Australia | Jul 04 2013
-Recall de-merger to simplify Brambles
-Attractive to two different investor types
-Broker focus on structural issues
-Weak paper pricing a factor
By Eva Brocklehurst
Brokers have welcomed Brambles' ((BXB)) decision to hive off its Recall business into a separate ASX-listed entity by the end of the year. The move simplifies the remaining business and, as CIMB observes, de-mergers are typically rewarded by the sharemarket.
Recall specialises in storage, secure destruction of documents and data protection. The main source of revenue is derived from North America and Brazil with just 30% coming form Australia. Brambles had previously tried to divest Recall but acceptable price and terms were not forthcoming. Earnings for FY13 are expected to be around US$140-144 million and there is US$450m in net debt attached to the new entity.
Macquarie found this guidance below expectations, reflecting soft transaction volumes in Europe as well as a normalisation of sales and marketing costs where there was likely to have been a level of underinvestment in FY12. Despite this, Brambles is confident Recall can deliver revenue and profit growth in FY14 and cash flow should support a strong dividend. Franking will be limited, given the smaller percentage of revenue in Australia. Deutsche Bank values a de-merged Recall business at around 88c a share while Credit Suisse believes Recall could be worth $1.26 a share. Macquarie expects Recall could trade around eight times FY14 earnings forecasts and support a potential dividend yield of 5%.
The de-merger is seen as a positive step as management in each business can focus capital and time on core activities. For Credit Suisse, this means investors need to consider the issues that are facing the Recall business such as structural challenges in physical document storage and whether management pursues a growth or yield strategy, as well as operation and capital expenditure requirements. Then there's the digitising of offices and the extent of the reduction in physical paper documentation. Recall will need to demonstrate a focus on growing data protection services, which accounted for around 10% of FY12 revenue. Brambles does not think digitisation is a threat and has pointed to an increase in regulation requiring companies to hold more documents as evidenced by growth in carton volumes.
The company's outlook for Recall shows a 3% decline in constant currency revenue. While this was consistent with the third quarter update, it reveals that revenue probably did not deteriorate further in the fourth quarter. Management highlighted continued weakness in paper prices as well as slow volumes in transactional revenue. Credit Suisse maintains that cyclical revenue streams, while accounting for only 38% of earnings, have a disproportionately large impact on the business because of the high margin nature. This has been characterised by weak merger and acquisition activity which has meant lower demand for some services. The other significant pressure is weak paper pricing. Paper recycling accounts for only 4% of revenue but it is a volatile business. Macquarie believes this volatility underpins the company's struggle to live up to the premium growth story but also suspects the unsuccessful sale process has not helped.
Credit Suisse thinks the market should look beyond these issues towards structural themes but admits that, if cyclical weakness persists, Recall may find it challenging to appeal to yield-focused investors. Recall continues to grow annual carton holdings, countering the argument that the underlying business is in decline and with some new business wins the broker considers there's a strong case for growth opportunities ahead. Deutsche Bank believes a different class of investor will be attracted to the higher yielding but lower growth investment that Recall represents. Macquarie maintains this theme as well. The two businesses are at different levels of maturity and likely to attract different investors. Large parts of Brambles' residual businesses are in a strong growth phase while Recall has higher free cash flow because of the annuity style revenues.
What does the de-merger augur for the parent? Brambles will focus on pallets, containers and reusable plastic containers (RPC). Deutsche Bank was encouraged by the unchanged guidance for FY13 earnings, being US$1.03-1.06 billion. After the de-merger Brambles can focus on the high growth pooling operations under the CHEP and IFCO brands. CIMB believes trading after the de-merger will likely favour Brambles as the majority of current shareholders have based investment decisions on the pallet businesses that will remain with Brambles. Macquarie will be watching to see whether Brambles can maintain or improve the momentum in the RPC and containers business to justify the recent investment in this area.
Brambles has a mixed coverage on the FNArena database. There are three Buy ratings, two Hold and one Sell. The targets range from $8.34 to $10.21. The consensus target is $9.61, signalling 3.6% upside from the last closing price. For Credit Suisse, the recent share price strength means, although Brambles is the highest quality stock in the Australian transport sector, at current multiples a Neutral rating is appropriate. CIMB retains an Underperform rating, as the stock is trading on 18 times FY14 price/earnings forecasts. With an Outperform rating, Macquarie is focused on Brambles' leverage to the falling Australian dollar and the FY14 outlook, conscious of the elevated trading multiples. Ex Recall, the core business is trading on around 10.1 times Macquarie's FY14 earnings forecasts.
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