Update to TAL short thesis
Key points this article:
- Management commentary on recent earnings call confirms my view.
- $2.52 EPS (My estimate) for 2014 -- 37% below consensus and less than the dividend.
- Believe TAL needs to issue equity to avoid bigger problems in 2015 (such as cutting the dividend and/or breaching covenants).
- Reiterate $18/share price target (57% decline) based on replacement value.
On January 6, 2014 I wrote "Trouble Ahead for TAL" and described the problems I foresaw for TAL International in 2014. I focused on revenue headwinds from leases set to re-strike lower, depreciation and gain-on-sale headwinds resulting from TAL's accounting changes, and the risk of rising interest rates.
TAL reported earnings on February 12, 2014 and confirmed many of my concerns. In this article, I will update my views. In short, I believe there is more trouble ahead because I think estimates remain too high, TAL is paying out too much of their earnings as a dividend, and their DTL is a significant potential threat.
Summary of Thesis:
I expect 2014 to be difficult for TAL and earnings estimates are still way too high. If the year plays out as I expect, TAL could be forced to cut its dividend later in the year unless they issue equity (which would be dilutive and cause further EPS misses). The primary headwinds I see for TAL are (1) expiring leases re-striking lower, (2) rising depreciation (3) declining gains on sale, and (4) rising interest expense.
Issue #1: Expiring Leases Re-Striking Lower
In my original article, I noted that TAL's fleet is growing faster than revenues because the container market has cooled from the boom times of 2010/11 when there was a container shortage. I then noted that manufacturers have added capacity and lessees' financing rates have normalized, causing lease rates to decline as evidenced by TAL's average lease rate declining. Finally, I said that "this is just the beginning" and estimated that average lease rates could decline 10-15% with an approximately 5% decline occurring in 2014 (used 10% to be conservative and said half in 2014).
On TAL's 4q13 earnings call, the CFO said:
"In addition to the pressure on disposal prices, market lease rates have been under pressure. At year end, we estimate that the current market lease rate a roughly 10% to 15% below our portfolio average reflecting low newbuild prices, widely available debt financing and aggressive competition."
Management went on to say that they have "limited lease expirations in 2014" but declined to quantify the percent of the fleet set to expire. In an apparent criticism of my article, TAL management also provided a presentation that included a slide showing how only a small portion of the 2010 and 2011 vintages are subject to expiration until 2015 (slide 27 - TAL Presentation Feb 2014).
The problem with this slide is that management used the end of the penalty period instead of the end of the contractual period.
"SL included in future periods have significant contractual off hire penalties and are shown to expire at end of penalty period." (slide 27 - TAL Presentation Feb 2014)
TAL consistently recognizes "fee and ancillary lease revenues" that result from customers dropping off containers that are past the contractual period but still within the penalty period. Therefore, I think the slide is misleading and I expect that lessees will return these high lease rate containers ASAP -- to the surprise of gullible sell-side analysts who fail to read that footnote.
Additionally, TAL's presentation showed the 2008 vintage as having very high lease rates. These are very likely to be subject to re-delivery now that the leases are 5+ years old.
One only needs to look at TAL's own disclosure to see that lease rates are falling:
(1) Excludes impact of sale-leaseback transactions
Source: TAL Presentation (Feb 2014)
Based on a review of sell-side estimates, it appears that consensus estimates assume TAL's average lease rate is flat in 2014. If my estimate of a 5% decline (one could say this is inclusive of a decline in utilization; I haven't specifically addressed utilization but I expect it to be down in 2014). A 5% lower average lease rate would cause a miss of approximately $0.55 in EPS.
Issue #2: Rising Depreciation
My original article also warned about rising depreciation for TAL as a result of the company's change in residual value assumptions. Confirming my view, TAL's CEO said this about the depreciation expense for 2013 on the recent call:
"But we made up for it with growth in our fleet and in particular we got a lot of efficiency in our interest expense, by all the refinancing activity we did and also depreciation expense was lower from the change in residuals at the end of 2012."
The data confirms my view -- depreciation per TEU is starting to ramp-up as I predicted. If 2014 follows the pattern of 2012 (4q10 and 4q12 assumption changes), TAL's depreciation is about to catch investors off-guard in a meaningful way:
Consensus estimates for depreciation only reflect fleet growth. Assuming depreciation / TEU increases 10% (less than after the prior accounting change), depreciation will be at least a $20mm headwind in 2014 ($0.39 EPS impact).
Issue #3: Declining Gains on Sale
I also discussed how TAL's gains on sale would be under increasing pressure due to the weakening market for used containers and rising cost basis resulting from their accounting changes.
Here is what TAL had to say about these issues on the call last week:
"As I discussed previously, used container selling prices have been trending down since reaching record levels in 2011. And our average used container selling prices were down 14% from 2012 to 2013. We expect used container selling prices and our disposal gains will continue to moderate."
"In addition, these original TAL units have somewhat higher book values reflecting the increases in residual value assumptions made in 2010 and 2012. We have made up for the lower volume of original TAL units with a sale of older units purchased through sale-leaseback transactions. However, these units typically generate lower per unit gains than the original TAL units because they were purchased for prices higher than the net book value of light vintage original TAL units."
TAL's presentation shows used container prices continue to fall:
Source: TAL Presentation (Feb 2014)
I previously pegged 2014 gains on sale at ~$15m. However, I now expect them to be $7-8mm while street estimates remain in the $20-25m range. A $15mm difference equates to a $0.29 per share shortfall in EPS.
Issue #4: Rising Interest Expense
My previous article also discussed how I thought the amortization of terminated swaps would create an earnings headwind for TAL ($0.26 impact). TAL did not address this point, so there is little to add at this point. Consensus estimates appear to assume TAL's interest expense will grow less than the fleet (and debt balance), so I believe the $0.26 headwind is not factored into consensus estimates.
Combined Variance Relative to Consensus:
The table below shows how I arrive at my $2.52 estimate for 2014 earnings.
Importantly, TAL is paying a $0.72 per share quarterly dividend ($2.88 annualized). At my estimate of EPS, TAL will not have sufficient earnings to cover the dividend and will be at increasing risk of breaching covenants if the company does not cut the dividend or issue equity.
I continue to believe tangible book value (~$18/share) is appropriate to value TAL due to the commoditized nature of the business. In fact, one could argue that this is generous to TAL since the book value of assets reflects higher purchase prices than are available on the market.