Why Treatt shares are a beautiful thing

Two things bothered me after I profiled Treatt just before its AGM. The first was profitability. Evidently, profitability has improved, but I think shareholders could be in for a rough time over the next few years as the company invests in a new headquarters and manufacturing facility in the UK and expands its US operation. Return on capital will fall even as returns grow due to the sheer amount of capital Treatt is investing.

The second thing bothering me was that I couldn't attend the AGM, where I'd planned to learn more about what's behind Treatt's growing profitability, and how it might be impacted by the relocation.

Don't write off big-spending Treatt

Specifically, I needed numbers... Fortunately, chief executive Daemonn Reeve and finance director Richard Hope agreed to provide them. The pair, I believe, are the principal architects of Treatt's strategy to make higher value ingredients and sell direct to beverage companies.

Treatt has long sourced essential oils, particularly orange and lemon oil, which it sells on to large flavour houses who process it and sell it to beverage companies like Coca-Cola and Pepsi. Sometimes Treatt's only input is to transfer the commodity from large barrels to smaller ones.

Adding value

When Reeve became chief executive in 2012, Treatt earned 50% of revenue trading ingredients, and 50% was achieved by distilling the oils to certain specifications, and distilling especially flavoursome and 100% natural ingredients from whole fruit.

Today, Treatt tells me, the balance has swung heavily in favour of these added value ingredients, which account for 66% of revenue. In particular, Treatt's capitalising on industry trends by developing more exotic flavours, and flavours designed to neutralise the bitter aftertaste of sweetners. Reeve reckons 70% of projects at large beverage companies relate to sugar reduction.

Cutting out the middleman

Value added ingredients achieve higher profit margins, which are boosted again if Treatt can sell them direct to beverage companies. When Reeve took over, 48% of revenue came from beverage companies and 52% of revenue came from the middleman, flavour houses. Today Treatt is earning 50% more revenue and the position has reversed. 52% of sales are direct.

I think that's a beautiful thing, and as long as these numbers keep moving in the right direction they will mute some of the impact the investment programme will have on profitability.

Return on new investment

The big investment risk is the unprecedented relocation in the UK, which should cost about £35 million. The company calculates it will make a return of between 10 and 15%, upwards of £3.5 million, from three years after it moves in, based on the efficiencies it will achieve from being in one building with a substantial amount of new equipment. Treatt will only need to operate six forklifts, for example, while currently 20 scurry between warehouses and distilleries on its fractured site.

The upper bound, 15% return on incremental (new) capital is, incidentally, very roughly the return Treatt has been achieving on its existing capital in recent years, but even if Treatt only achieves a 10% return from efficiencies, it should get a boost from revenue growth too. That's because Treatt expects new laboratories and open work areas to allow it to collaborate better with large beverage companies.

Payback from adding a second still in its Florida distillery will happen much more quickly, within two years the two men tell me.

There are a lot of moving parts, but it doesn't seem fanciful to suggest that in a few years time Treatt will not only be earning more profit than it is now, but it will be no less profitable in terms of return on capital.

Our conversation ended with an amusing postscript. My suspicion the company might have orchestrated outrageously good approval ratings (4.9/5 for Treatt and 100% for its CEO) on recruitment site Glassdoor turned out to be true.

This is a typical review:

Pros

There is a genuine desire to encourage employees to be the best version of themselves. Since my very first day I have felt incredibly valued as an employee.

Cons

Our current facility is the only drawback, however the knowledge we will be moving to a purpose built site in due course very much negates this.

But the two executives say the 20 staff that wrote so positively about the company and its chief executive were not obliged to write. Neither were they told what to write. And that means by encouraging staff to go public, Treatt's Human Resources department believes their unedited views will attract people to join the company.

I think that's a good sign.

Victrex

Victrex is so enormously profitable, it's prepared to sacrifice some profit margin to grow. I went to the polymer manufacturer's AGM earlier this month to find out why its medical division seems to be contracting slightly. Three of its products in development, spinal, dental and knee implants, underpin a substantial part of Victrex's strategy to grow revenue by an additional 10% to 20% in the medium term by fashioning products, or semi-finished products.

Though PEEK, the polymer Victrex manufactures is no commodity, like Treatt, Victrex is moving downstream, and supplying industries that have never used PEEK parts before. To do that, it must prove its material is better than metal to customers that, hitherto have used nothing else but metal. That is, I now understand, quite an undertaking. Especially when you are proposing is to put the material in somebody's body.

Growth has stalled because in the US, Victrex's biggest market, 70% of spinal implants already use PEEK, much of which comes from Victrex. Titanium, the alternative, is making something of a comeback too. Victrex has a new product, that counters titanium's advantage, superior bone growth on the implant, and has substantial advantages of its own, it doesn't weaken the spine like titanium and its much cheaper to manufacture. But sales of the new product are largely replacing sales of the older product.

Meanwhile, Victrex must commercialise its dental technologies, and get its knee implants tested and approved. It says it's on the verge of breakthroughs, but even once PEEK devices are routinely being used, it could take quite a while for revenues to grow to levels that would make much difference to a company already bringing in nearly £300 million a year.

One question I failed to ask, is roughly how long the "medium term" is. Investors may need to be patient.

Contact Richard Beddard by email: richard@beddard.net or on Twitter: @RichardBeddard

Richard owns shares in Treatt and Victrex.

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