Synlait Milk Limited (SML) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to Synlait's half year results conference call. I'm Hannah Lynch, Synlait's Corporate Affairs Manager. And today on our call, we are joined by our Chair, John Penno; our new CEO, Grant Watson; and our CFO, Robert Stowell. There will be an opportunity to ask questions at the end of the presentation. [Operator Instructions] I'll now hand over to John for opening remarks.

All right. Thank you, everyone, for joining the call today. Look, and it's my pleasure to be joining this call and as the Chairman of the company, and it's an equal pleasure to be introducing Grant, which I'll get to in a moment. But firstly, I want to acknowledge again the very challenging environment that we have come through in the last couple of years. As we've talked about, part of it coming about because of the big changes that have happened through the COVID environment in terms of our demand profile, but also that leading to us discovering changes that we needed to make inside the business and have worked hard on. Look, I'm pleased to be presenting an interim result, which I think demonstrates that we're well on our way to doing what we said we would, and that is returning the company to robust profitability and making some pretty important improvements to our balance sheet strength. Now look, part of -- in a few moments, the team will talk to the themes that we've been working our way through and the result. But of course, very important has been finding the right leader for the business. And it's my absolute pleasure to introduce Grant to you. At our last results call, we announced that we were appointing Grant Watson. He started with the business on the 24th of January, and he's made a great start. We've brought in Grant because he's someone who we believe takes a very data and sort of a thorough approach to evaluating and developing strategy with us and the team, but also he's someone who has a track record and relentless focus on execution. And we are already seeing that in the business after his short time with us, and I'm sure you're going to see it in the next -- over the course of this call, but also in the next few days, as many as you have the opportunity to have some one-on-one time with Grant and with Rob. So look, we're pleased with the results. And I'll hand to Grant at this point and will be on the call available for questions later, but I have no question that Grant and Rob will be able to handle all of your questions about the business. So thanks for joining. And let me hand over to Grant.

Great. Thank you, John. It's great to be a part of the business and to be on this call today. Shortly, I'll hand over to Robert Stowell, our CFO, who will take you through the numbers. I'll then touch on my first impressions of Synlait after 2.5 months, take you through, at a very high level, business performance by business unit, talk through our priorities for the balance of the year and then just speak to guidance for FY '22. I'll hand over to Rob.

