The bottom line

Rising input costs, more demanding customers and growing competition from rivals in lower cost production areas. It's a margin-crushingly familiar tale of woe, and as a result, every enterprising ingredients supplier worth its salt is now on a mission to claw back the initiative and boost its portfolio with more 'value added' products.

The situation is far from hopeless, however. A quick look at the accounts of some of the big hitters in this sector reveals that returns for some at least remain very respectable, while margins are actually on the increase for those that have managed to move into new areas, or cut costs.

What they are making their money from, however, has changed considerably in recent years, with some companies now realising they can make more money from biofuel than food, while others are pumping all available cash into developing - or buying other companies that are developing - new, specialised ingredients, targeting the burgeoning health and wellbeing sectors.

Indeed, if column inches equate to commercial promise, makers of so-called 'functional' food ingredients should be laughing all the way to the bank by now.

How quickly this promise will translate to the bottom line however, is a moot point, as the sector becomes increasingly crowded and costs ramp up for suppliers building up the weighty clinical data they need to support their claims.

It is also worth pointing out that despite all the hype, functional foods represent just 0.5% of the food market in Europe, and even if they continue to grow as fast as the experts predict, they will still only represent just over 1% by the end of the decade, according to Leatherhead Food International (LFI). "It is apparent that functional foods are unlikely to reach even 5% of the food and drinks market internationally for at least 10-15 years, and it could be much longer than that." On the plus side, says LFI, functional foods will nevertheless "continue to outperform the food and drinks market as a whole"

Slow boat to China

There are clearly still growth opportunities in the US and Europe, with recent figures from the European food manufacturers' association CIAA showing 2.6% growth in the revenue of Europe's food manufacturing sector to ?836bn in 2005, with strong performances from dairy, water and soft drinks in particular.

However, this pales in comparison to the double digit growth rates in China's food sector, and any major ingredients supplier without a direct presence there risks missing a sizeable bus, says Rohit Talwar, who advises companies trying to build a presence in China. "It's got a fifth of the world's population, an economy growing at more than 10% a year and a burgeoning middle class with cash to spend on your products."

Ingredients suppliers best positioned to cash in will be those that can work in tandem with big customers and help them plan their market entry, says Johan Kauphuis, European boss at essential fatty acids specialist Bioriginal: "More customers are now coming to us saying, can we take them into the Philippines and China?"

The big boys meanwhile, are demonstrating their commitment to the market by pouring millions into acquisitions, joint ventures or new production facilities in and around major conurbations such as Shanghai.

Even if you're not currently supplying the local market, it makes very sound economic sense to manufacture in China, points out Kathy Brownlie, global programme manager at Frost & Sullivan's food and beverage ingredients practice. "Labour there is cheaper, energy is cheaper and set up and building costs are cheaper, quite apart from the fact that you also have one of the world's biggest food markets on your doorstep."

But don't think you can just march in and conquer China overnight, she stresses: "There is a lot of hype about the 'Bric' countries [Brazil, Russia, India, and China], but they're still extremely fragmented. Many clients I talk to are more interested in cashing in on a 2% growth opportunity in Germany than going for a potential 10% growth opportunity in Brazil."

CONSOLIDATION

There has been a fair amount of mergers and acquisitions activity in the ingredients sector over the last couple of years, mainly driven by large companies hoovering up small firms operating in higher margin sectors like weight management, natural colours and essential fatty acids.

Larger firms like Nestlé, DSM and Tate & Lyle have also made more strategic investments in start-up companies in technologically advanced areas such as nutrigenomics and personalised nutrition or firms using biological screening techniques to identify substances that bind to specific taste receptors.

However, there have also been some megadeals in recent years, notably Cargill's acquisitions of Cerestar in 2003 and Degussa in 2005; DSM's 2003 acquisition of Roche's vitamins division and Givaudan's recent purchase of Quest. Kerry Group and Arla have also been highly acquisitive, while Associated British Foods has splashed out millions on strategic deals in recent years.

Meanwhile, other big hitters such as Tate & Lyle have been looking to shed less profitable parts of their business (European starches) in order to pump all available resources into higher-value ingredients.

When it comes to nutrition, however, size isn't everything, says Raj Sinhal, director of corporate finance at Tenon Corporate Finance. Intellectual property is what matters, although the costs of clinical trials and research and development (R&D) mean that in practice it is often only the larger companies that can afford to commercialise these ideas.

Some minnows do manage to swim in a pond dominated by a handful of global giants, although not without a lot of blood, sweat and tears. UK-based start-up Provexis is a case in point. While it had an exciting product (a blood thinning tomato extract called Fruitflow), it struggled to get investors and potential partners interested until it had proved itself not only with the obligatory clinical trials and regulatory approvals, but by actually launching a functional drink containing the ingredient in question. "Money is always conditional - attached to certain milestones," say bosses. "However, now that we've done what we said we were going to do, people are taking us seriously."

