Edited Transcript of SML.NZ earnings conference call or presentation 18-Mar-20 9:00pm GMT

The second area that’s really important to us is making (inaudible) that our plants remain operational. We’ve moved swiftly and quickly there to really adopt the same approach that the New Zealand government is taking, which is to flatten the curve of the spread, and many countries around the world are doing the same. And it’s our responsibility to do the same for our sites. So many of our staff who can, where practical, have been asked to work from home. We’ve put in place a reasonable travel restrictions for only essential business travel. And look, we continue to make sure that we limit interaction with the key capability that we have to run our sites. We’re running some detailed scenario planning for how attendance may impact our ability to do that. So far, we see that we have reasonable resilience should that develop. And look at this stage, we’re really hopeful we’re going to be able to see our plants operating. And I call out to all our staff who are really leaning in here.

From a product perspective, just to make sure that it’s clear that there’s no evidence that food is likely to be a transmission risk of this virus. So European Food Safety and Ministry of Primary Industries here in New Zealand all support that position. And it’s important that, that’s understood as well.

So look, I’ll move through now straight through to Slide 5. The key highlights on our half year financials. I think we did signal in our guidance update in February where we would be, so this shouldn’t be a significant surprise. Revenue up 19% to $559 million, supported by a 22% increase in consumer package and from formula sales. Our EBITDA line is flat and consistent with where we were this time last half. You will see some dilution in our net profit after tax, 30% down versus last half, reflecting the higher depreciation and interest costs as we invest for future growth. So it’s important that it’s understood that our EBITDA earnings stream is largely stable. You’ll see in our outlook, it’s also — we’re forecasting that to grow this year. The costs of both borrowing and running the depreciation on our new assets is what’s pulling our bottom line a little bit back this year. But we do see, in the longer term, us emerging and pushing through that. As I said at the start, current milk price forecast is $7.25, reasonably encouraging to see GDT holding up well in the auction this week, but we will monitor that and see what happens going forward. And notwithstanding that, on Slide 6 now. I’ll step through some of the challenges that we have had, and I think it’s important that we go through this just to make sure the key messages are understood. We’ve talked a lot in recent months about Pokeno and the uncertainty around our land and site there with the covenant. Really pleased to see that the Supreme Court will hear that case in April. The key message there is if we won there, this thing goes away. If we lose in the Supreme Court, we’re basically back where we are today, with a dispute with our neighbor on how we resolve that. So we’re really comfortable with our legal position, and we’ll look forward to our Supreme Court hearing.

We recognize we have significant capacity to fill. Our customer pipeline is really exciting, but we don’t have material announcements to make this time around. We are well progressed on material customer opportunities that will diversify both Synlait and fill up on new facilities. And I did want to clarify that despite the fact that this year, we’ve seen our infant-base powder sales drop away, and that’s largely because of the dynamic in China. We are moving swiftly to rebuild that pipeline as we move into FY ’21 with multinational brand owners as they reset their supply options.

We did talk a little bit about the dynamic in China about a deceleration of some of the growth in the market and that SAMR registrations were limiting opportunities for new entrants. The implication for us is that we pivot our focus to supporting that the a2 Milk Company to build a strong leadership position there and start to leverage that capability to partner with established players. We are seeing the China infant nutrition regulatory environment continue to move towards the Synlait model of integrated manufacturing. And that’s the model that we’ve invested, and it’s the model where we take raw milk all the way through to the finished product in a can. It’s the model where we hold the license and market access requirements for our customers. It’s the model where we invest heavily in quality and the regulatory systems to ensure market access is available. So those changes that we talked around are starting to both shift our strategic direction to move and work with established players, leverage their credibility and protect the investment we’ve made across our value chain.

Talking about the long-life commissioning and the long-life line within our advanced dairy liquid plant. We’ve got a strong customer pipeline there. We’re excited about the recipes we’re developing out of (inaudible). And we are seeing some commissioning delay with the knock-on impact of the liquid milk line and do expect sales of our UHT to kick off in the first half next year.

COVID-19, I’ve spoken to and the short-term financial performance. We’ll also cover off in a bit more detail as we go through. Slide 7, I’ll also go reasonably quickly through because there is more detail on the subsequent slides. But this is really how it ladders up into our strategy. So our purpose of doing that differently for a healthier world. Our growth paths of infant nutrition, everyday dairy and food service are our current and medium-term focuses, and we’re making some good progress on our enabling strategy across people, planet and enterprise.

Turning now to Slide 8. I just want to stress that I noticed is a standard slide, but it’s important that everybody understands that we are making investments to continue to strengthen this. A large portion of our capital investment has been to strengthen what we see is our core point of difference when we look across our competitive set and what our customers value and what creates competitive advantage for us. Differentiated milk supply, the integration of our manufacturing chain, how we navigate complex regulatory environments and the quality testing are established and fundamentally key points of difference for us, our investments in R&D and our move towards sustainable activity within the marketplace, we believe, will be future differentiators. We fundamentally believe that customers value or simply can’t do without some of these aspects and that’s really important as we go forward, particularly in our infant nutrition strategy.

On Slide 9, there is — as we move into Infant Nutrition, there’s quite a bit of tick stone here, but there’s 5 key points that I want everybody to take away. The first one is that when we look at Infant Nutrition, COVID-19, initially, we are seeing a small lift coming through from the a2 Milk Company in the first 2 months of the 2020 calendar year. So that’s starting to lift positive demand signals that will come through in the first pass of this half. It’s a little early to see how that will quantify up for the full financial year, but initial signals suggest that demand is holding up and growing initially, and that will bring forward some of the orders that we have in our pipeline.

