Ann: COVID 19 Trading Update, page-26

Freedom Foods Group (FNP) PDF COVID-19 update no. 3 – trading gets worse HOLD (downgrade) | current price: A$3.72 | target price: A$4.33(previous: A$5.05)

§FNP's high margin products (MILKLAB and cream) have been severely impacted by COVID-19 restrictions, while Retail sales are now normalising. §We have made material downgrades to our forecasts and note that earnings uncertainty remains. We expect that it will take time for the Out of Home (OOH) channel to fully recover. In our view, FNP now needs to closely manage its balance sheet or an equity raising will be required to restore it. §Given earnings will take some time to recover, its near term multiples are steep and its balance sheet is stretched, we move to a Hold rating.

OHH gets worse, high margin cream sales don't eventuate FNP said that shifts in channel and portfolio mix are now having a material impact on its 2H20 profitability. Like other FMCG companies, FNP continues to be impacted by the slowdown in the high margin OOH channel given stay at home restrictions. In April and May, FNP's OOH sales were 75% and 50% below budget. This has affected its MILKLAB sales in particular. However from July, MILKLAB will be ranged nationally with McDonalds. Sales in the OOH channel in SE Asia have also been impacted. Additionally, FNP's Industrial sales (food service and hospitality) are weak (particularly cream sales). In April and May, its cream sales were 55% and 45% below budget. Margins on cream sales have been impacted by lower selling prices given there has been oversupply following two factory closures due to COVID-19 and FNP has incurred higher seasonal milk pricing. Retail sales are now normalising to pre COVID-19 levels after the initial pantry stockpiling benefit. Grocery promotions have also resumed. On a positive note, demand for lactoferrin is strong, reflecting continuing interest in immunity and its application to infant formula. FNP has now contracted ~80% of its FY21 capacity (was 60% previously). While FNP's 3Q20 China sales fell 35% vs budget, they are now recovering. COVID-19 has caused the company to fast track the reshaping its operational footprint. FNP's warehousing and logistics will now be done internally. Material cost savings are forecast from this move. Balance sheet needs to be closely managed A debtor provision of approx. A$4m on an export account will now be required in the 2H20. FNP said that the consolidation of its external warehousing activities and the rationalisation of its lower margin SKUs will result in a A$25m write-down of inventory in FY20. As we expected, there will be no dividend in FY20. Group capex is now expected to be A$120-130m (Morgans was A$110m). In addition we expect A$14m of NPD will be capitalised. Capex is forecast to fall materially in FY21 as key growth projects have been completed. FNP has previously announced that it has increased its short term liquidity limits by A$100m so it has additional financing flexibility and its debt covenants have also risen so the company has more headroom. Given we now expect FNP to generate minimal operating cashflow in FY20, our gearing forecasts have risen to ND/EBITDA (depressed earnings) of 4.0x, ND/E of 41.8% and EBIT interest cover has fallen to 3.1x. We revise our forecasts We have reduced our EBITDA forecasts by 20.0%/24.5%/8.1% in FY20/21/22. We expect OOH will still be impacted in the 1H21 due to social distancing measures and a cautious consumer. Given the company's operating and financial leverage, the downgrades at the NPAT level are more severe. Due to the quantum of one-off items (restructuring costs, provision, write-down of stock), we now expect FNP to report an FY20 statutory loss. Still a lot to like but rerating will take time – we move to Hold rating While FNP's trading update was disappointing, we recognise that the impacts of COVID-19 on its business are out of its control. When markets normalise, FNP is well positioned given the popularity of its brands, exciting nutritional product pipeline and there exists material operating leverage from the scaling of its facilities. A stretched balance sheet causes us to move to a Hold rating with a new price target of A$4.33 (was A$5.05).