Synlait Milk Limited (SML) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to Synlait Milk's Half Year Results Conference Call. My name Hannah Lynch, and I am the Corporate Affairs Manager here at Synlait. I'm joined in the room here today by Leon Clement, our CEO; and Angela Dixon, our CFO. There'll be an opportunity to ask questions at the end of the presentation from Leon and Angela, but if your question is not answered, please feel free to follow up with me directly after the call. I'll now hand over to Leon.

[Foreign Language] and welcome to Synlait's interim investor results presentation for the financial year for FY '21. Thank you very much for joining this morning. For those of you that have read forward in the presentation or had a look at our guidance, you will see that we are signaling an outlook of broadly breakeven for the full year FY '21. Today is an opportunity for us to have a good look at the result for the first half but also to help understand how we're thinking about our business going forward. It's been well signaled that -- the impact of the infant nutrition drop on our demand back in December has been well signaled, how that's impacted our organization. And today is an opportunity to further understand that, have a look at what's happening in the organization, talk a little bit about what we're doing about the situation and why we still feel really optimistic about the future in the medium to long term. I've just got a couple of slides upfront that I'll skip through. And then I'll hand over to Angela to talk through the financials, and I'll come back to then talk through our plan and the outlook going forward. So just moving to our first slide, you'll see that revenue continues to be a key feature of Synlait's results. We're up 19%, slightly different mix of what's driving that this half. We've got a full-period impact of Dairyworks coming in there. And you can see the reference to that at just over $112 million for the first half year. So that's a good result, and Dairyworks continues to perform at or about the levels that we expect it. In our core business, revenue has also been supported by strong Global Dairy Trade prices. So commodity prices drive higher revenue outlook for us, but that has been offset by lower infant nutrition sales, which you'll see later on in the pack. The next metric there is the consumer packaged infant formula sales, which was down 16% on period, but what's more relevant there is the considerable drop in infant base powder production, which was down more than 60%. That's a core driver in our business, and I'll come back a little bit later just to why that has a material impact on the way that we operate and perform. Our EBITDA is down 29%, largely driven by again the infant nutrition drop. And the decline [ in NPAT ] demonstrates the importance of keeping our plants full and the impact of the base powder production levels being down; NPAT at $6.4 million for the period, down 76% on prior period. I'll just move through to Slide 3 now before I hand to Angela. This is a really important contextual slide for you to understand what's going on in our business and why a sudden drop in forward demand for our customers results in us essentially considerably dropping in utilization of our factories which drives our profitability for us. Many of you who have been following Synlait for some time will know that we have a seasonal nature for the production in our organization. In our first half, we're predominantly focused on processing peak milk. New Zealand has a seasonal milk curve which starts about October, what we call peak season; and runs through till about December, January. During that period, our plants are largely focused on processing milk into commodities. Because the milk flow is so high, we can't slow our dryers down to make high-value infant nutrition, but this time for us to produce our base powders for infant nutrition is typically between January to April, May. We call that our shoulder season, and it's when we have a combination of high-quality milk and capacity in our dryers to be able to run. As you can see from the chart, back in the shoulder season in the second half of FY '20, we were predicting that our infant nutrition business would continue to grow on the FY '20 levels. For those of you that remember, we produced about -- or we sold about 50,000 tonnes of infant nutrition in the FY '20 year, so our production plan in that shoulder season reflected that growth rate and was producing materials accordingly. With the suddenness of the drop in infant nutrition outlook coming through in December, we've had to rapidly reset our production levels within our factories so that we could reset our inventories to a much softer forward outlook. That meant that the product that we produced in the second half of last year largely covered us for much more of the demand for FY '21. And essentially we turned our plants [ right down ] and experienced what's typically described as a classic bullet effect in the supply chain. This factor has been made slightly worse because of the seasonal nature of our business. It's also been further impacted by the fact that we're emerging from a significant investment phase and are carrying the costs of additional capacity that we have built. And finally, as we flipped the infant nutrition production over to ingredients, we faced quite a volatile commodity and ingredients market, with product mix diverging markets and customer mix also diverging for us. And finally, the shipping delays have further impacted our result in this half. So I think it's really important we set the scene for the dynamic in our business at the moment. In a growth year, we typically produce more than we will sell because we're looking forward to a higher-demand profile in the following year. In a declining year, we're forced to produce less than we plan to sell as we reset and inventories for a new outlook. That's the dynamic in our business at the moment. It restabilizes as we get back in balance, but obviously, this year we're resetting ourselves, and that's having an impact on our forward outlook. So I ask that you keep that context in mind as Angela walks through our financials. And I'll return at the end to take you through what we're doing about it and why we remain optimistic about our future. Angela?

