New Zealand Professional Investment Services Firm

Forsyth Barr

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New Zealand Professional Investment Services Firm, Forsyth Barr

Equity Bottom-Up

<h2>The a2 Milk Company<br>Taking a Step into Processing</h2>
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<p><strong>OUTPERFORM</strong></p>
<p>The a2 Milk Company (ATM) has entered into exclusive due diligence and filed a non-binding indicative offer to purchase a 75% interest in NZ dairy processor, Mataura Valley Milk (MVM). Strategically the transaction makes sense, particularly for risk mitigation over the longer-term. Importantly it provides manufacturing diversification, future proofing in case of regulatory change (requiring integrated manufacturing) and a stronger relationship with China State Farms. However, we expect it to take time to provide an adequate payback / return, with risk of a (small) operating loss near-term, depending how much volume is able to be shifted. Using Synlait Milk (SML.NZ) as a benchmark suggests returns above WACC (albeit unsurprisingly well below ATM's current ROIC) is achievable in time, particularly should the facility get Chinese regulatory approval.</p>
<figure class="editor-figure mceNonEditable"><img src="https://static-prod.smartkarma.com/images/media/000/154/526/original/blobid0.png?1598229171" class="editor-image img-responsive" data-smartkarma-image-id="154526"></figure>
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<h3>Transaction key points of note</h3>
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<li>Non-binding indicative offer for 75% interest in MVM: For NZ$270m, as part of ATM's long-term strategy to "participate in manufacturing". This implies an enterprise value of ~NZ$360m for MVM (~1.4x build cost; ~1.3x total assets). China Animal Husbandry Group, who is directly linked to China State Farms (ATM's main China distributor), will retain a 25% holding in MVM.</li>
<li>What is ATM buying: MVM owns a new, high spec, processing facility in Gore, New Zealand. The plant commenced production in November 2018, cost ~NZ$258m, and is designed for manufacturing nutritional grade milk powders with a 30,000MT capacity. MVM reported an EBIT loss of -NZ$36m (FY19) given low plant utilisation and a skew towards commodity ingredients.</li>
<li>Additional investment likely:&nbsp;Including a blending &amp; canning facility and the potential need to move the plant away from coal. We estimate this could cost an additional c. NZ$100m.</li>
<li>Timing:&nbsp;The transaction is subject to further due diligence, among other things, albeit expected to settle towards the end of FY21.</li>
<li>Funding:&nbsp;Solely cash reserves. The transaction, and likely additional investment, will only utilise c. 30% of&nbsp;ATM's&nbsp;FY21E cash.</li>
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<h3>What do we think — ticks a number of boxes strategically; may take time to deliver reasonable returns</h3>
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<p>Strategically the acquisition ticks a number of boxes, particularly taking a long-term view. Namely (1) manufacturing diversification, (2) high quality facility in a strong farming area, (3)&nbsp;vertical integration; risk mitigation in case of any shift in Chinese regulation, (4) strengthening its relationship with China State Farms. However, it will take time (and some investment) for&nbsp;MVM&nbsp;to be capable of producing finished infant formula (IF) for&nbsp;ATM, including herd conversion for an a2 milk pool and adding a blending &amp; canning line. For China label product it also requires China factory registration (GACC) and China brand registration (SAMR).</p>
<p>There is a lot we don't know, particularly on production plans and thereby earnings profile. At this stage we leave our forecasts unchanged. We assume ATM would look to move some volumes to the facility initially (some share of whole milk powder, skim milk powder, Smart Nutrition and/or Stage 4). However, to generate an adequate return is reliant on MVM being able to supply IF — with a circa five year time horizon seemingly more realistic.</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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<div><strong>Matt Montgomerie</strong></div>
<div><a href="mailto:matt.montgomerie@forsythbarr.co.nz" target="_blank" rel="noopener">matt.montgomerie@forsythbarr.<wbr>co.nz</a></div>
<div>+64 9 368 0124</div>
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The a2 Milk Company Taking a Step into Processing

OUTPERFORM
The a2 Milk Company (ATM) has entered into exclusive due diligence and filed a non-binding indicative offer to purchase a 75% interest in NZ dairy processor, Mataura Valley Milk (MVM). Strategically the transaction makes sense, particularly for risk mitigation over the longer-term. Importantly it provides manufacturing diversification, future proofing in case of regulatory change (requiring integrated manufacturing) and a stronger relationship with China State Farms. However, we expect it to take time to provide an adequate payback / return, with risk of a (small) operating loss near-term, depending how much volume is able to be shifted. Using Synlait Milk (SML.NZ) as a benchmark suggests returns above WACC (albeit unsurprisingly well below ATM's current ROIC) is achievable in time, particularly should the facility get Chinese regulatory approval.


Transaction key points of note



Non-binding indicative offer for 75% interest in MVM: For NZ$270m, as part of ATM's long-term strategy to "participate in manufacturing". This implies an enterprise value of ~NZ$360m for MVM (~1.4x build cost; ~1.3x total assets). China Animal Husbandry Group, who is directly linked to China State Farms (ATM's main China distributor), will retain a 25% holding in MVM.
What is ATM buying: MVM owns a new, high spec, processing facility in Gore, New Zealand. The plant commenced production in November 2018, cost ~NZ$258m, and is designed for manufacturing nutritional grade milk powders with a 30,000MT capacity. MVM reported an EBIT loss of -NZ$36m (FY19) given low plant utilisation and a skew towards commodity ingredients.
Additional investment likely:&nbsp;Including a blending &amp; canning facility and the potential need to move the plant away from coal. We estimate this could cost an additional c. NZ$100m.
Timing:&nbsp;The transaction is subject to further due diligence, among other things, albeit expected to settle towards the end of FY21.
Funding:&nbsp;Solely cash reserves. The transaction, and likely additional investment, will only utilise c. 30% of&nbsp;ATM's&nbsp;FY21E cash.



What do we think — ticks a number of boxes strategically; may take time to deliver reasonable returns


Strategically the acquisition ticks a number of boxes, particularly taking a long-term view. Namely (1) manufacturing diversification, (2) high quality facility in a strong farming area, (3)&nbsp;vertical integration; risk mitigation in case of any shift in Chinese regulation, (4) strengthening its relationship with China State Farms. However, it will take time (and some investment) for&nbsp;MVM&nbsp;to be capable of producing finished infant formula (IF) for&nbsp;ATM, including herd conversion for an a2 milk pool and adding a blending &amp; canning line. For China label product it also requires China factory registration (GACC) and China brand registration (SAMR).
There is a lot we don't know, particularly on production plans and thereby earnings profile. At this stage we leave our forecasts unchanged. We assume ATM would look to move some volumes to the facility initially (some share of whole milk powder, skim milk powder, Smart Nutrition and/or Stage 4). However, to generate an adequate return is reliant on MVM being able to supply IF — with a circa five year time horizon seemingly more realistic.



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





Matt Montgomerie
matt.montgomerie@forsythbarr.co.nz
+64 9 368 0124



The A2 Milk Company: Taking a Step into Processing

A2 Milk Co Ltd

The A2 Milk Company: Taking a Step into Processing