Take a look around your house.
Every item of furniture you own, every product in your pantry, every material of your house construction would have been transported, at some point, on a wooden pallet.
The humble pallet is the vessel that transports $trillions of goods around the globe.
The design hasn’t changed in decades. It’s literally a bunch of wooden planks nailed together.
Yet, this unassuming product generates billions of dollars of revenue each year.
And the largest pallet company in the world is headquartered in our own backyard. The business is ASX listed company Brambles. Last year it generated over $5Bn of sales!
In this financial teardown, I analyse what could be Australia’s most boring business.
The billion dollar pallet business
Brambles has an interesting history. It all started back in World War II.
If you think managing inventory for your small business is hard, just imagine how much of a clusterf^&ck it would have been to coordinate the supply chain for the Allies in the Second World War. Millions of tonnes of munitions, food, and other military goods needed to be shipped around the world, ready to be deployed for combat.
Supply chain and warehousing efficiency can play a decisive role in war – a late shipment of munitions can result in troops fighting with rifles, or their fists.
Wars are an incubator for rapid development of new products (the Nuclear bomb is the most cited example). For logistics, the innovation was the invention of a standardised, 4-way pallet. It was designed by the Allies to simplify and accelerate the transport of goods across borders.
The Allied Materials Handling Standing Committee, an organisation developed by the Australian government was established to provide efficient handling of defense supplies during World War II.
When the war ended in 1945, Australian military bases were left with millions of blue pallets that were used to transport these supplies.
Rather than using them as kindling for cold winters, the Australian Government continued the operations to support the national economy, shipping supplies around the country using these blue pallets. It was renamed to the Commonwealth Handling Equipment Pool (CHEP).
CHEP was eventually privatised and bought by the company Brambles in 1958. Today, it represents Brambles’ core business. Its signature blue pallets are painted such that they are distinguishable from ordinary “white wood pallets”, so they can be collected and added back into the rental pool.
Having owned a few different businesses in the past, today CHEP is basically the sole business unit of Brambles. In this article, I will refer to Brambles/CHEP interchangeably.
How CHEP makes money
CHEP makes its money by manufacturing and renting out its pallets via a “pooling model”. Pallet pooling is like carpooling, but instead of sharing a car with others, you share pallets with other companies.
The diagram below shows the three pooling models:
The One Way Trip
This pooling model is when the pallet goes from CHEP directly to the manufacturer – a FMCG company like Heinz – then to a retailer and back to CHEP. CHEP performs any necessary repairs before sending the pallet to another manufacturer. This is used in the USA.
The Exchange
This model is when the pallets flow through multiple supply chain loops, only returning to CHEP sporadically. This is used in the UK.
The Transfer Hire
This works like the Exchange model, except the main difference is that the responsibility for the pallets is transferred between manufacturers, transporters, and retailers as they physically move through the supply chain. Contrast this with the Exchange pooling model, where responsibility for the pallets remains with the manufacturer. This is the model used in APAC.
CHEP primarily generates its revenue from:
- An issue fee – the customer gets charged a one-off fee per pallet of around 68 cents (AUD)
- A daily hire fee for each day the customers uses the pallet – around $5 – $7 a month. This generates ~95% of total revenue
- A bunch of other fees, including fees for lost pallets, transport etc.
As of FY22, Brambles has a worldwide pool of ~360 Million pallets that it rents out, equating to over USD $5Bn of revenue. That’s a shed load of pallets!
The Moat
The alternative to customers using CHEP is a generic ‘white wood’ pallet. These are bought, rather than borrowed. They are also apparently lower quality compared to the CHEP ‘blue’ pallet.
Ownership of the white wood pallet transfers through the supply chain, after which the retailer sends it to a recycler who repairs and resells it back to manufacturers. It’s up to the manufacturer to manage the supply and demand of these pallets.
CHEP ultimately solves a supply chain headache by managing the supply and demand of pallets, the repairs and capital costs (CAPEX) – which can quickly add up. Economically speaking, CHEP shifts these crucial supply chain costs from a fixed cost to variable cost.
CHEP is the backbone to the logistics world, much like Amazon’s AWS is to the cloud.
Combine this with the vast network infrastructure of CHEP plants and service centers around the world, you can start to picture why this business is not easily disrupted.
It’s an underappreciated and necessary function that plays a critical role in the global supply chain.
As global trade grows with consumer spending, so will the need for the humble pallet.
The financial teardown
Now, let’s teardown how much money Brambles makes from pallets.
Below is a summary of Brambles’ FY22 financials, broken down by geography.
My observations:
- CHEP Americas is by far the largest contributor to revenue, comprising 53% of revenue to the business, followed by CHEP EMEA and CHEP Asia Pacific (APAC)
- In terms of profitability, CHEP APAC has the highest operating margins at 32% – which is probably result of the tenure and market share it has in the region
- Blended EBIT is ~17% – not a bad margin.
Side note: Here’s why we look at EBIT instead of EBITDA for capital intensive businesses.
Terms like EBITDA is not appropriate to use when analysing Brambles, as depreciation is a large and real expense needed to keep the business running. For capital intensive businesses where depreciation is a significant expense, use EBIT.
Whilst Bramble is profitable on paper, we need to analyse the CAPEX requirements as well to understand its cash flow.
Because Brambles rents out assets in the form of pallets, it’s important to assess the capital expenditure required to maintain and grow the business.
