Ingredion Has the Recipe for Growth

The investment case is built on specialty ingredients’ growing share (26% of sales) at the expense of low-value-added, or core, ingredients (74% of sales), which are barely growing and are much less profitable. We think the specialty segment has an operating margin of 30% and generates 47% of EBIT, while the core segment has an 11.5% margin and generates 53% of EBIT. By 2020, we expect specialty will generate 32% of sales and 54% of operating profit, accounting for three fourths of the increase in Ingredion’s operating profit over 2016-20. Because Ingredion’s acquisition strategy is focused on expanding the specialty segment, specialty’s share of sales and profit is likely to be higher than that achievable from organic growth alone.

Ingredion has a high exposure to developing markets, where it generates an estimated 45% of sales. Much of its future growth is expected to come from these markets. It is the leader in South America, with strong positions built up in Brazil, Argentina, and Colombia over decades. Ingredion is a leader in texturants--its specialty--and is renowned for starches.

Management has a good record, particularly relating to mergers and acquisitions. The company has made numerous tuck-in acquisitions and in 2010 purchased National Starch. This increased the weight of starch-based ingredients, gave Ingredion exposure to Europe for the first time, and was a highly earnings- and value-enhancing acquisition.

Ingredion is a high-quality play in ingredients, despite being more commodified. The market may not be taking into account that its bulk business is not declining, its operating margins and returns on invested capital are respectable, and it is creating shareholder value overall, with returns on invested capital well in excess of the weighted average cost of capital.

Business Lacks Switching Costs We don't believe Ingredion has an economic moat. The company's ingredients business can be split into two parts: core and specialty ingredients. Core ingredients are the low-margin, barely growing bulk ingredients that are more standardized, have no pricing power, and don't carry any characteristics worthy of a moat, lacking switching costs and intangible assets, such as the use of proprietary technology. For instance, there is no research and development spending on core ingredients. While core ingredients customers' focus is on quality and reliability--they don't want to risk the quality of their products or be out of stock because of a supply problem--these are not factors that amount to switching costs, as alternative suppliers are also focused on these criteria, which are not exclusive to Ingredion.

The specialty business is less standardized, as the products are formulated with the customer in mind. Ingredion can partner with its clients to develop new formulations and applications for their products, so there is an element of customization in specialty ingredients. This definition falls somewhat short of amounting to switching costs: The cost of the ingredients is a very small part of a client’s cost of production, and Ingredion cannot charge a premium for its specialty products because the market is sufficiently competitive to prevent this. Nonetheless, switching rarely happens, especially on the basis of price, and it is cumbersome for clients to do so, given the knock-on effects on logistics.

In terms of intangible assets, R&D spending is 3% of the specialty division’s sales, the same percentage as that for Tate & Lyle TATE, and there does not appear to be extensive use of proprietary technology; while Ingredion has some 900 patents, none of them are material to the business. This means that despite customization, specialty ingredients can be closely replicated by another supplier, diminishing the extent of switching costs.

As usual in the ingredients industry, branding is either nonexistent or, where present, has limited relevance. There is increasing regulation of the food and beverage industry, but this is mainly driving increased demand for ingredients, especially sweeteners (to replace sugar). It is not conferring any pricing power on Ingredion, nor is it erecting significant barriers to entry to the industry.

A further argument against awarding Ingredion a moat relates to the fickle nature of the sweetener industry, particularly sugar-replacement products and high-intensity sweeteners. Ingredion’s sweeteners (syrups, dextrose, and polyols) account for 40% of sales, so the firm has a significant exposure. We believe the business has low barriers to entry, is prone to the potentially disruptive effects of groundbreaking product innovation that can render established sweeteners redundant, and is subject to the vagaries of consumer tastes, which can evolve rapidly. The growing use of plant-derived Stevia for sweetening beverages and the rapid demise of sucralose’s profitability (to which Ingredion is not exposed, but Tate & Lyle is) highlight the unpredictability of the sweetener business. Furthermore, customer demand is moving toward natural sweeteners and away from artificial sweeteners, which are the mainstay of Ingredion’s sweetener business.

Main Risks Are Geopolitical, Operational, and Economic Ingredion has a high exposure (an estimated 45% of sales) to emerging markets, where economic performance and currencies are typically volatile and governments can be unstable and prone to regulation, including price controls, all to Ingredion's detriment. South America accounts for 18% of sales, which amounts to significant exposure.

There are inherent operating risks in the business, notably the unpredictable nature of the sweeteners business (40% of sales), where barriers to entry are low, demand patterns are evolving rapidly, and there is a high risk of a major disruptive technology arising to destabilize the businesses of established players, potentially displacing established sweeteners. Additionally, changes in sugar prices can influence demand for sweetener products, as they are a sugar substitute.

Ingredion has a moderate exposure (about 10% of sales) to high-fructose corn syrup, whose sales are on a declining trend. This syrup is mostly used as a sweetener for carbonated soft drinks and has been associated with obesity and diabetes. Furthermore, the sweetener industry is moving increasingly in the direction of natural sweeteners, to which Ingredion is not highly exposed.

Unpredictable swings in consumer trends can cause shifts in demand from customers for different types of ingredients, which can cause customers to substitute one type for another. The existing supplier might not be competent in manufacturing the new requested ingredient and could therefore lose the contract.

Energy costs are significant, amounting to 11% of finished product costs, so a steep jump in energy costs could negatively affect profit margins. Likewise, there is no guarantee that a jump in corn costs, the major raw material that Ingredion processes to manufacture ingredients, can easily be passed on to customers in a timely manner.

Ingredion has been quite generous with the dividend payment, as it targets a payout ratio of 25%-30%, but has paid out slightly more than this in each of the past three years. The dividend payment absorbs less than 20% of operating cash flow. Aside from the transformational 2010 acquisition of National Starch, Ingredion has not been particularly acquisitive; only occasionally has it made small, tuck-in acquisitions. Its policy is to buy back shares as an additional means of returning cash to shareholders when there are no planned major acquisitions. This was the case in 2013 and 2014, when share buybacks accelerated to 4.4% and 4.9% of share capital, respectively.