Synlait Milk Eyes Recovery, But Risks Remain

This story features SYNLAIT MILK LIMITED, and other companies. For more info SHARE ANALYSIS: SM1

While investors are encouraged to look through the one-off issues that have plagued Synlait Milk over the last year, uncertainty over demand from a2 Milk the company’s single biggest customer weighs on valuations.

-Synlait Milk has flagged a FY21 loss of between -NZ$20m and -NZ$30m
-Exposure to a2 Milk’s recovery story is a lingering risk
-It is possible FY21 is the low point for the company, but risks remain

By Mark Story

When it comes to reviewing the fortunes of battle weary Synlait Milk ((SM1)) it may be apt to coin the phase: What a difference a year makes. Last year the NZ-based dairy processor and leading manufacturer of milk powders recorded a profit of NZ$75.2m, with management guiding to a break even in FY21.

Since then, Synlait has had to contend with a perfect storm of issues, which saw the company’s share price fall to five-year lows, after peaking at over $12 in late 2018.

The company was a direct casualty of the coronavirus which resulted in Chinese demand for milk and baby formula entering a hiatus. Daigou channels out of Australian and New Zealand were also closed along with borders.

The next blow arrived late March this year after a bombshell announcement by one of its major customers (and shareholder) The a2 Milk Company ((A2M)) of a significant drop in demand at a time when it simply had too much inventory. This led to a series of downgrades, with sales expectations for FY21 also being hacked.

If bad news comes in threes, the most recent revelation for Synlait to contend with is shipping delays out of NZ. Due to sales-phasing impacts and volume pressure, management is also flagging lower than expected prices for its ingredient products.

Following an internal review, the company decided to adopt a “more conservative” approach to year-end inventory volumes and valuation, leading to what it believes is a safer guidance figure. As a result, the company’s board was left with no choice but to downgrade its guidance. As a result, Synlait is now flagging a loss of between -NZ$20m and -NZ$30m in FY21.

Beyond current issues

Despite concerns over Synlait’s limited near-term earnings visibility, and longer-term challenges with a2 Milk beyond FY25, Morgans thinks investors could start to look through these issues if the company can start to rebuild confidence in a FY22 earnings recovery story.

The broker has taken some comfort from management’s reminder that the 24 May downgrade reflects the quantification of risks flagged in its previous guidance, with the company focused on delivering a much improved FY22 result.

Given that today’s issues are expected to be largely confined to FY21, Morgans’ FY22 and FY23 earnings forecasts are unchanged, following a FY21 forecast loss of -NZ$25.0m. As a result, the broker has moved to a Hold from a Reduce rating on Synlait with a target price of $2.55.

Morgans sees multiple drivers underpinning an earnings recovery post the current financial year, including Dry Store 4 efficiency savings (NZ$8m benefits in FY22), continued growth in Dairyworks and benefit from Synlait’s new multinational contract at Pokeno in FY23.

But due to the apparent structural changes in a2 Milk’s demand profile, changing business mix and long lead time to optimal asset utilisation, Morgans has concerns over Synlait's gearing level. While management was explicit that it does not intend to undertake a capital raising, the broker would like to see the company’s net debt, which is expected to exceed NZ$500m in the present financial year, lowered.

Meantime, Synlait has reassured the market its banking syndicate remains supportive. A covenant waiver has been granted in FY21 and management is working with the syndicate to ensure it has sufficient funding for FY22.

a2 Milk recovery

Taking a decidedly more cautious approach to Synlait’s recovery, Jarden’s medium-term downgrade reflects the broker’s lower a2 Milk’s volume track (following its May downgrade).

Within a recent trading update, a2 Milk – which being the major customer is a key growth driver for the business — announced its fourth downgrade to the FY21 outlook. a2 Milk attributed the latest downgrade to a poor April and an inventory review suggesting higher excess inventory and aging.

Reflecting the earnings downgrade, valuation downside, high debt loading and low confidence over near-term outlook improvement drivers, Jarden retains an Underweight rating on Synlait, with the target price dropping -19% to NZ$2.90.

On Jarden’s revised FY22 estimates, net debt to earnings (EBITDA) remains at covenant levels of 4x, highlighting limited scope the broker sees for any further issues and/or delayed a2 Milk recovery.

Clearing the decks

Having concluded that the 10,000t shipment delay flagged by management which impacts both year-end inventory and debt positions – while also delaying profit recognition until FY22 – is largely one-off in nature and likely to unwind in FY22, Bell Potter retains a Buy rating.

The broker reminds investors management anticipates a material recovery in net profit in FY22, even assuming no material growth in packaged IMF volumes.

Major drivers of FY22 highlighted by Bell Potter include non-recurrence of recent issues, delivery against NZ$22m in cost out initiatives; rebalancing of AMF-butter premiums toward historical levels; and delivery against lead with pride premiums and functional cream products.

Like Morgans, Bell Potter has made no material changes to FY22-23 forecasts, and the broker’s $3.85 target price also remains unchanged.

Bell Potter attributes Synlait’s FY21 performance to a business that has completed the commissioning of major capital works, while experiencing an unfavourable shift in sales mix. Contributing to that complexity, adds Bell Potter, is the unwinding of IMF inventory positions accumulated over second half FY20 and first half FY21.

As Synlait unwinds these inventory positions and moves from the commissioning phase of the asset life cycle, to the product mix optimisation phase, the broker expects a material recovery in earnings and return on invested capital (ROIC).

Synlait is covered by three of the seven stockbrokers monitored daily by FNArena. While Macquarie is sitting on the fence with a Neutral rating, the broker is yet to update post the result release.

Morgans has upgraded to a Hold from Reduce, while UBS maintains a Buy rating based on an expectant large jump in a2 Milk’s infant formula manufacturing requirements over the next three years.

UBS is expecting recovery in indirect sales, share gains through Synlait’s offline rollout and free trade zone expansion, on top of a normalisation in inventory levels. The broker also expects adult nutritional volumes to materially offset a2 Milk's partial manufacturing internalisation over the long-term.

While UBS forecasts pretax ROIC to lift from 0% in FY21 to 16% in FY25, the broker reminds investors that Synlait trades on a record discount to book value for a business with hard assets and proven world-class manufacturing capability.

UBS’s FY23 net profit at NZ$80m is broadly in line with pre-covid levels as a2 Milk's infant formula requirements normalise.

The sole price target in Aussie dollars for Synlait is set by stockbroker Morgans, at $2.55 it suggests some -10% downside to the last closing price.

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