International Flavors & Fragrances Inc. — Q2 2019 Form 10-Q Summary
Business context and reporting period
IFF filed an unaudited Form 10-Q for the quarter and six months ended June 30, 2019. The company operates through Taste, Scent and Frutarom, following its October 2018 acquisition of Frutarom. Reported 2019 results include Frutarom, while the comparable 2018 GAAP results generally do not. The fiscal quarter actually closed June 28, 2019.
Financial performance and key metrics
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Net sales | $1,291.6 million | $920.0 million | $2,589.0 million | $1,850.9 million |
| Gross profit | $546.2 million | $398.7 million | $1,077.5 million | $804.5 million |
| Gross margin | 42.3% | 43.3% | 41.6% | 43.5% |
| Operating profit | $199.9 million | $154.5 million | $363.8 million | $329.4 million |
| Operating margin | 15.5% | 16.8% | 14.1% | 17.8% |
| Net income attributable to IFF | $136.4 million | $99.1 million | $245.2 million | $228.6 million |
| Diluted EPS | $1.20 | $1.25 | $2.16 | $2.87 |
| Operating cash flow | Not separately provided | Not separately provided | $184.9 million | $55.2 million |
Second-quarter sales increased 40% on a reported basis and 45% on a currency-neutral basis. Frutarom contributed approximately 41% of reported growth. Six-month sales increased 40% reported and 44% currency neutral. Q2 adjusted operating profit was $213.9 million, with adjusted operating margin of 16.6%, compared with 18.5% in the prior-year quarter. Six-month adjusted operating profit was $418.6 million.
- Segment sales, Q2: Taste $434.2 million, down 4%; Scent $475.7 million, up 1%; and Frutarom $381.7 million.
- Segment profit, Q2: Taste $98.1 million, Scent $91.2 million and Frutarom $37.5 million.
- Drivers: Acquisition-related sales and Scent pricing and new wins were partly offset by volume reductions, higher raw-material costs, unfavorable price-versus-input-cost effects and foreign exchange.
- Cash flow: Operating cash flow improved primarily because of higher earnings, the absence of the prior-year product-recall settlement payments and working-capital effects. Factoring programs increased operating cash flow by $24.0 million in the first half of 2019.
Balance sheet, debt and liquidity
- Cash and cash equivalents were $426.7 million at June 30, 2019, down from $634.9 million at December 31, 2018. Restricted cash was $28.1 million.
- Total debt was $4.513 billion, including $4.429 billion of long-term debt and $84.2 million of short-term borrowings. Net debt, as defined for covenant purposes, was $4.086 billion.
- Operating cash flow was $184.9 million; investing cash outflow was $146.2 million and financing cash outflow was $234.4 million. Financing outflows included $155.6 million of dividends, $47.4 million of debt repayments and $21.8 million of contingent consideration payments.
- Capital expenditures were $119.1 million in the first half. Management expects 2019 capital spending of approximately 4%–5% of sales, net of potential grants and reimbursements.
- The company had no borrowings under its $1.0 billion amended credit facility, $325 million outstanding under the term loan and approximately $978 million of credit-facility draw capacity. It reported compliance with all covenants; the covenant net-debt-to-adjusted-EBITDA ratio was 3.63x versus a 4.5x limit at June 30, 2019.
- Working capital was approximately $1.8 billion. Management stated that operating cash flow, existing cash and available credit facilities should be sufficient for operating, investing and financing requirements.
Material changes versus the prior comparable period
- Frutarom added substantial revenue and profit but also increased amortization, integration costs, restructuring activity and leverage. Acquisition-related intangible amortization rose to $47.9 million in Q2 and $95.5 million for the first six months, versus $9.6 million and $18.8 million, respectively.
- Gross margin declined 100 basis points in Q2 and 190 basis points for the first half, principally because of higher raw-material costs and lower Frutarom margins.
- GAAP operating profit increased 29% in Q2 and 10% for the first six months, but operating margin declined because of the acquisition mix and related charges.
- Net income attributable to IFF increased 38% in Q2 and 7% for the first six months, while diluted EPS fell to $1.20 and $2.16, respectively, partly reflecting a larger share count following the tangible equity unit issuance and the Frutarom transaction.
- Interest expense fell sharply in Q2 because the 2018 period included approximately $35.7 million of Frutarom financing fees; six-month interest expense was broadly flat because higher borrowings partly offset the absence of those fees.
- The company adopted lease accounting under ASC 842, recording approximately $308.3 million of right-of-use assets and $313.3 million of operating lease liabilities at adoption.
Guidance, outlook, management commentary and risks
- Management expects to achieve $145 million of Frutarom synergy targets, including approximately $40 million of cost synergies, by the end of 2019. The filing also references expected cost synergies of $30 million–$35 million by year-end in its forward-looking statement discussion.
- IFF expects to close approximately 35 manufacturing sites over two years, with most closures targeted before the end of fiscal 2020. Integration efforts are expected to take approximately 12–18 months from June 30, 2019.
- Management expects continued input-cost pressure over the next two quarters, partly offset by Frutarom integration cost synergies.
- The company announced a future reorganization into Taste, Scent and Nutrition & Ingredients, with implementation expected over six to nine months.
- IFF is investigating allegations of improper payments by two Frutarom businesses principally operating in Russia and Ukraine. The investigation was incomplete; management stated that affected sales were less than 1% of combined 2018 sales, but investigation, remediation, legal or regulatory costs could be material in a particular quarter.
- Key operational risks include raw-material, energy and transportation inflation; supply-chain or manufacturing disruption; foreign-exchange volatility; integration execution; regulatory, product-safety, environmental and anti-corruption matters; litigation and tax audits; and elevated leverage.
- China facility zoning and relocation matters could require future charges. The Guangzhou Taste plant had a net book value of approximately $64 million, the Guangzhou Scent plant approximately $9 million and the Zhejiang Ingredients plant approximately $19 million at June 30, 2019.
- The company disclosed aggregate reasonably possible losses in excess of accrued liabilities of $0 to approximately $10 million for other third-party contingencies, and estimated environmental liabilities of less than $3 million.
Most important facts for investors to verify
- Whether Frutarom integration delivers the targeted synergies without additional restructuring, remediation or compliance costs.
- Whether gross and adjusted operating margins recover as pricing, raw-material costs, foreign exchange and productivity initiatives evolve.
- Progress toward debt reduction and compliance with tightening leverage covenants, including the 4.25x limit beginning September 30, 2019.
- Outcome and potential financial impact of the improper-payment investigations and any related government proceedings.
- Actual 2019 capital spending, manufacturing-site closures, China relocation costs and cash requirements.
- Finalization of the preliminary Frutarom purchase-price allocation, including goodwill, intangible assets, deferred taxes and redeemable noncontrolling interests.
- Conversion of reported growth into organic and currency-neutral growth, particularly excluding acquisition effects and price increases.