Ingredion Benefits From Improving Product Mix

The company classifies its products as either core or specialty ingredients, with core ingredients generating roughly 70% of companywide sales (as reported) and just below 50% of profits (based on our estimates). Core ingredients are typically commodity-grade, providing no pricing power for Ingredion. Ingredion sells roughly half of its core sales on a cost-plus basis. Specialty ingredients are value-added, requiring additional processing and, in many cases, proprietary formulations. They typically command twice the gross margins and enjoy twice the sales growth of core ingredients. Although we expect demand for Ingredion’s core ingredients to grow roughly in line with GDP in the regions where they are sold, specialty ingredient volume should grow in the mid- to high single digits.

Ingredion has a multinational footprint, reporting via four geographic segments: North America (60% of sales); South America (17%); Asia-Pacific (13%); and Europe, the Middle East, and Africa (10%). Raw materials account for roughly half of the company’s unit costs. Corn, which is purchased around the world at market prices, represents the company’s single-largest expense. Accordingly, Ingredion actively hedges against corn price fluctuations in North America, which helps stabilize gross margins for the segment. Regardless, changes in corn prices can materially affect margins in its other segments. This is reflected by recent results, as a sharp rise in corn prices weighed on profitability from 2009 to 2012 before a subsequent decline drove margin expansion in the following years. We forecast that corn prices will settle at roughly $4.40 per bushel in a midcycle environment, which is more than 15% above the current price.

Specialty Business Drives Narrow Moat The most appropriate lens through which to analyze Ingredion's competitive advantage is our moat framework for commodity processors. Moaty businesses that operate in this space tend to benefit from switching costs, intangible assets, or cost advantage. For Ingredion, we see evidence of switching costs and intangible assets, but not cost advantage. Slightly more than 70% of companywide sales involve the processing of raw materials (corn, tapioca, potatoes, rice) purchased at market prices into commodity-grade starch and sweetener ingredients over which Ingredion commands no pricing power. We view this core ingredients business as having no moat. With roughly half of its sales priced on a cost-plus basis, the core ingredients business should generally deliver returns on invested capital in line with the company's weighted average cost of capital.

We believe Ingredion’s specialty ingredients business operates with a narrow moat and earns excess ROICs. As a result, it has served as the key driver of the positive economic profit spread witnessed on a companywide basis each year over the past decade. The evidence for switching costs and intangible assets stems predominantly from Ingredion’s specialty ingredients business, which accounts for slightly less than 30% of Ingredion’s sales and just over half of its profits. These solutions include an array of proprietary offerings that align with growing market and consumer trends. Switching costs stem from the fact that when these proprietary formulations are used by consumer packaged goods customers for food and beverages, buyers are often unwilling to jeopardize the brand equity of their products by switching to alternative solutions that consumers might reject. Often, specialty solutions are formulated with specific customer needs in mind, as Ingredion partners with its customers to develop new formulations and applications for their products. With the consumables space subject to a high degree of regulatory oversight, we see traces of switching costs for even the company’s commodity-grade ingredients. Customers are often hesitant to switch away from suppliers like Ingredion that have established a lengthy record of quality and reliability with regard to food safety compliance.

Intangible assets stem from the research and development spending required for these specialty ingredients, which establishes intellectual property that protects them from replication. The company has more than 850 product-related patents and patents pending, in addition to a number of established trademarks. Although no individual patent or trademark is material to the business, we believe they are valuable in aggregate as they make the company’s offerings more difficult to replicate. Ingredion expects that demand for its specialty ingredients will continue to grow more than twice the rate of its commodity ingredients. Specialty margins are also more than twice as high as commodity margins, as Ingredion commands more favorable pricing power for its specialty products. Accordingly, the proportion of companywide sales from specialty ingredients has been rising slowly but steadily, reaching 28% in 2017 from only 21% as recently as 2013.

For wide-moat flavor and fragrance companies, research and development spending as a percentage of sales typically exceeds 8%. For Ingredion’s specialty ingredients business, R&D accounts for 3% of sales, indicating that although intangible assets are present, they are not as strong as those of moatier operators. For Ingredion’s commodity-grade operations, the wet milling process by which raw materials are processed into starches and sweeteners provides few inroads for differentiation, preventing the company from establishing a cost advantage over peers. Although commodity ingredient processing has historically served as the company’s core function, this will continue to change over the foreseeable future as Ingredion makes incremental investments in expanding its specialty volume, both organically and via acquisition.

Given the scale of Ingredion’s commodity operations, the qualitative evidence for a companywide moat is arguable. However, the quantitative evidence is strong. Ingredion’s ROICs have consistently exceeded the company’s weighted average cost of capital in recent years. Based on our calculations, ROICs have averaged 11.5% over the trailing 10-year period, safely above our assumed 8.2% WACC. Due primarily to an improving product mix driving very modest margin expansion, our midcycle ROIC forecast sits slightly above 12%, and we feel confident that economic profits will persist at least 10 years into the future. Although corn prices, Ingredion’s key input cost, can fluctuate significantly, half of Ingredion’s core sales are priced on a cost-plus basis, which essentially locks in returns roughly in line with the company’s cost of capital. For the remaining half of core sales, the company’s active hedging strategy should help minimize ROIC volatility in the years to come. As evidence of the stability of its business, Ingredion generated positive economic profits during both the financial crisis and the North American corn drought of 2012.

Stable Cash Flows Reduce Risk We assign a medium fair value uncertainty rating to Ingredion. The company's cash flows are generally quite stable, revenue cyclicality is low, and financial leverage is manageable. Ingredion's consistent free cash flow generation should allow the company to sustain its strong financial condition and capitalize on value-accretive, tuck-in merger and acquisition opportunities when they arise.

Corn input costs represent a significant source of uncertainty for Ingredion; the company’s hedging efforts are focused largely on its North American corn purchases and corn prices have been highly volatile in recent years. For example, a significant drought in North America could prove highly problematic. Although corn could be sourced abroad, the associated incremental transportation costs would probably weigh on profitability. Cash flows could also be heavily affected by geopolitical instability, particularly given Ingredion’s market leadership in Pakistan as well as its exposure to Korea and various South American economies. Although its significant exposure to developing economies should more often than not drive attractive volume growth, GDP growth in these regions can fluctuate meaningfully from year to year. The company has plants in more than 40 countries.

Regardless, sales and profits have been relatively steady in recent years, and the company’s raw material hedging strategy and cost-plus contracts for its nonspecialty core products help to reduce earnings volatility. These dynamics improve our conviction in forecasting future cash flows. Even in the wake of the financial crisis and the North American corn drought in 2012, operating margins remained in the high single digits.

The company has exhibited prudent capital allocation and wise decisions regarding mergers and acquisitions, avoiding value destruction and favoring strong value creation. Management has been friendly to shareholders in recent years thanks to a careful balance of dividend growth and share buybacks. The company targets a dividend payout ratio of 25%-30% and should have no problem maintaining this.