|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||860||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
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I believe Williams Scotsman (WLSC) is an interesting short. The company is widely hyped by the sell side as a great non-residential construction play (seemingly the Street’s favorite theme these days). Naturally the Street is myopically focused on the company’s exposure to non-residential construction at the expense of trifle concerns such as valuation, business quality and profit sustainability, industry structure, returns, free cash flow generation and balance sheet.
Before delving into my short thesis, let me provide a little company background: WLSC leases and sells modular office space and portable storage units (basically trailers) to construction firms, school districts and other organizations seeking to add cheap, temporary space. Historically, the industry has not been attractive. The business is mature, commoditized and highly asset intensive. Barriers to entry are low, demand is cyclical and overcapacity is a chronic problem because growing one’s fleet is easy, but units last forever – usually twenty years or more (in fact, during downturns, the company sometimes parks surplus units on unused farmland!). As a result, returns on capital are poor. WLSC and GE Modular Space are the industry’s two largest players, each with over 20% market share.
WLSC is an LBO roll-up that came together through the 1990s. The business was hit hard after 9/11 as demand shriveled and the industry faced a glut of capacity. Business began to improve in late 2004, and in September 2005, WLSC went public. Over the past eighteen months, the company has benefited from several phenomena. First, hurricane-related strength in the Gulf region and a cyclical upturn in non-residential construction improved pricing for the first time in several years. Second, in the undersupplied Canadian market, the oil and gas business is booming, creating substantial demand for temporary facilities. Third, several one-off projects, including large sales of units to the military and to a few state governments, further boosted results. Naturally, these favorable developments prompted the Street (analysts and investment bankers alike) to fall in love with WLSC, which they viewed as a non-residential construction and emerging energy services play with sizable operating leverage and free cash flow potential. I believe they’re overlooking several glaring problems:
The real improvement at the company has nothing to do with its core business, however, and happens to be far less sustainable. As a result of extremely tight supply in the southeast following last year’s hurricanes, surging exploration activity for oil and gas in Canada and some one-off military projects, sales of new and used modular units are currently well above normal levels, both in terms of revenue contribution and profitability. Over the last four quarters, the ratio of sales from new and used units to leasing and other revenues was over 42%, compared to an historic ratio (based on ten years of data) of about 31%. Moreover, gross margins from new and used sales are nearly 420 basis points higher than the historic average. To illustrate the magnitude of this differential, the earnings impact from normalizing sales levels and gross margins would cost WLSC $0.27 of earnings on an L12M basis, or about 27% of the company’s reported EPS. While it’s great that the company benefited from these abnormally high sales and profits, I believe it’s unrealistic to extrapolate such strength going forward, especially given the industry’s inherent cyclicality and the fickleness of large customers, especially the government. As if to prove this point, on the company’s Q3-06 call, management admitted that the U.S. Army did not award the second half of the large
We have had several conversations with industry participants substantiating this. Manufactures tell us that they are adding capacity, usually in the form of labor, but sometimes in terms of new physical infrastructure, to accommodate much higher demand from leasing companies, which the manufacturers claim are adding capacity to their fleets for the first time since 9/11. But backlogs that were as high as four-to-five months earlier in the year have shrunk to two months in most regions. WLSC’s competitors are also throwing units at the same markets, which isn’t surprising given the commodity nature of the business. One contact told us that he was shifting many of his units to
In any cyclical industry with few barriers to entry, capacity always seems to return at the same time demand appears to be slowing. The modular storage business is no different. On its Q3-06 conference call, WLSC management conceded that growth in quote volumes slowed to 2% from the 5% range earlier in the year. I find this unsurprising given the dramatic slowdown in the industry’s leading indicators: construction permits and new home sales, both of with look like they’re falling off a cliff. Naturally the first thing management at WLSC points out is that only about 5% of their business is related to residential construction. This is true; however, it is not true for the rest of the industry. For example, residential construction represents as much as 15% of GE’s business. With the same situation at many other private leasing companies, it seems like only a matter of time before these units are reallocated to the non-residential construction business, which ought to cause problems for WLSC regardless of its lower residential construction exposure.
So what is WLSC worth? Since this is a very cyclical company, I believe the proper way to value it is to use mid-cycle earnings (shown below). Based on my analysis, mid-cycle EPS for WLSC is about $0.68. Applying a 15x multiple, which is probably generous, you get a stock price of $10.20. To this I add the present value of the company’s NOL tax shield of about $1.25 per share, producing a total value of $11.45, or more than 40% below the current share price.
In terms of earnings expectations, it should come as no surprise that the Street has high hopes for WLSC. Consensus EPS are $1.21 in 2007 (14% growth y/y) and $1.45 in 2008 (19% growth y/y). I find the notion of accelerating EPS growth in 2008 rather suspect given the cyclicality of this business and the numerous warning signs of an economic slowdown. It would seem that the risks are to the downside with respect to meeting Street estimates, which obviously favors the short.
2006 2007 2008 Mid-Cycle
Lease Fleet (000 units) 100 103 106 100
Utilization Rate (%) 82.0 83.0 82.0 81.5
Monthly Rental Rate ($) 292 305 305 280
Leasing Gross Margin (%) 56.5 57.5 56.5 56.0
Sales 688 675 652 571
EBITDA 225 232 219 205
EBIT 147 142 130 124
Net Income 46 42 34 30
EPS (me) 1.06 0.95 0.76 0.68
EPS (consensus) 1.06 1.21 1.45 NA
EV / EBITDA 7.6x 7.4x 7.8x 8.4x
P / E Ratio (me) 19x 21x 26x 30x
P / E Ratio (consensus) 19x 17x 14x NA
Stock price 20.00
Market cap 861m
PV of NOL 55m
1. Several of the end markets WLSC serves are strong right now, especially non-residential construction and Canadian oil and gas. This will likely enable the company to post decent numbers in the near-term as prices rise and utilization rates improve. But this strength is temporary. These markets are notoriously cyclical, and new capacity is rushing to serve them already. The company’s other potential growth markets, education and military, are driven by fickle government customers. To date, with the exception of a single large contract (a one-off sale), WLSC’s military work has been small.
2. WLSC is currently raising prices and will benefit as older leases terminate and the company marks prices to market. Offsetting this risk is downward pressure that growing supply and competition should exert.
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