Are Synlait Milk’s Implied Returns Excessive?

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            [1] => ((A2M))
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This story features SYNLAIT MILK LIMITED, and other companies.
For more info SHARE ANALYSIS: SM1

Synlait Milk is moving towards a higher value packaged product as the industry focus remains on the large Chinese infant formula market.

-Market paying little attention to downside risks associated with margin contraction
-Synlait Milk increasingly benefiting from supply agreements outside of a2 Milk
-Are long-term returns implied in the share price excessive?
 

By Eva Brocklehurst

Key customers and smoother operations helped Synlait Milk ((SM1)) deliver a robust first half result, reflecting a growing proportion of the business exposed to infant formula. The value per kilogram of milk solids processed and sold by the company has grown materially.

Gross margins expanded significantly, although there was a positive contribution that was likely to be one-off in the first half. The company's margins on ingredients have improved which reflects the mix, operating efficiencies and supply chain benefits.

Synlait Milk, in ramping up canning capacity, expects some softening of margins in the second half because of the under-recovery of overheads and higher R&D spending. Guidance for packaged infant formula volumes in FY18 has been raised to 35,000t from 28,000t.

Bell Potter considers the volume guidance achievable but offset by higher fixed costs on the back of recent capacity additions. The half-on-half sales profile in the powders and creams business will also be more evenly distributed versus historical outcomes.

It would appear to Credit Suisse that the company may be guiding to lower profit in the second half, although the earnings growth outlook remains attractive. Still, the broker suspects there is little attention being paid to the downside risks associated with margin contraction in a business that still has limited diversity in its customer base.

Sustainability of long-term margins remains a consideration for Macquarie, as well as the risk with plant commissioning. However, the broker believes the company is well-positioned for its capital investments, which include the NZ$125m at the liquid milk plant and NZ$260m at the new Pokeno site, and incorporates these into forecasts.

The broker assumes a modest ramp up and long-term return of a little over 20% for both of these facilities. Deutsche Bank also suggests the next phase for the company is the super-sizing of its footprint in cream and the North Island site.

Valuation

The main surprise in the results was the stronger margins in ingredients, resulting from the shift in mix towards higher-value products, and Deutsche Bank rolls forward its target price, increasing this by 25% to NZ$7.50. This reflects a material upgrade to near-term earnings forecasts, although the broker cannot justify the share price and maintains a Sell rating.

Catalysts may all turn out to be positive but Credit Suisse requires more visibility and, hence, maintains a Underperform rating with an NZ$6.64 target. Meanwhile, Macquarie downgrades to Underperform from Neutral on valuation, raising the target to NZ$7.00 from NZ$5.29.

The broker likes the company's high-value B2B strategy but believes the share price is implying a long-term return on capital employed of over 30%, which is ahead of even the company's target of around 20%.

Bell Potter counters this view with a Buy rating and $10.45 target, raised from $7.90. The broker acknowledges, while the move to a higher-value packaged and infant formula product (versus bulk commodities) is largely being driven by a2 Milk ((A2M)), the company is increasingly benefiting from supply agreements with several other customers, namely New Hope Nutritionals, Bright Dairy, Munchkin and Foodstuffs.

New five-year supply agreements have recently been arranged with both New Hope and Bright Foods and Synlait Milk is in the process of securing Chinese FDA registration for both brands. Bell Potter also suggests operating cash flow is increasingly underpinning the company's ability to internally generate capital to fund growth initiatives.

The main earnings drivers currently include the pace at which a2 Milk secures market share in the Chinese infant formula market, the timing of US FDA approval for the Munchkin grass-fed product, as well as the timing of CFDA approval for New Hope and Bright Foods brands in China.

Key Customer

What happens with key customer a2 Milk over the next 12-24 months will be of interest to Credit Suisse, given recent developments in that company's arrangements with competitor Fonterra. Importantly, a longer-term contract with a2 Milk could lock in long-term margin expectations in Synlait Milk's existing business and de-risk the second site.

Synlait Milk is the exclusive supplier of a2 Milk's infant formula products in China and holder of the CFDA registration for the product. Bell Potter suggests if a2 milk can generate sales velocity in the Chinese market anywhere near the level it achieves in Australia, then leverage for the Synlait business will be material.

Yet Credit Suisse wants more detail on regulatory approvals, customer commitments and a firm plan for market entry that utilises the liquid processing plant, where investment is now underway. This would go a long way to generating the comfort that the broker requires for the company to move beyond securing the second site and meet the hurdles to de-risking investment in a fourth dryer.

Detailed disclosure remains a problem for Macquarie too, because of variable margins for differing volumes, as it remains hard to isolate one-off movements from underlying improvements in the business.

The broker suspects that, as the company did not signal margin expansion in infant formula in the results, despite increased volumes, some of the operating leverage of the plant is being passed back to the customer under a contractual arrangement.

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