Australia | Sep 16 2021
This story features BRAMBLES LIMITED. For more info SHARE ANALYSIS: BXB
To improve the efficiency of its global pallet operations, Brambles will incur a significant investment over the four years from FY22. Will it be worthwhile?
-A structurally better business could result from the transformation plan
-Key decision on the Brambles/Costco plastic pallets trial expected in H2
-Investment requires capital at a time when expenditure is already elevated
By Eva Brocklehurst
Brambles ((BXB)) has outlined ambitious plans to improve the efficiency of its global pallet operations. This requires a digital transformation, centred on using GPS-tagged plastic pallets to identify sources of pallet losses and unauthorised pallet usage.
The company has used 5000 GPS-tagged pallets in its Irish business and found a tenfold investment return from the use of digital capability. This has spurred the company to focus on extending the digital transformation, particularly with Costco which, as Macquarie alludes, is pushing hard for a plastic pallets solution.
The investment required involves US$480m of operating expenditure spread across this transformation plan and US$625m in capital expenditure out to FY25. Brambles is guiding to 5-7% revenue growth to FY25 yet net profit growth of just 1-2% in FY22, which will move to high single digits in FY23-25. Guidance excludes the impact of plastic pallet outcomes.
Macquarie can envisage a structurally better business as a result of the transformation plan, with cash generation that should lead to value creation for shareholders (Brambles is guiding to 10% shareholder value creation) but acknowledges the substantial costs upfront make for caution.
Morgans believes the initiatives make sense but agrees the investment is significant and the key will be the execution over the next few years as well as proving up the returns. Margins will be affected in FY22 by higher transformation and digital costs, although operating leverage should improve over the medium term as these investments are realised.
The opportunity is fairly large should the company be successful and Citi agrees Brambles could become a better business structurally. The re-start of the share buyback should support earnings growth and provide some offset to the higher investment expenditure in FY22.
All up, management has flagged a potential US$1.1bn four-year investment plan with the offset being a -4% downgrade to FY22, Citi concludes, and the risk of projected returns not materialising from the US$450m to be spent on the supply chain is low, given US$235m relates to already-proven technology, US$60m to continuation of an existing pallet durability program and US$120m to purchasing new automation technology.
Yet Jarden questions why the transformation decisions are being made now, although understands the company wants to entrench its competitiveness. The broker points out customers are accepting higher prices at present and current conditions are most conducive to profitable growth, as pallet supply remains tight over key markets in CHEP Americas and CHEP EMEA (Europe, Middle East, Africa).
Instead, investors are now faced with a lower earnings growth outlook over the short term and prospects of execution risk at a time when the market is still recovering from the pandemic.
Jarden lowers forecasts to reflect a combination of a lower margin outlook for the US pallets division and incremental costs as well as a step up in the tax rate. Even without this investment decision, the broker believes free cash generation will be constrained going forward and is unlikely to cover any dividends before FY25.
Hence, Jarden, not one of the seven monitored daily on the FNArena database, downgrades to Underweight from Overweight and reduces its target to $11.60 from $12.75.
In order to become more positive, the broker would need to find sustained competitive gains and benefits from the transformation along with operating leverage. Credit Suisse, too, has downgraded estimates following the presentations, reducing FY22-23 forecasts by -5-6%.
Most of this pertains to lower margins in operating segments and the remainder from higher transformation costs. Nevertheless, the broker is still ahead of management's guidance for FY22-24, noting historically the company tends to be quite conservative.
Management has expressed concern that costs may not fully return to pre-pandemic levels while Credit Suisse, suspecting this assumption is included in guidance, envisages no reason why costs cannot return closer to pre-pandemic levels and allow for stronger margins.
Brambles has low penetration in Germany, partly because of the popularity of a competitor's whitewood exchange, but expects higher growth in the future after gaining retail acceptance from the likes of Aldi and Lidl.
While the company has experienced a strong recovery in automotive container demand this has slowed because of a semiconductor shortage. As many vehicle manufacturers are moving to a higher proportion of electric vehicles Brambles is intent on gaining exposure to parts logistics. Specialised containers for batteries produced in China are considered another opportunity.
Management is currently undertaking a trial of plastic pallets with Costco and iGPS. Costco comprises around 10% of the company's volume in the US and a decision is expected in the second half of FY22.
Brambles will not go ahead if the return is less than 10%. Jarden calculates a best case return is 13.8% for plastic pallets, although this fails to account for any network inefficiencies from running a large wooden pallet pool elsewhere in the US.
Credit Suisse also points out, while the plastic pallet loss rate is around -30-50% lower than for wooden pallets, these are typically deployed across low-loss lanes, given the pricing premium.
Plastic pallets cost around three times more to produce than wooden pallets so efficiency is critical, although Macquarie suspects Costco will go ahead regardless of whether Brambles comes to the party.
Besides the return on investment, the company will also require a commitment from Costco to transport collaboration along with acceptance from Costco suppliers. In the event Costco switches to plastic pallets a three-year conversion timeframe is anticipated.
Morgans considers the future of plastic pallets at Costco comes down to whether the price premium can be justified, noting if Brambles decides not to proceed the lost Costco volumes could take years to replace. On the other hand, the investment will require capital expenditure of US$450-700m over three years during a period when expenditure is already elevated.
FNArena's database has three Buy ratings and two Hold. The consensus target is $12.68, suggesting 15.3% upside to the last share price.
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