Knowledge Leader Company Spotlight: International Flavors & Fragrances by Eric Bush, CFA, Gavekal Capital Blog
International Flavors & Fragrances is a “leading global creator of flavors and fragrances used in a wide variety of consumer products”. IFF produces fragrances used in perfumes, cosmetics, and fabrics among other personal and household products and is also a global leader in creating flavors for beverages, sweet goods, savory and dairy products around the world. IFF currently has the second largest market shares in the $18 billion flavor and fragrance market and has a longstanding history of profitability as it has been in business for 126 years. While headquartered in New York, IFF is truly a global company as 79% of IFF’s sales come from outside of the United States. IFF has 29 manufacturing facilities that serve customers and consumer in over 100 countries.
At the recent Barclays Global Consumer Staples Conference in Boston, new CFO Alison Cornell touched on several keys to success for IFF. Not surprisingly for those that study innovation and growth, intangible investments such as research & development (R&D) and firm-specific resources play a critical role in their recently implemented Vision 2020 strategy “which focus on building greater differentiation, accelerating profitable growth, and increasing shareholder value” (source: Call Street transcript for Barclays Global Consumer Staples Conference in Boston). Vision 2020 has four pillars: 1) win where we compete 2) innovate first 3) become their customers’ partner of choice and 4) strengthen and expand the portfolio. While all four pillars rely upon intangible investments to differing extents, let’s focus on pillars two and three.
While intangible investments in R&D are a staple for corporate growth strategies, R&D investments are still treated as an expense on the income statement under GAAP accounting standards. We attempt to compensate for the shortcomings in the Financial Accounting Standards Board (FASB) rule SFAS #2 by capitalizing R&D and other intangible investments and carry that intangible investment at historic cost on the balance sheet. By making these adjustments, one gets a much better picture of a company’s capital stock of which future profits are derived from. IFF has been a consistent and industry leading investor in R&D for several decades. They use a “customer-driven” approach to R&D that allows IFF to focus its efforts on areas that offer the best possible return. IFF spends approximately 8.2% of their sales on R&D which is 36% more than their nearest competitor. Over the past 20 years, IFF has spent 8% of their sales on R&D annually. It is through this continued investment that the second pillar of IFF’s Vision 2020 strategy will be achieved.
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The third pillar of IFF’s strategy, become their customer’s partner of choice, relies upon intangible investments in their workforce and a unique organizational structure to drive their brand success. IFF focuses on understanding their local consumer and provide outstanding service in all countries where they sell their products. This cannot be done without trained workforce and interconnected organizational structure. IFF has structured their organization so that the creative teams work in close partnership with the product development team to create scents and tastes that their consumers are seeking. IFF spends an additional 5% of sales each year on non-R&D firm-specific resources in order to train their workforce and create unique organizational capital. This helps IFF able to command above average margins for their innovative products as they have the second highest net profit margin among their peers and increase sales at a nearly 7% rate annually for the past 20 years.
As usual for highly innovative companies, analysts are losing the forest for the trees and have been lowering growth expectations for the company in the face of a new R&D campaign. Over the past six months, FY1 sales estimates have been lowered by 90 bps and FY1 EPS estimates have dropped by 220 bps. This means that analysts now only expect IFF to grow sales by 3.6% annually over the next three years and grow EPS by 7.3% annually over the next three years. This is well below the 10-year least squares growth rate that IFF has managed. IFF has grown sales by 6.2% and EPS by 8.3% annually for the past decade. In the Knowledge Effect, we identified the cause of this mismatch between growth expectations and actual returns. Innovative companies that invest heavily in intangible capital are usually punished in the short-term by analysts since these investments are forced to be expensed immediately by traditional accounting procedures which lowers current period net income. However, when the fruits of these investments are realized down the road, there is usually a catch-up period where analysts are forced to revise their estimates higher as the company is far surpassing expectations and this leads to a period of significant positive abnormal returns for the stock. With management’s focus on the Vision 2020 strategy and with growth expectations currently being cut, IFF may be on the verge of such a catch-up period.