Treatt — Update 5 January 2016

Treatt provides high-quality innovative ingredient solutions to the flavours, fragrance and cosmetics industries, as well as directly to global fast-moving consumer goods (FMCG) manufacturers. Its in-depth knowledge of the commodities markets in which it operates (none exchange traded) and its long-term relationships with suppliers provide the group with an important competitive advantage. Treatt has more than 125 years of experience and knowledge of sourcing and trading raw materials, which acts as a barrier to entry for potential new entrants.

Despite the share price having risen by 23% in absolute and 26% in relative (FTSE All-Share) terms over the last 12 months, it still trades at a significant discount to its peer group based on benchmark valuation metrics. We value Treatt on a DCF basis and derive fair value of 190p, or c 15% upside. We note that on a benchmark valuation basis, Treatt trades at a substantial (c 40%) discount to its ingredients peer group on both P/E and EV/EBITDA. This gap is unwarranted in our view.

The company had yet another strong year in FY15, despite the quiet start. The new year has started steadily, and management is confident of building “a successful, strong business for the long term”. We recognise that Q1 is always seasonally the smallest quarter, and hence expect any momentum built through FY15 to somewhat dampen at the start of FY16. New business wins are continuing, particularly in the beverages space, and we expect this trend to continue.

Looking into the medium term, we forecast 2.6% revenue CAGR and 4.9% pre-exceptional PBT CAGR, translating to 3.8% pre-exceptional earnings CAGR for 2015-18. Management’s proven track record in meeting or beating expectations, in combination with the positive outlook for the natural ingredients industry, gives us confidence that our forecasts will be met. In addition, we note that management has been successful in controlling costs through internal self-help measures, and we expect this trend to continue.

Despite 60% of turnover being exposed to the ‘defensive’ beverage sector, 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 undertaking an active hedging policy where possible:

Treatt has more than 125 years’ experience as a supplier of innovative ingredient solutions to the flavour, fragrance and consumer goods industries. Its historic strength has been in ingredient sourcing and risk management, but over time it has invested in manufacturing its own higher value-added, higher-margin products. These now account for more than half of sales and three-quarters of group profits. Treatt’s main customers operate in the flavours and fragrance industries: its products are used by flavours and fragrances manufacturers and blended together to create highly value-added ingredients, which are in turn sold to fast-moving consumer goods (FMCG) companies. Treatt also sells directly to FMCG companies for use in their products.

Treatt’s customer base is broad reaching in terms of size and geographic reach and, while a key part of the new strategy is to focus on growing sales with a smaller number of larger customers, at present the breadth of its customer base means the group is not overly dependent on any one relationship, with its largest customer representing c 10% sales, and the top 10 customers representing c 35% sales. Approximately 75% of Treatt’s product portfolio is flavour ingredients, with approximately 25% fragrance ingredients. Typical end-products that use Treatt ingredients range from soft drinks, alcoholic beverages (mainly craft beers) and confectionery, to soaps, shampoos and basic pharmaceutical products. Treatt has manufacturing sites in the UK, US and Kenya, in which its three 100%-owned subsidiaries, RC Treatt, Treatt USA and Earthoil, are principally based. In addition to its manufacturing centres, Treatt has sales offices in China and France and a network of agents throughout the world, through which it exports to more than 90 countries worldwide.

Exhibit 1 and Exhibit 2 show a breakdown of revenue by geographic market and by customer sector.

In Exhibit 3 we illustrate Treatt’s product suite. Treatt used to be run along discrete product lines, but when CEO Daemmon Reeve took over in 2012 one of his key strategic priorities was to break down the ‘silo’ mentality that existed among the three operating units.

Treatt has outgrown its current UK manufacturing facilities in Bury St Edmunds. In May 2015 the company announced its intention to fully relocate the UK business to another site near the existing one. The estimated cost is £15-20m, although the exact timing is still not known as the new site is part of a major strategic business development in the area and Treatt has not yet been able to purchase the land.

