On Aug 13, we issued an updated research report on International Flavors & Fragrances Inc. IFF. Notably, the company is well poised to benefit from cost cutting efforts, productivity initiatives, acquisitions and surging demand in global market for flavors and fragrances (particularly in emerging markets). However, higher costs along with huge debt levels remain headwinds.
Better-Than-Expected Q2
International Flavors & Fragrances reported adjusted earnings of $1.66 per share in second-quarter 2018, up 11% from the year-ago tally of $1.50.  Net sales were $920 million, reflecting year-over-year growth of 9%. Both beat the respective Zacks Consensus Estimate. This upbeat performance was aided by new wins and price increases implemented to counter rising raw material input costs inflation in both Flavors and Fragrances segments.
Upbeat Outlook for 2018
Focus to drive greater efficiencies throughout the business through costs and productivity initiatives as well as favorable taxes continue to support overall profitability. Robust growth is being noted with local and regional customers, almost twice that of global customers. The company expects sales and operating income to grow 4-7% and 6.5-8.5%, respectively, in 2018.  On a currency-neutral basis, sales growth is projected at 3-5% and operating income improvement is estimated to be 5-7%. Earnings per share are likely to be up 5.5-7.5% or 4-6% on a constant-currency basis.
Long-term Prospects Remains Solid
The global market for flavors and fragrances continues to grow, spurred by increasing in demand for a variety of consumer products containing flavors and fragrances. The market which was around $24.8 billion in 2017 is projected to grow approximately 2-3% by 2021, primarily driven by anticipated growth in emerging markets. Growing economy in these countries bolsters demand for consumer products, and in turn the requirement for flavors and fragrances used in them.
Consequently, International Flavors & Fragrances is focused on gaining share in emerging markets. Over the past five years, the company’s currency neutral sales growth rate in emerging markets has outpaced that of developed markets. The company will be able to capitalize on the expansion in flavors and fragrances markets and deliver long-term growth on the back of its global presence, diversified business platform, broad product portfolio, and global and regional customer base.
Strategic Initiatives a Growth Driver
The company’s concerted efforts to innovate products by a dedicated research and development wing will be a catalyst. Notably, the company’s introduction of Veraspice — a fragrance ingredient; Re-Imagine — programs that enable the company to pursue unaddressed opportunities in the food and beverage industry as well as assist it in innovation initiatives; and Tastepoint — a new company formed to serve middle-market customers are worth mentioning here.
Further, the company has been working on its multi-year productivity program, which is anticipated to yield annualized savings of $40-$45 million by the end of 2019.
Acquisitions to be Catalysts
Over time, the company has reinforced its product portfolio and leveraged business opportunities through the addition of assets. The buyouts of David Michael & Company in October 2016, Fragrance Resources in January 2017 and PowderPure in April 2017 are worth mentioning in this regard.
In May 2018, the company signed an agreement to combine its operations with Frutarom. International Flavors & Fragrances anticipates concluding the deal in the fourth quarter. Together, International Flavors & Fragrances and Frutarom will create a global leader in natural taste, scent and nutrition with an expected 2018 pro forma sales of $5.3 billion. It will also have a broader customer base, more diversified product offerings and an increased market penetration.
For 2016-2020 timeframe, the company anticipates acquisitions to generate approximately $500 million to $1 billion in revenues.
Higher Costs & Disruption in Supply Chain: Near-term Headwinds 
International Flavors & Fragrances is dealing with adverse impacts of rising costs and operating expenses. Notably, the company’s cost of sales in the last five years (2013-2017) grew at 2.8% (CAGR) while operating expenses (including adjusted selling, general and administrative as well as research and development expenses) went up 2.4%. The trend continued in the first half of 2018 as well, with costs and sales, and operating expenses increasing 12% and 6% from their respective tallies in the year-ago comparable quarter.
In 2018, higher costs of raw materials across a range of categories (including turpentine, citrus and petro-derived products) will continue to impact margins. Unwarranted rise in costs and expenses is likely to prove detrimental to its margins and profitability.
In 2017, a fire at the manufacturing facility of BASF Group (“BASF”), one of the company’s suppliers, caused them to declare a force majeure and resulted in a disruption of the availability of certain ingredients used in some of the fragrance and flavor compounds. This BASF supply chain disruption issue impacted the margins of the Fragrances segment in the first half of 2018, which is likely to persist in the second half of 2018 as well. Moreover, increased environmental actions on suppliers in China are likely to impact International Flavors & Fragrances’ operations.
High Leverage a Concern
International Flavors & Fragrances is a highly leveraged company. In the last five years (2013-2017), the company’s long-term debt has soared at a CAGR of 11.8%. At second-quarter end, it stood at $1,717 million, a 6% sequential growth. Moreover, the company’s total debt/total equity has increased from 63.6% in 2013 to 96.6% in 2017. It was 97.8% at the end of second-quarter 2018. High-debt levels can inflate the company’s financial obligations and put pressure on margins.
In the last year, International Flavors & Fragrances’ shares have declined 4%, against growth of 2% recorded by the industry.
International Flavors & Fragrances currently carries a Zacks Rank #3 (Hold).
Stocks to Consider
Some better-ranked stocks in the same sector include Celanese Corporation CE, Huntsman Corporation HUN and KMG Chemicals, Inc. KMG. All three stocks flaunt a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.
Celanese has a long-term earnings growth rate of 10%. The stock has gained around 18% in a year’s time.
Huntsman Corporation has a long-term earnings growth rate of 8.5%. The company’s shares have been up 24% during the past year.
KMG Chemicals has a long-term earnings growth rate of 28.5%. Its shares have appreciated 38% in the past year.
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