Friday, April 12, 2024

Where does Synlait’s future lie?

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Synlait is in big trouble with losses mounting up and no easy answers, says Keith Woodford.
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For much of the past 20 years, Synlait was an entrepreneurial player in the New Zealand dairy industry, with a strong focus on growth. For a long time, it seemed to be doing everything right. 

Alas, after remarkable growth through to 2019, the wheels have progressively fallen off over the past four years. Synlait now faces an existential threat. Where did things go wrong and where does the path now lie? 

Synlait’s fundamental problem is that for the second year running it is operating at a loss. Synlait’s recent stock exchange guidance is that it expects to report a loss of between $17 million and $21 million for the first half of the 2023/24 year. 

Go forward a little further, and unless there is a big unexpected turnaround in the next few months, Synlait will have made a loss in three out of the past four years. 

Another issue is that Synlait has begun leaking nervous farmers to Fonterra. Several years ago, there was a waiting list of farmers wanting to join Synlait.

Despite the lack of profit, Synlait has recently been earning around $1.6 billion in annual export revenue, comprising about 6% of New Zealand’s dairy industry exports. It is an important company.

My interest in Synlait has been twofold. Given that I was Lincoln’s professor of farm management and agribusiness from 2000 to 2015, I was interested in all the NZ dairy companies, including Synlait. 

Perhaps more importantly, I have also been interested in the issue of A1 versus A2 milk ever since 2004, and in 2007 the first edition of my book on the topic, Devil in the Milk, was published. 

In 2010, I was in some discussions with Australia-based Geoff Babidge who was the CEO at the a2 Milk Company (a2Milk). It was obvious that a2Milk needed a reliable supply of top quality A2 milk if it was going to produce infant formula. It was also obvious that this would be hard to get in Australia. 

So, I said to Geoff that he needed to talk to Synlait in NZ, which was too small to have come on Babidge’s radar.

To cut a long story short, I teed up a meeting between Babidge and Synlait CEO Dr John Penno in January 2011. Babidge knew that he needed Penno, not that he actually voiced that to Penno, being too smart for that. But Penno was not convinced he needed Babidge. It was an interesting meeting.

However, the seeds for mutual benefit between Synlait and a2Milk were sown, and I then stepped aside. Fourteen months later a detailed agreement between the parties in relation to A2 infant formula was finally inked. 

It was that partnership between a2Milk and Synlait that set both companies on an amazing journey of interdependency and wealth generation. I kept watching from the sidelines.

Returning to the current situation, the focus within the financial media has been that Synlait’s existential problems are a consequence of high debt. However, debt would not be a problem if Synlait were making good margins on its manufactured products. The accounts as at July 31 2023 show debt of $413 million but this is only 34% of debt plus book equity. 

There should not be anything frightening about the current financial leverage, if only Synlait were profitable. However, Synlait’s operating margins have declined markedly as revenue has stalled but costs have risen. Hence, Synlait is at the mercy of its bankers.

The share market has now lost confidence in Synlait, with shares as I write this article in mid-February 2024 selling for 70 cents. One year ago, the shares were selling at around $3.50.

In 2019, the shares were selling at up to $13, based largely on outstanding profitability of Synlait’s “a2 Platinum” infant formula manufactured for a2Milk, before a precipitous drop in earnings on the arrival of covid. 

Synlait’s immediate challenge is to repay $130m of bank debt in late March 2024. I have some confidence that Synlait’s bankers will renew this debt on a short-term basis, but at a considerably increased interest rate.

A bigger challenge for Synlait is that it has to repay $180m of five-year bonds in December 2024. These bonds, with a face value of $1, are currently trading for 79 cents, providing a yield, assuming Synlait can actually repay the bonds, of 30%. That reflects the scepticism of the market that Synlait can manage its debt repayment obligations.

There are only two options for Synlait. Either it has to sell assets or it has to raise more share capital.

The most obvious asset to sell is its consumer products division, Dairyworks. This was acquired in 2020 for $116m. Dairyworks now focuses on cheese, having discontinued its yoghurt and spreadable butter products under Synlait management. 

However, unless Dairyworks can be sold at a huge premium, which is doubtful, it won’t be enough to turn the books around.

The Dairyworks assets have been for sale since June 2023, but so far no one has come forward at a price that Synlait considers satisfactory. Perhaps that will change soon, given that Synlait needs to make something happen urgently. Time is running out.

Synlait also owns mothballed cheese-manufacturing facilities at Temuka, which it acquired in 2019 for between $30m and $40m. It has written down these assets by $12m but a further write-down seems likely, which will increase the net loss for 2023/2024.

The other potential sale would be the underutilised Pōkeno processing facilities, south of Auckland. But who would purchase those right now? Perhaps Singapore-based Olam, which already has a new plant at Tokoroa, could be interested if it were a bargain. 

Would Olam want another plant drawing on an overlapping milk-supply catchment, within which there is already significant competition for milk? I am confident that they could rustle up the necessary funds if they wanted to.

If Synlait cannot successfully sell assets, the only other options are to either raise more share capital or to be bought out totally by a new owner. This gets tricky given two existing major shareholders.

The biggest financial stakeholder is Bright Dairy from Shanghai with 39% shareholding. Bright has been a shareholder since 2010, when Synlait was still a private company. 

Bright cannot increase its shareholding unless it offers to purchase all shares. Would it be willing to buyout the company itself, or alternatively sell its shares in a buyout? Bright’s public response until now has been that it is happy with its current shareholding and intends to stay as a long-term shareholder. That could change either way. 

If Bright really wanted to, it could find funds to purchase 100% of Synlait. However, there is a big fly in the ointment – a2Milk.

a2Milk is the second biggest Synlait shareholder with a 19.9% shareholding, theoretically headquartered in NZ but with all senior executives based in Australia, China and the United States. Most of the share trading occurs in Australia despite it being a NZ company. Like Bright, a2Milk can only increase its percentage of shares by offering to buy all shares.

a2Milk is also the most important purchaser of Synlait’s products. It is debt free and has more than $750m sitting in the bank. This would be more than sufficient to purchase Synlait.

Both Bright and a2Milk have shareholdings that effectively prevent other corporates from pursuing an outright purchase unless at least one of them agrees to sell. Also, there are particularly strong reasons why a2Milk cannot afford to let go of Synlait. 

Without Synlait, which holds the licence for manufacture of Chinese-labelled “a2 Platinum”, a2Milk is in big trouble. It would mean a2Milk would need to obtain an equivalent licence for its majority-owned Mataura Milk in Southland. 

Obtaining that licence could be a long process, and there is also a long herd-conversion process before Mataura will have the necessary volume of A2 milk.

Things have got more complicated over the past year with a very strained relationship between a2Milk and Synlait. Not only is a2Milk now seeking damages from Synlait for non-performance, it also wants to use non-performance as a reason for breaking commitments relating to exclusive sourcing of supply.

The two companies are in arbitration but it is far from clear how that will end up. I could say a lot more about the disagreements but all I want to say here is that it is a nasty situation.

The cleanest outcome would be if a2Milk were to make an outright bid to purchase Synlait. Bright could then decide to sell or retain its shares. 

If Bright decided to retain the shares, then a2milk would need to buy at least 76% of other shareholdings to obtain control. Perhaps a2Milk is biding its time, as the screws are tightened on Synlait. And then, what would Bright decide to do? Perhaps a counter offer to ratchet up the price?

The only thing close to a certainty is that something big now has to happen. The Synlait of the future is going to be very different to the current Synlait. 

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