McGrath Rentcorp (MGRC) is a leading equipment rental company of relocatable modular buildings and electronic testing equipment. The Modular business primarily rents classrooms and office spaces to customers in California, Texas and (recently) Florida.  The Electronics business rents general-purpose and communications testing equipment that are used in research & development, manufacturing processes, field service and general testing of products and networks.  Each segment contributed equally to MGRC’s $125mm of EBITDA in 2006.  These business lines possess uniquely powerful economics that have consistently generated 13%+ ROIC, 20%+ROE, and 40-50% EBITDA margins.  Misunderstood and underfollowed, MGRC’s stock has been hampered by cyclical fears at other capital equipment leasing companies despite being driven by very different cycles and has traded at a discount to its primary modular peer, Williams Scotsman (WLSC), due to poor perceptions of its Electronics business.  In fact, MGRC is about to see a rebound from a cyclical low in its largest Modular sector with the recent passage of a $10bn education construction bill in California that will drive a multiple year acceleration in profits.  Further, the Electronics business is actually a very attractive segment that one could argue should command an even higher valuation than Modulars, which should drive a significantly higher valuation as investors recognize the true sum-of-the parts value of the firm. 

 

The way to think about MGRC is as two separate asset portfolios that are constantly managed by expert product managers.  The Modular business, which has over 23,000 units and is predominantly classrooms, and the Electronics business, which has a diverse array of hundreds of test equipment (e.g., oscilloscopes and spectrum analyzers), have strikingly similar economic propositions. 

 

Modulars have an 18 year useful life and rent out for approximately $400 per month for approximately 24 months.  Each time a classroom is returned, for example, minor repairs are made (typically $500 - $2,000 is expensed) and the classroom is re-rented.  The average classroom is re-rented several times, reaches payback in 5 years and then is sold after 10-13 years for 90+% of its original cost yielding an average after-tax ROIC of 12+%. 

 

Electronics products have shorter product life cycles (fleet avg of 6 yrs) and rent out at monthly rates of up to 10% of their capitalized cost for periods of 1-6 months.  Payback is 2.5 years and after-tax ROIC over the last 4 years (including maintenance and operating expenses) has been 17% with EBITDA margins increasing from 40% in 2002 to 60% today.  More about this segment will be mentioned later because admittedly when we first heard about this business (i.e., renting electronics) there was a temptation to dismiss it as too risky and not worth much.  Upon further diligence, this could not be further from the truth as this business is a) actually quite stable after revamping the portfolio post-telecom bust and b) so grossly undervalued that you are more than compensated for even overly perceived risks associated with the business.

 

Both businesses enjoy significant secular winds at their backs.  The Modular business customer mix is 60% education (~40% of total revenues) with the remaining 40% split evenly between commercial and construction customers.  Unlike its primary public comparable, WLSC, MGRC is much more focused on education and is regionally concentrated in California and Texas and is ramping up in the fast growing Florida education market, which it entered in 2004.  The chief drivers of classroom growth are principally three-fold:  1) growth in student populations in these states; 2) several decades worth of underinvestment in educational infrastructure and 3) state legislation mandating reduced student/teacher ratios.  There is a lot of public literature but, briefly, California needs 22,000 to 40,000 new classrooms, depending on whose figure you look at.  Florida passed a state constitutional amendment in 2002 mandating step downs in student/teacher ratios through 2010.  These trends have created sustained multi-year demand trends for classrooms.  School districts typically rent modular units if they are constructing new permanent facilities or have temporary space needs driven by, for example, an excess of fourth graders in a particular year.  In addition, an increasing number of permanent structures are now being built using many modular units versus more traditional building materials (e.g., brick or concrete) as permanent modular buildings are up to one-eighth the cost to build. 

 

On November 7^th, California voters approved a bond bill for over $10bn for classroom construction and modernization projects, which is double the previous March 2004 bond bill.  In California, which represents approximately 75% of MGRC’s modular education revenues (28% of total revenues), there are two types of demand: 1) an underlying base load of demand created from growing student populations and 2) large modernization projects where a school is totally or partially closed down for modernization upgrade/repairs for a couple of years thereby temporarily displacing large numbers of classrooms.  These modernization projects are funded typically 40% from the local community and 60% from the state.  The local money has already come through various local bond bills and initiatives over the past 18 months but the state money had been delayed until now causing a pause in MGRC’s California classroom business, which was the primary driver of their earnings deceleration in 2006.  Historically these bills have fueled 2-3 years of accelerating demand for vendors like MGRC, which is the leading provider of California modular classrooms with distant competition from WLSC and numerous other small businesses.  This bill will create a windfall of project activity, which as in years passed, will provide material upside to 2007 numbers and significant growth in 2008 and 2009.   To attempt to quantify, this summer, which is the time when classrooms are delivered in anticipation for the start of a new school year, this bill could potentially create incremental demand for 1,000-2,000 classrooms.  The annualized cash profit contribution from these units once on rent could be $10-$20mm or $0.20 - $0.50 of EPS.  In addition, these units will be coming out of inventory so there is no additional capital required.  2008 and 2009 will show the full year impact plus additional growth that should at least match 2007 quantities.    

