Structural and Empirical Attractiveness of Flavors and Fragrances industry
This article will serve as a model for initial decision making for financial investment in a sector
Structural Attractiveness
Flavors and Fragrances (F&F) are used as a raw material in the manufacturing of products such as foods, hygiene products, cosmetics, beverages etc. The raw material may either be natural or synthetic. The majority of operations and transactions in F&F industries takes place in the B2B domain, and B2C transactions are significantly minimal.
The F&F industry is led by 4 major players.
International Flavors & Fragrances, Inc. (IFF, NYSE)
Symrise, (SY1,ETR)
Frutarom, (Privately held)
Givaudan, (GIVN, SWX)
There are many other local small players as well, but they don’t have enough power to have an impact on the industry dynamics, hence, the structural attractiveness of the above mentioned four firms will serve as a proxy for the entire industry’s attractiveness.
Bargaining Power of Customers
F&F is ubiquitous. An average consumer interacts with F&F product numerous times, right from using the tooth-paste early in the morning or moisturizing the skin at late night. The F&F has become an integrated part in the day to day life of a consumer, and it cannot be easily replaced. One possible replacement is the use of natural F&F, but that would be costlier than the synthetic products and might even not go along the tastes of the consumers, the switching cost is significantly higher. Moreover, the adoption of natural F&F will be a diversification opportunity for existing manufacturers.
In B2B interactions, the needs for each consumer (a manufacturer of end product) is different; the product differentiation is high. In addition, the reputation of the suppliers (i.e. the F&F players), is a crucial determining factor while procuring F&F raw materials. The F&F industry’s vendors space is only slightly fragmented; on the other hand, the buyers are highly fragmented.
Thus, we may say that “Bargaining Power of Customers” is Low.
Bargaining Power of Suppliers
F&F industry is highly dependent on their Research & Development (R&D), which is an internal division of the organisations. The natural chemical elements are commodity products, and procurement is less costly; also, there are numerous distributors providing the ingredients.
Supplier power is “Low”.
Threat of New Entrants
A new entrant will need to develop R&D capabilities, to compete with the existing players, which is not only difficult in terms of intellectual capital required but also in terms of financial. It would require a long time to develop trust among the B2B customers, and the probability of R&D delivering successful, safe and economical product will be small, because of the already existing patents. Economies of scale are difficult to achieve for new entrants, and product differentiation will also be difficult because of underdeveloped R&D. The existing players have a well-developed distribution network which again poses a hindrance before the new entrants.
Threat is “Low”.
Threat of Substitutes
Natural extracts could be one possible substitute for the offerings of F&F, and using them in Flavouring or Fragrances needs to be validated by critical R&D, which is already developed in existing F&F players. Moreover, the move towards natural extracts will serve as a diversifying opportunity for the existing players.
Threat is “Low”.
Rivalry among existing players
The F&F industry is dominated by only a few players. Four players (Givaudan, Symrise, IFF, Firmenich) combined have a market share of close to 49%. The four players operate in many segments, namely scent, flavour, nutrition. They also have a different concentration in different markets, but they are dominant in Europe and North America.
Rivalry: “High”.
Structurally, the F&F industry is an attractive investing opportunity.
Empirical Attractiveness (Financial Analysis)
Return on Capital Employed (ROCE)
ROCE ratio tells us how well a company/industry is generating profits from its capital.
The trend in ROCE is stabilizing, for the industry, nevertheless, an ROCE of ~15% is an attractive proposal, especially if you are a value investor.
Return on Tangible Capital Employed (ROTCE)
The ROTCE ratio is same as ROCE, except that we discount the intangible capitals in calculating the returns. The ratio gives an objective measure of the return generated by the management by using the tangible capital they have at their disposal.
ROTCE has been continuously above 15% (from 2005–2017), indicating the empirical attractiveness of the industry.
The ROTCE has declined slightly beyond 2015, which indicates that new assets have been added.
Revenue Growth and EBITDA Margin
EBITDA- Earnings Before Interest Taxes Depreciation and Amortization
EBITDA margin is a measure of a company’s operating profit as a percentage of its revenue. The acronym stands for earnings before interest, taxes, depreciation, and amortization. Knowing the EBITDA margin allows for a comparison of one company’s real performance to others in its industry. (Investopedia, 2020)
The industrial revenue has been continuously increasing (in the 16 years 2002–2017), but the growth rate is highly cyclical. Industrial EBITDA margin is stable and are converging because of the competition among the 4 players.
Operating Cash Flow Contribution and Revenue Share
Givaudan’s share in the revenue pool is the largest and has been increasing. On the other hand, Frutarom’s share has been very less, although the industrial growth momentum has helped it for revenue growth. The OCF/EBITDA has been relatively stable for the industry suggesting high cash generation.
Winners and Losers of F&F industry
Winners: Givaudan, EBITDA margin, has been slightly higher than the industrial margin, and revenue share has increased.
Losers: Frutarom, EBITDA margin has underperformed in comparison with the industry and revenue share is also less.
Overall the F&F industry is structurally and empirically attractive.