I Smell Deep Value At International Flavors & Fragrances

Summary

• International Flavors & Fragrances is a major player that holds market-leading positions in its fields of expertise.
• The last couple of years have been hard on the business and the market has derated it considerably both in absolute and relative terms.
• Storm clouds are clearing, earnings are derisked, and the valuation is compelling.
• IFF is a deep value turnaround opportunity.
• With total return potential of 34%, IFF stock is a BUY.

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The Opportunity

International Flavors & Fragrances (NYSE:IFF) has underperformed the market considerably over the last few years. In fact, since the onset of COVID-19 it has underperformed the S&P500 by about 50%. From 1 Jan 2020 to date, it has declined by almost 30% vs a broad market gain of just over 20%. This underperformance has manifested itself via both a derating in absolute terms where its EV/EBITDA multiple has declined to 13.3x 2023 guidance vs an average valuation of 15x over the last 5yrs. Similarly, its PE has fallen from an average of 22x to one of 17x at current prices. This in turn has pushed up the dividend yield to around 4% per annum at present well the above steady state yield for the company. This ushers in a deep value buying opportunity.

The obvious question to ask is: Why has this happened? Well, the answers can be found in the numbers.

Company Background

International Flavors & Fragrances is a global leader in the creation and production of artificial and natural aromas, flavors, food ingredient enzymes, probiotics and pharmaceutical binding agents. For readers out there that don't know them, the business is split into four parts:

1. The first called the Nourish segment (55% of sales) sells flavor solutions to the makers of prepared foods, dairy foods, beverages, and confectionaries.
2. The second known as ‘Scent’ (20% of sales) makes fragrances that are used in perfumes, cosmetics, soaps, and personal and household products.
3. The third ‘Health and Biosciences’ (20% of sales) produces food ingredient enzymes and probiotic cultures. This business was purchased from DuPont (DD) in 2021
4. The last segment is called ‘Pharma’ (5% of sales) and this division is a leading provider of binding agents or pharmaceutical excipients.

The company manufactures product that we don’t necessarily see but use every day. For example, one out of 3 Probiotic supplements contain IFF Probiotics, and 1 in 3 yogurts globally have IFF cultures inside them. Fifty percent of cold laundry wash products, 20% of baked goods, and a whopping 20% of global beer volumes are made using their enzymes. So, in all likelihood if you’re washing your clothes, drinking a beer, eating yogurt, and looking after your gut health, you’re quite possibly supporting this business.

In my opinion, these are the types of products that are quite resilient and should be able to weather an economic downturn should one transpire. The company is globally diversified too with earnings split as follows: 34% of sales from Europe, the Middle East and Africa, 31% from North America, 23% in Asia Pacific and the balance of 12% is derived in Latin America. From my perspective this balance shields the company somewhat from country/region specific risk and provides a nice mix of solid and stable first world exposure and higher growth markets.

The company aims to grow sales by 4-6% annually and this should translate into Adjusted Operating EBIDTA growth of 8-10%. It also sees itself generating Adjusted Average Free Cash Flow (FCF) of $1.5bn per annum for the period 2023 to 2026.

The numbers

The latest results did not instill confidence.

EBITDA of $441m was down 17% Y/Y and came in 12% below consensus. Organic sales were up 4% at the low end of targets and EPS met expectations but it was a ‘poor quality’ meet helped by lower taxes. What rocked the market however was sales volumes declining. The source of those declines too had a disproportionate impact on mix and margins. Destocking by customers seemed to be the major culprit here.

Nourish (55% of sales) saw EBITDA decline by 11% with margins taking a beating too (12.4% vs 16.9% in the prior quarter). Health and Bio (20% of sales) also took an 11% EBITDA knock with sales declining by 3% driven by probiotic destocking. Pharma (5% of sales) had a 10% EBITDA decline despite sales growing by 15%. Only scent (20% of sales) bucked the trend and had a stellar quarter with EBITDA soaring 25% on solid growth and margins.

