KDSKF - Royal DSM: Significant Execution Risk

2023-03-08 14:16:37 ET

Summary

• DSM continues to engage in optimization of their product portfolio, which introduces execution risk related to integrating acquisitions, particularly with Firmenich due to its size.
• DSM expects inflation to be an ongoing problem, which may contribute to growth but will likely undermine margins. Declining volumes could also become a problem going forward.
• DSM's valuation is relatively high given execution risks and the uncertainty of expansion into new markets.

DSM ( KDSKF ) is a large supplier of ingredients to end markets like health, nutrition, F&B, and personal care. DSM continues to shift their product portfolio towards higher value add products, through a combination of M&A, divestitures, and internal development. In particular, DSM is merging with Firmenich, which could create synergies, but also introduces significant execution risks.

Whether DSM can drive growth in markets like alternative proteins and sweeteners and improve margins remains to be seen. DSM's valuation has drifted higher in recent years, creating downside risk if expected growth and margin improvements do not eventuate.

Market

DSM competes across a number of large markets, although many of these are mature and offer limited growth potential. DSM is actively increasing exposure to growth markets though, which could contribute to performance going forward. This is somewhat unclear though, as many of these markets are nascent and their ultimate potential is not well understood.

• The market for alternative proteins is expected to reach 140-150 billion EUR by 2025.
• The market for high-intensity sweeteners produced by fermentation is expected to exceed 3 billion USD by 2025.
• The market for Human Milk Oligosaccharides (HMOs) is expected to reach 1 billion USD by 2030.
• The market for menopause products could present a 600 billion USD opportunity.

DSM

DSM is focusing their business on health, nutrition and bioscience, and in support of this is merging with Firmenich, while divesting their materials businesses. DSM also simplified their operating structure at the beginning of 2022 . DSM now has three end market-focused segments:

• Animal Nutrition & Health
• Health, Nutrition & Care
• Food & Beverage

DSM products include:

• Vitamins
• Nutritional lipids
• Carotenoids
• Minerals
• Eubiotics
• Enzymes and yeasts
• Texturants
• Flavors
• Cultures

Animal Nutrition & Health

DSM's animal nutrition and health solutions include:

• Mycotoxin absorbers to prevent fungal contamination of animal feed
• Eubiotics to displace the use of antibiotics as growth promoters
• Bovaer - a feed ingredient that reduces methane emissions from ruminants
• Veramaris - an omega-3 rich algal oil for fish feed
• Sustell - a service that combines environmental footprint calculations with nutritional knowledge to improve animal farming

Health, Nutrition & Care

DSM produces a range of nutritional and personal care ingredients and biomedical materials focused on immunity, gut, brain and skin health, as well as solutions for orthopedics and cardiovascular. Their supplements provide micronutrients like vitamins C and D and omega-3s, along with things like algal lipids.

HMOs are a potential growth area for DSM, which the company has begun to focus on in the past few years. HMOs are used as an additive in early-life nutrition products, dietary supplements, medical nutrition products, and pet foods. HMOs are a group of carbohydrates found in human breast milk that act as prebiotics, helping beneficial bacteria to flourish. HMOs are essential for both immune and cognitive development and are the third largest component in breast milk, after lactose and lipids. More than 200 different HMOs have so far been identified in human milk. HMOs are not found in other milk sources and are generally not currently added to infant formula.

DSM acquired Glycom in 2020 for an enterprise value of 765 million Euro , representing an EV/EBITDA multiple of 20.6x based on 2019 results. Glycom generated 74 million Euro of sales in 2019, primarily to Nestle. Glycom was founded in 2005 and has over 150 employees. The company pioneered the development and commercialization of HMOs, starting with production based on organic chemistry followed by a switch to fermentation.

While HMOs offer a large opportunity, competition is increasing. Amyris ( AMRS ) has been developing microbial strains to produce HMOs, although it is possible that if they are successful, they will commercialize in partnership with DSM. Ginkgo Bioworks ( DNA ) also recently announced a partnership with NAMUH to develop HMOs.

Chr. Hansen ( CHYHY ) acquired Jennewein Biotechnologie in 2020 to gain exposure to the HMO market. At the time Jennewein had 100 employees and was expected to generate sales of around 50 million EUR in 2021. Jennewein is a leader in the HMO market, with six commercialized HMOs. The acquisition aligned with Chr. Hansen's strategy of pursuing bolt-on acquisitions that leverage their microbial and fermentation expertise. Synergies were also expected from Chr. Hansen's probiotic bacteria offerings. Chr. Hansen is now merging with Novozymes ( NVZMF ).

Personalized nutrition is another focus area for DSM, which is being led by their Hologram Sciences initiative . Hologram offers consumer-facing personalized solutions by combining health diagnostics, digital coaching, and personalized nutrition.

