Brambles (BXB) has provided details to the market regarding the...

Brambles (BXB) has provided details to the market regarding the review of its US pallet business. At the same time the company announced Tom Gorman will take over as CEO from November 1st , but it is the results of the former that have been met with mixed reviews to the extent the stock has been downgraded to a Sell rating by a couple of brokers.

Those making the move to a Sell rating are Bank of America Merrill Lynch and Citi, the former downgrading from a Buy rating previously and the latter moving from a Hold rating. For Bank of America Merrill Lynch the reason is simply one of the reforms, designed to lift the overall quality of the group's pallet offering, costing more than had previously been expected.

The move will see the company split its pallet pool into two groups, one with a higher quality level and one with an "as new" level of repair. While this is exactly what Bank of America Merrill Lynch expected would be the outcome of the review, the issue in the broker's view is the cost of the process will impact on margins for the division. Guidance from management indicates US$110 million in non-recurring costs as well as US$50 million annually on maintaining the quality of the pallet pool.

As an example the broker notes CHEP Americas generated underlying earnings before interest and tax (EBIT) margins of 28% in FY09 despite a difficult operating environment. Under the new pallet division scenario, however, this margin is expected to decline to the mid 20% range by 2013.

To reflect this the broker has lowered its net profit after tax forecasts by 14% in FY10, 10% in FY11 and 8% in FY12, which in earnings per share (EPS) terms means it now expects outcomes of US34c, US38c and US43c for FY10-FY12. This has pushed down its valuation and price target to $7.20 from $7.66 and supports the downgrade in rating.

It is a similar outcome for Citi, who like Bank of America Merrill Lynch, saw the move as the right thing to do but one that will be costly in terms of earnings. Post the announcement the broker has also cut its numbers, though the magnitude of the cuts is not as severe as its profit forecasts come down by 7-12% over the next three years.

As Citi points out its numbers in coming years were already below market consensus, so the changes post the update have done nothing to change this. In EPS terms Citi expects US33.6c, US35.6c and US39.9c through to FY12. This compares to Maquarie's reductions of just 2.7% in FY10, 6% in FY11 an 2.3% in FY12, as in its view the company should still be able to get margins back to around 29% - it's just that the process will take longer than previously expected.

In Macquarie's view the changes, while costly, should allow for the company to grow its market share in the US over the longer-term and should also provide greater clarity to the market with respect to the near-term margin impact of the changes. As a result the broker retains its Outperform rating on the stock, sticking to its view the company offers good leverage to an upturn in the economic cycle.

JP Morgan is similarly positive, taking the view while the changes announced yesterday will have a short-term earnings impact, and it has cut its EPS numbers by 4-5% through to FY12 to reflect this, the long-term outlook is better than the changes suggest because capex is being replaced by operating costs and so guidance for long-term margins in the "mid 20s" is likely to prove conservative.

UBS agrees the margin outlook appears conservative. UBS also retains its Buy rating despite lowering its target 30c to $8.60, the broker also taking the view an improved pallet range should allow the company to enjoy a faster rate of market penetration going forward, which justifies the money being spent now.

This is in line with the bigger picture in JP Morgan's view, which is the move to address quality of service issues in the US should remove a hurdle that had been holding back the division, which it suggests was also undermining the perceived growth potential of CHEP in other markets as well.

But Citi argues on valuation grounds the stock is now a Sell as the modest earnings growth outlook in coming years can only justify a modest premium to the market for the stock whereas more is currently being factored in to the share price. Deutsche Bank is taking the middle ground, noting the impact of higher costs on earnings will simply delay the expected earnings improvement from a cyclical recovery in the US economy.

Overall the FNArena database shows Brambles is rated as Buy four times, Hold three times and Sell three times, with an average price target of $7.85, down from $7.96 prior to the announcement. Targets range from Macquarie at $8.80 to Citi and Deutsche Bank at $6.75.

Shares in Brambles today are weaker as the market digests the pallet plan and as at 11.35am the stock was down 43c or 5.8% at $7.02. Over the past year the shares have traded between $4.08 and $8.85.