*BIL-Look to the CALL Warrants BILWGG / BILWMK.*, page-31

re: BIL European CHEP America to offset any drag on CHEP

By Mark Todd
September 3 2002

Brambles Industries's problem-plagued CHEP pallet management business in the US has not only turned the corner but is trading strongly enough to compensate for any unexpected weakness in Europe.

Chief executive Sir CK Chow indicated fears that the company's CHEP division had faltered in another region, this time Europe, were misplaced. Brambles shares plunged 16 per cent last week to their lowest point in almost five years after the company revealed an 18 per cent fall in pre-tax profit from Europe and foreshadowed no growth in 2002-03.

The division was the focus of Brambles' $545 million annual net profit, which was criticised by several analysts for a lack of guidance on future profits and for the cautious outlook for Europe.

"The improvements that we are seeing evident in CHEP US, which is the fastest growing part of CHEP, outweigh any concern there could be in CHEP Europe," Sir CK told the Herald. "The growth in profit in the US should offset the slower progress in Europe."

Sir CK pointed to a strong fourth quarter for CHEP US, which helped swing profits for the Americas from an 18 per cent fall for the first half to a 3 per cent rise at the end of the full year. Europe will return to profit growth in 2003-04. Productivity improvements and dramatically lower capital expenditure by CHEP Americas will mean the region will start producing positive cash flow from the second half of 2002-03. It is the last jurisdiction within CHEP to reach the milestone and, once it is achieved, will end the Americas division's days as a drain on group financial resources.

At the same time, Sir CK defended Brambles' dual listing in Australia and the UK and was adamant the company would not relent to calls to provide more guidance on future earnings.

He would not speculate on whether Brambles, after its sharp price slide in the past two months, faced having its stock removed from the FTSE 100. Some analysts have suggested such a move could further erode already wavering support for the company.

"It's a lot of if, if, if," Sir CK said. The business he used to run, GKN, drifted in and out of the index and "it never affected the company in any way."

In any event, the dual listing was the only method available to merge the industrial services assets of Brambles and GKN - such as CHEP and Cleanaway waste management - into a single $20 billion entity. "That rational is as compelling today as it was a year ago," he said.

Brambles' former chief executive John Fletcher set a target for annual earnings growth between 12 per cent and 15 per cent. Sir CK would not recommit to the goal, but indicated he was trying to create a business in which profits increased at least as swiftly as sales.

"Let the market come to its own position on how fast the company can grow," he said. "When you look at the revenue side you see some very encouraging signs. What we're in the middle of doing is to build a basis where the profit growth will be much more aligned to revenue growth."

Revenue from continuing businesses was up 11 per cent in 2001-02, with CHEP's sales up 15 per cent and Cleanaway ahead by 17 per cent.

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Apologies if the layout is crook......
this from Sanfords last week re CHEP
Industrial Services Australia

Price@28/08/2002: A$7.42

12 month range: A$11.43 - 7.42

Valuation: A$9.31

Price Target: A$8.78 (+18%)

Market Cap: A$11.9bn/US$6.6bn

Shares on Issue: 1.6bn

Average Volume (000's): 4,447


Source: Sanford

Source: Company Data and Sanford Estimates

FY ’02 results – CHEP Europe now the problem.


Once the adjustments for GAAP, exceptionals and accounting policy changes had been deciphered it became clear that FY ’02 results were broadly as expected


However, CHEP’s performance continues to be the main concern – whilst the issues in the US appear to have been resolved European profits fell sharply (-18%).


We believe Brambles has been trading on a premium valuation in the expectation that it would return to a premium growth trajectory. This does not look imminent.

Event


The main surprise in Brambles’ results was the fall in CHEP’s European profits (-18%). The market’s attention to date has been firmly on problems in the US. Whilst CHEP America’s performance has begun to respond to management actions, European profits are likely to be flat in FY ’03. Accounting for 46% of CHEP’s EBITA, this is a major drag on overall growth.

Impact


We have revised our forecasts for FY ’03 and FY ’04 to reflect primarily slower growth assumptions in CHEP Europe. Our earnings estimates have been reduced by 3% and 5% in these years respectively.

Valuation


We believe CHEP is the key valuation driver for Brambles (representing around 70% of our sum-of-the-parts). We have reduced our long term CHEP margin assumption from 22.5% to 21% in our base case; this has reduced our sum-of-the-parts price target from $9.47 to $8.78.

