Treatt is a natural choice

Founded in 1886 by essential oil merchant Richard Treatt, Treatt (TET) specialises in natural extracts and ingredients for the beverage, flavour and fragrance industries. Its products are found in everything from speciality teas and cold brew coffee, to alcoholic drinks and meat alternatives. The group is tapping into a global flavour and fragrance market that is estimated to be worth £27bn and is projected to grow by 5 per cent each year.

With manufacturing sites in the UK and US, the group sells more than 3,000 products across 90 countries, focusing on seven categories – citrus, tea, coffee, ‘fruit and vegetables’, ‘herbs, spice and florals’, ‘health and wellness’, and ‘aroma and high impact chemicals.’

The largest category is citrus. Treatt makes products based on the oils that come from fruits such as oranges, lemons and limes. That means it is exposed to cyclical raw material prices that are subject to the vagaries of the weather. For example, while the orange oil price surpassed $12 (£9) per kilogram (kg) in 2017, it fell to as low as $4/kg last year. It has since rebounded to around $7/kg, and chief executive Daemmon Reeve believes that prices are now stabilising.  

“In the past two years we’ve seen some weakness in citrus raw material prices, but they’ve now recovered to a more typical level,” he said at the time of the group’s half-year results in May.

Treatt has worked hard to decouple the trajectory of its earnings from movements in the orange oil price. It's done this by shifting up the value chain for citrus products, while also growing its non-citrus businesses. The proportion of revenue derived from citrus fell from 54 per cent in 2019 to 45 per cent in the six months to 31 March 2021.

Moving away from commoditised, higher-volume citrus products towards the production of more sophisticated, ‘value-added’ ingredients has helped boost margins. The operating profit margin has improved from 10.8 per cent in 2016 to 13.8 per cent in 2020, and the group is aiming to hit 15 per cent. It exceeded this ambition in the first half of its 2021 financial year, with the margin increasing by 6.1 percentage points to 17.4 per cent, translating to a 74 per cent rise in profit to £10.6m. As the shift to value added products continues, analysts believe that annual margins will keep expanding. 

Natural focus bears fruit

More than three-quarters of Treatt’s sales are generated by natural products. Demand is benefiting from the ongoing shift towards healthier eating, sustainability and so-called ‘clean labels’, which is where fewer artificial ingredients and less ingredients in total are used. This long-term structural tailwind is being bolstered by regulation such as sugar taxes.

The group’s exposure to the healthy living trend has attracted the attention of top-performing sustainability fund Liontrust UK Ethical (GB00B8HCSD36), where it is a top 10 holding.

"Treatt’s positioning towards authentic flavour, taste and fragrance with natural ingredient and sugar reduction technology has proved astute,” says the fund’s co-manager Martyn Jones. “Our research highlights continued strong demand from consumers wishing to eat healthier and more natural food and beverages – particularly in the wake of the pandemic when many people are thinking carefully about health and wellbeing.”

‘Better for you’ products can often compromise on taste, and it takes skill to keep their flavours as true as possible to the original version. For example, Treatt’s products enable companies to reduce the sugar content of their food and drinks while maintaining their sweetness and mouthfeel. The group says that “demand from the health-conscious consumer shows no sign of slowing down”, and indeed sales of its ‘healthier living’ products – which span tea, health and wellness, and fruit and vegetables – jumped by 57 per cent year on year in the six months to 31 March.

This helped push overall revenue up by 14 per cent in the first half of the year to £61m. The bumper set of results prompted analysts to nudge up their forecasts yet again.

Momentum has also been aided by the rising popularity of low-calorie alcoholic beverages, in particular ‘hard seltzers’. These are naturally fruit-flavoured sparkling water drinks, typically with about 5 per cent alcohol and 100 calories a serving. This has been a particular boon in Treatt’s largest market, the US, which accounted for 45 per cent of revenue in the first half. Hard seltzers are winning market share from beer and wine in the US, where the group is investing $1.5m in plant and machinery to take advantage of growth. They are also gaining traction in the UK and Europe. The global alcoholic seltzer market was estimated to be worth $4.4bn in 2019 and is project to grow by 16 per cent annually between 2020 and 2027.

“It’s largely driven by consumers wanting an alcoholic beverage, but increasingly with a consciousness around the calorific content,” says Reeve. “Unlike a beer, the natural extract has to do all of the heavy lifting in terms of flavour, therefore customers are prepared to pay for high-quality, authentic, natural extracts.”

