Sensient: Not Cheap Enough Given The Lack Of Growth

Sensient Technologies (NYSE:SXT) is a company focused on flavors and ingredients for food and beverage products. The firm is often categorized as a specialty chemical firm, though it is also involved in many organic products, such as in the sale of dehydrated herbs and vegetables. It also produces colorings for foods along with cosmetics and other applications.

Long-time readers may know that spices and flavorings company McCormick (MKC) is one of my favorite long-term investments and larger portfolio positions. And yet, I don't own the other companies that seem like natural peers, such as Sensient or International Flavors & Fragrances (IFF). What explains why McCormick is a core holding, while I don't own Sensient?

Brands Matter

While both McCormick and Sensient sell products which enhance the flavor or appearance of food, the similarity largely ends there.

McCormick sells mostly branded products. The most obvious are the company's spice bottles with the McCormick logo on them. But it also has a bunch of branded consumer spices, hot sauces, and other flavors under well-known retail brands such as French's, Frank's, and Cholula.

Sensient, by contrast, tends to sell commodity products that go into other people's value-added products. Browse Sensient's website and you'll see them touting coloring or flavor solutions for soy sauce, curry coatings, ice cream toppings, and mac & cheese products among others. The difference being that it is ultimately a different brand that slaps its label on that box of mac and cheese or bottle of soy sauce, rather than Sensient.

There's nothing wrong with making key inputs into other people's products, of course. However, it inherently tends to be less profitable than owning a brand itself.

Indeed, McCormick has long maintained an operating margin significantly above Sensient's:

There tends to be less volatility in the branded goods' makers margins as well, as there is usually more pricing power when you own the label rather than selling a commodity good.

McCormick is currently facing its worst margin compression in quite a while thanks to supply chain and inflationary pressures. Still, it pales to the drop Sensient saw in 2020, for example. Investors tend to assign a fatter multiple for a higher-margin and lower-volatility business.

Of course, at the right price, the lower-quality business can be a better investment than the higher-quality one. However, I'd argue that Sensient simply isn't cheap enough to merit investment capital at this time. That comes both from the starting valuation and the growth (or in this case, lack thereof).

Sensient: Struggling To Grow

The core issue with Sensient starts on the top-line. The company's revenues peaked at nearly $1.5 billion annually back in 2013 and have failed to grow at all since then:

This is reflected across the company's other key financial metrics as well. Over the past decade, Sensient has seen no growth in total assets. Meanwhile, earnings and free cash flow have both grown at a roughly 2% annualized rate over the past decade.

In effect, Sensient has been running in place. The business generally does no better, nor any worse, in any given year. The company has seen virtually flat gross margins and operating margins as well; the business just keeps humming along spitting out virtually the same results year in and year out, with the exception of the dip in 2020.

To the extent anything has changed, it has been due to Sensient's share buyback. The company reduced its shares outstanding from 50 million to 42 million over the past decade, allowing it to generate a modest amount of earnings growth despite the lack of top-line growth.

While income hasn't gone up, the significant reduction in the share count has given each share of the company ownership of a larger piece of the pie. That said, the buyback hasn't been enough to really move the needle given the weak top-line results.

Over the past decade, McCormick has grown earnings per share roughly 70%. Sensient has had slower growth. International Flavors and Fragrances, by contrast, has seen its earnings tumble thanks to a bad M&A deal and operational problems.

To be clear, there is a right price for this sort of business.

However, Sensient is currently trading at 23x this year's estimated earnings. And analysts project earnings to grow just 1% this year. That's not too great.

The common complaint with higher-P/E companies like McCormick is that they are too expensive compared to peers. But, at least, you usually get 7-9% annualized earnings growth out of the higher-quality staples names. High single digits growth can get you out of a lot of valuation troubles with time. 23x times forward earnings for Sensient -- with no revenue growth for a decade -- seems like a trickier valuation puzzle.

SXT Stock Verdict

At the right price, I could understand an investment in a company like Sensient. The products aren't glamorous, but they are also unlikely to disappear anytime soon. Basic colors, food ingredients, and flavorings don't go out of style, and Sensient should be able to keep grinding out its usual level of revenues and earnings for many years to come.

If purchased at a favorable price, this sort of steady-state investment can deliver attractive returns.

Unfortunately, I just don't see Sensient offering up that value today. Shares are at 24x current and 23x forward earnings. This amounts to an earnings yield in the low 5s. With very low expected earnings growth, it's hard to forecast total returns much above 5%/year plus the dividend given that starting point. And it wouldn't be at all surprising if Sensient's P/E ratio drops to 18-20x over time, which would be a drag on future returns.

Barring some sort of major change, Sensient will probably be in a similar place in a few years as it is today. That is to say, around $3-$3.50/share of annual earnings, a 2% dividend yield, and a stock price still lingering around $80 as it has done for many years now.

Indeed, shares have essentially traded flat since the mid-2010s, only dropping during the pandemic and then briefly hitting $100 in the 2021 market melt-up before returning to the long-term average. Without any fundamental change to the business' earnings or prospects, it's hard to see much upside from here. The company will remain solidly profitable and paying its dividend, but there just isn't enough else here to merit an investment today.

To change my view, I'd need one of either two things. One, a better starting valuation would make the math easier. At a 17x P/E ratio, for example, we'd get a 6% starting earnings yield. Even 2% annualized EPS growth on top of that plus the dividend gets to a 10% annualized total return forecast.

If the P/E ratio doesn't come down, the other method would be through re-establishing top-line growth. Acquisitions or investments in proprietary products which would drive either demand or margin growth would be favorable. That said, as long as Sensient keeps kicking out the same $1.4 billion a year in revenues with roughly flat net income, I just don't see 23x earnings as a cheap enough entry point.

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