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Erik Bethel is a Managing Director at Darby Overseas Investments, the private equity arm of Franklin Templeton Investments. Mr. Bethel has 20 years worth of experience in private equity and investment banking in the natural resources and infrastructure sectors in Latin America and China. Prior... More
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  • Theobroma Cacao: Food Of The Gods (Part I) 0 comments
    Feb 19, 2013 4:39 PM

    Theobroma cacao is the botanical, or scientific name for the cocoa tree. Cocoa, which originated in Latin America, is today grown in virtually every tropical part of the world. Theobroma grandiflorum, known in Brazil as cupuaçu, is a related Amazonian species, and we describe it briefly in this White Paper as well.

    The companies covered in this report include major confectionary companies and multinational food companies. They include Hershey's, ADM, Mondelez, M&M Mars, and Barry Callebaut, among others.

    Cocoa, the thrust of this White Paper, is part of a complex and labyrinthine industry. The crop provides subsistence to millions of people in developing parts of Africa, Asia and Latin America. Cocoa forests are also bio-diverse habitats for a number of animals and birds. We like cocoa as an investment thesis and also because it ultimately becomes one of our favorite foods - chocolate!

    A few years ago, global chocolate sales hit a record of US$100 billion. SinoLatin believes that global demand for chocolate will continue, particularly in places with a rapidly growing middle class such as China and India. According to many industry experts, demand for cocoa may outpace supply over the coming years and this could have important implications for the cocoa industry in Latin America as well as the rest of the world. In the following report, we attempt to demystify cocoa as well as its cousin cupuaçu.

    Our firm, SinoLatin Capital is the leading investment platform focused exclusively on natural resource transactions between China and Latin America. We generate long-term value for our clients and stakeholders through alternative investments and financial advisory. With deep roots in Latin America and China, SinoLatin Capital has developed a unique understanding of the interrelationships between the two regions and creates value through investment products that benefit from these regional complementarities.

    What is Cacao?

    The origin of chocolate is the cacao, or cocoa bean. These beans are found in the fruit of a tree known as theobroma cacao - also called the cacao, or cocoa tree. Theobroma cacao is a relatively small tree ranging in size from 12-24 feet (roughly 4-8 meters) in height. Cocoa originated in Latin America where it was consumed by pre-Columbian people for thousands of years. The Spaniards brought cocoa to Europe in the 16th century. For two centuries it was only consumed as a drink. In the 1800's, the Swiss invented a way to separate cocoa butter from the dried beans. This invention was the foundation for solid chocolate and for today's multi-billion dollar chocolate industry. Cocoa trees are found in many parts of the world including Latin America, Africa and Asia. They grow best in tropical climates 20 degrees north or south of the Equator.

    Cocoa Value Chain

    The graphic below describes the cocoa chain. The term "smallholder" below is the industry term for farmer. In most parts of the world, cocoa is farmed on small plots of land of only a few hectares - hence the name small holder.

    (click to enlarge)

    Farming and Planting:

    Once planted, cocoa trees begin to bear fruit in approximately 24 months and reach peak production in four to six years (this could of course vary based on cocoa varietal, weather conditions, and disease/pests). Young cocoa trees require protection from wind and direct sun. For this reason, cocoa is planted in the shade of upper canopy rainforest trees. In many circles, cocoa is viewed as an environmentally friendly crop because cocoa farms have greater biodiversity than other plantation agriculture and many animals that live in the rainforest flourish in cocoa forests. According to Chris Bright, the lead author of Venture Capitalism for a Tropical Forest, "cocoa has serious potential for conservation because it is a high-value crop that can be grown under rainforest canopy." He adds, "Cocoa is shade-tolerant, so farmers don't have to clear all their forest in order to make a living with it."

    Around cocoa trees, farmers often plant vegetables, bananas, mango trees, and other crops that can be harvested together. The other crops complement the rainforest's natural shade. They also provide income to the farmers as the cocoa trees mature.

    Figure 1: Cocoa Tree

    (click to enlarge)

    Cocoa trees produce a fruit called a cocoa pod. Cocoa pods vary in color from red to green to yellow. Mature trees yield 20-50 pods per year for roughly three decades, depending on the varietal, soil conditions and other factors. The pod is opened to reveal a fragrant, edible pulp. The cocoa beans are embedded inside of the pulp. Depending upon the type/varietal of cocoa tree planted, each pod can hold 24-50 beans. The raw beans are acidic and unsavory. Nature intended for animals to eat the pulp and leave the beans in order for them to germinate and become new cocoa trees.

