Business Context and Reporting Period
International Flavors & Fragrances Inc. filed this Form 10-K for the fiscal year ended December 31, 2018. IFF develops and manufactures flavors, fragrances, cosmetic actives, specialty ingredients and related sensory products serving customers in approximately 195 countries.
The October 4, 2018 acquisition of Frutarom Industries materially expanded IFF’s natural flavors, colors, food-protection, nutraceutical, savory-solutions and specialty-ingredients portfolio. Frutarom’s results are included from the acquisition date; reported 2018 results therefore are not fully comparable with prior periods.
- Reportable segments: Taste, Scent and Frutarom.
- Reported 2018 sales mix: Taste 44%, Scent 47% and Frutarom 9%.
- Full-year 2018 combined IFF and Frutarom sales, including pre-acquisition Frutarom sales, were approximately $5.1 billion.
Financial Performance and Key Metrics
| Metric | 2018 | 2017 | Change |
|---|---|---|---|
| Net sales | $3.978 billion | $3.399 billion | 17.0% |
| Gross profit | $1.683 billion | $1.472 billion | 14.3% |
| Gross margin | 42.3% | 43.3% | Down 102 bps |
| Operating profit | $583.9 million | $552.6 million | 5.7% |
| Operating margin | 14.7% | 16.3% | Down 158 bps |
| Adjusted operating profit | $677.4 million | $618.6 million | 9.5% |
| Adjusted operating margin | 17.0% | 18.2% | Down 117 bps |
| Net income attributable to IFF | $337.3 million | $295.7 million | 14.1% |
| Diluted EPS | $3.79 | $3.72 | 1.8% |
| Cash flow from operations | $437.6 million | $390.8 million | 12.0% |
| Capital expenditures | $170.1 million | $129.0 million | 31.9% |
Sales increased 15% on a currency-neutral basis. Frutarom contributed approximately 11% of reported growth and 10% of currency-neutral growth. Taste sales increased 6% reported and 5% currency-neutral; Scent sales increased 6% reported and 4% currency-neutral; Frutarom contributed $359.6 million of reported sales from October 4 through December 31.
Profitability was pressured by unfavorable pricing relative to input costs, including the BASF supply disruption, higher selling and administrative costs and increased acquisition-related amortization. R&D expense was $311.6 million, or 7.8% of sales, versus 8.7% in 2017.
At December 31, 2018, cash and cash equivalents were $634.9 million, current assets were $2.942 billion, current liabilities were $1.128 billion and the current ratio was 2.6. Total debt was $4.553 billion versus $1.639 billion in 2017, producing reported net debt of approximately $3.918 billion. The company had $1.0 billion of undrawn revolving-credit capacity and $350 million outstanding under its term loan.
Cash flow from operations was $437.6 million, while investing activities used $5.013 billion, principally because approximately $4.857 billion was paid for acquisitions, including Frutarom. Financing activities provided $4.871 billion through new debt and equity financing. Dividends paid were $230.2 million, and the declared dividend increased to $2.84 per share from $2.66.
Fourth-Quarter Results
| Metric | Q4 2018 | Q4 2017 |
|---|---|---|
| Net sales | $1.219 billion | $854.6 million |
| Gross profit | $477.5 million | $356.0 million |
| Net income | $15.5 million | $(40.2) million |
| Diluted EPS | $0.09 | $(0.51) |
Fourth-quarter results included substantial Frutarom acquisition and integration costs, inventory fair-value step-up costs, restructuring charges and a $32.8 million U.S. tax-reform-related charge associated with repatriation taxes.
Material Changes Versus the Prior Comparable Period
- Frutarom was acquired for total consideration of approximately $7.031 billion, including $4.289 billion in cash consideration, $2.047 billion in equity consideration and repayment of approximately $695 million of Frutarom debt.
- IFF issued approximately 14.9 million common shares to former Frutarom shareholders, who held approximately 14% of IFF’s shares after closing, and raised approximately $2.3 billion through equity and tangible equity units.
- Debt increased by approximately $2.9 billion year over year to fund the acquisition, increasing interest expense to $132.6 million from $65.4 million.
- Goodwill and intangible assets increased to $8.418 billion from $1.572 billion, including approximately $6.9 billion associated with Frutarom.
- Adjusted operating profit increased, but adjusted operating margin declined because input-cost inflation and supply-chain disruption exceeded pricing benefits and productivity savings.
- Net working capital increased by approximately $685.8 million, principally from higher receivables and inventories.
- Share repurchases were suspended until the company meets its deleveraging target.
Guidance, Outlook, Risks and Unusual Items
Management expected volatile market and macroeconomic conditions in 2019, with slight overall improvement but continued pressure from raw-material inflation and supply-chain disruptions. Management stated that currency-neutral operating-profit growth could be reduced by these pressures and expected 2019 capital spending of approximately 5% to 6% of sales.
Management intends to prioritize debt repayment, capital investment and Frutarom integration savings. It expects to reduce net debt over the following three years using operating cash flow and suspended share repurchases. The filing does not provide a specific 2019 revenue or EPS guidance range.
- Frutarom integration: anticipated synergies and cross-selling benefits may not be realized; the purchase-price allocation remained preliminary, including approximately $4.2 billion of Frutarom goodwill.
- Leverage and covenant risk: the debt agreements require net debt to adjusted EBITDA to decline from a maximum of 4.5 times to 3.5 times over time. The reported covenant ratio at year-end was 3.56 times, and IFF stated it was in compliance.
- Input costs and supply chain: natural raw materials, energy, transportation and disruptions involving key suppliers may compress margins or impair production.
- Operational and regulatory risks: facility relocations and environmental matters in China, increasingly stringent product and environmental regulations, product liability, recalls and potential litigation remain relevant.
- International exposure: 75% of 2018 reported sales were outside the United States; currency movements, emerging-market conditions, Brexit, tariffs and geopolitical developments may affect results.
- Goodwill and intangible assets: Frutarom’s reporting unit had an estimated fair value approximating carrying value at the annual impairment test, increasing sensitivity to weaker performance or adverse market conditions.
- Unusual 2018 items included $156.7 million of Frutarom acquisition-related costs, a $38.8 million loss on extinguishment of debt, $23.6 million of inventory step-up costs and net insurance or supplier recoveries related to the FDA-mandated recall.
- Environmental exposure: IFF estimated its share of remediation costs at seven third-party sites at less than $3 million, while aggregate reasonably possible losses above accrued liabilities for other contingencies were estimated at $0 to approximately $10 million.
Important Facts for Investors to Verify
- Reconcile reported results with pro forma combined results: unaudited pro forma 2018 sales were $5.136 billion and pro forma net income attributable to IFF was $474.5 million.
- Assess whether Frutarom’s reported 7.6% segment profit margin can improve through integration, cost savings and cross-selling.
- Review debt maturities, including $1.074 billion due in 2020–2021 and $300 million due in 2022–2023, and monitor covenant headroom.
- Separate recurring operating performance from acquisition, integration, tax, recall, restructuring and debt-refinancing items.
- Monitor gross-margin recovery, pricing relative to raw-material costs and the continuing BASF-related supply disruption.
- Evaluate working-capital and inventory growth, planned 2019 capital spending and cash available for debt repayment.
- Review the final Frutarom purchase-price allocation, goodwill impairment sensitivity and acquired contingent liabilities.
- Confirm the effect of the Tax Cuts and Jobs Act, repatriation taxes and the remaining cash toll-charge obligations.