Treatt — New facility to drive growth

Treatt provides ingredients and ingredient solutions both to the flavours and fragrance industries, and directly to global FMCG manufacturers. The beverages space (c 65–70% of sales) has proved to be the fastest-growing segment for the company over the past few years, in particular health and wellness, citrus, ready-to-drink (RTD) tea flavours and fruit and vegetable clean-label extracts. Given the strength in product demand, Treatt expanded its capacity in the United States in FY19 and during FY22 will have fully commissioned its new UK facility. It opened an office in China in FY21, and we expect global expansion to continue.

Over the last 12 months, the share price is down c 40% in absolute and c 35% in relative (FTSE All-Share) terms, while over the last three months these figures are 32% and 26% respectively. The company trades at a discount to its larger peers based on benchmark valuation metrics. Treatt has suffered as the market has become increasingly concerned about the inflationary effects on consumer stocks and it has also derated versus its larger peers. We calculate that the current share price is discounting medium-term sales growth of 5.7%, falling to 2.0% in perpetuity, with a WACC of 7.7% and a terminal EBIT margin of 20.0%. A terminal growth rate of 2.5% would result in a fair value of 812p/share. Treatt trades at 23.7x and 16.1x FY22 P/E and EV/EBITDA, representing discounts of c 10% and c 5% respectively to its peers.

Treatt’s revenues during H122 were up 9.0% with growth in most categories. Gross margins were down 750bp on the prior year, but up 130bp versus H120, which was mostly unaffected by the pandemic. Adjusted PBT was £6.3m, versus £10.4m in H121 and £6.1m in H120. There was material revenue growth in citrus (+15%), Treatt’s largest category, and synthetic aroma (+20%) and herbs, spices and florals (+23%) also performed very well. Citrus represented 47% of revenue during the period (up from 44% in H121). Net debt stood at £19.8m at end H122, predominantly due to a working capital outflow of £15.1m during the period, which was in turn due to a combination of an increase in trade receivables and a strategic decision to increase inventories (to shield the business from supply chain disruption, and is justified by the H2 order book being up 25% on the prior year). We forecast a net cash position from FY23.

For the next three years (FY21–24) we forecast an 8.9% revenue CAGR and a 7.1% pre-exceptional PBT CAGR (slower due to increased depreciation from the new UK facility), translating to 6.5% growth in pre-exceptional earnings. The business is cash generative, and we estimate it will have a free cash flow yield of 4.1% in FY23.

Treatt has a couple of key sensitivities, which it seeks to mitigate through the in-depth knowledge and skills base of its buying team and by employing an active hedging policy where possible:

Founded over 130 years ago, Treatt combines deep expertise in flavours and fragrance solutions with its close relationships with customers to help them create appealing and innovative products. Treatt’s historical strength was in ingredient sourcing and risk management, but over time it has transformed itself into an innovative supplier of high-quality, value-added ingredient solutions and partners with its customers to create new products. Around 75% of Treatt’s sales are in the natural segment. Treatt’s customers consist of a balance between flavour and fragrance (F&F) companies (59% of sales in FY21) and FMCG and other manufacturers (41% of sales). Its products are used by the former and blended to create highly value-added ingredients, which may be themselves sold to FMCG companies. F&F houses typically value competitive pricing and technical or regulatory knowledge. In addition, some products are sold directly to FMCG and other players for use in their products. In this case, the clients typically most value innovation and technical knowledge. Health and wellness has been a growth segment over recent years, as consumers have looked for better-for-you products and new products with clean labels have been developed to serve this need.

Treatt has a wide customer base in terms of size and geographic spread. While over the years the business has focused on its larger customers, the breadth of its customer base means the group is not overly dependent on any one relationship, with its largest customer representing c 10% of sales and the top 10 customers representing c 48% of sales. There is a reasonable degree of movement in the importance of each client over time, again demonstrating that Treatt is not dependent on any particular relationships. Approximately 80% of Treatt’s product portfolio is flavour ingredients, which are mostly used in the beverages space. The remaining 20% of the portfolio encompasses fragrance ingredients. Typical end products that use Treatt ingredients range from soft drinks including mixers, alcoholic beverages (including hard seltzers) and confectionery, to soaps, shampoos and basic pharmaceutical products. Treatt has manufacturing sites in the United Kingdom and United States, where its two 100%-owned subsidiaries, RC Treatt and Treatt USA, are based. In addition to its manufacturing centres, Treatt has a wholly owned subsidiary in China and a network of agents throughout the world, through which it exports to more than 90 countries worldwide.

