Givaudan (GIVN), Robertet (RBT) and the flavors and fragrances industry

“Everyone wants the scent of flowers, but few dirty their hands to cultivate them.”

Augusto Cury

Since the earliest civilizations, fragrances and scents have evoked a series of sensations that were related to divine exaltation, health or luxury. Already among the clay tablets that the Sumerians used to write in Mesopotamia (3,500 BC), recipes were found for the elaboration of perfumes based on oils, jasmine, honeysuckle, lily and hyacinth. Centuries later, it was the ancient priests of Egypt who used their own perfumes before invoking the gods, to promote the elevation of the spirit and to obtain their protection. The ancient Romans were also perfume enthusiasts. Gladiators were covered it before fighting, perfumes were used in all public shows to mask the smell of the masses and it was mandatory at banquets while it was offered in jars as gifts for diners. Different perfumes were also developed for different parts of the body and the frequency of daily use was constantly increasing.

Civilizations have since developed better techniques for the extraction and production of perfumes, but their relevance throughout history has always been the same. Fragrances have brought pleasure to our lives evoking different feelings of joy, relaxation, increased self-esteem or exaltation of individualism, but it is the memories that we associate with them that bring the greatest feelings. According to a study by Ambi Pur, people remember 35% of what they smell compared to 5% of what they see, and 46.3% of the thousand study participants admit that smelling something familiar again influences them more than seeing or hearing it. In the same study it was concluded that 84.2% are influenced by the smell of a store when deciding whether to go inside or not.

The study is conclusive. Although the techniques of extraction and production of fragrances have been changing throughout civilizations, their relevance in history has remained practically intact. Haute Luxe is the result of the most unique combination of materials from the British perfume house Roja Dove, and it sells for $3,500 a bottle ($35,000/liter). The perfumery itself describes it as "a chypre wrapped in cashmere" and claims that it brings together the best rose and jasmine fragrances in the world. The truth is that, although the raw material of the essence may be of exquisite quality, the two main ingredients of any perfume in the world are alcohol and distilled water. Depending on the fragrance concentration, a perfume can be labeled as Eau Fraîche (the amount of essence in water and alcohol is between 1-3%), Eau de Cologne (2-4%), Eau de Toilette (5- 15%) or Eau de Parfum (15-20%), with a difference in intensity and duration. Fragrance is the key to the end product, but the cost barely represents 4 - 6% of the price the consumer ends up paying (not bad for Roja Dove, which may be making a gross profit of at least $3,200 - $3,300 for each of these bottles).

Fragrances are unique and complex combinations of natural and synthetic ingredients that are added to products to give them a distinctive smell, becoming the olfactory signatures of the great national and international brands. Today they are not only used in perfumes, but in hundreds of everyday products that we use daily such as cosmetics, hygiene and care products, textiles and household products. The fragrances in these products are essential to generate brand loyalty, since their smell influences a consumer's repurchase decision between 1 and 4 times more than the brand, price and image of the product, while the cost is still lower than in pure perfumery market, representing between 0.5% - 2% of the end-product price.

Givaudan and Robertet are two companies with roots in the 19th century of classical Europe, and both have retained their industry benchmark status over the decades. They currently develop, produce and sell these fragrances on a global scale. They are critical suppliers in the supply chain of their clients (L'Oréal, Hermès, Chanel, Unilever, etc.) and provide solutions of great added value, which are key to ensuring the success of the end product and at the same time represent a very small percentage of the client’s cost of goods sold.

The fragrance business of Givaudan and Robertet is focused on creating compounds and ingredients that will end up being integral elements of thousands of products in different categories (from household and personal care products to luxury perfumes). The operations in this segment are vertically integrated. New natural or synthetic molecules are being developed in research centers and later patented. The development of these molecules is a complex process as well as costly in terms of capital and time. A perfume usually contains 80 different molecules within the fragrance and, although the processes are being shortened, for the development of a new molecule it takes between 2 and 5 years from the beginning of the research until it can finally be used for commercial purposes.

While new molecules are being developed, new ways of extracting ingredients and new encapsulation systems for shipment and delivery to the end client are also being searched. These high complexity systems transport and release fragrance molecules at the right moment and with the right intensity to achieve freshness over a long period of time. Modern perfumery focuses not only on transmitting the perfect scent, but on transmitting it at the perfect moment. An example in response to these challenges is the melamine-formaldehyde microcapsule that Givaudan has developed. Mechacaps® allows the release of fragrances in textiles or hygiene products such as deodorants that respond to friction or contact with water or sweat.

