Business Context and Reporting Period
International Flavors & Fragrances Inc. (IFF) filed an unaudited Form 10-Q for the quarter and six months ended June 30, 2018. IFF operates through Flavors and Fragrances segments, developing customized flavor and fragrance compounds and fragrance ingredients for food, beverage, personal care, household and other consumer products.
IFF adopted ASC 606 using the modified retrospective method at the start of fiscal 2018. The adoption increased opening retained earnings by $2.1 million and reduced second-quarter 2018 revenue, gross profit and net income by $1.9 million, $1.2 million and $0.9 million, respectively, versus the amounts that would have been reported under the prior standard.
Key Financial Metrics
| Metric | Q2 2018 | Q2 2017 | Six Months 2018 | Six Months 2017 |
|---|---|---|---|---|
| Net sales | $920.0 million | $842.9 million | $1.851 billion | $1.671 billion |
| Gross profit | $398.7 million | $373.0 million | $804.5 million | $736.1 million |
| Gross margin | 43.3% | 44.3% | 43.5% | 44.0% |
| Operating profit | $154.5 million | $151.7 million | $329.4 million | $281.8 million |
| Operating margin | 16.8% | 18.0% | 17.8% | 16.9% |
| Net income | $99.1 million | $109.8 million | $228.6 million | $225.6 million |
| Diluted EPS | $1.25 | $1.38 | $2.87 | $2.84 |
| Operating cash flow | Not separately provided | Not separately provided | $55.2 million | $57.9 million |
Second-quarter sales increased 9% on a reported basis and 5% on a currency-neutral basis. Flavors sales rose 9% reported and 6% currency-neutral; Fragrances sales rose 10% reported and 5% currency-neutral. Fragrance Ingredients sales increased 16% reported and 10% currency-neutral.
Six-month sales increased 11% reported and 6% currency-neutral. Flavors segment profit increased to $221.2 million from $191.4 million, while Fragrances segment profit increased to $174.1 million from $158.9 million. Second-quarter Flavors segment margin improved to 24.3% from 23.4%; Fragrances segment margin declined to 17.2% from 18.9%.
Cash, Debt and Liquidity
- Cash and cash equivalents were $322.4 million at June 30, 2018, down from $368.0 million at December 31, 2017; $246.7 million was held outside the United States.
- Total debt was $1.724 billion, including $104.0 million drawn under the revolving credit facility. Long-term debt reported on the balance sheet was $1.717 billion.
- The amended revolving credit facility had $1.0 billion of drawn capacity and approximately $1.6 billion of total availability as disclosed in Note 6. IFF reported compliance with all debt covenants and a debt-agreement Net Debt/adjusted EBITDA ratio of 1.61x.
- Six-month capital expenditures were $67.4 million. Management expected 2018 capital spending of approximately 4.5% to 5.0% of sales, net of potential government grants and reimbursements.
- Six-month dividends paid were $108.8 million; the quarterly dividend declared was $0.69 per share. Share repurchases were suspended beginning May 7, 2018 pending deleveraging following the proposed Frutarom acquisition.
Material Changes Versus the Prior Comparable Period
- Revenue growth was strong, but gross margin declined 100 basis points in the second quarter and 50 basis points for the six months. Management attributed the pressure primarily to unfavorable pricing versus input costs, including the BASF supply disruption, partially offset by productivity and cost-saving initiatives.
- Second-quarter operating profit increased only $2.8 million despite higher sales, and operating margin declined 120 basis points. Reported net income decreased 10% because interest expense rose $35.7 million to $53.2 million.
- Interest expense included approximately $10.7 million of bridge-loan commitment fees and a $25.0 million mark-to-market loss on deal-contingent interest-rate derivatives related to Frutarom.
- Other income increased to $20.7 million in the second quarter, including an $11.0 million mark-to-market gain on a deal-contingent foreign-currency derivative.
- Operating cash flow declined modestly to $55.2 million from $57.9 million, reflecting higher working capital, bridge-loan fees and product-recall costs. Factoring contributed approximately $25.5 million less beneficial operating-cash-flow impact than in the prior-year period.
- The 2017 comparison included $56.0 million paid for the ZoomEssence litigation settlement, while 2018 included approximately $13.0 million paid for the FDA-mandated product recall claim.
Outlook, Unusual Items and Risks
IFF did not provide a specific quantitative sales or earnings forecast in the filing. Management expected continued raw-material cost pressure, including costs for turpentine, citrus and petro-derived products, and continued BASF-related supply-chain pressure. Management expected margin improvement efforts to come from operational performance, cost reduction, productivity and mix enhancement.
- IFF agreed to acquire Frutarom for an estimated $7.1 billion, including approximately $681 million of assumed net debt. Consideration included $71.19 in cash and 0.2490 IFF shares per Frutarom share. Closing was expected in the fourth quarter of 2018, subject to regulatory and customary conditions.
- IFF planned to fund the transaction using cash, up to $3.1 billion of debt financing and up to $2.2 billion of new equity. A $5.45 billion, 364-day bridge facility was committed, subject to customary conditions; a $350 million term facility was also arranged for expected issuance in the fourth quarter.
- The pending transaction creates material execution, regulatory, integration, financing, dilution and leverage risks. IFF expected to issue approximately 14.88 million shares to Frutarom shareholders, with former Frutarom shareholders expected to own approximately 15.8% of fully diluted IFF shares before acquisition-related financing.
- IFF had recorded $12.5 million of Frutarom transaction costs in selling and administrative expense and identified total second-quarter Frutarom-related impacts of approximately $37.0 million before tax, including financing fees and derivative mark-to-market adjustments.
- The 2017 productivity program had generated $22.5 million of charges through the second quarter of 2018, with total expected cash charges of $30 million to $35 million and an expected workforce reduction of approximately 370 employees.
- The Tax Cuts and Jobs Act charge recorded in 2017 was provisional. IFF recorded an additional $0.6 million charge in the first six months of 2018 and expected finalization of the tax accounting no later than the fourth quarter of 2018.
- Other risks include raw-material inflation, supply-chain and manufacturing disruptions, product liability and recall claims, environmental matters, tax disputes, foreign-exchange volatility, and potential closure or relocation of Chinese facilities. The Guangzhou plant had approximately $71 million of net book value subject to zoning uncertainty.
Most Important Facts for Investors to Verify
- Whether the Frutarom acquisition closed on schedule, received required regulatory approvals and was financed on the planned debt/equity terms.
- Post-acquisition leverage, covenant headroom, interest expense and the effect of planned refinancing and equity issuance on existing shareholders.
- Whether pricing actions and productivity savings offset raw-material inflation and the BASF supply disruption.
- Operating cash-flow conversion, inventory and receivables growth, and the ongoing use and cash-flow impact of receivables factoring.
- Final tax accounting under the Tax Cuts and Jobs Act and any effects on the effective tax rate or cash taxes.
- Remaining costs and benefits from the productivity program, capital spending related to China and India facilities, and potential impairment or relocation charges.
- Resolution of the FDA recall reimbursement claims, environmental and Brazilian tax contingencies, and other litigation exposures.