Thank you, Grant. Good morning to all those online. Look, if you're in the room with us today, you'd see we're smiling. It's fantastic to see our 6 monthly results showing a strong bounce back. However, while this is a positive milestone, we remain grounded as there's still lots of unfinished work and opportunities to chase down over the next 18 months and beyond. If I can get everyone to turn to Page 3, key financial metrics. This is a comparison to the last 6 months with the first 6 months of FY '21. Revenue was up 19% to $790.6 million. That's a new record for us at Synlait. NPAT is up 338% to $27.9 million. Last year, we made $6.4 million for H1. That's a really solid bounce back for us. Now, we were assisted by a one-off sale of Richard Pearse Drive in Auckland, which contributed $13.4 million if you include the tax adjustment. Normalized, we get to $14.5 million NPAT. Obviously, we're still happy with that increase, which is 128%. EBITDA is up 45% to $68.4 million. Operating cash is up 269% to $117.3 million. A great result there also and one way we were looking for 6 months ago. CapEx streaked down 37% to $46 million as we continue to constrain our capital expenditure to critical or high-returning projects. Net debt is down 19% to $391.8 million. Again, we're happy with the progress here. That's an important metric for us. Our base milk price is forecasted at $9.60, which will be another record for us this year. Previous highest base milk price was in 2014 at $8.27. And while this is confirmed in September, clearly, it's going to be another stellar year for milk suppliers. If we can turn to Page 4. We've got a slide on our business review actions. We had several actions that came out of our business review last year. What we've done is plotted the amount of matrix showing a traffic-light system on how much they financially impacted the H1 results. There is a range of progress between green, amber and red. I'm not going to go through the slide on details, but I just want to give you a few takeaways. You can see there's several key workstreams underway in the business. We've made really solid progress on our cost structuring, working capital management and Ingredient business turnaround. We've got several workstreams that have a lot of potential and which will give a lot more value to us over the next 18 months. And that's Nutritionals, capital projects management, Consumer Foods, Beverages & Cream and operational performance. We've had challenges. Look, if you look through here within our capital projects, we've had an ERP project which has gone over budget. It was expected to go live in December and is now planned for August 2022. Under operations, our key metrics that we wanted to increase has been slow to improve due to the reorganization we completed, the advent of COVID continuing to impact us and supply chain challenges being our key focus. We also failed to launch the UHT cream product within Beverages & Cream. However, we are confident we will work through these challenges over the next 6 months and have a clearer view on the size of the opportunities and how fast we can progress them. If we can turn to Page 5, I'll talk to revenues and sales volumes. Look, overall revenue is up 19% or $126 million, which is a great result. The slide gives visibility by business unit. The increase is mainly driven by Ingredients. So we shipped and invoiced another 15,000 metric tonnes of ingredients this year at slightly higher commodity prices. This was down to good planning and great work by our sales and operations team. It was also a record volume for us in a challenging supply chain environment. If we look to Nutritionals, our volume and revenue, as expected, were down a little bit, so down $49 million, roughly 5,900 metric tonnes in volume as we see a2 showing modest signs of recovery from H2 FY '21. As a reminder, our multinational customer will come online with sales volumes mid-FY '23. Both the Beverages & Cream and Consumer Foods business units were relatively flat half-on-half. The key factor to note here is that we have delays in our UHT cream launch due to formulation refinements, while disappointing, is expected later this year. If we turn to Page 6, I'll just talk a little bit about production and inventory volumes. Look, this is a mixed result. Overall production reduced by 9% or roughly 10,400 metric tonnes. This was mainly seen in Ingredients production being down and was driven by our milk supply bank adversely affected by weather, both in the North Island and the South Island. We also sold milk to commission our Pokeno site for our new multinational customer. This was planned, but it is a difference compared to last year. And we sold cream for good returns as we maximize skin milk powder to take advantage of large price differentials, which have opened up between the skim milk powder basket and the whole milk powder basket. If we look at