While food and soaps are part of our everyday consumer staples, we tend to neglect why we choose these products in the first place. Most of the time, it is the flavors and fragrances that influence our purchasing decisions, and this has a positive impact on the pricing power of these suppliers.
In fact, all three publicly-traded flavor suppliers, Ingredion (NYSE:INGR), McCormick (NYSE:MKC), and International Flavors & Fragrances (NYSE:IFF), or IFF, have exhibited either margin stability or margin expansion over the past decade. Both McCormick and International Flavors & Fragrances have delivered stable gross margins in the 40%-42% range for the past 10 years; while Ingredion achieved record margins of 18% in fiscal 2011 and 2012, up from 14% in 2009.
Quality and functionality matter
For the customers of the three favor suppliers, quality and functionality are simply much more important than price. According to a study done by the Alcott Group, close to two-thirds of survey respondents claimed that "flavor makes all the difference." This is hardly surprising, considering that an increasing number of consumers are eating at home more often. Given that most of them are not Michelin Star chefs, they rely heavily on spices and seasonings from McCormick to make their food taste better.
This is a similar case for Ingredion, a producer of starch and sweetener ingredients. Putting health issues aside, high fructose corn syrup, one of Ingredion's key products, is largely responsible for the sweetness of items such as soft drinks, yogurts, and ice cream.
There may be a thousand and one reasons why we like our favorite ice cream, but if it isn't sweet, other features don't even come into consideration. Another example is Ingredion's starches, which are used as binding agents for sauces in frozen foods so that food quality isn't affected by the freezing and cooking processes.
Another way to assess product quality is to look at the amount of money that a company spends on research and development (R&D). Approximately 8% of IFF's sales is reinvested in R&D to develop new flavors and fragrances, and this hasn't gone to waste. As of year-end 2012, IFF has a portfolio of 235 patents, including 11 granted in 2012.
Lower relative cost
The smaller the proportion of a customer's budget spent on a product, the lower the price sensitivity of the customer. McCormick claims that its products account for about 10% of the cost of a meal but 90% of the flavor. Similarly, Ingredion's ingredients represent less than one-tenth of customers' product costs. According to an article on Daily Mail U.K., the liquid concentrate only makes up approximately 3% of the total cost of a perfume.
This disproportionate benefits-to-costs ratio suggests that customers are less likely to squeeze flavors and fragrances suppliers as part of cost-cutting initiatives.
Customer profitability and diversity
Profitable customers are less likely to haggle over price with their suppliers. In the case of McCormick, its customers include most of the top-10 global food manufacturers and restaurant operators. By virtue of diversifying its sales among the market leaders, any single customer that performs poorly doesn't have a big impact on McCormick.
This is the same case for Ingredion, whose customer list reads like a who's-who of top companies in the world including General Mills, Kraft Foods, and Nestle. Furthermore, except for the food industry, no single industry accounted for more than 15% of Ingredion's fiscal 2012 sales.
IFF also has limited customer concentration risks, with only one single customer representing more than 10% of sales.
For those who worry about relative bargaining power, their concerns are unfounded. According to Euromonitor, McCormick is the market leader in the $10 billion food-flavor market, with four times the market share of its nearest competitor. In its 2012 annual report, Ingredion claims to be the largest producer of corn-based starches and sweeteners in South America. IFF also has about 16% market share of the global flavors and fragrances industry and is among the four-largest players.
Foolish final thoughts
In an increasingly challenging environment where companies face rising commodity and labor costs, the ability to pass on cost increases to your customers is priceless. All three listed flavor suppliers are your safest bets in such an environment. They should continue to enjoy strong pricing power because of the high benefits-to-cost ratio of their products and relatively strong bargaining power with customers.