CHEP pallets vary in cost, depending on the price of lumber – but it fluctuates between US$25- US$35 a pallet.
In FY22, Brambles spent $1,782M on new pallets.
This exceeded the amount of cash it generated from the business operations.
In other words, Brambles cash flow position went backwards. Despite being profitable on paper, the CAPEX requirement to make new pallets outpaced the cash generated from renting them.
But how much of this capex is an investment to grow, vs required to maintain current business?
We can answer this by analysing growth capex vs maintenance capex.
Growth Capex vs Maintenance Capex
Capex (short for capital expenditures) is money that a business spends to maintain or grow its asset base. In the Brambles’ example, the capex are the pallets it rents to customers.
Capex can be further divided into maintenance capex and growth capex. Maintenance capex is the cost to maintain the existing operations – replacing broken or lost pallets, repairing/upgrading machinery and equipment. Maintaining the existing pallet pool is required to retain the existing revenues, customers and capacity. A business with a high maintenance capex, relative to profit, is generally a bad thing, as it means the business has poor capital efficiency. It could be ‘profitable’ on paper, but consuming high amounts of cash just to maintain the asset pool.
Growth capex is the cost of manufacturing new pallets in order to expand capacity and generate net new revenue. An important dynamic about growth capex is that it is completely discretionary. If management wants to grow revenues and profit, there is a clear decision to manufacture more pallets and increase the pool size.
Now, let’s attempt to break down the maintenance capex and growth capex of Brambles.
- As you can see, of the total $1,811M spent on CAPEX in FY22, a whopping 25% revenue was spent just to maintain the operations, with 6% related to growth (expanding the pallet pool)
- Total CAPEX efficiency in FY22 pales in comparison to FY21, which increased from 23% to 33% of total CAPEX spent as a percentage of sales.
So what happened?
As you know, inflation was, and still is, running rampant in the global economy. Lumber prices in particular skyrocketed in FY22, which had a direct impact on the cost to manufacture and repair new pallets.
As demonstrated by the following image, Brambles stated that their base pooling capex % actually maintained at around 20% of sales. Lumber inflation comprised of c. 10% of additional costs.
In other words, the additional maintenance capex was inflation driven and out of their control.
Businesses with Pricing Power would be able to on-charge the costs of inflation onto customers.
But it appears Brambles didn’t on-charge these costs 1-for-1 to customers. The question is was this intentional?
Was it because they thought that lumber inflation would be transitory, or is that they couldn’t?
Another systemic issue with the Brambles’ maintenance CAPEX is the problem of lost pallets.
Lost pallets = lost profits
With over 360 million pallets floating around the world, many are bound to get ‘misplaced’ right?
Well yes, according to CHEP, only 90% of the pool is expected to survive through to the next year.
The remaining 10% of pallets are deemed ‘irrecoverable’.
Of that 10%:
- Around 2% will reach the end of their useful life (~10 years) to be scrapped.
- The remaining 8% to 9% are deemed lost. Of these lost pallets, only about half are compensable, meaning the customer who had responsibility for the pallet pays a fine for losing them. CHEP absorbs the losses on the other half.
On the subject of lost pallets, check out this Facebook page dedicated to CHEP pallets spotted in random places…
It’s like Where’s Wally.
Where, where, where, where’s that damn CHEP pallet?
At around $20 a pop, CHEP spends around $360M every year in CAPEX for lost pallets that they don’t get any compensation for. This equates to around 6.5% of revenue – a huge cost of business!
Lost pallets are an unavoidable part of CHEP’s business. It’s largely out of CHEP’s control.
Tweaking a few of key drivers, including pushing up the price of a new pallet from $20 to $25 and increasing the unrecoverable rate from 10% to 12% – the business becomes ugly pretty quickly.
So what can they do about it?
How does the future of pallets stack up?
With the global shift towards sustainability, the future of the pallet is actually plastic.
Plastic pallets are more durable and 100% recyclable.
The best feature is that they can even be embedded with GPS and temperature tracking, resulting in lower loss rates by up to 50%.
The issue is that they are up to 4x more expensive to manufacture compared to their wooden predecessors.
One of Brambles’ largest US customers, Costco mandated a switch to plastic pallets in 2019. Sustainability issues aside, they apparently also look better in the aisles – aesthetics matter if you’re selling stuff directly off pallets.
The other reason is that too many Costco customers are apparently getting splinters (lol).
Anyway, after a cost benefit analysis in Mid-2022, Brambles pulled the pin on the Costco contract as the economics didn’t make sense to convert their wooden pool to plastic. It meant having to invest close to $1Bn in plastic pallet capex just for the Costco contract alone!
Is this short-sightedness from the Brambles Board?
If the USA’s leading department store is mandating the shift to plastic, others will no doubt follow.
With their decision not to convert to plastics, Brambles is effectively betting against change.
Short-term, they’re safe to do so. There’s currently a global shortage of pallets, many of them sitting in warehouses as customers have been hoarding them with higher levels of stock to buffer against supply chain disruption. Bramble’s is betting that any customers that churn will be easily replaced.
If it ain’t broke, don’t fix it.
But long term, it’s obvious that plastic pallets are the future. The humble wooden pallet model is ripe for disruption.
If you want my honest opinion, startup founders should be looking at the pallet industry instead of building the next 15-minute food delivery app.
It’s not sexy, but it’s a proven business that prints cash.
