McGrath RentCorp's CEO Discusses Q3 2013 Results - Earnings Call Transcript

Oct.30.13 | About: McGrath RentCorp (MGRC)

McGrath RentCorp (NASDAQ:MGRC)

Q3 2013 Earnings Conference Call

October 30, 2013 5:00 PM ET

Executives

Geoffrey Buscher – Investor Relations, SBG

Keith Pratt – Senior Vice President and Chief Financial Officer

Dennis Kakures – President and Chief Executive Officer

Analysts

David Gold – Sidoti & Company, LLC

Joe G. Box – KeyBanc Capital Markets, Inc.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Operator

Welcome to the McGrath RentCorp Third Quarter 2013 Conference Call. At this time, all conference participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) This conference is being recorded today, Wednesday, October 30, 2013.

Now I’d like to turn the conference over to Geoff Buscher of SBG Investor Relations. Please go ahead.

Geoffrey Buscher

Thank you, operator. Good afternoon. I’m the Investor Relations Advisor of McGrath RentCorp and will be acting as moderator of the conference call today. On the call today from McGrath RentCorp are Dennis Kakures, President and CEO; and Keith Pratt, Senior Vice President and CFO.

Please note that this call is being recorded and will be available for telephone replay for up to seven days following the call by dialing 1-800-406-7325 for domestic callers, and 1-303-590-3030 for international callers. The pass code for the call replay is 4643659.

This call is also being broadcast live over the internet and will be available for replay. We encourage you to visit the Investor Relations section of the company’s website at mgrc.com. A press release was sent out today at approximately 4:05 Eastern Time or 1:05 Pacific Time. If you did not receive a copy but would like one, it is available online in the Investor Relations section of our website, or you may call 1-206-652-9704, and one will be sent to you.

Before getting started, let me remind everyone that the matters we will be discussing today that are not truly historical are forward-looking statements within the meaning of Section 21-E of the Securities and Exchange Act of 1934, including statements regarding McGrath RentCorp’s expectations, intentions or strategies regarding the future. All forward-looking statements are based upon information currently available to McGrath RentCorp and McGrath RentCorp assumes no obligation to update any such forward-looking statements. Forward-looking statements involve risks and uncertainties which could cause actual results to differ materially from those projected. These and other risks relating to McGrath RentCorp’s business are set forth in the documents filed by McGrath RentCorp with the Securities and Exchange Commission, including the company’s most recent Form 10-K and Form 10-Q.

I would now like to turn the call over to Keith Pratt.

Keith E. Pratt

Thank you, Geoffrey. In addition to the press release issued today, the company also filed with the SEC the earnings release on Form 8-K and the Form 10-Q for the quarter. For the third quarter 2013, total revenues increased 10% to $108.9 million from $99.4 million for the same period in 2012. Net income increased 1% to $12.6 million from $12.5 million and earnings per diluted share decreased 4% to $0.48 from $0.50.

Reviewing the third quarter results for the Company’s Mobile Modular division compared to the third quarter of 2012, total revenues increased $6.7 million, or 20%, to $39.7 million due to higher sales, rental related services and rental revenues. Gross profit on rents decreased $2.6 million, or 27%, to $7.2 million, primarily due to a decrease in rental margins to 34% from 49%, partly offset by 5% higher rental revenues. Lower rental margins were a result of $3.6 million higher other direct costs for labor and materials and $0.2 million higher depreciation.

Selling and administrative expenses increased $0.9 million, or 11%, to $9.4 million, primarily as a result of increased personnel and benefit costs. The lower gross profit on rents partly offset by higher gross profit on rental related services and sales revenues combined with increased selling and administrative expenses, resulted in a decrease in operating income of $2.1 million, or 45%, to $2.5 million. Finally, average modular rental equipment for the quarter was $549 million, an increase of $23 million. Equipment additions were to support growth in Texas, Florida and the Mid-Atlantic region and for our portable storage business. Average utilization for the third quarter increased from 66.2% to 69.1%.

Turning next to third quarter results for the company’s TRS-RenTelco division compared to the third quarter of 2012. Total revenues were flat at $33.9 million, as higher sales revenues were offset by lower rental and rental related services revenues. Gross profit on rents decreased $0.9 million or 7% to $12.1 million. Rental revenues decreased $0.8 million or 3% and rental margins decreased to 47% from 49% as depreciation as a percentage of rents increased to 39% from 36% and other direct costs as a percentage of rents decreased to 14% from 15%.

Selling and administrative expense decreased $0.5 million, or 8%, to $5.7 million primarily due to decreased salary and benefit costs related to the exit of the environmental test equipment business in November 2012. As a result operating income decreased $0.6 million, or 6%, to $9.5 million. Finally, average electronics rental equipment at original cost for the quarter was $266 million, a decrease of $6 million, average utilization for the third quarter decreased from 65.7% to 62.5%.