Good morning, everyone. Thank you, Leon. I'm just going to really focus on the half results for the year, but as you'll see, a lot of those drivers flow through into our outlook. So starting on Page 5, the results at a glance. The impact of COVID and the ongoing recovery of our key customer is having a significant impact on production and profitability, and I'll walk you through this, as Leon had outlined, both in this half and going forward. As Leon said, we've got a net profit after tax of $6.4 million and that's significantly down on same period last year, and you can see that in the graph to the right. And revenue, while being up, has been significantly impacted by our infant formula volumes and our base powder production. Therefore, our EBITDA is down 29% for the half. And it has been further influenced by the full impact of depreciation and interest costs as a result of our capacity build in previous years continuing to flow through. On a more positive note, as Leon alluded to, Dairyworks is on track to deliver a full EBITDA growth of $15 million to $20 million, in line with what we have signaled in the past. Now on to Page 6, revenue and sales volumes. As I explained earlier, revenue was up 19%. And it's predominantly through the inclusion of Dairyworks, our new acquisition last year; higher commodity volumes; and GDT prices having an influence as well. Also we have been impacted by the global shipping delays that everyone is well versed about. This is having an adverse impact on our ability to get product out to customers, and that's particularly impacted in December and January this year. In a little bit more detail. The consumer packaged infant formula volumes were down about 3,500 metric tons, as our key customer reset their profile through the year. China label volumes did continue to grow in the half. And English label was the label that fell, reflecting the demand profile with the daigou channel issues, but as emphasized earlier, the biggest impact has been the base formula production which was down over 60%. We have had some small offsets in the half through powders and creams or otherwise referred to as ingredients, where we have had increased sales of about 11,000 metric tons. And we've also had some positive impacts through lactoferrin. So our sales have remained strong at 21%, offset by a softer pricing as global capacity increases around the world. Liquid milk volumes continued to be stable, but are -- that remained below expectations. We will continue to work in collaboration with Foodstuffs as we foster this partnership more. And pleasingly, cheese and butter has had strong domestic demand through the COVID periods we've had, supported by an increase in the Australian market share. It's really pleasing to see the success of this acquisition come through into our results [ in the past ]. Moving on, Page 7, production volumes. From a production perspective, the half has been really positive, utilizing the capacity we do have, given the dramatic shift in the mix that occurred in the last 6 weeks of the year. Firstly, lactoferrin. It's pleasing to see that we got a further increase in production of about 2 metric tons or 16%. And the teams have had great results continuing to optimize lactoferrin extraction methods and have worked that plant really well to get these results. And you can see that on the bottom right-hand graph and the continued growth in our production of lactoferrin. We've also had a positive milk collection this year. We're up almost 18%, as Pokeno has come on stream and we've got a North Island milk pool increasing. And our ingredients or powders and cream production increased almost 16,000 metric tons or 22% as the mix changed, as I've stated earlier. And our liquid milk remained consistent through the year. Now moving over to what the impact, therefore, is on our gross profit on Page 8. As a consequence of the volume and mix changes, our gross profit performance has been impacted, and gross profit was down 28% to roughly $60 million. This was driven by the lower demand from infant formula, as our key customer resets its demand profile and rebalances their inventories. The consequence on us is we need to also rebalance our inventories to align our production with that demand. The switch in the product mix impacts us significantly because we are moving our milk into a much-lower-margin commodity product. And we've also had the unfortunate, bad luck of a sudden switch into -- from New Zealand dollars into U.S. sales mix, which results in an unfavorable FX position which creates a further headwind as we didn't have the time to get the favorable hedges in place against the rising FX market in the later part of the half. Turning the page now to Page 9, SG&A costs, always a favorite slide. As a consequence of this lower demand, the costs are a really strong focus in our business at the moment, and this will continue throughout the year. Discretionary costs have improved. Or we've had savings of $3.5 million half-on-half, as this has been a conscious effort to reduce spend where it has been sensible to. And we completed the reset of our organizational structure to reduce salary costs. This is starting to flow through in this half, and more savings will be realized in the second half. These savings, as you can see in the graph to the right, is offset by the costs of Dairyworks coming in on the half, as we didn't have Dairyworks in the FY '20 half. Depreciation continues to roll through from previous upgrades. And technology costs are increasing as we -- our business gets more sophisticated. Moving now to Page 10 with the impact on our cash flow. As we've been highlighting previously, Synlait does typically have a seasonal cash flow due to the milk production curve that Leon talked about earlier, and you can see that in the graph to the right. We've also had an impact on cash flow this year because of higher Global Dairy Trade pricing for milk. And as that price has increased, we've had to adjust our cash flows to our farmers. The operating cash flow now is down roughly $70 million or $69 million in the half; and that's quite a dramatic shift where we've been in previous years, reflecting this lower-margin mix and an increase in receivables. We've also got the Dairyworks receivables coming into that cash flow view this year. And we've also been impacted by shipping because shipping continues to impact the timing of our cash collections as the product is delayed hitting out of port. We have managed to keep investing capital more constrained this year, as we signaled that we would be moving out of the build phase and into our fill-up phase. And the costs this year are at $62 million of cash flow, so far, on our key projects. And our financing costs are up slightly because of the increased debt levels, which were partly offset by lower interest rates that we experienced in the period. Moving now to my last slide, Page 11, with net debt, a topic that I guess everyone is really interested to understand given our outlook. The net debt has decreased to $485 million, and you can see how that compares to previous periods in the graph to the right. We completed our $20 million -- sorry, $200 million equity raise in November. And this did reduce debt, but as we have moved through this half, we have had to use some of that headroom that we planned for in that capital raise to help cushion our business as we navigate through the issues of COVID-19. All our relevant banking covenants were met in the half year. And we have been proactively working with our banks and our banking syndicates to increase the leverage ratios to ensure we've got the ability to navigate the remainder of this year and meet all of our banking needs, so I feel like we're leaving the half in a really positive position to address the headwinds that are ahead of us. Now I'll close on that note. I'll hand back to Leon.

