This Moat Passes the Sniff Test

We now believe that

We’ve always argued that strong switching costs are at play, as customers are typically unwilling to switch away from IFF’s customized, proprietary formulations on the basis of cost alone. Doing so risks jeopardizing the customer experience, when flavor and fragrance solutions usually account for less than 2% of the cost of production for a given consumer-facing product.

Now, however, we also contend that IFF enjoys powerful intangible assets stemming from its considerable research and development spending, which typically exceeds 8% of sales. Additionally, IFF’s inclusion on core supplier lists serves as a valuable intangible asset that helps moderate competitive threats from smaller peers. Combined, these factors provide IFF with pricing power that helps the company generate returns on invested capital consistently above its cost of capital.

Along with the moat change, we’ve softened our long-term profit outlook. We expect the company to achieve modest margin expansion as a result of a gradually improving product mix and the benefits of a new productivity plan that will reduce overhead. However, in recent years, IFF has struggled to deliver organic revenue growth, and adjusted operating margins have been stagnant around 20%. We forecast only a 21% midcycle margin by 2021 as compound average sales growth accelerates to 4%. Still, IFF is a steady, high-quality operator that has delivered attractive returns in recent years. It would represent an attractive holding if the shares were to fall below our fair value estimate.

Proprietary Formulations Drive Growth IFF is the world's second-largest flavor and fragrance manufacturer with a 16% market share. Its products impart a desired taste, smell, or feel based on customer specifications. Customers primarily operate in the food, beverage, and personal care industries.

IFF operates via two reporting segments--flavors and fragrances--that contribute about equally to companywide sales. Flavors enjoys slightly higher margins and therefore generates a slightly larger share of profits versus fragrances. IFF has a global footprint that helps it land supply agreements with large, global consumer packaged goods companies. Half of sales are directed to customers with a global presence and half to customers with a regional presence. In 2016, 31% of sales were from Europe, the Middle East, and Africa, 28% from Greater Asia, 25% from North America, and 16% from Latin America. Sales are split equally between emerging and developed economies.

Proprietary formulations are a key driver of revenue growth. For example, rather than supplying basic flavor solutions, IFF’s sweet spot is supplying innovative solutions that modulate the consumer experience. Accordingly, the company can help save costs for its customers by providing “fine-tuning” flavor agents that allow for the use of cheaper ingredients or extend a product’s shelf life. Additionally, its offerings help customers remove undesirable content (fat, sugar, and sodium) from their products without sacrificing the consumer experience.

Intangible Assets Widen IFF's Moat The most appropriate lens through which to analyze IFF's competitive advantage is our moat framework for commodity processors. Moaty businesses that operate in this space tend to benefit from switching costs, intangible assets, or cost advantage. For IFF, we cite only intangible assets and switching costs. Its highly valuable intangible assets in the form of proprietary formulations provide significant pricing power while switching costs help ensure the durability of economic profit generation.

Intangible assets stem from the R&D spending required to develop highly engineered, proprietary formulations that can’t be precisely replicated. Although customers outline the specific flavor and fragrance profiles they are looking to achieve, the resulting intellectual property developed by IFF stays with the company. This establishes valuable intangible assets that allow IFF to generate economic profit over the lifecycle of the products in which the proprietary formulations are used. As with Givaudan and Symrise, IFF’s R&D spending accounts for over 8% of sales. This substantial R&D spending ensures that IFF’s pipeline of proprietary formulations remains strong and helps the company stay ahead of the curve in identifying and servicing new customer trends. The company has been granted more than 300 patents in the United States since 2000 as it develops customized molecules and delivery systems for specific customers.

Widespread acceptance on customer core lists serves as an additional intangible asset. The large multinational consumer packaged goods companies, and increasingly midsize companies, use core lists for their flavor and fragrance suppliers. A core list is a select list of typically two to four authorized suppliers. Suppliers not on the core list will not have the opportunity to bid on the company’s business, which reduces overall competitive intensity. Only the top four flavor and fragrance companies have truly global operations, which means competition for multinational customers is largely limited to them. As small companies are prevented from competing for larger customers, they are unable to achieve sufficient scale to match the R&D investment (and thus innovation capabilities) of the top flavor and fragrance players.

