International Flavors & Fragrances: Time To Take Profits

| About: International Flavors (IFF)
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Summary

International Flavors & Fragrances has been a long-term value generator for shareholders.

The company is well-run. Management has positioned the company for continued earnings growth and market share gains in a stagnant business.

A recent acquisition positions the company in a new end market with higher margins.

The story falls apart on valuation. The company is more expensive today than it has been in the past ten years on trailing/forward multiples.

It is time for long-term shareholders to realize some gains and deploy those funds elsewhere.

As an extremely health-conscious individual, I've always been extremely wary of companies operating in the flavor and fragrance businesses - an industry most often characterized by chemically-derived, artificial products. But as a lover of food, I can't deny the importance of taste and smell when it comes to driving a successful customer experience. So overall, I try to keep an open mind when judging companies like International Flavors and Fragrances (NYSE:IFF).

Shareholders that have kept an open mind have reaped stellar long-term returns. IFF equity is up more than 260% over the past ten years, compared to a rather uninspiring 60% return for the S&P 500. The company has been consistently stealing market share from the competition, and has rightly moved a large base of its sales overseas. This positioning came prior to a large sales shift, in which 75% of the flavoring and fragrance market's growth is expected to come overseas (Asia, Africa, Latin America) in emerging markets through 2019.

There was a time when investors that did not engage forward thinking punished the company for having 75% of its 2015 sales occur overseas. The strong dollar worried many, but the company still posted marginal earnings per share growth in 2015, putting some of those fears to rest. Nonetheless, a weak Q4 2015 bottom line miss sent shareholders for the exits. Q1 2016 was much better, and the dollar is some distance from the highs it made toward the end of 2015. Are more gains to come?

Business Practices

The plan outlined by International Flavors & Fragrances in 2015 which laid the framework for the company's path to 2020 ("Vision 2020") really outlines what makes the company different from other companies within this space. There are three key themes from that Vision 2020 groundwork in my opinion:

Innovation First. R&D investment is incredibly important to the flavors and fragrances markets. Once developed, the actual flavor profile is a minimal portion of a product's total cost, but it can make all the difference when it comes product's market penetration and growth.

The flavors and fragrances markets is essentially an oligopoly, with four competitors holding 69% of total market share. These are Givaudan (OTCPK:GVDNY) (25%), Symrise (OTCPK:SYIEY) (12%), Firmenich (16%), and International Flavors and Fragrances (16%). Firmenich is privately-held, so Givaudan and Symrise are the primary comps that can be used for comparison. When it comes to R&D/revenue spending, International Flavors & Fragrances is now the leader, as Givaudan investment has slumped considerably over the past five years. It likely isn't a surprise that growth among the three has been weakest at Givaudan, growing just 5% in absolute terms from 2011-2015.

Coming up with a winning idea in this space is incredibly important. When International Flavors & Fragrances develops a molecule that is a winner with a collaborator - say, a key flavor component of a canned soup - that relationship becomes intensely sticky. Contracts are structured that the molecule is proprietary to International Flavors & Fragrances, not the customer. So long as the partnership remains in place, that proprietary flavoring recipe remains exclusive. If the company elects to move its flavoring sourcing elsewhere, it risks the competition electing to source that flavor profile from International Flavor & Fragrances instead.

Now, spending money doesn't necessarily mean a return on investment. Historically, however, returns on invested capital have been high, ranging from 10-18% over the past decade. That is well above costs of capital within the industry. It does remain to be seen if the consistent spending by the company will drive net income materially higher in the future, given that the market is at a crossroads (massive growth in "natural flavoring"). I do think it is likely that companies in this space do need to spend money today, especially in the production of natural flavoring, in order to generate future returns - especially when it comes to maintaining revenue in the domestic market.

Win Where We Compete. Rather than competing wherever it can globally, International Flavors & Fragrances has instead targeted reaching leadership positions in three key markets: North America, Africa/Middle East, and Greater Asia (especially China). Most clear here is that the company has basically shunned Europe, and that shouldn't be a surprise. Market leader Givaudan is based out of Switzerland, and up-and-comer Symrise out of Germany. It makes little sense to compete with these two companies on their home turf, and in doing so the company has lucked into not having to deal with the still substantial weakness in the euro versus many world currencies. While the company can't shun the United States or Asia and will be forced to compete there, I am encouraged by the company's substantial presence in Africa, an area in which many product categories are experiencing greater growth than what can be found in Asia.

Expansion. Value creation through partnership, collaboration, and acquisition is an integral facet of this business. I firmly believe International Flavors & Fragrances' long-term success or failure relies heavily on its expansion into the cosmetic market. Unlike the relatively stagnant (long-term growth rate approximate to global GDP) flavoring and fragrance businesses that primarily target products in the food, beverage, and household product categories, the active cosmetics category is faster growing with higher margins. International Flavors & Fragrances diversified into this business by acquiring Lucas Meyer Cosmetics for $493M in total consideration.

The active cosmetics industry (cosmetics with an "active" ingredient; something with pharmacological benefit) looks much like the flavoring and fragrance business did a decade ago. It's highly fragmented, and it's ripe for consolidation. The company needed a foothold in this industry, and it got it this way. This won't be a primary driver of operating profit for the company for years most likely, but it does give the company a growth story to focus on that is highly complementary to the core business.

Acquisitions are to be a key part of the story here going forward. Management is hoping to acquire $500M-1B of sales through acquisitions by 2020. Coupled with organic growth, sales will likely approach $4.5B by 2020.

2020 Projection

All in all, given management estimates in the 2020 Vision, the below is essentially the standing guidance for the firm (assuming no acquisitions):

The Wall Street analyst community isn't dumb, and it isn't a surprise that my estimates given the mid-point of the 2020 Vision Plan coincide with current consensus ($5.50/share in 2016, $5.93 in 2017 is the Street's take as of today). My numbers are lower than the Street primarily due to assuming flat share count (management does do small share repurchases) and higher estimates on SG&A.

All in all, the overall market looks solid for the company and it appears to be headed in the right direction. Unfortunately, International Flavors & Fragrances trades more expensively on trailing/forward P/E estimates today than it has at any point in the past ten years. A return to historical averages by 2020 (18x trailing) would value shares at $124.02; essentially what the company trades for today.

Fair value in my opinion (discounting the shares back to present value) is closer to $90/share. That would represent significant downside from today's price, and it is likely that Wall Street has come to similar conclusions as me, with most advisory firms becoming increasingly cautious on the earnings multiple expansion that has taken place.

Is the company a short? Not at all. There isn't a compelling reason to take a short position. Nothing above is ground-breaking or enlightening to most market participants, but they are clearly willing to pay that premium for the safety that can be found here currently. There isn't a catalyst here besides "people are paying too much". As we all know, people can often pay too much for a company for quite some time before they come to their senses.

For investors that have held the company long term, it is, however, likely time do a little trimming and realize some of those paper gains. There are much better opportunities out there; International Flavors & Fragrances is a weak hold.

For more research like this on small/mid cap companies perpetually underfollowed by Wall Street and under-owned by retail investors, consider following me (by clicking the "Follow" button at the top of this article next to my name) to receive notification when I publish research. Feel free to ask any questions in the Comments section below.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.