Thanks, Angela. So it's pretty clear that COVID has hit us late, and it's important that as an organization we rally around what we can control as we move forward. I'm picking up on Slide 13, which is a conceptual diagram to show what our focus is right now. In any business that I've seen successfully navigate through crises, those businesses have always found a way to focus simultaneously on 2 things. The first one is to how do we successfully mitigate the impacts of the crisis and the impacts on the business. And secondly, how do we simultaneously make sure that we're doing the right thing for our strategy and pulling forward value and accelerating the delivery of execution through that plan? So I'd like to take you through how we're working through this: firstly, on how we're mitigating the impacts of this current year; and secondly, how we're pulling forward value as the organic business recovers and our waste, yield and efficiency programs start to deliver and we start to extract growth from the recent investments that we've made. I'd like to really thank our staff and our teams and suppliers and our network who have been very supportive of making sure that we make these changes in a really agile nature and the [ spurt in which they've leaned into ] pulling forward some of the strategic value that's available for us. As you know, we've made significant investments previously. And we're really well placed to emerge from this crisis as we pull together these 2 simultaneous focuses. So there's 2 slides on 14 and 15 that talk through around $22 million worth of cost and efficiencies that we're looking to extract from the business and [ effected ] really quickly to make some appropriate changes to our organization given what's happening around us. The first slide focuses on operating cost savings. We've made a -- and worked through a significant organizational structure reset to ensure that we have the capabilities that we feel are appropriate for our organization right now and are aligned to our strategy. And the savings within this financial year are just under $2 million for that. We also moved really swiftly in the new year, over the holiday period, to make sure that the labor levels against our factories were appropriately matched to the customer demand that we saw moving forward. That meant [ governing Synlait Pokeno to ] make sure that it focused predominantly on manufacturing ingredients only and preparing for our new multinational customer. That results in a different shift and labor structure against that site, as did the changes that we made to our Auckland and Dunsandel blending and canning facilities to adjust shifting operations [ to look ] for the new demand outlook. And finally, we optimized our Dunsandel dryer network against the new product mix and made sure that we were segmenting our assets and facilities to ensure that they met what we saw going forward. Against that initiative, about $5.4 million worth of costs has come out of the organization in FY '21. As we see demand start to increase in the outturn period, that will of course start to flex up, but it's an indication of the swift movement that our operations team took to adjust to the changes in our forward demand. And the third area on that slide is an ongoing focus that we've had on our discretionary spend, travels and consultancies, entertainment, all the usual things you'd expect us to be monitoring. So far this year, $3.5 million has been pulled out of our cost base there. The second slide, on Page 15, around the short-term impacts. There's a focus on extracting value chain cost savings. And a really great project that is delivered on time and to budget is our Dry Store 4 and rail siding project, which we see coming to life in May this year. We announced this some time ago, but it's important that we flag the efficiency that this will be bringing to Synlait as we continue to grow and invest in integrating manufacturing facilities. And really what this one does is moves us from a farm-to-can value chain all the way from (sic) [ to ] a "farm to a port" value chain, with containerized goods trained between Synlait Dunsandel and Lyttelton Port, but this initiative takes 16,000 truck movements off the road. There's a great picture, an aerial shot, on Page 12 which shows the project and how it's making a difference for us, but it also generates a permanent annualized EBITDA contribution of $8 million from FY '22 onwards. And we're looking forward to those benefits coming through into our organization. In addition to that, the teams have been really focused on some waste reduction and yield improvement initiatives, and there's an annualized benefit that we've seen from the changes that the team have made there of $3 million. And we continue to focus on quality and right-first-time production metrics, which reduces rework and waste. So those are some examples of the great work that the team have been doing to adjust to the current situation and pull costs and efficiencies into our organization as we go forward and face the current challenges that we're working through. Picking up on Slide 16, I just want to talk through what we're doing around pulling forward value and our strategy. And the first thing is to make sure that we're really focused on the right things. If you've been following Synlait for some time, you will notice that we've narrowed up our strategic choices around the hands part of our framework here, our strategy. The nutrition, food service and ingredients and consumer foods pathways have been narrowed from 5 pathways that we had around growth down to 2. This reflects a shift in the opportunities that we're facing and our focusing on the things where we believe we can create the most value. We haven't changed our purpose or our ambition. And they will continue to stay the same or the enabling strategy framework of net positive for our planet, a healthier Synlait and a world-class value chain. It's really important we don't compromise who we are or what we stand for, and we'll continue to balance people and planet at the same level as profit in our business. Moving to Slide 17. It's also important to acknowledge that Synlait is moving from a build phase and an investment phase to create opportunities and reduce strategic risks and into a phase where we're focused on filling the assets and opportunities that we've created and extracting new value from them. As we move into this phase, you can see that that's the opportunity to extract value from the significant investments we've made in Synlait Pokeno, in our liquids plant and in our cheese categories. So essentially we're [ moving ] from a build-up phase to a fill-up phase and focusing on completing the investment with our new multinational customer in Synlait Pokeno this year as we move into realizing some value in FY '22 from that initiative, but essentially it also sets us up for some amazing opportunities. And it's really coming just at the right time for us as we start to focus on building a more sustainable Synlait in the medium to long term. The slide, Page 18, I'm on now just shows the assets that we now have to tap. We have a customer base that would be the envy of any main -- any dairy processor in the world. We have a strong base in New Zealand and Australia with all the main retailers in New Zealand and a strong partnership with Woolworths Australia, led by our Dairyworks team. We have a strong list of multinational customers in our repertoire. Not all are listed here but some fantastic names in that stable and increasingly a strong set of partnerships emerging around China. Yili and Mengniu have been ingredients customers for some time, but also you'll see the emerging domestic players of Feihe and Junlebao who we are increasingly working with on specialized ingredients. We've also got a great set of categories, which are increasingly listed there, that we can start to tap to create opportunities against the facilities that we've built. Coming to Slide 19, I wanted to provide some insight into the value that we are starting to chase as we look forward in our strategy. And I've put this over 3 main horizons: the short term, the medium term and the long term. We're getting really focused on these initiatives and organizing ourselves around teams that convert these into value. The pictures and opportunities on the slide are examples only, but as we start to total these up, we're eyeballing around $200 million worth of value coming from these opportunities. Now before you all go and put these in your models, I'll just caution you that this does not include the headwinds that we would naturally face as part of this. It focuses on the new value that we would create, but some examples are in there. In the short term, we're excited about the pending launch of a differentiated ingredient stream. Our "made with better milk" proposition reflects the differentiated milk that we captured from our Lead With Pride program with our farmers, and we're looking forward to starting to capture the value that we see on that. We've got strong customer interest in that proposition. Later this financial year, we'll be launching our food service creams, starting with a beachhead in China. We're really excited about the quality of the product and the functionality that we're currently producing and looking forward to that making a significant contribution in FY '22. It's been well canvased that we've got a new multinational customer that we're working on to develop in Synlait Pokeno. That customer and the new opportunities start to create value for us at the start of FY '23, so just over 12 months time. And we also see opportunities, as we go forward, around Synlait-branded consumer products. As you know, we've got fresh milk capability which we're looking at, but we've also got a great-quality lactoferrin product. And whilst that product is a little bit hard to see, starting to think about immunity-based propositions using our lactoferrin is something that we're considering. And longer term, we have a product mix that's made in heaven for a dairy processing company, infant nutrition against cheese, with strong demand for both products. Capturing the whey and casein interchange between those 2 products represents significant value opportunity for us. It will require some investment, but if we can get this right over time, we see strong value emerging in the longer term. And finally, we're continuing to progress our liquid infant nutrition products as we start to build capability in that space against our advanced liquids dairy factory. So moving now to Slide 20, our guidance update. As we signaled earlier this month, Synlait is continuing to experience uncertainty and volatility within its business. This is due to the uncertainty of The a2 Milk Company's expected demand for the remainder of FY '21 and for FY '22. And as we spoke to earlier this March, we don't have current sufficient confidence to forecast when this recovery will occur, and this has 2 main impacts on Synlait. The demand for Synlait -- for consumer packaged infant formula remains uncertain, which in turn impacts the forward infant base powder production and the asset use and utilization of our facilities. Secondly, Synlait's ingredients business. With the sudden drop in consumer packaged infant formula demand, combined with the rapidly rising GDT prices, foreign exchange and changing product mix, this has created volatility for us and limits the returns that we would otherwise expect against a more stable demand profile. And finally, the expectation that global shipping delays will continue to further impact our FY '21 result. We've considered the above factors and how that will impact Synlait's FY '21 profitability. You will note the word uncertain is used a number of times in our guidance such -- statement, but we also think it's important we provide you with a signal of where we're heading. And our current outlook suggests a broadly break-even FY '21 NPAT result. Given the above factors, while all of our banking covenant ratios had been met for this half, we've proactively engaged with our banking syndicate to increase our leverage ratios and manage any risk at the end of FY '21, so therefore, the company's FY '21 business plan is fully funded by its current banking syndicate. That concludes our presentation this morning and we'll pause there for questions. Thank you.

