Greystone Logistics is a manufacturing and leasing company specializing in the production, selling, and leasing of high quality plastic pallets for the automotive, chemical, pharmaceutical, consumer product, and food & beverage industries. Greystone is the only publicly traded company that specializes in manufacturing of plastic pallets, and they are the largest plastic pallet manufacturer in the United States. The company currently offers 16 different types of pallets to suit its customers’ needs, cranking out an average of 120,00 pallets per month. GLGI has grown revenue at a 29% 4yr CAGR, increased gross profit at 18% 4yr CAGR, and EBIT growth of 35% 4yr CAGR. The company sports double-digit returns on capital and increased FCF from $0.6M to $1.4M over the last year amidst increasing CapEx by a few million in response to large shipment requests. The company trades around 8x EV/EBIT compared to the industry average of 12.5x. Even if GLGI fails to grow revenues at all for the next five years, the company has upside of 41% – 111% between an 8x – 12x EV/EBIT multiple. Greystone has a long runway for growth in a durable industry that’s shifting its desires from wooden pallets to plastic pallets. Management has skin in the game, starting with CEO Warren Kruger who owns roughly 34% of the company. Management in total owns roughly 41% of the company; interests are aligned.

Pallet Industry: Plastic The New Gold?

Greystone is an easy-to-understand business. They make pallets for various kinds of freight. These pallets are used as bases for assembling, storing, stacking, handling, and transporting products. The industry passes the question: will it be around for the next 20 years? As long as there is freight to be shipped there will be a need for storing, stacking, assembling, and handling such freight. As of 2017 data, 80-90% of all U.S. commerce is transported on pallets, translating into an average of 2.0 billion pallets daily in circulation. Currently, the pallet market is dominated by wooden pallets. Around 45% of total US lumber is used strictly for pallet production. Of these wooden pallets, 60% in circulation are used pallets. These used pallets are becoming less durable, however, and an increase in the demand for new wooden pallets (or alternative material pallets) is expected over the next few years.

The pallet industry is expected to grow close to 4%, which makes sense given the increased production in GDP in the United States, as well as the White House’s efforts to bring manufacturing back to the United States. Wooden pallets won’t be driving that growth, it’ll be plastic. Plastic pallets are expected to grow more than 5% over the next five years as more and more companies shift their demand from wooden to alternative products. Modern Materials Handling Magazine pointed out that plastic pallets have seen, “their strongest advances in percentage terms ever … and will continue to record above average growth.” What separates plastic pallets from its wooden competitors?

1. Cleanliness

Wooden pallets will always be the lowest-cost solution. There’s no doubt about that. Companies that strictly focus on achieving maximum short-term margin growth will continue to use the wooden pallets. However, industries are changing their attitude towards pallets. For example, in the food industry, food safety and compliance issues are leading companies to invest in plastic pallets as a sustainable option due to its sanitary benefits.

Used (and even new) wooden pallets present sanitation problems. Wooden pallets can rot, deteriorate, and cause sharp blisters and cuts. In an industry like food & beverage or pharmaceutical, rising compliance standards make it vitally important that shipment arrives clean, un-infected, and in tact. The saying, “one bad apple ruins the bunch” applies here as well. If the wooden pallet rots and infects produce, it could ruin the entire shipment causing a total loss of revenue for the business, and a loss of product for the customer. Plastic pallets address these problems head on. Plastic can be cleaned and sanitized with each use, ensuring your produce ships on the cleanest surface possible. You simply can’t do that with wooden pallets. With wood, you just get a new pallet each time you want to ship something. Food and beverage companies will realize the tremendous value in plastic pallets once they realize they can clean the pallet, sanitize it, and put it right back into production without the need of ordering a new one.

2. Less Product Damage

Wooden pallets break, sometimes fairly easily. Since 60% of wooden pallets in production are used, it makes the odds of a pallet breaking that much higher. Plastic pallets don’t have that same worry. There is a critical mass plastic pallets can handle before breaking themselves, but that weight is more easily known and anticipated than that of a wooden pallet. When pallets break, usually it means the product breaks, falls apart, or is permanently damaged (think of any perishable food item). When faced with a decision on which pallet to use to support their freight, a business will eventually choose the pallet that has the best chance at getting their product to its destination without failure. Any break in a used wooden pallet is a hit to the businesses incremental revenue opportunity, and those losses add up fast.

