INTERNATIONAL FLAVORS & FRAGRANCES INC quarterly report, Q3 FY2018

International Flavors & Fragrances Inc. — Form 10-Q Summary

Business context and reporting period

IFF is a global developer and manufacturer of flavor compounds, fragrance compounds, and fragrance ingredients serving food, beverage, personal care, household, and related markets. This unaudited Form 10-Q covers the three and nine months ended September 30, 2018; the actual quarter-end date was September 28, 2018.

The company completed its acquisition of Frutarom Industries on October 4, 2018, after the reporting date. The transaction was valued at approximately $7.1 billion, including approximately $797 million of assumed net debt, and was funded through debt, equity, and equity-linked offerings described below. Frutarom results were not included in the September 30 financial statements.

Financial performance and key metrics

Metric	Q3 2018	Q3 2017	9M 2018	9M 2017
Net sales	$907.5 million	$872.9 million	$2.758 billion	$2.544 billion
Gross profit	$400.7 million	$380.4 million	$1.205 billion	$1.116 billion
Gross margin	44.1%	43.6%	43.7%	43.9%
Operating profit	$159.3 million	$149.0 million	$488.6 million	$430.8 million
Operating margin	17.5%	17.1%	17.7%	16.9%
Net income	$95.7 million	$110.3 million	$324.3 million	$335.8 million
Diluted EPS	$1.17	$1.39	$4.04	$4.22

Third-quarter sales increased 4% on both a reported and currency-neutral basis. Flavors sales increased 6% reported and 7% currency-neutral, while Fragrances sales increased 2% on both bases. For the first nine months, reported sales increased 8% and currency-neutral sales increased 6%; Flavors grew 9% reported and Fragrances grew 8% reported.

Operating profit increased 7% in the third quarter and 13% for the first nine months. Third-quarter adjusted operating profit was $164.4 million, compared with $158.6 million in the prior-year period, while adjusted operating margin declined slightly to 18.1% from 18.2%. Management attributed pressure on underlying margins primarily to unfavorable price versus input costs, including the BASF supply disruption, and higher selling and administrative expenses.

Third-quarter net income declined 13% and diluted EPS declined 16%, despite higher operating profit, primarily because of higher interest expense and a $38.8 million loss on extinguishment of debt associated with the Frutarom financing. The effective tax rate declined to 5.0% from 22.0%, partly due to an $8.2 million tax benefit related to U.S. tax reform adjustments and other favorable tax items. The nine-month effective tax rate was 15.0%, compared with 20.4%.

Net cash provided by operating activities was $202.0 million for the first nine months, compared with $199.5 million in 2017.
Capital expenditures were $102.4 million, compared with $77.3 million in the prior-year period.
Net cash used in investing activities was $102.3 million, compared with $263.2 million, primarily because 2017 included acquisitions.
Net cash provided by financing activities was $4.821 billion, driven by acquisition-related debt and equity issuance.
Cash and cash equivalents were $5.274 billion at September 30, 2018, compared with $368.0 million at December 31, 2017; $609.2 million was held outside the United States.
Total debt was $4.377 billion, including $4.331 billion of long-term debt, compared with $1.639 billion at year-end 2017.
Net debt as defined under the debt agreements was negative $895.2 million because cash exceeded debt before the Frutarom closing.

Material changes versus the prior comparable period

IFF issued approximately $1.6 billion of common stock and approximately $799 million of net proceeds from 6.00% tangible equity units in September 2018.
IFF issued approximately $2.8 billion of new debt in connection with the Frutarom acquisition, including euro- and dollar-denominated senior notes and the amortizing-note component of the tangible equity units.
The company repaid the $250 million principal amount of its 2007 senior notes and incurred a $38.8 million extinguishment loss, including a $34.9 million make-whole payment and a $3.9 million hedge termination loss.
Frutarom acquisition-related expenses totaled $26.8 million in selling and administrative expense for the first nine months, in addition to financing and other transaction costs.
Third-quarter gross margin benefited from a $9.8 million recovery related to an FDA-mandated product recall. Excluding this recovery and other comparability items, management stated that gross margin declined 111 basis points year over year.
The Flavors segment’s third-quarter profit increased to $96.5 million, or 22.1% of sales, while Fragrances segment profit declined to $87.5 million, or 18.6% of sales.
IFF adopted the new revenue recognition standard using the modified retrospective method. The adoption increased opening retained earnings by $2.1 million and reduced third-quarter 2018 revenue, gross profit, and net income by $0.8 million, $0.6 million, and $0.5 million, respectively.

Guidance, outlook, management commentary, risks, and unusual items

Management expected 2018 capital spending of approximately 4.5% to 5.0% of sales, net of potential government grants and reimbursements.
Management stated that operating cash flow and available credit facilities should be sufficient to meet investing and financing needs for at least the next 18 months.
IFF expected to reduce net debt over the following three years using operating cash flow and proceeds supported by suspension of share repurchases. Share repurchases were suspended until the company met its deleveraging target following the Frutarom acquisition.
The company expected higher raw-material costs across several categories, including turpentine, citrus, and petro-derived products, and continued effects from the BASF supply disruption.
The 2017 productivity program had generated $23.4 million of charges through the third quarter of 2018, with remaining personnel-related and other costs expected by year-end. The program was expected to reduce the global workforce by approximately 370 employees.
The company’s revolving credit facility provided $1.0 billion of capacity, with $105.7 million outstanding under the facility at September 30. IFF was in compliance with its covenants, including the applicable net debt-to-adjusted-EBITDA requirements.
Key risks include integrating Frutarom, achieving anticipated synergies and earnings accretion, retaining personnel, managing increased leverage, raw-material and supply-chain volatility, product quality and recall exposure, foreign currency movements, tax-law changes, litigation, environmental obligations, and potential disruption or relocation of Chinese facilities.
The company estimated environmental liabilities at identified third-party sites at less than $5 million and estimated reasonably possible losses in excess of accrued liabilities for other contingencies at $0 to approximately $12 million, while noting that actual outcomes could differ materially.
IFF expected to adopt lease accounting guidance at the beginning of fiscal 2019, which it expected would significantly increase reported assets and liabilities.

Most important facts for investors to verify

Post-quarter-end Frutarom closing date, final purchase price allocation, acquired net debt, shares issued, and the effect on leverage and earnings.
Whether the company achieves projected Frutarom synergies, integration benefits, and expected earnings and cash-flow accretion.
The sustainability of reported margins after excluding the $9.8 million recall recovery and other unusual items.
Exposure to higher raw-material costs and the continuing impact of the BASF supply disruption.
Debt maturities, interest costs, covenant compliance, and progress toward the stated three-year deleveraging objective.
Finalization of provisional U.S. Tax Act calculations and any resulting changes to tax expense, cash taxes, or deferred tax balances.
Potential costs associated with Chinese plant relocations, the Guangzhou zoning matter, product claims, environmental matters, and other contingencies.