Treatt has evolved from a commodity-based ingredient trading house into a supplier of value-added ingredients (value-added products represented 82% of sales in FY21 vs 68% in FY17). This has brought substantial sales growth and higher margins, and helped to decouple the business performance from fluctuations in raw material pricing. We expect margin improvement to remain a feature as Treatt continues to move up the value chain, particularly in the citrus and synthetic aroma categories.

Over the last few years, Treatt has embarked on substantial capacity expansion, resulting in elevated capex in recent years, though we forecast a capex decline in FY22 and FY23 as the expansion is complete for now. Treatt first increased its capacity in the United States. This work was completed in FY19 and added 60,000sq ft of space, and doubled capacity in the three categories of tea, health and wellness (including sugar reduction), and fruit and vegetables. The expansion took into account future needs and there is c 40,000sq ft of additional space to further increase capacity in the long term, with an extra six acres of space bought more recently. Treatt’s UK relocation has been a larger project: in May 2015, the company first announced its intention to fully relocate the business to another site near the existing one. The new UK site is now being commissioned, with only the distillation lines left to transfer to the new site (which are scheduled to move by the middle of calendar 2023). The new site has catapulted forward the business capabilities, with far more modern and efficient manufacturing equipment, and an optimised layout of the facility. This will allow the business to continue to grow and to capitalise on the opportunities in its faster-growing and higher-margin categories such as tea, coffee and the complex ingredients solutions required in alcoholic seltzers. In addition, the new facility is more appealing to potential customers, allowing Treatt to showcase its business.

Treatt supplies an extensive range of flavour and fragrance ingredients to its customers. It collaborates closely with its customers to develop an ingredient solution for a particular problem or new product. Treatt’s specialists help customers to find the ideal ingredient and are constantly developing new ones. Treatt has seven segments in which it operates: citrus; health and wellness; tea; fruit and vegetables; coffee; synthetic aroma; and herb, spice and floral. Coffee is a recent addition as a standalone segment: its revenue so far has been reported in the tea category until revenue from coffee becomes material. The company stated at the H122 results that it had contracts and orders placed for nearly £2m in the coffee category.

Within flavours, Treatt has five key areas of focus: citrus, tea, fruit and vegetables, health and wellness, and aroma chemicals. Citrus has been a historical area of strength and expertise for Treatt, while health and wellness (mainly sugar reduction), fruit and vegetables, and tea have exhibited strong growth over the last few years as they are in the sweet spot of current consumer demand for healthy products that do not compromise on taste or convenience. Treatt has dedicated resources to these four leading product categories to increase their success, without leaving behind the rest of the business. More recently, Treatt has been developing its expertise within the coffee segment, and more specifically cold brew coffee. The popularity of cold brew coffee has been gaining traction over the last few years, although the United States is currently the largest market by a significant margin as consumers in the rest of the world have been slower to embrace the trend.

As Treatt has moved its citrus business away from the more commoditised end and into higher-margin, value-added solutions, volumes have been lower, and profitability has moved away from simply tracking the price of citrus oil. Beverages remain Treatt’s main area of expertise as liquid flavourings are most often used in beverages. The company now derives around 65–70% of its revenues from the beverage industry (including ingredients that are sold on to the beverages industry via flavour houses). The high-impact and aroma (synthetic) flavours business continues to contribute to the group overall (it accounts for c 20% of revenues), but generally at a somewhat lower margin Treatt’s synthetic flavours have increasingly been used by alternative protein manufacturers and thus exhibited strong growth in H122.

