International Flavors & Fragrances

International Flavors & Fragrances reported solid second-quarter results highlighted by sales growth in all three segments.

Why it matters: IFF shares were up 6% on Aug. 5 at the time of writing as the market reacted to management's outlook for higher revenue and profit growth excluding divestitures. The outlook is directionally in line with our long-term view that revenue growth will drive margin expansion. Management also revealed it will use proceeds from the food ingredients divestiture to pay down debt and repurchase shares. We are in favor of both moves. Reduced debt will keep the balance sheet healthy and as IFF shares trade below our fair value estimate, we view repurchases as value accretive. IFF has been able to quickly raise prices to offset energy and commodity chemicals cost inflation as a result of the Middle East conflict. This supports our view that IFF has strong pricing power, which enables the company to quickly pass along higher costs.

The bottom line: We raise our fair value estimate for narrow-moat IFF to $95 from $90. The increase is driven by our outlook for higher near-term growth versus our prior forecast. At current prices, we view IFF shares as undervalued, with the stock trading a little more than 10% below our updated fair value estimate, which puts shares in 4-star territory. IFF is amid a transformation, finishing divestitures of noncore businesses, while investing in its three segments—taste, scent, and health and biosciences—where the company is a market leader and has pricing power.

We raise our IFF fair value estimate to $95 from $90 following the company's second-quarter earnings. The increase is driven by our outlook for higher near-term growth versus our prior forecast. Our valuation includes the food ingredients divestiture. We assume the deal closes as proposed in 2027 and IFF receives $3.8 billion in cash net of taxes and fees and retains a 10% equity stake, valued at $200 million.

Our weighted average cost of capital for IFF is about 7.5%. Our stage two EBI growth rate is 4.5%, reflecting IFF's pricing power from its specialty ingredients and the growing demand for its products, especially in emerging markets as incomes rise.

In the near term, we see slightly higher segment profits driven by growth across all three businesses, partially offset by divestitures in the taste, scent, and food ingredients segments. Excluding divestitures, we forecast IFF would see mid-single-digit profit growth in 2026. IFF has a negligible direct impact from tariffs of 1%-2% of sales, and the company should be able to pass along any input cost inflation resulting from the energy and commodity chemicals supply shock caused by the Middle East conflict. We expect this impact will largely be mitigated through supply chain initiatives to reroute production and price increases.

Longer-term, excluding the food ingredients divestiture, we see low- to mid-single-digit annual companywide revenue growth, driven primarily by higher volume. We expect the taste and scent to grow slightly below the companywide rate, while the adjusted EBITDA margin will be in the low 20s, in line with historical levels. In health and biosciences, we assume IFF's Danisco enzyme and probiotics businesses can maintain their number-two market shares by developing new products, as the market grows at a mid-single-digit annual rate, driven by increased consumer demand for more health-focused products. We forecast long-term segment EBITDA margin to expand slightly, but remain in the mid-20% range generated in 2025.

In a downside scenario, we assume low-single-digit companywide revenue growth, excluding the food ingredients divestiture. We also assume EBITDA margins in the low 20% range, below our base-case margin assumption of the mid 20s. Our fair value estimate would fall to $70 in this scenario.

We assign International Flavors & Fragrances a narrow Morningstar Economic Moat Rating. The most appropriate lens for analyzing the company’s competitive advantage is our moat framework for commodity processors. Moaty businesses that operate in this space tend to benefit from switching costs, intangible assets, or cost advantage. For IFF, we cite intangible assets and switching costs as its two sources of moat. The company’s highly valuable intangible assets in the form of proprietary formulations provide significant pricing power, while switching costs ensure the durability of economic profit generation.

Intangible Assets

The taste and scent segments generate around 60% of companywide profits excluding divestitures. Here, intangible assets stem from research and development spending required to develop highly engineered, proprietary formulations that can’t be precisely replicated. Although customers specify the flavor, texture, and fragrance profiles they seek, the resulting formulations are proprietary and remain IFF's intellectual property. This establishes valuable intangible assets that enable IFF to generate economic profit over the product lifecycle in which the proprietary formulations are used.

