Source: Archer Daniels Midland

In the first week of July, Archer Daniels Midland (NYSE:ADM), one of the largest food processing companies in the world, announced that it planned to acquire WILD Flavors, a global market leader in natural flavoring ingredients. While the academic evidence on M&A value creation has been mostly discouraging, Archer Daniels Midland's planned purchase of WILD Flavors could be a notable exception. Comparing the target with flavoring company International Flavors & Fragrances (NYSE:IFF), or IFF, provides more evidence for this.

Synergies between the two companies
When one company acquires another company, the key question is whether the two companies are better off as one entity. The business world typically calls this synergy. The transaction between Archer Daniels Midland and WILD Flavors is synergistic for three reasons.

Firstly, both Archer Daniels Midland and WILD Flavors have complementary capabilities; they have no significant overlaps in products, geography, or customer segments. Archer Daniels Midland has a greater focus on food ingredients, while WILD Flavors' strengths are in beverage ingredients. WILD Flavors has a strong presence in Europe; Archer Daniels Midland derived close to three-quarters of its 2013 earnings before taxes from the US. WILD Flavors' customer base comprises mainly small and medium-sized consumer packaged goods, or CPG, companies; Archer Daniels Midland deals more frequently with large CPG companies.

Secondly, the combination of Archer Daniels Midland and WILD Flavors will put the new entity in a better position to leverage the health & wellness trend. As more consumers seek healthier food & beverages, they will prefer more fiber and protein and lower their intakes of sugar, fat, and sodium. At the same time, most people aren't ready to compromise on the taste of their food and drinks as well. Archer Daniels Midland and WILD Flavors supply the fiber & protein and the taste, respectively, which makes them a good match.

Thirdly, the new entity will be able to establish stronger relationships with its customers because it will have a portfolio that will allow it to offer collections of blended or co-processed ingredients. Corporate customers prefer to deal with complete food solution providers (which offer ingredients and flavorings) rather than individual ingredient suppliers.

The numbers speak for themselves. Archer Daniels Midland expects synergies of EUR 100 million in the third year after the completion of the deal, with two-thirds coming from cross-selling opportunities, joint product development, and new markets. The remaining third of the synergies will result from improved cost efficiencies.

Source: Archer Daniels Midland

Why flavoring companies are good businesses to own
Synergies aside, it's also worth considering why Archer Daniels Midland decided to buy a flavoring company. As an example, IFF, among the top four players in the flavors and fragrances industry, has approximately 16% global market share.

It boasts a stellar financial track record, as it has achieved attractive gross margins of 40%-44% and operating margins of 14%-18% for the past decade.

Two factors play parts in IFF's consistent profitability. Firstly, the flavors and fragrances market is fragmented and the four big players within it, which include IFF, account for two-thirds of market share. That suggests that IFF has significant bargaining power with its customers.

Secondly, end customers are less price sensitive when it comes to flavors. A study by Alcott Group showed that 65% of respondents indicated that flavor makes all the difference in their meals. As a result, a consumer is more likely to pay a 'premium' for such flavoring products, notwithstanding their costs.

Similarly, WILD Flavors has an EBITDA margin in the mid-teens, which is equally impressive, as the company benefits from low customer price sensitivity toward flavoring products. In addition, its status as the market leader in global natural beverage ingredients and flavor systems for the global natural F&B ingredients market puts it in a position to negotiate for better prices with its customers.

Foolish final thoughts
In my opinion, Archer Daniels Midland made the right decision to buy WILD Flavors, given the deal synergies and the strong margins of a flavoring business. Going forward, with the WILD Flavors and specialty ingredients business expected to account for more than 10% of its sales, Archer Daniels Midland is well-positioned to capitalize on consumer demand for specialty ingredients and flavors.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.