We recently reviewed Brambles (ASX:BXB) after the Company provided an update for the 3rd quarter of financial year 2020 (3Q20). The trading update highlighted the overall defensiveness of BXB’s revenue base in light of COVID-19. The key issue underpinning the outlook for BXB is the extent to which operating leverage can return, given that the expected earnings growth rate for FY20 is lower than the rate of revenue growth.
Brambles is the largest provider of pallet services. Following the announced sale of IFCO (a reusable plastic crates business) on 25 February 2019, the Company’s main operations will soon solely comprise the CHEP (pallets) division. This has operations in Americas, Europe, Middle East & Africa (EMEA) and Asia. In the US, Europe and Australia, CHEP’s market share is estimated to be 55%, 25% and 70%, respectively.
Key Investment Considerations
Revenue Base is Highly Defensive
CHEP derives over 80% of revenues from customers in the consumer staples sectors. It experienced record levels of pallet demand across grocery supply chains in key markets during March 2020. Revenue from higher pallet volumes in grocery supply chains has more than offset demand-related increases in pallet repair & collection costs. Only 5% of the overall revenue base, which is derived from its automotive containers business, is exposed to automotive manufacturing shutdowns and government lockdowns in key regions.
Can Operating Leverage Return?
The solid performance of CHEP in 3Q20, which offset weaker container revenues, saw FY20 revenue guidance upgraded to 5-7%. This was from previous guidance of mid-single digit revenue growth. However, underlying profit growth is now expected to be 3-5%. This is lower than previous guidance for underlying profit growth to be in line with revenue growth.
The updated guidance assumes a similar operating environment in 4Q20 to that in 3Q20 (i.e. higher consumable volumes and lower automotive volumes). The lower guidance for underlying profit reflecting the temporary closure of the automotive business and higher costs related to demand spikes from grocery customers.
Higher operating costs are due to changes in the network resulting from COVID-19. The Company is using operating expenditure instead of CAPEX to service elevated demand.
We outline a number of factors supporting the likelihood of operating leverage returning for CHEP Americas, with a return in operating leverage for CHEP EMEA likely to be more challenging.
i. Margin for the CHEP Americas division has suffered in recent years, partly due to high cost inflation (primarily from transport, lumber, labour, property leases). In response, the Company introduced an automation program, as well as productivity and pricing initiatives to improve US pallets margins by one percentage point annually across FY20-22.
ii. The Company is also likely benefit from temporarily lower labour and transport costs arising from the economic slowdown due to COVID-19. However, this is also likely to result in lower margin for Brambles as the pallet repair process incurs inefficiencies and a large number of pallets are returned.
Balance Sheet Remain Conservative
Brambles has a conservative gearing profile and has access to significant liquidity. Gearing (on a net debt to EBITDA basis) remains sound, at 0.94x as at 31 December 2019. Gearing is expected to remain ~1x as at 30 June 2020 and below both the gearing target of <2x and the covenant level of 3.5x. This provides a buffer in the event of an increase in net debt levels in FY21 and FY22, potentially from higher pooling CAPEX, as well as impacts of the COVID-19 environment on EBITDA and cash levels. Having said that, BXB commented in the recent trading update that cash performance for the nine months to 31 March 2020 was strong.
The strong balance sheet position also allows the Company to continue with its capital management initiatives. The current share buyback program is likely to continue until the end of FY21.
We consider the potential for operating leverage a group level to return from FY21 to be the main catalyst for the stock over the short term. This is due to the cyclical nature of COVID-19 impacts, which resulted in a downgrade to earnings growth guidance for FY20, to subside.
The shares are currently trading on a 1-year forward P/E multiple of ~18x. While the current multiple is broadly in line with the 3-year average, it is not demanding in the context of, firstly, a strong balance sheet and liquidity position and secondly, a 3-year EPS CAGR growth outlook of around +14%, driven by:
i. Margin expansion from US pallets automation,
ii. Lower cost inflation in the US and
iii. A considerable on-market share buyback. (i.e. the continuing share buyback supports EPS as the number of shares on issue progressively declines as more shares a bought back).
BXB has under-performed over the last several weeks where it is still trading under its peak from early April. Most recently, it has found resistance just above $11.50. We need to see it break clear of that level before we can be certain that the share price will head higher. Unless it can do that, we may see it drift lower towards support near $10.50, which would provide a better entry point.
Michael Gable is managing director of Fairmont Equities.
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