The Takeaway: A Q&A With Eric Samuels on the Specialty Ingredients Sector
How does Houlihan Lokey define the specialty ingredients market?
We define a specialty ingredients company as any B2B-oriented provider of value-added inputs into consumer products. Broadly speaking, those value-added inputs can have a sensory effect, they can have a nutritional effect, or they can have a functional effect. We view the specialty ingredients market not as a vertical, but rather as a horizontal across the entirety of the consumer landscape.
For example, you have specialty ingredients companies focused on food and beverage; a preservative formulated into a food product being an example. There are also specialty ingredients providers that focus on servicing consumer health, such as a probiotic strain that’s developed for a supplement or a company focused on beauty/personal care that would create a botanical extract that is sold into a cosmetic product. There are other ingredient companies that sell into a home/staple product, such as a fragrance developed for an air care application. And finally, you see specialty ingredients companies focused on products consumed by animals; those companies may produce ingredients for household animals, such as a protein ingredient sold into a super-premium pet food, or for a pharmaceutical application, like a flavor base that is added to a prescription pet drug.
What do investors like about the specialty ingredients sector?
Regardless of the end market, there are consistent themes that you see with B2B-oriented specialty ingredients companies. The first is “stickiness”; typically, these ingredients deliver a defining feature to the finished product at a very favorable cost-in-use ratio. A great example is compounded flavor. Let’s say you’re selling a black cherry flavor into a better-for-you carbonated beverage; that flavor could be half a percentage point of the cost of a total finished product, but it provides the defining sensory characteristic of that beverage. That means that when the beverage brand is trying to save a couple of pennies, they’re not going to risk changing the flavor, which could alienate the consumer; the flavor tends to be the last place they’d look for cost savings. So, because of this dynamic, these specialty ingredients companies have strong pricing power, strong margins, and are very “sticky.”
A second theme is that there is fragmentation across this industry. There are big players in each of these major categories of specialty ingredients, but there is also a long tail of attractive small and midsize businesses. Unlike branded products, where you analyze scanner data and see who the interesting category participants are, ingredients is a much quieter market. This creates a compelling investment opportunity to unearth attractive businesses that aren’t on the radar of the broader market.
Finally, when you can find more innovative midsize companies with a unique value proposition (whether that be a unique go-to-market strategy or differentiated product capabilities), there’s a chance to drive outsized growth. Typically, ingredient companies are going to grow at the growth rate of the end markets, so large food ingredient companies will grow with food consumption. But when you find companies that are indexed to faster-growing pockets of the markets, you can drive more attractive growth rates than market norms.
Let’s talk a bit more about the faster-growing “pockets” in the sector, given the importance of growth to investors. Which of those are poised for outsized growth these days?
Everything, in our view, starts in the mindset of the consumer.
For example, in food and beverage, the consumer wants to understand the ingredients that they see on their finished product. The clean label movement is here to stay. Consumers want to flip over their product and understand the ingredients that they read on the label. So, being able to see an ingredient statement that comes from natural raw materials is very interesting to them. Consequently, companies that can take natural raw materials, utilize value-added manufacturing processes to convert the substrates into high-impact ingredients, and then have the R&D capabilities to help their customers use these ingredients are well situated to benefit from this trend.
For example, you could have a company that takes block cheese and then concentrates that cheese through an enzyme modification process. This creates a clean label cheese flavoring that can be labeled on your favorite cheddar snack as “cheddar cheese.” It’s not labeled as a flavor; it’s labeled as the natural raw material substrate. Companies that have this combination of competencies—procurement of these ingredients, value-added conversion (i.e., fermentation, extraction), and customer-centric R&D—are well situated to benefit from the clean label trend.
A second trend would be the continued evolution of where people eat. Despite some foodservice volume headwinds in 2024 that we view as temporary, as consumers continue to consume out of the house more, ingredient providers that have the capabilities to partner with national chains for direct innovation to create new menu items that address consumer demands are situated to benefit. If you look at the food ingredient industry, it’s generally indexed to the grocery store, and while the grocery store isn’t going anywhere, we believe that, long-term, this trend of out-of-home consumption will continue. So, ingredient companies that have skill sets suited to working with the foodservice channel, such as culinary teams that work directly with national chain chefs, are well situated.
The final trend I would call out is the growth of ingredients that provide a science-backed nutritional benefit to end products. Consumers want more functionality, whether in their food, beverage, or supplement products. They want to consume products that have science-backed health benefits, in addition to tasting good. The recent rise of carbonated beverages featuring prebiotics is a great example of this. Ingredient companies that can offer substrates (whether they be plant-based or biotics) that have health benefits backed by reputable clinical studies are well positioned to benefit from this trend and reap the benefits when exploring M&A opportunities. Whether you are a sensory or functional-oriented ingredient company, you want to be able to provide your food and beverage or nutraceutical customers with these ingredients that can provide tangible health benefits, which makes companies that offer these science-backed ingredients in-demand M&A targets.
So, what does specialty ingredients M&A activity look like in the current market?
As much as I’d like for this to be a simple answer, I think a recap of the recent history is needed to understand today’s market. 2024 is shaping up to be the most normal year for the ingredient operating environment since 2019, so a little bit of explanation on what’s happened in between is helpful.
In 2020, ingredient companies typically performed very well; for these companies, the “COVID bump” was beneficial. This strong performance, coupled with a great M&A market generally in late 2020 and 2021, led to a lot of activity in the sector. The public ingredient companies continued to trade at high multiples and used that currency to pay strong prices for businesses, and the market hummed along quite well through the first chapter of COVID.
We started to see some choppiness in mid-2022 with the rapid rise of inflation. Specialty ingredients companies tend to have the ability to pass prices onto their customers to maintain their margins, but there’s typically a timing lag. So, when we experienced rapid inflation, there was a period where a lot of businesses felt margin compression and income statements started to look a little bit challenged in this period. This more challenging operating performance, coupled with broader market issues driven by inflation, corresponding higher interest rates, and debt market challenges, resulted in M&A slowing significantly.
In 2023, inflation started to normalize, but that’s when we experienced the retailer “destocking” dynamic. Due to supply chain uncertainty during COVID, retailers erred on the side of holding higher levels of inventory to ensure that they wouldn’t be caught short during a period of elevated demand. But as inflation occurred, consumer spending started to drop, and to more efficiently manage their inventory, the entire supply chain worked down inventory levels and decreased ordering frequency, leading to volume shortfalls. So, in 2023, volumes across the ingredient sector were challenged.
It wasn’t until the beginning of 2024 when it looked like supply chains had normalized, inflation had abated, customers returned more or less to typical order patterns, and brands and foodservice operators began to innovate and launch new products again following the prolonged period of focusing on the core product assortment during a turbulent market.
As a result of this normalization, for specialty ingredients companies, in the first half of 2024, core business performed at normal levels again. This, coupled with growth from customer new product development, is leading to much stronger business performance, which in turn is driving increased M&A activity. We have been more active in 2024 than we have been at any time since the beginning of 2022.
So, what’s The Takeaway?
The fundamentals in the specialty ingredients space that drive high levels of investment in the category remain as strong as ever, following a uniquely turbulent period in 2022 and 2023, and as the operating environment has normalized, we’ve seen M&A activity levels pick back up in 2024. We’re optimistic that the trend is going to continue going forward, and we’re excited to help our clients navigate this healthy, normalized environment and take advantage of the attractive opportunities in the sector.