Phenology is a menopause solution that is the latest offering from Hologram Sciences. Phenology takes a holistic approach to menopause, aiming to address both health and beauty concerns. Solutions include a self-administered saliva-based hormone testing, offered in partnership with Inne. Phenology also offers a coaching app, nutritional supplements, and wellness and beauty essentials.

iHealth is a CPG company owned by DSM that is focused on health and wellness. Brands include:

• Culturelle Probiotics
• AZO - products for urinary, vaginal, and bladder health
• Estroven for menopause relief
• UP4 probiotics

iHealth products are found in most major mass, club, drug, grocery, and specialty stores in the United States, and they are currently expanding internationally.

Food & Beverage

DSM's capabilities position them to offer solutions that address taste, texture and health in an integrated manner. Potential growth areas include plant-based proteins and alternative sweeteners.

Plant-based proteins are a potential growth area, but improvements need to be made in product quality and cost before wide-spread adoption occurs. Consumers want alternative protein products that provide the right texture, taste, and mouthfeel. DSM is making progress with their plant-based protein capabilities.

CanolaPRO is plant-based protein derived from non-GMO canola that is supposed to improve vegan and vegetarian products. DSM believes it has superior taste, texture and nutritional properties to soy, pea, rice, and wheat gluten proteins. It can be used in meat alternatives, dairy alternatives, protein shakes, bread, sauces, juices, and smoothies. DSM has also introduced a textured pea protein that contains sufficient levels of all nine essential amino acids to be considered a complete protein.

DSM also has exposure to alternative sweeteners through their Avansya JV with Cargill. DSM brings biotech capabilities to the JV while Cargill provides fermentation capacity. The 50 million USD commercial-scale fermentation facility is located in Blair, Nebraska. In addition to taste, manufacturers need to consider things like texture, which the JV is well-positioned to do.

Avansya's first product is the zero-calorie sweetener EverSweet, which utilizes Reb M and Reb D produced through fermentation. One ton of EverSweet is enough to sweeten 7.5 million cans of 12-ounce soda. In 2019 there were over 300 customer trials and product development projects in progress.

Early expectations appear to have been high, with DSM suggesting that sales could potentially amount to several hundred million USD annually. While DSM and Cargill have given limited information about EverSweet's success, Evolva's ( ELVAF ) half year 2022 results suggested that uptake was below expectations. Evolva developed the strains that are used by Anvansya for fermentation and they receive a royalty on EverSweet sales. Their financial statements hint that EverSweet sales may only have been something like 10 million USD in 2021. Avansya continues to make progress on the regulatory front across geographies though, and DSM has suggested that customer interest is growing.

DSM is in the process of building a Health & Nutrition Innovation Campus in Switzerland. This appears to be aligned with strategy of moving closer to end customers to improve competitive positioning and margins. Their increased focus on product formulation and consumer insights will also be supported by the Firmenich acquisition.

Firmenich Acquisition

DSM initially announced their merger with Firmenich in May 2022. DSM received clearance from the European Commission in February 2023 and has now obtained clearance in nine out of the ten required jurisdictions. The combined company is expected to be a leader in nutrition, beauty, and well-being, based on their complementary capabilities in fragrance, taste, texture, and nutrition.

Firmenich brings strong capabilities in product creation based on consumer insights, which should build on DSM's health and nutrition portfolio. The combined company should also have significant technical capabilities, particularly within biology and machine learning.

There has been significant consolidation in the space in recent years, with IFF and DuPont's Nutrition and Biosciences business merging in 2021. This consolidation could increase pricing power for the remaining companies.

Perfumery & Beauty

The combined revenues of DSM and Firmenich within Perfumery and Beauty were 3.3 billion EUR in 2021. The combined company should be a leader in the creation of fragrances and beauty products and ingredients. Firmenich is strong in perfumery and ingredients, while DSM has a rapidly developing personal care and aroma business.

Food & Beverage/Taste & Beyond

The combined revenues of DSM and Firmenich within F&B was 2.7 billion EUR in 2021. The combined company will have extensive capabilities in taste, nutrition and functionality and should provide a strong partner to the F&B industry. The company's focus will be on more natural and sustainable ingredients and enhancing food's nutritional profile (for example with vitamins, probiotics, and lipids and reducing sugar and salt).

Health, Nutrition & Care

The combined revenues of DSM and Firmenich within Health, Nutrition, and Care was 2.2 billion EUR in 2021. The combined company will have a broad portfolio of solutions addressing health and lifestyle needs across every stage of life. Target markets include dietary supplements, early-life nutrition, pharmaceuticals, medical nutrition, nutrition improvement for the under-nourished, and medical device markets.

Animal Nutrition & Health

The combined revenues of DSM and Firmenich within Animal Nutrition & Health were 3.3 billion EUR in 2021. The combined company will focus on developing technology-driven solutions to meet increasing demand for protein (meat, eggs, fish, and dairy).

Other Acquisitions

DSM has made a number of other acquisitions in recent years to support their strategy. Most of these acquisitions were relatively small and aimed at adding specific capabilities to DSM's portfolio.

