International Flavors & Fragrances Inc. — Q3 2019 Form 10-Q Summary
Business context and reporting period
IFF filed an unaudited Form 10-Q for the quarter and nine months ended September 30, 2019. The company develops and manufactures flavor compounds, fragrance compounds and ingredients. Reportable segments were Taste, Scent and Frutarom; management expected to reorganize into Taste, Scent, and Nutrition & Ingredients by the end of the first quarter of 2020.
Frutarom results were included for the full third quarter and first nine months of 2019 following the October 4, 2018 acquisition.
Key financial metrics
| Metric | Q3 2019 | Q3 2018 | 9M 2019 | 9M 2018 |
|---|---|---|---|---|
| Net sales | $1,267.3 million | $907.5 million | $3,856.3 million | $2,758.5 million |
| Gross profit | $533.1 million | $400.7 million | $1,610.6 million | $1,205.2 million |
| Gross margin | 42.1% | 44.1% | 41.8% | 43.7% |
| Operating profit | $184.7 million | $159.3 million | $548.5 million | $488.6 million |
| Operating margin | 14.6% | 17.5% | 14.2% | 17.7% |
| Net income attributable to IFF | $127.1 million | $95.7 million | $372.3 million | $324.3 million |
| Diluted EPS | $1.13 | $1.17 | $3.30 | $4.04 |
| Operating cash flow | Not separately provided | Not separately provided | $383.0 million | $202.0 million |
Reported sales increased 40% year over year in both the quarter and nine-month period. Currency-neutral sales increased 41% in the quarter and 43% for nine months. Frutarom contributed approximately 40% of reported sales growth.
Adjusted operating profit was $200.9 million in the quarter and $619.6 million for nine months. Adjusted operating margin was 15.9% and 16.1%, respectively, compared with 18.1% and 18.7% in the prior-year periods.
Liquidity, debt and capital allocation
- Cash and cash equivalents were $494.9 million at September 30, 2019, compared with $634.9 million at December 31, 2018; restricted cash was $9.2 million.
- Total debt was $4.393 billion, including $384.8 million of short-term borrowings and current maturities; long-term debt was $4.008 billion.
- Net debt, as defined for the debt covenant, was $3.898 billion. The covenant net debt-to-adjusted-EBITDA ratio was 3.42x, versus a 4.25x maximum at September 30, 2019.
- IFF had no borrowings under its $1.0 billion amended revolving credit facility and reported $948.0 million of available capacity. It was in compliance with all debt covenants.
- Operating cash flow funded dividends, capital expenditures and debt service. Nine-month capital expenditures were $160.4 million, and cash dividends paid were $233.5 million.
- Management expected 2019 capital spending of approximately 4% to 5% of sales, net of potential government grants and reimbursements. Share repurchases remained suspended; $279.7 million remained under the approved program.
Material changes versus the prior comparable period
- Acquisition impact: Frutarom added $363.7 million of Q3 sales and $1.110 billion of nine-month sales. Acquisition-related intangible amortization increased to $48.4 million in Q3 and $144.0 million for nine months, versus $9.0 million and $27.8 million, respectively.
- Profitability pressure: Gross margin declined 200 basis points in Q3 and 190 basis points for nine months, primarily due to unfavorable pricing versus input costs and lower Frutarom margins. Legacy business volumes also declined.
- Operating earnings: GAAP operating profit increased, but operating margin declined because of integration costs, restructuring, amortization and other unusual items.
- Interest expense: Q3 interest expense increased 40% to $33.5 million due largely to a full period of interest on debt issued in connection with the Frutarom transaction. The prior-year period included a $38.8 million loss on debt extinguishment, which did not recur.
- Cash flow: Nine-month operating cash flow increased by $181.1 million, primarily reflecting higher earnings. Receivables factoring contributed approximately $76 million of additional operating cash flow compared with the prior-year period.
- Other comprehensive income: Foreign currency translation losses produced nine-month other comprehensive loss of $165.3 million and reduced accumulated other comprehensive loss to $867.6 million.
Guidance, outlook, risks and unusual items
- IFF targeted $145 million of Frutarom synergies, including approximately $50 million of cost synergies by the end of 2019. Management reported approximately $30 million of year-to-date cost synergies and $15 million of third-quarter cost synergies.
- The company expected to close approximately 35 manufacturing sites over two years, with most closures targeted before the end of fiscal 2020. Total Frutarom integration restructuring costs were estimated at approximately $60 million, including cash and non-cash items.
- Management expected continued input-cost pressure over the next two quarters, partially offset by Frutarom cost synergies. Frutarom integration was expected to take an additional 9 to 15 months from September 30, 2019.
- Other 2019 restructuring programs included approximately $20 million of expected severance costs and approximately $25 million of total 2017 Productivity Program costs.
- IFF substantiated improper-payment allegations involving certain Frutarom businesses principally in Russia and Ukraine. The company stated that affected sales were less than 1% of combined 2018 sales and that related costs had not been material; however, securities class actions were filed in the United States and Israel.
- Goodwill recoverability depends substantially on future revenue growth and achievement of Frutarom synergies. Failure to meet these assumptions or increases in applicable interest rates could result in impairment.
- Environmental, tax, product, contract and other contingencies remained outstanding. The company estimated reasonably possible losses in excess of accrued liabilities for third-party contingencies at $0 to approximately $25 million, excluding matters for which loss was not determinable.
- IFF estimated its share of environmental cleanup costs at seven third-party sites at less than $3 million, but noted that future costs could increase. China facility zoning and relocation matters could require future charges affecting results, financial position or cash flow.
Important facts for investors to verify
- Whether Frutarom integration achieves the stated $145 million total and $50 million cost-synergy targets, and the timing and cash cost of manufacturing-site closures.
- Whether gross and operating margins recover from the declines caused by input costs, pricing pressure, lower legacy volumes and Frutarom’s lower margins.
- Progress on deleveraging, covenant headroom and the reduction of the net debt-to-adjusted-EBITDA ratio.
- The ultimate exposure from improper-payment investigations, related U.S. and Israeli litigation, compliance costs and potential regulatory actions.
- The risk of goodwill or intangible-asset impairment if Frutarom growth or synergy assumptions are not achieved.
- The effect of receivables factoring on reported operating cash flow and working-capital trends.
- Potential liabilities from environmental matters, China plant relocations, tax disputes and other contingencies.