Treatt - Scenting Long Term Progression

With markets continuing to correct lower, there are now an increasing number of companies trading off their highs. The AIM index alone has dropped around 150 points off its high at around 900, which helps understand the major level of pullback that small caps have recently suffered. Treatt (LSE:TET) is a company that has largely weathered the storm though - the share price is only circa 15% off the closing highs made back in May/June. Treatt, a niche manufacturer of fragrances and flavours, is currently capitalised at £78.4m, and seems to offer an interesting play on the shift towards natural ingredients in consumer products. Treatt's share price currently stands at 149.5p, through having 52.4m shares in issue.

One point to note is that Treatt underwent a 1:5 share split earlier in the year, such that for every share that investors previously held, they now hold five times as many, but at one fifth of the price. Therefore, the total value of the holdings are unchanged, but when looking at past figures such as earnings per share, those numbers need to be divided by five.

Treatt's technical position remains strong currently, with a series of higher highs and lower lows pictured. However, there are perhaps signs that the share price action may continue to weaken. That is largely based on whether the share price manages to stay above the 200-day MA that currently lies around 146p. The share price today ceased falling just above that level, which indicates that initial support has worked well. However, that is far from confirmed and there is potential for that level to be re-tested in coming trading sessions since previous linear support between the lows has been broken through rather comfortably. That suggests a return to residual support at 140p. Therefore, there is a material risk currently that the stock will enter a consolidation or slight downtrend taking a technical view, and that the steep bullish climb may not be set to continue.

Director holdings are not particularly large in relation to the market capitalisation, but stand at £500,000 between them. Most notably, the CEO purchased £14,000 worth of stock back in July, which is a positive sign, albeit it is not all that significant compares to his salary. What are more material are the institutional holdings, which are highly significantly. There is major backing from institutions such as Schroders, Henderson and Milton to the extent that the top six holders carry over 25m shares collectively. That does however mean that retail investors are at the mercy of institutional movements, especially given the lack of liquidity and that can work both positively and negatively. Therefore, institutional movements should be watched carefully. The latest two have been contradictory with Schroders passing up through 17% in May, whilst Henderson dropped down through 5% in June.

The current spread on Treatt is roughly 147p - 152p.

Treatt is a global manufacturer of flavours and fragrances for consumer goods industries such as beverages and consumer goods, supported through sales offices in North America, Asia and Europe. With end markets including soft drinks, fragrances and coffee/teas, the products span sectors that can be deemed as essential and others that are cyclical, so the company has the advantage of a growing global economy. The customer base is high quality with Diageo (LSE:DGE) being just one of many blue chip clients.

Treatt's name actually works very well in creating a strong brand for its own branded products. For example, Treatt's citrus oil based products include Citreatt whereas their concentrate range is branded as Concentreatt - a clever play on words. However, the fact that the products are based on natural ingredients does open the company up to raw material fluctuations. For example, orange oil prices are trading at historically high levels as a result of low crop levels in the Americas, and that has two impacts. Firstly £ denominated inventory levels rise, and that is important given that Treatt's business model involves keeping very high levels of stock. Secondly, and less encouragingly, it can cause margin pressures as increased cost of sourcing inputs is rarely matched by increasing the sales price of outputs.

The financial performance over the past five years has seen improvements in both top-line sales growth, and overall in net debt, whilst adjusted pre-tax profits have increased significantly. However, top line growth does appear to have stalled over the past few years albeit that is forecast to pick up slightly through 2014 and more materially in 2015.

During the period, operating margins have improved to over 9% with return on capital employed (ROCE) near the top of the range at 19.4%. Importantly, dividends have also been in a consistent upgrade cycle, which is encouraging, even though debt has been relatively stubborn. The trailing yield stands at over 2.5% and whilst that is not enough to attract yield chasers, it represents a good return alongside share price appreciation. Nonetheless, the net debt figure dropped by £4.7m in 2013 on the back of strong cash flows, with gearing reducing by 40% year-on-year.

The 2013 results showed a 1.1% rise in gross margins, and that was the major cause of a rise in profits despite steady revenues. US dollar sales and factors associated with the strength of sterling will however come back into play during 2014 and could slightly dampen results. With the company selling products into the US, dollar sales convert into lower sterling levels, which means lower sterling figures within results. However, if the company can kick back into a growth phase then that is not a material concern and might be mitigable - 76% of revenues in 2013 were derived from the US/Europe with all regions up or relatively flat except for the US. There are no customers representing 10% or above in revenues, so earnings quality looks pretty high.

It is the 2014 half-year results that are more interesting though, as they show better progress year-on-year and set up a solid foundation for H2 since Q1 is a historically quiet period for the group
- Revenues up 11% to £37.1m
- Adjusted EPS up 37% to 3.87p
- Interim dividend up to 1.24p
CEO Daemmon Reeve commented: "We continue to focus our efforts on long term success.  Our strategy is gaining good traction and, coupled with the effort and focus of our teams across the globe, the results are both translating into profits today and laying the groundwork for opportunities tomorrow."