IFF’s volume represents specialty solutions rather than commoditized ingredients. The company manufactures customized solutions for the food, beverage, personal care, and household product industries, providing specialized taste, texture, and aroma profiles for a wide variety of consumer products. If a customer were to switch suppliers, it would risk losing the highly specific characteristics provided by IFF’s products, potentially impairing its own brand equity. This is a particularly risky proposition for many consumer packaged goods companies, given the substantial amount of their own capital they invest in building and marketing their brands. This concern, combined with the fact that IFF’s solutions account for a very small portion of their customers’ unit costs of production, typically leads to sticky business relationships. Once a customer selects a specific taste, texture, or aroma solution, it is generally unwilling to switch suppliers on the basis of cost alone. Research by AC Nielsen indicates that a product’s smell and taste is the largest driver of consumer repurchase decisions (at 45% versus only 15% for price). The sophistication of flavor and fragrance products continues to increase as consumers demand less sugar, fat, and salt but are not willing to sacrifice taste. Typically, customers retain IFF as the sole supplier of custom flavor and fragrance solutions for the full life cycle of a given product.

Accordingly, IFF becomes deeply ingrained in the supply chains of its customers, serving as a key supplier in the manufacture of well-established brands as well as development efforts for new products. It does so while maintaining control of the associated intellectual property, a key distinction that separates it from less moaty ingredient suppliers. This dynamic endows IFF with pricing power. No-moat ingredient companies under our coverage offer commoditized, bulk ingredients where price is the key purchasing criterion. This does not apply to IFF’s main product lines.

IFF has generated a relatively wide economic profit spread each year over the past decade. We forecast that ROICs will be relatively flat over our explicit forecast period, and we have a high degree of confidence that positive economic profits will prove durable for at least the next 20 years. We forecast a midcycle ROIC of roughly 15%, well above the company’s 7.2% cost of capital. Our ROIC forecast is adjusted downward to account for the capitalization of operating leases and R&D spending. Even our bear-case assumptions imply a wide margin of safety for ROICs above the cost of capital.

Fair Value Uncertainty Is Low IFF's cash flows are generally quite stable, revenue cyclicality is low, and financial leverage is manageable. Consistent free cash flow generation should allow IFF to maintain a strong financial condition and capitalize on value-accretive, tuck-in M&A opportunities.

Sources of uncertainty include a shift toward manufacturing robotics shaking up the competitive balance, although IFF has already begun to invest in automation solutions. Additionally, there always remains the possibility that weak execution could lead to IFF’s removal from the core supplier list embraced by large consumer packaged goods customers. This did happen once, although IFF was able to quickly restore its position on the core list.

Management turnover has been high, which could lead to instability and associated dysfunction. But IFF appears to have coped quite well in previous transition periods and the board has been able to find replacements for key posts like CEO and CFO reasonably quickly.

IFF has not been a highly acquisitive company, so its skill in integrating acquisitions has not been tested to the full. Between 2002 and 2013, IFF undertook no acquisitions big enough to feature on the investor radar. Those undertaken since 2014 have been small enough not to endanger the company’s overall stability. We are skeptical about management’s stated long-term goal of attaining $500 million-$1 billion of incremental revenue via acquisitions by year-end 2020. Although a desire to achieve growth by acquisition is understandable, we question the decision to publicize a concrete target, as this could reduce bargaining power or press management to consummate value-destructive deals.

International Flavors & Fragrances has had a good record of returning cash to shareholders, with a regular dividend and share buybacks. The latter dried up for a time after the global financial crisis but have been reactivated since. Gearing has been on a falling trajectory, and with net debt/EBITDA of only 1.4 times at the end of 2016. Although this is consistent with historical levels, IFF could be considered underleveraged. With management having indicated that capital intensity should fall between now and the end of the decade, we would expect a sustained program of share buybacks to complement the regular dividend.