In research and development centers, the laboratory team works with perfumers to develop, in partnership with the client, new fragrances that consumers associate with a sensation, a moment, an object or a place. Having a portfolio with a greater number of patented molecules than the competition is an asset that perfumers can take advantage of to enhance their creativity and be able to promote the development of new innovative fragrances and a greater palette of scents, thus improving their value proposition for the client. The success of fragrance manufacturers is directly related to their ability to innovate and tailor fragrances to specific consumer preferences. Although smells don’t vary from one country to another, the emotions associated with a smell are different (ex: in the West, fragrances associated with babies have more powdery notes while in Latin America they are more citrusy).

Companies such as Givaudan and Robertet leverage their research centers to expand their operations to adjacent industries such as flavors, thanks to the similarities and synergies with the fragrance industry. However, the nature the market of food and beverage flavors has a more local nature due to the logistical difficulties of transporting and preserving the quality of the raw material. For this reason, production centers are smaller in scale, closer to the end market and more focused on serving local needs. Sometimes, flavor manufacturers must develop different formulas for the same global end product, since they need not only to adapt the flavor and the ingredients according to the preferences of the local consumer, but also to fit both into the corresponding regulatory framework for that market. The fragrance business has a more global distribution model (encapsulated molecules are more stable and easier to transport) and the number of required production centers is lower. The unit economics of the flavors business are worse because global scale is not a determining competitive advantage per se, since the local/regional nature of the market gives small competitors the opportunity to dominate certain niches.

Flavor compounds are used by clients in the pharmaceutical industry and CPG clients in the food industry, both in salty products (soups, snacks, sauces...), sweets (pastries, cereals, gummies ...), dairy products (yogurts, cheese, ice cream ...) and precooked, as in beverages (soft drinks, juices, spirits...). In recent decades, companies in the food industry have resorted to flavor manufacturers’ innovation to adapt to changing consumer preferences. Society’s pursuit of healthy products that make them feel good about what they eat while being responsible for the environment has been on the rise. According to the 2017 Council Foundation Food & Health Survey, 1 in 5 consumers directly link "being healthy" to "eating healthy." Another study carried out by the Kerry Group found that 66% of consumers look at the nutritional labels of products before buying them. These studies illustrate consumers’ active search for products with nutritional properties that promote good eating habits. From a nutritional point of view, flavor manufacturers seek to develop healthier solutions to reduce the amount of salt, sugar or fat in their client's end products based on natural and synthetic ingredients (although the latter are becoming less and less frequent due to the demand for simpler and more natural ingredient labeling). Consumers generally perceive products with a shorter ingredient list as healthier, and in the same study, 75% of consumers said they were willing to pay more for products with simpler labeling (fewer additives and preservatives).

All this innovation has to happen without compromising the taste and texture of the end product and the reputation of the brand, since regardless of how healthy a product is, flavor continues to represent 45% of the reasons why consumers end up repurchasing a product. In the same study, 84% of consumers declared that taste was the factor that most impacted their purchasing preferences (above the nutritional quality of the product) and 50% confessed that they would be willing to buy a product that tasted better and had artificial ingredients versus one that tasted half as good and had better nutritional values.

Adapting to this change in consumer preferences entails greater complexity in formulating solutions and a greater need to expand the catalog of specialized ingredients that flavor manufacturers must have access to. The reduction of salt/sugar/fat amount in food and beverages implies working with ingredients with greater added value and the commitment to the substitution of synthetic ingredients entails having a greater supply of natural raw material that is often scarce and more expensive to acquire. The availability of these ingredients must be accompanied by a technology that enables the exploitation of the characteristics of this raw material. Manufacturers are indeed redesigning special applications/natural extracts that directly stimulate the taste buds without the need to add sugar/salt/fat to the end product. In Givaudan and Robertet’s research centers, with the support of sensory panels, consumers’ taste sensations are analyzed so that expectations are met without compromising the success of a new product or the legacy of a brand. The technology developed by manufacturers around flavor modulators is making it possible to reduce the number of additives without altering the original flavor because of how they transform the consumer's sensation when eating/drinking. This is especially important given government pressure on soft drink manufacturers. Taxes on sugary drinks to fight obesity and diabetes are also accelerating innovation and reinforcing dependence on flavor providers such as Givaudan and Robertet. Essences for flavors barely represent 0.5% of the final price of a product and have become the most economical innovation tool for CPG clients who have to adapt to this new regulation.

The global fragrance and flavor industry, which has historically grown at 2-3% annualized, is $26 billion in size and oligopolistic in nature. Consolidation makes sense given the amount of capital that players have invested in R&D. In a way, investing in Givaudan and Robertet allows exposure to the consumer staples industry without companies having to invest in marketing and advertising, but these cost savings are offset by the heavy investment needed in R&D (on average they allocate 9-10% of sales). Givaudan, International Flavors & Fragrances, Firmenich (private) and Symrise, the 4 largest companies in that order, make up more than 2/3 of the industry. The remaining third is made up of dozens of medium-sized companies (Tier 2) such as Robertet and hundreds of smaller-scale companies (Tier 3) that serve one or a few clients from a single market segment. As the industry becomes more complex as a result of strict regulations, the growth in market share of the leading companies will come at the expense of the smaller ones. Givaudan's goal is to continue leading the industry and Robertet's is to maintain its competitive position by relying on strategic acquisitions to remain among the 10 largest manufacturers in the world.