Inflation is a concern at present. Treatt should be relatively insulated as its products have a very low inclusion rate (typically 1–2%) in the final consumer goods that are found on-shelf. In an inflationary environment, consumers tend to trade down and retrench to long-term favourites rather than being more open to trying new, premium products. We therefore believe this is the bigger risk in the space, which may lead to a margin squeeze owing to downtrading across the board.

We believe Treatt is in an excellent position to benefit from the constant need for FMCG manufacturers to produce a stream of new product formulations to keep consumers engaged, particularly given its focus on deep customer knowledge and relationships, thus enabling it to work closely with its clients. It is also well-placed to capitalise on the natural and clean-label trends given its expertise in from the named fruit (FTNF) solutions.

One of the overarching trends in the consumer space in the past decade has been a greater interest in health and healthy eating, with more products striving to be natural, clean-label, calorie-free and sustainable. Consumers demand these product features, causing the market for natural and naturally derived products to accelerate in growth, and creating significant profit potential for both the food and beverage manufacturers and ingredients suppliers if they can deliver these. The products are highly desirable but also require a significant degree of complexity and know-how to formulate and use, thus giving rise to higher margins.

Consumers currently perceive natural ingredients as having a positive effect on general health, while synthetic ingredients are viewed less positively, though there is currently a debate in the industry with regards to the sustainability and resource-intensity of natural ingredients. As a result, food and beverage manufacturers have promptly responded to the situation by completely or partially replacing synthetic ingredients with their natural or clean-label counterparts. Consumers are increasingly shying away from certain food groups and avoiding products that are viewed as overly processed. Similarly, within the personal care space, consumers are eschewing the larger brands in favour of more niche, sustainable and natural products. The larger FMCG manufacturers have sought to embrace this trend by both reformulating products with cleaner labels and buying out smaller, niche brands with more organic/natural credentials.

A common problem in the wellness space is that the better-for-you variants often have a compromised taste. To keep taste as close as possible to the regular product requires complex formulations and an ongoing iterative process to optimise the taste. For example, stevia is a popular 100% natural sweetener; however, it is also renowned for a signature bitter liquorice aftertaste. Treatt can work with customers to provide its expertise and develop an ingredient solution to address this particular issue. Another emerging consumer trend is functional health claims, which are becoming more prevalent in the FMCG space as consumers are willing to pay a premium for products that can claim to boost immunity, increase energy levels or enhance performance. Treatt is strongly positioned to serve this market.

A significant trend in the FMCG space has been the willingness of consumers to trade up in certain specific segments, where they perceive a benefit. For example, alcoholic drinks mixers used to be a low-value proposition, but over the last few years consumers have started to take more note, and hence want seasonal specialties, new profiles and high-quality blends that can also be consumed without alcohol. Treatt’s expertise in sugar reduction and natural flavours can help its customers to reformulate an existing beverage to improve it, or launch a new product, all without affecting taste. Consumer demand for low/no alcohol alternatives has also helped to grow the market, with more consumers buying premium non-alcoholic drinks than alcoholic drinks (source: Global Data), while alcohol consumption is declining globally.

Sustainability and consumer ethics has also been emerging as a new trend, with mindful consumers opting for products that are good for them and better for the world around them. Treatt’s stable and traceable supply chains across its product categories can help deliver accountability to its customers.

Treatt has transformed itself from a commodities trading house to a provider of value-added, technical flavour and fragrance solutions. It seeks to build close, mutually beneficial relationships with its customers across as many touch points as possible.

Treatt’s strategy has evolved but its underlying aim is to create outstanding sustainable ingredients solutions, designed around its customers’ needs. In turn, this should result in the delivery of long-term and consistent growth in profitability. Treatt’s strategic priorities remain the same as in prior years:

Over the past few years, Treatt has invested heavily in how it uses market insights across its business and shares information, with a view to becoming more agile. The commercial functions have come closer together and work in partnership with category managers to unlock more effective and targeted marketing. The move to the new UK headquarters has significantly accelerated this process, as the layout of the offices, the manufacturing facility and the warehouse/logistics hub have all been designed to optimise collaboration.