 

The Electronics rental business is supported by different secular trends.  General-purpose testing equipment (67% of segment revenues), are tools used in a diverse array of industries, including aerospace, defense and general industrial, to design, manufacture and manage a variety of end-products.  There are a multitude of secular sub-currents supporting growth, whether in the development of new weapons systems or more generally in the incorporation of higher technology content in many different end applications.  Because it is so diversified and driven by numerous functions within its clients, this segment has exhibited low levels of cyclicality and life cycles of 7-8 years.  MGRC’s largest suppliers of equipment in this category are Agilent and Techtronix.  Currently, MGRC is benefiting from strong, broad-based demand from its customers as well as from the roll-out of a series of new product families from its equipment vendors.

 

Communications testing equipment represents 33% of segment revenues and is the area with historically the greatest earnings volatility.  Like many telecom equipment companies, MGRC overbought telecom testing equipment during the boom years only to find several years of little demand and, hence, wrote-off the value of much of its communications equipment in 2002.  This painful period of 2001-2003 set the stage for sustained, disciplined growth on two levels.  First, the telecom bust enabled MGRC to purchase its largest competitor (a unit of Tyco) in 2004 for 55 cents on the dollar just as the communications market began to recover.  As the largest national player in the market, MGRC has purchasing scale with its suppliers, superior product availability and is optimally positioned to capture and service large accounts, such as Lockheed Martin.  Second, the bust taught some very valuable lessons on asset management and asset diversification that have led to a more rigorous underwriting process and greater discipline on fleet additions.  In the background, several strong secular trends, such as wireless network expansion and upgrades to 3G as well as the continued convergence of voice and data networks, have only recently reinvigorated a once dead engine of high margin growth that will likely provide significant growth opportunities over the next several years.

 

As I mentioned earlier, we were initially very skeptical of the Electronics segment but we took the time that few have to conduct extensive diligence of this business.  After visiting with their management team, seeing their facilities and seeking input from third parties we completely reversed our opinion and saw the fundamental attractiveness of this business.  First, from a risk perspective, the business is diversified in terms of customer, industry and even product exposures. Today, there are no specific industry or customer concentrations (the largest customer is 2% of revenues).   Furthermore, after excluding the effects of the telecom bubble, this business is too diversified to be cyclical.  At any given time there are products or customers or industries that are hot or cold, which in turn tends to neutralize any particularly strong effect. Second, the segment employs people with considerable technical expertise and tenure.  This has enabled very special relationships with equipment vendors that minimizes another key concern we had which was technological obsolescence. Third, the management team has instilled a return-on-capital driven mentality and a long term growth focus, which is a natural brake against speculative asset purchases.  2Q05 was a perfect example of this return focus where they deliberately missed their Electronics used equipment sales target because the alternative of re-renting that equipment yielded more attractive returns over the longer run.  Fourth, there is a robust equipment rental market that has existed for decades and continues to grow as companies large and small become more discerning with their capital spending (i.e., renting a piece of equipment for 3 months that you only need sporadically is more economical than buying that piece only to sit on the shelf even if you are Lockheed Martin).  Finally, there is only one other competitor of any scale, a small public company called ElectroRent that dedicates half of its business to this endeavor.  (The other half of their business is an unattractive laptop rental business, principally serving conventions and training seminar markets).

 

There is significant earnings upside at MGRC.  First, the California bond bill will drive the Modular business out of its 2006 trough and by 2H07 position the business firmly in at least a three year upswing.  Second, the Florida classroom business continues to ramp quickly under strong demand as schools are now scrambling to meet the 2008/9 teacher/student minimum ratios.  Third, MGRC’s commercial modular business, which is characterized by long term contracts with significantly higher than the corporate average ROICs, continues to benefit from strong demand.  Finally, in either 4Q06 or 1Q07 the Electronics business will hit an inflection point in its asset yields that in addition to continued capital investment and strong end markets will drive revenue growth of 15-20% in 2007 and 2008.  These factors in addition to underlying demand for MGRC’s services should re-accelerate revenues from -3% growth in 2006 to 16% over the next two years.  EBITDA margins can expand from 45% to 50% due principally to operating leverage and mix shift.  EPS growth will likely accelerate to over 30% over the next two years yielding $2.80 in 2008 while FCF should increase from an estimated $9.5mm in 2006 to $85mm in 2008.

