Description

McGrath RentCorp (MGRC) consists of three businesses: (1) Mobile Modular Management Corp, which is the largest provider of rental modular classroom for school districts in the state of California; (2) RenTelco, which is the leading communications and fiber optic test equipment rental business in the U.S.; and (3) through a majority ownership in Enviroplex, it manufactures and sells modular classroom facilities to school districts in the state of California.

MGRC was founded in 1979 and has become a market leader in the rentals of telecommunications equipment and modular classrooms. Given the enormous market downturn in spending in the fiber optic and telecommunications business this past 18 months, I realize at first glance this idea should result in healthy skepticism. I believe that it is difficult to have a higher degree of skepticism than I typically have with investment ideas. I firmly believe that McGrath RentCorp has positioned itself in such a manner that it will enjoy the same success it has in the past as it will into the future. I am not typically interested in technology-based companies, however the real business behind MGRC is that it is a rental business, which when properly managed can be an excellent business. MGRC has been managed by a very shrewd CEO and has performed very well during its history.

Initially, MGRC has just announced record quarterly and six-month earnings, in the midst of this near term catastrophe of the telecommunications field. This is one of the factors that has made this business an interesting investment. MGRC has an ROE consistently in the 25% range, has grown earnings at 21% over the past 4 years, repurchases shares, generates significant cash flow and pays an annual dividend with a current yield of 2.5%.

Mobile Modular Management Corp (59% of revenues)
Economic downturns should really not impact this business. Demand for rental classrooms in the state of California continues to increase significantly. MGRC continues to build a strong annuity with rental income and also realizes income from the sale of rental units. Rental revenue for the past six months grew at 13% compared to the first six months of 2000 and sales revenue also grew at 13% for the same time period. The rental of modular classrooms has been a very profitable business with gross margins typically in the area of 58%. This has proven to be a very good business as school populations continue to increase. Management has recently stated that is has a very good backlog of classroom orders that have been taken, but not yet shipped. Average utilization rate as of June 2001 was 85%. Whether in strong or weak economic times, school populations are increasing and the demand for modular classrooms will continue to grow. Whether a school is in the midst of rebuilding permanent facilities or simply out of room in existing facilities, this is a very good business to be in.

RenTelco (33% of revenues)
MGRC, through RenTelco rents various communication and fiber optic test equipment as well as general purpose test equipment. This business has historically grown steadily over the past number of years and has provided higher margins than the mobile modular business. What has continued to surprise me with this business is that the revenue from this business was 13% higher in the 2nd quarter of 2001 than it was in the 2nd quarter of 2000. Given the complete spending freeze that has impacted the entire telecommunications field, this really is amazing. Needless to say, MGRC will not be immune from this spending freeze in this field. The revenue in the 2nd quarter was 6% less than the revenue in the 1st quarter of 2001. MGRC, like every other company in the telecommunications field is unable to predict with any degree of certainty what will happen during the next year. There will be an impact; the degree of that impact is what isn’t quite certain. The reality is that should the company annualize the results of the latest operating month (July, 2001) results, then the total earnings for MGRC will be flat for the next year. The utilization rate at the end of June 2001 had fallen to 49.3% from 65.4% a year earlier. Even with this significant fall in utilization rates, the revenue increased 13%. I find this to be pretty remarkable, given the complete collapse of spending in this market. During periods of economic downturns, companies will always look to rent equipment before expending capital for purchases of such equipment. Thus, MGRC has a very nice niche in this market, companies will typically turn to rent test equipment in both strong and weak markets. The difference here is the very significant downturn in corporate spending in this market.

Enviroplex (8% of revenues)
Enviroplex was formed in 1991 and it manufactures mobile classrooms and sells them directly to school districts in the state of California. MGRC has recently increased its ownership of Enviroplex from 73.2% to 80.7% as it issued 85,000 shares for this investment.

MGRC, even in this market, continues to generate EBITDA margins of over 50 cents for every $1 in revenue. The company is able to generate significant cash flow in this difficult environment. MGRC just has record earnings for the past quarter and six months and it is possible that those earnings can be exceeded in the upcoming year, even in this economic downturn. The freeze in corporate spending will not last forever, and when the spending does return, the earnings shall continue to grow at very healthy amounts. MGRC has been repurchasing shares steadily over the past ten years and has reduced the outstanding shares from 16.9 million in 1991 to 12.2 million currently. They have board approval for an additional repurchase of over 800,000 shares at the present time.

In 2000, MGRC had earnings per share of $2.19 and for the first six months of 2001, the EPS was $1.16. MGRC expects to earn between $2.25 and $2.35 during 2001. The wild card is the RenTelco business. Should spending return to the market, this figure would increase, perhaps significantly. At earnings of $2.25, MGRC is trading at 11.51 times earnings. Going forward, I would anticipate that normalized earnings will grow between 15 – 20% realized through growth in both segments of their markets as well as continued share repurchases.

The company is in the midst of a catastrophic spending freeze in the telecommunications field and is expected to grow earnings higher year over year, is trading at a P/E of 11.5, generates an ROE of 25%, is a historical purchaser of its own shares, generates significant cash flow and pays a dividend of 2.5%

Catalyst

1) Current valuation is low. Trades at 11.5 P/E, ROE of 25%, historically growing earnings in excess of 20% annually, and repurchases its own shares.
2) A return to normal spending in the telecommunications and fiber optic field will have a significant impact on growing earnings into the future.
3) Continued share repurchases will enhance shareholder value.