Given the continuing weakness of the British pound sterling against major currencies such as the euro and the U.S. dollar since the U.K.'s EU referendum in June 2016, we are upgrading our earnings forecasts and fair value estimate for Tate & Lyle. Our new fair value estimate is £5.90 per share, up 7%, but shares remain overvalued at current levels.
Our no-moat and stable moat trend ratings are unchanged. While Tate & Lyle is domiciled in the United Kingdom, the company generates only 1% of its sales in the country, versus a dominant 69% of sales in the United States. The company generates a further 9% of sales in other European countries. Thus, the weakness of the British pound relative to most currencies has a significant impact on our forecast. We think most of the U.S. dollar exposure is translational.
Investment Thesis
Tate & Lyle is a play on secular growth trends such as the increasing use of ingredients in food and beverage to remove unhealthy components such as sugar, fat, salt, and sodium; reduce the cost of raw materials for manufacturers and increase shelf life of the product; and satisfy the increasing number of formulations being requested by manufacturers. The business is split into speciality which makes up 38% of sales, 64% of earnings before tax, and bulk, making up 62% of sales, 36% of earnings before tax ingredients.
Functionality is the main difference between bulk and speciality ingredients, as the latter provide clients' products with key selling attributes. The company's strategy is to expand its speciality business at the expense of its bulk business. Faster growth of speciality versus bulk is driving a significant mix improvement in margins, which alone is contributing a 19-basis-point annual uplift to the group operating margin.
Bulk ingredients are commodified and in long-term decline because of declining end-user markets, such as carbonated soft drinks and printed materials. All of the company's growth is therefore from specialty ingredients, which are higher-margin and are expected to increase revenue by 6%-7% in the longer term. We expect bulk to see revenue decline 1% annually; this results in T&L having one of the slowest revenue growth rates in the ingredient space. It also has some of the lowest operating margins and returns on invested capital.
The speciality ingredient business includes high-intensity sweeteners, supported by the need to cut calories and replace sugar with sweeteners in food and beverages. The opportunity is substantial as the addressable market in speciality sweeteners is close to £30 billion; T&L's market share is roughly 3%, and sugar still accounts for 80% of all sweeteners. However, the space is competitive and has seen a number of new entrants recently, with T&L's sucralose suffering a significant drop in profitability, while new products like stevia have made inroads into established ones.