Turning next to third quarter results for the company’s Adler Tanks division compared to the third quarter of 2012. Total revenues increased $2.4 million, or 10%, to $25.8 million due to higher rental and rental related services revenues partly offset by lower sales revenue. Gross profit on rents increased $1.3 million, or 11%, to $13.1 million. Rental revenues increased $2.3 million, or 13%, and rental margins decreased to 68% from 70% as depreciation as a percentage of rents was flat at 18% and other direct costs as a percentage of rents increased to 13% from 20%.

Selling and administrative expenses increased $1.4 million, or 29%, to $6.4 million primarily due to increased personnel and benefit costs. As a result, operating income increased $0.9 million, or 12%, to $8.5 million. Finally, average rental equipment for the quarter was $268 million, an increase of $36 million. Average utilization for the third quarter decreased from 68.9% to 66.8%. On a consolidated basis, interest expense for the third quarter 2013 decreased $0.2 million, or 7%, to $2.1 million from the same period in 2012. As a result of the company’s lower average debt levels partly offset by higher average interest rates. The third quarter provision for income taxes was based on an effective tax rate of 39.2% unchanged from the third quarter 2012.

Next, I’d like to review our 2013 cash flows. For the nine months ended September 30, 2013 highlights in our cash flows included net cash provided by operating activities was $99.9 million, an increase of $8.9 million compared to 2012. The increase was primarily attributable to a lower increase in accounts receivable and prepaid expenses and other assets, partly offset by a lower increase in deferred income, lower income from operations and other balance sheet changes.

We invested $93.4 million for rental equipment purchases compared to $106.2 million for the same period in 2012, and proceeds from the sales of used rental equipment were higher by $4.8 million. Property, plant and equipment purchases decreased $3 million to $8 million in 2013. Net borrowings decreased $21 million from $302 million at the end of 2012 to $281 million at the end of the third quarter 2013. Dividend payments to shareholders were $18.3 million.

With total debt at quarter end of $281 million, the company had capacity to borrow an additional $249 million under its lines of credit, and the ratio of funded debt to the last 12 months actual adjusted EBITDA was 1.76 to 1. For 2013, third quarter adjusted EBITDA increased $1.2 million, or 3%, to $43.4 million compared to the same period in 2012 with consolidated adjusted EBITDA margin at 40% compared to 42% in 2012. Our definition of adjusted EBITDA and a reconciliation of adjusted EBITDA to net income are included in our press release for the quarter. Turning next to 2013 earnings guidance, we reconfirm our previous 2013 full-year earnings guidance range of $1.65 to $1.80 per diluted share.

Now, I would like to turn the call over to Dennis.

Dennis C. Kakures

Thank you, Keith. Although we are disappointed, the company-wide net income was relatively flat and EPS down 4% from a year ago. We’re pleased with the underlying favorable business activity levels and momentum, we’re seeing overall in our rental business portfolio. A higher fully diluted share count from a year ago led to the $0.02 reduction in the EPS.

Now let’s take a closer look at each business for the quarter. Modular division-wide rental revenues for the quarter increased by $1.1 million, or 5%, to $21.1 million from a year ago as well as sequentially from the second quarter of 2013. During the third quarter, we experienced a 15% increase in division-wide year-over-year first month’s rental revenue booking for modular buildings with an increase of 39% in California, and a decline of 3% outside of the State. Over the first nine months of 2013, we experienced an 18% increase in division-wide year-over-year first month’s rental revenue bookings for modular buildings with an increase of 24% in our markets outside of California and 11% within the State.

Rental bookings in 2013 are at their highest levels since 2007 prior to the Great Recession. Rental bookings have continued favorably into the fourth quarter. A number of orders booked over the past few months have only billed for a portion of the third quarter, or are not scheduled to ship and bill until either the fourth quarter of 2013 or the first quarter of 2014. We’re also continuing to see rental rates rise for various sized products as demand exceeds readily available supply. Modular division ending utilization for the third quarter 2013 rose to 70.4% compared to 66.6% a year ago and 67.6% at the end of the second quarter of 2013. This is the highest modular division utilization level since the second quarter of 2009.

Modular division income from operations for the quarter decreased by $2.1 million, or 45%, to $2.5 million from a year ago. The reduction in operating income is directly related to the increase in overall divisional booking levels and the significant increase in related inventory center costs for labor and materials to prepare and modify equipment for rental. This is compounded by needing to redeploy various rental assets that have been sitting idle for extended timeframes, which tend to have higher processing costs than inventory that turns more frequently.

