James Faulkner on Tate & Lyle. Shares in a sweet spot?

Tate & Lyle (TATE) recently issued its third profit warning in a year, after it was hit by weak trading at its sweetener business. The company warned that annual profits would be “modestly below” the range of £230 million to £245 million that it forecast in September, and blamed the setback on competition from cheaper Chinese sweeteners and falling sugar prices in Europe.

As a result, the shares are now trading at 588p, down from highs of almost £9 back in 2013. However, at these prices, Tate & Lyle is worthy of further appraisal, not least given that the dividend yield is now around 5%.

The basis of Tate & Lyle’s strategy in recent years has been one of refocusing its efforts away from low-margin commoditised operations, and towards higher-margin speciality food ingredients and product innovation. As part of this new approach, the firm’s famous sugar arm was sold off back in 2010, and the company was reorganised into two global divisions – Speciality Food Ingredients and Bulk Ingredients – supported by Innovation, Commercial Development and Global Operations groups. Essentially, the cash generated by the Bulk Ingredients arm is being used to grow the Speciality Food Ingredients business, via its Innovation department.

This is an important point, as the mix of R&D and marketing employed by Tate actually conveys some very significant competitive advantages in that it is complex, difficult to replicate and protected by patents. This creates barriers to entry and, ultimately, higher profit margins. In particular, the company is focusing on the texturants, sweeteners and health & wellness markets, where it believes it benefits from “deep relevant scientific and technical knowledge; a portfolio of very high quality products with market leading positions; an efficient and scale manufacturing asset base; and long-standing customer relationships with some of the largest global and regional food companies.”

So what does the company have up its sleeve in terms of new and upcoming products that will drive future growth?

The following is an extract from the firm’s interim results dated 6th November 2014:

“We have continued to invest in developing a high quality and robust innovation pipeline. A good example of our innovation expertise was the launch on 30 September of our new CLARIA® line of functional clean-label starches. CLARIA® starches provide food manufacturers with functionality similar to modified food starches but with the benefits of a cleaner colour and a cleaner taste, and a ‘clean label’ (i.e. they label simply as ‘starch’). CLARIA® is just one line in a portfolio of high value products we have been building over the past few years through a combination of in-house innovation, Open Innovation and acquisition, specifically designed to meet our customers’ need for more label-friendly solutions. Our other ingredients in the ‘clean label’ space include SODA-LO® Salt Microspheres, TASTEVA® Stevia Sweetener, PUREFRUIT™ Monk Fruit Extract, PROMITOR® Soluble Gluco Fibre and PromOat® Beta Glucan, all of which are growing strongly. We expect to add more label-friendly and wellness ingredients to our portfolio over time, and expect to launch more new products in the next 12 months.”

This all sounds very impressive, and all the ®s and ™s serve to highlight the point about the barriers to entry the firm is erecting through innovation – but is it working for shareholders?

Well, during the period May 2010 to 31st March 2014, the Speciality Food Ingredients division has delivered average annual volume growth of 5% and compound annual operating profit growth of 7%. Excluding SPLENDA® Sucralose, where an increasingly competitive environment held back growth of the division as a whole, the firm delivered compound annual profit growth of 12% during the same four-year period across the rest of Speciality Food Ingredients.

That’s not bad going, but the performance is clearly being held back by the Bulk Ingredients division. However, there could be an inflection point soon, as Bulk Ingredients now accounts for less than half of group operating profit.

What’s it worth?

The market backdrop also provides a reassuring tailwind for Tate & Lyle. The $42 billion global market for speciality food ingredients continues to grow at around 4-5% annually, according to the company. What’s more, growth is underpinned by long term, structural global consumer trends such as consumer demand for convenience food and growth in packaged food particularly in the emerging markets; a focus on health and wellness in light of the rising incidence of obesity and diabetes worldwide; and an increasing preference for natural, ‘cleaner label’ foods.

Looking to the financials, Tate & Lyle also operates a relatively conservatively managed balance sheet, which suggests its dividend looks supportable. Net debt of £466 million as at 31st December was only slightly higher than FY14’s £349 million adjusted operating profit, interest costs were covered almost 13x by adjusted operating profit in FY14, and the total dividend was twice covered by earnings per share. All told, recent troubles seem to be reflected in the price, which leaves decent potential for long-term upside.