Company overview
We have had our eye on International Flavors and Fragrances (IFF, Financial) for years now. We have been waiting for the right buy opportunity and had established a 20% pull-back rule, whereby we would take a position anytime the stock dropped 20% below its 200-day moving average line. Unfortunately, not too many buy opportunities have arisen.
Operationally, this company has almost always passed our quality tests. The company is a leading manufacturer of natural and artificial flavoring and fragrance chemicals, seasonings, spices, enzymes, and fortified products. It serves primarily the food, consumer, beverage, perfumes, cosmetics, and soap industries. In total, the company produces over 46,000 products from within 37 manufacturing facilities located throughout the world. Its products are available for sale in 162 countries.
The global market for flavors and fragrance products is in reasonably good shape and continues to grow, primarily due to rising income levels and growing demand for scented products in emerging markets. It is also due to an increase in the variety of food and consumer products that contain flavors and fragrances. IFF’s management has estimated that the flavors and fragrances market is approximately $25 billion in size and that it will continue to grow by about 2-3% over the next few years.
The company operates in two principal segments. Its Flavors business represents about 48% of sales and its Fragrances business represents the other 52% of sales. The company is internationally diverse and its strategy is to differentiate itself through high quality products, custom made ingredients, and by positioning itself as a low cost producer.
Purchase considerations
We only wish that we had more aggressively purchased this company 10 years ago, having now seen the company’s stock price rise by over 350%. There is not much that we can do about that now. We still like this company a lot.
- It serves both broad and niche markets in regions all around the world and has tremendous international diversification.
- The company’s broad international diversification has largely render currency impacts neutralized. This has also been well supported through aggressive futures hedging.
- Customers across all markets rely heavily on IFF’s ingredients for its own products, which create substantial barriers to entry and switching costs, helping to protect the firm’s market share.
- The company has managed to differentiate itself in largely undifferentiated commodity based markets. This will become more important the more attached consumers become to certain tastes and smells.
- Rising income levels in emerging markets will prove to be a key growth driver moving forward.
- The company has a strong R&D presence, which will help to grow its market share over time.
- The company is largely recession-proof.
All that considered, there are still a couple of definite risk factors that cannot be ignored. For one, the intensity of competition within its respective markets is quite high and includes large multi-national companies and smaller regional and local competitors. Based on annual sales data, it is believed that IFF’s top competitors include Givaudan, Firmenich and Symrise—all companies that are well positioned globally. To compete successfully in such an environment, IFF will have to make continued investments in customer relationships and will need to effectively anticipate changing consumer preferences.
The cost and availability of key ingredients is also an important risk factor. Some key ingredients, like vanilla extract, are sourced heavily from certain African regions, which have proven to be unstable at times and can negatively impact IFF’s margins.
There is also the strong U.S. dollar. While being geographically diversified helps to neutralize currency fluctuations, the strong dollar does hurt sales of U.S. produced products and ingredients. It is also admittedly hard, and is going to remain hard, trying to stay ahead of changing consumer tastes and preferences in so many markets. Especially given how subjective and locally concentrated taste and scent preferences tend to be.
Protecting its intellectual property is also a risk factor. Competitors, particularly medium-sized manufacturers in many unregulated regions, try, and have tried successfully in many cases, to replicate ingredients and scent compositions to the detriment of IFF’s revenues.
Valuation methodology
For the purpose of assessing this company, we utilize a framework that we call the SEENSCO Earnings Calibration Model. The methodology is founded on a strong momentum-based stock selection criteria. The model is an equilibrium model that assumes a state in which market sentiment and supply and demand are in balance and, as a result, price multiples are stabilized. This means that stock prices are set as a function of earnings and earnings growth, not multiplier expansion or contraction. The process of evaluation is quite direct. First, we apply some basic screens to assess the company's earnings strength, balance sheet health, valuation levels, and value trap risk. Finally, we estimate the company's "Rate of Calibration," set a valuation range, and determine the return potential inherent in the stock.
Principal screens
Screen #1: Is the firm a competitively strong firm?
The first step in the model, and before committing the time to analyze the company in greater detail, is to perform a quick analysis of the company's ability to generate positive economic profits, or positive residual income. If preliminary research generally satisfies this condition, then it is worth moving on to the second screen. To assess whether the company has produced a history of positive residual income we calculate (1) the spread between the firm's return on invested capital (ROI) and weighted average cost of capital (WACC) and (2) the spread between the firm's return on equity (ROE) and required rate of return on equity (Re) over as long a period as possible. (Note that the required return on equity is calculated using the Capital Asset Pricing Model (CAPM)).