[Operator Instructions] Your first question comes from Stephen Ridgewell from Craigs Investment Partners.

Just firstly, on the guidance. I mean, given we've had 2 pretty large downgrades and in pretty quick succession, I'm just wondering if you can give us a little bit more clarity or specificity on the key assumptions that are underpinning that guidance for break-even NPAT for the full year.

Yes, Stephen, and thanks for the question. I think essentially what's significant in the assumptions that sit behind that is the uncertainty that we have around the -- [ our ] a2 infant nutrition demand and what that looks like in FY '22. I think the slide that we presented upfront shows that our forward view starts to inform how busy our factories are, especially in those shoulder seasons. And so what's materially changed from our position in December, where we felt we had some confidence that a recovery may occur in FY '22, as we signaled in March, we were no longer confident that we had sufficient evidence to be able to call that. And as a result, we can no longer get confidence that our factories will be turned back on in the second half. So that's one of the main assumptions. Another one is the significant volatility that's occurred around our ingredients business as a high level of new ingredients business came back onto our plan, so as we reset our base powder production, what we do with the milk as we flip it back to commodity products. That means, in the rest of this financial year, we're selling far more ingredients products than we anticipated and we're selling them into a market that has got somewhat abnormal for us. We've seen divergence of butter and AMF. We've seen divergence of customer buying patterns and markets. We've also seen sudden changes in FX that limited our ability to capture that. So those assumptions are driving the softening of our outlook and the reason that we're saying we'll be broadly breakeven against the uncertain scenarios that we're facing.

That's helpful. And just wondering: I mean compared to the kind of demand levels of production, what you've seen in the last couple of months for canned IF. Are you assuming that, that doesn't get better over the balance of the half? Is that what we should take in too as guidance?

[ Correct ].

Okay. And then just on -- maybe one for Angela, just on CapEx for the full year. I think you called out $60-odd million in the first half. Can you just remind us the level of CapEx for the second half; and also, just given the NPAT guide, roughly where you might expect bank debt to end the full year?

Thanks, Stephen. So I'm just finding my page. I think we've always signaled that our new multinational customer will be roughly about $70 million split over 2 years, and that's expected to continue as planned. We have continued out the completion of our dry store, which Leon talked to. And that is operational from May, so that will have some costs still flowing into the second half of the year. We're continuing to do our ERP system and upgrade our systems across our business, and that will continue on in the second half of the year as well. And then this year, in the $70 million -- or the $60 million that I talked about for the first half has also got the costs of buying the farms that happened last year, but the cash flow actually came through in this year, in August. And then the rest is we are containing our operational cash flow tightly while ensuring that we are still spending what's necessary to get optimized production out of our facilities and keep our assets in good shape. So that's pretty much where we are from a CapEx perspective, so guiding very similar to what it was at the first -- at full year result last -- 6 months ago.

