You probably use several products every day that are touched by IFF. The company has a presence in thousands of consumer products, yet it has largely flown under the radar operating in the chemicals industry. We like boring, durable businesses that can predictably pay us more income every year, and IFF certainly checks these boxes.
We added IFF to our Long-term Dividend Growth Portfolio earlier this year. While the stock trades at a premium relative to the market today, we continue to believe the company is a solid long-term holding that will reward investors with double-digit dividend growth for years to come.
IFF was founded over 125 years ago and is the behind-the-scenes company that works with 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 80% of sales coming from outside of the US 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:
IFF is very entrenched with its customers. 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 IFF’s compounds are really important to a company’s brand. Importantly, IFF’s products also represent a small proportion of a customer’s total product cost, allowing IFF to enjoy strong pricing power.
Many of IFF’s compound formulas are unique to the customers that use them. A company such as P&G that has found a winning detergent scent with IFF doesn’t want anyone else using that fragrant compound, leading to a sticky and long-lasting relationship with IFF. This is somewhat similar to the favorable phenomenon we noted in our analysis of Omnicom (OMC), a large advertising agency.
The research and development process required to create certain scents and tastes is also very intensive. IFF routinely spends between 8% and 9% of its sales on R&D. The goal is recreate a particular taste or scent by using computers to identifying hundreds of molecules from different foods. Next, a group of molecules is formed by IFF 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, IFF 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 produce development to companies such as IFF. Today, around 80% of all flavors are outsourced because they make up such a small portion of a product’s cost. This requires IFF to conduct significant field research to gauge changing consumer preferences and help its customers maintain strong brands in the marketplace. To this point, IFF actually has more “creative centers” (31) than it does manufacturing facilities (29) to ensure its staff is on top of local consumer trends.
Finally, the industry’s structure is also attractive because it has gradually been consolidating over the past few decades. Today, the top four companies (Givaudan, IFF, 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.
All of these industry characteristics have resulted in high and stable returns on invested capital for IFF over the past decade:
From a growth perspective, IFF has compounded its sales at a 6% CAGR 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. Half of IFF’s sales come from emerging markets, where rising consumer wealth should boost demand for household products using ingredients made by IFF. As seen below, IFF’s markets are expected to grow 2% to 5% per year, with the strongest growth coming from emerging markets.
Source: IFF Investor Presentation
From 2016 through 2020, IFF’s stated objectives are to grow sales by 4-6% per year and increase EPS by 10% annually, assuming constant currency exchange rates. Its goal is to achieve a number one or number two market share position in key markets and categories, and with specific customers. One of its 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 IFF’s biggest opportunities, and it is moderately increasing R&D spending to achieve its objectives.
One of the biggest long-term risks to IFF’s 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. IFF 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. IFF says it has a higher win rate in naturals and is well positioned for it. 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. IFF has stated that it expects its R&D spending as a percentage of sales to increase by 1% over the next few years as it invests to regain market share in the US and grow its portfolio of natural products.
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 IFF.
Another risk to consider is pricing pressure. Parts of IFF’s portfolio have also been subject to intense pricing competition in the past, causing the company to move out of certain areas. The diversity of IFF’s 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 from the company’s customers, some of which are likely facing pressure from private label products. IFF’s operating margins are now close to 20% and have likely gotten the attention of its customers. Those that are facing some struggles in their markets might be more apt to push back on pricing, but once again, the diversity of IFF’s markets, customers, and products helps mitigate this risk. 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.
IFF’s business can also be impacted by swings in raw material prices (IFF uses over 10,000 raw materials) and foreign currency fluctuations (nearly 80% of sales are outside the US). However, neither of these issues poses long-term risks to the company’s health and profitability.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. IFF’s long-term dividend and fundamental data charts can all be seen by clicking here and support the following analysis.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
IFF recorded an excellent Safety Score of 98, suggesting its current dividend payment is safer than 98% of other dividend-paying stocks in the market. The company’s moderate payout ratios, healthy balance sheet, very consistent cash flow, and wide moat support the favorable ranking.
Over the trailing twelve months, IFF’s dividend has consumed 37% of its GAAP earnings and 41% of its free cash flow. These are extremely healthy ratios, especially considering the stability of IFF’s 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, IFF’s payout ratios have generally remained below 40% for most of its history and in line with its current ratios.
For dividend companies with enough operating history, it’s always a prudent exercise to observe how their businesses performed during the financial crisis. IFF’s 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. IFF’s 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, IFF has generated healthy free cash flow in each of the past 10 years while maintaining excellent operating margins for a chemical company.
While payout ratios, margins, industry cyclicality, free cash flow generation, and business performance during recessionary conditions help give us 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, IFF has reduced its debt to capital ratio since fiscal year 2008 and ended last fiscal year at a healthy ratio of 38%. We typically prefer to see levels less than 50% for average businesses, and IFF looks especially conservative given the stable nature of its operations and cash flows.
Taking a closer look at IFF’s balance sheet, we can see the company has $2 of cash on hand for every $1 of dividends it paid last year. The company’s debt is also very manageable, as evidenced by its Net Debt / EBIT ratio of 1.3x, which means IFF’s net debt would be covered with 1.3 years of EBIT generation.
Altogether, IFF’s dividend is 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.
Dividend Growth Score
Our 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.
IFF’s Growth Score is 87, meaning its dividend’s growth potential ranks higher than over 85% of all other dividend stocks we monitor. The company has grown its dividend for 13 consecutive years, reaching the halfway point to joining the list of dividend aristocrats.
As seen below, IFF’s dividend increased at a 9% annualized rate over the last decade but has seen its growth rate accelerate in each of the subsequent periods, capped off by a 20% dividend increase in August. The company’s goal is to return 50-60% of net income to shareholders, and its expectations for double-digit earnings growth should fuel at least 8-10% annual dividend increases going forward.
IFF trades at 20.7x next year’s consensus earnings estimates, reflecting the high quality and consistency of its operations. IFF’s dividend yield is 1.9%, below the market’s average.
To justify its premium, IFF needs to execute on its objective to grow earnings by 10% per year, excluding foreign currency movements. We believe the company can hit its goal because it basically calls for the business to do more of the same – over the past five years, sales and GAAP earnings have compounded at annual rates of 5.8% and 15.5%, respectively.
With about 16% market share and half of sales coming from emerging markets, where per capita consumer spending is on the rise, IFF should have plenty of opportunities for profitable growth. Should foreign currency volatility or raw material costs create headwinds for IFF, we would view them as buying opportunities. The company doesn’t appear to be a bargain today, but we have no 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, the stock’s yield and earnings growth still suggest total return potential of about 10% per year.
We won’t lose any sleep holding the stock for the long term and look forward to more dividend growth ahead.
IFF is a wonderful company trading at a fair price. While the company’s dividend yield is too low for investors living off dividends in retirement, the dividend’s growth prospects appear excellent. We think the business is well positioned for future sales and earnings growth with half of its business in emerging markets and continual R&D investments that will further entrench the company with its customers. Any noise caused by foreign currency fluctuations or raw material price volatility would appear to be an opportunity to accumulate more of the stock.