Synlait doubles down on Dairyworks amid global coronavirus pandemic

Monday, 6 April 2020

Mergers and acquisitions are a risky business. The right deal can transform a company and boost income and growth. The wrong deal can leave a business lumbered with debt, lower profits, and shareholder discontent.

A takeover during an unprecedented global pandemic, however, is another matter entirely. 

In October, dairy company Synlait announced a $112 million deal to buy Christchurch cheese-maker Dairyworks.

The deal was heralded as an opportunity for Synlait, a key producer for a2 Milk, to diversify further into consumer-branded products.

**READ MORE:

* Synlait buys dairy farm next to Canterbury factory for $25.7m

* Synlait poised to buy Dairyworks

* Synlait's partner defers infant formula registration process in the US

* More than $400m of Synlait Milk developments on track**

Synlait was poised to complete the takeover in early April, but the two companies will join up in a markedly different world.

The dairy sector is scrambling to assess the impact of the Covid-19 coronavirus pandemic. Synlait has already suffered a torrid year, with its share price falling from $10 to just $4.95 as of March 23.

Consolidation in China's infant formula market, the price volatility of key product lactoferrin, and investments in factories have taken their toll on profits.

Amid the escalating coronavirus crisis, the Dairyworks deal looks riskier than it did five months ago. Will Synlait's finances come under pressure? And how has the new global crisis impacted plans so far? 

The rationale behind the Dairyworks deal remains clear. With cheese, butter, and ice cream brands, Dairyworks gives Synlait more direct exposure to Kiwi consumers.

Synlait will be able to supply Dairyworks, and the business fits neatly with its other cheese-maker, Talbot Forest, acquired last year. 

The deal also means Synlait is less reliant on its main source of income, the manufacturing and supply partnership it has with a2 Milk.

'Historically, they have been highly exposed to a2, and they're looking to diversify,' says Chelsea Leadbetter, an analyst at Forsyth Barr.

'We're trying to understand the returns that come from this category compared with infant formula, as this category [consumer] usually has a lower return profile.'

Dairyworks has performed strongly since the takeover was announced, making its $112m price tag look slightly better value for money.

Its upturn in performance provides a counterbalance to Synlait's recent woes. Synlait expects to make a profit of between $70m and $85m this year, compared to last year's $82.2m.

'The [Dairyworks] price didn't look out of touch with similar assets in that category,' Leadbetter says. 'But it's difficult to know in today's environment. Things are changing, and they are changing quite fast,' she says.

Synlait's balance sheet is likely to come under more strain after the takeover, especially as the global economy heads towards one of the deepest financial crises in history. Synlait's debt increased by $159.7m to $447.4m in the six months to January, and the deal may take longer to pay off in a steep downturn. 

Leadbetter says: 'Synlait is a cash-generative business, so debt should come down quite quickly. However, in the environment we're in, gearing is the one thing you'd want to be aware of.'

According to Marcus Curley, an analyst at UBS, Synlait shouldn't have too many problems absorbing the cost of the Dairyworks acquisition. Curley describes the deal as a 'bolt-on' for Synlait.

'In itself, it's not that big a deal,' Curley says.

'Synlait had debt at a comfortable level, and this puts it at the upper end of what it normally would be. However, the timing is not ideal. They are taking on debt at a time when you want less of it.'

Synlait says it is on a sound footing. The company issued new debt at the end of last year, 'reducing our exposure and reliance on our banking partners', according to chief executive Leon Clement.

Clement says the business is 'nearing the end of its current investment cycle'. 

The coronavirus continues to take a stranglehold on the New Zealand economy. The NZX is down more than 22 per cent in the year-to-date. With the economy expected to grind to a halt, the crisis will put more pressure on Synlait. It is considered an 'essential' business, so will remain open during the national lockdown.

The diary sector believes it can withstand the coronavirus crisis. Dairy businesses, including Fonterra, had already agreed most of their full-year supply contracts before the crisis deepened. Meanwhile, a2 Milk indicated covid-19 had a positive impact on infant formula sales in the first two months of 2020.

Synlait has played down the potential impact of covid-19, so far. Last month, the company announced its half-year profit was down 30 per cent from the same period the previous year due to shipping issues and a 'timing issue' exporting products. Revenue was up 19 per cent for the six months. 

On a call with investors and analysts on March 19, Clement says he is encouraged by current dairy prices. He says the dairy sector is 'holding up fairly well' and is 'resilient' at this stage. 

'We are not seeing a significant operational impact to date,' Clement told analysts, speaking days before the nation went into alert level 3 and 4.

'We are feeling reasonably comfortable with the supply chain at this stage, we don't foresee any immediate impacts, but with the uncertainty, we are monitoring this daily.'

As customers flock to the supermarkets to stock up during the coronavirus lockdown, Synlait might even benefit from its increased exposure to consumer staples in the near-term.

Leadbetter says says: 'Dairyworks is exposed to cheese and butter, which are consumer staples, and less discretionary than other categories. So that may be beneficial to them.'

While the Dairyworks acquisition completes at one of the most volatile times in recent history, Synlait believes its bet on consumer goods will pay off.

Clement says: 'We'll now be closer to the consumer at a time when more New Zealanders are eating at home and going to the supermarket to ensure they are well-prepared for the uncertain times ahead.'