International Flavors & Fragrances (IFF): A Dividend Achiever Worth Reviewing

You probably use several products every day that are touched by International Flavors & Fragrances (IFF), a dividend achiever that has raised its payout every year since 2003.

The company has a presence in thousands of consumer products, yet it 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.

Let’s take a closer look at International Flavors & Fragrances to see if this strong dividend grower is appealing today.

Business Overview

International Flavors 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 product portfolio is split roughly 50/50 between fragrances and flavors.

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 almost 75% of sales coming from outside of the U.S. and about 50% of revenue coming from emerging markets.

Here is 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:

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.

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

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

The research and development process required to create certain scents and tastes is also very intensive. International Flavors & Fragrances routinely spends approximately 8% of its sales on R&D, for example (the industry average is closer to 3%).

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 thousands of 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” (70) than it does manufacturing facilities (42) 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.

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 January 2017, the company completed the acquisition of Fragrance Resources, a fragrance company with a wide international footprint.

David Michael & Company was acquired in October 2016 to strengthen the company’s North American flavors business.

These two acquisitions, as well as the 2015 acquisitions of Ottens Flavors and Lucas Meyer Cosmetics, are expected to add approximately $265 million in annualized revenue, helping International Flavors achieve additional sales of $500 million to $1 billion by 2020, representing 6% annualized growth since 2014.

All of these industry characteristics have resulted in high and stable returns on invested capital for International Flavors & Fragrances over the past decade:

From a growth perspective, International Flavors & Fragrances has compounded its sales at a 6% annualized rate over the last five years. The company’s 16% market share provides room for the company to continue expanding as it capitalizes on increased R&D investments, and its geographical mix is supportive as well.

It doesn’t hurt that the global flavor and fragrance market is estimated to grow at a compound annual growth rate of more than 4% from 2017 to 2022, too.

Approximately half of International Flavors & Fragrances’ sales come from emerging markets, where rising consumer wealth should boost demand for household products using ingredients made by the company.

As seen below, International Flavors & Fragrances’ markets are expected to grow 2% to 6% per year, with the strongest growth coming from emerging markets.

Source: IFF Investor Presentation

From 2016 through 2020, 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.

Its 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.

The Home Care and Fine Fragrances markets are International Flavors’ biggest opportunities, and it is moderately increasing R&D spending to achieve its objectives.

Overall, International Flavors & Fragrances appears to be a company that is built to last. It 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.

The company has 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.

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 will also be acquiring 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 customer 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 customers. 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 18% 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, 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 over 9,000 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.

International Flavors & Fragrances’ Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

International Flavors & Fragrances recorded an excellent Safety Score of 87, suggesting its current dividend payment is one of the safest in the market. The company’s moderate payout ratios, healthy balance sheet,  consistent free cash flow generation, and wide moat support the favorable ranking.

Over the trailing twelve months, International Flavors & Fragrances’ dividend has consumed 52% of its earnings and 69% of its free cash flow. These are reasonably healthy ratios, especially considering the stability of International Flavors & Fragrances’ business. The company has plenty of room to continue paying and growing its dividend.

Looking at longer-term trends in payout ratios can also be helpful to see if growth in earnings per share has kept up with dividend growth. As seen below, International Flavors & Fragrances’ payout ratios have generally remained below 50% for most of its history.

For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis.

International Flavors & Fragrances’ reported sales fell 3% in fiscal year 2009, and its earnings dropped by 14%. Not surprisingly, consumers still needed soap, shampoo, packaged foods, and other essentials when the economy softened. The company’s relatively stable sales growth reinforces the consistent nature of the business.

High quality companies are able to generate free cash flow year in and year out. Rising cash flow is very important because it supports continued dividend growth without expanding the payout ratio.

As seen below, International Flavors & Fragrances has generated healthy free cash flow in each of the past 10 years while maintaining remarkably high and stable operating margins for a chemical company.

While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give a better sense of a dividend’s safety, the balance sheet is an extremely important indicator as well.

Companies with high amounts of debt, cyclical business operations, and inconsistent cash flow generation could find themselves in a cash crunch if demand unexpectedly weakens and they have overextended themselves. They will always cut the dividend before missing a debt payment, so monitoring cash and debt levels is important.

As seen below, International Flavors & Fragrances has reduced its debt to capital ratio since fiscal year 2008 and ended last fiscal year at a healthy ratio of 40%. Levels less than 50% are preferable for average businesses, and International Flavors & Fragrances looks especially conservative given the stable nature of its operations and cash flows.

Taking a closer look at International Flavors & Fragrances’ balance sheet, the company’s debt appears to be manageable despite its acquisitions in recent years. Cash on hand comfortably covers annual dividend commitments, and the company’s net debt is nicely supported by the cash flow the business generates.

Altogether, International Flavors & Fragrances’ dividend appears to be extremely safe. The company’s payout ratios are low, the business generates plenty of free cash flow, the balance sheet is flexible, and the business is very consistent, even during recessionary conditions.

International Flavors & Fragrances’ Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

International Flavors & Fragrances’ Dividend Growth Score is 83, suggesting that its payout can grow relatively fast. The company has grown its dividend for 15 consecutive years at a fairly brisk pace, so this isn’t overly surprising.

As seen below, International Flavors & Fragrances’ dividend increased at a 12% annualized rate over the last decade and has consistently recorded double-digit increases, capped off by a 15% dividend increase in August.

The company’s goal is to return 50% to 60% of net income to shareholders, and its expectations for double-digit earnings growth should fuel at least 8-10% annual dividend increases going forward.

Valuation

IFF trades at a forward P/E ratio of 25.1, a meaningful premium compared to the S&P 500 and Basic Materials’ forward P/E ratios of 17.7 and 18.4, respectively.

While the stock’s 1.9% dividend yield is slightly above its five-year average yield of 1.7%, it’s hard to get comfortable with IFF’s rich valuation multiple.

To justify its premium, International Flavors & Fragrances needs to execute on its objective to grow earnings by 10% per year, excluding foreign currency movements.

The company seems to have decent potential to hit its goal because it basically calls for the business to do more of the same – over the past five years, earnings per share have compounded at an annual rate of 9.1%.

With about 16% market share and half of sales coming from emerging markets, where per capita consumer spending is on the rise, IFF should seemingly have plenty of opportunities for profitable growth.

International Flavors & Fragrances doesn’t appear to be a bargain today, but there’s little reason to believe that IFF won’t be a larger, stronger company by 2020.

While the stock’s earnings multiple is at a premium relative to the market, IFF appears to offer annual total return potential between 9.9% and 11.9% (1.9% dividend yield plus 8% to 10% annual earnings growth), assuming its multiple holds.

A 10%+ pullback in the stock would make IFF look more interesting for long-term investors considering opening a position, especially if the weakness was caused by transitory factors such as foreign currency volatility or raw material cost inflation.

Conclusion

International Flavors & Fragrances appears to be a wonderful company trading at a fair, if not somewhat steep, price.

While the company’s dividend yield is too low for investors living off dividends in retirement, IFF’s dividend growth prospects are very strong.

The business seems 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 further entrench the company with its customers.

A pullback in the stock caused by by foreign currency fluctuations or raw material price volatility would create a more interesting investment opportunity, but International Flavors & Fragrances deserves to be watched either way.