Small Caps | Sep 30 2020
A new global customer should help Synlait Milk counter the potential entry into manufacturing by chief customer a2 Milk but risks remain.
-New customer to make positive contribution from FY23
-Diversification has been costly to date
-Material risk beyond the current supply agreement with a2 Milk
By Eva Brocklehurst
Despite a solid FY20 result, the company has made a material downgrade to FY21 on the back of the corporate daigou disruption for a2 Milk and a significant cost impact from recent investment in diversification.
Infant formula production volumes in FY21 are expected to in line with FY20 as a result with a bias towards the second half. Net profit is expected to be slightly ahead of FY20 levels.
A recovery is anticipated in FY22 as pandemic restrictions ease. Moreover, the addition of a new multi-national customer could offset a reduction in a2's infant formula requirements.
This is the main positive in the company's update as this customer is being finalised for packaged products that should make a positive contribution from FY23. The new contract is also expected to improve utilisation of manufacturing capacity and return on capital.
Credit Suisse appears hopeful the new global customer will provide some counterweight to the potential entry into manufacturing by a2 but downgrades Synlait to Neutral from Outperform based on the more limited valuation support envisaged, as well as the tail risks that exist over pricing for a2.
The downgraded outlook reflects higher levels of inventory at a2, hence less demand for Synlait products following strong third quarter sales, and now sales have reduced further in the corporate daigou/reseller channel because of stage 4 lockdowns in Victoria.
Given the flat outlook and the impact of the upcoming renegotiation of the a2 contract, Morgans expects the company's combined internal infant formula business and blending/canning activities will decline at a gross profit level in FY21.
Moreover, guidance assumes no disruption to manufacturing or demand for the ingredients and lactoferrin business. On the positive side, there are benefits ensuing from canning efficiency investment and lactoferrin, which comprises 14% of gross profit, has performed strongly. Around two thirds of lactoferrin volume is now under long-term contracts, the company asserts.
Still, diversification is been costly to date with management estimating a drag of -NZ$20-25m at the net profit level. Credit Suisse notes net debt is now elevated at NZ$527m. No news has been provided on the legal case regarding Pokeno but a judgement is expected by the end of the year.
Manufacturing efficiency is expected to improve from a shift of infant formula base powders to Pokeno and increased basic ingredient production at Dunsandel. Synlait will use increased production at Dunsandel to improve overheads and then use Pokeno for more infant formula production.
Macquarie assesses this leverages the cost base at Pokeno and shows the company's ability to optimise its network. A full contribution from Dairyworks as well as a move to profitability in Talbot Cheese should also help. Dairyworks and Talbot Cheese are seen sustaining operating earnings of NZ$15-20m over the next two years.
A2 Milk/Mataura Valley Milk
Synlait's largest customer, a2, is seeking to vertically integrate through the potential acquisition of 75% of Mataura Valley Milk. Bell Potter does point out, while this may pose a threat to volumes in future, Synlait owns the a2 Milk brand registration in China and this improves Synlait is negotiating power.
Synlait has reiterated its view that it holds exclusive infant formula supply to a2 Milk for China and Australasia to July 2025 and the exclusive volume limit is currently well above its near-term demand forecasts.
Bell Potter, not one of the seven stockbrokers monitored daily on the FNArena database, retains a Hold rating with a $5.35 target and does not believe relative trading multiples are elevated, although acknowledges gearing is high for a company that faces material earnings risk beyond the current supply agreement with a2.
UBS assesses stronger cash generation in FY21 should reduce debt and avoid the need for additional equity. Nutritional ingredients sales, manufacturing efficiencies should also mean pre-tax returns lift.
Morgans agrees leverage has built sharply because of new capacity investment and acquisitions over FY18-20, suspecting this leaves little room for earnings disappointment, and does not rule out an equity raising.
The company still has considerable capacity to fill across both its core and new dairy categories as well as a need to further integrate its recent acquisitions so the broker prefers to wait until there is greater visibility on new supply contracts, maintaining a Hold rating with a target of $5.53. FNArena has two Buy and two Hold ratings on the database.
See also, Daigou Drought Sours a2 Milk Outlook on September 29, 2020.
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