Treatt: Plenty of reasons to stay bullish

Treatt (TET) is a very well managed business that is exposed to some very attractive end markets. This is reflected in the price of its shares which have more than tripled in value since the lows of March last year. Profit forecast upgrades are probably needed to drive the share price higher but cannot be ruled out given the strong momentum in the business.

The business

Bury St Edmunds based Treatt has been in business since 1886. Today it makes its money by making and selling natural extracts and ingredients that are used in the beverages, flavour and fragrance industries.

At the end of September 2020, the company sold 1,848 different products in over 75 different countries.

The backbone of its business is based on citrus products based on the oils that come from the orange family of fruits as well as lemons, lime and grapefruit. These are used as flavourings in juices and drinks, but also in cosmetics, perfumes, cleaning and chemical products. The citrus fruits used also produce a lot of by-products such as juices, pulp and peels which are sold on to generate revenues – albeit ones that don’t come with very rich profits attached to them.

For years, Treatt’s profits were highly correlated with trends in the orange oil price. This has changed in more recent times as the company has branched out into more value added and niche products.

Citrus will still remain a big part of Treatt’s revenues but the growth and future value of the business is now focused on providing flavours and products into the growing parts of the global drinks markets. There is a big emphasis on bespoke and ready to drink tea and coffee products, reduced sugar products, alcoholic fizzy drinks, tonic waters and sodas, fruit and vegetable flavours and high impact aromas and chemicals (HIAC).

Back in 2018, citrus was 60 per cent of annual revenues. This business has been shrinking while sales of tea products, sugar reduction techniques (health & wellness) and fruit and vegetables flavours have grown rapidly from a comparatively low base. This is improving the revenue mix of the business towards higher margin products and the growth potential of them underpins the bullish case for investing in the company’s shares.

The customer base is dominated by fast moving consumer goods (FMCG) companies which contain some of the best known global drinks brands. Almost half of the company's total revenues in 2020 were direct sales to FMCG companies with the remainder going through third parties such as flavour and fragrance houses.

The customer base is also quite concentrated with 34 per cent of total revenues coming from the top five biggest customers and 48 per cent coming from the top 10 customers. Treatt is a global business with the vast majority of its revenues generated outside the UK, with the USA being by far its biggest and most important market.

Treatt’s business model is based on scientific research and innovation. It has been spending more money on research and development in recent years and has been recruiting more scientists. It spends a lot of time gathering market intelligence and consumer insights into its customers' end markets and then sets about making differentiated flavours and products that tap into growing trends. It also adopts a partnership approach with its customers and works very closely with them in developing new products.

The company has many long lasting relationships with its key customers. Over the years Treatt has built up a track record of innovation, technical knowledge and an awareness of changing regulatory requirements in its markets. This has earned it the trust of big global companies and when combined with its focus on natural products gives it a key edge over its competitors.

Treatt has invested significantly in modern, state-of-the-art production and research facilities in the US (Florida) and the UK (Bury St Edmunds). The new US facility came onstream in 2020 with the UK plant expected to be occupied some time this year. The company is also expected to set up a Chinese subsidiary in 2021 and these three developments are expected to generate significant growth potential for the company.

Historic business performance and analysis points

Treatt has some hallmarks of a very good business and ones that have been on an improving trend in recent years. 

One of the most positive developments over the last year or so has been the uplift in gross profit margins as the company has moved its business away from the commoditised trading elements of the citrus business towards more value added products. This shift in revenue mix bodes well for future gross and operating margin improvements in the coming years.

While profit margins have been tending up, return on operating capital employed (ROOCE) has been going down. The main reason for this is the investment in new facilities in the US and UK which will have cost nearly £50m when the new UK site has been completed this year. This has contributed to an almost doubling of capital invested in the business since 2016 with very little extra revenue and profit earned from it. Over the next few years, there are good grounds for thinking that Treatt’s ROOCE will make significant improvements to very good levels.

One thing that is not so great is the company’s ability to turn its profits into free cash flow. High levels of capital expenditure on new facilities explain some of this but the company also has significant amounts of money tied up in stocks and trade debtors. Changes in these from year to year have not always been offset by extending payment terms to suppliers. As a result there have been some significant working capital cash outflows.

If we look at stocks – or inventories – first, we can see that Treatt holds a very high level of stocks relative to its revenues.

Just looking at stock numbers in total, Treatt’s closing stock position was a third of its annual revenue in 2020 – and has been much higher – which is a big number. 

The devil, as always, is in the detail. Holding high levels of stock is part of Treatt’s business model. It enters into long-term agreements with powerful customers and needs to make sure it has enough ingredients to meet demand as failure to supply could do significant long-term damage to its reputation.

