Sensient Technologies Smashed Through Our Price Target. The Company Now Looks Overvalued

There might be two factors contributing to Sensient Technologies' (SXT) share price appreciation. We believe the strong momentum behind the industrial sector is contributing to the bidding up of manufacturing companies as investors are betting on a quick recovery in global consumption once the COVID vaccine is broadly distributed. And secondly, the company is divesting non-core assets to concentrate on its most profitable operating segments and improve profit margins to re-ignite the bottom line.

Sensient is currently up 10% year-to-date and has been on an upward trend since bottoming out in April. Since our first write-up, the company has exceeded our target price of $65 per share by a wide margin. Back then, we believed the company was undervalued, and the market was giving us an opportunity to acquire a good business at an excellent price.

With that said, the tide has quickly turned, and we now believe Sensient is trading in overvalued territory. At 25x forward earnings, the company is trading at historically high P/E multiples, compared to the company's 5-year average earnings multiple of approximately 22x. Sensient would now have to show strong earnings growth in the upcoming quarters to justify such premium valuation. A small hiccup in growth expectations would cause the earnings multiple to contract, which we believe is a major risk. We are changing our view to neutral from bullish.

Strong third-quarter results

Sensient reported third-quarter sales of $323 million, up 1.9% compared to its prior-year period and ahead of the consensus by $20 million.

Since the company has divested two non-core business lines and is in the process of divesting its fragrances business to Symrise, adjusting for these non-core assets, the company reported adjusted revenue of $300 million, an increase of approximately 6.1% in local currency compared to last year's third quarter.

By operating segment, the recently rebranded Flavors and Extracts group (from Flavors and Fragrances) increased sales by 13% in local currency compared to the prior-year quarter and grew profits by 24%, marking its third straight quarter of revenue growth. Within the Flavors and Extracts group, Sensient's Natural Ingredients business had a strong quarter with sales growing by 14.5% driven by strong demand for seasoning, snacks, and packaged foods. Overall operating margins for the Flavors and Extracts group was up 110 basis points during the quarter as operating leverage started to kick in.

While there were some pockets of weakness within the Flavors and Extracts group segment, such as low demand in quick service restaurants, management noted pretty solid overall demand across the board. Importantly, the company saw levels of attrition "way down" coupled with very good win rates last year. With the divestiture of the now 3 non-core assets, management expects more predictability and sustainability in the Flavors segment.

Within the company's Color segment, sales in food and pharmaceutical colors were up 1.9% compared to last year's third quarter but offset by a decrease of approximately 13% in its Personal Care line of business, mostly attributed to weakness in the color makeup market which represents approximately 50% of the Personal Care revenues. That resulted in overall segment sales down 8% during the quarter.

The company continues to anticipate challenges in the cosmetic products market driven by lower demand for makeup and personal care products. That said, management noted an improvement in operating profit margins of 110 basis points this quarter, with sales of $116 million and $23.5 million in operating income, compared to $127 million in sales and $23.4 million in operating income in Q3 of 2019.

The company's Asia Pacific group segment saw a slight increase in sales of 1.6% compared to its prior-year period, but profitability had a significant improvement of 16% with operating margins by 200 basis points in the quarter.

Capital Allocation

Management's main capital allocation priorities concentrate on paying down its debt obligations and sustaining its dividend payments. The company mentioned the possibility of buying back shares absent any M&A opportunities, but given the high earnings multiple it currently trades at, we believe debt repayment should remain management's priority.

The company ended its third quarter with $26.9 million in cash on the balance sheet. For the 9-month period, Sensient has generated approximately $143 million in cash from operations while spending $34 million in CAPEX. Free cash flow has increased by 7% to $109 million compared to the prior 9-month period.

Management has used its cash to pay down approximately $60 million of debt, decreasing its debt-to-EBITDA ratio to 2.6x from 2.9x at the beginning of the year, while using $49.5 million for dividend payments. Sensient has a dividend yield of 2.14%.

What's next

A rebound in makeup color sales should bode well for Sensient moving forward, especially from a profitability point of view. We already saw strong margins in the Color segment by growing 110 basis points considering a drop of 8% in sales. As volumes return to normalized levels, which we believe could take a few more quarters, the operating segment should benefit from operating leverage as more fixed costs get absorbed.

There is no reason to believe makeup products are on a secular downtrend, so is just a matter of time before we see a rebound in that sector. With makeup colors being 50% of sales within the company's personal care business line, incremental increases in sales could have a positive impact on the bottom line:

The majority of our business, more than 50% of that business that we have is makeup. Makeup is still going to be a very good category. I think as restrictions continue to ease and as we potentially find vaccines and other opportunities to suppress this virus, I think we're going to see a very nice return to that business. The dynamics are outstanding in it, and I think we've got a very strong leadership position there to boot. - Q3 call

We touched upon the competitive advantages we see in Sensient's business model in our previous article, but to recap, there are some barriers to entry due to the technical "know-how" and switching cost advantages. Management defines its switching cost advantage as "high impact relative to cost", meaning the highly specialized nature of its products, customized to the customer's specification, relative to the total overall cost of a product, makes switching to different providers highly impractical. That is why we believe Sensient would have no trouble recuperating the lost volumes due to COVID once there is a rebound in the cosmetics market.

The Bottom Line

Trading above its historical P/E range, at 25x forward earnings, we believe the market is already discounting a rebound in the company's end markets.

A high P/E multiple coupled with high market expectations makes way for a risky combination. It would take extremely positive news for the market to assign Sensient a higher multiple, yet slower than expected growth rates would deflate Sensient's current multiple back to its historical range, which is somewhere around 18x earnings. We believe the current risk/reward scenario doesn't benefit the investor. We are changing our view to neutral from bullish.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.