I mentioned before, we’re moving quickly to rebuild our pipeline of IFB. Just to provide a bit more context here, the sales that dropped out of our expectations this year were roughly 50% with established players and 50% with emerging players that were struggling to get registrations. Both of those existing sales were exposed to China. As we see multinational brand companies start to bring those manufacturing ingredients into their own network, we’re also seeing them start to outsource and reset the supply expectations for their non-China customers and the non-China manufacturing footprint. And those are the opportunities we’re hunting down and helping us rebuild our IFB pipeline, which is critical to support the investment in new assets and optimize them as we start to increase utilization.

The third important there — the third important point there relates to the section on our customers and the a2 Milk Company partnership that we continue to value very much in terms of creating value for each other. I want to clarify, there was some perhaps either speculation or questioning when we did the recent guidance update, that perhaps historical margins and now a2 relationship we’re looking to dilute or could be diluting as a result of that contract renegotiation. We have, at minimum, 5.5 years to run on that exclusive supply agreement, and we’re real confident that historical margins can be protected, provided Synlait continues to generate manufacturing efficiencies. So that’s an important message we want everybody to take away that our historical margins aren’t under threat as a result of that renegotiation, and we feel comfortable that we’re creating value and sharing the benefits of scale with our partners.

Also looking forward, you may have noted a2’s intention to participate in manufacturing, and we’re looking forward to those discussions with the a2 Milk Company as we consider that and their desire to have them potentially participating in manufacturing as we also recognize similar expertise. So we’ll move forward with those discussions and look forward to the recognition of all of the investments we made across the quality aspects, our integrated manufacturing site and the fact that we hold the registration for a2’s market access into China.

We also have strong customer pipeline. We’ve referred to this a number of times. But we have a material opportunities well progressed with established players in the space, and those are moving forward at a good pace. So those are the key items on the Infant Nutrition. It’s a key slide for us in terms of looking at that sector. I know you understand the impact on our business. And overall, there’s some good signs there, albeit we’ve invested heavily in our future growth. We are working at the same rates and supporting that growth with the activity I’ve just spoken through.

Moving to Slide 10. Many of you think you joined the update that we had once, the Dairyworks acquisition that gone through. So the key news in the Everyday Dairy space is this acquisition. Look, we feel we’ve got a really good business here with Dairyworks. We bought it at a strong multiple. It’s got strong momentum at 7.1x EBITDA, which improved from the 7.5x we announced. There were some questions around how we saw the earnings trends develop. And I just wanted to clarify that today, that we see a good, stable earnings streams based on that multiple of $15 million to $20 million EBITDA as growth momentum consolidates and we realize the synergies that we see with Talbot Forest Cheese. So we see some strong upside coming into our businesses as associated with that. I also want to just remind those of you that were on the call, that we had a transaction date here 1st of September, a settlement date 1st of April. The retained earnings that were created through that period remain for the benefit of Synlait and sit with a lock box. And those earnings totaled $7 million. So they will transfer to Synlait as we settle on this transaction on the 1st of April. The chart on the middle just demonstrates that there’s material diversification around customer category and market concentration, and the chart on the right just demonstrates how this delivers an opportunity for us to optimize our milk solids. We have a bias towards protein and fat within the cheese category that we’re entering into here or growing. And it also allows us to participate and moving closer to the consumer and moving up the value chain.

Just moving to Slide 10. Some quick updates on our enabling strategy and the work that we’re doing on sustainability and for the environment. Some really good progress on nitrogen loss trials, alternative fuels and biodiesel for logistics partners. We have a metric that we run with Sustainalytics, which feeds into some of our other key tools. And really pleased to share that Synlait now ranks third of all packaged food companies with that risk score improving from 34.9 to 21.3.

Building a Healthier Synlait on Slide 12. Some great progress there with our initiative and commitment to native trees, starting to build some good momentum. We’ve got our ERP project well progressed, completing the design stage there. Our engagement continues to improve. There’s a chart on the top right there that shows some good product there. And that continues to be a strong support for our culture and the organization that we’re building and our people’s commitment to our purpose and our core and what we’re trying to create. And also safety rates continuing to drop now below 10. We see lots of opportunity for further improvement there, and we need to continue to reduce that and ensure that our people go home safely every day.

And on Slide 13, the world-class value chain, good progress against Dry Store 4. The IWS program and manufacturing excellence is also continuing to make good progress. There’s an example there of Synlait Auckland reducing the unplanned downtime by 21% versus same period last year as we start to step up and use that facility more. Safe food and market access, I’ve talked to this being a key point of difference across our value chain. And actually, it’s a testament to the work that the guys do here. In the last half we’ve got 3 GACC registrations. The first one for our Synlait Auckland site for blending and canning infant formula registration. The second one, Synlait Pokeno recently received GACC general dairy registration, which covers IFB powders. And also, we’ve got GACC registration for our advanced dairy liquid facility. So those are well positioned to have market access into China. Synlait also hosted the Minister of the State Administration for Market Regulation in November at our Pokeno site. It was a great opportunity for us to showcase that site and make sure that key officials within the China regulatory team understand the role that we’re playing in terms of tapping high-quality museum ingredients and moving them to provide nutrition for Chinese families. And in healthier farming practices, some good progress there on our Lead –

With Pride program, which continues to be a best-in-class program (inaudible) farming. So I’ll finish up the sort of intro comments there. I’ll now pass to Nigel, who’ll kind of provide a bit of an update on our financial performance. I’ll be back to talk you later on.

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Nigel Greenwood, Synlait Milk Limited – CFO [3]

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Good morning, everyone. It’s nice to join all of you on the call again. So looking at Slide 15, results at a glance. So our net profit for the first half was down 30% on the last year’s first half. And that’s primarily as a result of the higher depreciation and interest costs that we incurred and now associated with the commissioning of both our Pokeno site and our liquid milk plant. Positive news that we had was, as Leon mentioned earlier, was a 22% increase in our infant formula sales, reflecting that we are still seeing strong growth in our core business. We processed 8.5% more milk as a result of taking on milk supply and to support our Pokeno plant. However, we did sell less ingredient products in the first half, mainly due to delivery delays and product mix issues that will see higher volumes of ingredient sales coming through in the second half, which will support our full year guidance. As we communicated back in February, the key reasons for our lower first half result were the increased interest manufacturing and SG&A costs associated with the Pokeno and advanced dairy liquid processing plants. The lower sales volumes of our ingredient products than anticipated due to sales phasing and product mix impacts and also the lower sales of our infant base products due to the consolidation of the China infant nutrition market.