Based on the historical numbers, IFF appears to be a competitively strong company. As can be seen in the figure below, IFF earned substantial residual income, with an average ROI-WACC spread of 9.5% and an average ROE-Re spread of 20.5% over the last 10 years. The more recent data somewhat contradicts the historical data with International Flavors and Fragrances's 2017 economic profit spread (ROI-WACC) averaging 7.5% over the last three years and its current profit spread at 2.7%.
Screen #2: Does the firm’s market capitalization exceed at least $1 billion?
This is a simple screen. Basically we are only interested in companies that have a market capitalization of at least $1 billion. Market capitalization is defined as the total value of the company. This is the stock price multiplied by every outstanding share in the company. So why does market cap matter to us? Larger companies are typically more capable than smaller firms of withstanding economic shocks. That is, size contributes to business stability. Large companies aren't always fast movers, but their performance is usually fairly steady and predictable. Larger companies typically control larger market shares and are less susceptible to technological shifts and competitive forces, such as, for example, the sudden entry of a new major competitor or substitute product. International Flavors and Fragrances's capitalization at the end of 2017 was $12.0 billion.
Screen #3: Does the firm have strong, upward trending, and predictable earnings?
Our third screen requires that the company have strong, upward trending, and predictable EPS. This screen is critical as earnings are the primary driver of company value. When earnings rise, stock prices are almost always soon to follow. When they drop, normally so do the stocks. This is an important concept to grasp: earnings tell investors why a company's stock price has moved in the direction it has in the past as well as where a company's stock price is going to move in the future.
First, to judge the strength of the company's earnings, we determine the number of years within its operating history that it has generated sufficiently strong EPS. To determine whether the firm's EPS are sufficiently strong we determine the level of earnings in each year that corresponds with a return on investment of 12.0%. If the firm has been able to meet the minimum earnings requirement 75% of the time, then it will pass the first component of this screen. International Flavors and Fragrances has been able to meet the minimum earnings requirement 73% of the time.
Next, we want to see that the firm's EPS are trending upwards. A firm with strong, but downward trending earnings, is not the type of firm that we're looking for. In International Flavors and Fragrances's case, its long-term earnings trend has been positive, with EPS growing by 229.2% over the last 30 years. Its short-term earnings trend, however, has been negative with EPS falling by -26.3% over the last two years. A final determination of the company's earnings trend involves an assessment of the full curvature of the company's historical EPS line. We consider all segments of the curve and calculate a triangular weighted average trendline, with greater weights applied to the more recent earnings data. Only if the weighted average trendline is positive would the company pass this component of the screen. In International Flavors and Fragrances's case, the weighted average trendline is negative.
The last component of this screen relates to the stability of the company's earnings. Companies with more stable earnings have a history of producing a predictable pattern of performance and tend to display more stable stock prices. We measure the stability in the company's earnings by calculating a 10-year trailing coefficient of determination, or R-Squared. This indicator measures how tightly trending EPS is around a straight line projection. The indicator lies between 0 and 1. We require a score of at least 0.85 to pass this component of the screen. International Flavors and Fragrances's 10 year trailing R-Squared is currently 0.59.
Screen #4: Does the firm have a manageable level of debt?
The company that we want to invest in should have limited financial leverage. Firms that exhibit high leverage tend to be more risky than firms with low leverage, all else equal. We assess leverage through the use of the firm's adjusted debt-to-income ratio. Firms that are over 10x on this metric, we rate as having high leverage and high financial risk. Firms that have less than 5.0x, we rate as having low leverage and low financial risk. International Flavors and Fragrances's debt-to-income ratio is currently 5.6x, which is lower than our accepted threshhold of 10x.
Screen #5: Does the company trade at a stable P/E multiple?
The company that we want to invest in should also trade at a stable P/E. It is easy to waste time studying companies only to find them trading at ridiculous and unstable multiples. It is wise at the start of any evaluation to quickly look at a company's current and historical P/E to get an idea of whether the stock is likely overvalued and whether its valuations trend erratically.
To assess the stability at which the company's multiple trades, we evaluate the historial trend in the company's P/E and then establish what we consider an acceptable value range. This can be done in many ways. For our purposes, we use the interquartile range. Provided that the company's P/E has not strayed from this acceptable range more than 10% of the time over its 30-year operating history, we would consider the company's P/E to be relatively stable. International Flavors and Fragrances's P/E has trended outside the acceptable range 3.3% of the time.
