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Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Synlait Milk<br>Christmas&nbsp;Grinch&nbsp;— Part Two</h2>
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<p><strong>NEUTRAL</strong></p>
<p>Key customer The a2 Milk Company (ATM) blindsided the market and Synlait Milk (SML) with a substantial downgrade to its near-term volume expectations; which has flowed through to a sharp contraction in FY21 profit guidance for SML. 2020 has been an eventful year for SML, including: a key new customer win, settlement of its Pokeno dispute, a capital raise, and three material cuts to near-term earnings. It has reinforced (1) the pace at which the outlook can change, (2) SML's dependence on external factors outside of its control (e.g. customer decision making &amp; demand), (3) lack of external visibility on key drivers, and (4) operating leverage given a large fixed cost base — painful in FY21, although leverage can work both ways. Valuation metrics are attractive assuming it executes on our near-term growth expectations, however, we require a higher margin of safety. NEUTRAL.</p>
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<h3>What's changed?&nbsp;</h3>
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<li><strong>Earnings</strong>:&nbsp; Material NPAT downgrades.&nbsp;FY21E -49%, FY22E -40% and FY23E -28%.&nbsp;</li>
<li><strong>Target price</strong>:&nbsp;NZ$5.50 (prior NZ$6.30) —&nbsp;materially lower DCF (earnings revisions), while price to book is only moderately lower.</li>
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<h3>SML's&nbsp;guidance cut follows&nbsp;ATM's&nbsp;disappointing updated outlook; although the magnitude is larger given fixed cost base</h3>
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<p>SML materially lowered its FY21 guidance, with NPAT now expected to be "approximately half" that of FY20, or c.NZ$38m. This compares to prior&nbsp;guidance provided on 10 November 2020, for NPAT “at or slightly below FY20”.&nbsp;The downgrade follows the material&nbsp;reduction in volume expectations from ATM (SML is forecasting volumes down ~-35%) given its slower than anticipated recovery in the under-pressure&nbsp;daigou&nbsp;channel, which has not been made up for by other channels —&nbsp;refer our note&nbsp;The a2 Milk Company: The&nbsp;Grinch&nbsp;Stole Christmas, 21 December, for more detail.&nbsp;The impact of a material decline in Infant Formula (IF) volumes is significant on SML given operational de-leverage and as IF is its highest margin product, by some magnitude.</p>
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<h3>Where to from here?</h3>
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<p>There are&nbsp;a lot of unknowns, with visibility low and accordingly a high margin of error in earnings&nbsp;forecasts.&nbsp;While FY21 is a much larger than expected step-back, we are forecasting an attractive medium-term growth profile as SML begins to leverage recent investment, ATM volumes return to growth, and its new customer starts from FY23E. Focus will be on execution, particularly leveraging recent investment / initiatives, to drive an improved return on capital following a disappointing FY21.</p>
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<h3>Gearing returns to levels we were forecasting pre the recent capital raise</h3>
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<p>Our revised gearing expectations are for net debt to EBITDA of ~2.6x in FY21E. The profit contraction returns gearing near its internal long-term target (~2.5x) and levels we were forecasting pre capital raise. While disappointing, there is still reasonable headroom in its covenants. SML is nearing the end of its expansionary capex phase and this, coupled with expected earnings growth from FY22E, should see leverage reduce in the short to medium-term.</p>
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<div><strong>Chelsea Leadbetter CFA</strong></div>
<div><a href="mailto:chelsea.leadbetter@forsythbarr.co.nz" target="_blank" rel="noopener">chelsea.leadbetter@<wbr>forsythbarr.co.nz</a></div>
<div>+64 4 495 5262</div>
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Synlait Milk Christmas&nbsp;Grinch&nbsp;— Part Two

NEUTRAL
Key customer The a2 Milk Company (ATM) blindsided the market and Synlait Milk (SML) with a substantial downgrade to its near-term volume expectations; which has flowed through to a sharp contraction in FY21 profit guidance for SML. 2020 has been an eventful year for SML, including: a key new customer win, settlement of its Pokeno dispute, a capital raise, and three material cuts to near-term earnings. It has reinforced (1) the pace at which the outlook can change, (2) SML's dependence on external factors outside of its control (e.g. customer decision making &amp; demand), (3) lack of external visibility on key drivers, and (4) operating leverage given a large fixed cost base — painful in FY21, although leverage can work both ways. Valuation metrics are attractive assuming it executes on our near-term growth expectations, however, we require a higher margin of safety. NEUTRAL.


What's changed?&nbsp;



Earnings:&nbsp; Material NPAT downgrades.&nbsp;FY21E -49%, FY22E -40% and FY23E -28%.&nbsp;
Target price:&nbsp;NZ$5.50 (prior NZ$6.30) —&nbsp;materially lower DCF (earnings revisions), while price to book is only moderately lower.



SML's&nbsp;guidance cut follows&nbsp;ATM's&nbsp;disappointing updated outlook; although the magnitude is larger given fixed cost base


SML materially lowered its FY21 guidance, with NPAT now expected to be "approximately half" that of FY20, or c.NZ$38m. This compares to prior&nbsp;guidance provided on 10 November 2020, for NPAT “at or slightly below FY20”.&nbsp;The downgrade follows the material&nbsp;reduction in volume expectations from ATM (SML is forecasting volumes down ~-35%) given its slower than anticipated recovery in the under-pressure&nbsp;daigou&nbsp;channel, which has not been made up for by other channels —&nbsp;refer our note&nbsp;The a2 Milk Company: The&nbsp;Grinch&nbsp;Stole Christmas, 21 December, for more detail.&nbsp;The impact of a material decline in Infant Formula (IF) volumes is significant on SML given operational de-leverage and as IF is its highest margin product, by some magnitude.


Where to from here?


There are&nbsp;a lot of unknowns, with visibility low and accordingly a high margin of error in earnings&nbsp;forecasts.&nbsp;While FY21 is a much larger than expected step-back, we are forecasting an attractive medium-term growth profile as SML begins to leverage recent investment, ATM volumes return to growth, and its new customer starts from FY23E. Focus will be on execution, particularly leveraging recent investment / initiatives, to drive an improved return on capital following a disappointing FY21.


Gearing returns to levels we were forecasting pre the recent capital raise


Our revised gearing expectations are for net debt to EBITDA of ~2.6x in FY21E. The profit contraction returns gearing near its internal long-term target (~2.5x) and levels we were forecasting pre capital raise. While disappointing, there is still reasonable headroom in its covenants. SML is nearing the end of its expansionary capex phase and this, coupled with expected earnings growth from FY22E, should see leverage reduce in the short to medium-term.




Chelsea Leadbetter CFA
chelsea.leadbetter@forsythbarr.co.nz
+64 4 495 5262




Synlait Milk: Christmas Grinch — Part Two