It's Not All Sweetness for Splenda


By Beth Carney For a slow-growth maker of sugar and starch whose roots go back to the mid-19th century, Britain's Tate & Lyle was an unexpected success story in 2004. It started off last year warning that due to rising raw materials costs it wouldn't meet profit forecasts. But by November it boasted a 9% jump in profits in the prior six months. And by yearend, Tate & Lyle's stock price was at $8.86 on the London stock change, a jump of nearly 50% from $5.94 when 2004 began. It was recently readmitted into the blue chip FTSE 100-stock index after being out for seven years.

The reason for Tate & Lyle's turnaround? The newfound popularity of sucralose, a sweetener it manufactures that's used as an ingredient in low-calorie products and sold in tabletop form under the name Splenda. While sales of the sweetener, which was approved in the U.S. in 1998, seem set to grow worldwide for years to come, that doesn't mean shares of Tate & Lyle, (which has a thinly traded American depositary receipt [ADR] that trades over-the-counter in the U.S. with the symbol TATYY), will continue to soar in 2005. Analysts who cover the sugarmaker warn some potential bitterness may be ahead.

The reasons have nothing to do with sucralose's popularity. Indeed, Splenda is gaining market share over other tabletop sweeteners. Its sales have grown 126% in the past two years while rival sugar substitutes have declined by 8%, according to research firm Mintel International Group. The sweetener is also being used as an additive in a growing number of packaged foods.

A CLEAR WINNER. Unlike artificial sweeteners like aspartame, sucralose retains its taste after being heated, which means it can be used as an ingredient in products that are baked and pasteurized. It was used in 1,436 new products worldwide in 2004, up from 573 in 2003 and 35 when research firm Datamonitor started tracking it in 1999. Sucralose "was one of the major trends for the last year," says Tom Vierhile, executive editor of Datamonitor's new-product database Productscan Online.

In an era of heightened concern over obesity and devotion to low-carb eating, sucralose has been a clear winner. And Tate & Lyle is its sole manufacturer, thanks to an agreement arranged last February with its longstanding partner in the sucralose business, Johnson & Johnson's (JNJ) McNeil Nutritionals, which markets Splenda in the U.S.

In the six months ended in September, Tate & Lyle booked $46 million of profits on $113 million of Splenda sales in the U.S., by far its biggest current market for the product. Tate & Lyle's total worldwide sales of all its products, including sugar and starch, for that time were $3.11 billion, up from $3.10 billion in the same period in 2003. Profit before tax, amortization, and exceptional items was $243 million, up from $222 million in 2003.

Without Splenda, its 9% profit increase would have been a 10% profit decline, according to analysts at Citigroup. "They quite clearly are making hay at the moment," says Charlie Mills, analyst at Credit Suisse First Boston.

CAPACITY BOTTLENECK. That doesn't mean the profit growth and stock gains will continue for long, however. Despite sucralose's popularity, Tate & Lyle faces several major hurdles that could trip it up in 2005, warn analysts.

The most immediate problem: Tate & Lyle can't produce enough sucralose to meet demand. In November, it announced that it wouldn't be taking on new customers until it had increased its production capacity. Tate & Lyle is spending $75 million to double capacity in its single existing sucralose manufacturing plant in Alabama by 2006. It's also building a new $175 million factory in Singapore that will be ready in 2007. Until those plants come on-line, Tate & Lyle won't be able to handle a big increase in new customers or products.

Increased competition is another threat. With growing demand for sugar substitutes, new products are likely to come on the market. NutraSweet, which sells the sugar substitute aspartame, has begun selling a new sweetener called neotame as an ingredient in beverages, sweets, and ready-to-eat meals. "We see the category as such that there's room for a lot of players," says Kevin Bauer, senior vice-president for marketing at NutraSweet.

"UNSUSTAINABLE" MARGINS? Indeed, production of sucralose itself could become competitive. Although Tate & Lyle holds 32 patents on the manufacture and application of sucralose, some of its patents will expire in 2006. "In the food-ingredients market, if something is so successful that it goes to large-scale production, over time it tends to commoditize," says Graham Jones, analyst at stockbroker Panmure Gordon. The better than 40% operating margins that Tate & Lyle has been earning on sucralose are "simply unsustainable," he says.

New legal entanglements also could be a hindrance for expanding the brand. Analysts largely dismiss the potential damage that could be caused by lawsuits alleging misleading advertising that Merisant Worldwide, maker of Equal tabletop sweetener, and the Sugar Assn. have brought against McNeil Nutritionals. The plaintiffs are arguing that McNeil's claims that sucralose is made from sugar is misleading. Analysts expect sucralose's popularity to endure, even if the ads change, but some consumers could be turned off if McNeil loses the lawsuits.

Mark Robinson, head of investor relations for Tate & Lyle, says the company feels secure about Splenda's future appeal. The fact that Splenda had captured 50% of the U.S. tabletop sweetener market in four years shows the strength of the product, which isn't being used yet in every possible application, he says. Highlighting the additional manufacturing capacity being added in Alabama and Singapore, Robinson says: "Clearly, we wouldn't be investing that sort of capital if we weren't confident of the demand."

OVEREXTENDED RALLY. Still, 80% of Tate & Lyle's sales are tied up in the relatively low-margin sugar, starch, and high-fructose corn syrup business, which remains linked to volatile commodity prices. And this year the European Union is expected to announce a major overhaul of sugar industry regulation. The reforms under debate -- including a proposal to abolish the aid that Tate & Lyle receives for refining sugar -- could hurt the company in that sector.

And the stock isn't cheap relative to its historical valuation. Merrill Lynch analysts wrote in a November report that the price was already "almost entirely factoring in the benefits from the additional capacity for Splenda production including the additional plant in Singapore."

Citigroup rates the stock a sell noting that its price-earnings ratio, at 12.9 times fiscal 2005 earnings, is "significantly ahead" of the past two years' range from 8.5 to 11.4. "We are of the view that this is a rally that has gone too far," writes analyst Jayshree Venkatramani in a November note. The stock closed in London at $8.86 on Jan. 18 and she gives it a fair value of $6.92.

Tate & Lyle's shares are 70% higher than they were January, 2004, when the company issued its profit warning. Given the uncertainties, it's unlikely that investors will see similar returns in 2005. Sucralose "does genuinely change the prospect," says Venkatramani. What's less certain is whether it can keep improving the growth potential of Tate & Lyle's shares. Carney is a contributing correspondent for BusinessWeek Online in London


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