Brambles: A pallet of poor returns

I can't help but feel a little sorry for Brambles. Its pallet pooling operation, CHEP, is at the centre of world trade, helping to move goods from suppliers to customers. The company made a net profit of US$557m this year – a 10% profit margin and a return on equity of 20%. Not bad at all. Yet, still, Brambles is about as popular among the analyst team as singers who mime at concerts.

From a distance, the company looks like a high-quality business with a commanding market share, earning decent margins and returns on capital. Up close, though, you realise that Brambles doesn't distribute its earnings to shareholders as cash. It pays them in pallets.  

Brambles made US$3.3bn in cumulative net profit over the past five years, yet only paid US$1.8bn in dividends. What's more, the company needed to raise US$448m in additional capital in 2012. So where did the extra US$1.9bn of retained earnings and fresh capital go?

Every last cent needed to be reinvested into the business for it to maintain its operations. We can't even say that the money was spent growing the business – underlying earnings per share are still 8% below where they were in 2012.

A losing game

We're not being entirely fair: Brambles used a bit under US$400m paying off debt, which we like to see – though there's still around US$2.6bn of net debt on the balance sheet. And around US$700m evaporated due to the translation of earnings and assets at foreign subsidiaries back to the US dollar while the currency strengthened.  

That still leaves an earnings gap, and Chart 1 shows you where the profits went – or, to be more accurate, why they were never really there to begin with.

Brambles currently owns 550 million pallets worldwide but, in a typical year, around 1-in-10 are either lost, damaged or otherwise deemed ‘irrecoverable'. Of these, only around half garner any compensation from the customer, so Brambles is usually left footing the bill. It must constantly buy new pallets just to maintain a steady level of stock.

Last year Brambles wrote off US$75m of lost pallets – with a further depreciation expense of US$373m for the battered survivors – but the company spent US$620m replacing all the irrecoverable and scrapped stock. The difference will eventually flow through the income statement as higher depreciation in future years, but the cash is still out the door today.

Bad renters

Why does this matter? Imagine you want to earn a little extra income each month and so decide to rent out part of your home. One of your neighbours offers to pay $50 a month to rent a car space on your driveway, and another neighbour pays $100 a month to rent a granny flat in your backyard for their teenage son.

At the end of the month, the cash comes rolling in – but there's a problem. When you inspect the teenager's granny flat, it looks like he drove a forklift through the living room before hitting a landmine in the bedroom. You'll need to spend at least $100 on repairs. In contrast, the car space is still sitting there in the same condition you left it.

Here, the car space is considered ‘capital light' as it doesn't need constant reinvestment, whereas the granny flat is considered ‘capital intensive' as you need to spend lots of cash to maintain it. On paper, the granny flat is earning more in rent, but, in reality, the car space is producing more ‘free cash flow'. And whether it's an investment property you own or a business, free cash flow is what matters.

Brambles produced US$1,167m of operating cash flow in the year to June, but needed to spend US$1,081m – 19% of revenue and more than double depreciation expense – on replacing old pallets and buying more to grow (see Chart 2). That leaves just US$86m of free cash flow.

Even if we add to this the US$104m received from the sale of old pallets to third parties, the company still only has free cash flow of around US$190m – a far cry from the US$557m in statutory net profit.   

Still, Brambles does have a few things going for it. Pallets are an important cog in global trade and the company dominates its industry – a position we expect it to maintain for decades to come. The business enjoys significant economies of scale, which is a formidable competitive advantage. And although growth hasn't been stellar, there will almost certainly be more goods shuffled around the world economy in 10 years' time than there are today, so Brambles at least has a little wind in its sails.

This isn't a high-quality business the likes of Cochlear or REA Group, but we would still be happy to recommend buying the stock – if the price is right.

The price is wrong

Despite Brambles' earnings per share going absolutely nowhere since 2012, the share price has almost doubled. Investors are paying a good 90% more per dollar of earnings today than a few years ago, despite very little change in the long-term outlook.

A price-earnings ratio of 25 and free cash flow yield of 1.4% simply doesn't provide adequate compensation for the risks.

In 2016, the Americas pallets business – where Brambles has a 40% market share – increased earnings before interest and tax (EBIT) by 2.5% to US$428m. The Europe, Middle East and Africa pallets operation did slightly better at 3% EBIT growth to US$355m.

That's reasonable given Europe's current economic woes – and management forecasts revenue growth of 7–9% in 2017 – but it's still nowhere near enough given the low yield on offer. And we haven't even touched on the potential effect of Donald Trump's proposed scrapping of various US free trade agreements (hint: it's not a positive).

A final point of concern is the recently announced retirement of chief executive Tom Gorman, which is to take effect in February 2017. A new chief financial officer also came on board last month. If we know one thing about business, it's that new managements like to work with a clean slate. This coming year's financial results would be a perfect time to air any skeleton-filled closets, write off extra pallets, and catch up on any delayed capital investment. We don't necessarily expect bad news, but new managements tend to crystallise it.

We're reducing our maximum portfolio weighting from 8% to 5% and, even though the stock is just above our recommended Sell price of $12, we're disinclined to give it much leeway. We're downgrading to SELL.