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Morningstar | Trimming Ingredion FVE to $125 on Lower Near-Term Profits; Shares Remain Undervalued

Ingredion reported mixed fourth-quarter results. Soft results from the North America segment, which generates roughly 60% of revenue, were partially offset by higher profits in the Asia-Pacific segment. In its earnings release, management guided to 2019 adjusted EPS of $6.80-7.50, which is lower than our previous forecast because of weaker sweetener prices and reduced corn byproduct sales. As a result, we've reduced our near-term outlook and now forecast 2019 adjusted EPS to come in at just shy of $7 per share. Having updated our forecast to incorporate our lower near-term outlook, we reduce our fair value estimate to $125 per share from $128 for narrow-moat Ingredion.

At current prices, we view Ingredion as undervalued, with shares trading firmly in 4-star territory. Despite the continued near-term headwinds in Ingredion's North American sweetener sales, the market underappreciates the company's long-term growth prospects from its specialty ingredients portfolio. In 2018, 29% of Ingredion's sales came from specialty ingredients, up from 28% in the prior year. This is in line with our long-term outlook that specialty ingredients will grow to a mid-30% proportion of sales over the next five years. Because specialty product sales command margins double those of commodity products, on average, even a small increase in specialty product sales can have an outsize impact on companywide profits. Accordingly, we forecast that operating margins will expand from 13% in 2018 to over 15% by 2023 (midcycle). This implies a 5% CAGR for adjusted operating income over the same time period.

In North America, adjusted operating income declined 18% year on year during the quarter due to lower sweetener volumes and higher transportation costs. Although we expect specialty volumes to grow in 2019, management forecasts flat operating profits as higher specialty profits will be offset by reduced core sweetener profits due to lower corn co-product prices.

Soy meal and soy oil are substitutes for certain corn co-products, which are left over from the wet milling process. Excess soybean inventories in the U.S. from the trade conflict with China have led to a greater U.S. supply of the soy-based products. As a result, prices for the corn co-products have declined. This leads to higher average costs for corn processors such as Ingredion, as there are lower byproduct sales to offset to the purchase price of corn. While Ingredion is typically able to pass on cost increases to its customers, management stated that the company will be unable to fully pass on the co-product-based cost increases for its core sweetener products. As such, Ingredion will realize lower margins for its North American sweeteners in 2019.

To counter the continued secular decline in corn-based sweetener products, we are in favor of management's investments to grow its exposure to specialty product lines, including plant proteins and natural sweeteners. Capital allocation towards specialty product development will better align the company's portfolio with changing consumer food preferences.