Action


The 11% fall in Brambles share price suggests that investors are losing patience waiting for a turnaround in fortunes. Whilst we believe a turnaround is underway, there are still some problematic areas and so the net momentum of the turnaround is unlikely to be sufficient to justify the premium valuation. The current 27% PE premium may well come under further pressure.
Fy ’02 results overview

A$m
Fy ‘02
Fy ‘01
% change

Revenue
8820
8646
2

EBITA
1137
1206
-6

Profit before tax
867
918
-6

Profit after tax
617
615
0

EPS (cents)
36.6
36.6
0

Net debt
4308
5164



Source: Brambles, as reported under UK GAAP pre-CHEP profit harmonisation

FY’02 results were broadly in line with expectations. However, as is often the case with Brambles GAAP adjustments, accounting harmonisation changes and exceptional items interfered with line item comparisons which caused confusion. We were analysing the result as a guide to the operational performance of the group - on this basis EBITA at $1137m was in line with our $1138m target.

The disappointment with the result was less in the actual numbers and more in the guidance that accompanied the figures. We believe there has been an expectation in the market that Brambles is close to an inflection point, with margin decline in CHEP about to end and a strong growth trajectory re-established. However, we believe the statement and results presentation did little to give investors confidence that the problems are over.

Revised forecasts

Based on the new financial information and management’s results commentary, we have revised our forecasts to reflect primarily a slower pick up in CHEP profits. We have also shaved back our CLEANAWAY profit expectations. As a result, our earnings estimate for Fy ’03 has been reduced by 3% and for Fy ’04 by 5%.

Summary EPS estimate revisions


Fy ‘03E
Fy ‘04E

OLD
39.8c
46.0c

New
38.6c
43.5c

Chg
-3%
-5%


Source: Sanford estimates, normalised earnings

Divisional Commentary

CHEP prospects

The market has been focusing on CHEP’s problems in the US and has been hoping that management actions, including the revised terms of the Wal*Mart advocacy, will see profits there begin to improve. The good news from the presentation was that the American business appears to have turned the corner. Management disclosed that Q4 profit from CHEP Americas was up year-on-year and that Q4 was the most profitable quarter for the year. However management would not indicate what this profit was.

Whilst the US news was well received, the problem is that CHEP Europe saw profits decrease by 18%. This was a big negative surprise and we believe has led many to conclude that CHEP’s problems have just shifted from one geographical region to another.

In management’s commentary it was suggested that CHEP’s European problems would take longer to resolve than in the US. At the presentation, guidance of flat EBITA for FY’03 was suggested. It was also noted that the introduction of channel pricing in Europe would be key to any margin pick up in Europe and that channel pricing had taken three years to be fully incorporated into the UK model (back in 1994).


Source: Brambles

Management disclosed for the first time a breakdown of CHEP’s profits by region. There were a number of surprises from this:


One key thrust of the bull case has been the assumption that margins in the Americas have been extremely low (less than 10%) and have been diluting the overall result. Whilst margins are relatively low in the Americas and have been dilutive, we believe they may not have been as low as many had expected – highlighting other areas have not been as profitable as assumed.


Margins outside of Europe and America have been between 21% and 24% over the last two years. Given this is predominantly Australia, this is indicative of a "mature" CHEP business. Again we believe this may have been lower than many observers had expected.


The collapse in European margins was a big surprise. We believe this may reflect more prudent accounting that is now taking place under the DLC structure (as opposed to p&l focused accounting under the jv structure). The fall has also raised concerns over pricing pressures given the greater competitive environment in Europe.

Recap on other issues


CLEANAWAY and Recall performed as expected. CLEANAWAY UK benefited from the Serviceteam acquisition and Recall from small acquisitions. Both businesses generated record sales.


The industrial and regional businesses also performed well with an impressive turnaround in the Australian industrial services operations.


The divestment programme is now complete. $1.37bn of disposal proceeds were generated, comfortably ahead of the $1.2bn guidance given at the time of the DLC formation.

Valuation

We have re-calibrated our DCF-based sum-of-the-parts model. The main change is that we have set our CHEP base case long term margin assumption to 21% (previously 22.5%). This reflects less confidence in this assumption.

As a result of this change the price target has fallen from $9.47 to $8.78. Our bear case valuation (assuming CHEP margins do not improve) is $7.55 and our bull case valuation (assuming CHEP margins recover to 24%) is $10.42.

Sum-of-the-parts valuation


Source: Sanford estimates
Investment Risks


Recovery in CHEP margins: Management is very focused on initiatives to improve margins. Whilst the US appears to be responding, it could be some time before Europe makes progress. We assume margins are likely to see some recovery over the next three years, back to 21% from 18% currently.


Continued underperformance of UK peers: Brambles’ UK peer group has been substantially de-rated since the beginning of this year. Whilst there is no direct comparable to Brambles in the UK market, it is benchmarked (rightly or wrongly) against the support services sector. It is not clear whether this underperformance will continue or not, and whether Brambles will continue to track the UK support services sector.