Description

Summary: 

·         Structural Industry Shift:  A structural shipping container shortage emerged in Q416 after Hanjin’s bankruptcy, and our field research indicates new container prices have increased from $1,800 to $2,300 (expressed in TEU’s or 20-ft. equivalents) and cash-on-cash (“CoC”) leasing yields from 8% to 12%, creating major tailwinds for lease rates and asset values.  Meanwhile, TRTN has been aggressively deploying capital as its competitors remain paralyzed by fear and lack of financing following the 2015/2016 industry downturn, creating the perfect (good) storm for TRTN.

TRTN management also downplayed the market’s strength on its March 15^th earnings call to prevent unwelcome attention.  TRTN stated new box prices are $2,000/TEU without addressing yields (the sell side infers 10-12%), and our field research indicates box prices continue to increase to $2,300/TEU with yields of “at least” 12%. 

·         Earnings Beat:  Public market investors don’t appreciate the significance of what’s happening, and the sell side improperly models the business when the cycle turns as it is now.  Using quite conservative assumptions, TRTN should earn $2.85 of GAAP EPS / $3.31 of cash EPS in 2018 (TRTN does not pay cash taxes) vs. sell side 2018 GAAP EPS estimates of $2.28/share.

·         Cheap Valuation:  TRTN’s through-cycle GAAP TBV multiple of 2.2x creates a $40 stock, upside of ~65%, but if legacy TAL’s container assets were written back up to the original cost basis of $2,000/TEU from $1,400/TEU (in terms of new container prices), TRTN is a $54 stock at 2.2x TBV. 

Why the Opportunity Exists:  There are two reasons for the opportunity.  First is fear and recent memories for both investors and leasing industry executives.  We’ve spoken to TRTN’s top competitors who remain fearful after the devastation of 2015 and 2016 as global trade slowed from 4% to 1% and the industry became oversupplied, causing every lessor – with the exception of Triton – to lose money and violate bank covenants in 2016 from aggressively buying excess containers at the peak of the market and/or being overly exposed to now-bankrupt Hanjin. 

Lenders have similarly cut off financing for new container purchases for TRTN’s competitors.  Public market investors have also lost a lot of money the past two years.  This has translated into low equity valuations for container stocks and a general sense of fear among TRTN’s competitors and their investors that any fundamental improvements may be short lived.

This industry-wide fear creates the ideal competitive situation for TRTN.  The peers cannot access capital and are hesitant to purchase containers even if capital were available over fear that the $2,300/TEU new box price may not hold.  However, the fear is not grounded in evidence – it’s just fear.  These views have been triangulated from speaking with numerous senior executives at the top-5 lessors.  Even Triton’s top competitor TGH has been unable to purchase new containers from violating debt covenants.

Second, the industry is quite poorly modeled by the Street.  Historically, sell side estimates have significantly lagged actual results in both up and down cycles.  Wells Fargo, which is the most closely followed sell-side analyst, projects 2018 GAAP EPS of $2.28 vs. our estimate of $2.85.  The delta derives from a combination of misunderstanding how per diem rates on new boxes and direct container expenses behave as TRTN’s fleet and utilization rates grow. 

WF does not factor in: (1) The level of fleet growth that TRTN is generating in 2017; (2) the impact of the higher cash-on-cash yields on these new containers, and; (3) the fact that direct container expenses are primarily storage costs that decline as utilization on the existing fleet increases, not the opposite.

Why the Cycle Turned:  The cycle turned sharply positive in Q416 for several reasons including: (1) Hanjin’s August 2016 bankruptcy, which created a subsequent container shortage as shipping competitors picked up Hanjin’s lost business; (2) the Chinese container factories cut production in the 2015/2016 downturn such that factory inventories are at record lows today; (3) the Chinese factories are now shutting down production until May preparing for the transition from solvent to waterborne based container paint, and; (4) after the 2015/2016 downturn, banks / lenders cut off capex spending / container financing for every lessor except Triton, including TGH.  While TGH’s covenant restrictions have recently been lifted, the private competitors remain capital constrained.

Why the Cycle Should Continue:  The cycle should continue because both capital and production will be constrained for the foreseeable future.  Lenders and private equity investors are experiencing significant impairments on their container investments through 2016 and have pulled back capital for the foreseeable future.  Confidence comes back into the market much more slowly than it leaves, and the memories are still fresh in the minds of the lenders and PE investors. 