Importantly however they were not alone in this trend, looking through the peer group in the core flavor/fragrance parts of the business both, Givaudan (OTCPK:GVDBF)(OTCPK:GVDNY) and Symrise (OTCPK:SYIEF)(OTCPK:SYIEY) volumes were also weaker. NA in particular showing destocking trends which resulted in a 10% decline in sales. For IFF, this resulted in a lower than forecast guidance of flat EBITDA (excluding the sale of savory and solutions business announced in December 2022) versus what was expected to be low single digit growth.

This guide was roughly 10% below consensus. The culmination of this profit warning was the straw that broke the camel's back, and the share price cratered on results day. Trading at $112 it sank 18% to close at $91.36 and has since faded all the way down to current prices of roughly $83 which is a touch away from its 52-week low.

What followed the results was a flurry of earnings downgrades (11.4% on average) settling expectations for EPS at $ 4.92

At current prices this translates into a PE of 17x earnings.

Earnings Revisions (Seeking Alpha)

The recent sell off has taken absolute and relative valuation levels to a point where the risk vs reward is now compelling. This is a buying opportunity in my view.

Destocking is not unique to IFF and is impacting many companies across the globe from chip companies (yes unbelievably some chips are in oversupply now!) to well-known large retail brands such as NIKE (NKE), Target (TGT) and Walmart (WMT). In an effort to stave off supply constraints and bottlenecks many businesses ramped up inventories only to see consumer demand begin to wane as a buying binge during COVID began to slow, inflation soared, and interest rates rocketed last year. This caught many companies with too much stock which they are now trying to run down, the results of which are discounting and delays in re-ordering. Once this process is complete however, we could very well see a new earnings base created from which companies can now grow.

In the case of IFF we see the most pronounced destocking in protein solutions and probiotics. The company has responded by also cutting its inventory and costs by reducing production. Combined with the Chinese reopening demand this should aid in reducing their own excess stock position.

Once both customers and IFF have run inventories down and they are normalised then a shift to 'business as usual' could see the company recover faster than many out there expect. In my view this is why, prices will rise as inflationary increases are passed on and volumes will begin to recover as normal buying patterns resume. Cost cutting and declining input costs later on in the year mean margins should improve too.

Many out there are concerned with the companies leverage. During its recent results call the company highlighted its ability to generate greater than $1.5bn in cash each year in 2024/2025/2026. This coupled with cost cutting strategies and certain dispositions will likely reduce debt levels quite quickly. This slide from current results shows the plan and how it's going to be done. First, pricing, cost cuts and portfolio sales.

IFF earnings presentation (Company website)

Secondly, through healthy cash generation.

Long Term Targets (Corporate Presentation)

Why I think it's cheap.

Let's look at EPS estimates going out to 2026. As you can see there is a sharp recovery in earnings expected by analysts, these aren’t my estimates but those of analysts in the market out there and published by Seeking Alpha.

IFF earnings forecasts (Seeking Alpha)

This in my view is evidence that company earnings might have bottomed with this last earnings release.

The expected recovery in earnings comes from the following expectations in the market.

TOP LINE GROWTH of 4-6% (vs management guidance of 4-6% and actual 6% over the last few years). Volumes have been guided lower this year, but price gains can offset this to a degree. Going forward it will require steady volume and price growth to achieve this. The market itself is expected to grow at 3% annually with the balance made up in price and or market share gains.

This should in turn result in EPS GROWTH of roughly 10% per annum (again 2023 has been guided lower and the market has reduced EPS forecasts by -11.39% and priced this in) however as volumes and pricing recover into 2024 a large rebound in earnings is expected for 2024 of almost 20% followed by 13% in 2025 and 8.47% in 2026 equating to average earnings growth of 13% per annum over the next 3 years.

Over and above this LEVERAGE should continue to decline too as higher EBITDA and the $1.5bn of annual FCF eats into debt and drops net debt/EBITDA to roughly 3x from 4.3x currently. (This could be reduced even further if more divestments are made).