3. Cheaper Over Time

Plastic pallets are more expensive up-front, but over the long-run they present a tremendous value compared to their wooden counterparts. Because you can clean and re-use the plastic, it removes the necessity to buy more and more pallets to ship and store product. Over time this has a positive incremental impact on the company’s margins, thus creating a customer for life. Once the plastic pallets start paying for themselves, the switching costs go through the roof. Who would want to go back to paying for more and more pallets when you can simply re-use the ones you currently have? Take any industry, for example, and try to think in terms of the business owner. Let’s say you’re the owner of a brewery. Switching to plastic pallets might hurt margins and bottom-line numbers in the short-term (say a few quarters at most), but over the long run you’ll experience increased margin expansion due to cost savings from buying new and used wooden pallets.

Just how much longer do plastic pallets last compared to wooden pallets? According to Greystone’s research, plastic lasts up to 10 years longer than wooden pallets. Ten years of not having to constantly purchase used pallets to replace the ones that broke. Another way plastic pallets are cheaper (at least in Greystone’s case), is that a customer can return pallets they didn’t use as a trade-in credit which reduces the overall cost of purchasing the pallets. Finally, plastic pallets can be paid for via leasing options, which helps reduce the up-front cost of trading up for the durability.

There are more advantages to using plastic pallets than just the three I mentioned, however most of the other advantages are merely ancillary benefactors from the three majors advantages mentioned above. We know there are industry tailwinds, and we know that plastic pallets are a superior alternative to the more common wooden pallet that still dominates the market. So how does Greystone anticipate capturing this large addressable market, and what sets their business apart?

Business Overview

Greystone’s primary business objective is to manufacture plastic pallets using recycled plastic, and then selling those pallets through one of its wholly owned subsidiaries, GSM. Greystone sells its pallets to independent contractors, private distributors, and directly to businesses. Greystone currently has capacity to manufacture 16 different types of pallets, cranking out an average of 120,000 pallets per month. This is a stark increase in production numbers compared to the mere 70,000 they were able to produce not even five years ago. The raw materials that go into the pallets are abundant with some of the materials coming from their own recycled pallets. When it’s not using its recycled plastic, Greystone built out capacity to sell the recycled ‘pellets’ to other companies. To go along with these two ventures, the company also engages (somewhat infrequently) in tolling services, where it grinds and pelletizes the plastic material for various customers, charging a fee. By re-using their own recycled pallets as raw materials, the company is able to significantly reduce its cost of materials to produce their pallets.

However, as their manufacturing business continues to grow, management hasn’t placed much importance on its two smaller ventures. Currently all pelletized plastics are being used in-house for the production of Greystone’s pallets. This is subject to change depending on customer demand, as well as changes in supply of recycled plastics. In all, I like management’s decision to stick to what they do best in times of highest demand for their product. If anything, they can always go back to those ancillary business ventures, but for now, it’s good to see them focused on their specialty.

The company is selling its product well, with close to 40% top-line revenue growth over the last four years. However, as we will get to in the risks section, they haven’t been able to keep cost of sales steady, with COS increasing to 86% of revenues for 2018. The company managed roughly 81% COS as a % of revenue from 2014 – 2017.

Customers and Competition

Greystone is the leading pallet manufacturer in the beer and beverage industry, shipping out over 5 million pallets to its customers. The company has big name customers, all of which you probably have already heard of: Pfizer, Apotex, Miller Brewing Company, Coors Brewing Company, and Merck. These customers make up a very significant portion of the company’s overall revenues (especially Coors and Miller Brewing, which represents close to 70% of sales).

