TAL International Group, Inc., Q2 2008 Earnings Call Transcript

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 |  About: TAL International Group (TAL)
by: SA Transcripts

Operator

Welcome to the TAL International Group Second Quarter 2008 Results Conference Call. As a reminder, all participants will be in listen-only mode. There will be an opportunity for you to ask questions at the end of today's presentation. (Operator Instructions). The conference is being recorded.

At this time, I would like to turn the conference over to Jeff Casucci, Vice President of Treasury and Investor Relations. Please go ahead, sir.

Jeff Casucci

Thank you. Good morning and thank you for joining us on today's call. We are here to discuss TAL's second quarter 2008 results, which were reported yesterday evening. Joining me on this morning's call from TAL are Brian Sondey, President and Chief Executive Officer, and Chand Khan, Vice President and Chief Financial Officer.

Before I turn the call over to Brian and Chand, I would like to point out that this conference call may contain certain forward-looking statements as that term is defined under the Private Securities Litigation Reform Act of 1995 regarding expectations for future financial performance.

It is possible that the Company's future financial performance may differ from expectations due to a variety of factors. Any forward-looking statements made on this call are based on certain assumptions and analysis made by the Company in light of its experience and perception of historical trends, current conditions, expected future developments and other factors it believes are appropriate. Any such statements are not a guarantee of future performance, and actual results or developments may differ materially from those projected.

Finally, the Company's views, estimates, plans, and outlook as described within this call may change subsequent to this discussion. The Company is under no obligation to modify or update any or all of the statements that is made here and despite any subsequent changes the Company may make in its views, estimates, plans, or outlook for the future. These statements involve risks and uncertainties, are only predictions, and may differ materially from the actual future events or results.

For a discussion of such risks and uncertainties, please see the risk factors listed in the Company's annual report filed on Form 10-K with the Securities and Exchange Commission on March 10, 2008.

With these formalities out of the way, I would now like to turn the call over to Brian Sondey. Brian?

Brian Sondey

Thanks, Jeff. And welcome to TAL's second quarter 2008 earnings conference call. As indicated in our press release, we achieved excellent results in the second quarter of 2008. Adjusted pretax income increased over 26% compared to the second quarter of 2007, and our annualized adjusted pre-tax or cash return on equity increased to over 27% in the second quarter of 2008.

Our excellent performance in 2008 continues to be supported by a favorable market environment. And in fact, a lot of the economic factors that are creating challenges for many companies today have so far played to our favor. First, while the US economy, consumption, and import growth have been slow, growth in non-US trades has remained strong in 2008 and overall global trade growth remains solid. All of our large customers have global operations, and our containers flow naturally to the trade lanes where growth is strongest.

In addition, we are benefiting from commodity inflation. Steel makes up the majority of the cost for a new dry container, so the large increase in steel prices has led to more than a 35% increase in dry container prices, and this significantly increases the re-lease and resale value of our dry container fleet. The price for a new 20 foot dry container is currently more than $2,500 compared to $1,850 during the fourth quarter of last year. Due to this increase in dry container prices, market lease rates for new dry containers are currently almost 40% higher than the average long-term lease rate in our portfolio, though the impact on our overall portfolio is not yet substantial. Used dry container selling prices are up over 10% this year.

Increase in fuel costs has been helping us indirectly as well. Many shipping lines have responded to the dramatic increase in bunker costs by decreasing the speed of their vessels and adding a ship to their strings in order to economize on fuel consumption. The increased number of containers on the water and the reduced velocity of container turns increases the demand for containers. We also believe that we are getting a net benefit from the current financial disruptions. While there is no doubt that the cost of our debt has gone up. Our lease rates for new container transactions reflect this increased financing cost, and we believe that the tighter financial markets are creating two opportunities for us.