While Cognis and Chr Hansen are owned by private equity firms, venture capitalists (VCs) are only just starting to delve into the ingredients sector, says PriceWaterhouseCoopers (PWC) director Graham Bell. "VCs own major players in food manufacturing, but have not historically spent a lot on ingredients because they're competing with global trade buyers in this sector like Nestlé, Unilever, Glanbia or Kerry, and they haven't been prepared to pay over the odds."

However, as Glanbia Nutritionals chief executive Hugh McGuire points out (News, p4), things are beginning to change, as VCs are increasingly competing with trade buyers sniffing around some of the firms in the nutritionals market.

That said, they are not usually prepared to wait for a decade before they see a return on their investment, says PWC's Bell. "The VCs are now starting to look more carefully at things like medical foods, allergy-free foods and sports nutrition."

And they are not alone, says Philip Fass, executive director, sales and marketing, at omega-3 supplier Martek Biosciences. "Like a lot of companies that have been successful in one area of this market, we are now looking right across the nutritional ingredients area for acquisition opportunities." Indeed, Martek's meteoric rise (turnover has increased from $10M in 2002 to $270M today) demonstrates the size of the prize in this market for companies that get it right.

Speed and adaptability

Without a doubt there will be more rationalisation this year, predicts Peter Hardy, business manager for food ingredients at S Black. "You typically end up with two to three major suppliers in any given market. Any more and it gets very crowded. It's all about cost leadership, service leadership and innovation. However, the big companies don't always win. Sometimes being small, flexible and agile will give you the edge."

Paul Prendergast, UK md at GC Hahn, agrees: "Speed and the ability to adapt to changing circumstances is critical in this industry, as there is so much pressure to get products to market more quickly. We can provide customers with technical solutions to their problems fast, and unless you're supplying a unique ingredient, it's things like this that will give you the edge over the competition. "However, you can only do this if you have technical staff that can think laterally and creatively. We have turned around significant technical developments in three days to help customers get out of very difficult situations. We're a problem solving business."

National Starch Food Innovation is also pretty adept at solving customers' immediate problems, says divisional vice president, Natural Polymers Group Europe, Terry Thomas. But it's also looking much further ahead, he says. "We call it strategy technology roadmapping, which is looking at consumers' needs 10 years down the line and working backwards. What technology will we need to meet those needs? Will it require product or process innovation? Can we do this in-house or will we need to look externally? If a smaller company has something unique, we have the global infrastructure to develop it and provide access to a broader group of geographies."

winners and losers

As to who the winners and losers will be in the ingredients sector in the future, it is very hard to predict, says S Black's Hardy. Likewise, the metrics we apply to a traditional food business in order to determine whether it is a good investment may not be applicable to some of the companies now moving into the sector.

Indeed, many firms selling nutritional ingredients are more like pharmaceutical firms than food businesses, investing heavily in costly clinical trials and having to go through time consuming and expensive regulatory approvals processes such as the Novel Food Regulation before the market will take them seriously, he says.

"The biggest challenge is being able to get value out of innovation quickly enough before the sector becomes commoditised."

He adds: "Bringing a completely new concept or ingredient to the market can be potentially lucrative and very exciting, but also highly risky. Even if it is successful, it could take a very long time to make a return on your investment. You need to exploit long and short term opportunities."

One company successfully achieving this balance is DD Williamson, which has built up its business chiefly through supplying caramel colour to the carbonated soft drinks industry. While growth in this market is now levelling off in the US and Europe, bosses haven't thrown out the baby with the bathwater, and are now focusing their attention on Asia, where carbonated soft drinks sales are in the double digits.

All available cash, meanwhile, is being invested in higher margin, faster-growing areas such as natural and organic colours. "We're buying up smaller companies in these areas and exposing them to a global market," says the company.

The only dark cloud on the horizon is the growth in biofuels, which is driving up the price of many food crops as they are diverted into fuel production, says the firm (News, p4). "This is a massive issue for us right now, and it's not just about price, it's about long term security of supply."

Frank Horan, who heads up Fuerst Day Lawson's seeds and natural products division, adds: "Most of our edible seed crops are being impacted one way or another by biofuels." However, the future looks bright, as demand for hemp, pumpkin, linseed, sunflower and sesame seeds rises, with manufacturers increasingly incorporating them into everything from smoothies to salad dressings. "My priority is to capitalise on this demand by ensuring safety, quality, service and traceability and completing the transition from a commodities trader to a fully-fledged ingredients supplier, adding real value for our customers."