In fact, inventory center costs primarily for the preparation of booked orders and anticipated near-term orders were approximately $3.6 million higher during the third quarter compared to a year ago. For the first nine months of 2013, these equipment preparation costs are approximately $5.9 million higher than for the same time period in 2012. Keep in mind that almost all of our inventory center cost for building preparation and modification work are expensed in the quarter in which they are incurred. However, we benefit from the associated rental revenue stream from such expenditures in the quarters ahead.

We’re beginning to see the early signs of quarterly rental revenue and utilization lift from the past few quarters of these higher than normal inventory center expenditures. We also had higher SG&A expenses during the quarter from a year ago. These costs were primarily related to increased sales and operations staffing level to support the recovery of our modular rental business, as well as the continued expansion of our portable storage rental business. Finally, some of these increased costs were offset by higher gross profit on sales of equipment as well as on rental related services from a year ago.

Now, let’s turn our attention to Adler Tank Rentals and their results. Rental revenues at Adler Tank Rentals, our tank and box division, increased by $2.3 million or 13% to $19.1 million from a year ago. New business activity as measured by first month’s rent and units booked continued favorably with increases of 20% and 26%, respectively, from the same period a year ago. With an increasing mix of non-fracking related rentals, we are seeing shorter average rental terms and a greater churn of rental equipment which has put downward pressure on utilization.

Average utilization was 66.8% for the third quarter compared to 68.9% in 2012; however average equipment on rent was $179.4 million during the quarter compared to $159.8 million a year ago. This is reflective of our need to continue to acquire a variety of tanks and boxes other than 21K standard frack tanks to support non-fracking end markets. In fact during the third quarter, non-fracking related rental revenues increased by 24% to 88% of our rental revenue mix from 81% for the same period in 2012. Adler is serving a wide variety of market segments including industrial plant, petrochemical, pipeline, oil and gas, waste management, environmental field service and heavy construction. By design, we have pursued and been successful in generating higher business activity levels across our broader mix of non-fracking and historically less volatile vertical markets.

Although, we were disappointed with Adler’s results for the first half of 2013, third quarter divisional income from operations increased by $0.9 million, or 12%, to $8.5 million from a year ago. We benefited favorably from increases in both rental and rental related services gross profit during the quarter, due to higher business activity levels and movement of incoming and outgoing equipment from the same period in 2012. However, we also experienced significantly higher SG&A expenses overall from a year ago primarily due to increased business activity levels and related sales compensation, additional headcount and facility infrastructure costs associated with building at a broader national footprint and higher bad debt and health insurance costs. Over the past 21 months, Adler Tank Rentals has entered 10 new U.S. markets to support higher rental revenue and earnings growth in the years ahead. Finally, inventory center expenses were also higher as a percentage of rents from the same period in 2012 due to the increased flow of incoming and outgoing equipment.

Now let me turn our attention to TRS-RenTelco and their results. TRS-RenTelco, our electronics division, rental revenues for the quarter decreased by $0.8 million, or 3%, to $25.7 million from a year ago. The decline is directly related to the sale of our environmental test equipment assets and related rental revenue stream late in 2012. We also experienced lower business activity levels for general purpose test equipment with high-tech and aerospace and defense firms. This is further reflected in average utilization for the quarter of 62.5% compared to 65.7% in 2012. In part, we believe the softness in general purpose test equipment rentals during the third quarter is related to the federal sequester and aerospace and defense related budget.

Average monthly rental rates for the quarter actually increased to 5.15% from 4.95% compared to a year ago; however, this is primarily due to an increased mix of communications test equipment, which has shorter depreciable lives but higher rental rates than general purpose test equipment. Excluding environmental test equipment rental revenues for 2012, TRS-RenTelco rental revenues grew by approximately 1%; however, divisional income from operation decreased by $0.6 million, or 6%, to $9.6 million for the quarter. The higher percentage reduction in income from operation as compared to rental revenues is primarily due to higher depreciation expense as a percentage of rents and lower profit on equipment sales, partly offset by lower SG&A and laboratory costs as compared to the same period in 2012.

Now let me take a moment and update everyone on our portable storage business. Mobile modular portable storage continued to make good progress during the quarter in building its customer following, increasing booking levels and growing rental revenues from a year ago. Rental revenues for the third quarter of 2013 grew by 35% from a year ago, as well as 16% sequentially over the second quarter of 2013. Income from operations also grew favorably from a year ago. We’re continuing to execute on our plans for a larger geographic footprint for our storage container rental business. At the same time, we’re striving to create higher business activity levels in greater critical math in each of the markets in which we operate. We also continue to explore smaller fleet acquisition opportunities to accelerate our growth.

