- I have been critical of TAL's disclosures and hope they will provide clarity at their analyst day.
- TAL has consistently missed estimates for the last year which implies management might be under-estimating the company's problems.
- The container market is very weak, as evidenced by falling average lease rates at TAL and its peers.
- I expect TAL to cut its dividend by the end of this year.
- Reiterate $18/share price target (replacement value).
Last week, TAL International (NYSE:TAL) announced they will host an investor event on June 10th. I have been and remain skeptical about the outlook for TAL and believe they will have to cut their dividend later this year.
Below are questions I suggest analysts and investors ask management to better understand the Company and gauge whether my analysis and view are correct. After the questions, I provide additional context and related background.
- Average CEU on-hire / average CEU owned = 76.7%, but TAL reports 97.1% utilization. Which measure is a better indicator of the portion of the owned fleet that is employed and contributing to revenue?
- What is the average remaining lease duration on long-term leases (Ie: excluding finance leases)?
- Including service and expired leases, what percentage of the fleet is subject to renewal this year?
- Of the $60m revenue decline expected from 2010 and 2011 leases (10-K, page 13), how much of that will occur in 2014/2015/2016, respectively (using contracted lease expiry)?
- Assuming market rates remain where they are currently, should we expect the average lease rate decline of approximately 2% per quarter, decline more as the 2010 and 2011 vintages begin expiring, or decline less for some other reason?
- Do you expect the "equity cash flow after 10% growth" to continue to decline at the current pace (27c / qtr!) throughout the year or will it accelerate as more high rate leases expire?
- If the equity cash flow after 10% growth falls below the dividend rate, will you cut the dividend or grow below 10%?
- In light of the significant declines in asset values and lease rates, do you expect to impair any of the high carrying value assets (2010 / 2011)? Please walk through the math (carrying value, expected utilization, margin, remaining life, expected residual value).
- If the company does need to take an impairment, what is the resulting leverage and how does it compare to the company's covenants?
- What are the Company's contingency plans if there is a recession and it must begin liquidating assets rather than growing them, thus pulling forward the time frame for cash taxes?
Question #1: Utilization
Investors care about utilization as an indicator of revenues.
TAL's most recent 10-Q reports an average owned CEU in 1q14 of 2,628,264 (4q13: 2,609,681 & 1q14: 2,646,846). Elsewhere in the 10-Q, TAL reports that an average number of units on hire of 2,017,018 CEUs, implying an average utilization of 76.7%, down from 82.0% in 1q13 (1,965,650 / average of: 2,367,636 & 2,428,725).
In contrast, TAL reports an average utilization (excluding new units not yet leased and returned units designated as held for sale) of 97.1%.
Which measure is a better indicator of the portion of the owned fleet that is employed and contributing to revenue?
Question #2: Remaining Lease Duration
TAL reports an average remaining contract term of 44 months for long-term and finance leases combined. However, under finance leases "customers are generally required to retain the equipment for the duration of its useful life" (10-K, page 4), so a mix shift towards finance leases (as TAL has had over the last four quarters) distorts this metric.
What is the average remaining lease duration on long-term leases (ie: excluding finance leases)?
Questions #3, 4, & 5: Rent Roll
TAL often mentions that over 75% of the fleet on-hire is subject to long-term or finance leases and how they have minimal renewals on those leases in 2014. However, management rarely discusses the other nearly 25% of the fleet on-hire that has expired leases or short-term service leases or the portion of the fleet that is NOT on-hire.
Regardless of lease type, what percentage of the fleet will re-price annually?
TAL's 10-K notes that the average lease rates on containers purchased in 2010 and 2011 are roughly 30% higher than the current market lease rates. Further, it notes that for each 1% reduction in the average lease rate on the containers purchased in 2010 and 2011, revenue will decline approximately $2.0 million.
Using contractual lease expirations, how much of the $60m impact will occur in 2014? How much more in 2015? 2016?
The chart below shows TAL's overall lease rate index (excluding sale-leasebacks) has been declining and shows that the rate of decline is accelerating.
Source: 1q14 TAL Investor Presentation
Question #6 & 7: Dividend Coverage
TAL's investor presentations show the LTM "Equity Cash Flow After 10% Growth". As of 3q13, the Company reported $3.89 for this measure.
Source: 3q13 TAL Investor Presentation
At 4q13, the amount fell to $3.76.
Source: 4q13 TAL Investor Presentation
The 1q14 amount is down to $3.49, indicating the decline in cash flow available to pay dividends -- as calculated by the company -- is declining at an accelerated rate.
Source: 1q14 TAL Investor Presentation
If the trend continues, by 4q14 TAL's equity cash flow after 10% growth will be approximately $2.68 (27c decline in each of the next three quarters) which is BELOW the current dividend rate of $2.88. And that's before the big rent roll head winds begin in 2015 and 2016.
We expect our dry container lease rates will continue to decrease in 2014 and if market lease rates remain near their current low level for an extended period of time, we expect the decrease in our average dry container lease rates will accelerate in 2015 and 2016 due to the large number of leases with high lease rates that are scheduled to expire in those years.
Source: 1q14 10-Q
TAL's "steady-state" cash flow is declining and the decline is accelerating. In addition, TAL has to continue growing to continue avoiding cash taxes. As a result, the "equity cash flow after 10% growth" is declining even further and is rapidly approaching their dividend level ($2.88).
If equity cash flow after funding growth continues to decline (as one would expect in light of the company's guidance), TAL will have to choose between funding growth (to avoid cash taxes) and funding the dividend.
I expect the company to choose growth / tax avoidance because the cash drain from unwinding the deferred tax liability would be more painful ($371.6m) than cutting the dividend by half.
What does the Company expect the "equity cash flow after 10% growth" to be at year-end?
Question #8: Asset Impairments
As the company has acknowledged, newbuild prices have fallen from as high as $2,800 to approximately $2,100 and lease rates have fallen even further (yields in the single digits). Since lease rates are so much lower, lessees will look to return assets or renew at much lower rates.
TAL's carrying value for the 2010 and 2011 vintages is based on ~$2,800-$3,000 per 20' dry, but the future revenues will be a function of the current $2100 per 20' dry.
Will the company recover its current carrying value?
Additionally, the company's disclosures indicate particular weakness and erosion of value for reefers.
For several years, our average lease rates for refrigerated containers have been negatively impacted by low market leasing rates. The cost of the refrigeration machines included in refrigerated containers has trended down over the last few years, which has led to lower refrigerated container prices and lease rates. Lease rates for new refrigerated containers are also being negatively impacted by the widespread availability of attractively priced financing and aggressive competition.
Source: 10-K, page 36
Question #9: Leverage
The company's debt agreements are subject to covenants, including maximum indebtedness to tangible net worth. If the company has to impair assets, these covenants could trigger a default.
If the company does need to take an impairment, what is the resulting leverage and how does it compare to the company's covenants?
Question #10: Deferred Tax Liability
In the company's risk factors, the company said:
In addition, even under current tax rules, we need to make substantial, ongoing investments in new containers in order to continue to benefit from the tax deferral generated by accelerated tax depreciation. If our investment level slows due to a decrease in the growth rate of world trade, decisions by our customers to buy more of their containers, a loss of market share to one or more of our peers, or for any other reason, the favorable tax treatment from accelerated tax depreciation would diminish, and we could face significantly increased cash tax payments.
Source: 10-K, page 22
What are the Company's contingency plans if there is a recession and it must begin liquidating assets rather than growing them, thus pulling forward the time frame for cash taxes?