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H&E Equipment Services, Inc. (NASDAQ:HEES)

Q2 2008 Earnings Call Transcript

August 7, 2008 10:00 am ET

Executives

Kevin Inda – IR

John Engquist – President and CEO

Leslie Magee – CFO and Secretary

Analysts

Jamie Cook – Credit Suisse

Henry Kirn – UBS

Seth Weber – Banc of America Securities

Jason Molick [ph] – Goldman Sachs

Chris Daugherty – Oppenheimer & Company

Jeff Lignelli – Stonebrook

Operator

Good day, and welcome to today's H&E Equipment Services second quarter 2008 earnings conference call. This call is being recorded. At this time for opening remarks and introductions, I'd like to turn the call over to Mr. Kevin Inda. Please go ahead, sir.

Kevin Inda

Thank you, Matt, and welcome to the H&E Equipment Services conference call to review the company's results for the second quarter ended June 30, 2008, which were released earlier this morning. The format for today's call includes PowerPoint presentation, which is posted on our website at www.he-equipment.com.

Please proceed to slide one. Conducting the call today will be John Engquist, President and Chief Executive Officer; and Leslie Magee, Chief Financial Officer and Secretary. Please proceed to slide two. During today's call, we will refer to certain non-GAAP financial measures and we reconcile these measures to GAAP figures in our earnings release, which are available on our website.

Before we start, let me offer the cautionary note that this call contains forward-looking statements within the meaning of the Federal Securities Laws. Statements about our beliefs and expectations and statements containing the words such as may, could, believe, expect, anticipate, and similar expressions constitute forward-looking statements. Forward-looking statements involve known and unknown risks and uncertainties, which could cause actual results to differ materially from those contained in any forward-looking statements. These risk factors are included in the company's most recent Annual Report on Form 10-K and quarterly report on Form 10-Q.

Investors, potential investors, and other listeners are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The company does not undertake publicly update or revise any forward-looking statements after the date of this conference call. Except as required by applicable law including the securities laws of the United States and the rules and regulations of the SEC, we are under no obligation to publicly update or revise any forward-looking statements after the date of this conference call.

With that stated, I'll now turn the call over John Engquist.

John Engquist

Thank you, Kevin, and good morning everyone. Welcome to H&E Equipment Services second quarter 2008 earnings call. On the call with me today is Leslie Magee, our Chief Financial Officer. Please proceed to slide three. Today I’ll go over the highlights of the second quarter and discuss our end markets by region. I will also talk about the steps we are taking to ensure we continue to deliver solid results in a more challenging environment. Leslie will then go over our financials in more detail. When Leslie concludes, I will discuss our outlook for the remainder of the year and we will then take questions.

Please proceed to slide five. Despite a challenging economy that is starting to pressure the non-residential construction market, we continue to deliver strong year-over-year results. In the second quarter, our total revenue increased 21.2% to $282.6 million, EBITDA increased 12.2% to $64.6 million, and net income increased 5.9% to $16.1 million or $0.45 per diluted share. We believe this is impressive performance when you consider the struggling economy and weakness in several of our major markets.

Please proceed to slide six. Our footprint in geographic diversity continued to provide opportunity for our company. This is due to our strong presence in geographic regions with tremendous exposure to the industrial sector. Demand for our products and services remained strong in our Gulf Coast and Intermountain regions due to the petrochemical, oil patch, energy and mining sectors. We believe these sectors will continue to show growth for the foreseeable future.

Increased construction cost such as steel, asphalt, plastic, wallboard, and fuel have presented new challenges to the construction markets. In particular, the Florida, Southern California and Mid-Atlantic regions remain very challenging. We are however pleased with the progress we are making in our operations in the Mid-Atlantic region. We continue to develop their rental operations and transition them to our integrated business model and we are confident they will become a strong contributor to our performance.

Please proceed to slide seven. To summarize, we delivered a strong second quarter in spite of a struggling economy that is beginning to impact the non-residential construction sector. We believe our performance speaks to the strength of our integrated business model and our strong ties to the high-growth industrial sector. Florida, Southern California, and the Mid-Atlantic continue to be our most challenging markets.