Greystone competes with both wooden and plastic pallet manufacturers. Although GLGI is the only publicly traded plastic pallet manufacturer, competition is alive and well, and there are a few companies with deeper pockets than Kruger and company over at Greystone. In Greystone’s latest 10-K, they give us a specific number of firms that are competing: 3 large and 10 small manufacturers.

Greystone’s Competitive Advantage

Although GLGI faces competition from both small and large manufacturers in plastics, the company is confident in their proprietary designs, patented technologies, and competitive pricing of products to dig a moat around their castle of sustainability. When it comes to the competition from wooden competitors, the company once again touts their designs, patents, and technologies, but more importantly, they stress the cost-savings that would accumulate should a customer switch from wood to plastic. The company lists around 20 reasons why plastic pallets are better than wood on their website, but for sake of time, I’ll list five I found:

Last 10 – 50 times longer than wood. Have residual (trade-in) value. Can make pallets flame retardant. Better aesthetics for more attractive displays. Lighter and stronger than wood.

The company’s advantages also include its leading position in the beer and beverage industry. This shouldn’t be overlooked as the beer and beverage industry make up 35% of pallets used in production. Of these pallets used, 10 – 15% of pallets “go missing” whether in transit or within the warehouse. This creates a constant demand for new pallets from GLGI’s biggest customers. It also doesn’t hurt that GLGI has positive business relationships with the two largest beer distributors in the United States, Coors and Miller. These are businesses that aren’t going to go away anytime soon. In fact, these businesses are recession proof as more people tend to drown their sorrows of a down economy in an alcoholic beverage. Since GLGI already provides plastic pallets to these companies, its hard for competitors to come in and undercut their prices because they are already so low compared to their peers. Plus. GLGI offers value-added benefits to their pallets such as RFID Chip Reading capability. GLGI can embed chips into each pallet produced, which makes locating certain shipments and product faster in warehouses while offering logistics support to help customers manage pallets used in dead hand shipments.

Why Does The Mis-pricing Exist?

Up-Front Expenses Show Decreased Earnings

The company is pouring a lot of money into machinery to produce more and more pallets. All of this money is being spent up-front before the additional revenue generated from the added capacity gets realized on the income statement. For instance, the company spent close to $5M this year on new equipment to ramp up production after one of their biggest customers placed the largest order the company has ever received. This order caused management to increase necessary expenses on all fronts: hiring workers, buying more machines, and spending more on higher volumes of raw materials. By looking at the income statement alone, its easy to see why share prices fell close to 20% after the 10-K was released. The company recognized lower gross profits, which in turn reduced the total amount of net income attributable to its shareholders compared to 2017.

Taking a look at the cash-flow statement shows a different picture. GLGI is free-cash flow positive, and has consistent positive operating cash-flows over the last five years. For the year-end 2018, the company was able to increase operating cash flow by close to $1M ($8.1M from $7.4). So although the company’s net income took a hit showing negative net income growth, internally the company is generating high returns from their operations on a YoY basis. Greystone has been able to achieve higher returns on capital compared to its working cost of capital by a net +4%.

Micro-Cap, Low Volume & Zero Analyst Coverage

GLGI trades roughly 20,000 shares daily. Management owns close to 40% of shares outstanding, which makes trading shares even harder. The lower average volume makes it difficult for larger firms and funds to own the company given various restrictions and requirements for investments. Even if a fund wanted to purchase GLGI, assets under management would need to be small enough to not make a market during purchase.

Greystone has 321 followers on Seeking Alpha, with the latest analysis coming from 2015; virtually three years of Seeking Alpha silence (maybe this is a good thing?). The company isn’t on StockTwits either; a real under-the-radar micro-cap company. GLGI has a market cap of $15MM making it one of the smallest companies I’ve ever researched. The amount of funds that can actually buy shares if they wanted to is extremely low.

Growth of Pallet Industry Isn’t Priced In

The pallet industry is at an inflection point and the market hasn’t priced in the potential shift from wooden to plastic demand changes. Even at current earnings the company is under-priced compared to industry averages, this isn’t even including growth. Miller and Coors are growing revenues and the trend seems to be steadily higher as they have both been predictable businesses. The plastic pallet industry is set to grow over 5% per year, and right now GLGI is the only way to play the growing plastic pallet industry in the public markets.