Moving on to sales volume and inventory. Total revenue is up 19% to $560 million, again, reflecting the growth of our business, but also the higher commodity price market we are in versus first half last year. We increased our sales of infant formula by 22%. We are holding more inventory at half year than we did this time last year by 9%. That’s partly driven by increased milk that we’re getting through Pokeno, but also for sales phasing issues that I mentioned earlier that will see higher volumes of products sold in the second half. And we had made a conscious decision to manufacture higher levels of infant base powder from fresh milk in the first half in order to reduce the amount of reprocessing that we have to do in the second half as we ramp up our infant formula production. And also pleasing to see our lactoferrin volumes increase in production in the first half as well as we now have both of our lactoferrin plants operating at capacity. Production volume, already talked to the increased milk processed and the total production being up on last year. Product mix moved towards consumer packaged infant formula, with 19% last year up to 24% this year, again, reflecting our — converting our milk solids into higher-value product production. Lactoferrin production up. We now have both plants operating. With the acquisition of Talbot Forest Cheese on the 1st of August last year, we now have produced 2,000 tonne of cheese in the first half of that company. And our advanced liquid dairy packaging facility produced 15.5 million liters of cream for food stuff in the first half. Gross profit performance. Well, again, notwithstanding the lower net impact performance half-on-half, we are keeping our gross profit relatively line bar with last year at $83 million versus $86 million last year, reflecting the shift towards infant formula. So that’s driven by the increased sales of consumer packaged infant formula, but it’s offset by the drag that the Pokeno site, in particular, is having on our financial performance in the first half. We’ve also introduced a new measure or a new metric. Because we are now manufacturing both powders and liquids, it no longer is possible to reflect a gross margin per metric tonne effectively. So we’re now measuring the conversion of our kilograms of milk sold into higher-valued product, which is the gross profit per kilogram sold. So you can see from the chart on the right that we are still maintaining a very strong conversion rate of our kilograms that we receive in and to the — converting them into high profit performing products. Overheads are up 27% to $37 million. That’s again driven by increased focus on our growth opportunities, but also as a consequence of taking on new facilities, such as Talbot Forest Cheese and Pokeno, where they do bring increased overheads as well as establishing our China office. We incurred some upfront costs and then the establishment of that, that will smooth out over time. And of course, we continue to see increases in our employee cost in the back office. Having said that, the last pillar point is very important in this very challenging environment and uncertain environment in which we are all operating. We are having a very strong focus at looking at our overhead expenditure in the second half and have a process underway to ensure that we manage that effectively. We only spend what we need to spend, and we would expect to see some reasonably material reductions in our forecast overhead spend in the second half of the year as a consequence of the review currently underway.

Operating cash flow was down in the first half this last year. That’s predominantly a result of the lower ingredient deliveries that we’ve experienced and seeing higher inventories being held at the half year. We are a seasonal business, we’ve always talked about being a seasonal business, and we will see stronger operating cash flows come through in the second half through the sell-down of our inventory, the increased sales of infant formula and also lactoferrin. So we remain positive about achieving a very strong overall operating cash flow for the full year.

Net debt has increased significantly from the first half last year. And of course, that’s as a consequence of the investments we made into Pokeno and liquid milk, the investment we made into Talbot Forest Cheese as well. So that’s of no surprise. Having said that, we are now in a somewhat better position, having done the bond issue in December last year. And we consider ourselves very fortunate that we got that completed and got that done at the right time because that reduces our exposure to our banking partners, and ensures that we’ve got committed debt facilities of $180 million for the next 5 years. We’ve still got some major investments to complete over the next half, previously signaled to the market being the payment for the Dairyworks acquisition of approximately $112 million and also the purchase of our 2 dairy farms of $26 million. With all that said, our current forecast give us confidence that we will remain within our banking covenants through to the end of the year, albeit at slightly higher ratios than previously anticipated, but we remain comfortable that we should achieve that outcome.

And that’s the completion of the slides that I’m presenting, and I will now hand back to Leon.

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Leon Clement, Synlait Milk Limited – CEO [4]

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Thank you, Nigel. So I’ll just move to outlook and some context slides for the dynamic within our business, which I think are also helpful when we’ll pick up in subsequent conversations with many of you. Look, Nigel mentioned this before and on Slide 23, we really just want to flag that we are a seasonal business. We’d encourage you to continue to look at us on a year-on-year basis. And then there are some key factors that have historically driven that, that remain true. If anything, the seasonality of half-on-half or a lower first half and a stronger second half continue to evolve in our business. The first one is, as you can see on the chart on the right is expectations that we will have a very strong first second half in our Infant Nutrition business. You can see from the FY ’19 second half that we had a run rate exiting there of 25,000-odd tonne. We did feel that, that was a good starting point for our full year forecast this year. And clearly, that was one of the reasons why we came out with this guidance update in February, we’ve seen in the first half that moderated down to 21,500 tonne. We do see a strong second half coming back, which should land us just below 50,000 in the consumer package infant formula sales for the full year.

