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This Stock Makes Scents for Investors

S&P says flavor and fragrance maker Sensient has good growth opportunities outside the U.S. and rates the shares strong buy

From Standard & Poor's Equity ResearchBy our analysis, the stock valuation of the flavoring, coloring, and fragrance company Sensient Technologies (SXT; $25.66) is compelling. We see opportunities for Sensient to benefit from new product development by companies in the food, personal-care, and health-care industries.

In addition, we believe that the company's geographic diversity will help to build growth opportunities in markets outside the U.S. The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

Sensient: In 31 Countries

Sensient produces flavors, colors, and fragrances for businesses operating in various industries, including food, pharmaceutical, and personal care. Customers include major international manufacturers representing some well-known brands.

Milwaukee-based Sensient has locations in about 31 countries, and has approximately 3,600 employees. In November, 2000, the company changed its name to Sensient Technologies, from Universal Foods. It did so to reflect its current business, which includes nonfood markets such as cosmetics and specialty inks.

The company's two main operating segments are the Flavors & Fragrances Group (65% of 2006 sales) and the Color Group (31%). In 2006, the Flavors & Fragrance segment provided $104 million of segment operating profit, and the Color Group provided $59 million. Sensient had net operating profit of $129 million in 2006.

Of Sensient's $1.1 billion of revenue from customers in 2006, 57% was from North America, 29% from Europe, 8.6% from what it calls Asia Pacific, and 5.5% from elsewhere.

Key Products

The main products of the Flavors & Fragrances Group are flavor-delivery systems, and compounded and blended products. This business includes the company's dehydrated-flavors business, which produces ingredients for food processors.

The Flavors & Fragrance business includes positions in selected ingredient products such as essential oils, natural and synthetic flavors, and aroma chemicals. Sensient's products are used in dairy, savory, beverage, and confectionery and bakery flavors. In the nonfood area, it supplies fragrance products to the personal- and home-care markets and supplies flavor products to the pharmaceuticals market. In 2006, Flavors & Fragrances Group had revenue of $733.4 million, and operating profit of $104.5 million. We believe that about 33% of Flavors & Fragrances' revenue came from dairy or beverage flavors.

The Color Group provides natural and synthetic color systems for use in foods, beverages, and pharmaceuticals; colors and other ingredients for cosmetics and pharmaceuticals; and technical colors for industrial applications and digital imaging. In 2006, revenue totaled $350.2 million, and operating income was $59.4 million. About 57% of revenue was for food and beverage colors.

The company has a third segment, called Corporate & Other, which includes its Asia Pacific Group. This segment produces and markets colors, flavors, and fragrances for Australia and other Asia Pacific countries. Manufacturing operations are in Australia, New Zealand, and the Philippines. In 2006, this segment had revenue of $41.3 million.

Consolidation and Competitors

The flavor, fragrance, and coloring industry has been consolidating during the past decade. Sensient has made various acquisitions, a number of which were relatively small. During 2003, it acquired Formulabs Iberica, a manufacturer of specialty inks. In 2002, it acquired four companies: Cadre, a manufacturer of specialty ingredients used in cosmetics; ECS Specialty Inks & Dyes, a producer and marketer of inks for specialty printing applications; SynTec, a German manufacturer of specialty dyes and chemicals for the imaging industry; and the flavors and essential oil operations of C. Melchers.

Competitors in the flavor, fragrance, or coloring industry include Swiss company Givaudan, U.S.-based International Flavors & Fragrances (IFF), privately owned Swiss company Firmenich Aromatics, German company Symrise, and Japanese company Takasago International.

In March, 2007, Givaudan acquired Quest International, a division of Imperial Chemical Industries, for roughly £1.2 billion, subject to adjustments. This brought together two of the largest participants in the flavor and fragrance industry.

Quest for Efficiency

We project that net revenues will rise moderately in 2007 from the $1.1 billion reported for 2006, bolstered by new products and geographic expansion.

We look for the operating margin to expand modestly from 11.8% in 2006, and with a projected effective tax rate somewhat above the 29% tax rate in 2006, we estimate 2007 net income at $73.7 million ($1.57 a share), up from $66.3 million ($1.44). In 2008, with some expected additional operating margin improvement, we look for earnings per share of $1.70. Sensient's reported EPS of 94 cents in 2005 included 21 cents of restructuring and other charges.

In 2007, we look for cash flow from operating activities to at least approximate the $99 million that Sensient reported for 2006. We expect uses of cash flow in 2007 to include capital expenditures, dividend payments, and debt reduction. The company reduced total debt by about $21 million in 2006, to $532.5 million at yearend.

We see Sensient focusing on new product development, helped by the presence of 30 research and development facilities in various locations. In 2006, the company had R&D expenditures of $24.8 million, compared with $26.4 million in 2005. Also, we expect Sensient to take steps to become more efficient. The company recently said that it has cut about $30 million in annual expenses since the end of 2000 and expects to make further cost improvements.

We believe Sensient will have additional expansion opportunities in nonfood businesses, including products for the cosmetics and pharmaceutical industries. We also expect it to focus on growth opportunities outside the U.S.

Likely Dividend Hike

Sensient shares recently traded at a price-to-earnings ratio of 16.3 times estimated 2007 EPS, about a 16% discount to the recent valuations of a couple of competitors and peers. In our view, Sensient stock warrants a p-e closer to that of these competitors, which leads to our 12-month target price of $31 for the shares.

Our 12-month target price of $31 is based on a blend of peer-based p-e comparisons and our discounted cash flow (DCF) model. Our target price reflects an expected p-e of about 19.7 times our 2007 EPS of $1.57, about 5% below the average p-e that we expect from a small group of competitors or peers. The stocks of two peers or competitors—International Flavors & Fragrances (IFF: 3 STARS, hold; $51), and McCormick & Co. (MKC: 3 STARS; $37)—were recently trading at close to 20 times our fiscal 2007 EPS estimates, which is about a 20% premium to SXT's recent p-e multiple. Our DCF model for Sensient indicates a per share value of about $30.

SXT shares recently had an indicated dividend yield of about 2.5%. We believe a dividend increase is likely later in 2007.

We have a generally favorable view of Sensient's corporate governance. The company has an experienced management team, including Kenneth Manning, who has been CEO since 1996. The Board of Directors has eight members, who are each elected annually for one-year terms. Five of the current directors have been on the board since at least 1998, while three other members joined the board from 2004 to 2006. We view seven of the eight members as meeting criteria for being independent directors, with Manning being the exception.

Scant Coverage From Sell-Side

We do not see any major conflicts of interest relating to the board. One member is president and CEO of a company—Sealed Air (SEE)—which has done a relatively modest amount of business with Sensient in recent years. Also, the board's Audit, Finance, and Nominating & Corporate Governance committees were recently comprised entirely of independent directors.

One aspect we view unfavorably is that the chairman and CEO positions are held by the same person (Manning). We would prefer that these positions be held by two individuals.

Risks to our recommendation and target price include competitive pressures in Sensient's businesses, commodity cost inflation, and the company's ability to achieve sales and earnings growth forecasts. Also, we believe that the stock receives relatively little analyst coverage from major sell-side firms.

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