Treatt frayed at the margins

The share price of Treatt (TET) has retraced slightly since August when it announced that full-year profits would come up short of earlier guidance. In the event, adjusted pre-tax profits were down 27.1 per cent year on year to £15.3mn, although the difficult transition from an improved top line is best illustrated by the 610 basis point reduction in the gross margin.

The company produces a range of natural extracts and ingredients, supplied across various industries and locales from bases in the US, the UK, and China. The diverse business model helps garner market share, but it obviously comes with a degree of sectoral and regional risk. As foreshadowed at the August trading update, comparative trading at the higher-margin tea category was the principal drag on margins and profitability.

Bosses maintain that the business is “typically not highly exposed to such volatility in margins”. This claim seems at odds with events on the ground. The hit to margins in the tea category was linked to a “niche product and an unusually sized win”, although how unusual remains to be seen. After all, would it be described as something of a one-off if it had a positive impact on margins?

Foreign exchange volatility provided another headache through the period, especially in terms of over-hedged contracts, but measures have been put in place to mitigate any further currency-linked problems going forward. One issue completely beyond Treatt’s control is China’s continued heavy-handed response to the pandemic. Whether the latest uprisings in Wuhan and elsewhere will trigger a change of strategy in Beijing is anyone’s guess, but the company’s financial performance suffered through the loss of “some higher-margin revenue” through the year. By contrast, sales to mainland Europe increased by a quarter to £34mn, driven by citrus and synthetic aroma. Revenues from the “rest of the world” category (excluding China) improved by a similar margin to £21.8mn.

Investment given over a UK relocation, much of which has been completed, will more than double domestic production capacity. Inventory levels were also bolstered through the period to reduce supply chain risks. These actions meant that net debt as a proportion of adjusted cash profit increased to a multiple of 1.21, against 0.39 last time around, but it remains well within the target leverage range.

Despite faltering margins through FY2022, we think that the long-term growth narrative remains intact, although wider economic challenges could impact short- to medium-term demand for fragrance products. With the shares changing hands at 29 times forecast consensus earnings, we move back to hold even though we foresee a long-term retracement. Hold.

Last IC View: Buy, 556p, 15 Aug 2022