Most of the stock value is made up of raw material and work in progress. Finished goods is a very small part of it and has been coming down as a percentage of revenues in recent years which is a good sign.

The danger with having high stock levels is that a company might not be able to sell them and turn them into cash. This increases the risk of stocks losing value and being written off which reduces profits. We can see that stock losses and write backs are a regular feature of Treatt’s accounts. A write back boosted profits by £0.6m in 2017 but was followed by a loss of £1.2m in 2017 – just under 10 per cent of total operating profit that year. 

Stock losses have been coming down in recent years which is good to see and are certainly not at a level that should cause concern. That said, the stock position is worth keeping an eye on as this still remains an area where companies can keep overheads off the income statement and put them on the balance sheet in stock instead. That said, I see nothing to suggest that any profit manipulation is going on here.

Like most businesses, Treatt makes sales on credit. We can see that the ratio of trade debtors to sales has trended up since 2016 and this is explained by its customers taking longer to pay their bills. Debtor days averaged 57 in but were 73 in 2020. Rising trade debtors can be a sign of trouble as a company can try to grow revenues aggressively by selling to customers who might not pay up. Provisions for bad debts did rise slightly to £0.6m in 2020, but the rising debtors days are probably a reflection of the buying power of the FMCG customer base.

The stock and debtor issues are unlikely to change much and do make you wonder if Treatt’s free cash conversion of its profits will improve much. Lower capex going forward will help, but the expectation of growing revenues is likely to come at the expense of free cash flow and this could give some investors grounds for questioning the quality of profits and the valuation put on them.

Tapping into growth markets

The outlook for Treatt’s future growth prospects look to be very healthy and are supported by the trends in the market for global beverages.

The key trends of premiumisation and wellness fits Treatt’s product portfolio and business focus very well. There is a growing tendency for consumers to want to buy better products rather than to buy more. This is combined with a growing trend for bespoke products based on natural and ethically sourced ingredients and healthier ones without added sugar and the calories that go with it.

Treatt is making great strides in growing its sales in tea and coffee products, especially in ready to drink categories. It has its own in house coffee roasting capability – which gives it an edge in developing products with the right flavour intensity and caffeine content – and is looking to offer coffee flavours into beers as well as developing products such as keto coffee which is popular with people looking to manage their weight. Kombucha fermented teas as well as herbal and green teas are also good sources of growth.

Treatt’s sugar reduction technology has proven to be a big hit with customers. It adds sweetness without adding calories or colour and does so without impacting the character of the drink. Zero sugar drinks continue to grow with encouraging potential in areas such as juices, bottled waters and energy drinks.

The use of botanicals – plants like elderflower, hibiscus, ginger, mint and lemongrass – is booming and not just in gins. Good growth is coming from tea but also from premium sodas and mixer drinks such as tonic water. Treatt is very well placed here.

Perhaps the most exciting growth area right now for Treatt comes in hard seltzer drinks. These drinks have become very popular in the US and are set to be so in Europe. They are low in alcohol – less than 5 per cent ABV – and tend to be low in calories as well. They are taking market share from wine and beers for these reasons. 

Treatt has invested £1.5m in plant and machinery in the US to tap into this market and has been building relationships with the major brands. A recent customer win contributed to a significant upgrade in profit forecasts in January and there are grounds for thinking that there could be more wins to come.

If the shift in revenue growth towards higher margin growth products wasn’t enough, there is the potential for Treatt to turbo charge these returns by leveraging the production of them from its new and more efficient production facilities in the US and the UK.

Treatt has set itself a short term profit margin target of 15 per cent, but I think there is scope to believe this can be exceeded. As Treatt’s product portfolio improves and increases there is more scope to cross sell to existing customers which will accelerate the gross margin and operating leverage effect. This is probably not factored into current market forecasts.

January’s trading statement saw a big upgrade in consensus pre-tax profit forecasts for the year to September 2021 from £15.1m to nearly £19m on the back of strong growth in tea, sugar reduction, fruit and vegetables and hard seltzers and the margin improvements that come with it.

I think further upgrades are possible – especially in relation to hard seltzers – but these could be muted by the recent strength in sterling. There’s also the fact that the market arguably already expects this given the high valuation of the shares which trade on a rolling one year rolling forecast PE of 36 times at a share price of 934p. 

That said, Treatt offers the potential for strong revenue and profit growth with improving margins and ROOCE. Free cash conversion is the one weak point with free cash flow not expected to exceed 75 per cent of net income despite a fall off in capital expenditure.

This is a cost of growth but as long as the cash from profits flows in, there’s a lot to like about the long-term outlook for this company.