A Taste of the Flavor Company Sector

by: Stephen Simpson, CFA

Is it any surprise that the worldwide market for flavors is a multi-billion dollar per year business? After all, what really separates a Coke drinker from a Pepsi drinker other than the taste? Likewise, until Frito-Lay figures out how to grow a potato that comes out of the ground tasting like sour cream and onion, there will be a strong demand for both novel and familiar flavors, and companies like International Flavors and Fragrances (NYSE:IFF) and Senomyx (NASDAQ:SNMX) will stand to benefit.

Good Taste Really Matters

It is hardly controversial to suggest that a huge amount of packaged food brand value is wrapped up in taste. To paraphrase comedian Dave Chappelle, aside from trace amounts of flavorings, Coca-Cola is really just "sugar, water, and brown (caramel color)." We like things that taste good, and we naturally crave particular combinations of salt, sweet, and savory. Consequently, it's a safe bet that packaged food companies will continue to build brand identity around flavor.

Taste is increasingly taking on a nutritional aspect as well. We humans have taste receptors that lead us to seek out things we need (sugar, salt) and avoid harmful things (many toxic compounds are bitter), and packaged food companies and restaurants have dutifully exploited this. Due in large part to the outsized role of packaged and processed food in the Western diet, consumption of salt and sugar is far higher than it needs to be and is implicated in a variety of health problems. Accordingly, there is a large and growing market for safe alternatives to ingredients like sugar and salt.

The Industrializiation of Taste

Many consumers assume that food companies develop and source their own flavors, and it is true that some do. Many others, though, either outsource the process almost entirely or work in close collaboration with companies that focus on developing and manufacturing flavors for the food industry. Given that flavorings do represent a fairly small percentage of the final product cost, it is often more efficient to outsource them than develop the internal capabilities to produce them. That has led to a global flavor business worth in excess of $6 billion a year.

While it is a lucrative business, it is also a difficult business. Customers are very demanding and the average acceptance rate of new flavors and fragrances (many companies involved in flavors also supply fragrances) across the industry is about 5 – 10%. Moreover, it takes scale to cost-effectively source ingredients from around the world, and to supply to multinational food corporations with global brands. In other words, this is an industry where being big is important.

This is also an industry that requires significant science and testing capabilities. The FDA regulates flavors and additives, and though the process is simpler than the drug or device approval process, it still takes time and money to secure FDA approval for new compounds – to say nothing of the capital and infrastructure it takes to design, develop, and test a new compound. Again, there are advantages to being big.

Putting Biology To Work

Science is becoming an increasingly important part of the flavor industry. Concerns about environmental sustainability, political stability, and ethical trade have made sourcing some flavors more difficult and expensive, and synthetics can be appealing alternatives.

At the same time, though, consumers are increasingly worried about the ingredients that go into their food and the potential health ramifications of them. Take the case of high fructose corn syrup (HFCS). Though there is some evidence that consuming fructose is marginally less healthy than sucrose (which is a compound of fructose and glucose), companies like Corn Products (CPO) and Archer Daniels Midland (NYSE:ADM) have been put on the defense by all sorts of negative health and taste claims about HFCS.

Most of these claims are overstated or outright bunk. Nevertheless, the reality is that consumers have turned against HFCS, and food companies have rushed to reformulate products and brag about using only "real" sugar. Likewise, there are still occasional rumors about aspartame (NutraSweet) causing all sorts of health problems, and a similar backlash may be brewing against sucralose (the generic name of the sugar substitute Splenda).

What this all means, then, is that the packaged food industry (and by extension the flavor industry) has to continue to innovate and develop new compounds. Growing knowledge about the biochemistry of taste and advanced screening technologies are leading the flavor industry to develop compounds that adequately trigger the desired taste response with lesser amounts of harmful or objectionable ingredients.