 

MGRC has given back most of the gains it made on the election news, despite a strong market.  Valuation is quite attractive under a variety of methodologies.  On a PE basis the stock currently trades at 13.9x ’07 and 10.5x my $2.80 2008 EPS estimate.  Assuming 15x, which would still conservatively reflect the strength in the underlying business model, the stock should trade to $42 (43% upside).  On an EV/EBITDA basis, MGRC is currently valued at 5.9x ’07 and 4.9x my $186mm ’08 estimate.  Finally, and perhaps the most compelling metric given the capital intensiveness of this business, the FCF yield in ’08 is 11.3% despite continued heavy capital investments.    

 

Given the capital intensive nature of the business, it is also helpful to think of MGRC as a portfolio of assets that today is yielding a cash return of approximately 11% with each incremental dollar invested yielding mid-teens.  (To arrive at the 11% cash return, we calculated the 2006 FCF yield adjusted for maintenance capex, which represents the amount of capital required to replace the units in the fleet that were sold grossed up to today’s dollars to account for cost inflation over the last ten years plus any capitalized maintenance on the continuing fleet.)  This yield is very compelling, particularly given MGRC’s historical track record as a fine steward of capital.  It is notable that despite the capital intensiveness of their business, MGRC runs FCF positive in even heavy spending years (such as 2005), distributes a dividend (now yielding 2.2%), which has grown 15% over the last five years, and when times were the toughest (e.g., 2003) MGRC conducted a share buyback (albeit a small one).

 

On a relative basis, WLSC is the only other publicly traded modular rental company but that is effectively were the similarity ends.  Despite generating significant negative FCF, a reliance on large sales, significant financial leverage and ROICs consistently below its cost of capital (currently just 8%), it trades at a 0-15% premium to MGRC depending on the earnings metric used. WLSC’s current valuation is 7.2x/6.5x 07/08 EV/EBITDA and 16.4x/14.1x 07/08 PE.  With better growth prospects, less cyclicality, superior education economics and positive FCF, MGRC’s Modular business should arguably trade at a premium to WLSC – not a discount.

 

From a sum-of-the parts perspective, MGRC again looks attractive.   Using WLSC’s valuation for MGRC’s Modular business, the Electronics business trades at an implied 4.8x 2007 and 3.4x 2008 EBITDA.  This seems like a gross value discrepancy considering that Electronics should do an estimated $74mm and $87mm in EBITDA in 2007 and 2008, respectively, representing 20+% average annual growth and is deploying over $50mm of capital each year that will likely return a high-teens ROIC.  Arguably, the Electronics business deserves at least the same multiple as modulars given its better ROIC and better margins.  On a sum of the parts basis, MGRC should then trade at approximately $44 per share or 50% higher.

 

MGRC faces some risks, both from a trading and fundamental perspective. Management has historically been very conservative with guidance (they typically only provide an annual EPS range), and I would not expect that to change when they discuss 2007 on the next call.  More fundamentally, any pullback in commercial construction will impact 8% of their revenue, while the timing of the windfall from the CA bond bill is somewhat uncertain and there should be a fair amount of lumpiness from quarter to quarter over the next few years.  Fortunately, there are two strategic alternatives that should provide protection from an enduring downside scenario:    First, a spin-off or sale of the Electronics business would unlock the value described above.  Second, there is a private equity put.  MGRC could easily be taken private at these levels.  Warburg Pincus recently bought Mobile Storage for 9.2x LTM EBITDA (excl. fees and expenses) with 6.9x leverage through the holdco.  WLSC and Resun (private) have also been LBO’d.  MGRC has superior fundamentals – not the least of which is positive FCF - to all of these companies and middle market private equity funds are flush with cash.

 

In summary, as in any asset intensive business, investors should demand a high and durable ROIC and a management team that understands where and how much capital to deploy because no business is completely insulated from cycles.   MGRC provides a demonstrable track record of over 20 years of delivering exactly these things to maximize shareholder value.  MGRC represents a collection of significantly mis-priced assets with favorable secular trends.