ( BYND ) and Oatly ( OTLY ) are indicative of the broader market. Both companies are struggling with weak demand, elevated costs and weak balance sheets. As a result, both companies are drawing down inventory from elevated levels to reduce cash burn.
Protein Solutions make up around a third of IFF's Functional Ingredients business and Specialty Proteins constitute around half of Protein Solutions. Isolated soy proteins that go into nutritional bars and beverages has also been an area of weakness.
Functional Ingredients also include emulsifiers, sweeteners and texturants. IFF believes that its Specialty Protein portfolio is differentiated, although there is competition amongst other proteins. There are also competitive pressures within some parts of the emulsifier and texturant portfolios.
To support the Functional Ingredients business, IFF has hired over 50 new commercial professionals to pursue incremental market opportunities. IFF believes that this is already leading to pipeline growth.
M&A and Divestitures
IFF is continuing to high-grade its portfolio, primarily through divestitures at this point. The company recently sold its Microbial Control Savory Solutions and Flavor Specialty Ingredients businesses and is preparing to sell Lucas Meyer Cosmetics. IFF has also hired JPMorgan to explore additional divestitures from its portfolio.
The benefit of these actions remains unclear though. In particular, IFF's merger with DuPont Nutrition and Biosciences in 2021 appears questionable given the recent performance of the Functional Ingredients business. The merger was supposed to create synergies and expose IFF to growth markets, but this hasn't been the case so far.
Financial Analysis
IFF's second quarter results came in below expectations, with -4% comparable currency neutral sales growth. Full year revenue growth guidance has been lowered to -8%, primarily on the back of anticipated lower volumes. Volumes are now expected to be down mid to high single digits in 2023. Volumes were down 4% in July, with August trending slightly below this.
Figure 2: IFF Revenue (source: Created by author using data from IFF)
Strong results in the Scent and Pharma Solutions segments were more than offset by softness in H&B and Nourish in the second quarter.
Figure 3: IFF Performance by Segment (source: IFF)
Gross profit margins have likely already bottomed, with easing supply chain pressures and higher prices providing tailwinds going forward. IFF's inventory reduction efforts are currently weighing on gross profit margins though, through negative manufacturing absorption. The estimated impact of this on profits for the full year is 180 million USD .
Operating profit margins also remain depressed due to the combined effect of lower revenues and lower gross profit margins. Given IFF's large debt position and associated interest costs, this is having an outsized impact on the bottom line. IFF now expects full year interest expenses to be roughly 425 million USD .
Figure 4: IFF Profit Margins (source: Created by author using data from IFF)
Deleveraging remains a top priority for IFF, and the importance of this has likely only increased in the face of margin pressures. Despite pressure on the bottom line, IFF is confident that it will not trip its debt covenants in the second half of the year as there are multiple levers it can pull. Ongoing weak performance will likely call into question the sustainability of dividends though.
Free cash flow was 85 million USD in the second quarter, although this included roughly 160 million USD primarily related to integration and transaction-related costs. In comparison, 413 million USD of dividends was distributed to shareholders in the first half of the year.
Valuation
Assuming IFF can resolve the problems with its Functional Ingredients business and the segment revenue mix remains similar going forward, EBITDA margins should return to something like 20% over the next few years. Based on IFF's average EV/EBITDA multiple in the past, this would suggest the stock is now fairly valued based on normalized earnings.
IFF's dividend yield also likely appeals to many investors but given the current interest rate environment and the fact that these dividends could be at risk, this is not a strong reason to hold the stock.
There is a high probability that demand softness is ongoing for at least the next few quarters, and it will take time for IFF to resolve issues in its Functional Ingredients business. In addition, higher prices are currently supporting the topline but given weak volume growth there is a risk that deflation will take hold at some point.
Figure 5: IFF EV/EBITDA Multiple (source: Seeking Alpha)
For further details see:
International Flavors & Fragrances: Protein Problems