SML - Synlait Milk Ltd

[chrisw]

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.

...Milton Friedman's pure capitalist view was front and central and certainly shaped my thinking at the time. His view if I remember correctly was that maximization of profit was the sole responsibility of a company and provided whatever they did to achieve that was within the rules that was okay.
...

It seems to me that Synlait directors play fast and loose with shareholders money and are shirking their responsibility to mitigate risk. Might be worth the directors time to read this https://corpgov.law.harvard.edu/2018...f-directors-5/

I think Synlait have taken ESG to the extreme and risk taking with Pokeno as well. No doubt shareholders can "look forward" to Synlait endlessly pontificating in their annual report and shareholder presentation about how they're meeting the most stringent carbon neutral processes, implementing widespread inclusiveness policies within the company, paying a living wage and they will wax lyrical about all the ways they are benefiting the planet and people because remember, these are just as important as shareholders...but all that time they fiddle while Rome burns and the risks they have taken with Pokeno are extreme to say the least and their debt level's keep on rising.

ESG is all about environment social and Governance. Shareholders could be easily forgiven for thinking the directors have almost completely overlooked governance.
Maybe there is wisdom in their methodologies but I struggle to see it and the market seems to agree with me.
The trend is not shareholders friend and it would seem that neither are management or the directors which begs the question seeing as capital is mobile with many other choices for a better home, why bother ?

I'm calling it. Leon Clement's appointment has been a complete failure for shareholders. He has presided over a massive destruction in shareholder value and his obsession with all things ESG has been massively harmful to shareholders. He needs to go ! (Very early on I called it that Herdlicka was a very bad fit for ATM and that call was bang on the money).

[dreamcatcher]

but what I am looking for now is evidence that the company is growing high-value customers beyond a2.

imo.. can only happen once Pokeno decision is clear

[Leftfield]

Blimmin good post Chrisw. Good to hear a different perspective on some rather grumpy dogged rants.

[winner69]

Good post there Chris ....couldn't have said it better myself

This paragraph is worth reposting .....in a funny (or maybe sad) sort of way it’s essentially the same point that beagle was making on the Oceania thread.

Chris said:
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.

[Beagle]

Hello Chris,

Thank you for your interesting and well articulated post.

No question John Penno gave Leon Clements something of a hospital pass with Pokeno but hasn't it been his responsibility to do everything in his power to mitigate the risk of this considering their growing debt burden ?

Are you satisfied the he has done that ? Do you feel comfortable with the possible consequences of an unfavorable Supreme court decision that could see Synlait having to rebuild their plant somewhere else ?

I agree with your contention that taking a "bold" position on all things ESG and long term profit maximization are not mutually exclusive activities but isn't elevating people and the planet to exactly the same level as shareholders a bridge too far ? Aren't the directors and senior management working for shareholders best interests and if so who gave the mandate to expend vast resources on this extreme accreditation process that took 30 senior people more than a year to achieve ?

Are shareholders simply being asked to have blind faith that the directors and senior management know what they're doing and if so what evidence are we seeing that would support the contention there are solid grounds for that confidence ?

To me the only things that have been growing strongly are legal risk and debt, hardly compelling encouragement for investment so when they go to the market for more capital and say trust us we know what we're doing, how will the market respond ?

Ultimately a company cannot survive without considering other stakeholders needs, especially in this day and age and greenwashing of a brand can be a very effective marketing tool so embracing inclusiveness in the workforce, carbon neutrality and all the other ESG factors is not inconsistent with the notion of profit maximization in the long term, in fact in this field of trying to create a premium image for their products it may be directly aligned with the long term maximization of profits...so we are in perfect agreement there but where is the emerging evidence that this approach is successful ? What brands have they received accreditation for in the last three years ? Have they simply been too busy on ESG initiatives to direct their management skills to brand accreditation ?

One has to wonder how much of a drain on management resources this accreditation to elevate people and the planet to the same level as shareholders really was, (30 senior people for more than a year is a major project without question) and wonder whether some of that time and effort might have been better directed at trying to effect a settlement in relation to the Pokeno dispute ?

I for one am not convinced they made the very most strenuous efforts to effect a settlement and continue to believe that risking the last 6 years of profits on the outcome of a supreme court case is one of the most blatant examples of gross recklessness I can recall in nearly 40 years of investing. Right from the outset from feedback I have received from one who attended SML's annual meetings Clement appears to have had an extremely strong focus on ESG matters and I don't think its really drawing a long bow to argue his focus should have been better directed elsewhere.

Ultimately as a numbers man I am always going to interpret results by the numbers, (its my life's work), so that will define how I characterize the success of a company.
I am deeply cynical that a lot of this greenwashing is anything other than a politically correct smokescreen to maximize profits and if it isn't and the company really has elevated itself to really putting people and the planet on exactly the same level as shareholders, (in effect becoming a social and environmental welfare distributor) I would argue that's a fundamental breech of the companies act to subvert the best interests of shareholders UNLESS the company got a special resolution mandate from shareholders to that effect, which of course they haven't.

Getting back to the numbers, no matter which angle one looks at this situation, the company is deeply indebted and dependent on a favorable outcome with the Supreme court ruling. An attempted capital raise in the very near future would not surprise me in the slightest. Whether the market has the appetite for it is another thing...thankfully the market is awash with liquidity so they will probably get away with it.

We'll see how they're getting on with other product accreditation very shortly. I will be surprised in the current geopolitical environment if they have made any meaningful progress. The Chinese appear to be stoking nationalistic fervor with unprecedented vigor and the geopolitical environment has frankly never looked worse.

Ultimately the market is a voting machine and its giving Clements the big thumbs down. As a former shareholder I am disappointed with the degree of risk the directors and senior management have exposed shareholders too and their extreme ESG approach adds insult to injury in my view so I cannot allow myself to be a shareholder again at any price.

Good luck with it Chris. I sold at an average price of about $10 some time back and have very profitably reallocated that capital elsewhere.
Ay one point ATM and SML were level pegging on share price. Now its more than 3:1. I think its pretty obvious which company has got the better end of the stick with the deal and it would appear to be so much in ATM's favor its hard to make the case that ATM won't outperform SML going into the future.

Finally on the technical analysis front I very seldom invest in a company in a confirmed downtrend unless there is an extremely compelling fundamental reason to do so, (which clearly there isn't with SML). I have learned that swimming against an outgoing tide is very rarely a profitable endeavor and more often than not you get into trouble to one varying degree or another.

Anyway I will leave it there. I have enjoyed the robust debate
Cheers
Beagle

[Beagle]

https://www.nzherald.co.nz/business/...ectid=12368065 Hardly a glowing endorsement. Average forecast by analysts is $78m down 5%

[winner69]

https://www.nzherald.co.nz/business/...ectid=12368065 Hardly a glowing endorsement. Average forecast by analysts is $78m down 5%

SMLshare price was $13 once

Nigelsays it will surpass previous highs -- that would be good return for him

[Baa_Baa]

SMLshare price was $13 once

Nigelsays it will surpass previous highs -- that would be good return for him

SML weekly chart log scale, brand colour way, sensitively diversified rainbow MA's tell the sad story.

[winner69]

SML weekly chart log scale, brand colour way, sensitively diversified rainbow MA's tell the sad story.

I love rainbow moving averages on a chart ...esp when heading up

[RupertBear]

SML weekly chart log scale, brand colour way, sensitively diversified rainbow MA's tell the sad story.

Awww rainbows are soo cool and your chart is too Baa Baa, even if the story is sad