Croda (CRDA / CRDA.L): Part 1

Croda is an interesting business to understand because their business model helps explain some of the long-term disruptions happening in the beauty industry, which I spoke about in this article: The Beauty Flywheel is Broken.

While Croda is playing an important role facilitating disruption, in terms of Croda as an investment Croda is a good (but not great) business and is attractive at the right price. In my view, the business was strategically mismanaged from 2019-24 and we will likely face the consequences of that mismanagement over the next 3 years after-which Croda has a chance to get back to its historical profile of 5% to 6% organic growth driven predominantly by price/mix with consistently expanding margins.

Founded in 1925, Croda is a leader in supplying specialty ingredients and actives into the personal care industry as well a leader in excipients used in life sciences. Excipients are the inactive part of a drug which helps deliver the active pharmaceutical ingredient to its intended target. While the end-markets are totally different, the products share common chemistries and expertise.

Industry Primer - Personal Care

What are personal care ingredients? Personal care ingredients are commodity chemicals, specialty ingredients and actives used in cosmetics (skin, hair, color, fragrances) and personal care products (soap, shampoo, toothpaste, detergents). Personal care ingredients are a $16bn sub-segment of the ingredients industry. Commodity chemicals form the base of the product, specialty ingredients add texture and smell and actives bring functional benefits allowing household and personal care (HPC) companies to make marketing claims like “clinically proven anti-aging” or “72 hours hydration”. A bottle of lotion by volume might be 70% water, 15% commodity chemicals, 10% specialty ingredients and 5% actives. As I talked about in my Beauty Industry Primer, Indie brands and Korean beauty brands have disrupted the traditional beauty market by innovating and pursuing an actives-led strategy with the help of ingredients suppliers like Croda.

What are the subsegments within personal care ingredients? At the top of the pyramid, you have patent-protected actives and specialty ingredients like emulsifiers and hair fixatives that have a high impact on performance that are unique to a single supplier. Developing these ingredients requires a combination of having strong consumer insights as well as strong chemistry. These ingredients are low volume but have pricing power because they help justify the $100+ price tag for certain cosmetics and therefore carry gross margins in the 60% to 80% range.

At the middle of the pyramid, you have ingredients which are novel but may have competition from alternatives like emollients and UV minerals. These ingredients may be formally top-of-pyramid products that are no longer under patent or bottom-pyramid products which have been modified or purified to become less commoditized. These ingredients have gross margins in the 40% range.

At the bottom of the pyramid, you have high volume commoditized ingredients that are sold based on chemical identity rather than performance like petrochemical-derived surfactants where gross margins may be 20%. Below is a summary of some of the major categories within personal care. The table is from Ashland.

• Surfactants (c.23% of TAM by Value) are detergents, conditioners, and emulsifiers. Detergents remove oil and dirt and are used in soap, shampoo, and laundry. Conditioners add properties like “silky feel”. Both are bottom-pyramid and dominated by large multinational chemical companies like BASF. Emulsifiers bind waters and oils and can be middle/top pyramid.
• Conditional Polymers (c.20% of TAM by Value) create waxy or oily textures and remove static and frizz and are used in gels and lotions. Hair fixatives are a conditional polymers sub-segment. These are considered middle pyramid and include players like Ashland and Croda.
• Emollients (19% of TAM by Value) are esters used to soften skin or hair. Traditionally, emollients were made of vegetable or mineral oils, but today, they can involve sophisticated chemistries which can be top of pyramid.
• Biofunctionals or “Actives” (14% off TAM by Value) are the highest value-added top-of-pyramid segment. Actives leverage chemistry and science to drive functional benefits. Actives are Croda's specialty. Below are some areas within actives. Many of these ingredients are becoming household names thanks to Tik Tok.

• Rheology Controls (9% of TAM) refer to thickeners to give shampoo, soaps, and lotions the desired viscosity or sheer. Ashland for example is a leader in rheology used in both personal care products and architectural paint.
• Color (7% of TAM). Color is bottom-pyramid market as the specialty pigments tends to be a high proportion of end-product costs leading to pricing pressure. Color cosmetics is dominated by specialists such as Merck KGaA.
• Antimicrobials (4% of TAM) are products that prevent bacteria and mould in cosmetics and cleaning products. Historically, parabens, a petrochemical based ingredient, were used but given evidence they cause cancer, there has been innovation in antimicrobials to create “top of pyramid” natural and preservative-free alternatives.
• UV Absorbers (4% of TAM). UV absorbers are a declining product as there is increasing evidence they can be absorbed into bloodstream. The alternative is top of pyramid mineral-based ingredients.
• Fragrances. Fragrances are considered their own ingredients sub-segment (c.5bn TAM) and are dominated by specialists like Givaudan and IFF. Croda has acquired their way into fragrances via Iberchem and focuses primarily on SMEs.  

