Morningstar | IFF's Fragrances Margins Continue to Diverge From Flavors Margins in 2Q; Frutarom Closure in Sight
IFF issued mixed second-quarter results, characterized by continued solid profits from the flavors segment but soft results from the fragrances segment. Having updated our valuation model, both our near- and long-term forecasts are effectively unchanged. Our fair value estimate rises to $138 per share from $137 on time value of money effects. IFF's wide moat rating remains intact and represents an exceedingly rare designation across our basic materials coverage.Although operating margins in the fragrances segment have historically trailed flavors margins by 2%-4%, this spread expanded to roughly 7% in the second quarter. This was driven, in part, by inflated raw material costs stemming from the shutdown of a BASF citral plant that represents a critical node in IFF's fragrance supply chain. Management expects the associated margin headwind to persist in the third quarter but wane by year-end. Meanwhile, flavors operating income grew 13% versus the prior-year period, sustaining strong momentum after an 18% year-on-year increase in the first quarter. Although cost-saving initiatives should help the company achieve slightly higher margins in the coming years, our midcycle 25% operating margin forecast for the flavors business sits only slightly above second-quarter margins of 24.3%.
Aside from the company's second-quarter performance, much of the commentary in the earnings call pertained to the pending Frutarom acquisition. We remain skeptical that the deal will prove value-accretive for IFF shareholders. The $145 million annual synergy target appears lofty given the heterogeneity of Frutarom's product lines as well as its geographically widespread asset base. Frutarom is a serial acquirer, having completed 12 acquisitions in 2017 alone. Although we buy into the notion that Frutarom will modestly improve IFF's growth and margin profiles, the acquisition price still seems high, and integration should prove challenging. Management expects the deal to close by year-end.
International Flavors & Fragrances is a creator and manufacturer of taste, scent and complementary adjacent products, including cosmetic active and natural health ingredients. The company's operating segments are Taste and Scent. The Taste segment develops a range of different flavors and taste offerings for its customers, most of which are tailor-made. The company's Taste business is comprised of various portfolios across flavor compounds, savory solutions, inclusions and nutrition and specialty ingredients. The Scent segment creates fragrance compounds and fragrance ingredients for the household and personal care products. The company also produces cosmetic active and functional ingredients for use in cosmetics.
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