International Flavors & Fragrances: More Asset Sales May Be Inevitable (NYSE:IFF)

International Flavors & Fragrances (NYSE:IFF) borrowed and overpaid for ill-timed acquisitions. The company is now using asset sales to pay down debt and prop up its balance sheet. The stock offers a good dividend for income seekers, but dividend growth may be limited for the next few years. A discounted cash flow model estimates the company may be overvalued by 24%. Investors should revisit the stock when it sells off to $90.

The company needs to grow organically

In Q3 2022, the company saw its sales decline by 17% in its health and biosciences unit (Exhibit 1). But, Nourish, Scent, and Pharma Solutions saw sales increase. Pharma Solutions was the best performer, with sales surging 22% compared to the previous year on a GAAP basis. This segment’s non-GAAP operating EBITDA surged 73% compared to last year. In Q2 2022, the company saw good sales growth in the mid-to-high single digits across all its segments (Exhibit 2). But these statistics are not organic growth numbers.

Exhibit 1:

Exhibit 2:

The company had good gross margins, averaging 41.6% over the past decade (Exhibit 3:). But inflation has taken its toll over the past two years, with gross margins dropping below 40%. Since the quarter-ending March 2020, the company’s quarterly gross margins have averaged 36.4% (Exhibit 4), a difference of 520 basis points compared to its average over the past decade.

Exhibit 3:

Exhibit 4:

Operating margins have nosedived from an average of 17.2% over the past decade to 8.6% for the quarter ending September 2022 (Exhibit 4). Even after massive price increases to counter the effects of inflation, the company’s non-GAAP operating EBITDA declined in Q3 2022 compared to the same quarter in 2021.

Debt is a concern, but the company is focused on deleveraging

International Flavors and Fragrances has grown using an acquisition-driven strategy. For instance, the company paid $7.1 billion to acquire Frutarom in May 2018. The company paid $106.25 per share for Frutarom, of which $71.19 was paid in cash. About 67% of the $7.1 billion acquisition was paid in cash. Due to this acquisition, the company’s long-term debt went from $1.6 billion to $4.5 billion. Frutarom was valued at 20.3x 2018 EBITDA at the time of the acquisition, in retrospect, a very high premium.

In December 2019, the company merged with Dupont’s Nutrition and Biosciences unit in a transaction valued at $26.2 billion. This merger transaction was executed at an 18x EBITDA multiple. The company’s net debt to EBITDA ratio increased to 4.

In December 2022, the company sold its Savory Solutions Group at 14x EBITDA. Given the rise in interest rates, it is reasonable to expect that valuation multiples have dropped since the acquisition of Frutarom. It was easy to pay a premium when interest rates were low, but the company is now saddled with high debt and is selling business units to raise cash and pay down its debt. The company raised $900 million via its sale of the Savory Solutions Group.

Both Frutarom and Dupont sold their assets at or near peak valuations. But, International Flavors and Fragrances sells assets when valuations have reset lower. The company has now officially acknowledged that it overpaid for its acquisitions by taking a goodwill write-off of $2.25 billion in Q3 2022 in its Health & Biosciences unit.

At the end of the September 2022 quarter, the company had $10.2 billion in net debt (Exhibit 5). The proceeds from its Savory Solutions group’s sale should drop below $10 billion for the first time since the end of 2020.

Exhibit 5:

The company has a manageable amount of debt coming due each year (Exhibit 6), assuming it can generate enough cash flow from operations. For instance, the company has $1.7 billion in debt coming due by 2025. But, the company is currently constrained by high inventory costs that have reduced its operating cash flows. The company generated $1.4 billion in operational cash flow in 2021 and just $500 million over the trailing twelve months.

Exhibit 6:

The company paid $805 million in dividends over the past twelve months. The stock yields 2.9% with a five-year average dividend payout ratio of 50%. The yield is less than the 2-year U.S. Treasury yield of 4.2%. The company has increased its dividend by 4% on average over the past five years, while the sector median is 6.6%. Given the current poor cash flow generation capacity of the business, the company may have to resort to further asset sales to bolster its balance sheet and pay down debt while maintaining its dividends. The current state of the business may also limit dividend increases.

High inventory reduces operating cash flows

The company’s carrying cost of inventory has increased over the past year. The company now holds over $3 billion in inventory and about 136 days’ worth of sales. International Flavors & Fragrances has always carried a high inventory compared to its sales, with an average days’ worth of sales of 130 and a standard deviation of 16.

Exhibit 7:

It will not come as a surprise if the company looks to reduce its working capital requirements by reducing its inventory. Given the debt reduction efforts the company has embarked on, optimizing its working capital is most likely a top priority for the company looking for cost savings.

The increase in inventory cost is the primary reason behind the decline in operating cash flows. In the September 2022 quarter, the company reported $289 million in operating cash flow. The positive contributor to this cash flow was the asset write-down (loss in goodwill) and restructuring costs of $2.2 billion and a gain in net operating assets of $208 million. The company had negative operating cash flows in March and June of 2022 due to increased inventories and decreased net assets.

High-interest rates and debt have lowered the company’s valuation

The company is trading at a forward EV to EBITDA multiple of 15x, compared to its five-year average multiple of 16x. The company is currently trading at $111.85, overvalued by 24%. But, the interest rate increase has reduced the valuations of companies with poor cash flow generation and high debt. A discounted cash flow model, with an optimistic growth estimate of 5%, a free cash flow margin of 10%, and a discount rate of 9%, yields an equity value of $89.85 per share.

Exhibit 8:

The company may be overvalued given its limited growth potential, poor cash flow generation, and high debt. The company took a massive goodwill impairment charge of over $2 billion, suggesting that it not only overpaid for its acquisition, but its valuation may have dropped due to an increase in interest rates and softening of demand. The company recently got just 14x EBITDA when it sold one of its units. It offers a good dividend, but dividend income seekers should prepare for a few years of low growth in dividends. Investors looking to buy should revisit the stock when it drops to $90.