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Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>Synlait Milk</h2>
FY19 — Adding Cost &amp; Capacity
Synlait Milk’s (SML) FY19 result and FY20 outlook commentary were both below our expectations as the cost burden of capacity expansion and some margin pressure takes the shine off growing volumes. SML is investing significantly for growth; however, there was nothing in the result to provide greater clarity on the medium to longer-term earnings and return profile. In the near-term, growing infant formula (IF) volumes for key customer, a2 Milk (ATM), will drive earnings growth for SML, while legal issues at Pokeno continue to overhang and add uncertainty. NEUTRAL.
What’s changed?
<ul>
<li>Earnings: EBIT lowered -8%/-10% in FY20/21E, driven by modestly lower gross margin assumptions, combined with higher opex.</li>
<li>Target Price:&nbsp;NZ$9.50 (prior NZ$10.50), with earnings downgrades and higher capex outweighing a lower WACC.</li>
</ul>
Key take-outs
<ul>
<li>Operating result falls short of expectations: FY19 NPAT of NZ$82m was below our (and market) expectations of NZ$88m. This was driven by lower than expected IF volume growth, some gross margin contraction (ATM contract renegotiation and a one-off cost drag from its new liquid facility) and higher net financing costs. Positively, operating cash flow was strong up +39%, benefitting from working capital improvements.</li>
<li>Material investment in opex and capex; no new colour on customers to support capacity expansion: Growth in operating expenses (+15% in FY19) and a material step-up in capex primarily reflects capacity expansion underway, with investment ahead of being operational. SML has material capacity to fill, with no further colour on new customers. The range of feasible outcomes remains very wide in terms of the potential return profile.</li>
<li>ATM still the primary value driver: Finished IF sales remain the key driver of earnings (and value) for SML. Finished IF is now almost entirely driven by ATM. Other brands are still awaiting Chinese regulatory approval and are unlikely to make a significant volume contribution near-term.</li>
<li>Pokeno — uncertainty remains:&nbsp;Legal issues continue for SML’s new facility, with an oral hearing set for 21 October and a “reasonable settlement offer” has been made. It is unclear, and largely out of SML’s hands, as to how/when/if this will be resolved. SML has indicated the facility will still be commissioned this month.</li>
</ul>
Where to from here? FY20 below expectations, medium-term no clearer
FY20 guidance is for “at least” +10% NPAT growth which see us downgrade our near-term forecasts. There are a number of moving parts, including continued IF growth, initial lower margin Pokeno and Liquid Milk production, higher depreciation and opex, and less capitalised interest of project debt.
Our visibility on the medium-term remains limited. SML has plenty of options to grow volumes and diversify, however, visibility on potential returns and likelihood of success is limited. Thus, gaining confidence around valuation is difficult, and we require a higher margin of safety to have a more positive investment view.&nbsp;
<div class="content-highlight">
Investment View
SML is a growth-focussed niche dairy processor. Success to date has been underpinned by key customer, The a2 Milk Company, which we also expect to support strong near-term earnings growth. The long-term trajectory is less clear and we expect to see at least some reversion in returns, albeit the extent is unlikely to be known near-term. NEUTRAL.
</div>
Chelsea Leadbetter, CFA
chelsea.leadbetter@forsythbarr.co.nz
+64 4 495 5262
Matt Dunn
matt.dunn@forsythbarr.co.nz
+64 9 368 0103

Synlait Milk
FY19 — Adding Cost &amp; Capacity
Synlait Milk’s (SML) FY19 result and FY20 outlook commentary were both below our expectations as the cost burden of capacity expansion and some margin pressure takes the shine off growing volumes. SML is investing significantly for growth; however, there was nothing in the result to provide greater clarity on the medium to longer-term earnings and return profile. In the near-term, growing infant formula (IF) volumes for key customer, a2 Milk (ATM), will drive earnings growth for SML, while legal issues at Pokeno continue to overhang and add uncertainty. NEUTRAL.
What’s changed?

Earnings: EBIT lowered -8%/-10% in FY20/21E, driven by modestly lower gross margin assumptions, combined with higher opex.
Target Price:&nbsp;NZ$9.50 (prior NZ$10.50), with earnings downgrades and higher capex outweighing a lower WACC.

Key take-outs

Operating result falls short of expectations: FY19 NPAT of NZ$82m was below our (and market) expectations of NZ$88m. This was driven by lower than expected IF volume growth, some gross margin contraction (ATM contract renegotiation and a one-off cost drag from its new liquid facility) and higher net financing costs. Positively, operating cash flow was strong up +39%, benefitting from working capital improvements.
Material investment in opex and capex; no new colour on customers to support capacity expansion: Growth in operating expenses (+15% in FY19) and a material step-up in capex primarily reflects capacity expansion underway, with investment ahead of being operational. SML has material capacity to fill, with no further colour on new customers. The range of feasible outcomes remains very wide in terms of the potential return profile.
ATM still the primary value driver: Finished IF sales remain the key driver of earnings (and value) for SML. Finished IF is now almost entirely driven by ATM. Other brands are still awaiting Chinese regulatory approval and are unlikely to make a significant volume contribution near-term.
Pokeno — uncertainty remains:&nbsp;Legal issues continue for SML’s new facility, with an oral hearing set for 21 October and a “reasonable settlement offer” has been made. It is unclear, and largely out of SML’s hands, as to how/when/if this will be resolved. SML has indicated the facility will still be commissioned this month.

Where to from here? FY20 below expectations, medium-term no clearer
FY20 guidance is for “at least” +10% NPAT growth which see us downgrade our near-term forecasts. There are a number of moving parts, including continued IF growth, initial lower margin Pokeno and Liquid Milk production, higher depreciation and opex, and less capitalised interest of project debt.
Our visibility on the medium-term remains limited. SML has plenty of options to grow volumes and diversify, however, visibility on potential returns and likelihood of success is limited. Thus, gaining confidence around valuation is difficult, and we require a higher margin of safety to have a more positive investment view.&nbsp;

Investment View
SML is a growth-focussed niche dairy processor. Success to date has been underpinned by key customer, The a2 Milk Company, which we also expect to support strong near-term earnings growth. The long-term trajectory is less clear and we expect to see at least some reversion in returns, albeit the extent is unlikely to be known near-term. NEUTRAL.

Chelsea Leadbetter, CFA
chelsea.leadbetter@forsythbarr.co.nz
+64 4 495 5262
Matt Dunn
matt.dunn@forsythbarr.co.nz
+64 9 368 0103

Synlait Milk: FY19 — Adding Cost & Capacity