Natural, clean label, green, calorie-free and sustainability are the new buzzwords in today’s food and beverage industry. Products and ingredients bearing these tags have created demand among consumers, and have therefore been significant purchase influencers. The markets for these natural and naturally derived products are growing at a fast rate, creating significant profit potential for food and beverage manufacturers and ingredients suppliers alike.

Consumers perceive natural ingredients as having a positive impact on general health, while synthetic ingredients are viewed with suspicion. As a result, food and beverage manufacturers have promptly responded to the situation by completely replacing or partially replacing synthetic ingredients with their natural or clean-label counterparts. One example is the launch by the Coca-Cola Company of Coca-Cola Life, which is sweetened with cane sugar and stevia leaf extract and has 35% fewer calories than other leading colas. This followed Pepsi’s launch of Pepsi True in October 2014 (and Pepsi Next in some markets), which is also sweetened with stevia leaf extract.

Stevia is an increasingly popular 100% natural sweetener; however, it is also renowned for a signature bitter liquorice aftertaste. Treattaromes are Treatt’s trademark From the Named Food (FTNF) portfolio of clear aqueous distillates that naturally offset the aftertaste. They provide a natural sweet top-note flavour and are an exciting potential way for Treatt to participate in this fast-growing sector of the beverage market.

With the sale of natural food and beverages predicted to reach US$39.1bn in 2015 (source: Prepared Foods 2013), the size of the market opportunity for Treatt is enormous relative to its current size and position. In addition, we highlight that 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. It is also well placed to capitalise on the natural and clean-label trends given its expertise in FTNF solutions. In the short term, we highlight that capacity constraints in the UK, and in the medium term in the US, are limiting factors in the group’s ability to take full advantage of its expertise; however, payback on any future capacity investment, both in terms of percentage return and the time taken to achieve it, is likely to look attractive.

Flavours and fragrances span a very wide range of products and applications. We outline below the factors that we believe make Treatt an attractive business:

The group updated its strategy in H215 as the business has evolved. The previous strategic priorities have now been embedded into the business, and the group now has five key pillars to support a focused sales approach, and thus lead to long term, sustainable profit growth:

Combined, all the individual strategies outlined above help to contribute to the final strategy objective, that of consistent, sustainable growth in profit. While in the short term gross margins can fluctuate due to cyclical changes in raw material costs (specifically citrus oils), in the longer term the evolution of the portfolio towards higher-margin, higher value-added ingredient solutions means that management views gross margin of 27% (versus our FY16e 22.4%) as plausible over the medium term. Equally, management commitment to contain fixed costs is clear; as such management views an EBIT margin in the low teens as achievable in the long term, versus our forecast for FY16 of 10.6%.

While M&A could prove to be a value-added opportunity in the medium to long term, in the near term management believes that enough opportunity exists in executing on its organic strategy, without the inevitable distraction of exploring external opportunities. In addition, the relocation of the UK head office and manufacturing site is likely to use much of the available financial as well as management resource over the next couple of years.

Due to its background as a trader in raw material ingredients and the breath 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’; however, the exception to this is the group’s sizeable exposure to citrus oils, namely orange and lemon oils.

Orange oil is a non-exchange traded commodity, so its supply is managed by Treatt’s highly skilled stock teams in the US and UK, with their deep market knowledge and expertise adding value to customers by consistently ensuring best prices and consistency of supply.

95% of Treatt’s supply of orange oil comes from two key markets – Brazil and Florida – yet both markets have been negatively affected in recent years by disease and adverse weather patterns that have reduced both quantities of oranges grown and the quality of the overall crop. Orange oil is a by-product of orange juice, extracted through the process of 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 that the processors need to buy to produce the quantities of juice they need to satisfy demand. The current influences on the price of orange oil are:

These two factors have sent the orange oil market into a frenzy, with prices heading towards the elevated levels of 2010-11, when prices reached $10/kg (vs the long-term average of $2-3/kg) due to the heightened demand for orange terpenes in the clean-up process following BP’s oil spill in the Gulf of Mexico. Management is expecting citrus oil prices to soften through FY16.

The lemon oil market, on the other hand, is stabilising. Supply is improving and the expectation is that the crop from the main markets of Spain and Italy is stable vis-à-vis last year, and hence pricing should not see a major fluctuation.

