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International Flavors & Fragrances (IFF)

International Flavors & Fragrances (IFF) was founded over 125 years ago and is the behind-the-scenes company that works with many of the world’s leading consumer brands to create scents and tastes used in thousands of household products.

The company’s portfolio is split roughly 50/50 between fragrances and flavors and consists of more than 45,000 products.

Fragrance products are used in soaps, detergents, lotions, lipsticks, deodorants, air fresheners, perfumes, colognes, and other products.

Flavor products are used in beverages, candies, baked goods, desserts, prepared foods, dairy products, pharmaceuticals, oral care products, and more.

The business is very international, with 75% of sales coming from outside of the U.S. and close to 50% of revenue coming from emerging markets.
Source: International Flavors Investor Presentation
You can watch a 3-minute video that provides a nice overview of the company and the amount of effort that goes into creating its flavors and smells by clicking here.

Business Analysis

International Flavors & Fragrances is very entrenched with its customers for several reasons, creating a moat around its business.

First, academic studies have shown that scent and flavor are two of the most important factors influencing consumers’ purchases of packaged food or household products, so it’s no surprise that International Flavors & Fragrances’ compounds are really important to a company’s brand.

International Flavors & Fragrances’ products also represent a small proportion of a customer’s total product cost, allowing the company to enjoy strong pricing power for its products.

Many of International Flavors & Fragrances’ compound formulas are unique to the customers that use them as well. A company such as Procter & Gamble (PG) that has found a winning detergent scent with International Flavors & Fragrances doesn’t want anyone else using that fragrant compound, leading to a sticky and long-lasting relationship with IFF.

The research and development process required to create certain scents and tastes is also very intensive. International Flavors & Fragrances employs 1,600 people globally in R&D activities and routinely spends more than $225 million, or 8% of its sales, on R&D (the industry average is closer to 3% of sales, according to Chemical & Engineering News). 

The goal is to recreate a particular taste or scent by using computers to identify hundreds of molecules from different foods. Next, a group of molecules is formed by International Flavors & Fragrances to recreate that taste while complying with regulations and a customer’s budget.

Many times these molecules have nothing to do with the initial food or product. Once the optimal molecule “recipe” has been created, International Flavors & Fragrances will create an artificial synthetic version and a natural version.

The company works with over 10,000 different raw materials to help it with this process and regularly collaborates with biotechnology firms to develop low cost, natural ingredients.

According to the Wall Street Journal, food and beverage companies have increasingly outsourced product development to companies such as International Flavors. Today, around 80% of all flavors are outsourced because they make up such a small portion of a product’s cost.

This requires International Flavors & Fragrances to conduct significant field research to gauge changing consumer preferences and help its customers maintain strong brands in the marketplace.

To this point, the company actually has more “creative centers” (69) than it does manufacturing facilities (37) to ensure its staff stays on top of local consumer trends.

The industry’s structure is also attractive because it has gradually been consolidating over the past few decades. Today, the top four companies (Givaudan, International Flavors, Firmenich, and Symrise) account for nearly 70% of the industry’s sales.
Source: International Flavors & Fragrances
Each company is focused on profitable growth, and the sensitive nature of customer relationships and formula IP have limited the industry’s pace of change.

As regulations increase, consumer brands become increasingly international, and more R&D is required for natural products, further industry consolidation is likely.

In fact, International Flavors & Fragrances has continued making acquisitions in recent years. In 2017, the company completed the acquisitions of Fragrance Resources, a specialty fragrance company with a wide international footprint, and PowderPure, a producer of clean label solutions that deliver the taste, nutrition, and color of real food.

These two acquisitions are expected to add approximately $90 million in annualized revenue, helping International Flavors achieve additional sales of $500 million to $1 billion by 2020, which would represent 6% annualized sales growth since 2014.

International Flavors & Fragrances' growth ambitions seem reasonable for several reasons. For one thing, management estimates that the flavors and fragrances market was $24.8 billion in 2017, implying that IFF has less than 14% market share. The global flavor and fragrance market is estimated to grow at a compound annual growth rate of more than 4% from 2017 to 2022 as well, per Research and Markets.

The majority of the market's growth is expected to come from emerging markets, where rising consumer wealth should boost demand for products using ingredients made by the company (recall that close to 50% of IFF's sales are derived from emerging markets).

Management has also had success extending the company's products into adjacent markets to drive growth. For example, IFF is the key supplier behind Lucas Meyer Cosmetics' Greyverse, which contains the first anti-grey hair biomimetic peptide on the market to help people look naturally younger by reversing the hair aging process. The total gray coverage market was valued at $8.7 billion in 2016 and is expected to grow by 8% annually through 2021.

Another example is found in the global skincare market, which is expected to grow 6.4% per year to hit $9 billion by 2027. International Flavors & Fragrances is behind Lucas Meyer Cosmetics' OiLESS’city product, which reduces the shiny appearance of oily skin to bring back a more natural look.