While we do not anticipate topside improvement in these markets in the near future, we are seeing better financial performance as a result of the steps we’ve taken to adjust these businesses to current market conditions. Due to an ongoing credit crisis and skyrocketing construction cost, we believe the non-residential construction markets may be negatively during the second half of this year.

We are currently taking steps to adjust our business to prepare for what we believe will be a more challenging environment in the second half. These steps include a measured fleet reduction to adjust to current market demand. This reduction to our fleet is a significant change from our original plan and will affect our guidance for the remainder of the year, which I will address in detail at the end of Leslie’s remarks. We are confident that we are taking the appropriate steps to ensure that we continue to deliver solid results. Our reduced capital spending will generate significant free cash flow, which we will use to pay down debt and/or repurchase shares. We remain committed to enhancing shareholder value.

At this time I’ll turn the call over to Leslie for the financial review.

Leslie Magee

Thank you, John, and good morning. I would like to go through our financials providing more detail on our second quarter results beginning on slide nine. Our total revenue increased to $282.6 million or 21.2% year-over-year, with $40.6 million of revenue from the Mid-Atlantic region. Top line revenue growth exclusive of the Mid-Atlantic revenues was 3.8%. In the current quarter, each operating segment reflected growth on an organic basis.

For the second quarter of 2008 on a segment basis, rental revenues increased 8.1% over the prior year on a larger fleet and with growth across all product lines. Rental revenue from the Mid-Atlantic was $3.8 million for the second quarter, resulting in a 2.7% increase in rental revenues and also with growth across all product lines on an organic basis. Our rental business continues to be impacted by weakness in Florida, Southern California, and the Mid-Atlantic, which are all still our most challenging markets. Rental revenues outside of these three markets grew 10.2% from the second quarter of 2007.

Our overall dollar return was 37.5% for the second quarter of 2008 as compared to 41.5% for the same period in 2007. As we’ve stated on our previous call, our dollar returns are lowered by the rental operations in the Mid-Atlantic. We continue to make progress on transitioning the rental operations to more of a rent-to-rent focus rather than a rent-to-sell focus. The Mid-Atlantic’s performance alone accounted for approximately 160 basis points of the decline in our dollar return. The remaining in dollar utilization is due to lower time utilization and rental rate.

Our average time utilization for the quarter was 67.9% as compared to 69.1% a year ago. Utilization of our aerial fleet increased100 basis points over the prior year as a result of strength in our aerial markets outside of Florida and Southern California and the positive results from deflating these markets. Earthmoving time utilization continues to be negatively impacted by our Mid-Atlantic region and our utility lines. Utility equipment has stronger ties to the residential market.

Cranes remain highly utilized but continue to be impacted by lower demand for boom trucks. Rates on average and excluding any impact from the Mid-Atlantic declined 2.9% over the prior year. Our aerial rates declined 3% over the prior year, again driven primarily by Florida and Southern California. Crane rental rates during the quarter declined 2.6% over the prior year due to lower rates on boom trucks. We continue to see positive rate increases on rough terrain cranes, but these increases were offset by rates on new rental contracts for boom trucks. Earthmoving rental rates declined 2%, which is primarily attributable to the utility line or smaller earthmoving equipment.

New equipment sales grew 27.4% over the prior period, including $20.4 million of new sales from the Mid-Atlantic region. Also the demand for cranes remains strong. On an organic growth, new sales of cranes and lift truck equipment increased and were partially offset by a decline in new earthmoving and aerial sales year-over-year. Used equipment sales increased approximately $12.5 million or 36%, including $9.5 million of the used equipment sales from the Mid-Atlantic. On an organic basis, all product lines increased year-over-year with the exception of used earthmoving equipment.

Our parts and service business continues to show solid growth at 20.3% or $7.9 million on a combined basis due to increased demand in revenues from the Mid-Atlantic of $6 million for the quarter. Our total gross profit margin decreased 28.5% as compared to 30.5%. The margin decline is due to a 15.9% gross margin on $40.6 million of revenues from the Mid-Atlantic operations. Our gross profit margin exclusive of Mid-Atlantic increased to 30.6% in the second quarter as compared to 30.5%.

Next I’d like to discuss gross margin by each segment to better explain the changes. We experienced declines in rental gross margins to 49.3% from 50.9% in the prior year. Rental depreciation has increased $3.7 million or 16.6% resulting from growth of the fleet including fleet associated with the acquisition and the aging of fleet.