It should also be noted that we have favorable room to grow rental revenues within the current cost structure. As the economy continues to improve and with the infrastructure and quality team we are continuing to build, our portable storage business should benefit very favorably. Looking forward, we continue to believe that we have an excellent opportunity to become a meaningful player in the portable storage rental industry.

Now for a few closing comments. As I shared with our second quarter 2013 results, we believe that each of our four rental businesses is fundamentally sound, strategically well-positioned and well-capitalized, both financially and operationally to thrive in the years ahead. Although modular building inventory center preparation expenses incurred during the third quarter and year-to-date are significantly higher than a year ago. We couldn't be more pleased to finally experience the strong modular building market activity that is driving these higher costs in 2013. To emphasize, these costs are for modular building equipment preparation including labor and materials to support maintenance, repairs and customer driven modification. We should benefit from these expenditures in the quarters ahead through rental revenue and utilization growth.

To the extent that we continue to experience elevated inventory center expenses for modular building preparation, it would likely mean that market demand is staying strong and that rental revenue and utilization levels are recovering further. At some point in the quarters ahead, these inventory center modular building preparation costs should normalize as we benefit from equipment turns that do not require the extent of work that some of the sitting inventory has over the past year. We should also see favorable gross profit on rents and margin expansion at that time.

Please keep in mind that McGrath RentCorp has a very strong balance sheet with a funded debt to last 12 months actual adjusted EBITDA ratio of 1.76 to 1, and with current capacity to borrow an additional $249 million under our lines of credit. We can be very opportunistic in growing our business lines with the availability of such funding.

Finally, we are committed to making each of our rental businesses meaningful in size and earnings contribution, and with the best operating metrics by industry. We continued to make favorable strides during the third quarter of 2013 towards achieving these goals.

And now Keith and I welcome your question.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from the line of David Gold with Sidoti & Company. Please go ahead.

David Gold – Sidoti & Company, LLC

Good afternoon.

Keith E. Pratt

Hi, David.

Dennis C. Kakures

Hi, David.

David Gold – Sidoti & Company, LLC

So a couple of questions around Mobile Modular. First, I wanted to get a sense obviously at this moment its a really good news with a little bit bad news story of the step-up revenue utilization and a little bit more cost. I wanted to get a sense for – if we can – how much more could be out there by way of cost? So in other words maybe an easy way to do it is to think about it on a unit basis of how many units might be subject to preparation and maybe repair and maintenance costs to make them – for them to be able for you to get them back out there on rent?

Keith E. Pratt

Yeah, David just a couple of thoughts on this and as Dennis’s comments reflected that the direct cost of rental operations, it’s really about preparing units for rent. And if we look at year-to-date, the expenses we incurred were up 32% compared to last year and the [indiscernible] is the following. The money we spent was really driven in by three reasons. The first is we did experienced a big up tick in modifications or customizations that our customer requested and typically we get paid for doing that work, but we don’t get the revenue and we only get that over the course of the lease. So we’re spending the money upfront, you’re seeing that in the income statement, but we don’t get the revenue benefit until future periods.

The rest of the spend is really a combination of much higher volume in terms of units and square footage that we’re preparing for customer orders And in some of cases, we’re spending more because some of those units have sat idle for an extended period. So the way I’d look at it is about a third of the increase year-over-year was related to those customer modifications and customizations. The rent has really tied to volume issues and probably secondarily to more cost per unit that sat off-rent for an extended period. So we’re incurring a lot of this expense ahead of really seeing the revenue. Some of the units that we did work on did go in rent in the third quarter, but we only recognized revenue for part of the quarter and we’re going to see more units go out in the fourth quarter and some even early next year. So it’s hard to be precise about where how much more of this expense we’re going to have. It’s all really tied to the health of customer demand and we’re pleased to see the demand much more healthy today than we’ve seen really in the last several years.

Dennis C. Kakures

Dave, I might add the other piece, Keith has done a very job of outlining the cost I think the other piece is you should start seeing, if we’ll continue to have these higher expenses. You should start seeing considerable lift in rental revenues and in utilization over the quarters to come. So there is a best expenses that company can have in terms of taking legacy inventory and getting it turns around back out and when those – when that equipment recycles again, we will have the lower cost typically associated with these returns.

David Gold – Sidoti & Company, LLC

Sure, sure and that’s definitely helpful. I guess, what I’m trying to get a better sense for an obviously it’s hard for me I’ll start working in – if you think about it presumably since let’s say 2008, since 2008 basically utilization. It’s up to Ramsey presumably you have units that are out there but maybe haven’t been touched in four or five years. And so just a better sense for what if we looked at in aggregate, what the potential cost whether it was in one quarter or over the next two years. What we might be looking at just have a sense for what the potential exposure is before we start to see that that return on it?