The set up then is as follows:

Earnings have bottomed. Valuation has bottomed and is both in relative and absolute terms way below the long-term average. The dividend yield has rocketed on the lower share price.

This is happening at a time when the companies' markets are expected to normalise, volumes begin to recover, margins widen, and leverage reduce quite quickly.

What is the company worth?

Below is a table of IFF with its peer group.

Peer group comparison (Seeking Alpha)

As you can see its cheaper than its peers on both its trailing PE and on an EV/EBITDA multiple. As mentioned above its 5yr average PE is around 22x and its 5yr average EV/EBITDA multiple is 15x. On this basis it would still trade at a discount to peers. What this his telling me is that the market has soured on this company in a major way. It was already trading at a discount to peers and since its last set of results that discount has widened even further.

In my mind this could be construed as peak pessimism. It’s percentage PE and EV/EBITDA discount to Peers and its own 5yr average is as follows:

Discount to peers and long term ave valuation (Author)

Looking at its long-term PE against analyst earnings expectations we get to the following target prices:

PE valuation vs long term ave (Author)

Turning to a DCF I make the following assumptions:

10% growth in earnings annually for the next 5yrs as earnings rebound from a low base. This then tapers off to 2% per annum in line with long term inflation forecasts. I’ll use a discount rate of 8.5% which is the long-term average return expectation for the S&P500.

DCF value = $108.33

DCF assumptions (Author)

That’s an interesting outcome, both the long-term average PE valuation and the DCF come out almost identically for an average value and my target price of $108.29.

Looking at the dividend, the companies track record has been excellent and I’d expect the dividend to grow in line with earnings (10% per annum) over the next 5yrs.

Dividend consistency (Seeking Alpha)

The current dividend is 81c per quarter implying $3.24 per annum. At current prices of $83.00 we have a starting yield of just on 4% which is unheard of for this company. Its average yield traded is usually around 2.5%. The mark down in share price and valuation is setting dividend investors up well for the future too.

What are the risks?

IFF is performing sub optimally at present and although its current performance is reflected in its share price and valuation it is something we as investors need to keep in mind. This is a turnaround/deep value play.

The company also faces the following risks to its business. Volume recoveries may not transpire as quickly as expected, the current slowdown in global economies can delay the recovery into next year. Current rates of inflation are putting pressure on input costs and although they are expected to subside later in the year, the company may not be able to pass those on to customers which could impact margins.

IFF competes on the global stage, so there are many different economic, interest and currency ramifications for the company. The strong dollar for example has hurt the translation of profits from rest of global divisions which are 69% of this business.

Global economic growth will impact the company performance. It is possible that we have a recession in 2023 which could impact performance. Outside of this competition from its peer group and the challenge posed from ‘all natural’ products and companies pose a threat too. In order to combat this the company has made a lot of effort to ensure its ESG position is world class.

Conclusion

IFF is a company operating in a defensive industry. It has market leading positions in several key product lines and a solid track record of performance over the long term. The last few years have been tough on the business culminating in a massive derating and severe underperformance vs the market. This derating was exacerbated after results released on 8 February 2023 saw the share price fall by over 18% in a single day and the share has fallen a further 10% since. This severe markdown places the stock price at a large discount to both its peers and its own long-term valuation which puts into deep value territory for me.

Sifting through the tea leaves I’m assuming that client destocking is near its end, both volumes and margins will recover from here and that investors getting in now will be buying into a solid business priced at peak pessimism at the same time as earnings have troughed and are ready to recover.

As a reward you get a 4% dividend yield which is expected to grow at 10% per annum while you wait for the company to prove its worth and the market to rerate it higher as it delivers.

My Target price of $108.29 represents 30% upside to current prices and a total return of 34% including dividends.

IFF is a deep value turnaround story and I rate it as a buy.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of IFF either through stock ownership, options, or other derivatives. 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.