Depreciation expense was 34.6% of rental revenues in the current quarter as compared to 32.1% in the prior year. As we've mentioned, our rental business has been impacted by the Mid-Atlantic focus on distribution versus rentals. Rental gross margins for the quarter exclusive of Mid-Atlantic results were 50.9%, which was consistent with the prior year. Partially offsetting these declines, maintenance and repair expenses improved as a percentage of rental revenues by approximately 40 basis points to 12.6%.

Margins on new equipment sales decreased to 12.8% from 12.9% a year ago. Margins on new sales of $20.4 million in the Mid-Atlantic were 14.3%. Our overall gross margin was impacted by a decline in used equipment gross margins to 22.7% from 24.2%. Used equipment margins declined primarily due to lower margins on fleet sales in the Mid-Atlantic due to the fair value adjustments required by purchase accounting at the time of the acquisition.

Margins on both parts and service revenues remained strong and had little to no impact to our overall gross margin in comparison to the second quarter of 2007. Parts gross margins increase to 29.1% from 28.9% and service gross margins increased 64.6% from 62.7% due primarily to revenue mix. Gross margins on other revenue, which is primarily related to equipment support activities such as hauling, freight and damage waiver, decreased to 0.3% [ph] from a gross margin of 8.5% in the prior year. The decline relates primarily to increased fuel costs and is also due to increased hauling costs associated with de-fleeting our softer markets.

Slide ten please. Income from operations increased to $34.9 million from $32.9 million. Our weaker markets continue to impact our overall performance, but we are beginning to realize improved financial performance as a result of de-fleeting and previous reductions. The Mid-Atlantic operations improved significantly at the EBITDA line since the first quarter. The Mid-Atlantic contributed $2.1 million of income from operations.

The EBIT contribution from our Southern California and Florida operations combined declined year-over-year by approximately $2.5 million. However, despite decline in revenues since the first quarter of 2008, operating margins have improved. In addition, rental depreciation increased $3.7 million. Non-rental fleet depreciation and amortization of intangibles $1.5 million over the prior year’s quarter.

Proceed to slide 11. Net income was $16.1 million in the current period as compared to $15.2 million in the prior year on a lower effective tax rate of 37% versus 37.6% in the prior year. For the quarter, interest expense increased $600,000 to $9.5 million over the prior year as a result of maintaining higher average borrowings under our senior secured credit facility. We have repurchased a total of 2.9 million shares of $45.8 million of common stock in the open market since the initiation of our buyback program.

Slide 12 please. EBITDA increased 12.2% as compared to the second quarter of 2007, with margins decreasing to 22.9% from 24.7%. The Mid-Atlantic contributed $4.6 million of EBITDA in the second quarter or 11.2% margin. These results reduced our consolidated margins by 190 basis points. Our EBITDA margin was 24.8% for the second quarter, excluding the Mid-Atlantic results. We continue to generate strong cash-on-cash returns. On an LTM basis, our cash-on-cash return was 31.4%.

Next, slide 13. Our SG&A cost decreased as a percent of revenue to 16.2% as compared to 16.5%. SG&A dollars increased $7.5 million to $45.9 million with the Mid-Atlantic contributing $4.5 million of this increase and an additional $800,000 amortization of intangible assets acquired in acquisitions. The remaining increase exclusive of the Mid-Atlantic is primarily related to an increase in employee salaries and wages, and other employee expenses and facility related expenses, which are all costs associated with the growth of our company.

And last, slide 14. Our gross fleet capital expenditures for the quarter were $55.9 million and net fleet capital expenditures were $20.2 million. Our fleet at the end of the quarter was $803.3 million, which is flat with our original equipment cost at the beginning of the year. Gross PP&E CapEx for the quarter was $8.5 million and net PP&E CapEx was $7.9 million. Our fleet age at the end of June was 31.2 months as compared to 36 months a year ago.

With that overview of our financial results, I would like to turn the call back to John so that he can discuss our 2008 outlook.