For taste and scent, widespread acceptance on customer core lists serves as an additional intangible asset. Large multinational consumer packaged-goods companies, and increasingly midsize companies, use core lists of flavor and fragrance suppliers. A core list is a select list of typically two to four authorized suppliers. Suppliers that are not on a customer's core list usually will not have the opportunity to bid on its business. Only the top four flavor and fragrance companies have truly global operations, so competition for multinational customers is largely limited to the Big Four: IFF, Givaudan, Symrise, and DSM-Firmenich.

In health and biosciences, IFF is the second-largest player, with approximately 25% market share in both the enzymes and cultures industries, second to Novonesis, which controls approximately 50% of these markets, but well ahead of DSM-Firmenich, which is third with a 5%-6% market share. We think IFF is well-positioned to maintain its market share through its portfolio of differentiated products that command pricing power. IFF's enzymes, which are naturally occurring proteins that catalyze chemical reactions, and culture products help its customers improve the performance of their household care or nutrition products, which allows their customers to charge a higher price for their products.

R&D capability is another intangible asset that enables IFF to win business at prices that generate economic profits. Innovation is critical for customers in the consumer staples industry; winning business is predicated on suppliers providing cutting-edge ingredients and solutions. Ingredient complexity continues to increase as consumers seek lower levels of sugar, fat, and salt while remaining unwilling to sacrifice taste. Like Givaudan, Symrise, Novonesis, and DSM-Firmenich (other wide-moat competitors that we cover), IFF makes a substantial investment in R&D spending. R&D accounts for roughly 6% of sales companywide, but we estimate IFF’s investment is around 8% of sales in its taste, scent, and health and biosciences segments. This level of investment is in line with its top peers and should ensure the product pipeline remains strong.

Switching Costs

After a brief is won, switching costs ensure the durability of economic profit generation. IFF manufactures customized solutions for the food, beverage, personal care, and household products industries. Once IFF wins its flavor or fragrance in a product, its customer will rarely, if ever, switch. This is because a formulation cannot be precisely replicated by a competitor, even among the four leaders. If a customer were to switch suppliers, it would risk altering the taste or scent of its products, which could impair its own brand equity. This is a particularly risky proposition for many CPG companies, given the capital they invest in building and marketing their brands. Typically, once IFF wins an ingredient, customers retain the firm as the sole supplier of that ingredient for the full lifecycle of a given product, which is an average of three to five years, but can last decades for popular products.

Similarly, in health and biosciences, IFF’s cultures and enzymes are often designed specifically for its customers. This is particularly important in nutritional products that offer probiotics or in laundry detergents, where unique health or performance attributes underpin marketing claims that establish brand differentiation. As enzymes and cultures are live, there is a long lead time for companies like IFF to be able to provide customized solutions, and a new formulation can take over two years to develop before it is ready to be tested by the customer.

The intangible assets and switching costs result in strong pricing power for IFF. IFF typically sets its prices to ensure a strong margin when it bids for a new product. Once its flavors or fragrances are selected to be in a product, prices are reset based on an agreed-upon index of raw materials prices, which are customized to represent the ingredient’s cost structure. This ensures that IFF continues to generate strong profits throughout a product’s life. IFF’s moat is also evidenced by higher profit margins. The top four companies, including IFF, have average EBITDA margins in the low- to mid-20s, while the second-tier companies have EBITDA margins in the mid- to high teens.

Historically, we viewed IFF as a wide-moat business and we view the taste, scent, and health and biosciences as worthy of wide moat ratings. However, the no-moat food ingredients business weighs on our companywide rating. All in all, we're confident IFF’s specialty ingredients will generate returns on invested capital for at least the next decade.

As the largest specialty ingredients producer globally, IFF holds an enviable portfolio of market-leading products spanning multiple industries.

The company is well positioned to capitalize on multiple growing end markets, including natural flavors, enzymes, and cultures.

IFF's high R&D spending acts as a barrier to entry, underpins innovation, and promotes future growth.

IFF overpaid for the Frutarom and DuPont nutrition and biosciences acquisitions, leading to shareholder value destruction.

IFF will see slow growth as a result of its mostly mature ingredients end markets.

Around 40% of IFF's sales are to developing markets, which brings increased volatility and exposure to currency, country, and geopolitical risks.