Following discussions with leading US pallet manufacturers, recyclers, poolers and customers, Ord Minnett sees the outlook for pallet industry profitability as improving. In our view, Brambles’ share price fails to capture the improving outlook for US industry profitability, which should be reflected in reported numbers from FY19.
We estimate the CHEP Americas division represents 35–40% of group earnings, and that the CHEP USA pallet business is the main contributor to this.
Prices for high-quality recycled whitewood – from which pallets are made – are rising and customers have been switching to pooling, implying the pallet poolers such as CHEP USA should be gaining market share. Customers focus on three key factors when deciding whether to buy whitewood pallets, or rent them from the likes of CHEP USA:
- Cost – Our analysis suggests the gap between the cost of buying a Grade A recycled whitewood pallet and renting a blue pallet (CHEP) or a red pallet (from CHEP rival PECO) has widened – we calculate it is now US$1.50–2.50 cheaper per pallet to rent than to buy.
- Availability – The industry inventory of Premium Grade A and Standard Grade A recycled pallets is very low with many recyclers telling us they hold less than one week of inventory, which is in stark contrast to the two to three months of inventory held this time last year. This will only become a bigger issue in the peak demand periods.
- Quality – This is critical for most customers as they can’t risk platform failures, product damage and/or production-line delays should a pallet become jammed in the process. Industry discussions reveal there has been a degradation in the quality of whitewood pallets, and so the supply of genuine Premium Grade A and even Standard Grade A recycled pallets has shrunk.
The trend of customers switching from recycled pallets to pooled solutions should ultimately be reflected in growth in CHEP USA’s net new business wins, which will help to drive revenues.
In the case of pallet manufacturers and recyclers, operating margins are already rising. The poolers, however, have been slower to react, although it appears poolers are targeting mid- to high-single-digit increases in their base rates. As a result, we believe FY18 is likely to mark the low point for CHEP USA’s operating margin and, if that is the case, we expect Brambles’ share price will be rerated.
We maintain our Buy recommendation on Brambles and have raised our target price to $12.50 from $12.25 as our model rolls forward to June 2019.