Who are the main players? The top 10 players of personal ingredients hold c.50% share. Large chemical multinationals (MNCs) like BASF (10% share), Dow, and Clariant lean higher-volume bottom-pyramid. While MNC’s benefit from scale, they struggle with the small pack sizes of actives or specialty ingredients and can be unfocused, e.g., Clariant’s personal care segment also sells to aviation, agriculture, and construction. HPC specialists like Croda (10% share) and Ashland (5%) have broad and deep portfolios exclusively focused on HPC giving them vertical-expertise and tailored strategies around R&D and customer service. Specialists like Givaudan, IFF, DSM, Kerry and Symrise are broadly in consumer areas like food, household products and fragrances but don’t specifically focus on HPC. Finally, there is a long tail of mom-and-pops focusing on niche ingredients, often spin-offs from chemistry departments at universities.

Who are the main customers? Global beauty is a $275bn market (at manufacturer level) broken into skin (30%), hair (17%), color (13%), fragrances (9%) and bath and shower (9%). Approx. 40% of customers are large-listed players like L’Oréal (15% share), Unilever (10%), Estee, Coty, P&G, etc. If you read my Beauty Industry Primer, a major theme is that large players have been losing share to indie brands and as a result, their market shares have been stagnant over the last 10 years. Approx. 30% of customers are regional champions like Natura or Amore Pacific. The last 30% are upstart indie brands. Indie brands often outsource formulation and manufacturing and the ease of outsourcing has significantly lowered barriers to entry leading to an explosion in successful indie brands, especially celebrity-backed brands.

Why are ingredients attractive? First, specialty ingredients are a small part of COGS but have a big impact on performance and product differentiation, driving pricing power. This is pronounced in high-end cosmetics where face cream can cost $300 while the active accounts for <1% of COGS, but even in mainstream cosmetics, ingredients represent just 5% to 10% of total COGS. Second, there are switching costs given reformulations require months of testing and can alter performance upsetting existing customers, so once an ingredient is specified in, it is usually for the life of that product. Finally, large ingredients players like Ashland and Croda gain all the benefits of HPC exposure such as resilience and diversification by end-product, customer, and geography, while benefiting (rather than getting hurt) from trends like sustainability and the rise of indie brands.

Why are ingredients unattractive? First, at the top of the pyramid, there are average barriers to entry because the capex to start an R&D lab is low and ingredients are batch manufactured in small quantities so economies of scale are not critical. Second, 5% to 10% of products in a given year are reformulated or terminated so there is attrition which ingredients companies need to overcome. This can be painful if a large product line gets reformulated (e.g., Ashland took a big hit when Colgate Total got reformulated). Third, on higher-volume ingredients like middle-pyramid surfactants, margins erode over time as those ingredients commoditize. Finally, while HPC is arguably the most attractive subsegment within the entire ingredients space, every ingredient player from Givaudan, IFF, and Symrise is trying to gain greater exposure increasing competitive intensity.

How do companies differentiate? There are multiple ways. First is R&D and manufacturing. At the top-of-pyramid, it's about better innovation. Small labs or university spin-offs can arguably discover innovative new botanicals just as easily sa large players but small players often need to be acquired by a larger company like Croda with global scale in order to reliably manufacture these ingredients and for a large HPC to specify that ingredient into a major product range. Second is speed-to-market. When Ashland or Croda create a new active, it can do the lab testing and consumer panels in-house meaning they can supply an ingredient along with all the necessary data an HPC needs to bring this to market fast, something critical for indie brands that have faster product cycles. Third is breadth. In the case of Croda, it combines breadth with direct distribution to cross-sell formulations or in some cases provide advice on entire product lines to an upstart indie brand allowing them to be a valuable one-stop-shop whereas smaller ingredients players may be reliant on distributors like Brenntag, IMCD and Azelis to access their end-customers.

What are the growth and economics? Ingredient player sales are ultimately tied to HPC sales growth of 2% to 3% so ingredients growth tends to be 3% long-term with higher growth in top-of-pyramid and lower growth in the bottom. In terms of margins, low-end ingredients are 20% gross margins whereas high-end can be 60%+ which average-out to 30% to 40% and translates into high-20%’s EBITDA margins. There is a natural cycle where middle pyramid ingredients commoditize over-time which get offset by new product introductions. Ingredients and actives are low volume so are batch manufactured but still require capex of MSD% of revenue. Inventory days need to be relatively high at c.100 days to supply large MNCs, but most ingredients companies operate with healthy 20%+ tangible ROIC. The table below shows a range of EBITDA margins for consumer-focused ingredients players as well as some distributors (Brenntag, IMCD). As you would expect, ingredients suppliers like Ashland and Croda selling into high-margin personal care have the highest margins as opposed to lower-margin food and industrial end-markets (AAK, Kerry).

The next section will include a Deep dive on Croda's Consumer Care segment including a detailed analysis of the recent headwinds and margin issues from 2019-24. In the forthcoming Part 2, I will do an Industry Primer on Life Sciences followed by a Deep Dive on Croda's Life Sciences segment followed by an analysis of Croda's Management, Key Drivers, and Valuation. You can sample the depth I go into for deep dives by checking out my deep dive on HEICO (analysis of the main PMA business is above paywall).