The other factor that is materially impacting our seasonality as we’ve stood up our second plant in lactoferrin, we do see sales matching our production volumes and output. We’ve increased our consumer — our lactoferrin sales to 7.7 metric tonnes. We see quite a significant build in the second half. And I would like to flag that both volume and prices will be well up on what we achieved last year. We did flag that we saw some moderation in our initial assumptions on pricing, that does not mean that we are seeing a decline in both price and volume versus same period last year for the second half. And lactoferrin continues to contribute really positively to our organization. And finally, just to flag that Pokeno has been running for 4 months in the first half, it will run for 6 months in the second. So that’s another factor that supports both operational output, overhead recoveries as we move into the second half.

So full year outlook, the slide on Page 24, just peels back the onion a little bit on our NPAT outlook. And we’re just making sure that it’s well understood that our earnings growth is forecast to grow this year at an EBITDA level. And the key driver why NPAT is moderating to flat — to a soft decline, is because of the depreciation and financing costs associated with us creating new opportunities. So EBITDA to grow, NPAT broadly flat to slightly declining, driven by a significant step-up in the depreciation and financing costs. And they are coming because we’re creating exciting new future opportunities for our business. At the start of this year, we expected that our earnings will grow through that and allow us to grow both EBITDA and NPAT. That hasn’t transpired for the assumptions that we stepped you through in February. But look, we’re still excited about the future of our organization as we start to bring utilization on to our plants. And that’s the key driver for us.

So if you move to Slide 25, I think it’s just a really simple diagram that shows the dynamic in our core business and how that’s being offset by the cost to accommodate future opportunities as we go forward. Effectively, our strong core business growth, if we did nothing and did not invest in new liquids or new capacity for Infant Nutrition, as we have, we would see our core business growing circa $25 million to $30 million this year. However, we would not be creating or seeking the future earnings growth that we see and the opportunities that are up there both for our customers and for ourselves. Offsetting that strong business growth of circa $25 million to $30 million are the cost to accommodate future growth. And effectively, it’s a balancing figure this year. So those costs are, again, in the same range of $25 million to $30 million. At the start of the year, we felt that we potentially had $30 million to $35 million, even $40 million that we have coming through in our core business. And as that washed through, we would have also seen the cost to accommodate future growth be a little bit later.

So at the moment, as we start to fill facilities, this is a key dynamic in our business and a core part of what’s sitting in behind our forecast result this year. But also why we remain really optimistic about moving forward into next year.

And then if you look at Page 26, this is not a new dynamic for us. We’ve just done some analysis on the return on capital and employed profile. We are a capital-intensive business and to create future opportunities, we have to invest. And what you can see from the chart is every time we’ve invested, a return on capital employed has dropped a little bit and then increased as utilization and capacity has been filled. So you can see that happened when we brought on our second dryer. You can see it on the third dryer, where that net operating asset comes up, return on capital goes down, and that’s the same dynamic this year with a significant step-up in our net operating assets. Return on capital, moderating down, a little bit of a salted profile in the return on capital, it will start to grow again as we fill things up.

Slide 27 just talks and gives a little bit of color, I think, to how we develop customer opportunities, which is important because that’s what we’re chasing to fill up our plants. Synlait’s always focused on doing that differently for a healthy world. We’re focused on creating value of the products and the milk pool that we collect. And that means we focus and put a lot of attention into creating high-value customer opportunities and attracting customers that value what we do with future growth. And this is how we assess both potential markets and potential customers, how we take them through our pipeline. But it does mean that sometimes the higher value opportunities for us take longer to build. And that’s the key message here, and we’re working on a number of those opportunities that we look forward to updating you on.

At 28, just talk to you a little bit about how we’re thinking about Pokeno. Look, these are illustrative slides, but as we commission that factory, we’re largely doing so on an ingredient position. We start to populate more utilization, higher growth with higher infant grade products, which drive stronger returns and strong overhead recoveries as we start to move through that and lift our return on capital employed profile for that facility.

So coming to the last slide around guidance and then some key takeaways for me just to finish up. The guidance update, we remain really comfortable with our range at the moment. There’s a few things that are obviously developing because of the evolving situation with COVID-19. But look, our range, we’re holding at $70 million to $85 million, supported by strong consumer packaged infant formula sales. As we mentioned at the recent update, we’ve got the incremental cost of Pokeno coming on. We have the infant base powders that have dropped away a little bit as we’ve seen that market consolidate. We’re looking to build that pipeline again. We have the higher fixed costs as we invest in future growth opportunities, and lactoferrin with strong pricing and volumes continues to contribute. Some of you may be wondering whether the Dairyworks acquisition has a material impact on our guidance range. Yes, we will be picking up from the 1st of April in earnings streams there. At an NPAT level, that contributes about $2 million to our bottom line. But as we’ve seen, we’ve also seen a sort of an escalation of the COVID-19 impacts and the wider certainty that exists when we made that initial guidance update. And those are some of the factors that are leaving us pretty comfortable with where we’re sitting at the moment in terms of our range.

So last slide for me, and then we’ll open up for questions. Slide 30, key takeaways from today. Our core business continues to perform well. It’s an extension of the strong growth story that is part of what Synlait is about. We’re really confident that we can maintain previous margins under the extended a2 Milk Company agreement that has us at a minimum working out under exclusivity to July 2025. Our customer pipeline remains strong. We’ve got good material opportunities well progressed across both our facilities. Dairyworks is going to provide a great base for us to continue to build on with an earnings stream in the next 2 years, developing a $15 million to $20 million at an EBITDA level.

So despite the moderation in our expectations this year, I hope that gives you some context into the dynamic that we’re working through. As our core business and our new opportunities to continue to grow, we will push through some of the costs that are coming online to create future opportunities. And we remain really confident that we are building a strong and sustainable company that we can all be proud of, and we think that you should be, too.

So those are the key takeaways from today. And it concludes the key materials that we wanted to cover off. Obviously, a lot of detail in the pack, a lot to understand, but we can open now for some questions. Thank you.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Chelsea Leadbetter with Forsyth Barr.

