[Chr. Hansen, Novozymes] All the small things (plus some quick thoughts on The Trade Desk)
Industrial enzyme production beings with several thousand bacteria1 dunked into ever larger containers of liquid and nutrients. These microorganisms feast on the nutrients and replicate like crazy before being transferred to a fermenter — a giant steel vat that regulates temperature, pressure, oxygen, and Ph levels — where they are suspended within another nutrient-infused medium. Within a day, a single microorganism will have replicated into trillions, each producing enzymes that can be combined in various ways to fulfill a mundane but valuable purpose.
Like what? Like reducing the amount of water and energy required to soak the grain used in beer production; replacing high volume surfactants (oils) in shampoos and lotions to enable lower packaging and shipping costs; releasing the starch and protein that stubbornly binds to corn and wheat fibers at the processing mills; clearing out dead bacteria from a chicken’s gut to improve digestion and limit feed; reducing the temperature at which detergents can remove stains, and so on. Around 6bn people use products containing a Novozyme product every week.
Today’s manufacturers of microbes and microbial byproducts are, for the most part, greybeards that have been around for 100 or more years. During that time, they’ve accumulated huge portfolios of patent protected bacterial strains. The enzymes manufactured by Novozymes often possess features applicable across several markets, which can shave considerable time off product development. For instance, the company recently launched a detergent enzyme, part of its Freshness platform, that more effectively removes grease stains on white shirts by cutting through biofilm (a protective web that bacteria weave around themselves). Well, it turns out these enzymes can also replace harsh chemicals that erode the membranes used in wastewater treatment. There are some molecular changes required to tailor detergent enzymes to wastewater treatment, but much of the heavy lift has already occurred, so rather than needing 3 to 5 years to develop a formulation for a specific application, Novozymes might only require one. There are many such examples of cross-pollination that grant the company a running start on product development and yield scale economies on R&D.
As you might expect of an IP-intensive industry with formidable R&D investments and scale economies, market share is concentrated. Novozymes accounts for nearly half of global enzyme revenue. IFF, following its acquisition of DuPont’s Nutrition and Biosciences unit2, will have ~20%. Chr. Hansen supplies microbials to half the dairy market.
Moreover, these companies enjoy tight relationships with customers. Novozymes doesn’t just drop a bag of pellets off at P&G’s manufacturing plants. The company sends technical advisors to troubleshoot production issues and adjust enzyme combinations to suit local tastes, and collaborates on new products with customers’ R&D teams (the Novozyme’s Freshness product launch that I referenced earlier was co-developed with P&G, who has exclusive access to it). Likewise, Chr. Hansen frequently runs trials on the premises of its 3,000 customers (prior to COVID, Hansen was making 100 customer visits per day.)
Novozymes and Chr. Hansen are wonderful businesses, as evidenced by their lofty and consistent returns on tangible capital and total over time:
(Note: 2012 = fiscal year end August 2013 for Chr. Hansen. Chr. Hansen return metrics exclude the Natural Colors business, which is in the process of being sold)
One may be inclined to believe that enzymes and microbe suppliers possess pricing power as their products cost so little compared to the value they offer, either in the form of higher yields, lower energy costs, less packaging, better taste, product longevity, etc. Customers won’t really notice 2%-3% annual price hikes on something that comprises just 1%-2% of their COGS, right? But then again, it seems just as reasonable to think that a large CPG like Procter & Gamble has procurement teams staffed with people who spend their days tracking and negotiating every component of cost, no matter how trivial.
The ability to regularly push price in excess of inflation is a function of market power and switching costs. Altria sells a chemically addictive product to brand loyal customers and enjoys massive scale economies and regulatory barriers that insulate it from competition. An addicted smoker can’t easily vary his consumption and remains loyal to his brand (as I can personally attest). Transdigm’s mission critical parts are small relative to an airline’s maintenance costs, sure, but the real reason it can push through pricing is that it is the sole supplier for 75%+ of its parts and the downside of trying out a new vendor is too high relative to the revenue lost from an expensive depreciating asset being less than maximally utilized.
Enzymes are different. They are ubiquitously adopted but their usage can be flexed to manage costs. A CPG can reformulate its product and trade down to a less effective, less expensive enzyme because in hard times, why should the CPG pony up for a higher performing enzyme that consumers won’t notice or pay up for? Over the last 5 years, revenue from Novozymes’ Household Care segment – which manufactures enzymes used in detergents and cleaning products – has stagnated in part because its large CPG customers, strained by brand erosion and share losses, have been reformulating detergents to contain costs.