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Tate & Lyle – 24th March 2014


Company Overview:

Tate and Lyle has been one of the world’s leading specialty food ingredient providers since it was formed through a merger of Henry Tate & Sons and Lyle’s Golden Syrup in 1921. The company discovered Sucralose (SPLENDA Sucralose) during the 1970s and later disposed of its sugar business in order to focus on maintaining its position as the world’s dominant force in artificial sweeteners and specialty food ingredients.

Index  FTSE 250 Ticker TATE.L Latest Close 650.00
52 Week High 889.00 52 Week Low 618.00 P/E 11.40
Dividend Yield % 4.1 Dividend Cover 2.2 CEO: Javed Ahmed
CFO: Tim Lodge

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Healthy Living and Demand for Sugar Alternatives Driving Shareholder Returns

Tate and Lyle operates a diverse business with revenues split between the supply of bulk ingredients and the development, then sale of specialty food ingredients. The specialty foods division is the main focus of the business as it contributes the larger portion of earnings while offering greater growth prospects.

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Although specialty foods is split across a range of products, it is the no calorie sweetener business of SPLENDA Sucralose that provides the greatest portion of company earnings. Comprising just 6% of overall sales volume, the business line produces 15% of overall earnings due to high margins attached to the product.

In addition to a proliferation of governmental campaigns against obesity, the current trend toward healthier diets in general within developed markets has created a generation of calorie conscious consumers. These consumers, along with government and lobbyists, have driven growth in both artificial and natural alternatives to sugar, changing the way that many foods and beverages are produced.

After discovering Sucralose in the 1970s, Tate and Lyle has since enjoyed total dominance over the rapidly growing market for sugar alternatives. This has helped the company to maintain double digit margins over an extended period of time and, as a result, continue to deliver healthy returns to shareholders.

However, a number of patent expirations in 2006 and 2009 have seen Chinese manufacturers aggressively pursue the development of generic substitutes, leading investors to fear that T&L will someday lose its crown to competition.

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Dovish trading update places Tate and Lyle under pressure; down but not quite out

The nine months since the announcement of 2012 full year results have not been kind to Tate and Lyle. The period has seen the company’s margins come under further pressure from Asian competitors amidst lower sales volumes in its North American beverages business due to a mild summer in the US.

This saw a profits warning in February followed by a 17% decline in share price, and relegation from the FTSE 100. The company’s most recent closing price sees the shares changing hands at a 26% discount to the all-time high reached in July of 2013.

Despite soured sentiment toward the stock, our view offers an alternative perspective on the road ahead for the world’s leading producer of artificial sweeteners and specialty food ingredients.

Tate and Lyle Daily Chart

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Competitive Advantage and the Competitive Environment for Tate and Lyle

Despite growing competition, Tate and Lyle remain the industry leader in Sucralose production processes and technology. Decades of experience in lab manufacturing and technology development place the company firmly ahead of all of its competitors when it comes to producing large volumes of high quality additives and specialty ingredients.

The greatest competitive risk to Tate is that some existing competitors do have the power to create further pressure upon margins by driving prices lower. Having said this, production costs for Tate are far lower than those of its competitors and capacity for production is also higher.

In addition to this, the T&L balance sheet is thought to be significantly stronger than those of  its smaller rivals where a lack of production capacity continues to compromise scalability and has had the effect of driving up costs, threatening quality and thus creating a weight around the ankles of what are still young businesses. As a result, it will be hard for these competitors to secure any meaningful victory through price competition.

The above, along with the costs of R&D, keep the bar for new entrants into the industry high. This is while T&L’s balance sheet and experience R&D innovation enable it to continue pioneering new products and practices. For these reasons, the threat of substitutes for core products that have not been engineered by T & L remains low – moderate.

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The Supply & Demand Dynamics Giving T & L a Headache and an Overview of Sucralose Prices Going Forward  

T & L has warned for some time of the potential for significantly weaker Sucralose prices over the course of 2014/15. This dovishness follows a fall of 25% in wholesale prices from their peak during 2012. It is worthy of note that 2012 price strength came as a result of growing demand and under supply derived from the lack of production capacity (at the time) in China.