Keith E. Pratt

Yes, what I’d say the way the calculus will work is as utilization increases with more units been on rent, we’re also have more of an opportunity to see rates move up in many categories of product around the country, not everywhere and not all at the same time. But what we look to see is the benefit of improving utilization, more units out on rent and the rental rates also adding to the revenue lift. And as we get these units out on rent, our typical rental terms can be two years plus, contractually we’re at close to two years, a lot of units will stay out of rent beyond the initial contract. What we’re really absorbing is the upfront cost of getting units out on rent which haven’t been out on rent because our utilization was in that sort of 60% to 68% range for the last four years.

Dennis C. Kakures

And David, I would also emphasis it’s a near-term if you want to call the next year to 12 months to 15 months, the near-term phenomena but it's the absolute one that we need. So we really get that business turned around and feel kind of margins we were experiencing historically for that business prior to the Great Recession. So if the near-term, as you said it’s kind of a near-term bad news, but it’s tremendously good news that needs – supporting the growth side. So we’re [Indiscernible] it’s hard to have the exact crystal ball here to know what we do know this year there is about $0.14. If you look at the EPS that’s associated with the higher costs in the inventory spend over last year. Now, you can imagine the horsepower going forward when you’re not having those types of heavy inventory center expenses.

Keith E. Pratt

And Dave, I think you’ll find when you look at fourth quarter, we’ll see the benefit of the units that have gone out on rent will be in the numbers for the full quarter from a revenue point of view and when we’re busy in the inventory center typically the second and third quarter is a busier periods. So when we look at the fourth quarter, our expenses may well be higher than a year ago just related to better business conditions. It’s unlikely they would be as high as what we saw in the third quarter.

David Gold – Sidoti & Company, LLC

Got you. One last, sort of, crack out it or just another sort of look, can you give a sense for say on an average Mobile Modular unit, what the incremental cost is of trapping it say that’s been on the sidelines for three or four years. Is it a $1000, $2500 or $3000?

Keith E. Pratt

Dave, it really depends on the type of equipment that you’re dealing with. For example, a classroom product typically has less expense than potentially a commercial complex building. If you had a commercial complex building that’s had an existing floor plan, if it has to be basically retrofitted or re-modified to be able to support a new floor plan et cetera. Those expenses can be very significant. For the classroom, it may be the fact that you’re going to replace cockpit that you’re going to reload the foundation material because it can really only be used once. And those are costs that we have to absorb to be able to get that classroom back out and really not a lot of the repair to the product, well, certainly no modification work to centre of classroom.

The one item here that we should talk a little bit about is the mix. A lot of the work that we’ve been doing over the last couple of quarters, there has been some classroom work that a lot of it is being commercial, which is probably our higher touch products both in single wise, as well as in complexes, because they already have certain prior tenant improvements in them and, so we opted for those buildings et cetera can take some added costs during the period. Now, actually in the situation where we’re having to go deep into our inventory levels because of the shortages of equipment in various sizes.

So some good problems to have and near-term costs that certainly make perfect sense to us and follow that driving utilization higher, getting higher rental rates, which we’re seeing as well in various product sizes very favorably, and then driving that top rental revenue line and then we’ll get to some normalization on inventory expenses here in the not too distant future, and then we should really see margin expansion grow quite favorably.

David Gold – Sidoti & Company, LLC

Perfect, perfect. That’s helpful. Thank you both.

Operator

Our next question comes from Joe Box with KeyBanc Capital Markets. Please go ahead.

Joe G. Box – KeyBanc Capital Markets, Inc.

Hey, Dennis, hey Keith.

Keith E. Pratt

Hi, Joe.

Joe G. Box – KeyBanc Capital Markets, Inc.

Couple of questions for you on Adler, I guess that the mix has shifted towards shorter duration rentals. Can you just help us understand, one, what the typical difference is and yield between long rents versus short rents, and then can you maybe put some color around what the specific variable costs are just from touching the assets more?

Dennis C. Kakures

Well, if you look at, let's go back to the big mix of fracking rentals that we had, we were about 35; they were made up about 35% of our rental revenue mix. A lot of those transactions were multi-year, I mean they were one, two, three year transactions and you can imagine you ship a brand new piece equipped from a factory, it goes on site, it goes on rent, and you don't touch it for two to three years. That’s a – and that was in a market where rental rates were very high because there was a supply demand problem with equipment versus demand. So when you look at that type of income stream contiguous coupled with very low costs, because you're using brand new equipment, the kind of margins you are able to drive out of that business are very significant.