    Figure 2: Cocoa Pod and Beans

    Above: Ecuadorean cocoa pod Source: Elemental Chocolate

    Cocoa trees are evergreen and pods constantly grow out of the tree, therefore cocoa is harvested year round. The work is labor intensive and cannot be mechanized. Cocoa also requires a lot of patience. Freshly planted cocoa trees can take from two to three years to bear fruit and up to five to six years to reach full production. This could pose a problem for the industry if demand growth outpaces current supply. Average global yields in cocoa are very low (500 kg/hectare), a figure that has not changed in decades. Comparatively speaking, soybean yields (2,400 kg/ha), palm oil (4,000 kg/ha), and other crops, have witnessed much larger increases. Lower crop yields relates to the fact that cocoa farming is still done in the poorest regions of the world on small plots of land where farmers have little access to training, proper plant material, and fertilizer.

    All Beans are Not Created Equal:

    Cocoa beans are not the same, in the same way that passenger cars and ultra-luxury cars are not the same. Some auto companies produce steady volumes of passenger cars and others produce small batches of expensive, premium vehicles. At the risk of overgeneralizing, certain regions - primarily Africa, Indonesia, and Brazil - are known for producing large quantities of lower-quality beans with a standard cocoa taste. The industry's term for this product is "bulk beans." Smaller quantities of other types of beans - mainly coming from Latin America and the Caribbean - are recognized for their unique flavor, and command a premium in the market. The industry calls these "flavor beans." Over a century ago, 50% of the word's cocoa production consisted of flavor beans. Today that number is a relatively insignificant 5%. The big changes occurred due to cocoa diseases in Latin America that wiped out production in Ecuador, Trinidad, and Venezuela, the expansion of cocoa plantations in Africa, and by the high demand for mass-produced chocolate coming from cheaper bulk beans.

    There are three main types of cocoa trees grown. However, hundreds of genetic hybrids exist that are more disease-resistant, have larger pods, more numerous beans, and other characteristics. We provide a general description of the three well-known types below:

    1. Forastero - This is the most common type of cocoa, accounting for roughly 80% of global production. Experts believe Forastero cocoa originated in the Amazon basin. It produces a yellow pod with 30 or so purple beans. The Forastero bean produces a consistent, standard chocolate flavor. Most commercial chocolate today is made solely with Forastero beans (perhaps with a small amount of other beans to add flavor). The Forastero bean is reliable and cheap, but its major shortcoming is that it doesn't have strong flavor or aromatic features. Many types of Forastero trees and hybrids exist. Of them, the most well-known is the Amelonado sub-varietal harvested in West Africa and Brazil. While most Forastero is considered bulk cocoa, there are exceptions. One is the Ecuadorian Cacao Nacional sometimes also called Nacional Arriba which is considered fine/flavor cocoa.
    2. Criollo - This is considered a fine cocoa varietal with special aromatic and flavor qualities. The Criollo cocoa tree is believed to have originated in Central America. The varietal generally produces a red pod containing 20-30 light colored beans ranging from white to pale purple. Criollo trees primarily grow in Latin America and they can be fragile and susceptible to disease. Among chocolate connoisseurs, the finest quality chocolate comes from Venezuelan Criollos. Until the 1800's Venezuela only produced Criollo beans. However, a cocoa disease struck neighboring Trinidad that wiped out production. Fearing that the disease would spread, most Venezuelan farmers cross-bred their trees with other, more disease-resistant varietals which virtually exterminated the pure Criollos. Some Venezuelan farmers managed to save their Criollo trees, and the demand for fine chocolate created a boom for their rare Criollo sub-varietals - Chuao and Porcelana. The latter's name comes from the color of the bean - a translucent white color, while Chuao is named after a small, coastal rainforest village where the beans originate. Porcelana and Chuao cocoa have a limited output (Chuao - 18-20 tons per year) and demand is extremely high. Until 2009, Italian gourmet chocolatier Amedei secured the sole ownership over the name Chuao with rights to acquire the Chuao village's entire production. In 2010 the leftist government of Hugo Chavez declared that chocolate was a "strategic asset" and today the Venezuelan government manages the cocoa industry according to state policies, compelling the Chuao growers to sell beans to the newly-created state controlled Corporacion Venezolana del Cacao.
    3. Trinitario - These cocoa trees are a genetic hybrid of Criollos and Forasteros. In some circles they are thought to combine the best qualities of both. They originated in the Caribbean island of Trinidad. In the late 1700's a disaster struck Trinidad and most of the island's Criollo trees died. Speculation as to why this happened includes disease, weather, and age of the trees. The massive crop failure resulted in the importation of the hardier Forastero varietal which was cross-bred with the remaining Criollos. In the 1800's, Venezuela imported this new Trinitario varietal. Later it spread throughout the world. Today, it accounts for 5% of the world's production and tends to thrive in the Caribbean. It is also found in Cameroon, Venezuela, Ecuador, Sri Lanka, Indonesia, and Papua New Guinea. Given the fact that they are genetic "mutts," the Trinitario pods vary in color, and their 30 or so beans also vary in color. The industry considers Trinitario a flavor bean except in Cameroon where it is sold as a bulk bean. Venezuela has two well-known types of Trinitario cocoa called Rio Caribe and Carenero. Many of the world's fine chocolate brands incorporate Trinitario cocoa as a flavor component.