First, our customers have generally been reluctant to place large container orders this year, and this has increased the demand for our leased containers. While we don't know the reasons for this reduced purchasing with certainty, we believe one of the reasons is that due to the tighter financing markets, our customers are allocating capital away from containers and toward more strategic assets, such as ships and terminals. The other benefit we believe we are getting from the tighter capital markets is a further tiering of leasing companies. And that while capital has become more difficult and more expensive for us to secure, we believe the effect on second and third tier leasing companies is even greater.

Finally, we are benefiting from the weak US dollar. The weaker dollar has increased demand for leased and purchased use containers in the United States, as US exports have increased. In addition, while our lease revenues are almost all in US dollars, our disposals of used containers are often priced in local currencies, so the dollar value of disposables in Europe and Asia have increased with the depreciation of the US dollar. Finally, almost 100% of the world's containers are produced in China, so the appreciation of the RMB compared to the dollar supports higher container prices.

While our market environment remains strong overall, there are several market developments that cause some concern for us. One issue we're monitoring is the risk that other major economies may start to share the current economic problems of the United States. As I mentioned previously, strong growth in non-US trades has been helping to make up for slow growth in the Asia to US trade. However, there is a growing concern that several major economies in Europe are beginning to slow, and this would have an impact on European imports and the growth of the Asia to Europe trade.

Nevertheless, forecasters continue to project healthy growth in containerized trade. For example, in their July issue, Clarkson projected that global containerized trade growth will remain over 8% in 2008 and over 9% in 2009. And despite the concern about the major European economies, Clarkson continues to project that growth in the Asia to Europe trade will be well over 10% this year. Another area of focus for us is the potential for defaults by second and third tier customers. In general, we are concerned that small shipping lines may find themselves increasingly squeezed by high fuel costs, weak freight rates due to vessel additions by the large shipping lines, and tight capital markets that would make it difficult for smaller shipping lines to fund any operating losses they may incur in the future. Fortunately, other than for one small customer we mentioned in the 10-K, we have not yet seen an increase in default activity.

Overall, our market environment remains a strongly positive factor in the second quarter, and we continue to capitalize on this attractive environment. Our core utilization, excluding the impact of new units not yet on-hire, increased 1.4% during the second quarter to reach 95.4% as of June 30.Our direct operating expense levels fell to 9.4% of our leasing revenue in the second quarter of 2008 from 11.0% in the second quarter of 2007. And we continue to invest in our fleet aggressively. We'd accepted or ordered over 130,000 TEU of new containers through the end of July, and we have generated lease commitments for about 125,000 TEU of new containers so far this year. Over 40,000 TEU of these new containers committed to leases have not yet been picked up by our customers, so we are heading into the third quarter with good leasing momentum.

Our strong operational performance this year has combined with our aggressive fleet growth over the last year to allow us to achieve an excellent level of top and bottom line growth this quarter. As Chand will describe in more detail, our average revenue earning assets increased over 20% compared to the second quarter of 2007. Our adjusted EBITDA, including principal payments on finance leases, increased 18%. And our adjusted pretax income increased over 26% compared to the first quarter of last year -- excuse me, second quarter of last year.

I'll now hand the call over to Chand Khan, our CFO.

Chand Khan

Thank you, Brian. Good morning and thank you for joining us. It is my pleasure to review the results of our second quarter and six months ended June 30, 2008. As we have said in the past, our financial results were affected by unrealized gains or losses on interest rate swaps, which we consider non-operational. During this call, we will only review our adjusted EBITDA, adjusted pre-tax and adjusted net income, since we believe these financial measures more accurately reflect the Company's operational performance. For a full reconciliation between our reported financial results and our adjusted financial results, please see our press release.

We continue to remind our investors that we believe our adjusted pre-tax results are the best measure of our business, since we pay very little income taxes due to our excess tax appreciation over book depreciation. Adjusted pretax income in the second quarter of 2008 increased $5.5 million or 26% to $26.6 million versus the second quarter of 2007. Our adjusted pre-tax EPS was $0.81 for this period versus $0.63 in the second quarter of 2007. Adjusted net income for the second quarter of 2008 increased $3.6 million or 27% to $17.2 million. EPS also increased 27% to $0.52 per fully diluted common share. Our EPS increased at a higher percent than the percentage increase in our pretax income due to share repurchase.