The flavors and fragrances industry is not focused on price competitiveness dynamics, but on competitiveness in innovation and development. The complexity of coordinating such a business model and high client switching costs also act as a moat against competitors. In Givaudan's vertically integrated supply chain, more than 11,400 different types of raw material are processed through over 2,500 suppliers to finally produce around 75,000 different end products and deliver them to about 10,000 customers around the world. The solutions developed for both the fragrance and flavor industry are customized and are all different from each other. The smell of our preferred fabric softener, the taste of the toothpaste we usually buy, the smell of our favorite perfume... these are the olfactory/gustatory signatures of some of our favorite staple brands, but those essences/formulations are not owned by the client per se, but by Givaudan or Robertet. The relationship between fragrance/flavor manufacturers and clients is extremely intimate due to the great added value of the solutions and the possible risk of plagiarism. Large and medium-sized CPG clients work with a very select list of suppliers of fragrances and flavors, contracts are usually long-term and contract renewals are typically recurring, so business relationships tend to last decades. These usually involve partnerships in which the client asks for advice on new fragrances or flavors for a new product, and they are reluctant to send samples of these new products to suppliers outside of that list. All this innovation is born first from consumer insight programs that Givaudan and Robertet carry out through the hundreds of thousands of annual surveys. These market studies are recurring activities due to the constant change in consumer preferences. Prior to the development of new fragrances (internally or with partnerships) an appropriate price for both parties is negotiated. Once the developed molecule is patented, the manufacturer has protection for almost two decades against anyone who tries to copy any of the ingredients. Manufacturers sometimes trade molecules with each other, but ROIC is better when the molecule is used to win new contracts with new customers and can be leveraged for use in multiple end-product categories. Neither Givaudan nor Robertet depend on the success of any specific patent, since the development of new molecules is a recurring and constant process motivated by the fact that most products have a useful life limited to 3 years on average.

Although there are cases when clients integrate this operational process in their business model, there are sufficient reasons to choose to outsource it as opposed to integrating it (Givaudan alone has invested about €4,500 million in R&D during the last decade). Increasingly stringent regulations (especially within the European Union) test the ability of manufacturers to harness their resources and successfully adapt products with formulations that expire and have to be superseded by law. Givaudan and Robertet’s activities must comply with federal, regional or sometimes local regulations in different jurisdictions around the world. Fragrance solutions, and especially those of flavors, must pass incredibly demanding quality standards, since all products end up directly impacting the health of end consumers. Operating in this industry regulated by large international agencies carries a price that only manufacturers with greater economies of scale can bear. Another factor that discourages clients from outsourcing is the need for skilled labor and the need to enhance and retain technical knowledge over the years (Robertet's French subsidiaries accumulate more than 160 years of ancestral know-how). This intangible asset influences the reputation of the group within the industry and is only preserved with the appropriate corporate culture. The French company invests in the continuous training of their employees on a recurring basis and cooperates with French schools of perfumers to try to obtain the best talent in an industry where human capital is critical to success (it is estimated that there are only about 600-700 perfumers worldwide). Robertet alone (2% global share in the flavors and fragrances industry) employs more than 2,000 people worldwide; 95% of them have permanent contracts and the average seniority exceeds 11 years.

Over the next decade, smaller-scale competitors will see their ROIC hurt by the increased investment in capex needed to adapt to changes in regulation. Those that manage to do so and do not disappear will become strategic assets for large firms to access new markets and clients. In addition, the fragrances and flavors industry is characterized by the great bargaining power of CGP clients, intensifying the consolidation of the supply side and also the competition between large manufacturers. Over the last three decades, the gross margin of the main fragrance and flavor companies has decreased by more than 1,000 basis points, although the pressure on the price of fragrances and flavor solutions is mitigated by the economies of scale achieved once they enter the supplier list of these large multinational clients. Wherever Nestlé opens a production facility, suppliers will tag along, and cross-selling will be promoted, thus reducing the percentage of OPEX with respect to total sales. Givaudan's operating margin has been more or less stable over the last 15 years, around 14% - 16% on average. Robertet's client base is more fragmented and with less bargaining power, as they are more regional or local in nature (gross margins are higher). However, economies of scale are more difficult to achieve, the life cycle of products is shorter and supplier rotation is higher, since the strategy followed by small clients is different from those who work with a limited list. There is increasing interest in accessing these regional/local clients because they tend to be present in emerging markets where growth prospects are higher (growth is double that in developed markets) as a result of increased population and income average per capita. On the other hand, the barriers to entry in the CPG industry are notably lower than in the last century. According to Givaudan, the 25 largest US CPG companies have lost more than $20 billion since 2009, replaced by new start-ups that have built powerful brands by bypassing traditional production and distribution channels. These startups, which are focused on building a brand through more efficient and affordable digital channels while outsourcing production and distribution, are adapting faster to new consumer trends. Brand creation times have been severely shortened and new products are being launched in just 9 months, while it would usually take between 2 and 5 years. under a traditional approach. Large multinationals have been forced to restructure their strategy as they try to cut costs (by putting pressure on the prices of suppliers such as fragrances and flavors) in order to survive in an industry with more competition than they were used to.

