International Flavors & Fragrances: Frutarom Deal Not Well Received, But Appeal Lures

Summary

• IFF announced a huge +$7 billion deal for Frutarom, a transaction not liked by its investors.
• The negative reaction in response to the deal makes that appeal is on the increase, although I am not pulling the trigger yet.
• Steady organic growth and realisation of synergies over time should continue to provide a nice road map for steady earnings growth going forward.

International Flavors & Fragrances (NYSE:IFF) has reached a multi-billion deal which is not well received at all by the market, as that same market has really liked the stock in recent years amidst steady growth and a world in which interest rates have continuously traded lower.

The company reached a +$7 billion deal to acquire Frutarom which indeed looks a bit pricey, although the consequent decline in the share price, and reduced expectations, have certainly boosted the appeal, as I am not pulling the buy trigger yet.

Buying Frutarom

IFF has reached an agreement to acquire Frutarom in a $7.1 billion deal, including the assumption of debt of course. Investors in Frutarom are seeing their shares being awarded a $106.25 per share valuation, consisting out of a $71.19 per share cash component and the remainder in shares as investors in Frutarom will obtain 0.249 shares of IFF for each share which they currently own.

IFF's CEO Andreas Fibig claims that the deal is consistent with the Vision 2020 strategy to be a global leader in scent, nutrition, and taste. The formation of a global leader and complementary qualities should create a stronger company, at least on paper.

Frutarom is especially strong in small- and medium-sized customers as it caters 30,000 customers across the globe with roughly 70,000 products. The company focuses heavily on natural products which make up 75% of sales allowing it to show very strong organic growth rates.

The focus on smaller customers and faster growing segments, such as natural colours and natural food protection, certainly boosts the growth profile of the business. For that reason, the company already outlined a $2.25 billion sales target for 2020, significantly higher than the expected $1.6 billion in sales this year, although deals would be necessary to achieve this revenue number, as Frutarom has been a real serial acquirer in recent years.

IFF claims that the deal comes in at 20.3 times 2018's expected EBITDA, which suggests an expected EBITDA number of $350 million this year. It goes without saying that these are high multiples, although the D&A component has not been announced. Synergies should make the deal worthwhile, seen at $145 million in year three. Roughly 25% of these synergies are expected to be realised in year one.

If we assume that these synergies would be achieved, they look pretty aggressive, equivalent to 9% of 2018 sales and 6-7% of anticipated sales in 2020. These are pretty targets in my opinion, certainly as EBITDA margins are quite high already at 22% of sales.

Pro-Forma Numbers

Alongside the deal announcement, IFF reported its first quarter results for 2018. The company sees sales increase by 6-8% this year, as earnings per share growth are expected to trail this number by just half a percent. While these look and certainly are very solid growth numbers, investors should realise that currencies provide a significant tailwind to the expected results.

Trading at $142 ahead of the deal announcement, the more than 79 million shares outstanding are awarded an $11.3 billion market capitalisation, or $12.7 billion if net debt is included.

Based on the 2017 results and the guidance provided, IFF should post sales of roughly $3.6 billion this year. Assuming 6% operating earnings growth, EBIT comes in around $615 million, for a $733 million EBITDA number based on depreciation and amortisation charges of $118 million. Based on this valuation, IFF traded at 3.5 times sales seen this year and 17.3 times EBITDA. Note that these are the reported numbers, not the adjusted metrics.

The $7.1 billion deal for Frutarom looks a bit expensive, at 4.4 times sales and 20.3 times EBITDA. That said, synergies should reduce the latter multiple to 14.3 times, a lot more appealing by all means.

As roughly two-thirds of the $7.1 billion deal component is in the form of cash and we take into account existing net debt of IFF of $1.4 billion, I peg pro-forma net debt at $6.2 billion or a little higher. The company itself reports that this is equivalent to 3.7 times adjusted EBITDA although it does not back up this calculation. Based on the numbers which I see, I come closer to a 5 times leverage ratio, even if I take into account the anticipated synergies.

Market Takes It As A Negative

The market reaction to the deal has been quite negative although we have to stress that the transaction announcement came alongside the release of the first quarter results. IFF has about 79.4 million shares outstanding on a diluted basis ahead of the deal. As roughly 15.5 million shares will be issued in connection to the deal, the share count jumps to 95 million shares. Those shares dropped $15 in response to the deal, reducing the valuation by $1.4 billion in connection to the $7.1 billion deal, quite a negative response by all means.

Part of the reason behind the fall is the premium paid by IFF for the acquired activities. While the acquired activities grow quickly, this is mostly the result of savvy dealmaking as organic growth is more or less in line with the segment at large, or perhaps just a little bit better. Hence, IFF is paying a relative higher multiple at 4.4 times sales, a 25% premium to its own sales multiple. The 20.3 times EBITDA multiple marks a 17% premium to its own valuation.

After $1.4 billion in shareholder value has gone up in smoke, the market is happy to value the acquired activities at $5.7 billion, equivalent to 3.5 times sales which is actually the same multiple at which IFF trades.

Buy Already?

It is very much the case that IFF has already seen a meaningful correction from $155 in January to $125 by now, yet consumer packaged companies at large have been struggling amidst negative or flattish growth, while these predictable companies have been hit by higher interest rates as well.

Of course, it is not fair to compare IFF to struggling traditional packaged food companies as its business continues to grow at a steady pace, yet investors should appreciate the big run enjoyed by the shares already after they have gone straight up from $25 in 2009 to levels now 5 times as high.

The company has reported adjusted earnings of $5.89 per share last year, although this kindly excludes various charges such as acquisition-related costs, operational costs improvements, integration charges, and restructuring charges, among others, as realistic earnings probably come in around $5.50 per share. Assuming 6% growth this year, earnings come in around $5.80 per share on a GAAP basis and $6.25 per share on a non-GAAP basis. Trading at $125, valuation multiples remain quite elevated by all means at 20 times adjusted earnings and 21-22 times reported earnings.

The deal should be neutral to first-year earnings in which synergies are seen at 25% of the promised $145 million run rate in three years from now. That suggests that after three years, incremental synergies of $109 million a year (75% of $145 million) could boost earnings by another $0.85 per share if we assume a 25% tax rate. Those expected realisations of synergies and modest deleveraging could boost earnings number by a dollar, but that will take 3-4 years to achieve.

The solid growth prospects and potential for synergies to roll in the coming years, combined with some deleveraging efforts, should provide a nice pathway for further earnings per share growth. Hence, I am attracted to the pullback in the shares, as I would be eager to buy shares at a market multiple of around 18 times earnings, translating into a targeted entry level around $115 per share. The discrepancy in the reported 3.7 times leverage number and my own calculations close to 5 times prevent me from going "all-in" until more clarity becomes available on the earnings numbers.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.