Midori in Animal Nutrition & Health

DSM acquired Midori for their eubiotics platform in 2021. Midori's technology can modulate how the gut microbiome functions in animals. This can lead to improved nutrient utilization and improved animal health. In this manner, eubiotics can potentially reduce the environmental footprint of animal farming and reduce the use of antibiotics in animal feed.

Antibiotics are currently used to prevent, treat and control bacterial infections in livestock. They can increase animal performance and allow farmers to produce more meat with less feed input.

First Choice Ingredients in Food & Beverages

DSM's acquisition of First Choice Ingredients in 2021 added dairy-based savory flavorings to DSM's portfolio. First Choice Ingredients ferments and blends a variety of natural dairy products to develop clean label, dairy and dairy-based savory flavorings.

Vestkorn Milling in Food & Beverages

DSM acquired Vestkorn Milling to accelerate growth in their plant-based proteins business. Vestkorn is a leading producer of pea- and bean-derived ingredients for plant-based protein products in Europe. The strategic reasoning for this acquisition is less clear than some of DSM's other acquisitions. DSM has in general been moving away from upstream production, but milling capacity is reportedly becoming strained. The Vestkorn acquisition may simply be to ensure supply in a tight market.

Flavor & Fragrance Portfolio from Amyris

In 2021 DSM acquired a number of flavor and fragrance intermediates from Amyris for their Personal Care and Aroma business.

Erber's Biomin and Romer Labs

DSM acquired Biomin and Romer Labs from Erber in 2020. Biomin specializes in mycotoxin risk management and gut health performance management, whereas the Romer Labs business focuses on food and feed safety diagnostic solutions.

Portfolio Rationalization

In addition to adding capabilities in potential growth areas, DSM has been divesting assets which no longer align with the company's strategic priorities. This includes their Performance Materials and Engineering Materials businesses. The disposal of the Performance Materials business was completed in September 2022 and divestment of the Engineering Materials business is planned for no later than April 2023. DSM historically was a commodity chemical and petrochemical company, and these divestments are part of a long-term shift towards specialty chemicals and applications that are closer to end consumers.

Financial Analysis

DSM has faced supply chain volatility and significantly higher costs (energy, raw materials, etc.) in recent years. Despite this, the company has still managed to log reasonable growth with fairly stable margins. Growth was driven primarily by pricing in 2022 though, and it is possible that weak volumes along with more stable prices could weigh on growth going forward.

DSM's Health, Nutrition & Care and Food & Beverage businesses achieved strong pricing and solid volume in 2022. The Animal Nutrition & Health business faced softer demand, particularly in China, and low vitamin prices towards the end of the year.

DSM saw weaker volumes in some areas towards the end of 2022, which the company attributed to destocking. Demand for immune-boosting dietary supplements has also been normalizing after the COVID pandemic, weighing on growth. These conditions are expected to carry over into Q1 2023, with EBITDA likely to be negatively impacted by inflation , lower vitamin prices, and the effects of inventory reductions. A stronger second half of the year is expected as the inflation overhang eases and volumes begin to pickup again. While DSM expects near-term conditions to remain challenging, they have reaffirmed midterm targets.

Animal Nutrition & Health

Farmers continue to focus on driving yields, resulting in solid growth for DSM's performance solutions. Poultry and eggs performed well in 2022, whilst pork recovered. Ruminants and aquaculture have been impacted by weak consumer purchasing power though.

Health, Nutrition & Care

Demand for dietary supplements was strong in 2022, although immunity-optimizing products have been normalizing compared to peak-COVID.

Food & Beverage

Dairy, baking, and beverages were areas of strength 2022. Hydrocolloids also delivered strong performance and demand for pet food was solid.

Raw materials price inflation is expected to remain a problem going forward, as are lower prices for some vitamins . The impact of China's reopening on vitamin markets is unclear. It could spur demand for vitamins, but as China is the biggest producer of vitamins, it is also likely to increase supply. DSM is at a cost disadvantage compared to Chinese producers and hence this could further damage vitamin margins.

Energy costs in particular have been a large problem for DSM, with energy costs increasing by approximately 150 million USD in 2022. Energy costs are expected to increase by another 100 million USD in 2023. 80% of DSM's energy costs are hedged.

DSM's shift into higher-value add areas should lead to an improvement in margins in time, but this has come at the cost of a large amount of goodwill on the balance sheet. Whether DSM's acquisitions end up justifying the price tag remains to be seen.

Valuation

DSM has fairly modest growth and margin objectives going forward, and there is a large amount of risk associated with the integration of Firmenich's business. This could be exacerbated by a period of weakness after pandemic tailwinds subside.

Given potential risks and the current interest rate environment, DSM's stock is not particularly cheap. If there are problems with the Firmenich acquisition, revenue growth is weak or margins remain depressed, DSM's stock could fall significantly.

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