Description

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:

 

• Beneficiary of unsustainable cyclical strength and one-off gains.  No one disputes the sharp improvement that non-residential construction has registered over the last 18 months, and not surprisingly, WLSC has benefited.  The company has raised lease prices and utilization has improved.  Yet despite the fact that since 2004 pricing has improved over 16% from $250/month to $291/month (Q3-06) and utilization has jumped 200 bps to 82%, leasing gross margins – the most important profitability metric – are up a mere 200 bps or so.  This is an improvement, of course, but hardly a surge in operating leverage.  The company is also nearing peak utilization levels, so further operating leverage must come from price gains, the bulk of which I believe have already been achieved.

 

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 Fort Bliss contract to WLSC, though the company handled the first part of the contract.  This was not a positive surprise. 

 

• More capacity coming, competition fierce and signs of demand slowing.  Part of my comfort in assuming weaker results ahead come from conversations with the company, competitors and modular space manufacturers that confirm capacity is returning to the industry.  Manufacturers are ramping up capacity across the country by adding labor shifts and, in some cases, building new plants and/or adding manufacturing lines.  After a brief period of lengthy backlogs, conditions are normalizing in most regions, implying that supply is catching up to higher demand levels.

 

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 Canada, where monthly rental rates were over twice those in his core market, the Pacific northwest.  In the education market (i.e. units for temporary classrooms), WLSC is just one of many competitors salivating over new state funding in places like California and Florida.  The classroom niche is dominated by McGrath Rentcorp (MGRC), but both leasing companies and manufacturers (who offer the product direct to the buyer without WLSC’s mark-up) are targeting the opportunity.  One contact told us that while two manufacturing companies went bankrupt last year in California, two new start-ups have already launched to fill the void.  The bottom line is that few barriers to entry exist on either the leasing or manufacturing side of the business, so mismatches in supply and demand are quickly rectified.

 

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.

 

• Consistently burns cash.  Over the last ten years, WLSC has generated over $200 million of negative free cash flow.  Adding in acquisitions, which are basically just purchases of used equipment (which in my opinion ought to be considered normal capex, especially if we are measuring a ten-year period), cumulative free cash flow is well over negative $600 million.  Note that this free cash flow number includes proceeds from used equipment sales.  Why is free cash flow so terrible?  For starters, I think it reflects the low quality of this business and a management bent on growth (in sales and EBITDA) at the expense of creating any real economic value for investors.  It also demonstrates that WLSC’s business is substantially more capital-intensive than many investors believe, and that expectations of meaningful free cash flow generation in the future are misplaced.  Units receive terrible wear and tear while they’re on rent, requiring the company to spend considerable capex dollars to refurbish them for new customers.  I would note that management has a fairly generous definition for what constitutes a capitalized versus expensed cost, which helps to obscure a unit’s true economics.  But in the end, free cash is free cash, and this company burns it.  Ironically, the only time the company has generated true free cash flow over the past decade was in 2002 and 2003, when business conditions were horrible and management slashed capex levels by 60%.

 

• Awful returns on capital.  WLSC generated an after-tax return on capital of 6.4% last year, which was actually an improvement over 2004 and 2003.  Over the last ten years, the average return on capital was only 7.7%, a result that trails any reasonable estimate of the company’s cost of capital, implying the business is, in fact, destroying value.  A unit level NPV analysis seems to confirm this number.  Using some basic assumptions for unit cost, rental rates, utilization, margins, etc, I get an IRR on a unit basis of 8.7%.  Note that this figure excludes corporate level expenses, so the company’s slightly lower overall returns seem to foot fairly well.  Given the company’s asset intensity (asset turnover averaging 0.4x) and horrid free cash flow generation, this shouldn’t be surprising.  What is unusual is management’s thinking about returns.  Most notably, management insists on evaluating ROIC on a pretax basis, since they have an NOL shielding them from paying cash taxes over the next few years.  On the Q3-06 conference call, management claimed to earn an 11.0% ROIC (untaxed) over the L12M period, compared to a WACC of 8.6%.  While this is hardly impressive in its own right, I would challenge the underlying logic management is using.  Why is it appropriate to evaluate a company’s returns on a tax-free basis simply because there’s an NOL offsetting some cash taxes for a period of time?  WLSC is a U.S. company subject to income taxes, which they will pay in time.  Perhaps returns measured on a cash basis will be slightly higher over the short term, but this is clearly not representative of the company’s true underlying return characteristics.  The use of an untaxed ROIC calculation to me seems like a flimsy way to hide the poor economics of a business.  I think it also reflects management’s willy-nilly approach to measuring their company’s results.  When asked about unit level economics, they respond by talking about the “returns” they get, which they define as how many months of revenue (not profit or cash flow) does it take to recover the initial cost of a unit.  Think of it as a DCF with one line: revenue.  Not to be too harsh on management, but I think this reflects a broader mentality toward economic returns that is unsophisticated and potentially dangerous.

 

• High financial leverage.  WLSC is burdened by an enormous debt load, a legacy of its LBO and acquisitive past.  The company has net debt of $908 million, which translates into about 4x my 2006 EBITDA estimate.  Considering WLSC generates no free cash flow, this seems quite high, especially for a cyclical business.  Amusingly, the Street pats management on the back for reducing leverage from 5x to 4x EBITDA, which was accomplished solely by raising equity.  In any event, you basically have a situation in which there is simply very little margin for error.  At a minimum, a debt load this high without solid free cash flow all but prevents the company from buying back stock or paying a dividend, which is good news for a short.  

 

• Premium valuation, high expectations.  Despite a cyclical, mediocre, highly leveraged business, WLSC trades at over 21x my 2007 EPS estimate (17x consensus) and 7.4x my 2007 EBITDA estimate.  In the private market, modular space leasing companies tend to trade for 5x trailing EBITDA, a huge discount to WLSC’s valuation.  It is easy to envision a sharp downward multiple re-rating when the industry’s current cyclical strength fades and investors realize that true earnings power is well below the current level (potentially much worse if the economy slows and WLSC’s steep financial leverage and lack of free cash flow works against it).

 

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.

 

• Insiders eager to sell.  Not surprisingly, insiders are selling aggressively.  In addition to shares sold in the company’s September 2005 IPO, management and WLSC’s private equity investors sold 6.3 million more shares in May, shortly after the IPO lock-up expired.  Further open market sales have followed that secondary offering.  The company’s private equity investors still own almost 34% of the shares, which they will no doubt want to dump while the fundamentals appear hot.  An additional twist is that the lead investor, Cypress Group, is apparently closing its fund.  Coupled with the fact that they have been an investor for nearly a decade, this makes Cypress quite keen to exit, I suspect.

 

 

Financials

                                                            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

Shares              43m

Market cap      861m

Cash                2m      

Debt                 910m

PV of NOL      55m

EV                   1,714m

 

Risks

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.  

 

Catalyst

1. Slowdown in non-residential construction activity. This would gut the long thesis entirely.
2. Sharper than expected slowdown in residential construction that frees up more capacity and dampens non-residential pricing power.
3. More insider selling.
4. Failure to win more large contracts from the federal and state governments (e.g. Ft. Bliss)
5. Earnings miss.