Aside from those headline figures, there are a number of points to note. Net debt did rise again, with the stated reasons to buy inventory as a result of potentially higher raw materials prices within orange, lemon and lime oil - a move that was in line with previous years. The debt will no doubt be a deterrent for some investors, and ideally it would be good to see greater (and quicker) inroads being made into the debt figure, but that is fairly difficult given the need to spend on research and development. Aside from that, total assets are a very solid 1.95x total liabilities, and even current assets are 1.48x total liabilities, which tells us that the levels of intangible assets are low. The slight problem is that cash levels are low, so the company is reliant on its banking facilities - the large asset base is largely the result of high levels of inventories (a massive £27m worth). Although only a small proportion of the inventories are associated with over 1 year timeframes, it is a very large figure, and a figure that has been growing in past years - it represents over a third of total annual sales.

Taking a look forward, 2014 forecasts look highly achievable given the strong H1 performance, and given that the company has been in a broker upgrade cycle in the past, you would give them the benefit of the doubt that they might slightly outperform in H2 if they can keep control of their costs - the high levels of existing inventories should provide some level of insulation for now.

2014 consensus forecasts are for £6.8m in pre-tax profits (PTP) filtering down into 9.6p in EPS giving a PE ratio (PER) of 15.6 - a level that sounds sensible. A dividend yield currently at 2.7% stands alongside. Beyond that in 2015, £7.5m in pre-tax profits are forecast, equating to 10.6p in EPS giving a PER of 14.1 with an accompanying 2.9% yield that is covered over 2x by earnings. The growth rate is not particularly exciting unfortunately, and that is likely to cap a great deal of upside unless the company can outperform in H2 and beat the forecasts. That could nudge the shares higher, but it is by no means a foregone conclusion as recent pointers from the company only point to results being in line with forecasts.

That said, it is sensible to adjust for the state of the balance sheet. Taking cash, adding receivables and subtracting debt and payables gives a figure of circa £8.8m. Adjusting that back into the market cap, and the adjusted market cap rises to £87.2m or around 166p. The forward PERs now rise to 17.3 and 15.7 - levels that don't look so cheap and perhaps hint that previous rises towards 180p were overheated and that levels around 130p-160p are "fair value". Considering that over 60% of the debts are non-current, less conservative investors could factor in half the debt into the adjusted figure, but the PE ratios do not drop all that much. In this instance, the exceptional figures adjusted for during H1 look fair since they were associated with legal fees. Given the H2 weighting to results, the full-year forecasts look highly achievable.

Further clarity was provided to the market last month in an Interim Management Statement, although it was not all plain sailing. Despite Q3 results being in line with expectations, a strong performance being put in during the period and a "materially higher order book", raw material costs remained high. That led to the company noting, "the impact of higher key raw material prices may present some challenges in terms of maintaining margins over the coming year". That is a concern given that the broker forecasts were derived before that target and were based on current margins being broadly maintained throughout next year - therefore, if margins start to suffer downward pressure then Treatt may just struggle to hit 2015 results. However, once again, that is far too early to say and the company only suggested it - nevertheless, it's important to watch margin levels on forthcoming sets of results to see if there is any clear change. To put it into perspective, using forecast 2015 revenues, just a 0.5% swing in gross margin would impact gross profit by £0.4m.

The company also noted, "Due to the FX hedging policies which are in place, the impact on the reported results for the current year will not be material and will largely relate to the re-translation of Treatt USA's profits at a weaker USD/GBP rate as compared with last year. This translation effect is expected to approximate to a £0.3m lower profit for the current financial year than otherwise would have been the case."

These are a couple of early warning signs that have seen appetite for Treatt cool off over the past week and are likely to have contributed to its decline, despite results expecting to be in line with market forecasts. What this does suggest is, if there had not been adverse forex movements, results would have topped expectations. A close eye should be kept on whether brokers decide to move from their modelled margins over the coming months, but Investec actually upgraded their target price to 160p on the IMS release (from 150p). The issue that many investors will take, like was the case with Sagentia (LSE:SAG), is that the broker target is not high and is less than 10% above current levels. That is a deterrent in some ways, especially since Investec is the nominated broker and those tend to be more bullish. More comforting to investors is that further beverage contract wins could materialise in H2.

Overall, Treatt gives investors an opportunity to gain exposure to a niche and growing sector, even if the company is not growing currently. The market rating at the moment looks to be around fair value given the potential headwinds during 2015 until the company can demonstrate a sustained pattern of growth, combined with management of the net debt figure. With the technical scenario appearing to be on the brink of a potential break, the current rating is not sufficiently low to interest me, although the company could be a potential bolt-on addition for a larger company in the sector. 130p - 160p looks to be a range in which Treatt is sensibly priced pending further news or results. No Rating.


  1. Cheers Elite. Interesting

    I wonder why Investec dont up their target to something like 200p

  2. Balanced piece on Treatt. Keep up the great work because resources like this are few and far between. Any hope that you could sneak a peek at ASC?

  3. Concentreatt, lol! What a great name. The share price looks like it may be running out of steam by my analysis.