And just on the net debt, is there any guidance here in terms of where that might land sort of given those working capital [ movements that you've cited ]?

I'm not really keen to guide yet. We're still working through all the options around our balance sheet. We've got -- we've reset the covenants, which allows us to consider a number of different scenarios we've got in our plan. And that's why our guidance talks to a broad break-even position, with some -- [ a whole of ] uncertainty around it. And I mean the good thing -- I mean the key thing, Stephen, is we're being very careful about what we spend. And we will continue to be very prudent right through to the remainder of the year given the scenario we're in.

Okay. And maybe just one last one for me. I mean, I guess, with the net debt-to-EBITDA kind of obviously lifting, if you look at sort of run rate-ing the first half with the guidance -- and appreciate the comments that you're fully funded for this year, but that would presume, just given [ the company has had kind of the preference ] for sort of, call it, 2x net debt-to-EBITDA, you'd be kind of needing a recovery into next year to remain within that target range for net debt-to-EBITDA. I mean, is an equity raising a possibility? If not -- if it's not a preferred option, are asset sales also under consideration?

Look, at this point in time -- well, we said at the full year that we would continue to look at our balance sheet and work through other additional options with our -- on -- with our debt portfolio. And we'll -- and that's the plan and it will continue on. I'm loath to go back to the capital markets at this point and further dilute our shareholders. This is a -- what we are perceiving as a timing issue. We just don't know when the swing back is. So if we can avoid that, we certainly will be. And we'll just continue to work through what options we have in the debt markets to get a stable position for the years ahead.

And Stephen, perhaps I can answer your question around asset sales and, I think, just building on Angela's answer. I mean I think it -- we're fairly clearly signaling on Page 23 that these are temporary resets of our covenants. And there is some work to look forward around what's an appropriate capital [ structure ] between equity and debt and how we'll move that forward. And Angela is committed to taking that forward given the context of the current environment. You'll see from the levers that we put forward around -- what we're doing around it. We spoke to operating costs. We spoke to value chain efficiencies that we've got in place. We are doing a review of our structural cost base, and we'll be making sure that we have a look at what sits within that. Obviously one of the levers in that bucket is asset sales, but no decisions have been made at this point.

Your next question comes from Chelsea Leadbetter from Forsyth Barr.

I guess extending that last question a little bit further in terms of covenant changes. So my understanding or interpretation here is that's just a temporary change, i.e., just for this financial year '21 period end. Is that right? Or is that extended into 1H '22 as well?

FY '21. It will be FY '21.

Okay. And in terms of the 7.5x total debt-to-EBITDA, I guess it's quite a large change. I'm just interested in, I guess, who drove that number. And ultimately are you trying to buy yourself quite a bit of headroom in case you need it? Or I'm just trying to understand. Why take it to that level? And then secondly, what's the cost of this change for your interest bill in the second half?

Yes, Chelsea, that's a really good question, yes. And as both, I think, Leon and I have talked to today, there is significant uncertainty of the recovery of the rebuild in our infant formula. I've had very open, sharing relationships and directions with our banking syndicate in the last wee while and that we've set that 7.5x at what we think is appropriate given the work we have worked through together on the different scenarios that could play out for our business given the timing impacts. So that's pretty much how we got to that number. In terms of the costs, it's fair to say you always pay. So it has cost us a little bit more given that we are going to be stretching our net debt and asking for more capacity from the banks. And that has taken into -- us into a slightly higher-risk profile within the range, but it's all manageable within our facility at this point in time.

I think, Chelsea, [ the story here is ] consistent with what we're saying. This is a temporary impact. What's being, I think, communicated via us through our banks is that there's headroom around a board (sic) [ broad ] range of scenarios that we're seeing there. We'll continue to do some work on that, but it also shows the confidence that they have in our medium- to long-term outlook here.

Okay. No, that's helpful. And Leon, you talked a lot at the beginning and obviously through the presentation about rebalancing and obviously the challenges that the sharp change in demand has created for the business. I'm just interested in how we think about when that has been rebalanced. Is this still kind of thinking into 1H '22? Is there still a challenging period here for you in terms of what that could look like?

Yes. Look, it does rebalance. It sort of takes a year to unwind as we -- as long as we get stability around that demand outlook. So I think we broadly signaled what we think the drop would be when we first assessed the impacts just post the December downgrade, assuming that's broadly stable and stays consistent over the next 12 to 18 months. Our production levels start to realign with our infant nutrition sales to those levels, as long as they remain stable, but in this year, unfortunately we're producing a lot less than we're selling. And that is painful on an organization that has recently invested in capacity. So if we, well, all things being equal, had stable demand on this year's outlook, we would be performing materially better. Unfortunately, I mean, we're seeing inventory from a view that we had in the second half of last year that we would continue to see growth on the 50,000-odd tonnes of infant nutrition sales that we made.

Your next question comes from Adrian Allbon from Jarden.

Just again just kind of, I guess, seeking a bit more clarification on, I guess, what both Stephen and Chelsea asked already in terms of the reset and at the first half. Like the canned infant formula was down 16%, the IFB production down 62%. Like are you -- in your -- in the plan that you've agreed with the bank around the covenants, are you expecting any sort of IFB production in the second half? I presume you are.