Nutritionals, not a lot of change there. We continue to rebalance our infant base powder inventories and look after our working capital positions as planned. So production was slightly down. Not a lot of change on Beverages & Cream volumes. They are relatively flat. The decrease in production you'll see in Consumer Foods, we're a Dairyworks unit, is due to the temporary closure of Talbot Forest Cheese to mitigate losses while we solve operational issues on that site. Look, the good news here is we've made fantastic progress with our finished goods inventory reductions, which reduced 29% due to strong sell-down of Ingredients products, reduction in our infant base powder production and strong reductions of our cheese inventories. If we turn to Page 7. This slide -- this slide unpacks, by business unit, where the gross margin was made in the half. So in total, we made $68.1 million gross margin. It's up 16% to $9.4 million. Ingredients were up, producing $34.7 million versus $19 million for the same period last year. This was down to more volume, better sales phasing and optimizing of our product mix, reduced cost structures through operations and a good FX position. So we're really happy to see that business unit turn around quite significantly in the half. Nutritionals is down, producing $25.6 million versus $31.7 million for the same period last year. This is still a solid return as our IFC sales for a2 Milk Company recover. Consistent results within the lactoferrin business has also been pleasing, with slightly less volume but slightly better pricing. And again, this business unit improved due to the work that we've done on cost structures and savings through operations. Beverages & Cream, look, the H1 result there was at $300,000 margin loss versus a $1.7 million margin loss for the same period last year. While better than last year, we still have a lot of work to do in this business unit. The key driver for improvement was the reduced cost structure. And I've noted the delays in our UHT cream launch. Consumer Foods is also down in H1, $8.1 million versus $10.1 million last year. And this was down to the strong butter margins that we enjoyed last year due to recent oversupply in the New Zealand market. The teams have also been working through some higher cost of cheese inventories and they only had a part period of cost savings. While disappointing first half for Consumer Foods, we expect some of the profit drag that they have encountered in H1 won't be there in H2. We turn to Page 8, and we talk about operating cost performance. As mentioned earlier, we've made good progress on cost reductions across the whole group despite the trading environment. Firstly, our organizational reset has made savings of $5.2 million compared to a full year target of $7 million. So this has been both helpful from a simplifying the organization point of view and also reducing costs. Note, most of these savings sit above gross margin so are not seen on the SG&A bridge offset. However, we have seen $1.5 million of cost increases in SG&A overall due to extra contract labor that we brought in as we're reshaping the business in the first part of the half in a tighter labor market. Extra IT costs, mainly ERP-related, but also some cloud accounting costs have come in there as well. And we've had some increases in distribution costs. Now most of these increases have been offset by our project we ran for Dry Store 4 and rail. Look, costs continue to be a focus for us as the trading environment continues to be challenging and inflation comes into the frame. We turn to Page 8 (sic) [ Page 9 ]. It's my final slide. On cash flows and net debt. We've made fantastic progress in this space. I'm really pleased about this. It's neat. We continue to stay well within our extended banking arrangements set up last July. The key points on this slide are operating cash flows are up $187 million half-on-half due to selling record numbers of products in H1, making better margins on what we're selling, careful management of our working capital. We've continued to reduce our capital expenditures. So our 2 major projects that we have in flight at the moment are our ERP or SAP project and the Synlait Pokeno project to set up for a multinational customer. We executed the sale and leaseback of RPD in October, which reduced debt by $30.1 million. Net debt is down $88 million since last July. Obviously, this has also helped reduce significantly our interest costs. Don't expect us to continue to reduce debt the same rate in H2. While it will continue to be a key focus, we see a more challenging trading environment in H2. You'll also see there has been a continuing of our target total debt-to-EBITDA ratio of between 3.5 and 4x for FY '22, and we expect further improvement back to normal metrics in FY '23. Look, there's a wrap on the financials. I'll hand back to Grant to take us through the business performance.