The group’s deep insight into the markets of both commodities has very clearly helped it navigate the worst of the volatility, but also provides a significant value-added service to customers who may not have a similar level of insight. Increasingly, Treatt is looking to secure longer-term contracts from both customers and suppliers to smooth out volatility in raw material procurement and revenues, thus hoping to reduce 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, Treatt has a policy of maintaining the majority of its cash balances – including group overdraft facilities – in US dollars, and to a lesser extent in euros, as this is a cost-effective way of providing a natural hedge. In addition, the company takes out forward FX contracts to hedge the risk.

For the full year to September 2015, we calculate that on average the US dollar weakened by 6.9% against sterling. However, due to the hedging activity undertaken by the company in 2014, the full-year foreign exchange impact on group results is expected to be negligible.

The vendors of the Earthoil group (purchased by Treatt in 2007-08) have filed a claim in the Chancery Division of the High Court against the company, originally for £1.8m, which they subsequently increased to £2.3m in H114. The claim relates to an earnout, being deferred consideration payable to the vendors in respect of the acquisition. The court found in favour of Treatt in two rulings and one in favour of the vendors. The matter was referred to chartered accountants for the determination of the substantive claim in February. The outcome is expected in H116. Treatt’s board remains of the view that no sums are due to the sellers in respect of this claim.

Treatt has outgrown its current UK manufacturing facilities in Bury St Edmunds and had been exploring options for some time. In May 2015 the company announced its intention to fully relocate the UK business to another site near the existing one. The estimated cost is £15-20m, although the exact timing is still unknown as the new site is part of a major strategic business development in the area and Treatt has not yet been able to purchase the land. We previously expected building of the new site to start in 2016, but given the land has not yet been purchased we now expect this to be the main focus for 2016 and for building to start in 2017. We have adjusted our forecasts accordingly and now estimate relocation costs of £3.5m in FY16, £10m in FY17 and £6.5m in FY18.

We illustrate Treatt’s valuation versus its ingredients peer group below. Treatt trades at a significant discount to its peer group on all metrics. While some discount can be applied given its small size and some of its products are relatively ‘upstream’ in the ingredients spectrum – in particular the bulk ingredients that are sold to other ingredients companies – and hence would command a lower multiple, we believe a 40% discount on EV/EBITDA and P/E is unwarranted.

Our DCF-derived fair value is 190p (previously 198p) following the various changes to our model. This is predicated on a WACC of 7.9% (encompassing a beta of 0.8, an equity risk premium of 5.0% and a borrowing spread of 5.0%) and a terminal growth rate of 2%.

Below, we show a sensitivity analysis to these assumptions and note that the current share price is implying a terminal EBIT margin of 11% and a terminal growth rate of c 1%.

FY15 sales grew by an impressive 9%. The beverages market in particular is proving a source of growth for Treatt. Craft beer is one of the fastest growing sub-segments in the beverages market and is proving to be a successful market for the company. Moreover, the reduced-calorie/diet segment is also providing growth as consumers (and hence manufacturers) become more interested in natural products and shy away from artificial flavourings and sweeteners. Profits were held back in H1 by adverse raw material price movements relating to some longer-term, fixed-price contracts and by the timing of FX hedges. The latter unwound as forecast in H2. Net debt was considerably better than forecast. We illustrate the actual FY results compared with our forecasts in 6 below.

We have trimmed our FY16 sales forecast to reflect the slightly lower than expected sales figure reported for FY15. We have left our sales growth assumption of 0% unchanged. We also reduce our EBITDA very slightly given the currently high orange oil prices. A better than expected net debt figure for FY15 results in a small upgrade at interest level and hence our PBT and EPS are broadly unchanged, as illustrated in Exhibit 6 below.

We have adjusted our forecasts following the news on the UK business relocation. Previously we forecast £7m in FY16, £10m in FY17 and £3m in FY18 in respect of the move, but we believe there may be a delay given formal negotiations to purchase the land have not yet started, and hence we now forecast £3.5m in FY16, £10m in FY17 and £6.5m in FY18.