John Engquist

Thank you, Leslie. If you’d go to slide 15, today we are dealing with tremendous macroeconomic uncertainty. The outlook for the overall economy in the non-residential construction markets has progressively weakened. Due to these factors and a material change to our fleet plan from our original forecast, we are revising our annual guidance as follows. We now expect revenues in the range of $1.094 million to $1.108 billion. We expect 2008 EBITDA in the range of $247 million to $255 million. And we expect EPS in the range of $1.57 to $1.71 based on an estimated 35.8 million diluted common shares outstanding, which reflect our stock repurchases through the end of the July.

With that, operator, we would now like to move on to the Q&A session. Please provide instructions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) We’ll go first to Jamie Cook with Credit Suisse.

Jamie Cook – Credit Suisse

Hi, good morning.

John Engquist

Good morning.

Jamie Cook – Credit Suisse

Just a couple of questions. Can you guys first give me an update for the full year, what you’re expecting sort of J.W. Burress to contribute on a revenue and EBIT basis versus where we were before as I think about your new guidance?

John Engquist

Jamie, I think the second quarter they were in the $40 million range on revenue, which was a big increase for them from the first quarter. Their equipment sales and rental purchase conversions were very strong. I don’t know that that will be a run rate for the third and fourth quarter. I would think more somewhere in the middle of that $30 million to $40 million would be more realistic.

Jamie Cook – Credit Suisse

Okay. And then just take sort of the same implied margins or should I see margins are down as well?

John Engquist

I would – I don’t anticipate margin deterioration there.

Jamie Cook – Credit Suisse

Okay. And then just my next question, you mentioned with some of the OEs that you are dealing with that they are having inventory issues, I guess, can you give a little more color there? Is it just on the aerial side or you seeing in earthmoving equipment as well?

John Engquist

I think the aerial manufacturers businesses have definitely slowed. There is no question about that. And I think the dirt manufacturers have seen the same thing. And I think if you listen to Caterpillar's reports, their domestic business has softened and they're really being carried by offshore business right now. The one area that demand is just phenomenal is on the crane side. The crane manufacturers really aren’t meeting the demand right now. So it’s basically aerial and dirt manufacturers.

Jamie Cook – Credit Suisse

And any idea when you think these inventory issues sort of work themselves through?

John Engquist

I don’t think it’s going to take long because I think the aerial manufacturers are being very disciplined in their approach right now. I don’t see them doing anything to try and force equipment into the marketplace and keep factories running. I think they’re taking a disciplined approach and I think they will deal with their inventory situation rather quickly.

Jamie Cook – Credit Suisse

All right. And then just my last question and I’ll get back in queue. I think you mentioned that your rental rates were down 2.9% and just from hearing what some of the other competitors are saying, I think URS – I’m sorry, United Rentals is more 1.5, I think RRR is more like down 0.5. So, just your rental rates seem to be declining more than your peers. Do you have any idea why or is it concentrated within one geographic area that's really pulling down the rental rate?

John Engquist

Well, no question the bulk of our rate pressure is coming out of Florida, Southern California and the Mid-Atlantic. I mean, those are the toughest markets. And I would also point to – you know, it’s product-specific. We’ve seen a lot of rate pressure on our boom trucks. If you look at our crane rates, we are quoting crane rates being down, but that’s all in boom trucks. Our rough terrain crane rates are up around 6%. So the pressure we’re seeing there is in boom trucks and that’s because the drivers of the boom truck business are residential markets and commercial construction markets. The drivers of our other crane business is the industrial sector. So, it’s somewhat product specific and it’s also regional. Our mix is so different from what other people are reporting. I don’t know that that’s a real meaningful comparison.

Jamie Cook – Credit Suisse

All right. Thank you. I’ll get back in queue.

Operator

We’ll go next to Henry Kirn with UBS.

Henry Kirn – UBS

Good morning guys.

John Engquist

Good morning.

Henry Kirn – UBS

Quick question on the crane market. How far out do the orders extend to and how much longer do you think the cycle can last? I mean, it’s already – it sounds like it’s now past the peak on the boom truck side, but how much longer do you see for rough terrains and the other categories?

John Engquist

Well, just don’t try and relate the boom truck markets to the rough terrain and lattice boom markets because they are totally different drivers. I think Manitowoc is looking for growth in their crane business through ’10 and we concur with that. The drivers of our hydraulic crane business, rough terrains, ATs, and lattice boom cranes, it’s petrochemical, it’s oil patch, it’s energy. And I just don’t see anything that’s going to change that environment in the near future. So we think that’s going to stay very strong for the foreseeable future.