    Many genetic variations exist of the three varietals mentioned above. They are bred to be disease resistant, to have larger/smaller fruits, and more/less cocoa beans. Getting the right genetic variation involves a lot of grafting, science, and trial and error. Not every variation suits a particular region's microclimate. Adding to the difficulty, it takes 4-6 years for a tree to mature. Until then, knowing whether a cocoa tree will thrive is uncertain.

    Harvesting, Fermenting and Drying:

    Cocoa pods mature after approximately six months. They are manually harvested using poles and machetes. Upon opening the pod, the pulpy cocoa beans are scooped out by hand. Afterwards, they move through a two-part curing process - first the beans are fermented, then they are dried.

    Fermentation strips the cocoa beans of their bitterness. During this process, the pulp surrounding the bean liquefies and converts into alcohol. The process triggers a number of chemical changes (enzymatic reactions) in the bean that are crucial to the development of its chocolate flavor. Most fermentation techniques are labor intensive, low-tech, and need to be done in relative proximity to where the beans are grown. From a technology standpoint, the process hasn't changed much since the 1700's. Given the complexities of cocoa farming and inadequate logistics in most parts of the world where cocoa is grown, fermentation is a process that has historically been difficult to industrialize.

    Means of fermentation vary considerably from country to country, but basically there are two methods - heap fermentation and box fermentation. In the heap process, wet cocoa beans and pulp are piled in layered "heaps" atop banana leaves. Over a five day period, workers manually mix the heap of material. This process is most common in West Africa. In box fermentation, wooden or bamboo boxes are used. These boxes contain holes or slats at the base of the box that drain the liquid. Latin American producers and larger commercial plantations commonly use box fermentation.

    Regardless of method, once the fermentation process begins, monitoring the beans remains a challenge for the producer. They need to be mixed, or turned, several times, to ensure even fermentation and there is no way to control the speed of the process. New advancements may revolutionize things. A new fermentation method using sealed tanks similar to winemaking could allow producers to control the temperature and speed of the fermentation process. If these new experimental methods prove successful, they will permit a much greater degree of control over the quality of the fermented bean, thereby removing the biggest challenge posed by the traditional fermentation processes. Obviously capital investment is required, but the degree of control afforded the producer and the quality of the end product could easily justify the expense in a large operation.

    Following fermentation, the beans need to be dried. In some cases they are dried naturally on mats in the sun while in others they are dried in commercial drying facilities that use blowers of hot air to dry the beans. Drying must be done carefully. If done too soon, before the fermentation process finishes, the beans will taste bitter. If not done in time, mold could develop causing the beans to rot.

    Figure 3: Cocoa Seeds Drying

    Cocoa drying: Photo courtesy ugacof.com

    After the cocoa beans have been harvested, fermented and dried, they are placed in sacks and transported to cocoa processing facilities. At these facilities, the beans are turned into cocoa liquor (to be clear this is not an alcoholic drink, but rather liquefied cocoa), cocoa butter, and cocoa powder. Cocoa processors - called grinders - are located all over the world, but Europe has the world's largest grinding capacity.

    Click (here) for Part II

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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