In addition to wanting to see stability in the firm's P/E, we want to see that the company's P/E is trading at an acceptable level relative to earnings growth. The PEG Ratio (price/earnings to growth ratio) is the valuation metric we use for determining the relative trade-off between the price of a stock, the earnings generated per share, and the company's expected growth. It is assumed that by dividing the P/E ratio by the earnings growth rate, the resulting ratio is a better indicator for comparing companies with different growth rates than the P/E ratio alone. The PEG ratio is considered to be a convenient approximation of fair value. That is, a fairly valued company is generally considered to have a PEG ratio equal to 1. In practice, however, the PEG ratio will be higher than 1 for most undervalued companies. As such, we set the condition that if the P/E for a company is less than 15x, a PEG of <1.3 is sufficient to pass the screen. Further if the company's P/E is greater than 15x, a PEG of <1.0 is sufficient to pass the screen. International Flavors and Fragrances's P/E is currently trading at 41.1x. The market's consensus 3 to 5 year EPS growth estimate is 9.0%. This translates into a PEG ratio of 4.6.
Screen #7: Is the company suffering from any recent value-breaks?
Our last screen involves conducting value-break tests. First, this involves assessing whether the firm's trailing 12-month earnings trend has displayed any consequtive three-quarter drops over the last 20 years, with a particular emphasis on the last two years. Historically we have found that once a company's earnings have shown a persistent deteriortion over a three-quarter period, the odds are high that earings will continue to fall over the next 2 years and, as such, the company's stock price will likely follow too. The more consecutive 3-quarter drops experieced over a 20-year period, the more unstable the firm's ernings stream. And consecutive three-quarter drops over the last two years is a strong signal to exit the stock. International Flavors and Fragrances's trailing 12-month earnings per share has declined by 3 consequative quarters 0 times over the last 20 years and 0 times over the last two years. We believe that International Flavors and Fragrances has passed this first value-break test.
The second value-break test involves ascertaining whether the firm is suffering from any recent abnormal drops, or structural breaks, in its trailing 12-month earnings per share line. To do this we construct a 2-standard error forecast band around the historical EPS line and assess whether there have been any abnormal drops outside of this band over the last 2 years. In International Flavors and Fragrances's case, the firm's EPS line has recently dropped below the lower band and, as such, fails this second value break test.
Pricing the company’s stock
The key component of the Earnings Calibration Model is the calculation of the "Rate of Calibration." This is the rate at which a company's EPS, and as such its stock price, is expected to appreciate/depreciate over the next eight quarters. Estimating the Rate of Calibration is done using weighted linear regression and is calculated in 6 steps:
- Build the company's 20-year historical EPS (TTM) chart;
- Overlay the company's 20-year historical high-low stock price line;
- Using linear regression, calculate the company's 6-quarter, 3-year, 5-year, 10-year, 15-year, and 20-year historical EPS (TTM) trend lines;
- Extrapolate each historical EPS (TTM) trend line forward 8 quarters;
- Using each extrapolated trend line, calculate a weighted moving average EPS trend line, applying the most weight to the 6-quarter trend line and the least weight to the 20-year trend line;
- Calculate the growth rate implied by the company's weighted moving average EPS (TTM) trend line. This implied growth rate represents the company's "Rate of Calibration".
The figure below presents our 8=eight-quarter forward projections based on data covering each period of the valuation as well as our weighted moving average projection line. Walking through the figure, it is clear that projections based on the company's long-term EPS trend line are upward sloping. Projections based on the EPS trend line from the last 10 years are more steep, reflecting a higher pace of EPS growth relative to the longer term trend. Based on the data from the previous six quarters, the projected slope of the EPS line appears to have decreased. When the slope of projection line flattens, it indicates that the operating performance of the company has likely been deteriorating and, as such, the company's stock has likely been deteriorating as well. The opposite is true when the slope gets steeper; this means that the company's operating performance has likely been improving. Considering all projections, we have derived a rate of calibration of -1.4%.
With the Rate of Calibration calculated, the company's stock price can be easily estimated by extrapolating the stock price forward eight quarters at the Rate of Calibration, starting from the last reported quarter's closing price. Doing this produces a stock price estimate of $124.60.
Next we need to set a valuation range around the price target to facilitate the comparison of the company's current stock price and return potential and should tell us whether it's a good time to buy or sell the stock. The upper part of the valuation range signals degrees of overvaluation while the lower part signals degrees of undervaluation, and this is where investors should look for buy opportunities. To determine the valuation range, the Earnings Calibration Model bounds the price target by the 10-year average stock price trading range, representing the stock's normal volatility. The span between the upper and lower valuation lines represents the stock's fair value range and indicates where you can expect the stock to trade fairly over the next 8 quarters, given the company's earnings history and forward trajectories.
Conclusion
In the figure above, International Flavors and Fragrances's valuation range is calculated to be between $112.78 and $136.42. With International Flavors and Fragrances's stock currenlty trading at $137.00, we set a REDUCE rating on the company's stock and expect its price to depreciate by -9.1% over the next 8 quarters. It looks like we will have to wait a little bit longer for this one. IFF is an absolutely great company, but still too rich for our blood.
Disclosure: We currently do not hold any long or short positions in this company.