Back of The Envelope Valuation

I am working on simplifying my valuation methods after reading more from the value guys I follow. One of the main characteristics of the collective valuations that I read is their simplicity in how income statement is broken down into various scenarios. So, instead of an envelope I’m using a simple excel spreadsheet. Anyways, let’s take a look at three possible outcomes for a 2022 valuation given three different scenarios; no growth & runaway costs, pallet-industry-level growth, and company average growth rate with streamlined cost of sales.

1. No Growth & Out-of-Control Cost of Sales

If we assume no top-line revenue growth, we have revenues of $48.6M in 2022. Now, let’s also assume that management can’t find a way to create economies of scale. As the company grows, so do their average cost of sales. This would signal management’s inability to streamline costs, cut where needed, and innovate technologies to make producing more pallets cheaper. This figure would produce a little over $43M in cost of sales, bringing our gross margin to 10%. After paying GSA expenses of $3M and interest expense of $0.65M (assuming 35% income tax), we’re left with $1.21M in EBIT for a 2% EBIT margin.

Assuming this $1.21M in EBIT we’re going to use a EV/EBIT range of 8x – 12x. At 8x EV/EBIT the company would be worth around $0.34/share, or a downside of 43%. At 10x EBIT share prices are worth $0.43, which represents a downside of 29%. Finally, at the industry average EV/EBIT of 12x, shares would be worth around $0.51 for a downside of 15% from current prices.

Remember, this valuation is assuming that revenue growth stalls at zero and cost of sales runs rampant at 90% of revenues, signaling inept management and lack of innovation within assembly line processes.

2. ‘Plastic-Pallet-Level’ Growth Fair Value Range

The industry is expected to grow above 5% from 2018 – 2022, so for this valuation we’ll assume the industry standard. With a 5% CAGR we get $59M in top-line sales. Taking out $49M for cost of sales gives us $10M in gross profit for that historic 17% gross margin. Backing out GSA of $3.65M and Interest Expense of $2.3M we’re left with EBIT of $4.2M. At 8x EBIT shares would be worth $1.17 for an upside of 101%. 10x EBIT gives us $1.47/share for a 151% upside. Finally, at industry mean 12x EBIT, shares would trade around $1.76, or 200% increase from current trading prices. This would put the company’s EV value between $56M – $73M normalizing for long-term debt.

2022 Valuation (5% CAGR Increase in Revenues) Sales 59.07 Cost of Sales 49.03 Gross Profit 10.04 Gross Margin % 17.00% General, Selling and Administrative Expenses 3.65 Operating Income 6.40 Other Income (Expense): Interest expense $ (2.24) EBIT 4.16 EBIT Margin % 7%

Per Share Value Upside % @ 8x EBIT $ 1.17 95% @ 10x EBIT $ 1.47 144% @ 12x EBIT $ 1.76 193%

3. Discounted Historical Average Top-Line Growth & Streamlined Cost of Sales

This valuation is our Goldilocks scenario. In our final valuation, the company manages to grow top-line revenues by 25% CAGR (which is still a discount to its 5 year average) while cutting cost of sales down to 80% of revenues, which will give us 20% gross margin. At this level of production and efficiency, 2022 sales are $118M, cost of sales $95M for a gross profit of $23.73M. Applying $7.32 for GSA expenses and $5.75M in Interest Expense, EBIT would be around $10.6M, or a 9% EBIT margin.

2022 Valuation (25% CAGR Increase in Revenues) Sales 118.65 Cost of Sales 94.92 Gross Profit 23.73 Gross Margin % 20.00% General, Selling and Administrative Expenses 7.32 Operating Income 16.41 Other Income (Expense): Interest expense $ (5.74) EBIT 10.66 EBIT Margin % 9%

Taking a look at EBIT multiples at this EBIT level produces extremely asymmetric risk/reward scenarios. At 8x EBIT, share prices would average around $3, a 400% upside. 10x EBIT puts share prices at $3.76 for an upside of over 500%. Finally, at industry mean 12x EBIT, share prices would be around $4.50 for an upside of 652%.

