We like businesses that cater to human needs and wants, through good times and bad, and we happened to find one this quarter trading at an attractive price. We have built a substantial position.
Two things that humans are likely to aways want, or need, are sex and food.
It all starts with smell. Our sense of smell (which is also taste) is a powerful trigger of emotion and memory. We’ve all had the experience of smelling something familiar or a particularly lovely fragrance and have it conjure up a feeling, a certain memory or a sense of Déjà vu.
The ability of scent to hit us at a visceral level was articulated by the former CEO of International Flavors & Fragrances, Hank Walter, who said: “We are the industry of sex and hunger.”
We like stable, repeat businesses and it is hard for us to imagine one that is more recurring or enduring than one linked to the human desire for both food and sex. And heck, it’s a lot more fun to think about than other categories linked to enduring features of the human condition – tax accounting or funeral providers.
The flavors and fragrances business imagines, creates, and sells scent. The characteristics of the scent business are very attractive and fit a pattern that we typically like. We like a business that provides a small, inexpensive, consumable component that is absolutely critical in customer’s production process. Those components experience recurring orders, quality and reliability are paramount, are sold to scientists or engineers by other scientists or engineers, and price can be based on the value the product delivers, rather than its cost to produce. Given its criticality and modest overall cost, customers tend be price insensitive. Where that product fits into a range of end markets, and where many of those are stable, non-cyclical and growing, so much the better.
The sale of flavors and fragrances fits that mold.
The key to the business is rooted in human physiology: smell is handled by the olfactory bulb, which runs from the nose to the base of the brain, with direct connections to the amygdala (the area of the brain responsible for processing emotion) and the hippocamus (an area linked to memory and cognition). As Harvard professor Venkatesh Murthy puts it, “The olfactory signals very quickly get to the limbic system”. It is the same for taste. When you chew, molecules in the food make their way back retro-nasally to your nasal epithelium. Venkatesh again: “all of what you consider flavor is smell”.
Neuroscientists believe that the close physical connection between our sense of smell and regions of the brain responsible for emotion and memory explain why the brain learns to associate smell with certain emotional memories. Studies have shown greater brain activity associated with olfactory stimuli (like the smell of a rose) than with visual stimuli (like the sight of a rose). Many of those memories may also be childhood memories, because that is when we experience those smells for the first time. Hence, a unique scent can spark a memory going back to one’s childhood often associated with a particular event, a particular place or even a certain product. And olfactory recall can extend to 10,000 different odors, if not more.
Businesses have recognized the power of scent and its importance in marketing, branding and product differentiation continues to grow. Advertising agencies are increasingly designing a unique fragrance to go alongside a product’s packaging and other marketing materials, in what is known as “scent branding”. A number of companies have even designed bespoke scents for their physical retail or hospitality locations. Nike for example, has designed a signature scent for its stores inspired by the smell of a rubber basketball sneaker as it scrapes across the court, as well as a soccer cleat in grass and dirt. Hyatt hotels developed a brand-defining “Seamless” scent in 2007, aimed at delivering the sensation of welcoming elegance and calm through a blend of fresh blueberries, light floral on a base of warm vanilla and musk.
Smell plays a similarly important role in food and beverage products, cosmetics, household consumer products (shampoos, moisturizers, soaps, detergents, cleaning products etc), and of course, perfumes. The power of scent branding is a unique ability to form immediate, powerful and differentiated connections with customers, especially within categories of functionally similar offerings.
The creation of scent (and flavor) requires deep expertise in the areas of molecule extraction, blending and also a deep insight into consumer preferences and associations, which are often cultural and therefore highly localized. The fragrance business is one that combines both science and art and there are only a handful of companies in the world with the history, the expertise, the technology, the trusted relationships with customers, and the scale to deliver on the creation and supply of ingredients for these unique scents.
At the same time, fragrance molecules represent a small component of a product’s overall cost, despite the outsized role they play in establishing an emotional connection with the customer. The co-creation of a bespoke scent and the ongoing supply of critical ingredients requires a trusted partnership with the customer, which also leads to reasonable pricing power while the end markets for fragrances such as food and beverage, cosmetics, personal care, household cleaning products and perfumes tend to be quite stable and not highly sensitive to economic conditions.
So in the first quarter we acquired shares in one of the leading flavors and fragrances companies in the world with a history going back 125 years. The outlook for this business is for revenue growth of between 5-7% p.a. over the medium term, with a target EBITDA margin of 21-22%. At the price we acquired we estimate we paid a multiple of 12x 2025 EBITDA and around 20x P/E (also 2025) and a similar multiple of free cash flow. While we are looking ahead 2.5 years out, and these numbers are still not an outright bargain, we view valuation as undemanding for a business with excellent long-term prospects. Peers tend to be valued on between 15-20x EV/EBITDA and P/Es in the mid- to high-20’s. This business is also ungeared with net debt to EBITDA of around 1x, giving the company room to continue to make incremental acquisitions or capital returns to shareholders.
Returns on capital have been around 20% in the past and we think the business is capable of sustaining those rates of return in future. In the past year or two returns have come down owing to acquisitions and higher fixed assets, while margins came under pressure due to the timing lag between rising input costs and price increases to customers. But we are confident price increases will be passed through and margins restored. We also see opportunities for the company to optimize its product portfolio, exiting lower margin lines and with the launch of a range of newer products, helping to drive returns higher.
The business is likely to dedicate around 5-6% of sales to capital expenditure each year (as well as making very significant R&D investments), or roughly one third of operating cash flow helping to generate significant long-term compound growth in per share value. There are also significant opportunities for flavors and fragrances businesses, with their fermentation expertise and ownership of customer route-to-market, to participate in the growing trend towards consumption of plant-based proteins.