Description

CAI International (“CAI”) is a US listed container leasing company. At $22.4/share, it trades at .67x Q220 P/B and 5.9x consensus FY21E P/E. While CAI historically earned above its cost of capital, in 2014 it made the strategic error of diversifying into several unrelated industries, depressing subsequent returns. In June, pressured by activist investor Weiss Asset Management, CAI concluded a strategic review which resulted in: 1) the resignation of the CEO; 2) a plan to divest its non-core segments; and 3) a commitment to focus on its core business and return to sound capital allocation. Coincidentally, we have seen an acceleration in industry fundamentals. Due to an uptick in global trade demand, containers are currently sold out, leading to demand for new containers and healthy lease rates. Additionally, lower interest rates are allowing the industry to reduce its funding costs and increasing returns on existing business. With the divestment of its loss-making segments and a return to sound capital allocation, CAI’s overall returns should again rise above its cost of capital and its shares should trade in line with its BV of $33.25/share, 48% above the stock’s current levels.  

Overview of Container Leasing Industry

The container leasing industry is a secured creditor to the major container shipping companies (Maersk, MSC, CMA, Cosco, Evergreen etc. – “liners”). The primary risks are counterparty risk, lease renewal rates (every 5-7yrs) and residual values at the end of a container's life (20yrs). Oddly, it took a recession for the liner industry to find the capacity discipline it historically lacked. Illustratively, today spot freight rates on the Shanghai -West Coast N. America route are at an all-time high of $3,508/FEU (WCIDSHLA Index), which should result in record profitability for the major liners. Lease rates and residual values are harder to track but primarily driven by steel prices (~70% of the cost of a container) and manufacturer discipline/profitability. Chinese hot roll coil prices at $591/ton (HRDCSHHA Index) are currently above pre-COVID levels. Anecdotally, manufacturers have also adopted, for the moment, new found discipline, prioritizing price over volume (per comments on recent CAI / Triton (“TRTN”) earnings calls). 

The following Loadstar article reports on current industry conditions: https://theloadstar.com/shippers-ocean-freight-budgets-about-to-explode-as-rates-hit-new-highs/

Leasing companies earn the spread between the lease rates they charge the liners and their funding costs. CAI typically targets a spread of 350-400bps above their borrowing costs on its new leases (which are 5-7yrs in duration) and containers are levered 70%, leading to higher equity returns. This is a cost of capital business and profitability is driven by competition among lessors. The best players earn slightly above their cost of capital through the cycle but one shouldn’t expect much more.  

Overview of CAI

CAI went public in 2007. For its first 7 years (through 2014), CAI grew book value per share by 15% per year. In 2014, the company made the strategic mistake of diversifying into rail cars and setting up a freight logistics business. As the industrial recession of 2015-2016 hit, CAI was forced to take delivery of a large batch of pre-ordered rail cars and lease them for multi-year contracts at the bottom of the cycle. This business has been a drag ever since. The freight logistics expansion, even more of a head scratcher, has been cashflow negative since inception. Despite these strategic errors, due to the continued high returns of the container segment and a series of well-timed share repurchases, between 2015 and 2019, CAI grew book value per share by 10% annually.

Below is a comparison of TRTN, CAI’s primary publicly listed peer, and CAI’s returns and trading levels since 2007.

-          Highlighted in yellow is the drop off in CAI’s ROE’s between 2015-2019 due to CAI’s diversification into rail car leasing and freight logistics, and CAI’s ROAs in those segments.

-          As part of the conclusion of its strategic review CAI agreed to divest its non-core segments and, like TRTN, implement a dividend.

o   In August 2020 CAI divested its freight logistics segment. Since 2019, CAI has sold half of its rail cars and has committed to exit the remainder. The market remains depressed though making timing difficult to predict.  

On 9/1/20, CAI refinanced its ABS facilities, lowering the associated interest cost from ~4% to ~2.3%, saving $12MM per year in interest expense or $.71/share per year.

There should be upside to FY21 consensus EPS of $3.78/share. During Q220 CAI reported EPS of $.79/share from continuing operations, or $3.15/share annualized. The Q220 earnings included several items which should not repeat: 1) a $.500MM impairment in the rail segment, 2) $1.2MM negative YoY impact associated with a troubled customer, PIL, which has since started paying on time and 3) $1MM in professional fee associated with the strategic review – totally $.14/share. Additionally, on its Q220 earnings call, CAI mentioned they leased out the remaining containers they had in inventory and entered into leases backing a $195MM of new containers, implying a small amount of growth. Bridging these items, and the ABS refinancing, should lead to a run-rate earnings power of >$4.25/share

Convergence between market and theoretical prices

One positive aspect of CAI’s business model is that 100% of capex is discretionary (though the business shrinks over time if CAI does not invest in new containers). Moreover, due to the lack of investment over the past year during the strategic review, the company is currently under levered with capacity to buy back shares. The only deterrent is a restricted payment test in CAI’s RCF. If total leverage is below 3.0x, there is no restriction. Between 3.0x and 3.75x, restricted payments are limited to LTM Net Income. At Q220, CAI’s total leverage was 2.81x, implying in excess of ~$60MM of buyback capacity vs. its $400MM market cap. This is before the LTM Net Income provision. In Q219 prior to the start of the strategic review, CAI repurchased 5% of its float.  While it is not realistic to expect the company not to invest, we’d expect share buybacks to be part of its capital allocation program at these trading levels.

Conclusion

CAI is a case of decent business, poor capital allocation. Post pressure by Weiss Asset Management, CAI appears to have found new capital discipline. Today you are buying a dollar at $.66, which should grow book value / share at low-teens per year going forward. While many financial companies currently trade at a large discount to book value, to the extent that the market does not recognize the changes taking place at CAI, the company generates significant free cashflow relative to its current market cap and capacity to buy back shares to close the gap.

Risks

Industry Competition – Historically competition has been benign as there has been amble demand from overall container shipping demand growth and increased mix shift from the major liners moving containers off their balance. From 2009 to 2019, the overall container fleet grew from ~28MM TEU to ~42MM TEU, or 4.7%/yr while leasing penetration grew from 41.2% to 53%, leading to 7.4%/yr growth in containers under lease (TRTN Nov 2019 Presentation). We note that CAI’s ROAs have gradually declined overtime though.

Capital Allocation / CEO Search – CAI is currently undergoing a CEO search. In the interim, CAI’s old CFO is acting as interim CEO.

Lease Renewal / Residual Values – The primary driver of both items is new container prices. The most volatile component of new container prices is steel, which makes up 70% of the cost. Steel prices in turn are largely driven by iron ore and met coal costs.

The following chart shows Chinese hot rolled steel prices over time. The drop-off in steel price during the 2015 and 2016 industrial recession was a large driver of TRTN and CAI’s depressed ROEs during the period. Renewed leases were at lower levels and secondary sales were below depreciated values resulting in accounting losses on those sales.

Residual values are hard to track although CAI provides the below chart tracking their secondary sales versus their assumed book values. While volatile, over the past six years realized secondary sale prices have averaged above CAI’s depreciated book values.

Catalyst

Complete divestiture of rail car segment

Conclusion of CEO search

Buybacks