Treatt runs its business by category but its sales effort is run by geography. Over the years it has increasingly strived to bring its people together and share knowledge globally. As part of its focus on culture and employee engagement, employees in each of the product categories are encouraged to share information and best practices globally. The US is Treatt’s largest and most dynamic market: it lends itself perfectly to Treatt’s clean-label proposition, as consumers increasingly demand healthier and more natural products. The Asian market has witnessed extremely fast growth over the past few years. While previously growth was driven by the trends of increasing affluence and urbanisation, more recently health and wellness has come to the fore as consumers shy away from high sugar content. Treatt opened a sales office in China several years ago to capitalise on the growth opportunity, appointing Steve Fan as Country Manager in 2014. China became a wholly owned subsidiary in FY21. In FY21, China contributed 6.0% to revenue versus the UK’s 7.6%. North America and Europe (including the UK) still represent 72% of overall sales.

The UK and Europe are diverse markets with each country having distinct consumer preferences, although in 2020 carbonated beverages represented the largest category across all the key markets of Germany, the UK, Russia, France and Poland (though we note Treatt suspended all offers orders and shipments to Russia in early March and does not expect any adverse consequences to trading due to this). The pandemic has affected and distorted consumer behaviour over the past 2.5 years, with direct to consumer (DTC) sales performing very well and on-trade sales of beverages being severely affected by lockdowns.

The fastest growing categories by volume between 2020 and 2024 are expected to be energy drinks, RTD iced coffee, RTD iced tea and flavoured water (source: Global Data). This plays into Treatt’s portfolio of natural flavourings and beverage solutions and its increasing expertise in the cold brew coffee segment. Sugar reduction continues to be a major trend, with consumers shifting their preferences towards ‘better-for-you’ products. New brands are establishing their credentials as natural, sugar free and ethical/sustainable and more established brands continue to reformulate to compete more effectively, stay relevant and avoid sugar levies and taxes. Treatt’s increasingly large portfolio of 100% natural sugar reduction solutions allows its customers to reduce sugar levels while maintaining a clean label, and not having a dramatic impact on taste.

The US market is witnessing growth in demand for beverages with functional benefits as consumers become increasingly concerned about their health. US consumers continue to seek authentic products with natural ingredients and claims, as the pandemic has heightened awareness of the effects of healthy living. Sustainability has also come to the fore as consumers become more concerned by the use of plastic in the beverage industry. Companies have responded by focusing on sustainability when launching new products. We note H122 revenue growth was weak in the United States (-13.1%), though this was caused mainly by the comparative period having benefited from disproportionate growth in retail demand due to the pandemic, with a higher than usual number of product launches. Management expects growth to rebound materially in H2.

The North American non-alcoholic beverage market is predicted to be worth $205bn in 2024 and is expected to grow at 3.8% CAGR 2020–24 (source: Global Data). The fastest growing categories are expected to be flavoured water, energy drinks, enhanced water and RTD coffee. Treatt’s increasing expertise in both functional ingredients and cold brew coffee means it is well-placed to capitalise on these trends.

The Asian market is also diverse, with China, Japan and India representing 65% of total non-alcoholic beverage volumes in Asia-Pacific. Generation Z is expected to account for a quarter of the region’s population by 2025, and the Asia-Pacific non-alcoholic beverage market is predicted to be worth $297bn by 2024, a CAGR of 7.9% 2020–24 (source: Global Data). The fastest growing categories are expected to be flavoured waters, energy drinks, RTD iced tea and RTD iced coffee (source: Global Data).

The Chinese market is witnessing an increase in demand for health and wellness as consumers become more concerned about their health. Online sales grew materially during the pandemic and this now represents an important channel for the beverage category. In Japan there has been strong growth in foods for special health uses, which is now valued at over $1bn. Products need to adhere to stringent rules to qualify, and high-sugar products are being driven to reformulate as consumers increasingly focus on health. Treatt’s portfolio of 100% natural sugar reduction solutions can capitalise on these trends, and its increasing expertise in functional ingredients can help its customers serve a consumer need.