Thank you, Rob. 2.5 months in for me and still a great deal to learn about this business. My initial impressions are that Synlait has fantastic DNA. It's got a culture that's disruptive, it's innovative, it's entrepreneurial, and it's extremely well positioned in terms of its -- our sustainability credentials. The second observation for me is that we are building very, very strong momentum within the business off the back of the recovery plan. But to be clear, we are 6 months into a 2-year recovery plan. What we do need to do is we need to increase our level of focus across the business. And what I mean by that is that we need to do less but do it better. We also need to ensure that there's the right level of accountability across the business. We need to increase accountability, and that starts literally at the top, from leadership team right throughout the business. The other area that we will focus on to drive greater performance is the need to improve systems tools and processes so that we really can execute well. The last observation for me is that Synlait has a wonderful group of loyal farmer suppliers. We have really strong relationships with our key customers, and we have a very committed and loyal base of staff within the business. So those are some of my initial impressions after 2.5 months. Just going through, on to Page 12 now, going through a brief overview of each of the business units. The Ingredients business has really increased their focus on delivering against the strategy with a high degree of discipline. Right throughout the value chain, we are looking for greater efficiencies and we have a very strong engagement with our key multinational customers. Moving on to Page #13, the Nutritionals business. A key focus there under our a2 Milk Company relationship is to ensure that we get reregistration for our license into China. We've submitted the initial information and that's currently subject to technical review. So that's the -- effectively, the new recipe. We are expecting an audit by MPI in the next couple of months, and we should get notification around reregistration towards the end of the year. So a very, very important and critical project. In terms of nutritional base powders, we're currently working with several multinational and China domestic players in terms of future business growth in the space. And from an innovation perspective, we're working up further portfolio development across all life stages for these nutritional powders. Lactoferrin business has really strong global demand. And off the back of that, we're seeing really strong pricing against our lactoferrin. And finally, in terms of our new multinational customer that will come onstream at Pokeno, we've had very good results come through from our product trials. The capital project is on track. The capital project is in budget, and we expect to be producing commercialized product towards the end of this calendar year. On to Page 14, Beverages & Cream. We've had great feedback around the Swappa Bottle initiative currently in 2 stores. Demand is well exceeding our original forecast. So before we move through to a more expanded trial, it's important that we take the learnings, review these against the business case and then proceed on the basis that there are very good returns to be had from that initiative. In terms of UHT cream, as Rob mentioned, we're not in market yet. It's really important that we get the formulation right. That has taken longer than expected. We think we're nearly there and certainly plan to have product into the market in the short term. Moving on to Page 15, our Consumer Foods business, Dairyworks. Two very successful launches in the first half. One has been around milk and cream into the foodservice channel in the South Island and in Wellington. And the second has been the launch of a yogurt, Protein Fit. We now have a new distribution center up and running to support the Dairyworks business, which will deliver strong financial benefit, but we're exploring market opportunities in Australia and China. And just to be clear, we already have a position in Australia, so it's looking to grow our position in Australia, and ongoing focus throughout the business on cost structure and working capital. Briefly touching on sustainability. Again, a very, very important part of who we are as Synlait. There's been great progress to transition our power generation on our South Island manufacturing site here in Dunsandel to a source that's more sustainable. We've seen really good improvements in terms of reducing our greenhouse emissions, both on-farm and in processing. And we're working with a number of existing and potential customers around our Made With Better Milk-branded product. And there's a clear demand globally for more sustainable -- sustainably-produced dairy products, both at customer and at consumer level. Moving on to Page 17. And again, for us to be very focused on what we need to deliver against in the second half, I mentioned the license reregistration for China, certainly a top priority for us. Rob mentioned the delivery of our ERP or SAP system planned for the 1st of August. And again, ensuring that we are ready, towards the end of this calendar year, to produce volume for our new multinational customer at commercialized volumes. Clearly, there are still challenges with Omicron throughout the business. It looks as though we've experienced a peak for our North Island manufacturing facilities. We're not there yet in the South Island, and so we need to manage our way through Omicron. It's really important that we look to rebuild and strengthen the culture of our teams within Synlait. It's been a very, very challenging period of time for a number of reasons. And so driving a stronger culture is really important as a platform for all that we do. And lastly, we've commenced a review of our strategies across the 4 business units. And look, again, the clear focus there being each strategy needs to be focused. We need to ensure that we know what our competitive advantages are in the market and that we're clear on what great execution looks like. Finally, if we just move on to Page 18 in terms of guidance. We expect that net profit after tax will return to robust profitability for FY '22. As Rob has mentioned, we don't expect the profitability will grow at the same rate in the second half as it has in the first half. We do have a number of challenges to contend with. Stating the obvious, Omicron, global supply chain. And there's also a lag effect to our margins when we have a significant upshift in milk price and the delay in passing those costs on to our customers. And look, just reinforcing the position that was communicated late last year, it is very much our intention that by the end of FY '23, the recovery plan will have Synlait return to similar levels of profitability as we saw leading into FY '21. So look, on that note, we can now open the line up to any questions that you may have.