All of these factors are tailwinds for larger-scale fragrance manufacturers, but future topline growth will be fairly limited. The industry is in a mature phase where 90% of global sales are already under the control of the 10 largest companies. Although the remaining 10% is dominated by hundreds of companies with sales of less than €100 million, the high prices in some recent acquisitions in the sector (above 15x EBITDA) call into question the creation of future value through this type of operation. The reason for these multiples is the high terminal value of the industry, and the fact that many companies are private, generational and possess strategic technology protected under patent. Most future growth will come from their ability to develop innovative solutions that bring greater added value (and through which better margins are obtained) and from success in leveraging technology and resources to expand into adjacent industries (Givaudan and Robertet have recently entered the health and cosmetic category).

I believe ​​being exposed to the industry through Robertet is especially interesting because of the company’s commitment to vertical integration in the supply chain, from raw material farming to extraction and transformation for the subsequent development of fragrances and flavors. New consumer preferences imply working with natural ingredients with higher added value that are more expensive and whose availability fluctuates, as they sometimes depend on uncontrollable external factors (meteorological agents, pests, bad quality harvest…). Robertet has been investing time and capital developing its own organic certified farmlands to position as a critical supplier for the cosmetic industry in the coming years (e.g., in Spain they acquired 450 acres to grow lemon balm, chamomile, rose, rosemary, thyme and oregano among many other ingredients). In geographies where farmland is scarce and governments favor local capital, Robertet works along with local farmers to source very specific raw materials. The good work of the company, the social programs carried out for decades, the prestige and reputation favor partnerships under long-term contracts that other competitors cannot access. Robertet usually finances crops or even machinery for harvesting or extraction centers in exchange for negotiating a fixed price for raw materials for the duration of the contract (minimum of 3 years). This is especially important in an industry where prices of some ingredients tend to have triple or quadruple digit appreciations in a relatively short time (natural vanilla from Madagascar went from $20/kg to $550/kg in the last 3-4 years). Controlling the entire growing and harvesting process first-hand also allows Robertet to maintain very demanding quality standards, essential to preserve the quality of raw materials that cosmetic clients such as Estée Lauder or L'Oréal are willing to purchase at a higher price. Higher quality natural ingredients are playing an important role for smaller customers, who need them to launch new brands that can take on multinational companies and gain a relevant position in the category of premium products. These small customers are less risk-averse, more innovative, and product life is shorter, so suppliers like Robertet benefit from exposure. Overall, 20% of a fragrance and flavor manufacturer's portfolio rotates each year. This does not mean that there is no revenue recurrence, since the manufacturer does not lose the contract itself, but that the useful life of products is reduced and usually requires reformulations to adapt to regulations and consumer preferences. At the end of the cycle of each product, manufacturers have the opportunity to offer a solution with greater added value to customers for which they are willing to pay a higher price, thus achieving a higher margin for that line of business.

Givaudan has similar partnerships with suppliers, but what I find especially interesting is that it is the undisputed leader in the industry with 25% market share. When some ingredients are scarce and prices increase, having scale and bargaining power to be able to pass the increase in production costs on to large CPG clients as soon as possible is vital to maintain the profitability of the business model. This is notably important when 75% of the costs of goods sold – or 35-40% of sales – represent the cost of raw materials. Negotiations are a delicate and complex process, as each product is different and requires independent negotiation. Unlike other competitors, Givaudan has historically been able to pass on the increase in production costs to a greater extent with a delay of only 6 months since the company is aware of the price increase in raw materials. Sometimes, as a result of a poor harvest, the availability of a specific natural ingredient is affected. Having the most advanced technology on the market to provide the client with alternative ingredients that do not affect the smell/taste of the end product is key to securing lasting contracts. Over the years, scale will be a more determining factor to win in the industry.

There is no doubt about the quality of this business and it is very likely that the importance of these products will not be altered for decades to come. However, I think that only those who manage to invest at the right prices and in manufacturers with a good track record in capital allocation will end up achieving a sufficiently attractive IRR.