Description

Description

Treatt is a UK headquartered business that sells flavors globally.  Over 85% of its products end up in beverages.  Citrus is the largest category at 53%.  US is its largest geography (41%); followed by Ireland (10%), and China (6%).  The company was historically strong in sourcing orange and lemon oils (35% of 2012 sales).  They have migrated somewhat to added-value products, so all low-margin, traded products were just 16% of 2023 sales.  The company is slowly evolving from being a commodity supplier to the main Flavor & Fragrance (“F&F”) houses (such as Givaudan, DSM-Firmenich, IFF and Symrise) to selling direct to FMCG companies; each channel now represents 50% of sales.  

The pitch

Cheapest house in a good neighborhood.  F&F houses are attractive because of economies of scale in R&D and high switching costs.  For example, Coca Cola does not vertically integrate its own lime flavoring production, but instead outsources to niche F&F specialists who spread their costs across many customers and different products containing a lime flavor.  High switching costs result from consumers’ attachment to a specific taste, combined with a typical flavoring representing less than 1% of total product cost.  

This week Treatt stock (light green below) hit a 7 year low, except for a brief March 2020 pandemic panic.  It now trades at 14.0x EV/EBIT LTM or 12.5-13.8x guided FYE Sep-24.  That is a relatively low valuation both for this group, and this business since it shifted towards higher added-value products over the last decade.  Sentiment is weak as the business appears rudderless before the appointed replacement CEO starts in June.

The outcome from here depends, I think to an unusual extent, on incoming management’s strategy and execution.  

In the best case, Treatt successfully innovates in areas of domain expertise (for example citrus, not coffee) and builds sustainable competitive advantages the hard way: through risky R&D.  Simultaneously they exploit major (35% US, 50% UK) capacity underutilization by the recent extravagant PP&E investments to increase volumes in mid to low margin products until the long term strategy bears fruit.   This scenario results in stock returns in the mid teens plus.  

The modal outcome, unfortunately for this UK small cap, is that such a transformation proves beyond management, R&D/sales remains below 2% compared to minimum 5% of some  smaller F&F houses and the 8% of the best (Givaudan) and capital allocation continues to be mediocre, as witnessed by large PP&E investments without the necessary follow-through of either innovation or volume strategies.  Mid single digit returns from this valuation would only be rescued, like the company itself, by the obvious solution: a sale and integration into one of the big F&F houses.

The downside is subdued by an almost debt-free balance sheet despite the recent completion of major PP&E investments in the UK and US.  Further multiple compression should become asymptotic due to increasing odds of an acquisition.  

But, without clear strategic progress from incoming management, I would not hold this long term because I think the industry dynamics do not favor being both sleepy and small. 

Management history by phase

1. Founded in 1886 by Richard Treatt.

        E.W. Bovill joined the board on Richard Treatt’s death in 1924.  

        The Bovill family held management roles and significant ownership stakes for almost 90 years until 2012.  

        Treatt went public in 1989, listing on the full London Stock Market in 1996.  

2. Hugo Bovill was MD (CEO) from 1987 to August 2012.

        Undisclosed disagreements resulted in Hugo Bovill leaving the board in 2012 while his family retained a 30% shareholding.  The Bovill family tried

        to get the Board to sell the company in February 2013, but the board said they considered it not the right time.  The Bovill family sold their shares. 

3. Tim Jones was Chairman from February 2012 to January 2023.  

        Daemon Reeve was CEO from August 2012 to December 2023 (joined in 1991).  

4. Vijay Thakrar has been Chairman since January 2023.

        CFO Ryan Govender (joined July 2022).  Interim CEO from January to June 2024. 

        CEO David Shannon will join in June 2024.

The Chairman, CEO and CFO are all therefore new to the company.  This contains risks (see antitrust comment below) but also the opportunity for change.

Data from past management

From 2017-2023 the company spent net £69 million on PP&E, almost 5 times depreciation during the period, and 8% compared to 1.5% historical capex/sales.  Much of this was on high quality UK headquarters which ran double the original budget without any change in management’s forecast ROI, as well as a $15 million Florida expansion.  They expected the UK HQ project to increase profits by 20-25% within 3 years of its 2023 completion, but since they left before this could be realized, this must be doubtful.   

The motives for so much capex were initially given as regulatory, then to increase capacity, improve operating efficiencies, increase innovation and customer collaboration.  But despite great enthusiasm to allocate significant capital to build and kit out new labs, it has not been matched so far by investment in R&D.

R&D/sales did increase from 0.6-0.9% of the prior decade, to its current 1.5%, but this still leaves Treatt as the least innovative publicly traded F&F company (5-8% is usual) on a relative basis, and obviously bottom on an absolute basis due to its small size.  The curious thing is that to hit a respectable R&D spend would have only taken an additional £5 million each year, which could have been funded for several years by just not over-running the HQ budget.  The board already has the necessary experience to make this kind of bet in David Johnston, Firmenich's former global head of flavor innovation, who has been on Treatt's board since 2011.

In short the strategic direction set by Jones and Reeve seems to have been hesitatingly executed.  It makes no sense to take all the pain on the key KPI of pre-tax ROCE, depressing its 20% pre-build average to the current 12% as the denominator increased, without putting all that potential to work.  

But now that capacity has been built out, and the stock price has declined by 72% in a little over 2 years, new managers get the chance to do things right, for the benefit of new owners.

The risks

1. Lack of scale.  For a F&F business which depends on economies of scale for its reason for being, I am not convinced that staying small is a viable option.  

It makes it harder to pursue a strategy of innovation, due to the lack of margin available to reinvest in building new moats.  So Treatt needs to target its R&D spend to competitively advantaged niches. 

The lack of scale is also evident in management quality and cost.  The amateurish budgeting process of the UK headquarters relocation and lack of focus on return on capital did not even come at a cheaper price.  From 2018-2023 the former CEO’s total compensation was 7.9% of operating income.  That is 15 times the proportion earned by Givaudan’s CEO.  Treatt is a mere 2% of Givaudan’s size, but in some years its CEO earned 60% of Givaudan’s CEO total compensation.  A side by side comparison on qualitative metrics would be brutal.

Potential mitigant: acquisition solves many of these risks.  Integrating Treatt’s operations in a larger group would utilize the new equipment and HQ.  Layers of management could be removed.  So lots of cost and sales synergies.  Treatt’s small size, lack of strategic shareholders, and relatively low valuation increases the odds of this solution.

2.  Antitrust.  The four largest F&F companies have faced mounting scrutiny after raids one year ago.  Treatt has not been named as involved.  The coincident timing of the retirements of the Chairman and CEO might be a worry to some investors. 

Note: header financials are consensus.

Catalyst

Execution by new management 

Clarity on lack of antitrust involvement