Friday, April 12, 2024

Synlait battles for survival

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Dairy company cannot survive without major asset sales plus major new equity, says Keith Woodford.
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Synlait’s announcements to the NZX on April 2 made it clear that it is battling for survival. Notes to the half-yearly accounts confirm that there are big doubts as to whether it will be able to continue as a going concern beyond the end of this year. 

Potentially, the final crash could occur even earlier, with the support of its bankers having been renewed only through to July and highly conditional on new outside funds becoming available. 

It all depends on whether Synlait can sell sufficient assets plus raise lots of new equity or quasi-equity elsewhere. It is now clear that Synlait, having made an after-tax half-yearly loss of $92.2 million, cannot hope to survive unless both can occur.  

Much of the big loss is due to asset impairments linked to underutilisation, particularly in the North Island. But the problems run a lot deeper than that. As Synlait CEO Grant Watson summed up succinctly in a subsequent audio hook-up for the financial community, the pickle (my term) that it finds itself in is having “too much debt and too much capacity”. 

At one level, there is nothing particularly surprising in the Synlait announcements. I was counting down the days over Easter, waiting for today’s report, knowing that it had to be bleak. But seeing it written so starkly, even with much of it relegated to the notes attached to the half-yearly financial report, reinforces that what I already suspected  is now very much the reality.

In relation to those financial report notes, I quote first from the Synlait directors themselves from a section headed Major Uncertainties relating to Going Concern. 

The directors say: “As at 31 January 2024, the Group recorded an after-tax loss for the six months of $92.2m, operating cash outflows of $98.1m and a working cash deficit of $204.9m, with loans and borrowings due for repayment and/or refinancing in the next twelve months of $514.1m. ” 

Further down they refer to Synlait’s “current liabilities exceeding its current assets by $204.9m” and that Synlait is “unable to repay these debts on demand without additional support from shareholders or other sources of capital”.  They add that Synlait’s “successful execution of an equity raise, in combination with other deleveraging options by 31 July 2024 … is critical to the ability of the group to continue as a trading concern”.

Auditors PwC in their signoff draw attention to these same statements. They then reinforce this by saying in their own words that: “The ability of the group to continue trading as a going concern is dependent on the ability of the directors to successfully execute an equity raise in combination with other deleveraging options by 31 July 2024”.  

If Synlait cannot continue as a going concern, that does not mean the that the big Dunsandel infrastructure will become redundant. Someone will buy it and milk will still flow through it, but there are big questions as to who the someone might be.  

In contrast, the questions about the future of Pōkeno in the North Island, which includes two wet-mix facilities, together with the Auckland dry-mix and canning operations, are less clear. Both suffer from serious underutilisation, which I have suspected for some time as being the situation, but previously I had no data to prove it. 

The Pōkeno and Auckland assets will soon go to market. 

Following the NZX announcements, Watson said in the subsequent audio hook-up that he thought those assets would be best sold as a package, with any likely buyer coming from the advanced nutrition rather than commodity sector.  

If the Pōkeno and Auckland canning operations do sell, it might be for a song. Currently, these facilities do not even cover their operating costs, with the most fundamental issue being not enough milk supply.

As for Synlait’s Dairyworks assets in the South Island, these have been on the market for almost a year. Watson said Synlait thought it was close to a binding offer last week, but the likely buyer withdrew at the last moment on account of the timing supposedly not being right. Watson also said in the audio hook-up that Synlait has two other potential buyers with whom it will have further discussions over the next two months in search of a binding offer.

Watson reported that Bright, as the major shareholder with just over 39% of ownership, was supportive of a capital raising and that it would participate in this raising. Watson implied that Bright would at least maintain its current percentage of overall shareholding. Unstated was that there are major hurdles to increasing their shareholding beyond 40% without an offer to buy out all shareholders.

Bright has also committed to short-term funding via a loan of $130m, with final details to be agreed to, but enough information to satisfy the banks in the meantime.

In response to a question on the audio hook-up, Watson advised that a capital raising had not been discussed with the a2 Milk Company (a2Milk), which is the second biggest shareholder at 19.9%.  Watson was clearly reluctant to be drawn out on the a2Milk relationship but implied that the a2 Chinese-label product, but possibly not the English-label product, was likely to continue being supplied by Synlait. 

The implication was that a2Milk will have nowhere else to go for quite some time given the licensing requirements for Chinese-label product. 

It is apparent that there has been absolutely no thawing of the relationship between Synlait and a2Milk. As one farmer described to me recently, it resembles a very acrimonious divorce. The two divorcees still have to deal with each other in relation to the “dairy child” that they conceived, nurtured and still love, but there is no longer any love or even civility in their own relationship. Indeed, the intensity of the personal dislike is at extreme. Binding arbitration has supposedly been going on for months. How much longer is needed?

Something that was not discussed in the audio hook-up was the major issue of farmer loyalty. Most of the farmer-suppliers are tied to Synlait through to June 2026, but a small number can and will leave this year. Many plan to submit “cease to supply” statements by June of this year, which will allow them to depart in June 2026. 

These farmers do have other options in 2026, or earlier if Synlait fails in its contractual requirements to pay a competitive price. The cash required to join Fonterra is now much less than a few years ago. Pokeno farmers also have at least two other Waikato processors available. In contrast, no one is going to sign up to a new supply contract with Synlait in the current environment.

My judgment is that Synlait has no long-term future without the unconstrained loyalty of its farmer-suppliers. I doubt whether that loyalty is now recoverable as long as Synlait is limping along. Synlait will certainly not regain that loyalty if there is any risk going forward of being constrained in any way by lack of capital.

This means that whoever comes into the Synlait business has to bring in enough cash via new shares to pay off the vast majority of the debt, and to satisfy farmers that it is there for the long term.

By my reckoning, that is an issue that only Bright or a2Milk can solve, either singly or together.  Otherwise, it is going to be a slow trainwreck. 

A detailed assessment of how Synlait ever got into this mess is something for another day. However, the starting point is that Synlait was always an entrepreneurial company that relied heavily on debt-funded growth. 

My brief assessment is that right back in 2018 the company started to fly too close to the sun, thinking that the good fortune that had befallen it in earlier years was repeatable. 

At that point it made a series of bad strategic choices relating to Pōkeno, Dairyworks and Talbot Cheese. Spacecraft Synlait then became too heavy. It lacked the rocket power once economic conditions changed and the sun got too close.

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