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Chelsea Arna Leadbetter, Forsyth Barr Group Ltd., Research Division – Senior Analyst of Equities [2]

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I guess, couple of questions for now from me. If I can start with picking up on your comment, Nigel, around material reductions in OpEx and some of the things, I guess, you’re putting in place, your initiatives for the second half. Can you give us a little more context on, I mean, the areas that’s coming from, just, I guess, trying to understand the pathway, not just second half, but further out? And then secondly, is that already factored into your guidance update?

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Nigel Greenwood, Synlait Milk Limited – CFO [3]

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Well, the obvious area is out there. I mean, clearly, as an organization right now, we basically are not traveling. So all the sort of costs associated with the travel will be significantly reviewed and significantly reduced for the out turn period. Working on the assumption that, that the restrictions on travel or the obvious ones will probably last through June, July period. Travel and entertainment, again, that’s part of a core business that you’re constantly undertaking. That’s likely to be very minimized. The training and conferences, all of those sorts of expenditure. It’s going to be completely cut back. We’re also — but in addition to that, we’re also focusing on what our priorities are in the business. Working under this arrangement, we need to make sure that our teams are focused on the core priorities. So some of the initiatives that we had that — but we would also wanted to invest time and money into — we’re probably going to put on the back burner and focus on those core priorities that we need to make sure we deliver on this year and into the future. So really, it’s across the board. And I guess the message that I was wanting to ensure the market got was that Synlait as an organization is not just standing back and saying, well, in this challenging environment, we just keep on continuing to spend. We are going to be looking carefully at our expenditure to make sure that we focus it on where it makes a difference. I hope that gives you some context.

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Chelsea Arna Leadbetter, Forsyth Barr Group Ltd., Research Division – Senior Analyst of Equities [4]

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Yes. Okay. And is that already in the guidance range that you’ve put, can you reiterate it?

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Nigel Greenwood, Synlait Milk Limited – CFO [5]

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Yes. Look, you could argue that it isn’t because some of it was, I would say. Because in our previous guidance, we had undertaken some assumptions around expenditure savings or less expenditure in the second half. But I think what we’re saying now is we believe that there is even more that we can take up. But of course, we remain uncertain around the potential risks associated with the COVID-19. And so we need to be aware of that as well.

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Chelsea Arna Leadbetter, Forsyth Barr Group Ltd., Research Division – Senior Analyst of Equities [6]

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Okay. And I guess, just changing check a little bit. In terms of registration, in fact, just thinking about SAMR in particular. You mentioned SAMR came down November 2019. And also, I guess, just — could you give an update on how you’re seeing that process in the current environment? Perhaps how we should think about getting registration for a2 from Pokeno and then perhaps were other finished infant formula customers are selling because there hasn’t been any mention, have you put that on the back burner at this point? Or how do we think about that?

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Leon Clement, Synlait Milk Limited – CEO [7]

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Yes. Thanks, Chelsea. So yes, we did host the Minister of SAMR. And again, it was a high-level visit to make sure that we were showcasing the best that New Zealand has to offer. And I think it just was a great opportunity to demonstrate the world-class facility that we do have at Pokeno. Look, I think in terms of registrations and what we are seeing. Look, I suspect that the state administration for market regulation is also distracted by many other issues at the moment. So it’s a little hard to see how the current situation will evolve. As we had spoken to previously, we are seeing some progress there and some — with some registrations being completed or given to 2 players in other countries. We’re yet to understand if that will evolve for New Zealand. However, look, I suppose the way that we’re thinking about it is I think that the SAMR process is now a little more embedded and in place. We think that effectively, the way that we’re looking at this strategically as it feels a bit more like we’re moving towards fewer, bigger players in China sooner than we expected. And that’s why we’re saying, look, we’re just pivoting our focus and perhaps not holding out hopes that we’ll be able to back the next big thing in infant nutrition. But it enhances our credibility and opportunity to partner with established players, of which we see a2 being — building a strong leadership position in China and making us more attractive to established players in that space. And we think that the regulatory climate continues to evolve towards that. And the regulatory climate continues to move towards the fact that we are an integrated model and supporting the fact that we have invested heavily in those aspects of our value chain.

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Chelsea Arna Leadbetter, Forsyth Barr Group Ltd., Research Division – Senior Analyst of Equities [8]

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Okay. I appreciate the color. And just last question, I guess, in terms of what you’re seeing with respect to supply chain. At the moment, you talk about space availability and shipping schedules, obviously. I guess can you just give us an update on prioritization? And how that’s sort of working at the moment? I appreciate things are probably evolving pretty quickly. But just, I guess, how that’s working now? And also what the cost or has there been cost escalation? And how you’re seeing that?

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Leon Clement, Synlait Milk Limited – CEO [9]

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Yes. Okay. I think around supply chain, there were 2 key areas that sort of emerged quite early. Can we get the ingredients we need, particularly when we’re sourcing from plants around the world? And I think we’ve done some good work there. And whilst there was some initial risk that we saw emerging, we have been able to either look at contingency plans for those raw materials. And we’ve actually seen some operations start to restart again and are up and running and supply chain seem open. We were able to airfreight some product in to just make sure we had some extra cover, with global airlines and the amount of movement starting to shut down pretty quickly. And I’m unsure that’s something we can rely on, but it’s provided some good buffer for them in the short term. The second area around supply chain was around shipping and the availability of containers, especially for outbound empty containers as we saw supply chain start to shut down. And we had some concern around the availability of those export containers, probably as recent as last week. However, we are starting to see that unlock. And look, I think that we’ve got great relationships with our shippers and because of that, they’re able to prioritize capacity for us. And at this stage, I’m not seeing any pricing escalation coming out of that. So look, I have to say I was probably more nervous about this a week to 10 days ago, but increasingly feeling more confident as we’re starting to see it unlock. And hopefully, it stays that way.

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Operator [10]

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The next question comes from Aaron Yeoh with Goldman Sachs.

