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Is Synlait Milk Limited a better bet than the A2 Milk Company Ltd?  

Synlait Milk Limited (ASX: SM1) is a New Zealand-based dairy processing company. It is focussed on developing nutritional milk products including infant formula and dairy supplements. The company claims to use innovative techniques to create a differentiated product out of a historically homogenous dairy commodity.   

It pays a premium to suppliers for milk that is seen as having specific health benefits, such as that from solely grass-fed cows, or milk that is rich in the A2 beta-casein protein. It uses this milk to manufacture higher margin nutritional products. 

Its share price has had a great year, hitting an all-time high of $7.39 in late October before falling off slightly to be now valued at $6.59. That still puts them up over 120% for 2017.   

The market has rewarded them for pursuing what has so far been an effective growth strategy. The share price really took off in September, after Synlait announced an 11% increase in NPAT for the year, as well as a 60% reduction in net debt. 

There was more good news for the market later in September, when the China Food and Drug Administration (CFDA) granted registration approval for Synlait and the A2 Milk Company Ltd (ASX: A2M) to continue to export its infant formula to the lucrative Chinese market.   

Synlait and A2 Milk formed a commercial partnership in 2010 with the goal of developing the world’s first A2 beta-casein infant formula. 

Synlait is not a particularly well-recognised brand in Australia, however it has slowly grown its market cap to the point where it is now valued at a respectable $1.19 billion.

To give a sense of its size, this puts it ahead of Freedom Foods Group Ltd (ASX: FNP) ($1.03 billion) and not too far behind more well-known brands such as Bega Cheese Ltd (ASX: BGA) ($1.38 billion) and Inghams Group Ltd (ASX: ING) ($1.32 billion). 

Shares in Synlait currently trade at around 32x earnings. This is higher than both Bega, which trades at 8.21x, and Inghams, which trades at 20.56x.

The three stocks all lag well behind Freedom Foods’ 161x, but its share price has risen significantly over the last couple of months on the back of a positive sales guidance update in November. 

This shows that investors are willing to pay a premium for the right to Synlait’s future cash flows, at least relative to both Bega and Inghams.

This could be due to the company’s increasing focus on research and development. Investment in R&D was equivalent to 1% of revenues in FY17, and this is set to grow to 1.5% in coming years. The company is also committed to establishing a new R&D centre in Palmerston North, on New Zealand’s North Island.  

Synlait also announced that they have entered into a strategic partnership with Foodstuffs South Island Limited. As part of the deal, Synlait will invest NZ$125 million into constructing a new milk packaging plant and become the exclusive supplier of fresh milk to Foodstuffs South Island. This represents Synlait’s first foray into the fresh milk market, and it is anticipated that products will start hitting shelves from early 2019. 

However, the Foodstuffs South Island partnership doesn’t come without its risks. In a note out of Credit Suisse, its analysts indicated that they weren’t confident the returns from the new plant would meet the company’s targets.  Consequently, they maintained an underperform rating on Synlait’s stock. 

Foolish takeaway

Realistically, Synlait is probably not going to light up the market this year. But it’s a solid company with some decent growth prospects, and while its current price multiple is a little high relative to its peers, it is able to justify it through an expansive business strategy that will see it branching out into new markets over the next couple years.   

After benefitting from some significant upward momentum mid-year, Synlait’s share price has been a bit up and down since November. This could show that the market was underwhelmed by the Chairman’s address at the company’s AGM, or that it is trying to price in the risk created after the company’s CEO John Penno announced that he would step down from his position sometime over the next 12 months.   

Or it also just might be some opportunistic investors taking a little profit after their big mid-year gains. 

But if you’re bullish on Synlait, the recent pullback in its share price could provide a good chance to invest at a decent price. That’s if you’re willing to accept the uncertainty of a new CEO – and bet against Credit Suisse’s analysts. 

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Motley Fool contributor Rhys Brock owns shares of Freedom Foods Group Limited. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended Freedom Foods Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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