Recovery will be sweet for this once-loved small cap

Flavour and fragrance provider Treatt (TET) makes about 60 per cent of its revenue from flavour houses, with the remainder coming from direct deals with brands. The group’s expertise is in the fractional distillation of essential oils, and most of its products ultimately wind up in beverages such as flavoured waters and canned cocktails. With its shares up by more than 150 per cent over the past 10 years, long-term investors may well feel that Treatt occupies an appetising niche in the chemicals market. 

However, the stock has been in a state of decline since late 2021, when it reached an all-time high of nearly 1,300p. Like so many others, the company experienced major input cost inflation in the aftermath of the pandemic, leading to a profit warning in August 2022. At the time, management also raised concerns about falling US sales of alcoholic iced tea – a trend attributed to belt tightening by the country’s consumers. The macroeconomic clouds have proved slow to lift and, more recently, Treatt has been plagued by destocking among the flavour houses. 

Lost flavour

These impacts were felt most acutely in the group’s portfolio of synthetic aromas (used in both flavour and fragrance applications) during the second half of FY2023, which ended on 30 September. According to a recent trading update, destocking continued between October and December, and revenue for that period was down year on year. Management did note some “encouraging signs” that the trend was reversing, however, and expects customer demand to return to "more normal levels" in the second quarter. 

FactSet broker consensus puts Treatt’s forward price/earnings multiple at 14.7 times for FY2024. That’s over a third lower than its 10-year average of 22.8 times. This low ebb represents a buying opportunity for investors who feel they missed out on the company’s initial ascent – provided its recovery goes according to plan. 

For their part, Peel Hunt analysts are optimistic. “Treatt has [more than] 50 per cent spare capacity and numerous growth opportunities,” they said following the group’s full-year results. “In addition, the main capex spend is done and net debt is reducing quickly.” The major outlay they referenced was the construction of, and relocation to, a new purpose-built headquarters in Suffolk. The move was completed last September, although some installations of new manufacturing equipment will take place during FY2024. 

As a result, management expects a further net cash outflow of just over £3mn. However, the group’s net debt to adjusted Ebitda figure, which excludes exceptional items, is not expected to exceed one times. For the financial year ended 31 September 2023, the ratio was under 0.5 times, down from more than 1.2 times in the previous year.

“Net debt was at its peak at £30mn in July 2022, and over a short space of time, we've managed to generate something like £20mn of cash,” said finance chief Ryan Govender on a November earnings call. “This is particularly impressive during the high commodity inflation cycle.”

Govender is currently serving as interim chief executive at Treatt following the retirement of long-standing chief executive Daemmon Reeve at the end of last year. This month it was announced that Reeve would be replaced in the summer by David Shannon, formerly the president of consumer care at speciality chemicals group Croda (CRDA). The shares saw a modest uplift on the news of Shannon’s appointment, although they have still declined by almost 10 per cent in the past month. 

This bout of pessimism comes as a number of London-listed chemical companies, including Croda and Synthomer (SYNT), report mixed annual results. Destocking and cost inflation are sector-wide problems that seem unlikely to abate in the near future. As in so many other industries, it seems rate cuts would be the best medicine. When these do occur – and customers feel confident enough to start stocking up on flavourings again – Treatt is well positioned for growth. 

Fresh appeal

Natural extracts (ie those derived from plants) account for around 80 per cent of the group’s sales. This means it’s well placed to serve health-conscious shoppers. “Changing consumer behaviours, in particular amongst the younger consumer cohorts... are creating new beverage categories and consumption occasions,” said analysts at Numis.

“These, in turn, are creating new growth opportunities for Treatt.” The broker cited sustained demand for low and no-sugar beverages as one structural growth driver for the company.

Coffee is among the fastest-growing categories in the company’s portfolio, although its contribution to group sales remains small in relative terms. Treatt uses Arabica beans to create a number of brewed coffee extracts, which are then used in a range of products, including increasingly popular 'cold brew' drinks. In FY2023, revenues from its latest line of business reached £5mn, up from just £1mn in FY2022. 

All told, the group’s new markets, which include coffee, Treattzest citrus oils and China, grew revenue by 61 per cent to £16mn last year, or 11 per cent of total sales. However, the group’s so-called heritage categories – citrus, herbs, spices & florals and synthetic aromas – remain the largest sources of turnover. This cohort netted two-thirds of the group’s annual revenue in FY2023, although its growth was muted at a total of 1 per cent. 

The company’s single-largest market in geographic terms is the US, but it is focused on growing its presence in China, where it has a small office and lab facilities. Treatt’s strategy in the country involves “leveraging its industry-leading know-how in beverage flavouring with the flavour houses operating in China, developing sales with drinks brands with pre-existing relationships and building relationships with local beverage brands,” according to Numis analysts.  

According to Govender, Treatt has now won business with three out of the four largest national beverage brands in China. The interim chief executive also told analysts that between 30 and 35 per cent of capacity is available at the group’s US manufacturing site, in addition to the spare capacity here in the UK. Filling this capacity, as well as growing the coffee business and expanding in China, will be crucial for the company’s future growth.

It was not so long ago that Treatt was considered a UK small-cap darling. Until its recent bout of operational difficulty, it had consistently commanded a premium valuation. The timing of a potential rebound is difficult to predict, and heavily dependent on factors outside of the company’s direct control. But management's tight control of costs and range of growth opportunities are reasons for optimism. Buying at this point would make Treatt’s eventual recovery taste even sweeter.