Interactive Investor

Stockwatch: a high-flying growth stock plunges, is it time to buy?

16th August 2022 11:12

Edmond Jackson from interactive investor

A sudden profit warning has sent the share price sharply lower. Companies analyst Edmond Jackson weighs up whether investors should attempt to buy low. 

Yesterday, the small-cap shares in Treatt (LSE:TET) plunged by more than a third after a sudden profit warning - contrary to a bullish outlook only three months ago, when annual revenue hopes were raised to 15%. 

The situation has relevance not only as a potential “buy” for recovery or even a takeover target, but more widely. It deals a blow to the sense that affluent people will keep buying luxury-type discretionary goods. Input costs are rising and for companies doing business abroad, foreign exchange volatility is another hurdle. 

It appears profit forecasts signed off only a month or so ago, are no longer relevant. 

Yet the chair and CEO have bought meaningful amounts of shares after the drop, something only a cynic would say is a propping-up exercise. 

Dialling into demand for more discerning products 

Treatt makes and supplies natural extracts and ingredients for the flavour, fragrance, beverage and consumer products industries.   

That puts it in an ideal position to capitalise on people’s tastes widening and becoming more refined; if making it somewhat at the behest of (multinational) manufacturers.  

From spring 2020, hopes soared on how a prized growth stock was taking shape. Indeed, the September 2021 annual advance in revenue/profit was material; although 2017 achieved near 44% earnings growth also. 

I have followed Treatt periodically since it floated in the late 1980s. Therefore, if its specialist area truly offered growth – and is able to withstand wider pressures – one might reasonably expect by now, revenue at a multiple of £124 million last year. 

Double-digit operating margins are respectable enough, advancing from 13% to 16% last year – even if they are now being checked. Likewise, return on capital in the mid-teen percentages, if hardly justifying a price/earnings ratio (P/E) over 20x. Yet serially high capital expenditure has meant a poor record of free cash flow. This is why earnings cover for dividends is kept at over 3x. 

For a company remaining small (in a listed context), Treatt is highly diversified geographically. The UK comprises only 7% of group revenue, and at 36% the US is by far the most significant, otherwise territories are quite evenly balanced.  

Potentially, this is a bonus for exporting if sterling continues to weaken given that the UK economy is expected to fare relatively worse over the next two years. It will also boost revenue translation back into sterling. But the update shows how things can work out different in reality.  

Why US dollar earnings have been compromised 

Despite using foreign exchange contracts to manage risk, either they were not up to the task or however things worked out in practice, the firm notes: “The rapid devaluation of the sterling against the US dollar during the period has had a significant impact on margins.” 

Yes, that is an issue, but I am surprised management can only cite it as a negative given US dollar strength will empower US buyers of its products. Perhaps “volatility” is the key issue here.  

It underlines how we need to consider exactly what US revenues at a company mean for profit. 

The latest advice is to structure an investment portfolio for greater US earnings, given the likely ongoing strength of the dollar versus sterling. But it is not proving so straightforward, even when hedging is apparently used. 

Growth expectations temporarily reduce for high-margin tea 

A strong performance had been anticipated from this category, driven by iced and hard tea consumption in the US.  

Instead, falling consumer confidence in recent months has hit demand, with lower year-on-year tea sales – which the update says, has materially reduced margins (as if operational gearing is involved, not just currency). 

So much for affluent consumers continuing to spend on their favourite items. But aside from tea, the firm points out: “We are seeing strong growth in all other Treatt categories…there continues to be sustained growth in demand for our natural and authentic extracts and bespoke solutions for a wide range of beverages.” 

Lower year-on-year sales are said partly due to an exceptional 2021 performance and a two-year growth rate over 60% highlights a significant opportunity. 

But will demand for this tea recover or be left impaired by stagflation in years ahead? If the economic situation worsens, are other Treatt items so immune? 

For now, management notes that its overall group order book remains up 25% year-on-year, as guided at the May interims. 

Input cost inflation is further compromising margin 

On input cost inflation, management points out that while in a number of cases, the business has been able to pass this on to its customers, some longer-term contracts have not yet allowed this to be achieved across the full portfolio.

It affirms a conservative gut feel, higher costs will catch up even with those firms that spent the first half of 2022 declaring that they were successfully passing on higher costs. 

The problem is central banks tackling inflation belatedly, meanwhile wage rises and labour shortages (linked for example to demographics and EU workers returned home) are ingraining price rises. 

Treatt says its challenges to profitability are “predominantly short term”, although I believe they could persist – or vary – over the next year or two. 

Bosses buy this steep drop in the stock chart 

The chair has picked up nearly £50,000 worth at 555p and the CEO nearly £20,000 worth at 559p; although despite this being announced late yesterday morning the price drifted to 525p before closing at 535p. 

With a further easing near 520p this morning, it marks an overall 60% fall from near £13 at the end of last December, when Treatt traded on around 50x earnings expected back then.

While it is not back to the 500p level from which it re-rated from spring 2020, the business has advanced by way of investment, etc. Now, however, there is no scope for governments and central banks to boost demand with stimulus measures.

A macro view is that such volatility was linked to ultra-low interest rates and excess speculation during Covid lockdowns – that guaranteed a mean-reversion.  

Treatt - financial summary
Year-end 30 Sep

 201620172018201920202021
Turnover (£ million)88.0101112113109124
Operating margin (%)10.212.411.411.312.916.1
Operating profit (£m)9.012.512.812.714.020.0
Net profit (£m)6.29.612.28.89.815.1
EPS - reported (p)11.715.915.916.518.124.9
EPS - normalised (p)12.718.219.018.420.525.5
Operating cashflow/share (p)16.73.51.030.622.514.1
Capital expenditure/share (p)1.59.711.317.641.523.6
Free cashflow/share (p)15.2-6.2-10.313.0-19.0-9.5
Dividends per share (p)4.44.85.15.56.07.5
Covered by earnings (x)2.73.33.13.03.03.3
Return on total capital (%)16.620.714.512.613.016.9
Cash (£m)6.64.832.337.27.77.3
Net debt (£m)2.310.2-10.1-16.0-0.49.1
Net assets (£m)37.246.581.687.191106
Net assets per share (p)70.687.9137145151176

Source: historic company REFS and company accounts

Remains on a high multiple of likely near-term earnings 

September 2022 annual profit is guided at just over £15 million, a significant drop £24 million as projected by Edison Investment Research barely five weeks ago. This is notable because paid-for research – especially its numbers - is normally signed off by the CFO, as if there was a rapid change of awareness. 

I would pencil in earning per share (EPS) around 20pm, which implies a 27x P/E – plenty high enough considering Treatt’s guidance has left at least one analyst, if not investors, exposed. 

With hindsight, a 39% drop in interim profit was a harbinger of tougher times, despite revenue up 9% to a record £66 million. Yet management was fully confident in a second half-year profit weighting, and momentum building. That results release is now shown as needing more respect of wider economic conditions. 

I suspect the 2022 total dividend will be held around 8p a share, with the prospective yield being 1.5%. 

Net assets of £115 million imply 192p a share with only 2.5% constituting intangibles. 

It may be late to sell, given Treatt’s US exposure may encourage takeover speculation, but equally, if economic conditions worsen on a one to two-year view, it is premature to buy. Hold. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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