Treatt has identified the categories of citrus, tea, health and wellness, and fruit and vegetables as key drivers of growth, given their size and Treatt’s expertise. This is to better serve its customers and to concentrate on the higher-growth and higher-margin opportunities within the business. Coffee is a relatively new area for Treatt and indeed it plans to comment on this separately for the first time in FY22 as the segment gains importance for the company. During H122, the fastest-growing category was herbs, spices and florals, which was up 23% versus H121, though we recognise that growth rates during the period were skewed by the comparative year being affected by pandemic-related restrictions (revenues were up 6.6% vs H120). We briefly set out the six main categories plus coffee in turn below. Coffee is not yet generating material revenues, though fast growth is expected, thus suggesting it will become significant for the group over the next two to three years.

Citrus is Treatt’s largest category. The company has a long history of expertise in citrus, which has been a core part of its business for many decades. The taste for citrus flavours (both natural and synthetic) remains a winner in the beverage industry and is often used to encourage consumers to try new or exotic flavours, as they can be paired with the more traditional orange, lemon or lime flavours. Brands can emphasise the natural citrus flavour together with its provenance. Citrus also has the advantage of working well in most beverage categories, from juices and flavoured waters to sparkling drinks, hard seltzers and teas. Treatt maintains long-term relationships with citrus growers and processors across more than 10 countries to provide a stable and sustainable supply and to smooth out some of the pricing volatility – as witnessed during FY19 and FY20, this can be material – which also helps Treatt’s customers. As Treatt has moved up the value chain in citrus, it has been able to somewhat decouple its profitability from the underlying price of citrus oil, demonstrating its credentials as a supplier of value-added ingredient solutions, rather than simply trading commoditised ingredients.

Tea is the second most widely consumed beverage worldwide, after water. All teas essentially come from the same plant; it is the processing method that gives each tea its distinctive properties. Tea is popular in different forms depending on geography, but RTD tea in particular continues to grow globally. Tea has a broad appeal and embraces the current consumer trends of low-sugar, natural products that have additional health benefits. Tea can be niche, premium or every day, giving Treatt a wide spectrum in which to operate. Following an extremely strong performance during H121 (when it was up an impressive 91%), revenue growth in the category fell back during H122 (41%), hence over a two-year period growth was a healthy 14%. Growth is expected during H2, driven primarily by North America.

Reducing sugar levels and calories in both food and drink is a global trend that is being driven by increasing consumer awareness of the detrimental effects of sugar on health. The food and drink industry as a whole has been reformulating its product ranges as sugar reduction concerns have become more prevalent and sugar taxes and levies have been introduced. The key concern, however, is not to have a detrimental effect on taste. Sugar reduction is also technically complicated, which is where Treatt’s expertise comes in. Sugar provides flavour, sweetness and texture/mouth feel. Treatt operates principally in the niche of flavour, which is difficult to replicate, but is essential to low-calorie product propositions. The pandemic has resulted in consumers taking a more proactive approach to their health, with an increasing interest in mental health. Ingredients that can make healthy functional claims such as boosting immunity or energy, or enhancing performance can result in a consumer product that is sold at a premium because of those health credentials. Treatt is strongly positioned in this market as it has an established and growing health and wellness portfolio with its natural, minimal-label ingredients.

Providing natural fruit and vegetable flavours to food and beverages or fragrance to home and personal care items is another capability that taps into the current consumer trend for more natural products with clean labels. Treatt’s fruit and vegetable flavour range is comprised of highly concentrated aqueous distillates. They are 100% natural and are distilled for shorter time periods at lower temperatures to maximise flavour. Their concentration results in them being extremely effective even at lower dosages.

Premium beverages come in a range of flavours and floral, herbed and spiced flavours have gained in popularity as consumers experiment with new and exotic flavours, particularly at the premium end of the spectrum. Treatt sources, manufactures and supplies over 300 herb, spice and floral products. They are 100% natural ingredients, made FTNF. Treatt works closely with its customers to match specific requirements. Products include essential oils such as peppermint and lavender, and are used in a diverse range of applications such as alcohol-free or flavoured spirits.

