International Flavors & Fragrances Inc. — Fiscal 2016 Form 10-K
Reporting period: Fiscal year ended December 31, 2016, representing a 52-week year with an actual fiscal closing date of December 30, 2016. The filing also presents fourth-quarter 2016 results and comparisons with 2015.
Business Context
IFF develops and manufactures flavors, fragrances, cosmetic active ingredients and related delivery systems for food, beverage, personal care, household and fine-fragrance customers. The company operates through Flavors and Fragrances, with 2016 sales of approximately 48% and 52%, respectively. Sales were geographically diversified: EAME 31%, Greater Asia 28%, North America 25% and Latin America 16%. Emerging markets represented 51% of sales.
- 2016 sales were approximately $3.1 billion across roughly 160 countries.
- The 25 largest customers represented 52% of sales; the largest customer represented 12% of sales.
- IFF completed the approximately $242 million acquisition of David Michael in October 2016 and completed the approximately $150.5 million acquisition of Fragrance Resources in January 2017.
Financial Performance
| Metric | 2016 | 2015 | Change |
|---|---|---|---|
| Net sales | $3,116.4 million | $3,023.2 million | +3.1% |
| Currency-neutral sales growth | 5% | Not stated in this table | Includes approximately 2% acquisition contribution |
| Gross profit | $1,399.1 million | $1,351.6 million | +3.5% |
| Gross margin | 44.9% | 44.7% | +20 bps |
| Operating profit | $567.4 million | $588.3 million | -3.6% |
| Operating margin | 18.2% | 19.5% | -130 bps |
| Adjusted operating profit | $623.0 million | $612.1 million | +1.8% |
| Adjusted operating margin | 20.0% | 20.2% | -20 bps |
| Net income | $405.0 million | $419.2 million | -3.4% |
| Diluted EPS | $5.05 | $5.16 | -2.1% |
| Cash flow from operations | $535.4 million | $433.6 million | +$101.8 million |
Flavors sales increased 3.7% to $1,496.5 million, with segment profit rising to $337.2 million and margin increasing to 22.5%. Fragrances sales increased 2.5% to $1,619.8 million, with segment profit rising to $334.2 million and margin increasing to 20.6%.
R&D expense was $254.3 million, or 8.2% of sales. Selling and administrative expense increased 14.5% to $566.2 million, or 18.2% of sales. The increase reflected litigation charges, acquisition-related expenses, severance, finance initiatives and acquired businesses.
Liquidity, Debt and Capital Allocation
- Cash and cash equivalents were $324.0 million at year-end, up from $182.0 million; approximately $252.6 million was held outside the United States.
- Total debt was $1,325.4 million, compared with $1,067.7 million in 2015. Net debt, as defined for debt covenants, was $1,000.1 million.
- Adjusted EBITDA for covenant purposes was $756.4 million, and net debt to adjusted EBITDA was 1.32x versus a 3.50x covenant limit.
- The company had no borrowings under its revolving credit facility and approximately $950 million of draw capacity at year-end. The facility matures in December 2021.
- Operating cash flow was $535.4 million; investing cash flow used $355.5 million, including $236.8 million for the David Michael acquisition and $126.4 million of capital expenditures.
- 2017 capital spending was expected to be approximately 5% of sales, excluding potential government grants and reimbursements.
- IFF paid $184.9 million in dividends and repurchased $127.4 million of stock in 2016. The remaining share-repurchase authorization was approximately $109.3 million at year-end.
- Management stated that operating cash flow and available credit facilities should be sufficient for investing and financing needs for at least the next 18 months.
Material Changes and Unusual Items
- Reported sales growth was reduced by approximately 2% from currency effects, while currency-neutral growth was 5%.
- Operating profit included $48.5 million of net legal charges and credits, principally a $50 million reserve related to ZoomEssence litigation, partially offset by favorable tax-related settlements.
- Other 2016 items included $12.2 million of acquisition-related costs, $2.4 million of operational improvement costs, $0.3 million of net restructuring charges and a $7.8 million gain on the sale of property in Brazil.
- Gross margin benefited from productivity initiatives, despite acquisition inventory step-up costs of $7.6 million and continued pressure from natural-material costs, including vanilla and citrus.
- Foreign exchange reduced operating profit by approximately 2% versus 2015. Interest expense increased to $53.0 million from $46.1 million, principally due to new Euro Senior Notes.
- Comprehensive income was $338.4 million, compared with $346.2 million in 2015, primarily reflecting foreign currency translation and pension-related adjustments.
Guidance, Outlook and Risks
Management expects challenging macroeconomic conditions, a stronger U.S. dollar and a reset of the incentive compensation program to pressure currency-neutral operating-profit growth in 2017. Raw-material prices, particularly for vanilla, citrus and certain oil-based derivatives, were expected to remain elevated.
On February 15, 2017, IFF announced a multi-year productivity program expected to generate $40 million to $45 million of annual run-rate savings by 2019. The program is expected to reduce the workforce by approximately 370 positions and require $30 million to $35 million of pre-tax cash charges, plus up to $5 million of accelerated depreciation. Approximately $10 million of charges were expected in the first quarter of 2017.
- Key risks include customer concentration and customer supplier rationalization, intense competition, changing consumer preferences, raw-material and energy inflation, currency volatility and emerging-market weakness.
- Operational risks include supply-chain disruption, specialized or single-source facilities, environmental compliance, product quality, cybersecurity and information-technology failures.
- China operations remain a material contingency: potential zoning changes could affect the Guangzhou Flavors plant, which had approximately $69 million of net book value. A requested relocation of the Zhejiang Ingredients plant could result in accelerated depreciation of $0 to $26 million.
- IFF had identified eight third-party environmental sites and estimated its share of future cleanup costs at less than $5 million.
- Aggregate reasonably possible losses in excess of accrued liabilities for third-party contingencies were estimated at $0 to approximately $28 million, excluding the uncertainty inherent in litigation outcomes.
- The company had $2,148 million of contractual obligations, including $1,321 million of borrowings, $180 million of pension funding obligations and $256 million of operating leases.
Investor Verification Priorities
- Reconcile GAAP earnings with adjusted operating profit and adjusted net income, particularly the $48.5 million legal charge and acquisition-related adjustments.
- Assess whether Flavors and Fragrances segment-margin improvements can offset higher corporate expenses, currency pressure and raw-material inflation.
- Monitor integration performance and purchase-price allocations for David Michael and Fragrance Resources.
- Verify progress, costs and potential impairment exposure associated with the Guangzhou and Zhejiang China facilities.
- Evaluate the productivity program’s actual charges, workforce reductions and realized savings against the 2019 target.
- Review debt maturities, including the $250 million Senior Notes maturity in 2017, and the company’s refinancing plans.
- Consider the effect of customer concentration, supplier “core lists,” litigation exposure, pension funding and international tax contingencies on future cash flow.