This has led to an influx of new entrants into the industry which Tate and Lyle believe will now drive down Sucralose prices. Despite the increase in the number of market participants, industry observers have questioned the production capacity and profitability of these newcomers.

An important question to ask here is, should the new market dynamics of increasing competition create a sustained period of lower selling prices, will these younger and less profitable competitors be able to withstand this?

If the answer is no, then the generic Sucralose industry in China could potentially undergo a period of consolidation which will be likely to constrict supply once again. Given that T & L has already shown an appetite for a greater physical presence in Asia, takeover attempts by the company cannot be ruled out.

This is while M&A among some Chinese generic producers themselves also remains a possibility. Given the growth prospects for the product area, the idea will be attractive to some, and for the sake of survival it could become a necessity.

For the time being, and fortunate for some, droughts and poor weather conditions in many major sugarcane producing countries have lead commodity analysts to predict a disappointing crop for 2014. This is likely to drive global sugar prices higher over the year ahead and could potentially improve demand for close substitutes such as Sucralose. Each of the above scenarios would be both demand and price positive for Tate and Lyle.

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Management on the Offensive with Acquisitions in China and Expansion in Japan

The 2013 year has also seen Tate and Lyle expand its Asia pacific exposure, with a new office in Tokyo intended to place the company’s R&D expertise within reach of Japanese food and beverage developers.

In addition to this, and a further sign of what may be in store for Chinese competitors, Tate made an incursion into mainland China during the year. This was with the acquisition of Winway Biotechnology, a polydextrose fibre business which will help the company to build up its specialty food ingredients business in Asia.

The buyout also adds further diversification to T & L’s Asia product portfolio, reducing its reliance upon Sucralose margins and providing exposure to what is expected to be a big growth area.

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Balance Sheet Management Continues to Improve While Valuation Remains Attractive

Tate and Lyle currently trades on a multiple of 11.4 x earnings which is a significant discount to the average of 16.2 for the UK Consumer Defensive Sector. This could be both a sign of investor discomfort over the relatively high degree of debt that has been attached to the company balance sheet for some time, as well as an indication of market concerns over the growing threat from competition to Tate’s dominance within the specialty foods industry.

However, over recent quarters T & L has showcased an ability to consistently and considerably reduce net debt, resulting in greater liquidity and improved financial strength. This is while management continue to expect strong growth across Specialty Foods over 2014 and 2015, despite competition.

As a result, and on a P/E basis, it is likely that the valuation will return toward its industry average over time. This is while shareholders continue to benefit from management’s ongoing commitment to a progressive dividend policy which has seen the pay-out increase by an average of 7.5% per year over the past five years.

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Risks

The primary risks facing investors in T & L shares centre around the potential for weaker prices in the specialty foods division and, as a result, narrower margins which could drive more investors away from the stock and exacerbate the recent sell off.

In addition to this, there are secondary risks which emerge from the potential for consolidation within the Chinese Sucralose market. Although this would be positive for price dynamics in the shorter term, a stronger competitive entity in Asia could increase the threat to Tate’s market share on a global scale.

Tate and Lyle (TATE.L) Hourly Chart

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Summary

In summary, Tate and Lyle remains a leader in development and production across the specialty foods spectrum. With ever growing volatility in global crop yields set to underpin demand for viable substitutes to traditional ingredients and flavours, T & L continues to hold an enviable position within what remains a high growth market.

In addition to this, the company has the benefit of decades’ worth of experience in product development and technology design. With a strong balance sheet supported by robust and improving cash flows, a fast reducing debt pile and an experienced management team, Tate and Lyle have all of the tools necessary for them to defend and grow their market share.

Although the risks attached to the stock cannot be completely discounted, our view is that the market’s reaction to a recent profits warning and the evolving competitive environment indicates that investors have overlooked the bigger picture surrounding the company.

Our outlook for the stock sees strong support for shares at the current level of 650.00 pence. This is while our medium term price target sees the stock trading back at previous highs, in the region of 820.00 pence.

The next event of significance for TATE.L is a trading update scheduled for release on 04 April 2014. This is followed by full year results on 29 May 2014.

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