Hello Beagle!
Your timing is good - Sep 2020 marks the 50th anniversary of the publication of Milton Friedman's seminal article in the New York Times entitled "A Friedman doctrine‐- The Social Responsibility Of Business Is to Increase Its Profits". It is well worth reading for any investor and being the anniversary there have been a lot of interesting articles published on the topic of shareholder versus stakeholder capitalism, and whether or not that is a false dichotomy.
Before I get into what may apply for Synlait, I just want to make the expand on a point I made in my previous post: the company has invested significantly in assets to make high specification milk powders, liquid products, and now has an interest in cheese production. While the court case is weighing somewhat on the minds of retail investors, the bigger issue for investors is the utilization of those assets with what products. If these assets are being filled with commodity products then the company will be at a cost disadvantage to Fonterra. When combined with the way the milk price is set, a high amount of commodities makes it very difficult for the company to make a reasonable return.
Thinking back to the profit warning earlier in the year, one of the items that stood out for me in the conference call after was the announcement that the company was pulling back on pursing additional infant formula business. If I understood it correctly, this also signalled a lack of confidence that regulatory approval could be gained to enable the fulfilment of the multi-year supply deals announced with New Hope in 2017 and Bright Dairy in 2018. It is not that I think they won't still be trying, but they just don't want analysts to include these sales in their forecasts.
When combined with the continuing effort of a2 to diversify its supply (while cunningly locking up all a2 milk in the country), is more than enough reason to explain the decline in the share price. Simply put: investors believe they see under-utilised expensive assets combined with a growth in operating costs that have been required to fund development activities and a high debt load for these plants. Longer term, as these assets are utilized I think that the company will do well, but right now the company has taken on risk by effectively building ahead of the demand curve. It's the entrepreneurial approach that can generate outsized returns, but in a market where all dairy companies are under pressure the company doesn't have a lot of room to maneuver unless its business development activities start generating quality margins. I am still a long-term investor though.
So, turning to the ECG stuff. Friedman's main point is that a single focus on profit maximisation is the only focus a company should have. A number of people at this time, took this as a justification to focus on short-term profits at the expense of stakeholders such as customers. This I think was a misinterpretation of his view, but unfortunately it held sway in the 1980s in particular where the movie Wall Street neatly encapsulated it in the Gordon Gecko's immortal line of "Greed, for lack of a better word, is good". Essentially this is a purely transactional view of the world that relies on perfect markets and a company's reputational value having little earning capacity for shareholders.
It also essentially ignores the importance of stakeholders in tightly regulated sensitive markets such as infant formula. The Chinese government has for many years now been trying its absolute hardest to grow its domestic manufacturing of infant formula, and indeed there are many domestic products on the market even after a series of scandals that essentially broke the business. But for an important (and somewhat price insensitive) segment of the market, they consider the reputation of Chinese businesses, and think about the ability of the Chinese government to actually temper their short-term profit focussed behaviour and buy overseas brands instead. Currently the top 4 brands in China account for 40% of the market.
Look to New Zealand examples as well. While generally well handled, the Botulism incident impacted the reputation of the entire NZ diary sector and it was months before high-value exports returned to normal. In the meantime our competitors in Europe and the USA had zero hesitation in using the doubt that this incident created to increase their marketshare. When combined with the growing concern over the environmental impact of dairy farming in NZ, the political and regulatory environment for NZ dairy companies has never been tougher.
In addition to the regular inspections required by MPI, customers that are buying high value milk products from NZ companies regularly conduct highly detailed invasive inspections of processes and rigorously test every single batch of product purchased. The problem for these customers is that they always have the risk that a supplier will take shortcuts without them knowing and somehow end up causing them a problem. For an infant formula customer, a problem that leads to a recall is not only a breach of trust but essentially a problem that leads to a brand death. So for them, a supplier that invests in ECG activities not only supports their brand's reputation but also strongly signals that it understands its role in preserving the value chain.
For smaller competitors like Synlait then, which may also be looking to develop a consumer brand, my conclusion is that the embrace of a focus on ECG activities is not at odds with profit maximisation, but a strategy to ensure long term profits through being able to sell high margin products to customers. The success of these activities is therefore not about boosting short-term profits but about ensuring the long term success of the business and the consequent return to shareholders.
So, overall I think that you are right to raise concerns about how equity and debt funding is being invested in assets, but I think that you are overlooking the fact that the investment in ECG activities is in itself a risk mitigation and growth strategy that has the goal of ensuring long-term profitability at its heart. I get that you don't see ECG activities as a risk management activity, but that is the logic!
As a coda to these thoughts, I think that it is too early to call Leon Clements reign as CEO a failure. The reason for this is that the three elements you have been focussed on, Pokeno, ESG activities and corporate rebranding, were all initiated sometime prior to his joining the company by prior leadership and the board. Execution of the brand building ESG activities was probably one of the main reasons he was employed. I can give him a pass for the most part for the first 12-months as the company's direction was fairly set, but what I am looking for now is evidence that the company is growing high-value customers beyond a2.
Cheers, Chris W.