Henry Kirn – UBS

Okay. And as you look at your overall fleet today and toward where you are looking to go by the end of the year, where are you looking to go for fleet age and original equipment cost by the end of the year? And can you give a little color around where you’d be looking to de-fleet?

John Engquist

Sure. Obviously we won’t be de-fleeting in cranes. If anything subject to availability, we’ll grow our crane fleet somewhat, but we will be significantly reducing our capital spending on our aerial fleet and our earthmoving fleets. So, our original plan called for some modest fleet growth to the $10 million to $25 million or $30 million this year, and now we’re looking at maybe bringing our fleet down $25 million or $30 million. And that’s primarily in the area of aerials and earthmoving equipment.

Henry Kirn – UBS

Okay. Thanks a lot guys.

Operator

We’ll go next to Seth Weber with Banc of America Securities.

Seth Weber – Banc of America Securities

Thanks. Good morning, everybody. Couple of clarifications. Just on the rental fleet, how much of the crane fleet is actually boom trucks versus rough terrains or crawlers, can you give us that number? And how much of the total rental fleet is aerials?

John Engquist

The total rental fleet is something north of 60% aerials.

Leslie Magee

About 59% aerials, right.

John Engquist

Yes, right. Our boom trucks, I’d have to break it out unit-wise. I think we have about 150 units of boom trucks in our fleet. Those are obviously smaller dollars than our other crane products. I’d have to get that for you. I don’t have it in front of me.

Seth Weber – Banc of America Securities

Okay.

John Engquist

We’ll (inaudible) get that for you.

Seth Weber – Banc of America Securities

But it’s enough to skew the – I mean, it’s surprising that it’s enough to skew the overall crane rate, rental rate bucket to be negative.

John Engquist

Let me explain why that is. We calculate rate increases or decreases only on new contracts. They are opened in a period. So during the second quarter, we had very high utilization, extremely high utilization on our rough terrain cranes. And we just in that time period had much more new contracts on boom trucks than we did on our rough terrain cranes. And that’s why it skewed that. We only calculate rate increases on newly open contracts.

Seth Weber – Banc of America Securities

Okay. Some of your competitors have talked about trying to lock up equipment for longer periods of time. And I think you’ve actually talked about this as well in past calls. I mean, is that still your strategy and how does that affect rates? Are you trying to lock in equipment at lower rates? Or when you lock in these longer-term contracts, is that at a higher rate, lower rate? Can you talk about that a little bit just in general?

John Engquist

Sure. Typically when you go on a big project that’s going to last a long time and you lock equipment up, you can afford to take a lower rental rate. I mean, there is no question about that. You end up for a given period of time with a 100% time utilization. You handle the equipment a lot less, so your maintenance cost goes down. So you can afford to take a lesser rate on a long-term project. Our position has always been that we like long-term projects. Our approach has not changed there. Typically today the average length of a rental contract for us is about 45 days. So our business is weighted to longer-term contracts. That also varies a lot by product type. Cranes typically stay out longer duration than some of our other products. But we like long-term contracts. No question.

Seth Weber – Banc of America Securities

Okay. And just two quick follow-ups. Are you planning to close any stores as part of this kind of strategic review of your business at this point?

John Engquist

We are not looking at store closure. We might be looking at some store consolidations down the line. We’ve got some markets where we have stores in close proximity so there may be some consolidation. But we’re certainly not looking at exiting any markets.

Seth Weber – Banc of America Securities

Okay. And then last question, can you try and strip out for us how much of your business is actually industrial? I don’t know how you would define it, but do you have an industrial bucket versus pure construction?

John Engquist

I’m very comfortable, Seth, that the industrial sector drives at least half of our revenue, and industrial being petrochemical, oil patch, mining and energy sectors.

Seth Weber – Banc of America Securities

Okay. Thank you very much.

Operator

(Operator instructions) We’ll go next to Philip Volpicelli [ph] with Goldman Sachs.

Jason Molick – Goldman Sachs

Thank you. This is actually Jason Molick [ph] in for Phil. How are you doing?