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Aaron Yeoh, Goldman Sachs Group Inc., Research Division – Equity Analyst [11]

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First question for me, just with regard to your comment on lactoferrin. It sounds like the overall outlook around that seems to have improved since February. Just wondering what you’re observing in the market, I guess, which has sort of driven, I guess, is slightly sort of rosier outlook?

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Nigel Greenwood, Synlait Milk Limited – CFO [12]

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Yes. Well, I guess there is a — well, thanks for the question, Aaron. I think what we’re doing is clarifying that what we were saying on our guidance update is our expectations of pricing has moderated down. What we’re trying to reinforce is, however, we still expect pricing and volume to be higher than last year. It’s just that when we set our expectations for this year and our guidance at the start of the year, we expected higher pricing. And look, I will flag that a very small moderation in lactoferrin pricing, $100 or $200 a kilo can have quite a material impact on what we expect coming off that. So it is quite sensitive to our overall business in terms of the earnings streams that we get from lactoferrin. So the first point is, are we calling that this is slightly rosier? No, I don’t think we are. We’re really just saying that don’t forget that our lactoferrin sales will grow materially on last year, albeit our assumptions have moderated down from our earlier guidance. And that’s what was one of the key factors of moving that assumption down. Having said that, I think we are seeing some firming. And — but it’s in line with the expectations that we put out in our guidance statement. A little bit unclear on what exactly are the drivers are, but we’ve got good leads in seeing pricing firming out of China, in particular for some of our customers in that space. But look, they’re broadly in line with our current assumptions. So I hope that helps, Aaron.

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Aaron Yeoh, Goldman Sachs Group Inc., Research Division – Equity Analyst [13]

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Yes. Sure. And then I was just wondering in terms of how to think about the sort of step-up in costs in the first half with relation to Pokeno commissioning? And I guess, specifically, how we should think about the sort of second half operating expenses in relation to the first half? I know that obviously, Pokeno has been — was running for, I guess, 4 months in the first half. And then in the second half, obviously, you’ll be sort of fully sort of running. Is that sort of the proportion, in addition to the 2 months operating expenses? Is that how we sort of think about it? Or are there some start-up costs in the first half?

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Leon Clement, Synlait Milk Limited – CEO [14]

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No. Generally speaking, when I get questions like this one about — thinking about Pokeno in isolation. It’s problematic because we obviously operate our drivers and allocate production to where it most makes sense. So from your perspective, obviously, you should assume that Pokeno is going to be operating for the full second half, and it will be. So there’ll be a full second half absorption of interest and depreciation costs associated with — and manufacturing overheads associated with it. We’ll also be processing all the milk we received through Pokeno in the second half as well, getting some recovery through overhead recoveries and margin on the products we make from that. But from a modeling point of view, if you’re thinking about it that way, then you need to look at it from a total demand perspective. What is our total anticipated demand for infant formula, for ingredients and lactoferrin? How we allocate that to various plants is not really the key issue here, it’s rather what are the expected return that we expect to get in that second half. We provided you with very good insight in the outlook section of the deck, to give you a lot more insight as to the sort of volumes you might expect we’re going to do for the full half, for the second half and therefore, for the full year. So I think try to just focus on try to work out a P&L for Pokeno and its own self is not the most effective way to think about it. But I hope I’ve given you enough information to understand how that’s going to work.

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Aaron Yeoh, Goldman Sachs Group Inc., Research Division – Equity Analyst [15]

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Yes. Sure. And then, Nigel, just you mentioned, I guess, a2’s intention with regards to participation in manufacturing. I’m just wondering, I guess, from your understanding, why do you think a2 is looking to participate in manufacturing, particularly given the fact that Pokeno is starting to sort of ramp-up, and so that single site risk isn’t really as much of a risk as it was before?

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Nigel Greenwood, Synlait Milk Limited – CFO [16]

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Look, I can’t comment on behalf of a a2 around their intentions. But I’ve said what their intentions are to participate in manufacturing. And look, I think we’re looking forward to discussions with them. And as long as they recognize the expertise that we bring. So look, I think that we bring a lot to the a2 partnership. We obviously play a strong role in helping ensure that they have market access into their key market in China. We’ve invested significantly out of the history of the business and an integrated value chain, which we see the regulatory climate moving towards and that’s important as we move forward to protect the share value that we create. The a2 Synlait model has been highly competitive from an infant manufacturing perspective in terms of our competitive set. We continue to share the benefits of scale with a2, and we look forward to those discussions and ensuring that they recognize some of those expertise and what we bring to the table.

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Operator [17]

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The next question comes from Stephen Ridgewell with Craigs.

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Stephen Ridgewell, Craigs Investment Partners Limited, Research Division – Deputy Head of Institutional Research [18]

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Just to follow-up on the discussion on overhead. Thanks for the color earlier, Nigel, on where those cuts might come from. I’m just wondering now if you could help us quantify that. So it was — as you mentioned, it was 37% in the first half. And what should we be thinking about overhead growth for the full year?

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Nigel Greenwood, Synlait Milk Limited – CFO [19]

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Yes. When you say overhead, I assume you’re — specifically, you’re referring to sort of SG&A costs, right?

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Stephen Ridgewell, Craigs Investment Partners Limited, Research Division – Deputy Head of Institutional Research [20]

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Yes.

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Nigel Greenwood, Synlait Milk Limited – CFO [21]

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So look, we haven’t given specific guidance around what we expect our SG&A cost to be for the second half, but it’s a fair question. What I would like — would like you to think about it is that, if you would assume, what’s the easy way to think about it? Well, if we took the first half and there was some annualized — because you often get the impact of annualized labor costs. So if you took that and doubled it for the second half and maybe edit a lot more if we did nothing different, that would be a sort of a starting point. Then assume, take off from that, the assumption, the reasonable assumption that we’re going to be doing a very deep dive in now in terms of our ability to retain, restrict spend only what we need to, to remove costs that are simply aren’t going to occur now because they won’t be undertaking a number of activities that I talked about earlier. And that they could be — when I say material, I’m talking about — in the millions, not the hundreds of thousands. If that gives you some insight.