Per Share Value Upside % @ 8x EBIT $ 3.01 401% @ 10x EBIT $ 3.76 527% @ 12x EBIT $ 4.51 652%

Obviously I am not expecting this final situation to play out exactly as I prescribe here, but it does provide an upper-bound of per-share ranges.

Why I Shouldn’t Own Greystone

Almost all of my write-ups have a section titled “Where Is My Fallibility?” in which I describe all of the ways in which the company could fail to reach its intrinsic business value. I do this to make sure that I am thinking about the other side of the trade as well as (or hopefully better) than the seller. Bruce Greenwald paints this perfectly when he says, “With every trade, there is someone on the other side thinking they are right and you are wrong … and you should hope that you know more than they do.” Charlie Munger echoes this sentiment when he talks about knowing the opposite thesis better than the opposition knows its thesis. For example, if someone wants to become a part owner in a business (like we do with investing), one should be able to argue why investing in that business is a bad idea; or at least be able to effectively present the reasons why someone wouldn’t.

Reason 1: Increased Cost of Sales

The company is growing top-line revenues at a fast pace, but they’re also growing their cost of sales at an even higher clip proportionally. At its current pace the company is getting close to single digit gross margins. Single digit gross margins would significantly reduce the company’s ability to increase shareholder value. It will be important to see how management deals with cost of sales over the next few years. If I see a trend towards declining cost of sales, that would be a very good sign.

Reason 2: Debt Levels

The company nearly doubled their long-term debt for the use of purchasing more equipment in response to the record order they received from their largest customer. On paper this looks bad, with cash to debt ratios around 0.02. The company pays roughly 4.75% in interest on their debt. The good news: they can afford it through cash from operations. The bad news: a rise in interest rates makes financing this debt more expensive, which would then eat into the business’ ability to plow capital back into the business for innovation, share repurchases, and re-investment into the business. Management is currently paying down debt in chunks of around $4M. I would like to see them raise the debt-repayment chunks as more cash becomes available through operations.

Reason 3: Extremely Illiquid Market

Like mentioned earlier, average trading volume is around 20,000 shares daily and a 55% float of total shares outstanding. This means that even if the company executes, reduces cost of sales and expands margins, it will be unlikely that share prices rise quickly due to the illiquidity of the market. If anything this is closer to a private equity investment, and it must be treated like that as getting in and out of the stock quickly will most likely not happen. If it does, you’ll be creating a market for yourself.

Reason 4: Plastic Pallet Growth May Not Take Off

The future of the plastic pallet industry is extremely promising. With over 5% CAGR in a $2B+ industry, the runway appears long. However, it could very well be the case that plastic pallets simply don’t take off. Companies could very well stick with what they know, with what’s familiar, and continue to purchase new and used wooden pallets simply because it hasn’t materially affected their business to date. Although this seems highly unlikely (especially in the food and beverage industry), the market might not gain enough traction to produce that 5% CAGR figure.

Wrapping It Up

Greystone Logistics operates in a simple to understand, even “boring” business. The company is positioning itself at the inflection point of a $2B+ industry on the verge of switching from wooden pallets to plastic. As the only publicly traded plastic pallet manufacturer, they present a positively asymmetric opportunity at capturing the change in preferences from pallet users. Even at no growth and runaway cost of sales, share prices would only be down around 20% from where they currently are, giving us a great margin of safety. The company habitually churns out positive cash from operations, and has grown production capacity from 70K units to 120K units per month. Large insider ownership helps me sleep at night, knowing management owns over 40% of the company, and CEO Warren Kruger owning over 30% himself. As long as debt stays payable through cash from operations, revenues continue to climb, and cost of sales trends downward, this is a company I would gladly hold for years.

Disclosure: I am currently long GLGI and looking to add more to establish larger position.

Sources: Greystone 10-K’s, https://www.persistencemarketresearch.com/market-research/pallets-market.asp