John Engquist

Fine. How are you?

Jason Molick – Goldman Sachs

Good. Just one quick housekeeping question. The floor plan financing, what was the balance at the end of the quarter?

Leslie Magee

$153 million.

Jason Molick – Goldman Sachs

Okay. Great. And as far as the used equipment market, have you guys still been seeing pretty good strength on that side? And are there any areas – I mean, earthmoving has kind of been a little bit weaker in the past, any areas that are still showing strength versus weakness?

John Engquist

We’re pretty much seeing strength across all of our used equipment product lines. We’re very pleased with residual value and the way pricing holding up.

Jason Molick – Goldman Sachs

Okay, great. And then as far as just kind of CapEx, I mean, I know you mentioned a little bit that you’re probably planning to grow parts of the fleet and shrink parts of the fleet. Specifically cranes, I mean, should we expect a good portion of the CapEx to go to the crane segment?

John Engquist

Yes. Any growth CapEx that you see from us will be on the crane side. Again, looking at aerials and looking at earthmoving equipment, we intend to reduce our capital spending there significantly.

Jason Molick – Goldman Sachs

Okay. And then it sounds like you spent about $45 million total on the share repurchase plan so far. The press release mentioned that you could use free cash flow to continue that or also to pay that debt. How are you thinking about the position that decision? And I guess, the debt you paid back, should we just assume that it would be the revolver or would you think about going to the open market for the bonds?

John Engquist

Yes. I think at this point -- and we’ll be looking at our options there, but at this point we would be paying down our revolver and/or repurchasing shares. So we’re going to get with our board and make those decisions and do what we think is in the best interest of our shareholders.

Jason Molick – Goldman Sachs

Okay. And then just the last question as far as from you guys standpoint, are there clients – if they end up canceling orders, I mean, is there a system in place where they get penalized for that or is that – they just have to give you a certain notice? And then on the other hand, when you guys are ordering cranes, for example, how much notice you have to give them and is there a penalty if you decide the demand isn't there, let's say, next year or something like that and you just want to cancel the order?

John Engquist

I don’t know that there’s anything written or any really policy on that. That has not been an issue for us. We have not been getting orders canceled that are in place and I don’t anticipate that happening. The bulk of our equipment sales today, plus-60% of our new equipment sales are on cranes. And I can tell you, nobody is canceling cranes because they can’t get enough of them. So I really don’t see that being a major issue. And other than cranes, we have very little new product on order right now.

Jason Molick – Goldman Sachs

Okay. And then just following up with that, as far as in the last downturn, I mean, do you have a sense that that became an issue as far as ordering, canceling of orders, or was there enough visibility that that wasn’t an issue?

John Engquist

The last downturn, I – frankly, I didn’t see a lot of orders canceled. And if you go back ’01, ’02, ’03, I just think we’re in a whole lot better position today than we were there. Again I think the manufacturers are really taking a disciplined prudent approach to this. I don’t see them trying to force equipment into the marketplace. I think they are cutting back their production to deal with this. As you know, the rental companies are taking a disciplined approach. Everybody that’s reported is reducing their capital spending and I think paying a real close attention to what’s going on here. So, I don’t think we’re going to develop any kind of capacity issue this go around.

Jason Molick – Goldman Sachs

Okay, great. All right. Good luck.

Operator

(Operator instructions) We’ll go next to Chris Daugherty with Oppenheimer & Company.

Chris Daugherty – Oppenheimer & Company

Good morning. I was just wondering, as you sort of maybe adjust your fleet in terms of mix, what is the – is there any big discrepancy with the dollar utilization between pieces of equipment?

John Engquist

Absolutely. Our lowest dollar returns or dollar utilization is in our crane business. Now -- it carries a high margin, it’s a very long life asset, it has very low maintenance cost, and it has outstanding residual value. So, on a lifecycle basis, it’s a very profitable asset for us, but the dollar returns are lower. Aerials and earthmoving have very strong dollar returns for us; lower residual values than the cranes have, but still it all sorts out. But yes, you have significant differences between product lines.

