Oliver Mander: How former dance partners A2 Milk and Synlait have drifted apart

Synlait has begun to lag its strategic partner. Photo / File

COMMENT:

Infant formula companies Synlait and a2 Milk had a history of moving in correlation to each other, a glamorous dance that appears to have ended abruptly about 9-12 months ago.

Given A2 infant formula is 'so hot right now', why has a share price divergence appeared between the fortunes of the two brightest talents on the dance card?

All share prices have their ups and downs. But even allowing for the vagaries of market sentiment, Synlait has begun to lag its strategic partner. The story behind this warranted a single note buried deep in Synlait's last issued financial statements in September 2019.

Graph

The two companies danced beautifully together through 2017, 2018 and into the first quarter of 2019 - riding the boom of Chinese infant formula. But the seeds of future doubt had already been planted in February 2018, when Synlait purchased land at Pokeno, south of Auckland, and began construction of a dairy processing plant to serve the Waikato.

Part of the purchase agreement included Synlait securing a release from a covenant on the land that restricted activity to farming, forestry and lifestyle blocks. This decision was only granted by the High Court in November 2018, when construction was well underway. A neighbouring landowner appealed the decision to the Court of Appeal, which reinstated the covenants. Synlait has been granted leave to appeal to the Supreme Court, which is expected to hear the case in late April.

From my perspective, it is the uncertainty around the future of Synlait's $280 million investment in Pokeno that has resulted in a steady downward trend in Synlait's share price since March 2019.

At the same time, a2 Milk seemed like it could (still) do no wrong. Volatility in its share price in mid-2019 reflected some uncertainty as to the effectiveness of increased marketing costs to maintain its margins, but the result announced in August propelled the stock to a new high of $18. This was followed in November by an upgrade in 2020 earnings expectations.

On February 13, Synlait delivered another hammer blow to the market, with a downgrade to its 2020 earnings expectations – partly created by increased costs associated with its Pokeno operation. That triggered a fall of nearly 25 per cent in Synlait's quoted share price.

Insights for A2

Tellingly, the Synlait announcement stated that sales of consumer-packaged infant formula volumes "have increased against the corresponding half year period" and "the a2 Milk Company's contribution to this growth has not changed".

That's good news for a2 shareholders. The pair are linked through an exclusive supply arrangement until July 2025 for infant formula for China, Australia and New Zealand.

A2 went so far as to announce that "its business performance remains strong and it continues to be in compliance with its continuous disclosure obligations". So, nothing to see here. Judging by the increases in a2's share price recently, investors expect the company to at least meet consensus forecasts to June 2020 ($1.665 billion in revenue, with net earnings of $345m).

In addition to Pokeno, Synlait was also likely to have been caught out by changes to its new revenue sources, with new markets (such as liquid milk) incurring more costs than expected. Coupled with its share price chart over the last few months, it looks like an organisation distracted by its Pokeno legal issues.

Upcoming results

My view is that Synlait's immediate future is heavily dependent on the outcome of the Supreme Court hearings in late April, relegating its March results announcement to a mere curtain-raiser.

A positive outcome will have a long-term beneficial impact on its volume sales and margins, offsetting the fixed costs it is now incurring with the new plant. With about a quarter of Synlait's total assets invested in Pokeno, a negative Supreme Court outcome will likely result in further significant impacts for shareholders.

When it comes to a2 Milk, it will be interesting to assess progress in the US liquid milk market on results day – this has potential to be the "next leg" of growth in the same way that sales of packaged infant formula within China have ballooned over the last 5 years.

Also of interest is whether Chinese growth rates and margins meet expectations. Synlait's announcement gives a hint that the growth rate, at least, will be met.

A2 Milk holds a 17.4 per cent shareholding in Synlait. Photo / Supplied

A2 also holds a 17.4 per cent shareholding in Synlait, with half of that purchased at over $11 per share. The reduction in Synlait's market value has a very real, albeit non-cash, impact on a2's balance sheet. This in itself is unlikely to spook investors.

Coronavirus represents downside risk for both companies, thanks to logistics and trade impacts. Investors will be watching keenly for any impact on sales.

Will the share prices ever dance again?

The two companies operate very different business models. The capital-light nature of a2's marketing investment means a much lower capital base compared to the asset-intensive nature of dairy product manufacturing and packaging. Those same assets, however, give a solid footprint for Synlait to participate in the market, whereas a2's risks relate to long-term margin erosion and 'commoditisation' of its key products.

In my opinion Synlait will benefit in the long-term from the diversified product range and customer base it is trying to create, but faces significant timing challenges to match revenues with its new (increasing) cost base. Depending on the outcome of the Supreme Court hearings, it may also face a significant re-investment challenge.

A2's next growth drivers will take it into areas outside of its exclusive deal with Synlait.

It is likely that its strategic relationship with Fonterra, announced in August 2018, will have an impact on a2's supply diversity; the company has already signalled increased sourcing from Fonterra during late 2019.

Therefore it is likely that the dance card won't feature another sizzling tango from these two, even though they remain strategically important to each other. Who knows … their share price charts might end up as 'just good friends'.

Disclosure: Oliver Mander has a family investment company and works as a business planner and strategist. He is a long-term shareholder in the A2 Milk Company.