Tuesday, February 28th, 2017
For so long Brambles had a reputation as one of the ASX’s more reliable, steadily growing large companies – a reputation reflected in an average premium of the stock’s price-earnings multiple to the market multiple of 10 per cent over the last 10 years. But the recent earnings downgrade, new adverse structural trends and the company’s withdrawal of its profitability target now leave investors asking if the premium is still justified. What’s Brambles now worth and what should investors pay for it?
On 23 January Brambles warned full-year constant-currency sales revenue and underlying earnings would fall short of existing guidance for respective growth of 7-9 per cent and 9-11 per cent. The shares fell 16 per cent that day. The stock has since slipped another eight per cent. After delivering interim constant currency sales and earnings growth of five and three per cent respectively, Brambles guided full-year sales growth of five per cent and flat earnings. The company then compounded the disappointment from this downgrade by dropping its target 20 per cent return on capital by 2019.
The problems are in the US business, where a smaller competitor is aggressively discounting to take share. This raises questions about how robust Brambles’ value proposition to customers is, especially if pallet volumes can be undermined by 5-10 per cent price cuts from a smaller competitor. Brambles will now have to price-match to retain share, compressing margins.
There is also a deeper and concerning new structural problem. Rather than buying and collecting in physical stores, US consumers are increasingly ordering goods online at the likes of Amazon for direct delivery to their homes by postal vans and parcel couriers. This reduces demand for pallets to convey goods to those stores. The trend will not go away and consumers’ substitution from physical shops to online ordering probably triggered the current bout of discounting, which could continue for some months.
Brambles needs to adjust the new competitive pressures and fashion a response to digital disruption. The return on capital target was dropped entirely, not downgraded to something more realistic, which means Brambles now has less control over its own profitability and indeed doesn’t know what it could expect to achieve. Previous cost savings targets were also downgraded.
Perhaps the market should have expected some kind of disappointment after CEO Tom Gorman retired after over seven years in the role. Bad news is common after longstanding CEOs leave as unresolved and new problems surface. Retirement at the top is too tempting.
However all is not lost. Brambles has depth of management and long experience in its markets. It understands the pallets and containers business as well as any other player and we think it will eventually sign supply chain deals with direct deliverers like Amazon. Brambles has expertise in the ‘first mile’, where goods are delivered from manufacturers and warehouses to distribution centres, and now needs to develop expertise in the ‘last mile’, the end point of deliveries to the home.
Also, our concerns about earlier retailer destocking are now resolved. The destocking seems to be confined to one very large US retailer, probably Wal-Mart, and could reflect its shift to smaller stores. Also there were no apparent problems in other countries where Brambles operates. As a very large, high-volume operator Brambles will find ways to reduce margin damage by lowering its unit costs.
Against the new US landscape of margin pressure and digital disruption, we think Brambles is now only worth $9.20 rising to $10.00 next year. Given the uncertainty about profitability, competitive advantage in the US and margins in the age of direct delivery, investors should require a 10 per cent discount to value before buying, so on an 18-month view we would not pay more than $9 for the stock.
Undervaluation, however, is not sufficient to justify buying a stock. There needs to be a positive catalyst for the gap to close. The market has lost some confidence in Brambles and the long journey back to a consistent share price premium can only begin with a recalibration of corporate strategy. A good start would be a credible statement about how Brambles will grow profitably in the age of Amazon.
Originally published in The Australian newspaper, Tuesday 28th February 2017.