In the world here where there is less fracking or fracking is more competitive and we are changing the mix, these transactions were the piece the equipment churns, they aren’t really high touch costs for Adler in churning the equipment. What happened so is equipment is on rent for three or four months, it comes back in, it sits for a month and then it goes up for another two or three months and comes back in and it sits for a month or two and goes out for another three or four months.

So you’ll lose the contagious nature of that income streams plus you’re still are having to touch it maybe three times in a year or as before you won’t have to really touch it for every two or three years. So and those touch costs are typically, you are doing some painting, maybe after change about, very different product in the modular product, it’s a fairly low touch costs to that product. So those are kind of the differences, that longer-term, term is everything in our rental businesses when you start looking at really strong margins.

So the other pieces here and as I mentioned in the prepared comments, the movements in and out when there is more churn, we actually benefit from that, because that business we can generate healthy margins on the shipping expenses, as well as on under the churn expenses. So that really helps on the profitability side of things, but if we had our brothers we’d let everything to be out on rent for two to three years and not have to touch it, but this is actually very healthy business that we are picking up, the industrial plant business, its more maintenance related, it’s a lot of pipeline work, it’s building infrastructure et cetera. So we still love the fracking business, but we’ve done a good job of really rounding up these other verticals that are less volatile.

Joe G. Box – KeyBanc Capital Markets, Inc.

That’s helpful. I’m sorry, Keith go ahead.

Keith E. Pratt

Yes, Joe. One metric you can look at on the income statement when we breakout the individual segments. If you look at that direct cost of rental operations other for the Adler business that in the last seven or eight quarters is typically been somewhere in the 10% to 15% range. So you can think of it as shorter-term project if you still have to touch the unit, get it prepared for the next rental. Shorter terms are going to drive you higher in that range, longer terms are going to drive you lower. But if you just look at our experience, we’ve been in that 10% to 15% range in terms of that cost as a percentage of the rental revenue.

Joe G. Box – KeyBanc Capital Markets, Inc.

Okay, prefect. And you know what obviously there is a lot of moving pieces here. And I guess Dennis I would have thought that even though maybe you are able to charge for transportation more ultimately the more you are touching the assets to lower the gross profit fee. So I guess my next question is as you look at gross profits for Adler, should we think about the margin profile in mid-50s being an appropriate margin or do you think that there is probably some things that you could adjust to eventually bring that back into the 60% range. I mean, given the mix shift that you are seeing now. How should we think about that margin profile?

Dennis C. Kakures

So, we will be adding one other item to help complicate matters at least on this past year’s numbers. Remember in the last 12 months to 15 months due to the Marcellus Shale dynamics and the redistribution of equipment, we have a category that’s called freight-in expense, that’s that cost to be able to move equipment either intra-regionally or inter-regionally to be able to get it into markets more fully utilized our newer markets et cetera. Those are costs that we would not expect to have to the same degree going forward. That’s in those numbers currently, so I’m just adding up another variable that just because of the build-out of the business over time coupled with that returning equipment, those are expenses that you really would not have to a degree that we had going forward. So that’s a good guide that will help on margin and those costs were not insignificant in the past 12 months to 15 months, but they certainly have steadily gone down here over the past year.

Keith E. Pratt

And Joe, keep in mind, we’re still building IP Adler branch network. We’ve had equipment moves as Dennis described it, but I would say another metric we look at which is the depreciation expense as a percentage of the rental revenue that also is not at a steady state. I mean, our utilizations are bit lower than we’d like and that hurts us on that metric and that erode some of the gross margin opportunity. So it’s just another factor to consider when you look at the fleet we have today and many of the units are on rent today and where that might be at some point in the future.

Dennis C. Kakures

It will be five years early in the business comes early December this year, imagine that almost been a five-years, yet we’re still trying to find out what normal looks like. And that’s not a bad thing, that’s just means that the business is moving quickly, its growing. We are trying to make the right chess moves based on what we learn as we go and we should be able to have greater visibility on the margin fixed over time here. And again we are just continuing to make appropriate adjustments, but very healthy margin business over time and we are going to have some of this ebb and flow.

Joe G. Box – KeyBanc Capital Markets, Inc.

Understood. Switching over to the modular business, Dennis you’ve always talked about modular pricing potentially correcting upward when demand starts to outstrip supply, you alluded to it earlier. I’m curious if that's across the Board for all product types or still just a large building complex that or maybe a little bit tighter on supply?

Dennis C. Kakures

Well, it’s certainly on a large complexes and where we’ve started to begin to seeing it particularly in California has been in the single wide fleet, when you look at 12 by 50 product, 12 by 42 et cetera. Just having that initially when business up tick that is still fairly competitive, but what’s starts happening is, but further you got to go into your availability supply and longer days to ready to prepare equipments. Inventory centers take on costs, you want to help cover those costs and all anybody in the business would deal with the same dynamic.