[Operator Instructions] Your first question comes from Matt Montgomerie from Forsyth Barr.

Just checking, you can hear me?

We can, Matt.

Great. Maybe firstly on the balance sheet. Clearly, debt's been quite volatile historically. But just interested in any comments you can provide for the direction of travel in the second half and then, I guess, the key drivers of change. And secondly, you make reference to a return to normal metrics. Are you able to remind us sort of what you view as the optimal capital structure or gearing in the business?

Thanks, Matt. Look, I'll answer that. First of all, to the balance sheet and our debt. Look, we've made really good progress in the first half. I expect we'll continue to make progress here in the second half, but just not by the same rate. And the reason I say that is the trading conditions in the second half, as we see milk prices rise and we've got risks around shipping, et cetera, will potentially impact us. But we will continue to reduce debt in the second half and obviously in FY '23. With regards to the metrics, look, this is difficult to forecast just with the trading environment at the moment. But ideally, we would get to this year is kind of around 3.5x total debt to EBITDA. That's what we're targeting. If we can do slightly better than that, great. The following year, like to see us in and around 2.5x, and then that will track down to 2x and 1.5x. It's really just hard for me to predict how some of those supply chain issues and COVID impacts are going to impact us over the next few months.

That's great. Maybe then secondly, on return on invested capital. At the last result, I recall you, I guess, retaining guidance for an expectation of around 20% over the medium term. Just interested in any comments you can make on that, if it's still current. And if so, what gives you the confidence to deliver on that target?

Look, we are still confident that we're going to get back to that sort of rate of return. However, it's going to take time. We've got a number of really good opportunities in front of us, especially across areas like Nutritionals. And we just need to keep working at those opportunities and make sure that as we spend any further capital, it's on high-returning projects. But it might take a couple of years.

Your next question comes from Nick Mar from Macquarie.

Just sort of expanding on the second half commentary. Can you just provide some context around the comment that it won't grow at the same rate in the second half, which line item you're talking about? And is it percentage-wise or dollar-wise? And is it sequential or on pcp? It's just a little bit vague.

Yes, and I appreciate that, Nick. Look, the best way I can explain this is if you take the $27.9 million, we're not going to grow at the same rate as that in the second half. So if you are thinking about the business on a normalized basis, i.e., taking out the effect of the Richard Pearse Drive sale, then we will be growing at or above that rate that we had in the first half. Does that make sense?

Yes. So that was like 130%. But you're obviously -- the second half '21 was a loss at the NPAT line. So how do you sort of line that commentary out? Or you've got...

I'm comparing, yes, sequentially. So probably just to give you some more insight, a lot of our nutritional and lactoferrin volumes and stuff are weighted towards the H2 in this financial year. So you will see some good, good gross margin coming through in the second half. If you look at the top line number, $27.9 million, we won't be doubling that or anything like that.

Okay. And then sort of just, I guess, trying to put in context. So you still expect net debt reduction over the second half, all things going well. And if you were in the 3.5x EBITDA range, that would suggest that the second half EBITDA is flat to down on the first half? I'm just trying to marry up those comments.

Yes. Look, there's a number of scenarios that could play out. And I guess the net -- when I comment on net debt, I'm actually taking into account some of the headwinds or challenges that we may encounter in the second half. And the big one for us, Nick, is getting shipping volumes out. As you know, with the Ukraine crisis and et cetera, things have actually got more difficult in the second half. So we're just being cautious here on debt. If we have a clean run and everything goes -- we don't have any of those challenges impact us, we will be below 3.5x.

That makes sense. And then just on the Ingredients margins. Just trying to understand what the driver was there. Was any of that sort of, I guess, uncontracted excess inventory that you benefited from a run-up in commodity prices over the period? Or is there sort of true margin gains from genuine improvements across the business?

Yes. Okay. It's relatively straightforward. So we -- as we noted last -- at our year-end last year, we had that product that we had on hand. So I indicated it was about 13,000 metric tonnes, okay? So we've got that extra volume coming through in the first half of this year, we've done a really good job of getting that all invoiced and out on ships. But there's some really good work that's been done within our sales team and the way they've managed to get the product mix right. So we've maximized skim milk powder. There's been some really big product differentials open up there compared to the whole milk powder basket, our sales phasing's been good, and we've also had a strong FX position and a lower cost structure in the first half as well. So all those things are combining to really bumping up our margin in H1.

Your next question comes from Adrian Allbon from Jarden.

Can you hear me okay? .

Yes.

Just wondering if you could -- if there's any more sort of detail or context to sort of provide around like the SAMR renewal delay? I think last time, when we heard from you at the last result, I think you were speaking -- or you were flagging an outcome kind of by August. Is there anything sort of specific to the delay? Or is it more a general delay across the international brands?

