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Morningstar | Cost Pressures Dampen Brambles' 1H19 Margins, but We See Longer-Term Expansion; FVE Maintained. See Updated Analyst Note from 17 Feb 2019

Wide-moat Brambles enjoyed 5% volume growth in the first half versus the previous corresponding period, or pcp, owing to good underlying U.S. economic conditions, share gains in Europe, and improved results in Asia-Pacific. Along with 2% contribution from price, revenue increased 7% on a constant-currency basis, tracking our full-year forecast. However, negative currency translation drove reported sales growth of only 3%, while continuing cost pressure in transport and lumber expenses led to operating income falling 3% to USD 504 million. The resulting drop in margin--about 100 basis points to 17.7%--trails our prior forecast for flat full-year profitability, and management’s outlook for underlying profit to only modestly grow this year is a bit worse than we had expected. We’ve lowered our near-term projections as result, but we think the firm’s longer-term opportunity for margin expansion remains, owing to further pricing actions, more-modest cost inflation, and investments in automation and other cost savings. We maintain our AUD 11.20 per share fair value estimate.

The CHEP Americas segment suffered the largest profitability degradation, but we see several signs that should lead to improved results past fiscal 2019. Despite 5% contribution from higher prices, underlying operating profit fell 11% versus pcp due to inflation in transport and lumber costs, to a margin of 14.7% compared with 17.3%. Nonetheless, we’re encouraged Brambles was still able to drive 2% greater volumes in the period, confirming management’s estimate that competitors have remained disciplined on price. And we expect better cost pass-throughs on newly signed contracts, investments in U.S. automation, and the passing of customer-led investments in Canada (to a different form of pallet) to drive markedly better profitability past this year. We now see margins in this business falling to 14% in fiscal 2019 versus 16% previously, but still see this metric climbing to 20% by fiscal 2022.

Brambles’ European business similarly continues to fight inflationary cost pressures, but profitability declines were far less pronounced than in the Americas given better-structured pricing mechanisms in the region’s contracts. Margins declined a modest 70 basis points to 24.4% versus the pcp, tracking our 25% full-year forecast. However, we caution that near-term economic risk remains paramount for this segment. While we’re encouraged the firm drove 5% volume through market share gains, like-for-like volume gains were a slower 1%, with management cautioning weaker economic conditions have impacted the business. And the uncertainty of Brexit could weigh on Brambles’ near-term revenue and cash flow, with key risks including access to timber supply, changes to customer demand patterns, and labour shortages. The company estimates about 10% of the segment’s volume relate to EU/U.K. cross-border flows, and customer inventory-builds ahead of a potential U.K. separation have already led Brambles to spend an additional USD 11 million in capital expenditures on new pallets. We forecast mid-single-digit annual revenue gains and flat profitability over the next several years, but worse macroeconomic conditions could drive operating income 8% to 10% lower than our base case by fiscal 2023, by our estimate.

Outside of these two core regions, CHEP APAC saw revenue climb at 3% on a constant currency basis, with volumes returning to growth and price gains driving improvement. Importantly, operating margins held up in this business, climbing 30 basis points on a reported basis to 25%, tracking slightly ahead of full-year expectations for margins to fall slightly. Now that the company has lapped the prior loss of a large Australian reusable plastic crate, or RPC, contract, we expect mid-single-digit revenue growth and margins around 23% can continue.

Brambles’ final segment, IFCO RPC, grew revenue 5% at constant currency in the period. While this performance trails our double-digit full-year target, we attribute the difference to continued exits from unprofitable contracts in North America, where revenue fell 5% versus the pcp. As such, we note that operating margins improved 40 basis points to 13.1%, ahead of our 12.5% full-year projection. IFCO remains on-track to be sold or divested by the end of calendar 2019.

Following the exit of a joint venture and the sale of CHEP Recycled in fiscal 2018, Brambles’ balance sheet continues to improve. Net debt/EBITDA was 1.51 times at Dec. 31, 2018, below management’s stated policy of 1.75, and fell from 1.69 this time last year. In our opinion, the firm retains ample liquidity to pursue potential capital returns. The company declared an interim dividend of AUD 14.5 cents per share, which will be 65% fully franked, although we note this franking amount was boosted by a one-time acceleration of Australian tax payments and will likely fall back to 30% going forward.