Yes, we are but at materially lower levels than historically, Adrian. So I mean I think what we're signaling is this dynamic is expected to continue for the rest of the year. And if you think about our seasonal production, normally we would be looking at this period around February, March, April to really be ramping up infant nutrition production and base powder production for a forward view into FY '22 that we'd be rebuilding on. Given we don't have certainty of what FY '22 looks like, we're not -- it's not like we're not running our plants, but they're running at materially lower levels than historical. So just to give you an indication: They're about as -- 1/3 as full as they were last year in totality. And that's what's causing us some pain because we've got a whole lot of expensive plants and some people that we can't let go that we're continuing to pay for, but we can't run product [ through them ].

And just related to that. Like what are you doing around the milk contracts like into '22 and '23?

Well, look, we still want milk. We still want the milk pools because we still use that ability to switch between ingredients products and infant nutrition as a natural hedge. We want our plants to be full, but we also prefer them to be full with a high-value product mix, so no change to our milk contracts. We're going to continue to protect the milk pool that we have. We really just move the lever between our commodity and ingredients business. And there's an indication on that side of how we're looking to differentiate that part of our business, what made with better milk, but also leaving -- and just leaving the flex for infant nutrition as and when that recovers.

Okay. And so look, I think at the year-end last year you had a reasonable stockpile of the IFB powder. With the dramatic reduction in production, have you worked through that now? Like are you -- like, the IFB production across the second half, will that be, I guess, [ full? And will ] that be new stuff, I suppose?

We are working through that now is probably the best term. So I think we're doing our best to smoothe base powder production given we're now in the shoulder season. It's when we typically start to move towards that. And we're assessing what we think our FY '22 demand will be, especially in that first half, to set those production plans, but over time, that inventory starts to moderate down to the new demand outlook. But I'd expect it to be moderated by the end of this financial year.

Okay. And then look. I think, like at the year-end last year, you provided a -- sort of a management estimate of the diversification drag, which I think was sort of the $20 million to $25 million of NPAT. I guess, with some of the stuff that you're indicating here, I think, through Slides 14 to 15, is that kind of like what your forward view on that be -- like into '22, '23, would there be sort of $10 million less with some of these efficiencies that you're targeting? Is that the right way to think about that?

I think we'd have to go away and do the maths against a quite slightly different scenario. The diversification drag is probably the costs of new optionality, which does include some Synlait Pokeno, but yes, I'm sorry, Adrian. I think we might just have to regroup on the maths around how we did that calculation last result.

Okay. And then just final question, on Slide 19. When you talk about $200 million of value, I presume that's some -- is that an -- are you talking about additional NPAT or additional EBIT? Or what's the reference here?

It depends on the nature of the initiatives and how it comes through in our P&L. It's indicative of a pipeline of value. And you'd hope that most of it will drop to the bottom line, although some of them come with investment. So for instance, say the top-right opportunity, around capturing the value of milk components, that will come with capital investment to invest in the required infrastructure to do that. And so you'd, we'd only see the value there dropping at an NPAT level. It's indicative of the new value that we would love to create, and we'll continue to focusing on chasing that.

Your next question comes from Richard Barwick from CLSA.

A couple of more detailed questions from me, for starters. When you talk about the sudden switch from NZ dollar to U.S. dollars re sales mix, are you talking about a2's English label weakness but China label strength? To clarify.

Yes, sort of. So when -- so most of our infant is paid for in New Zealand dollars. And when we've got to move that milk into our ingredients or commodity products, we sell all of that in U.S. dollars. So our U.S. dollars exposures changed quickly overnight, and that way, we didn't -- we weren't able to put ourselves in a position to hedge for those. And at the same time, we had the foreign exchange [ mark about ] around Christmas moving up significantly. So that has had -- has certainly had a headwind for us this year and will continue into the second half as well.

All right. And then on Slide 15, where you're talking about the $3 million for the -- under the efficiency initiatives. What's the timing associated with that $3 million? And also, if you're talking around sort of yield improvements, what sort of volumes are required to achieve that $3 million?

Yes. Those are this-year improvements that will contribute to FY '21. And on an annualized basis, the $3 million is locked in. There are a mixture of opportunities that sit across there. Some of them are sitting across our commodity and ingredients business, some in our infant; and they're broadly sized on our current mix. A lot of them, Richard, are around how we do things like make sure that we get really close to the standards specified within the bill of materials and whether or not we can get much closer to the levels of protein and fat within the mix. And so that's where the opportunity sits, and they're largely agnostic to the product mix that we have.

Right, but presumably, if you -- if volumes -- okay, [ if you're ] agnostic on the mix. Okay, that makes sense...

Yes. So we broadly have stable volumes. It's just the volumes of infant versus ingredients, and I would guess that these initiatives [ are spanned ] across both.

Okay. And then the last one for me, just thinking back, some of the wording you've used around the December downgrade and just the level of uncertainty that you have within the business. Just, I mean, how does this work when -- I mean you are reliant on a2 demand or a2 volumes for the English label. What sort of visibility do you get from a2? Is that improving? Because I mean it reads like you've got no visibility, if you go hark back to December, for instance. Is that -- is there a sense that that's improving? Or do you find out when the rest of the market finds out in terms of what the demand outlook looks like?

Well, I think that a2 have been reasonably clear that the December downgrade also came as a surprise to them, and that's reflected in how they went to market around it. So for that instance, we broadly found out as everybody else was, including a2 themselves. We get quite good forward forecasts from a2. We work collaboratively with them on that outlook. I guess what's changed is we've moved from a position in December, January, where we were taking that forward view and putting it back into our business and seeing what it could do, through to the fact that we decided that, until we saw really clear evidence of a recovery, it was inappropriate for us to start guiding on that basis. So it's not so much the visibility that we get. It's the confidence that we have in that forecast that we receive that is changing our position on the outlook that we're taking.