High-impact aroma chemicals are ideal for creating powerful flavours and fragrances and often offer a low-cost solution at low dosage. Treatt has an extensive range of speciality high-impact aroma chemicals and a long history in the space. Treatt’s ability to deliver a consistent and quality service in this space stands it apart from other players. More recently its synthetic aroma chemicals have gained traction in the plant-based food space, where they are used to improve the desired ‘meaty’ taste and mouthfeel of plant-based ingredients.

Coffee is one of the quickest-growing beverage categories in the world and, like tea, it is the processing method (blending and roasting) that gives each coffee its distinctive properties. Coffee has grown consistently as a beverage over the last decade, with an ever-increasing choice of variants and formats. UK production capability is being developed to provide greater agility in servicing UK and European markets (as previously Treatt produced its coffee products solely in the United States). Treatt expects the coffee segment to make a meaningful contribution to profits in the medium term, once it has had an opportunity to build scale. Its experts can craft blended solutions that take account of taste profile, naming, regional requirements and desired caffeine levels, thus enabling Treatt to deliver stand-out products in this diverse yet crowded market. Coffee is also slightly different from its other ingredients as Treatt’s coffee solutions tend to make up a much greater proportion of the finished product. While a citrus flavouring may only comprise 1–2% of a consumer beverage, Treatt’s coffee solutions can make up 20–30% of a coffee beverage.

One of the more fundamental changes that the management team has enacted is the significant cultural change they have made to the business since it was remodelled in 2012. Treatt recognises that a well-motivated and experienced workforce will be more successful and an important part of its strategy is to continuously enhance the engagement of its employees. Over the last decade, internal structures have been constantly improved to ensure collaboration across the business. The culture of openness, innovation and collaboration attracts and retains the brightest candidates and Treatt offers a tailored training and development programme to help individuals reach their full potential.

Engagement with local communities has resulted in Treatt being widely recognised as a desirable employer and a business committed to community responsibility. By fostering a culture of innovation, the company regularly sees cross-departmental teams coming together and identifying new opportunities to grow and improve efficiency.

Treatt’s focus on culture was showcased at Treatt’s recent capital markets day, with all employees demonstrating their enthusiasm for the new UK facility and the benefits it will bring to the business. The new United Kingdom and United States facilities have also helped the culture, as their layouts have been specifically designed to enhance collaboration and openness.

Treatt’s medium-term financial targets (as of the FY21 results, reported in November 2021) are operating margin in the range of 15–20% and return on average capital employed of 20–25%.

Given the FY21 guidance that profitability will revert to the more normal (H2-weighted) seasonal split and that margin growth will be stronger in H2, we forecast FY22 operating margin of 15.4% (vs 17.2% in FY21 and 9.9% in H122, though we note these were 13.8% in FY20 and 17.4% in H121).

Over the medium to long term, the evolution of the portfolio towards higher value-added technical ingredient solutions suggests gross margins should continue their upward trend. Given the strong move up in FY20 and FY21 (380bp and 480bp respectively), we forecast a gross margin decline of 30bp in FY22, before reverting back to growth in FY23 and beyond. The margin decline in FY22e is caused by mix, as the lower-margin categories recover following a weaker FY21 caused by the pandemic, and conversely the higher-margin categories decelerate somewhat and return to more normal levels of growth.

Treatt’s commitment to contain fixed costs remains clear and the new UK facility should allow for ample cost-saving opportunities due to its greater efficiency. We forecast operating margins rising to 16.0% by FY24. The relatively slow growth is a result of an increasing depreciation charge over the period, as the US expansion and new UK facility start to be depreciated. Over the medium term we forecast an operating margin improvement of 40bp pa.

In Exhibit 4 we illustrate Treatt’s EBITDA and operating margin over FY15–24e. We can see a broadly steady improvement from FY15–19 despite the economic and raw materials cycles that occurred over the period, before the material improvement witnessed during FY20 and FY21. The sharp reduction in FY22 EBIT margin is caused by the increased depreciation charge discussed above.