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Leon Clement, Synlait Milk Limited – CEO [22]

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Can I just add a little bit to that to Nigel’s point, I think he’s helping provide a bit of direction around how you might make assumptions for the second half. But strategically, I want to clarify, we’re not slashing and burning costs here. We’re moderating investment to make sure that our businesses set up appropriately for the new assumptions that we’re seeing emerging. So we’re going to be moderating down on the growth that you’ve seen historically and making sure that our organization is optimized and set up for success as we move forward in the future. So just from a strategic perspective, that’s how we’re looking at this.

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Stephen Ridgewell, Craigs Investment Partners Limited, Research Division – Deputy Head of Institutional Research [23]

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That’s helpful. And then just on Pokeno, the court hearing maybe the effect or may be delayed given what’s going on at the moment. But Leon, I mean, you sort of implied in the prepared remarks that the decision goes against Synlait, the business is not in a different position now. I just wonder if you can provide some additional commentary on that because I would say that there would be a potential range of outcomes here that some of those might be more from the company’s current position. And any contingency planning the company’s got in place if there is a kind of poor outcome there?

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Leon Clement, Synlait Milk Limited – CEO [24]

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Yes. No, thanks for asking for clarification there. Look, our legal advice suggests that the Supreme Court will not find an outcome that potentially is adverse for Synlait or limits our ability to operate the plant. That comes subsequently with any action that the neighbor then needs to take against us and a subsequent high court hearing if we lose. The case is about the removal of the covenants, not the operation of the site. So that’s why we’re framing it as if we win here, this was solved. If we lose, we’re broadly back to where we are today, where the neighbor would be obliged to take this case back to the High Court and seek some damages or outcomes that we would then need to work through again, which is why we’re feeling pretty confident about our legal position around that and looking forward to the Supreme Court case.

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Operator [25]

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The next question comes from Adrian Albon with Jarden.

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Adrian Allbon, [26]

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Can I ask two questions, please. You’ve obviously answered the question in the quarter a few different sort of, I guess, comments. But when you talk about — when you come back to your Slide 6 and you’re talking about the Chinese infant formula regulatory environment continuing to move towards the Synlait integrated model, are you — as what you suggest you’ve got some sort of signals that, that SAMR is going to — which sort of at the moment, when you think about your plant investment really designs the blending and canning part. Are you sort of seeing some signals that, that would sort of come back towards the heavy end of the capital investment in terms of the spray drives and stuff like that? Or are you sort of saying some sort of signal that you might have some sort of staple between SAMR and a get license, for example?

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Leon Clement, Synlait Milk Limited – CEO [27]

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Yes. Look, I think the answer to that is that we are seeing an evolution, or I guess, in some of the policy statements out of the regulatory and the policy settings that we’re seeing from regulators is that there is a movement towards the standardization of how they register plants and how they want to see integration and an integrated model being part of setting ourselves up for ensuring market access for China. And look, rather than getting into the sort of interpretation of all the different policy settings, probably the best way to describe it is, why would you think the China regulator would think that? They would think that because they’re trying to secure food safety for the industry and they want to make sure that players that participate in the industry have as much control around their entering value chain. And so players that have invested heavily to an integrated models like Synlait where we manage the blow of products from milk all the way to through to finished products, who hold the registrations. The registration for the safety of the product needs to sit against the factory. And so really, we’re just, I think, highlighting and flagging that increasingly, we’re seeing this idea that a separate blending and canning operation can source ingredients from a wider network of ingredients, players and spraygun is no longer a business model that we think will be sustainable. And the reason for that is that, obviously, the regulators are wanting to protect the rest of multiple players participating in that value chain and an integrated model is preferred. And Synlait has invested historically in that, and we feel that we’re well placed to benefit from that going forward.

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Adrian Allbon, [28]

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Okay. No, that’s helpful. The second question, just you touched on it when you sort of concluded and you’re sort of staying confident in sort of protecting the historical margins of the a2 Milk agreement. And those are — and the key driver there is your manufacturing efficiencies. But other than volume, what would be the key driver what we should understand operationally in terms of your ability to achieve that over time?

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Leon Clement, Synlait Milk Limited – CEO [29]

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Well, two things. Volume gives economies of scale. So as we’ve sort of described through the sort nature of our capital investments, when you establish a new facility, you’ve got overheads, you’ve got site services that you’re running across those. And as we have volume washing through those plants, we will generate efficiencies, that we’ve historically seen as we’ve done the same. Secondly, our IWS program continues to deliver benefits for us. And that program is focused on eliminating losses around time losses, waste and yield losses. We’ve got Dunsandel operating very efficiently and moving forward with the extension of our new facilities to generate manufacturing efficiencies there are very attainable. And I guess what I’m qualifying is that on the assumption that we continue to drive the manufacturing efficiencies that are available to us, and we know our realizable based on our track record, we’re really confident we can protect the margins that we’ve seen historically out of that relationship.

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Adrian Allbon, [30]

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Okay. So the way that we potentially would monitor that would be like you sort of did last year where we were able to process more milk versus what your stated previous manufacturing capacities were?

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Leon Clement, Synlait Milk Limited – CEO [31]

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Yes. On the basis that also when we process Infant Nutrition, we are processing lease milk because it has lease milk solids than normal powder. But — and that’s an optimization and product mix selection that we make. That also drives really strong efficiencies for our partners because we’re able to optimize our assets across that. But yes, look, I think it’s fair to say that the more we start to process an Infant Nutrition, and as that volume comes in, it’s reasonable to — we should be able to benefit from the scale opportunities to come with that and our own efficiency programs.