Thanks, Adrian. Look, we are following the process. It is taking a little longer than expected. To be really clear, we've submitted our information around the new recipe. We're waiting to hear back in terms of the technical review that's being completed. We're not expecting any issues there. Once that technical review has been completed, then an audit will be planned, and it will be completed by MPI as an agent for SAMR. Would expect that order to take place sometime in the middle of this calendar year. It's very hard to say exactly when at this point. But June, July, August, somewhere through that. And then there will -- then there'll be a period of time that we need to wait until we get final confirmation from SAMR. Hence, the indication from our perspective is we should get that towards the end of the year.

Okay. That's helpful. And maybe this is probably a question more for Rob. Look, if you come back to slide -- or to Page 4 and then the center there, the capital projects management, are you -- I'm sort of a little bit confused with this. Are you sort of flagging that the ERP stuff is $20 million over budget and there's more CapEx than you previously flagged on the Pokeno customer? Because I think later in the pack, you guys sort of signal there's more CapEx for the Pokeno customer.

Yes. No, thanks, Adrian. I can clarify that. Look, capital management's been -- it's a mix there. It's been relatively good, but we've had a couple of things, which has gone a little bit over. So our Synlait Pokeno customer, yes, we had an increase there. But to be honest, it was relatively small, it was $6 million or $7 million, and it was just to add a little bit more in for that project, more capability. The ERP project is the bigger increase, and that's $20 million above what we originally budgeted and we forecasted last year. So that's relatively significant. And we were trying to hold the project to that, and we're going live with it in 4 months' time. So hopefully, we do that. Is that clear enough?

Yes. So yes, I guess like so in terms of like -- if we're thinking about like you've done $46 million of CapEx in the first half, I mean, should we be thinking about $60 million in the second half? And then probably another $20 million flowing on, on those 2 projects in the first half '23?

Yes. Look, we've given guidance on this before. So we expected to spend around $90 million this year, and we're going to be probably just over $100 million. Obviously, some projects a little bit delayed and some are a little bit over budget. But it's in that sort of region of numbers. So $105 million versus $90 million target.

And flowing until first half '23 would be -- should we put in another $20 million? Like I guess there's a bit of flow on from ERP and it's a bit more on Pokeno potentially?

No, I'm accounting most. I'm probably accounting $15 million of that in FY '22 and $5 million in FY '23. We'll have another look at FY '23. I mean obviously, our capital expenditure will be still tracking down in FY '23 from roughly $100 million this year.

Okay. And then are you able just to go -- so just as we track the second half for the new multinational customer, as you sort of get into the commissioning phase, what are the kind of key milestones you're trying to hit there?

Yes. So the first milestone is really making sure that the products that we're making, inspect and going through shelf-life testing. And then once we've done that, we will be commercializing end of this calendar year and exporting probably around January '23.

Okay. And are those shelf-life studies at the moment, have you completed any of that stuff? Or that's still to be done?

No, they are underway at the moment and all that sort of stuff is going to plan.

Your next question comes from Richard Barwick from CLSA.

I was just going to ask as a bit of a follow-on from that last one. When you referenced opportunities in front of you, I assume you're talking about potential new customers. If there's any color you can give there in terms of how far away would you expect anything material in terms of a new customer coming on board?

Yes, Richard, we're working with customers across a number of the divisions. So we're working with several multinationals and China domestic customers on infant nutrition base powders. We're obviously working with a key customer against the foodservice cream opportunity, and that's targeting the China market. And from a Dairyworks perspective, we're also looking to build our customer base out in Australia and look for new opportunities up into China.

Any sense on timing for where we might see anything that moves the dot?

No material updates at this point.

Your next question comes from Stephen Ridgewell from Craigs Investment Partners.

I just wanted to follow up on the response to Adrian's question on the same registration delay. I guess I'm curious, was there -- it looks to be a 3 to 4 months delay. I'm just curious, was that mainly due to Synlait submitting the dossier behind schedule, which I think had been earmarked for January, February? Or is that a delay in SAMR's review in response to the dossier?

Certainly, the delays haven't been caused by Synlait. The process is just taking longer. And as you'd appreciate, this is a new registration process for all parties involved. So look, it is taking longer. We expect that if a notification of reregistration takes longer, there will be an extension to our current registration with our current product into the market. So from a timing perspective, that doesn't create any material risk.

