New Zealand’s fourth-largest milk processor, Synlait Milk ((SM1)), has had a strong run up in its shares on the strength of its relationship with a2 Milk ((A2M)). The company is the exclusive supplier of infant formula to a2 Milk for that company’s product base in China and Australasia.
Synlait Milk, as supplier of dairy ingredients, is a high-growth business with exposure to the agricultural supply chain, and management now considers the business can look to establish a brand, providing it does not conflict with existing relationships, and where it has significant consumer benefits.
This aspect of the company’s FY17 results interested Macquarie, as it differs from the previous business-to-business focus.To achieve its strategy, the company will establish further manufacturing sites over time, believing the current balance sheet and projected earnings should provide sufficient funding.
Macquarie suggests this is helped by the abandoning of the building of the additional dryer on the current site at Dunsandel, which frees up $130m. Management has indicated further manufacturing would be established in New Zealand, given the quality of milk and market opportunities.
The new Auckland canning line and investments in flexible packaging capacity for infant formula and adult nutrition products are progressing. Beyond this, the company has highlighted the potential to develop manufacturing capacity in base powders for the infant formula segment.
Any new investment will be conditional on further growth in demand in advance of current projections but for the Bell Potter this highlights the optimism management has in the business. Furthermore, the broker envisages internalisation of the packaging of the a2 Milk adult nutrition product will be a potential profit driver in the second half. The broker estimates a2 Milk accounted for in excess of 80% of the company’s consumer-packaged volumes and in excess of 30% of gross profit in FY17.
Outlook
No formal guidance was provided other than for canned infant formula volumes to be 30-35,000t in FY18, amid expectations of a step-up in profit in FY18 because of strong demand for infant formula. Bell Potter believes the transition towards higher margin canned infant formula and adult nutrition, and away from bulk dairy ingredients, remains a key driver of earnings, cash flow and value for the stock.
Following a stronger-than-expected FY17 result the broker upgrades forecasts for net profit by 5.5% in FY18 and FY19. Bell Potter, not one of the eight stockbrokers monitored daily on the FNArena database, lifts its target to NZ$6.07 from NZ$5.20 and maintains a Buy rating.
Deutsche Bank downgrades to Hold from Buy. This is based on a strong re-rating to a level where the stock now reflects the growth potential. Also, the broker points out regulatory processes are still in train for the company’s key infant formula customers.
Credit Suisse takes an even more cautious approach and would like to be confident in the transition through regulatory changes in China. While downgrading to Underperform from Neutral, the broker is not suggesting the company cannot meet market expectations but seeks a further de-risking of the company’s prospects. If this occurs then valuation should follow the share price.
The broker continues to base long-term forecasts on a reasonable return on investment for a contract manufacturing business. The momentum in the company’s key customer, a2 Milk, is such that further growth in volume and profitability can be expected but Credit Suisse, too, observes a number of hurdles to mount.
The China Food and Drug Administration is currently reviewing both applications for registration of imported product, with a new regulatory framework to begin January 1, 2018. Credit Suisse also points out that a2 Milk sales are heavily skewed to product that goes into China through various informal channels.
Moreover, the broker believes margins the company is currently enjoying from a2 Milk will not necessarily endure for the longer term and a trade-off for greater certainty on volume is likely to ensue.
Munchkin
Meanwhile, Bell Potter envisages scope for the Munchkin infant formula grass-fed product to become the growth story in the fourth quarter of FY18 based on the success of the grass-fed beef sector. The last hurdle is to gain US FDA approval.
This is a key prospective customer the company has been working with over the last two years. Munchkin is looking to launch infant formula in the US, providing the company with geographic and customer diversity.