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Adrian Allbon, [32]

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Yes. I was just trying to understand what other drivers there are other than the volume driver, which the a2 argument could be that they provide in the volume argument?

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Nigel Greenwood, Synlait Milk Limited – CFO [33]

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Adrian, Nigel, here. Look, we often don’t openly talk about the reality that in any manufacturing operation, you always have times when you don’t manufacture product right first time. And whenever you don’t, you build in cost associated with delayed shipments, you having to look at retesting the product to see whether in speck or not a speck. And even in some cases where you’ve manufactured product that actually has to be written off to stock food. Now we absorb all those costs within our cost of sales. And whilst not indicating what the level of those sort of costs might well be. But the IWS program over time, you build into the sort of the operating ethos, the way the culture and the performance of the plant, absolute increased improvement and right first time production, which will have positive impacts on our overall costs of sales of the manufacturer of that product. And it flows through the organization, not just in the product write-off, but in terms of the increased capacity you have to be able to not have to remanufacture product and therefore, process more milk. The overheads that you incur working through and resolving issues that occur with that. And that’s all those sort of hidden costs associated with that type of impact can be taken out of the process. And they can be material over time.

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Adrian Allbon, [34]

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Okay. No, that’s useful in terms of — it’s basically just being continued to get better at what you do.

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Operator [35]

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The last question comes from Marcus Curley with UBS.

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Marcus Curley, UBS Investment Bank, Research Division – Executive Director and Head of New Zealand Research [36]

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I might try for three, if I can. Just very quickly, on the a2 discussions, where are you at on the manufacturing intentions? And when do you expect to publicize the outcomes?

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Leon Clement, Synlait Milk Limited – CEO [37]

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Thanks, Marcus. I’m not going to get drawn on where those conversations are at. We look forward to those discussions and the fact that they’ll recognize some of that expertise. But those conversations as they progress as confidential as they develop.

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Marcus Curley, UBS Investment Bank, Research Division – Executive Director and Head of New Zealand Research [38]

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Yes. Could you talk a little bit about many discussions with the government with regard to coronavirus and whether you’d be deemed an essential service, some suggestions that the government is going to move to shut down all nonessential businesses by the end of the week.

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Leon Clement, Synlait Milk Limited – CEO [39]

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Unsure at this stage, Marcus, we’ve been feeding our comments up through our industry sector at this stage and industry sector representatives are closely in touch with MPR representative. We’ll continue fitting that up, but I’m uncertain around how we might be classified.

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Marcus Curley, UBS Investment Bank, Research Division – Executive Director and Head of New Zealand Research [40]

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And then finally, Nigel, could you talk a little bit about where you think debt levels get to by the end of the year? And what the covenant looks — sorry, what the debt-to-EBITDA looks like at that stage?

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Nigel Greenwood, Synlait Milk Limited – CFO [41]

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Yes. Look, clearly, debt levels are going to be higher than where we previously anticipated. And it’s — I think with the leverage ratios, you’ll be where markets if you have a lower EBITDA than what you thought you’re going to have, that affects the bottom line — the bottom end of the curve. And if you then also have more debt because you’ve not got as much cash flow coming in. So it actually — it’s kind of a double whammy effect. So what I’m trying to say is that we substantially depend on where we land up at the end of the year in terms of our overall EBITDA performance. So — which is a reasonable range right now, as you can see. All I can say is even at the top end of that, if you like, at the bottom end of our EBITDA range, right? And therefore, the consequential net debt — total debt position, we are still comfortable that we will live within our existing bank covenants, and that will not be at risk. Having said that, they will at a much higher level than we had earlier anticipated. So it’s manageable. We’re obviously keeping a close watch on it. And again, I mean, it’s almost one of those sort of move points, I mean, your previous question. I mean if what you said happened, I mean, that would blow it all out the water, wouldn’t it? So — but assure me that we continue to operate and we deliver on our expectations. We will live within our covenant levels.

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Marcus Curley, UBS Investment Bank, Research Division – Executive Director and Head of New Zealand Research [42]

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I suppose I was hitting with this is, I suppose, when you look back at history of this business, with gearing where it’s likely to be at the end of the year, the business has normally raise money, like you’ve been obviously investing a lot, you’ve bought things, is equity an active decision at the moment? Or how do you think about equity?

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Nigel Greenwood, Synlait Milk Limited – CFO [43]

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Right. Well, look, we’ve also been through cycles before when we heavily invest in new assets and acquisitions. It also takes us to our leverage to a higher level on the basis that very quickly with operating cash flows coming through from the performance of those businesses and the subsequent years, we get our debt levels down quite quickly. And especially based at the moment when we’ve got no other significantly announced capital investments in the pipeline. So with that said, it really is one of those things where, obviously, the board actively monitors and considers with a equity raising is going to be considered necessary, but we’re also continuing to review our long-range forecast around performance of the business. And wouldn’t necessarily go-to-market to rise equity if they felt that the operating cash flows were going to bring net debt down over time. So it’s really one of those things that, right now, of course, that’s not on the table, but it is obviously considered at all times.

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Leon Clement, Synlait Milk Limited – CEO [44]

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Marcus, I’ll just add, and I think that’s a bit of a no comment from Nigel for obvious reasons. But look, we remain comfortable with our covenant levels and we are nearing — or we’re actually at the end of a significant investment cycle for the business. So our key role now for shifts to utilization, filling up capacity, making sure we generating earnings to start to pay for the investments that we’ve made.

All right. I think we’ll conclude the call there. Thank you very much for joining. Obviously, uncertain times for everybody, and I appreciate the time that you’ve given to Synlait despite other global distractions. So thank you very much, and we’ll see many of you potentially online by VC in the coming weeks.

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Operator [45]

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Thank you. Your speaker line is now back in a private conference.