Right. And just to be clear in terms of your -- I know we're talking a mixed effect here, but the production of the infant formula, it sounds like you've really only made the switch post that December downgrade. There wasn't much of a change in your production ahead of that December downgrade. So I'm just thinking about...

No, no. We reacted post the December downgrade. There was probably a little bit of a softening that occurred in the first half, but it wasn't material. The impact was post the December 1. And I think the chart shows [ that a lost of ] -- sort of it probably gives you an indication of how we reacted. You combine that with making 45% to 50% of our base powder production in that 4-month window. We were assuming at that point that growth will continue on FY '20. So that's the inventory reset that we're experiencing.

Your next question comes from Andrew McLennan from Goldman Sachs.

There's quite a few impacts coming through on your working capital, to say the least. I'm just wondering. Receivables have clearly been quite dynamic. You've provided some commentary around what was driving that outcome, but can you just provide a bit more detail and specifically around what factors you may think are permanent versus temporary?

So if I got your question right, Andrew, you want just more color on what are the drivers of our cash flow outlook and cash flow impact on the half. Is that right?

Yes, particularly on the half, just so we can get a better understanding of what factors are permanent versus more temporary.

So one of the biggest factors was the fact that GDT prices started increasing halfway through the half year. And as that happens, that means we need to reset our milk pricing to our farmers to ensure that we catch up to where we think the end position will be. And we started the year at an announced milk price of about $6.40, and our most recent milk price announcement was $7.20. So that has significant impacts in your payments out to farmers. And we always -- and that's one of the reasons we have these cash flow impacts in the first half of the year compared to the second because we make our biggest proportion of our payments to farmers in the first half of the year. We've also had the switch effect from going from high-value margin products to lower-value products in the last 6 weeks of the year. Plus we've had some delayed cash flow impacts around shipping just because there's a certain quantity that's rolling through every month that we just can't get out and that's not catching up. So that -- those are the predominant drivers of our cash flow being negative this year. So -- and we would expect that to get better as the year goes through because we'll get the higher GDT prices on our ingredients flowing through in our revenue lines and our cash lines as we get the sales come through, but at this point in time, we effectively pay the farmers ahead of when we get the milk receipts of the products. So that's one of the phenomenon flowing through.

Okay. So in addition to that, you've had, as has been discussed earlier, the buildup of inventory within infant formula in particular you'll be working down by the end of the year. So a lot of it is temporary, and some of them quite unique, but how significant is the effect on the returns? You said it was just for 6 weeks, sort of the higher-margin product impact. Was that a significant component of the impact to, I guess, receivables?

[ Yes ], it certainly is when you compare half on half, yes. And I guess the other component that -- to look through is we do have receivable assignments for our big international players. And as we've had a significant volume of -- in commodities products that we now need to sell and will that -- in second half of the sales curve, we've broadened out our customer base. That means we've gone -- we're relying more on more general terms of trade rather than our receivables assignment, which gives us the cash right upfront. So there is a whole lot of factors in here, but I hope that gives you a bit of clarity.

Okay. So the GDT trade means that your payment terms or receivable terms will increase. So that will be an issue for the second half.

Yes.

Yes, okay. And also just, I guess, a bit similar bit to Richard's question earlier. I mean, what controls can you put on? Because obviously the key issue here is with a2. It seems like a pretty asymmetric situation when it comes to information. I'm just wondering. Are there better controls you can or have been able to put on in this relationship and the information sharing? Because it's interesting. It's quite an extraordinary limitation for you, although this is a pretty unique situation [ admittedly ], but I'm just wondering if there's anything we can do better here.

Yes, I think it's a good question and something that we have been reflecting on internally and in our discussions with a2. I mean I think it's a unique situation, but the dynamic of participants further up the value chain often experiencing more adverse and volatile impacts is well documented and understood. There are certainly ways that we can address that. It's been less visible to us in terms of the risks that we carry because we've broadly been following a2 up and investing ahead of its curve to create -- to be able to meet the demand as it's grown, but there are things that we can start to do both in the relationship and our own value chain to start to expand that planning window for the shoulder season. We can look at channeling milk down to seasonal plants like our cheese plants. That gives us the opportunity to just broaden that. We can go to more just-in-time inventory models and more robust planning arrangements, and we can also start to look at reshaping the nature of our contractual agreements. And certainly something -- it's something that both us and a2 are looking forward to in the second half that I think we'll look towards as we start to reset our relationship here.

Your next question comes from Marcus Curley from UBS.

Just a couple from me. Can you just talk a little bit to, I suppose, the guidance pointing to a lower second half profitability? Can you just talk a little bit to what the deltas are between the first half and the second half against the plan?

Well, I think -- can I just understand the question, Marcus? You're saying we've made -- well, I mean we've made [ the NPAT of $6 million ] in the first half...

And breakeven for the full year. So you're going to go from plus $6 million to minus $6 million if you take [indiscernible] -- yes. So why -- correct. Why...

[indiscernible] but assuming -- go ahead. Sorry.

So why $12 million profit worst off in the second half.