Due to its background as a trader in raw material ingredients and the breadth of the product range it offers to customers, Treatt is exposed to a wide range of commodities. In general, this means that fluctuations in commodity prices tend to even out across the portfolio as a ‘natural hedge’. The exception, however, is the group’s sizeable exposure to citrus oils, mainly orange and lemon. In the event of a price spike across all commodities, the ingredients space has generally shown some resilience and has demonstrated some pricing power, as flavours represent a tiny portion of raw material costs for its clients (the consumer companies), which have therefore been more accommodating with price increases. Again, however, the value-added end of the spectrum has more pricing power.

Citrus oils represent c 45–50% of Treatt’s raw materials expenditure. Orange oil is a non-exchange-traded commodity, so its supply is managed by Treatt’s highly skilled stock teams in the United States and United Kingdom, with their deep market knowledge and expertise adding value to customers by consistently ensuring best prices and consistency of supply.

A total of 95% of Treatt’s supply of orange oil comes from two key markets: Brazil and Florida. Orange oil is a by-product of orange juice, extracted through centrifugation. Despite being a by-product, there is no direct relationship between the price of orange oil and the publicly traded price of orange juice. This is because the key determinant of price is not simply the quantity of fruit grown in any one growing season, but rather the complex interaction of a number of influences, driven in the main by the amount of fruit the processors need to buy to produce the quantities of juice required to satisfy demand.

Prices of orange oil have been volatile, with the elevated levels of 2017 (when prices peaked at $12/kg vs the long-term average of $4–6/kg) having softened through FY19 and the start of FY20, but recovered since. Orange and lime oil prices reached record highs in H122, while lemon oil prices remain subdued.

The group’s deep insight into the markets of both commodities has very clearly helped it navigate the worst of the volatility during FY19 and FY20 and gives a significant value-added service to customers who may not have a similar level of insight. Increasingly, Treatt has secured longer-term contracts from both customers and suppliers to smooth out volatility in raw material procurement and revenues, with the aim of reducing volatility in group gross margin.

The principal foreign exchange risk is sterling/US dollar, which affects the company from both a transactional and a translational point of view:

To try to mitigate the main sterling/US dollar exposure, the company takes out forward FX contracts to hedge the risk.

We illustrate Treatt’s relative valuation versus its ingredients peer group in Exhibit 5 below. Treatt trades at 23.7x and 16.1x FY22 P/E and EV/EBITDA, representing discounts of c 10% and c 5% respectively to its peers.

We have rolled over our DCF to start in 2023, given we are more than halfway through 2022. We have also increased our WACC assumption to 7.7% (from 5.7%) given the inflationary environment. The current share price is discounting medium-term sales growth of 5.7%, falling to 2.0% in perpetuity, with a WACC of 7.7%. We illustrate a sensitivity analysis in Exhibit 6 below. We note that our FY22 EBIT margin forecast is 15.4%, and our terminal EBIT margin assumption is 20.0%. Over the medium term, we forecast an operating margin improvement of 40bp per year as the business continues to move to more value-added solutions, and the efficiency benefits of the new UK site feed through into the operating numbers.

As discussed more fully in our May update note, Treatt’s revenues during H122 were up 9.0% with growth in most categories. Gross margins were down 750bp on the prior year (which was distorted by the pandemic), but up 130bp versus H120, which was mostly unaffected by the lockdowns. Adjusted PBT was £6.3m, versus £10.4m in H121 and £6.1m in H120. There was material revenue growth in citrus, Treatt’s largest category, and synthetic aroma and herbs, spices and florals also performed very well. Citrus represented 47% of revenue during the period (up from 44% in H121). Net debt stood at £19.8m at end H122, predominantly due to a working capital outflow of £15.1m during the period. This was mainly caused by a strategic decision to increase inventories in order to shield the business from potential supply chain disruption. We forecast a net cash position from FY23 onwards.

For the next three years (FY21–24) we forecast an 8.9% revenue CAGR and a 7.1% pre-exceptional PBT CAGR (slower due to increased depreciation from the new UK facility), translating to 6.5% growth in pre-exceptional earnings. The business is cash generative, with an estimated free cash flow yield of 4.1% in FY23.