2023-05-04 10:45:19 ET
Summary
- Net sales increased in 2020, 2021, and 2022, and are expected to keep growing in 2023 and 2024, boosted by price increases and recent acquisitions.
- The company's profit margins remain very high despite current headwinds, which makes the dividend safe.
- The current debt pile, despite being high, doesn't represent a major risk as the company has vast inventories on its balance sheet.
- A potential recession would most likely have a further negative impact on the company's operations and balance sheet, for which I suggest averaging down as the optimal investment strategy.
- This represents a good opportunity to start adding shares to any conservative dividend growth portfolio.
Investment thesis
Sensient Technologies (SXT) is one of those companies that can be bought and held for decades while reaping an ever-growing dividend. It has also been a share repurchaser in the past, but an acquisition spree coupled with a growing need to deleverage the balance sheet will likely put further share repurchases on hold for some more quarters (or even a few years). Currently, the company is facing a series of headwinds that have deflated the price of its shares, and in this article, I will explain why current investors' pessimism represents a good opportunity for long-term dividend growth investors to average down from current share prices.
The company's net sales have remained somewhat stagnant for the past few years as a consequence of a restructuring process that began in 2014, but started to turn around in 2020 and are expected to keep rising through 2024. Still, inflationary pressures, supply chain issues, and elevated energy and commodity costs are currently having a mild impact on profit margins, for which the company adopted pricing actions. But the headwind that the company definitely couldn't dodge is doubling interest expenses in the first quarter of 2023, and said increase will have a significant impact on the company's operations in the short and medium term.
Luckily, the company holds vast inventories in its balance sheet, which will certainly allow for high cash from operations in the coming quarters with which the company should be able to significantly pay down its debt pile. Nevertheless, a P/S ratio that is still slightly above the average of the past decade suggests that it would be a wise idea to average down as further share price declines could bring further opportunities to decrease the average purchase price and thus increase the overall position's dividend yield on cost in the near future, especially considering the growing concerns of a potential recession as a consequence of recent interest rate hikes.
A brief overview of the company
Sensient Technologies is a global leading manufacturer and marketer of colors, flavors, and fragrances for food, pharmaceuticals, household products, and inks, as well as other specialty and fine chemicals. The company was founded in 1882, and its market cap currently stands at $3.18 billion, employing over 4,000 workers around the world. In this regard, the company has manufacturing plants in California, Illinois, Michigan, Wisconsin, New Mexico, Belgium, Costa Rica, Mexico, Germany, and the United Kingdom.
Sensient (First quarter 2023 investor presentation)
The company operates under three main business segments: Flavors & Extracts, Color, and Asia Pacific. Under the Flavors & Extracts segment, which provided 49.45% of the company's total net sales in 2022, the company provides flavors and fragrances for many of the world's best-known consumer products. Under the Color segment, which provided 40.60% of the company's total net sales in 2022, the company provides natural and synthetic colors for foods, beverages, pharmaceuticals, cosmetics, inks, and other industrial applications. And under the Asia Pacific segment, which provided 9.96% of the company's total net sales in 2022, the company sells its products to the Pacific Rim.
Currently, shares are trading at $75.42, which represents a 29.06% decline from all-time highs of $106.32 in November 2021. While this decline is not too significant given recent macroeconomic headwinds impacting a wide range of industries around the world, this represents, in my opinion, a good opportunity to start adding shares of Sensient to any dividend growth portfolio with the intention of adding more shares as the share price declines, if it does, as the company's operations and fundamentals remain intact while the outlook is very positive.
Acquisitions and divestitures
In recent years, the company has restructured its operations by divesting less profitable businesses and keeping the most profitable ones while targeting potential acquisitions to maintain its revenues, which significantly improved profit margins without compromising revenues in exchange for a relatively high debt level.
In March 2018, the company acquired the natural color business of GlobeNatural, a leading natural food and ingredient company based in Lima, Peru, for $10.8 million. During the same year, In July 2018, the company also acquired Mazza Innovation, a global leader in botanical extraction technology.
After some deleverage, in June 2020, the company divested its digital ink product line for $12.1 million to Sun Chemical and its parent company, DIC Corporation ( OTCPK:DICCF ). Later, in September 2020, it also sold certain assets related to the production of its yogurt fruit preparations product line to Frulact for $2 million.
The deleveraging process continued as the company sold its fragrance business to Symrise AG ( OTCPK:SYIEF ) for $36.3 million in April 2021, just after acquiring New Mexico Chili Products, a dehydrated chili production facility located in Deming, New Mexico, that processes capsicums and a variety of specialty chilies for commercial sale to CPG food manufacturers, spice blenders, and foodservice customers in March 2021. Acquisitions continued in July 2021 when the company acquired the assets of Flavor Solutions for $13.9 million, which provided Sensient with flavors and flavor technologies for the food, beverage, and nutraceutical markets.
