INTERNATIONAL FLAVORS & FRAGRANCES INC quarterly report, Q2 FY2017

International Flavors & Fragrances Inc. — Q2 2017 Form 10-Q

Reporting period: Three and six months ended June 30, 2017; comparable periods ended June 30, 2016. The interim financial statements are unaudited. IFF operates through Flavors and Fragrances segments.

Financial performance

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Net sales	$842.9 million	$793.5 million	$1,671.2 million	$1,576.8 million
Gross profit	$374.6 million	$365.6 million	$739.3 million	$725.8 million
Gross margin	44.4%	46.1%	44.2%	46.0%
Operating profit	$159.1 million	$164.7 million	$296.6 million	$334.6 million
Operating margin	18.9%	20.8%	17.7%	21.2%
Net income	$109.8 million	$116.7 million	$225.6 million	$235.3 million
Diluted EPS	$1.38	$1.46	$2.84	$2.93

Q2 reported sales increased 6%; currency-neutral sales increased 8%. Acquisitions contributed approximately 6 percentage points of growth.
Six-month sales increased 6% on a reported basis and 7% on a currency-neutral basis; acquisitions contributed approximately 5 percentage points.
Flavors Q2 sales increased 9% reported and 11% currency-neutral, while Fragrances increased 4% and 5%, respectively. Q2 Flavors segment profit increased to $100.3 million, while Fragrances segment profit declined to $84.9 million.
Operating profit and net income declined despite sales growth, primarily because of lower gross margins, higher acquisition-related and unusual costs, unfavorable price-versus-input-cost effects, and higher interest expense.
Reported Q2 adjusted operating profit was $171.8 million, with a 20.4% adjusted operating margin versus $165.7 million and 20.9% in the prior-year quarter. Six-month adjusted operating profit was $335.3 million; the filing reports a 20.1% adjusted operating margin versus 21.1%.

Cash flow, liquidity and capital structure

Six-month operating cash flow was $57.9 million versus $172.3 million in 2016, or 7.0% versus 22.0% of sales. The decline primarily reflected the $56 million ZoomEssence litigation settlement, lower net income and higher incentive compensation payments.
Investing cash outflow was $232.0 million, including approximately $191.3 million of acquisition spending and $46.2 million of capital expenditures.
Financing cash inflow was $343.6 million, including proceeds from the May 2017 issuance of $500 million face amount of 4.375% senior notes due 2047.
Cash and cash equivalents were $491.4 million at June 30, 2017, including $198.5 million held outside the United States. No commercial paper was outstanding.
Total debt was $1.894 billion, compared with $1.325 billion at December 31, 2016. Net debt was $1.402 billion and covenant net debt to adjusted EBITDA was 1.83 to 1, below the 3.5 to 1 covenant limit.
Revolving credit facility availability was $921.6 million, with $28.4 million drawn. Management stated that cash flows and available credit are sufficient for investing and financing needs for at least the next 18 months.
Capital expenditures are expected to be approximately 4.5% to 5.0% of 2017 sales. The company paid $101.2 million in dividends and repurchased $53.2 million of stock during the first six months.

Material changes and unusual items

IFF acquired Fragrance Resources in January 2017 for approximately $150.5 million and PowderPure in April 2017 for approximately $55 million. Both purchase price allocations remained preliminary, and neither acquisition was considered material to consolidated earnings.
The company launched a multi-year productivity program. It expects cumulative pre-tax cash charges of $30 million to $35 million, potentially up to $5 million of accelerated depreciation, workforce reductions of approximately 370 positions, and annual run-rate savings of $40 million to $45 million by 2019. Six-month charges were $13.2 million.
Q2 included $3.5 million of estimated incremental costs and customer reimbursement obligations related to an FDA-mandated product recall. Total recorded charges for the related product claim were approximately $5.3 million through June 30, and additional losses were probable but not estimable.
IFF paid $56 million to settle all ZoomEssence claims and counterclaims; it recorded an additional $1 million charge. The case was dismissed with prejudice on July 5, 2017.
Six-month results included a $12.2 million foreign-currency translation gain from liquidation of a foreign entity and a $5.3 million tax assessment related to prior periods.
The effective tax rate decreased to 22.7% in Q2 from 23.2% and to 19.6% for the first six months from 23.3%, reflecting earnings mix, certain non-taxable foreign-currency gains, the global supply-chain hub and the tax effect of stock compensation accounting changes.
Gross margin pressure reflected unfavorable pricing versus input costs, manufacturing performance and mix. Management expected higher 2017 costs for certain raw materials, including vanilla, citrus and oil-based derivatives.

Outlook and principal risks

Management focused on productivity, cost reduction, operational performance, mix improvement and integration of acquired businesses; no specific consolidated revenue or earnings guidance was provided in the filing.
Key risks include raw-material price and availability volatility, foreign-exchange movements, customer claims and product recalls, acquisition integration and realization of synergies, supply-chain disruption, emerging-market conditions, competition, regulatory and environmental matters, tax disputes, pension obligations and information-security risks.
IFF reported potential accelerated depreciation of up to $25 million related to possible relocation or closure of its Zhejiang and Guangzhou, China facilities. The Guangzhou plant had a June 30 net book value of approximately $67 million; the Zhejiang plant had a net book value of approximately $25 million.
Bank guarantees and standby letters of credit totaled approximately $37.1 million. The company estimated reasonably possible third-party contingency losses above accrued liabilities at $0 to approximately $8 million, excluding uncertainties for which losses were not estimable.
Environmental liabilities for eight third-party sites were estimated at less than $5 million, although management noted that future events could increase the amount.

Investor verification points

Verify the sustainability of sales growth excluding acquisitions and the recovery of Fragrances segment margins.
Track gross-margin recovery against raw-material inflation, pricing, mix and productivity savings.
Reconcile GAAP results with management’s adjusted measures and separately assess the recurring nature of excluded costs.
Monitor productivity-program charges, workforce reductions and whether the $40 million to $45 million annual savings target is achieved by 2019.
Assess leverage, refinancing requirements and interest expense following the $500 million long-term debt issuance.
Follow the FDA recall claim, potential reimbursement from insurance or the supplier, and any further litigation costs.
Evaluate outcomes of the China facility zoning and relocation discussions, including potential impairment or accelerated depreciation.
Review preliminary purchase price allocations and goodwill and intangible-asset balances related to the 2017 acquisitions.