Chris Daugherty – Oppenheimer & Company

And going to sort of the Mid-Atlantic, I mean, I know (inaudible) were much less, almost half of what they were for the rest of the business. But how much of that business is new sales versus rental? I know some of it I think they were doing more rent-to-own. But if I look at their gross margin at 15.9% and sort of look at what you are getting on a new equipment sale basis, it actually looks a little bit better. So, just wonder if you could – how much important is really there?

John Engquist

I think we have huge opportunity there on the rental side of their business. Their rental business is a much lower percentage of their overall revenue than the rest of our company. And that’s why their margins are lower. Rentals has a 50% gross margin equipment sales. I think they reported a 14% gross margin. So, their revenue mix is very different from ours, and we’re working very hard to develop their rental business and get them in a rental profile to replicate our revenue mix. And when we do that, their margins will replicate ours.

Chris Daugherty – Oppenheimer & Company

And that’s what I’m trying to get to understand. It's not as much about efficiencies, it's more about changing their model?

John Engquist

Changing their business model. They are a distribution model right now as opposed to a rental business.

Leslie Magee

Their new equipment sales were about 50% of their revenues for the second quarter and their rental business was less than 10% of their total revenues. So –

Chris Daugherty – Oppenheimer & Company

All right.

John Engquist

It’s a revenue mix issue.

Chris Daugherty – Oppenheimer & Company

And then lastly, I mean, just looking at your inventory, I mean, it’s been running high and it seems as if cranes are such a high percentage of your new sales. And assuming if they are on allocation, you would think that as soon as one comes in, it goes right out of the door. What’s the ability to adjust your inventory as the market slows down?

John Engquist

Could you repeat the question again, I’m sorry?

Chris Daugherty – Oppenheimer & Company

I mean, I’m sort of wondering – I mean, you guys carry relatively high inventory relative to other companies in the sector. And I think part of that is because you have a new sale business or relatively high new sale business. I’m just wondering what your ability to adjust that is as that market might be coming down as we see a slowdown?

John Engquist

I think we can adjust very quickly to that. And you’re exactly right. Our inventories are a function of our new equipment sales. We have to carry a certain level of dirt inventory; we have to carry a certain level of crane inventory. Right now, a big impact to our inventories is new cranes, but it’s a timing issue because all of that stuff is sold. I mean, we may show $25 million or $30 million of crane inventory that shows in our inventory on a snapshot basis, but it’s all sold. It’s just a timing issue.

Chris Daugherty – Oppenheimer & Company

All right. That’s it. Thank you.

Operator

We’ll go next to Jeff Lignelli with Stonebrook.

Jeff Lignelli – Stonebrook

For free cash flow purposes, what are you guys expecting your net CapEx to be for this year?

John Engquist

We don’t give CapEx guidance. I can tell you when we slow our capital spending like we’re going to do, we’re going to generate significant free cash flow. But we’ve never given CapEx guidance.

Jeff Lignelli – Stonebrook

Great. I guess what was the net CapEx that you kind of viewed last year? And order of magnitude, I mean, do you think it could be down in this year?

Leslie Magee

Our net CapEx last year was $136 million.

Jeff Lignelli – Stonebrook

And then just order of magnitude – I mean, I’m just trying to get a sense for how dramatically you can cut net CapEx through the rental CapEx for the first part of the year, as you guys have on the slide as $34 million. I mean, how dramatically can you slow it from that $136 million and still maintain the service quality of your machinery?

John Engquist

Well, we can – we could shut CapEx off in total and maintain our service quality. Our fleet age is 31 months and you look at the type of assets we have in our fleet, we can age that fleet significantly without it causing us any problem. So, I mean that we could shut it off and still provide service.

Jeff Lignelli – Stonebrook

I mean, on the aerial business, you have 34.8 months on the aerial business. Obviously it sounds like you’re shutting that down on the spending side. How long can you really shut the spending down until you – where you really need to maintain some sort of service quality and in addition to your machines not breaking out in the field?

John Engquist

I mean, our aerial fleet age in certain regions has been north of 60 months in the past and it didn’t create problems for us. And I think you’ve got to look at our product support capabilities in this integrated model with this big service and parts component that we have. We can age these type products a long way and without it causing us problems. If we needed to, I’m very comfortable we could take our fleet age to 50 months in total and not create problems for our sales.

Jeff Lignelli – Stonebrook

Is that your expectation now?

