International Flavors & Fragrances Inc. — Q1 2018 Form 10-Q Summary
Business context and reporting period
IFF develops and manufactures customized flavor and fragrance compounds and fragrance ingredients for food, beverage, fine fragrance, personal care, fabric care and household products. The filing covers the unaudited three months ended March 31, 2018, compared with the three months ended March 31, 2017. Approximately 90% of products are customized compounds. IFF adopted ASC 606 revenue recognition using the modified retrospective method at the beginning of fiscal 2018.
Financial performance and liquidity
| Metric | Q1 2018 | Q1 2017 | Change |
|---|---|---|---|
| Net sales | $930.9 million | $828.3 million | 12% reported; 7% currency neutral |
| Gross profit | $405.8 million | $363.1 million | 12% |
| Gross margin | 43.6% | 43.8% | Down 20 basis points |
| Operating profit | $174.9 million | $130.1 million | 34% |
| Operating margin | 18.8% | 15.7% | Up 310 basis points |
| Adjusted operating profit | $181.0 million | $156.1 million | 16% |
| Net income | $129.4 million | $115.8 million | 12% |
| Diluted EPS | $1.63 | $1.45 | 12% |
| Operating cash flow | $(11.4) million | $18.5 million | Decrease of $29.9 million |
- Flavors sales increased 11% reported and 6% currency neutral; segment profit rose to $111.6 million from $94.6 million.
- Fragrances sales increased 14% reported and 8% currency neutral; Fragrance Ingredients sales increased 26% reported and 18% currency neutral. Fragrances segment profit rose to $93.3 million from $77.9 million.
- Cost of goods sold increased 13%, faster than sales, reflecting unfavorable price-versus-input-cost trends, foreign exchange effects and the BASF supply disruption. Raw material inflation was particularly expected for vanilla, citrus, turpentine- and oil-derived materials, and a key BASF-affected ingredient.
- Cash and cash equivalents were $305.3 million at March 31, 2018, including $243.0 million held outside the United States. Working capital was $1.254 billion.
- Total debt was $1.713 billion, including $24.6 million drawn under the revolving credit facility and $29.9 million of commercial paper. Net debt for covenant purposes was $1.409 billion, and the covenant Net Debt/adjusted EBITDA ratio was 1.71x versus a 3.5x maximum.
- Capital expenditures were $33.1 million. Management expected 2018 capital spending of approximately 4.5% to 5% of sales.
- The company paid $54.4 million of dividends and declared a quarterly dividend of $0.69 per share. It repurchased 75,795 shares for $11.0 million during the quarter.
Material changes versus the prior comparable period
- Sales growth was broad-based and driven by new wins, higher volumes, favorable Flavors pricing and stronger Fragrance Ingredients demand. Emerging markets represented 47% of sales and grew 10% reported and 6% currency neutral.
- Operating profit benefited from volume growth, favorable mix, productivity initiatives and lower unusual charges. Q1 2018 included $6.2 million of specified charges, compared with $26.1 million in Q1 2017.
- Gross margin declined modestly despite revenue growth. Excluding specified items, management reported a 40-basis-point decline in gross margin.
- Other income declined to $0.6 million from $21.2 million, primarily because Q1 2017 included a $12.2 million foreign currency translation gain from liquidation of a foreign entity and more favorable foreign-exchange results.
- Interest expense increased 30% to $16.6 million, principally following the issuance of 2017 senior notes.
- The effective tax rate increased to 18.5% from 16.4%, largely reflecting U.S. tax reform and increased loss provisions, partly offset by earnings mix, lower repatriation costs and a state valuation allowance release.
- Operating cash flow turned negative because of higher working-capital requirements, a product-claim payment and timing of other items. The company paid $13.0 million related to an FDA-mandated product recall claim.
- Adoption of ASC 606 reduced Q1 2018 revenue, gross profit and net income by approximately $0.6 million, $0.4 million and $0.3 million, respectively, versus the prior revenue model. The adoption increased beginning retained earnings by approximately $2.1 million.
Guidance, outlook, risks and unusual items
- Management expected continued raw-material cost pressure in 2018 and planned to pursue productivity, cost reduction and mix improvements to protect margins.
- The 2017 productivity program is expected to generate cumulative pretax cash charges of $30 million to $35 million. IFF had recorded $21.3 million through Q1 2018, with remaining personnel and other costs expected by the end of 2018. The program is expected to reduce the global workforce by approximately 370 employees.
- The provisional Tax Cuts and Jobs Act accounting, including approximately $139.2 million of charges recorded in Q4 2017, remained subject to additional guidance and was expected to be finalized no later than Q4 2018. IFF recorded an additional $0.6 million withholding-tax charge in Q1 2018.
- On May 7, 2018, after quarter-end, IFF agreed to acquire Frutarom for approximately $7.1 billion, including assumed net debt of approximately $681 million. Consideration included $71.19 in cash and 0.2490 IFF shares per Frutarom share. The transaction was expected to require substantial new debt and equity financing, including a potential $5.5 billion bridge facility, and approximately 18.9% dilution based on the disclosed share count.
- IFF announced that it intended to suspend share repurchases until its deleveraging target was met following the planned Frutarom acquisition.
- Key risks include raw-material inflation, BASF supply disruption, manufacturing interruptions, product recalls, foreign-exchange volatility, tax uncertainty, litigation and environmental matters, and execution, financing, regulatory and integration risks related to Frutarom.
- IFF had approximately $51.7 million of bank guarantees and standby letters of credit, including Brazilian tax-related matters. Estimated environmental exposure at eight sites was less than $5 million, while aggregate reasonably possible losses in excess of accrued liabilities for other third-party contingencies were estimated at $0 to approximately $12 million.
- The Guangzhou plant’s potential zoning change could affect continued manufacturing; its net book value was approximately $70 million. The Zhejiang facility relocation was expected to generate compensation of up to approximately $50 million through 2020.
Most important facts for investors to verify
- Whether revenue growth and segment profitability remain strong after adjusting for currency, pricing, productivity benefits and unusual items.
- Whether raw-material inflation and the BASF supply disruption continue to compress gross margins.
- The timing, financing mix, regulatory approvals, dilution and eventual leverage impact of the Frutarom acquisition.
- Progress toward the productivity program’s $30 million to $35 million charge estimate and targeted workforce reduction.
- Resolution of provisional Tax Act accounting and its effect on the effective tax rate and cash taxes.
- Conversion of earnings into operating cash flow, particularly as working capital and acquisition-related funding needs increase.
- Compliance with debt covenants and the company’s ability to delever after the planned acquisition.