Demand picks up, and you can actually – if a customer is trying to get his unit in a timeframe to support his project. Well, in effect you can charge more to be able to turn that product. But we’ve seen very healthy increases in single wide product for whether its general construction or general commercial office space needs that has been a very good sign for us. And we’ll continue to repair and bring up to speed existing inventory that we have to be able to support that, but we are also starting to see it now in some of the smaller complex product as well.

So there is a lot of goodness happening across the board and if you look at our other markets, our Texas market has been similar dynamics, but probably on a much broader scale than we have yet in California and then the Florida market has continued very strong in terms of the hybrid classroom product being in very stable pricing and with some up tick here a little bit on the commercial, but still pretty competitive there.

Joe G. Box – KeyBanc Capital Markets, Inc.

Thanks, and you know what I suggest one follow-up on that, and then I’ll hop back in queue. I know I ask this every time, but are you at the point now in the cycle where rates for units are that are going out on rent are actually going out at higher rates than the ones that are actually being returned and I know it probably varies significantly across the board.

Dennis C. Kakures

What depends on what’s being returned, if its equipment that went out during the Great Recession that's being returned it’s likely it could be higher, but it really depends. I want to add one other item here that helps getting rates higher. Anytime a customer regard to the building size has a modification to be made and these are in effect for tenant improvements they want to certain layout et cetera. That's one of our great strengths. We do all that work in-house with our own folks and when we get really busy we bring out that contractors that work in inventory centers, that helps to be able to drive the base rental rate, hiring the building, because unless you can do that modification, you can’t really get that rental. And not everybody can do as quickly, as efficiently and as professionally as we can and that really helps us build to drive the overall rental rate higher for that product.

Joe G. Box – KeyBanc Capital Markets, Inc.

Thanks, I’ll hop back in queue.

Operator

(Operator Instructions) Our next question comes from the line of Scott Schneeberger with Oppenheimer. Please go ahead.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Thanks guys. I’m curious for RenTelco, you said that some headwinds with government sequester and high-tech. Could you take us a little deeper there? We’ve seen the utilization trickle down a little bit. And I’m wondering how long you think this will be sustained out on the government side? And then if you could delve a little bit deeper into what you’re seeing on high-tech? Thanks.

Dennis C. Kakures

The high-tech comment is primarily related to the semi-conductor industry that has had some softness. And so in the aerospace and defense, I think that speaks for itself with some of the defense cuts. Quite frankly, I’m not overly concerned with either of those segments at present. In fact, we’re looking for greater lift on the high-tech side of things that come in the second part of the first quarter next year maybe second quarter or third quarter. So we think there are just some timing issues here, but no real structural issues in those industry sectors. So fortunately, we’ve done a good job of being able to keep cost down for that business and even despite some of the revenue shortfall there. They’ve doing very well and we think we’re well positioned going into next year. So this is just some near-term softness that we have felt.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Thanks Dennis. And your answer right there was not only the high-tech, but also the aerospace and defense on timing?

Dennis C. Kakures

Right, you know it’s interesting. We’ll get our space and defense. We have one or two customers, we’re doing very good business type of risks and there are some other ones were not, but a little bit of who is in your mix versus your competitors and you just kind of go with the flow there. But we’re not seeing anything too demonstrative there on the downside. And overall, I think those sectors will be fine over time, but there were some current softness.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

All right, thanks. Switching I mean over around the horn a bit on Adler, one of the things and this might be broadly for across the whole group but Adler bad debt, but then you sited healthcare cost is that because you’re hiring rapidly or does that have anything to do with what you’re anticipating upcoming for 2014 for the whole business and maybe some positioning you are doing?

Dennis C. Kakures

I would just say that it’s too early in the whole healthcare dealer things that that to make complete predictions there. I will just say two things. One is there is some added expense on the healthcare side, mostly related to additional hirers that’s our biggest bucket and that’s – we would expect to occur as we’re growing et cetera. And we’re obviously as a management team, we over the last couple of years have spent a lot of time in analyzing healthcare cost and have best to address on more costly world and we continue to do that work and we’re still in the throws of that currently with our 2014 financial planning. So more to come on that front, but we’re looking at a lot of different ways to help but reduce those cost including potentially self-ensuring within the company. So again there is just a lot of pieces to that.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Okay, thanks. The cover what I was looking for there I appreciate it. Sticking in Adler on the CapEx side, you made the comments that will allow those and as you know you’re still trying to find your way on what is normal in that business after five years. And you certainly have been aggressive and continuing to grow its size. You said it buying some west standard type of equipment to fund non-fracking markets and again I think all of this is very constructive, but could you speak to how you think about balancing CapEx and just pushing forward as opposed to maintaining the utilization level and just delving into hopefully understand the concept of the question.