Right. But I mean has SAMR indicated that in the times that you've indicated today for an April response to the dossier, has the SAMR indicated April as when they plan to respond? Or is that just an estimate from the management?

That is the indication we've received from SAMR.

Okay. Great. Okay. And then just maybe moving on a little bit. Just with the a2 volumes, which is, as you know, there's some rebalance of inventories and so volumes were up about 30%. I guess I'm just curious, do you think that's all inventory rebalancing? Or was there a little bit of substitution particularly starting to happen for Mataura Valley? And I guess if we look forward to FY '23, does this guidance statement that you've put out for return to profitability to kind of pre-FY '21 levels, does that allow for some erosion of Mataura Valley volumes into next year?

Yes. Steve, it's Rob here. Look, with the a2 volumes, we do see that recovering. With your question around into FY '23, yes, we are assuming some erosion of our volumes going down to Mataura Valley, and we are still confident on our outlook. And the reason for that is some of the other customer volume that we have coming into the business, which is a good news story from our diversification strategy.

And I guess just on that story. I mean you mentioned a couple of new opportunities. What do you sort of see as well in that investment? I think you mentioned your Chinese domestic infant formula customers potentially offsetting any kind of volume loss to Mataura Valley.

Yes, that's one of the opportunities. And there's also other opportunities there as well that we're working on. So look, we're very comfortable with the way our volumes are shaping up for FY '23.

That's great. And then just on the inventories because look, it was a good half, as you noted in the prepared remarks, in terms of working capital reduction and cash flow. So well done. I guess just interested in something else that had been on the outlook. Just noting the stress in the supply chains, and I think you've even called out potential shortages of raw materials in some other parts of the business, continued shipping challenges, et cetera. I guess my question is, is the reduction in inventory that we've seen in the first half actually sustainable in a very volatile environment? Or are you sort of happy with the level of inventories you've got? Or is it just specific areas where you see inventory reduction potentially, inventories reduce and maybe some other areas, you might need to add a bit more?

Yes. No, great question. Look, I didn't really cover raw materials a lot in the presentation. But actually, our raw materials were actually increased a little bit on last year. And we've done that just to insulate ourselves from some of those supply chain disruptions. On the finished goods side, is it sustainable? Look, we're still operating so that we've got sufficient amounts of safety stock, both for ourselves and also our key customers. Over time, as you see demand recover, you will see us increasing some of those inventories a little bit, but not by much. We're really focused on making sure we keep those inventories at a level that unlocks that working capital. And it was fair to say probably towards the end of FY '21, we had got a little bit bloated on our inventory levels.

Got it. And just one last one for me. Just a comment you've made about the headwind from rising dairy prices in the second half. I mean are you able to, just where milk prices stand at the moment, are you able to give us some broad idea of the quantum of that headwind in terms of your gross margin?

Look, I guess the comment there was made in relation to if commodity prices kept on increasing kind of from where they are today -- they've kind of stabilized a little bit at the moment -- then we may see some further headwinds. Obviously, we do have net contracts across our business units. And so it would have just meant that we continue to pay as compared to milk price, and our revenue line wasn't probably going up quite at the same extent. So look, it's a factor, but it's probably less effective than the Omicron risk and the supply chain risk that we've noted in the guidance statement.

[Operator Instructions] Your next question comes from Marcus Curley from UBS.

A few for me. So you mentioned that you're expecting stronger Nutritional sales in the second half. I just wondered if you can provide any sort of color on where you think Nutritional volumes will end up for the year, up, down, sideways?

Marcus, it's Rob here. Look, what I would say is we do see some positive signs on -- and interest on volumes. Obviously -- and for this year, it really depends on a couple of things. I see the COVID, the supply chain risks could be a factor. But if they don't really play out, we could see ourselves at a similar sort of level as last year for the total year's result.

Okay. And then when you look at your first half result within the Nutritional division, and I suppose you break that down between, I suppose, the 3 key products being base infant formula, canned infant formula and lactoferrin, would you -- how would you typify the gross margins at the product level? Would you say that what you're achieving at the moment is pretty consistent with what you would expect medium term?