Seeds of growth

Some 46 per cent of Treatt’s revenue comes from selling directly to fast-moving consumer goods (FMCG) companies, most of which relates to products for beverages. Customers tend to be very ‘sticky’, as once Treatt’s flavours are included in a product, they tend not to be replaced due to the expense and risk of changes. This makes it difficult for new competitors to get established.

The group’s top 10 clients have been with it for at least a decade, and in some cases more than 25 years. These long-term partnerships are underpinned by its deep knowledge, as well as product innovation. Treatt co-develops products with its customers, creating bespoke ingredient solutions.

The remaining 54 per cent of revenue is derived from sales to flavour and fragrance houses, who are both customers and competitors. This includes industry leaders such as International Flavors & Fragrances Inc (US:IFF) and Givaudan (US:GIVN). While Treatt is a much smaller business, it enjoys competitive advantages over its larger peers. It specialises in natural extracts, whereas the big players focus on chemically processed ingredients. It also provides the broadest range of natural flavours for the beverage industry, supported by its superior sourcing and production capabilities.

Rather than grow their own organic capabilities, the bigger flavour and fragrance companies tend to buy from specialists in natural products or acquire them outright. This could make Treatt a potential takeover target, and analysts at Peel Hunt believe that “if the market does not value the future appropriately, one of the leading industry players surely will”.

The broker also believes that Treatt will be able to capture market share from its competitors as its scale increases, suggesting that larger beverage companies will choose to deal with it directly to develop customised solutions in lieu of the more opaque “black box” approach of flavour and fragrance houses.

Treatt initiated a £48m investment programme in 2017 to increase its manufacturing capacity and capabilities. It spent $15m to expand its facility in the US, doubling the production capacity for ‘healthier living’ products. The new addition came onstream last year.

It is also investing £41m in a new site in the UK, which is expected to begin production in the first half of 2022. With automated warehouses, upgraded laboratory equipment and digitised manufacturing processes, increased efficiency should help boost margins and also enable a step-up in scale of joint product developments with customers.

As the group continues to invest in its capabilities and deepens its relationships with its customers, Jones says he “remain[s] excited about the long-term compounding prospects for Treatt”.

These projects have pushed up the group's capital employed – a measure of the historical investment in the business – which has recently weighed on the popular quality metric ‘return on capital employed’ (ROCE). ROCE dropped from 25 per cent in 2016 to 16.9 per cent in 2020, but this should be temporary. Once the new facilities are fully operational, the group is aiming for ROCE to head back to a hearty 20 to 25 per cent. This expectation underlines just how worthwhile the investment is for growing shareholder value.

The capital expenditure (capex) on the new UK facility has pushed Treatt from £400,000 of net cash at its September year-end to £5.1m of net debt at the end of March. This swing also reflects a £5m increase in inventory, which the group says reflects a normal stock build-up ahead of the peak of the beverage season in the northern hemisphere. Treatt deliberately holds a significant amount of inventory to maintain a reliable supply of its products, and this can also help offset sudden fluctuations in raw material costs.

The group tends to invest in organic growth rather than using acquisitions to boost earnings, and with £8m of capex still to spend on the UK facility, it is guiding that net debt will increase to between £6m and £8m by the end of September. However, research house Edison forecasts that it will move back to a net cash position from FY2022 and believes this will underpin a “significant” increase in the dividend.

A zesty valuation

There’s no getting around the fact that the valuation of Treatt’s shares is high. This means any disappointment could be painful for shareholders. The shares currently trade at 42 times consensus 2022 earnings. That’s well ahead of their five-year price/-earnings (PE) ratio of 27, but is on par with most of the group’s larger peers.

And that lofty valuation looks more than justified if analysts are right about Treatt’s long-term growth potential. After normalising for citrus prices, Peel Hunt calculates that Treatt has seen a 7 per cent compound annual growth rate (CAGR) in sales over the past five years, compared with 5 per cent for its bigger rivals. The broker believes that in a ‘blue sky’ scenario, the CAGR could rise to 15 per cent over the next five years thanks to the investment in its facilities, new product development and a lower reliance on citrus. That would translate to an adjusted EPS of 68p in 2025, up from 21.1p in 2020, and on that basis, the shares could be considered good value right now. The forecast upgrade momentum suggests that the 'blue sky' is worth looking towards.

Last IC View: Buy, 506p, 12 May 2020