John Engquist

Absolutely not. I’m not saying that at all. I’m just telling you what we could do. Our fleet will age some as we slow our capital spending, but nothing like that.

Jeff Lignelli – Stonebrook

All right. I’m just trying to get a sense for how much you – what your plan is now to age the fleet because that’s pretty significant as far on the free cash flow side.

John Engquist

Repeat that, Jeff, I’m sorry.

Jeff Lignelli – Stonebrook

I’m just saying I’m trying to get a sense for this 31 months that your fleet age is now, what’s your goal given the current environment? What’s your goal to take it to reach realistically because that has implications for how much free cash flow this business is going to generate?

John Engquist

Again, we are going to generate very significant free cash flow in ’08. We’re not going to – our fleet may age a few months in the second half of the year. It’s not going to be a lot. And I don’t know what to tell you. We’re going to look at the environment for ’09 and then make some decision what we do there. But there’s so much uncertainty, the macroeconomic uncertainty, I can't tell you what we’re going to do in ’09.

Jeff Lignelli – Stonebrook

Sure. And then just lastly, on the share buyback issue, I mean, obviously your stock – if you use this $250 million EBITDA, you’re trading around three times EBITDA currently, which is obviously a very low valuation. And one of your competitors just did a pretty significant buyback and their debt-to-EBITDA is now over three times and your debt-to-EBITDA is in the 1.4 range now. What are your thoughts now on actually buying a significant amount of stock, given the free cash flow this business is going to generate with the CapEx decline relative to maybe a less certain outlook for the economy now?

John Engquist

Well, we certainly still have an appetite for stock repurchases. And as I stated, we're going to get with our Board and evaluate the options. And two options are paying down debt and/or repurchasing shares. So, we have a share repurchase plan in place and we’re going to be looking at that going forward.

Jeff Lignelli – Stonebrook

Okay. But I know you guys are buying shares back, but you are not really buying it back any kind of significant ways so far relative to your competitors and the diluted share count is not really going down that much. So I’m just saying, is now the time when you would consider doing something significant given the future cash flow or do you kind of say, well, that’s offset by the economic uncertainty now?

John Engquist

Well, one, we're limited by our indentures on how much we can do in a given time frame. And I think we’ve been buying as much as we can. And again, going forward, we’re going to weigh our options versus what’s going on from a macroeconomic standpoint and we’re going to make decisions that we think are in the best interest of our shareholders.

Jeff Lignelli – Stonebrook

Thank you.

Operator

We’ll go to a follow-up from Chris Daugherty with Oppenheimer & Company.

Chris Daugherty – Oppenheimer & Company

Following up to the prior call, Leslie, what is the RP [ph] basket currently?

Leslie Magee

We have about approximately $35 million after the second quarter in the basket.

Chris Daugherty – Oppenheimer & Company

And then in terms of your decision to start maybe possibly you’re reducing the fleet, when did you see that? If your original thought was maybe growing the fleet 20 million or 30 million, now it’s down 20 million or 30 million, when did you see this coming and how quickly can you pull back your fleet? I mean, what’s the lead time between orders and deliveries?

John Engquist

Well, again, I think that we’ve seen a general softening in the overall macro environment since the beginning of the year. I mean, there hadn’t been a whole lot of good news out there. We’re very fortunate with our heavy exposure to the industrial sector and that’s a big driver of our business and that’s certainly been very good for us. But we can make those decisions and we can adjust very quickly. And what we’ve really been doing is just not continuing to order equipment. So we had very little equipment coming right now. And our new inventories are coming down. So I think we have the ability to change our fleet and grow it or reduce it on a very short-term basis.

Chris Daugherty – Oppenheimer & Company

All right. Thank you.

Operator

And with no other questions, I’d like to turn the call back to management for any additional or closing comments.

John Engquist

Well, I appreciate everybody being on the call. Without question, we are in a more difficult environment and I think we are doing the appropriate things to make sure that we continue to deliver positive results and we’re going to do just that. So, look forward to talking to you on our next call. Thank you.

Operator

That does conclude today’s call. Again, thank you for your participation. Have a good day.

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Source: H&E Equipment Services, Inc. Q2 2008 Earnings Call Transcript
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