No, I would -- I mean, I think we'll probably expect to be a little bit better going forward, Marcus. Across those 3 things, we will see recovery in both IFC, infant base powder. And lactoferrin continues to be a strong performer for us as well. So I'd see growth on -- across all 3 of those areas.

And what's the driver of the improvement? Is that manufacturing efficiency? Or is it your pricing or other components?

Yes. The big one for me obviously taking -- putting aside volume, it's manufacturing efficiencies. We've done, as I mentioned on Page 4 on our review actions, we've done some good work within our cost structures, but there's a lot of other opportunities within our efficiencies as we improve reliability of your plants and quality right at this time and other areas like yields, and we increased the volumes that are going through those plants, including milk supply.

Okay. And then finally, a2's announced their intention to launch a new English-label product next year. My understanding is that's going to be produced by yourselves. Have you come to a separate agreement on that product? Or will it be just bolted into the existing agreement?

Marcus, that will, in short, it will be bolted into the existing agreement.

And probably gives you reasonable amount of confidence in terms of an offset to the internalization?

What do you mean by the internalization?

No. Yes, so...

Mataura Valley?

Yes, correct, yes.

Look, as mentioned -- yes. Look, it does give us some confidence there. The internalization of manufacture by a2, that will happen over time, and we've already built that into our plans.

Your next question comes from Jonathan Snape from Bell Potter.

Can you hear me okay?

Yes. Yes.

Good. Look, could I just circle back to, I think, some of the questions that [ Ben ] was asking earlier around the second half guidance and the debt and all that sort of stuff. If I look historically, you seem to be somewhere between about $70 million or $80 million operating cash flow after leases and financing in the second half, and it's probably not unreasonable to expect, everything being normal, you kind of do that again. CapEx sounds like it's going to be up closer to $60 million in the second half. So we're kind of talking $10 million, $20 million of free cash in the second half. Does that sound too far out of whack, I guess, considering where you're thinking?

Jon, it's Rob here. Look, in normal trading terms, I'll say, yes, you're not far off with those sorts of numbers. The big unknown for me is just what we're going to have to navigate across the next 4 months. And it's really around not so much manufacturing. We seem to be doing reasonably good with our plants and keeping up production. But it's more to do with the volume of products that we'll be able to invoice and ship. So that could swing us around quite a bit on those numbers. And then obviously, there's be a timing difference so that those sales would come into the start of next financial year. But yes, you're not far off the money on your -- on the normal trading terms basis.

Yes. And if that kind of happens and you said, okay, we finish it, we'll land at 3.5x EBITDA, then you're kind of getting close to $105 million, $110 million number, which is that EBITDA anyway, which kind of implies in the second half, you're doing around $35 million, $40-odd million, which is actually quite a big jump from the loss of $10.5 million last year. So what I'm trying to reconcile is the comment in the outlook statement that says we don't anticipate second half profitability growing at the same rate as first half, when if you look at the first half, you grew like $20 million. And in the second half, that would seem to imply you're going to double that rate in a nominal sense. So I guess the confusion, I think, maybe what [ Ben ] was getting at earlier is how do you reconcile your target EBITDA or net debt to EBITDA ratio to what you kind of imply for the growth rate in the second half with the comments that you actually don't expect to grow that much?

Yes. Look, I think there has been a little bit of confusion around that, Jon. Look, we -- in the second half, providing that we don't get disrupted by any of those challenges, and those challenges are real, we will perform, on a normalized basis, I'm taking out this effect of the one-off sale of our Auckland property, then we will be doing better in the second half than we did in the first half. Yes. And ratios will be a little bit better than 3.5x as well.

So again...

We've got time for one more question.

Okay. I'll take this one offline, if that's all right. Okay.

Thank you. There are no further questions at this time. I'll hand back to Mr. Watson for closing remarks.

Thank you very much for your time today, and thank you for your questions. We very much look forward to engaging with you over the following week to have further in-depth discussions.

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