The Players – The Big Four

Givaudan (OTCPK:GVDNY) is far and away the largest player in this industry, with roughly one-quarter of the market. This Swiss flavor and fragrance company has been a solid grower ever since it was spun off from Roche (OTCQX:RHHBY) in 2000 and has been a very willing acquirer of other competitors in the industry. While Givaudan is not an especially cheap stock, the company pays an attractive dividend while simultaneously reinvesting a lot of its profits into R&D. This is admittedly not a terrifically liquid stock, even on its home exchange in Europe (GIVN.VX).

The #2 slot in the flavor industry is basically shared between privately-held Swiss company Firmenich and America's International Flavors and Fragrances. While there is some discrepancy among sources in market share breakouts between the two companies, they are more or less neck-and-neck with high teens market shares in the flavor industry.

IFF works with many of the major names in packaged food, including Procter & Gamble (NYSE:PG), Nestle (OTCPK:NSRGY), Kraft (KFT), Unilever (NYSE:UL), and General Mills (NYSE:GIS). IFF also has a sizable fragrances business which makes up a little more than half of the company's total sales. IFF is a somewhat frustrating stock to evaluate. The long-term track record of free cash flow growth is okay, and the company produces a pretty fair free cash flow margin and a solid return on capital. On the other hand, the dividend yield is not exceptional and the stock seems fairly valued.

In fourth place comes yet another European company – Germany's Symrise (OTCPK:SYIEY). Symrise has a relatively high level of emerging market exposure, and this could really pay dividends to the company in the coming years as the same migration towards packaged and processed food that occurred in the Western world occurs in the developing world. Along those lines, Symrise has above-average growth prospects and actually looks attractively undervalued today. Unfortunately, the ADRs are not at all liquid, so investors will probably need to turn to the European shares if they wish to build a position.

Plus One

One of the small players hoping to one day break into the big leagues is Senomyx. This company operates something like an industrial biotech, leveraging knowledge about taste receptors and using assays and high-throughput screening to develop novel compounds that can enhance the sweetness, saltiness, or savory aspect of a food or beverage, or block bitter tastes. In theory, then, Senomyx's customers can use less salt, less, MSG, and/or less sugar (or other sweeteners) without compromising taste.

Like a biotech, Senomyx has opted to use development partnerships to help fund its R&D and mitigate its capital needs. Major partners include Ajinomoto, Firmenich, Kraft, Nestle, and Pepsico (NYSE:PEP), and Senomyx is targeting multi-billion dollar markets with its compounds.

That said, there are risks to the Senomyx story. So far there have been only trivial amounts of commercial revenue from Senomyx products (about $2.6 million in the last fiscal year and under $4 million in total). What's more, the company's agreements will generally deliver only single-digit royalties, and that is only if Senomyx successfully develops compounds that its customers choose to incorporate into their products (and those products sell well at the supermarket).

Not all of the development deals will succeed – the company's work with Campbell Soup (NYSE:CPB) appears to have ended without a commercially attractive product. Likewise, competition is a real threat. There are other small companies working on similar projects – Senomyx could not come to terms with Coca-Cola (NYSE:KO) on a collaboration, and Coca-Cola partnered instead with Chromocell. Beyond that, there are the major flavor and fragrance companies and other food ingredient players like Cargill and Tate & Lyle (OTCQX:TATYY) working on various enhancers and modulators.

Still, with a market capitalization of less than $250 million and several shots on goal worth tens or maybe hundreds of millions of dollars, it is an interesting opportunity for aggressive investors looking for new plays on a huge established industry. What's more, given the acquisitive nature of this industry, success in a major product category will not go unnoticed.

Picks And Shovels vs. Gold-Seekers

Processed and packaged food is a huge industry with no shortage of investment angles. Investors can go with blue-chip names like Coca-Cola and Pepsico, growth ideas like Smart Balance (SMBL), or emerging market picks like Tingyi (OTCPK:TCYMF). But as with so many industries, there are also behind the scenes pick-and-shovel plays that can do surprisingly well. With that in mind, investors should take a look at the flavor and fragrance industry with an eye towards some sweet bargains.

Disclosure: I am long SNMX, RHHBY.PK.