And as for more recently, in October 2022, the company acquired Endemix Do?al Maddeler, a vertically integrated natural color and extracts company servicing the food and beverage markets, for $23.3 million. The company is located in Turkey and works with multinationals that export their products to customers throughout Europe, the Middle East, and Asia.
The management is currently looking for further small acquisitions in order to keep driving revenue growth in the long term, but higher-than-usual interest expenses suggest these will be somehow limited for a few years.
Revenue is showing signs of improvement
The company's restructuring process since 2014 has been accompanied by declining revenues as a result of the mergers and acquisitions that have taken place in recent years. Still, revenues started to show signs of improvement in 2020 as they increased by 0.69% compared to 2019. Revenues also increased by 3.62% during 2021, and by a further 4.11% in 2022 to $1.44 billion.
Sensient Technologies revenue (10-K filings)
As for the first quarter of 2023, revenue increased by 3.79% year over year (and by 5.82% quarter over quarter), boosted by low-double-digit price increases that were partially offset by a mid-single-digit revenue headwind as a consequence of customer destocking and a 1% forex headwind impact.
Currently, the company's customers are normalizing their inventories to pre-pandemic levels as supply chains are easing, which is causing a temporary decrease in customer order lead times. Nevertheless, revenues are expected to improve in the short term as destocking is expected to moderate in the second half of 2023. In this regard, net sales are expected to increase by 5.56% in 2023 to $1.52 billion, and by a further 5.26% to $1.90 billion in 2024.
Using 2022 as a reference, 59% of the company's total revenues are generated within North America, whereas 19% are generated in Europe, 16% in Asia Pacific, and 7% in the rest of the world. The surge in sales experienced in 2021 and 2022, coupled with the recent decline in the share price, has caused a steep decline in the P/S ratio to 2.196, which means the company generates net sales of $0.46 for each dollar held in shares by investors, annually.
This ratio is still 0.64% higher than the average of the past decade but represents a 32.28% decline from decade highs of 3.243 reached in 2021, which suggest that although investors' pessimism has grown significantly in the past year, shares may continue to fall as investors' pessimism has been higher for a significant part of the past 10 years, and concerns about a potential recession as a consequence of rising interest rates are growing as time passes. Even so, improved profit margins and revenue growth expectations for 2023 and 2024 make me consider the recent share price decline as a good opportunity to obtain a decent yield on cost despite an increased risk derived from increasing interest expenses as the company has enough resources to pay down a significant portion of its debt pile in a relatively short period of time.
The company is highly profitable thanks to the restructuring process carried out
The company began a restructuring process in 2014 in order to eliminate underperforming operations, consolidate manufacturing facilities, and improve efficiencies, and both gross profit and EBITDA margins improved significantly (despite coronavirus-related contractions) since then. Nevertheless, inflationary pressures, supply chain issues, and elevated energy and commodity costs in certain geographic regions have caused a slight decline in the company's margins, but strong pricing actions are currently offsetting most of these impacts. In this regard, the trailing twelve months' gross profit margin currently stands at 33.71%, whereas the EBITDA margin stands at a very healthy 17.12%.
As for the first quarter of 2023, the gross profit margin showed a marginal improvement to 33.78% and the EBITDA margin showed a slighter better improvement at 17.61% as the company keeps raising the price of its products in order to offset ongoing inflationary pressures, which means the company remains highly profitable. This shows great flexibility in Sensient's operations and significant pricing power by Sensient as headwinds still persist in the macroeconomic landscape.
Such profit margins will be essential over the next few quarters as the company has huge inventories that will need to use in order to pay down its debt and continue to perform further acquisitions in order to continue growing its business.
The company's debt doesn't represent a significant risk as inventories are very high
As a consequence of the restructuring process that began in 2014, long-term debt significantly increased to over $700 million in 2018 but declined to around $500 million in 2021. In recent quarters, long-term debt has risen to $705 million as the company has been accumulating inventories as customers are postponing orders due to ongoing destocking. In this regard, the management expects to start reducing its long-term debt pile as it makes use of its unusually high inventories once customer inventories normalize.
On the other hand, cash and equivalents is very low at $24.02 million, and interest expense increased to $6 million during the first quarter of 2023 compared to $3 million during the same quarter of 2022. In this regard, making use of gigantic inventories of $573.7 million will be essential to help the company significantly reduce its outstanding long-term debt in order to reduce these annual interest expenses to more manageable levels.
During the first quarter 2023 earnings call , the management stated that it expects to manage the company's inventories down as soon as possible in order to generate strong cash from operations in the coming quarters as capital expenditures are expected to be high at around $95 million in 2023 while the dividend cash payout ratio skyrocketed in 2022.