TGH was able to start buying new containers again in March, but TGH is still very B/S constrained from the downturn and will not have the capacity to be aggressive in buying new containers.  It’s a classic example of TRTN being greedy when literally every competitor is (perhaps forcibly) fearful.  The container producers also have fresh memories from sustaining losses through 2016 and will be cautious with production volumes for the foreseeable future.

Second, our field research indicates new container production has been shut down until April/May when the waterborne containers will be launched.  Production will remain muted thereafter as the waterborne paint requires longer drying and production cycle times than solvent paint.  Customers are also skeptical of the quality which will require extra testing from the factories.

Estimates:  Our assumptions are quite conservative and based on 5-year historical averages for new box prices and CoC yields of $2,050/TEU and 9.5%, respectively; we know from our field research that container prices are $2,300/TEU with CoC yields of 12% or higher, which would add $0.45/share to our 2018 GAAP EPS estimates of $2.85.  Our assumptions are based on the.

Key operating assumptions include:

·         Per Diems – Current Fleet: The blended per-diem rate on the existing fleet remains flat at ~$0.59 through 2015.  This is conservative as it assumes no tailwinds from re-pricing the fleet at what are now premium market rates.

·         Per Diems – New Fleet:  For extra conservatism, we assume new containers are purchased at $2,050/TEU and a 9.5% cash-on-cash yield with $0.53 per diem rates – that’s significantly below the legacy fleet rate and current container prices of $2,300/TEU / CoC yields of 12%+.  Using these market rates would generate 2018 GAAP EPS of ~$3.30.

·         Utilization:  Utilization as of March 15^th was 95.5%.  We assume this reaches 97.0% in 2018.  Simply re-leasing the remaining Hanjin containers would get to 97.0% utilization, and given the structural container shortage we view this as conservative.

·         Direct Container Expenses:  These are primarily storage costs that will decline as utilization increases.  Before utilization declined in the recent downturn, TRTN had 2015 utilization of 96%  with Direct Container Expenses slightly above $100 MM, similar to our 2018 estimate of $102 MM with even higher utilization of 97.0%.  Note 2017 costs remain elevated from leasing the fleet back up to 96.0% from 93.6% as of Q416.

In terms of the fleet, the bulk of our 2017 growth has already been completed as of March 15^th with TRTN’s YTD container purchases of $600 MM, which imply ~272K TEU’s.  TRTN plans to continue buying at reasonably high volumes if CoC yields stay at 12%. 

See below for our key earnings assumptions.

* Includes $40 MM of synergies to be achieved by Q317.

Valuation:  TRTN is cheap by historical through-cycle averages of 2.2x GAAP TBV vs. 1.3x 2017E TBV.  That’s before factoring in legacy TAL’s assets being written down at the absolute trough to a new box price equivalent of $1,400/TEU vs. $2,300/TEU today.  Applying the long-term average new box price of $2,000/TEU takes 2017E TBV from ~$18.20/share to ~$24.60/share.  At 2.2x real TBV, TRTN stock would be worth $54/share.

From a free cash flow perspective, note that TRTN is not going to pay cash taxes for the foreseeable future unless the company stops buying containers altogether for multiple years. This is because containers are depreciated for tax purposes over a ~7 year life with a 0% residual value vs. GAAP depreciation of a ~14-15 year useful life depreciated to a ~50% residual value.  Levered FCF is therefore equivalent to pretax income, which is $3.31/share in 2018E, implying a ~13% LFCF yield.

The dividend yield is also ~7%, providing a margin of safety with substantial excess FCF left over after paying the dividend.

Private Equity Holders:  There are four PE investors from the legacy Triton business that still own TRTN stock.  Note that Warburg Pincus has a cost basis in its original Triton investment of ~$20/share; it would seem reasonable that they are not targeting an exit at a $25-$26 valuation after 6 years.  $40-$50/share would represent a more reasonable levered return.

Risks:  There are 3 fairly straight forward risks.  First is steel prices; today steel is inside its historical long term average of $500-$600/ton but if it drops significantly new box prices and therefore used box prices and per diem rates will as well. 

Second is global trade; if global trade decelerates significantly, supply / demand would come back into balance. 

Third is significant capital coming back into the container leasing business.  The business is cyclical and 3-4 ambitious PE-backed lessors and TGH fought for market share / scale during the prior cycle, which led to the excess supply and downturn of 2015/2016 when global trade decelerated.  The peers have been placed on the sidelines by their lenders / investors and it’s evident from speaking with them that they are still fearful of buying new containers.  However, if the good times last long enough, memories will eventually become distant and more capital will enter the business.

Catalyst

1. Earnings results beat expectations.

2. Valuation re-rates to through-cycle averages.