Dennis C. Kakures

Absolutely. As I mentioned, we’ve entered 10 new markets in the past 21 months. That’s real small undertaking. And in each one of those markets is at a different point in its evaluation. And one of the things as you got to make certain that they’re allocated with various types of equipments. Now, we certainly have not been ordering, we have not ordered any 21K frack tanks for quite some time because we’re really making use of that distribution of equipment. Now there’re different types of tanks whether there are weir tanks or open top tanks, we have vacuum boxes, we have regular standard solid boxes, mixed tanks, double wall tanks. There is a wide variety of equipment that’s used in the industry.

And as we shipped more towards perhaps a non-fracking or building up the verticals that are non-fracking, they have higher demand in various product areas, but if you were to look across the board at our inventory and if you had a list in front of you, the only real weak area would be in the 21K fracking arena. Most I would say virtually everything else is pretty healthy utilization level. And we realize that with the size we’re becoming, we need all that 21K fracking equipment that we have already. It’s just a matter of getting it distributed properly and we’ve done that for the most part and seeing some greater lift overall in some of those markets. So we think we’re making the adjustments correctly, but it just takes time to have things settle out, but the purchases we’re making almost exclusively are for much higher demand product.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Thanks Great. And then lastly, a question on modular is actually kind of re-asking one of David’s question, obviously you’re going to have these elevated operating expenses when you are getting the stuff that’s been [Indiscernible] back out on rent. What are your responses to David was, hey it could take 12 months to 15 months of heavy costs. And therefore I mean obviously that we know what comes after that.

It would be a very I feel earnings scenario if you have elevated growth over the next year, but it seems like it may even be in earnings headwind over the next year under the way it just it simply worked on the timing over the life of having these out on rents in the upfront costs, but you also said Dennis, that year-to-date I forget, you had stated I think it was year-to-date up 32%. And I’m curious you know likely annualized sooner than 12 to 15 months in a really bullish environment on the cost – did this – do this build start earlier or is that that growth really predominately third quarter. I hope the question is clear.

Dennis C. Kakures

Yes. Hopefully I’d be able to give you an answer that makes kind of rounds out everything. We’ve got a couple of quarters in a row here. The second and third quarter this year that have had very lofty building preparation cost that really speaks to demand.

In fact the first quarter I think was fairly up there as well. So we’re already into it. When I talk to 12 months to 15 months, we’ve already been added for a couple of quarters now minimally. And as I said here, if we’re going to continue to spend at this level, it’s kind of like the best thing that we could have asked for if it’s related to, as Keith mentioned, increase volumes and modification work. And you’re always going to have with that some additional prep cost if you got equipments fitting for extended periods of time.

Personally, I think going forward from here, we should see rising rental revenues and utilization in the quarters ahead. And when you look at margins, I would think they’re getting healthier already because of the income stream we’re going to be getting for we’ve already put out and so what we’ve booked hasn’t build yet, which we’ve got some good work in Q4 and Q1 that we’re looking towards. And again, those will be there then for in many cases many years to come because they’re longer-term transaction. So the way I would answer that is, is that even though it speak to potentially higher expenses going forward, this year was a pretty heavy spend year so far. If we did this again, we’d likely have much higher utilization. We’d be bucking north of 75% next year some time.

So it’s tough to kind of get a complete feel for everything, but quite frankly I think with what we should be seeing in the way of rental revenue growth that that is going to really help to offset any increased expenses that we see from the United States. And again I would be surprised personally if next year was higher than this year in the way of IC expenses. We have done a lot this year. Next year, we’ll likely be more classroom related I would say which tend not to have as much as the deferred maintenance or of the major re-outfitting involved with them, but time will tell. But I think we’re – I think I won’t be surprised if we saw better margins even in the first quarter of next year.

Scott A. Schneeberger – Oppenheimer & Co., Inc.

Okay. Thanks very much and thanks for taking all the questions.

Operator

Yes, there are no further questions at this time, gentlemen. Please continue with your closing remarks.

Dennis C. Kakures

I’d like to thank everybody for joining us this afternoon. We appreciate you and your good questions. Our next investor get together will be at the end – towards the end of February 2014 when we share our fourth quarter results as well as our 2014 guidance. Thank you all for being with us. Have a good evening.

Operator

Ladies and gentlemen, this concludes the McGrath RentCorp’s third quarter 2013 conference call. You may now disconnect. Thank you.

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