The dividend is safe despite a high cash payout ratio
If one looks at the chart below, it can be seen how the company has a very long track record of growing dividends over the years. The company raised its quarterly dividend by 5.1% to $0.41 per share in October 2021 for the last time. If we add the recent decline in the share price, the dividend yield currently stands at 2.17%, which is, in my opinion, very reasonable due to the company's historically low dividend cash payout ratio and its high potential once the balance sheet gets deleveraged.
In order to calculate the company's dividend sustainability, in the next table I have calculated what percentage of the cash from operations has been allocated to the payment of dividends and interest expenses year after year. In this way, one can assess the company's ability to cover both expenses through actual operations.
Year | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
Cash from operations (in millions) | $189.19 | $128.05 | $222.48 | $36.31 | $83.52 | $177.18 | $218.78 | $145.22 | $12.07 |
Dividends paid (in millions) | $47.89 | $48.11 | $49.64 | $54.04 | $57.41 | $62.19 | $66.06 | $66.69 | $68.92 |
Interest expenses (in millions) | $16.07 | $16.95 | $18.32 | $19.38 | $21.85 | $20.11 | $14.81 | $12.54 | $14.55 |
Cash payout ratio | 33.81% | 50.81% | 30.55% | 202.22% | 94.90% | 46.45% | 36.96% | 54.56% | 691.48% |
As you can see in the table above, the company has historically made a conservative use of its cash by paying out a relatively small fraction of the cash from operations in the form of dividends. Still, the cash payout ratio increased to a whopping 691% in 2022 as cash from operations was very low at $12.07 million. This is because inventories increased by $152.5 million compared to 2021, and accounts receivable by $41 million while accounts payable increased by only $16.9 million, which means the company remains highly profitable and the dividend and interest expenses don't represent a major issue for the company as it can cover both expenses with ease despite current headwinds.
As for the first quarter of 2023, the company reported cash from operations of -$3.0 million, but inventories increased by $9.6 million quarter over quarter and accounts receivable by $10.4 million while accounts payable decreased by $21.1 million, which reflects very healthy profit margins as the company reported net income of $33.7 million for the quarter.
Buybacks may be on hold for longer as economic uncertainties remain
Historically, the company has repurchased its own shares when operations allowed it, although in 2018 this practice ceased to form part of the capital allocation strategy as the management has been making acquisitions while deleveraging the balance sheet, which has helped to significantly reduce annual interest expenses (despite the recent surge) while acquiring some minor businesses in order to maintain revenue amidst the restructuring process.
Once the management pays down a good portion of its long-term debt, it is very likely, in my opinion, that we will see a new share repurchase program as a way of rewarding shareholders by increasing their positions passively thanks to a decreasing number of shares outstanding, which would eventually lead to improved per-share metrics. But before this happens, I believe that the management will instead try to preserve cash as recessionary risks should first ease and customers should complete their destocking processes before considering further share buybacks.
Risks worth mentioning
While I view Sensient Technologies' risks as fairly small thanks to inventories larger than its long-term debt and very resilient profit margins amidst current macroeconomic and industry-related headwinds, there are certain risks I'd like to highlight.
- Up to now, the company has managed to maintain very healthy profit margins despite inflationary pressures thanks to the increase in the price of its products, which have continued to rise during the first quarter of 2023. If inflationary headwinds continue to impact the company's operations for much longer, it may experience difficulties to keep raising prices without negatively impacting product demand.
- A potential recession as a consequence of rising interest rates would most likely have an adverse impact on the company's operations due to declining volumes and pricing power.
- The company could be forced to draw on more debt if retail inventory destocking takes longer than expected, which would lead to even higher interest expenses.
Conclusion
Certainly, some clouds are beginning to be seen on the horizon for Sensient Technologies as demand has slowed in recent quarters as a result of high retail inventories while profit margins are slightly affected by inflationary pressures, supply chain issues, and increased energy and raw material costs. Still, the company's strong pricing power has allowed it to pass the increased production costs on to customers. In this regard, the company's operations continue virtually intact despite such a complex macroeconomic environment. The problem is that interest expenses have doubled year over year during the first quarter of 2023 as long-term debt keeps rising while concerns about a potential recession as a result of recent interest rate hikes in order to combat high inflation rates are surfacing among investors.
Still, I believe that this is not the time to forget that the company has been operating since 1882, that it provides essential items to major players in key industries, that its current inventories will allow it to significantly reduce its debt levels, the dividend is safe thanks to high cash from operations (despite lower figures during 2022 and the first half of 2023 due to customer destocking), and revenue is expected to grow at a moderate rate in 2023 and 2024 as customer inventories normalize. Still, I strongly believe that averaging down from current prices is an optimal strategy as the P/S ratio is slightly above the average of the past decade and a potential recession could finally materialize, thus potentially driving down the share price significantly.
For further details see:
Sensient Technologies Has A Bright Future