Okay, I'm with you. Well, I think that there's 2 or 3 main factors that are indicating why our second half flips from small profit to assuming the broadly break-even guidance materializes in the second half. The first one is our factories remain relatively quiet. As you know, in the second half, we typically turn our factories on to infant base powder production. And so that not happening has a significant impact on our second half relative to other periods. And we were tracking through, I think, August, September, October, November the first half still broadly with a stronger outlook until we got to December. So we were still producing infant nutrition before the peak arrived. That drove profit for us in that first half. We're now saying for all of the second half we're broadly impacted by this impact, and that's coming through. The second major impact is what we've talked to around ingredients. We've seen quite material shifts in the ingredients market probably from about December onwards. What's pretty well signaled in the public domain is the rapid increase in dairy prices and commodity prices. Most of that demand is coming from China, but some of the challenges that we experienced there is around where that market demand comes from and where our key customer bases are formed. And what that means is we move a lot of our ingredients into spot contracts, as opposed to some of the more longer-term customized ingredients contracts that we have with some of our multinationals. They are less returning than the contracted volume that we would have within our ingredients space. And what we've also noticed is that product mix factors such as the divergence of the butter price from the AMF price are having an impact. So the milk price that we have to pay is derived on a notional producer model that assumes that we would have a butter plant. We don't have a butter plant. That's driving the milk price up, but we've seen butter diverge from AMF by as much as 18% this year, and that is creating some headwinds for us in the second half. Add to that the assumption that shipping delays will continue to impact our year, then I think it's fairly clear why the second half starts to look fairly challenging for us.

Great. Secondly, Leon, you spoke to your last milk price at $7.20. Fonterra's midpoint, $7.60. So is that a genuine sort of number that's in the plan? Because it's obviously quite a large variance at this stage.

Yes, we gave the $7.20 update guidance in January. We do another 1 in May. We typically only do 3 a year, Marcus. And that $7.20 has some upside to it. Our internal models are indicating that it will be higher than that. We typically don't tend to respond to external factors. We provide 3 a year and good communication with our farmers on the factors that are driving that. So we expect that $7.20 number will increase.

And then just finally. When you sort of articulated the issues around the a2 volumes, obviously you alluded to the fact that they're also managing down their own inventory levels. Do you have any visibility in terms of how much of this temporary impact reflects their inventory reductions at the moment, well, sort of versus the underlying demand picture?

No, I don't think we do have great visibility of inventory sitting within a2's network, so I think that question is better placed with them.

Your next question comes from Kurt Gelsomino from Morgans.

Leon and Angela, just a quick question from me. Maybe, can you just talk through, I guess, what you're assuming for lactoferrin pricing in the second half of '21? Do you expect them to be sort of broadly consistent with the first half of '21, or do you sort of expect them to weaken further?

I guess it's another factor where uncertainty prevails, Kurt. We've got, as signaled earlier, a lot of additional capacity globally coming on to the market against still relatively robust demand for high-quality infant lactoferrin, so -- but we're broadly assuming that it's relatively stable on our first half achievement in the current scenario. But again that has some fairly wide parameters around where it could swing. It's broadly stabilized for now, but there's still more capacity coming on the market.

Your next question comes from Xavier Waterstone from QuayStreet.

I've just got a quick one about the inventories, so specifically the finished goods. So there's been a reallocation from cost to net realizable value. So it looks like there's about an 87% increase in volumes in the inventory but a 23% decline in average unit value. Could you just talk a bit about what's driving that and whether or not there's further risk of finished goods write-downs if you don't get that buyer's pull-through in demand to -- which results in getting converted into commodity powder?

We might have to come back to you on that one because the challenge with understanding our closing inventories is, now that we've put Dairyworks into the mix, they have got a significantly different inventory profile because they have a longer-maturity maturation on their inventory products. So -- and we've got a lot more commodity products coming in to the business at the end of the year, but we are expecting to be largely fully sold and not holding a lot of commodity products at the end of the year, apart from what impacts on shipping.

Your next question comes from Nicholas Pointon from RNZ.

Did I -- sorry. Just to make sure -- did I -- yes, Nicholas from RNZ here. Sorry. [ Just a bit ] all over the place. Just want to go back to some of the conversations that were being had about bank and covenants. I think, Angela, [ you mentioned to say ] that you would be loath to go back to the capital markets. And then Leon, you followed it up by saying that asset sales were just one lever in a suite of measures that could be taken to sort of get capital -- how -- pay down that debt position and whatnot. Could you just run through what other options there are sort of available?

Well, I mean, look, I think -- I don't want those comments to be taken out of context. I think we're obviously facing a temporary challenge in our business as it washes through. We'd gone to shareholders last year and raised $200 million to complete out our investment phase; and for the purposes of phasing into the uncertainty that was well signaled from COVID, which has emerged. We also signaled at the end of last year, after the capital raise, that we wanted to come back to our capital structure and work through how we finance debt. Against that, we've got the optionality to consider structural cost implications to what we need going forward. So the way that I would look at this is this is a total package, but I think it's fair to say that, having gone to shareholders to support us for an investment cycle ahead and to make sure that we're well based for uncertainty, we wouldn't want to go back there again when we've still got the 2 levers of debt and structural costs to be able to look back. Until we fully work through those options, it's not something that we'll be returning to in the immediate term. So I hope that provides you with some context of how we're looking at [indiscernible].

Thank you. [ That does ] conclude our question session at this time. I will now hand back to Leon for closing remarks.

Okay. All right, well, thanks, everybody, for your well-placed questions. I'm sure we'll have follow-ups with many of you. I hope that the key messages that you've taken out of today is that we're working through a temporary but sudden impact on our business. We do have confidence that this will reverse. We just don't know when, and that uncertainty is reflected in our guidance statement. I hope that you've seen that we are taking appropriate action to mitigate the impacts and that we are continuing to be confident in our future given the investments that we've made and the confidence that we can have on the forward picture. So we'll close off there. And hopefully, we'll catch up with you all very soon. Thank you.

Thank you. That does conclude our conference for today. Thank you for participating. You may now [ disconnect ].