When combined with continuous efforts to cut costs and embrace more technology, International Flavors & Fragrances’ stated objectives are to grow sales by 4% to 6% per year and increase earnings per share by 10% annually, assuming constant currency exchange rates.

The company's goal is to achieve a number one or number two market share position in the key markets and categories it targets, and with specific customers. One of the company’s biggest goals is to increase its market position in North America, where it currently holds the number three spot.

Overall, International Flavors & Fragrances appears to be a company that is built to last. The firm is nicely diversified across many different customers, industries, and geographies, there appear to be meaningful switching costs and barriers to entry thanks to the proprietary scents and flavors it develops, and its business model generates plenty of free cash flow.

Key Risks

One of the biggest long-term risks to International Flavors & Fragrances’ business is the increasing shift in consumer preferences away from synthetics and towards natural products.

This is related to the rising health trend that is encouraging companies to cut down on sodium, saturated fat, and sugar across many of their brands.

International Flavors & Fragrances has produced natural products for many years but doesn’t disclose what percent of its sales are tied to natural versus synthetic products today. However, half of the raw materials IFF purchases are naturals or crop-related items rather than synthetics and chemicals.

The company has also said that more than 50% of all new flavor briefs it is working on are calling for natural solutions and that it has a higher win rate in naturals, suggesting it is positioned nicely for this trend. 

Sales of International Flavors & Fragrances' sweetness and savory modulation portfolio continue to grow strong double-digits across all of its categories, and the company is launching new natural taste modulators to maintain its robust growth rates.

Management is also encouraged because newer technologies, including some required for natural products, often carry higher margins. The shift to more natural products could also increase the industry’s barriers to entry for several reasons.

First, additional R&D is required to produce natural flavors and fragrances. International Flavors & Fragrances has stated that it expects its R&D spending as a percentage of sales to increase by about 1% over the next few years as it invests to regain market share in the U.S. and grow its portfolio of natural products.

International Flavors & Fragrances also intends to expand its access to natural raw materials for its cosmetic actives business through a strategic investment in Bio ForeXtra, a Canada-based R&D laboratory, which is highly specialized in the development of active cosmetic and botanical extracts.

To further increase its expertise in clean label solutions, International Flavors & Fragrances acquired PowderPure, whose patented technology is used to create all-natural food ingredients by eliminating water while leaving the taste, nutrition and color matrix intact.

As the definition of “natural” products continues to be refined and synthetics are perhaps more closely scrutinized, it’s also possible that industry regulations increase.

Smaller players are unlikely to be able to handle increased regulations from both a personnel and financial perspective, widening the moat of larger industry players such as International Flavors & Fragrances.

Another risk to consider is pricing pressure. Parts of International Flavors & Fragrances’ portfolio have also been subject to intense pricing competition in the past, causing the company to move out of certain areas.

The diversity of International Flavors & Fragrances’ product portfolio and geographic mix help mitigate this risk, and the company further benefits by being able to serve multinational customers with its global operations – many smaller regional players cannot handle these accounts and lack the customer relationships.

Pricing pressure could also be caused by the company’s concentrated customer base (top 25 customers = 50% of sales). Many consumer staples businesses are experiencing significant challenges to achieve profitable growth as consumers opt for fresher, healthier foods and private label keeps taking market share, for example.

They are responding by slashing costs aggressively, consolidating, and introducing more relevant products. International Flavors & Fragrances’ operating margins are now close to 20% and have likely gotten the attention of its customers.

Customers that are struggling in their markets might be more apt to push back on pricing and consolidate suppliers, but once again, the diversity of International Flavors & Fragrances’ markets, customers, and products helps mitigate this risk.

It also doesn’t hurt that the company’s products account for a relatively small percentage of customers’ total manufacturing cost.

As long as the industry’s players can continue developing scents and flavors that can compete on novelty rather than on price alone, profitability should remain healthy.

Despite its high margins, International Flavors & Fragrances is also undertaking various productivity measures which are expected to deliver annual savings between $40 million and $45 million by the end of 2019.

A final risk to consider is that International Flavors & Fragrances’ business can  be impacted by swings in raw material prices (IFF uses 11,000 raw materials) and foreign currency fluctuations (nearly 75% of sales are outside the U.S.). However, neither of these issues poses long-term risks to the company’s health and profitability.

Closing Thoughts on International Flavors & Fragrances

International Flavors & Fragrances has been able to raise its dividend every year since 2003 and possesses a number of enduring competitive advantages. 

The business appears to be well positioned for future sales and earnings growth with half of its business in emerging markets and continual R&D investments that should open up adjacent markets and further entrench the company with its customers.

Although the company has a presence in thousands of consumer products and generates excellent cash flow, IFF has largely flown under the radar operating in the chemicals industry.

Boring, durable businesses that can predictably pay higher dividends each year can often be some of the best investments for long-term investors, and International Flavors & Fragrances certainly seems to check many of these boxes.

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