Our adjusted EBITDA, which includes principal payments on finance lease for the second quarter of 2008 increased $11.7 million or 18% to $76.1 million versus the second quarter of 2007. For the first half of 2008, adjusted EBITDA increased $23.6 million or 19% to $150 million versus the first half of 2007.There were several items that contributed to the strong second quarter results. The first item is leasing revenue. In the second quarter of 2008, our leasing revenue increased $9.1 million or 13% versus the second quarter of 2007 as a result of our fleet growth. However, as you would expect, both our interest and the depreciation expense increased, which I will discuss later.

The second item is gain on sale of our used equipment, which remained strong through the second quarter 2008, increasing $3.1 million to $6.2 million versus the second quarter of 2007. During the second quarter of 2008, we benefited from very strong selling prices on our for sale equipment. We continue to sell our equipment at an older age than our competitors. The average sale age of our equipment during the first half of 2008 was 14.1 years versus 13.7 years in the first half of 2007. The highest sale age leads to lower net book value and higher gains when the units are sold.

The third item is our equipment trading margin, which consists of equipment trading revenue less equipment trading expenses. Equipment trading margin increased $2.1 million in the second quarter of 2008 versus the second quarter of 2007, due to a significant increase in the number of units sold and higher per unit gains. We typically purchase our trading units a few months before they are sold, so we were able to achieve higher than expected sale prices on margins as equipment prices increased during the quarter.

As promised earlier, let me review our interest and depreciation expense. Our interest expense in the second quarter of 2008 increased $3.6 million or 29% versus the second quarter of 2007 due to a few reasons. As you would expect, our interest expense increased as our average revenue earning assets grew 21%. In addition, we experienced higher interest costs due to the conversion of our $425 million warehouse facility into a term loan, which carries higher interest rates, and an increase in our debt balance from share repurchases.

Depreciation expense in the second quarter of 2008 increased $2.7 million versus the second quarter of 2007. While the average net book value of our revenue earning assets increased 21% in the second quarter of 2008 versus the second quarter of 2007, our depreciation expense grew only 11% in the second quarter due to the increasing number of fully depreciating units in our fleet. At the end of the second quarter of 2008, we had approximately 140,000 TEU of fully depreciated equipment, which represents a 25,000 TEU increase over the same time last year.

Let me make a few comments on our revenue earning assets, which consists of leasing equipment, net investment in finance leases, and equipment held for sale. We continue to invest in our fleet until the end of July, have purchased or have commitment to purchase approximately 130,000 TEU or $368 million of revenue earning assets, of which approximately $100 million of these units were not yet accepted as of June 30. Over the last 18 months, we have acquired almost $700 million of equipment, which represents over 40% of a carrying value of our revenue earning assets. Many of these units were leased to our customers on five to eight-year operating leases.

Due to the accounting nature of our operating leases, we report relatively low GAAP earnings on our new equipment. However, as these units get older and the associated debt declines, they are expected to contribute more significantly to our pre-tax results. Our revenue earning assets grew approximately $155 million in the first half of 2008 to approximately $1.7 billion.

I will now return to Brian for some additional comments.

Brian Sondey

Thank you, Chand. I'll now finish the prepared part of the call with some thoughts on our current outlook. As we look forward into the second half of the year, we expect that our major business drivers, our utilization, average lease rates, operating expense ratios, and the used container selling prices will be steady to slightly better than the first half level, assuming that our market environment remains favorable. In addition, we expect to see a benefit again in November when another vintage year of containers reaches the end of its depreciable life. So we also expect that our third party trading margins will trend down to more normal levels.

Overall, we expect that our results for the second half of 2008 will continue to track well ahead of our results from 2007, and we expect that our second half results in 2008 will be equal to or slightly better than our results in the first half of the year. In summary, we are very pleased with our performance and results in the second quarter and first half of 2008. Our first half results are up sharply from last year; we continue to benefit from a favorable market environment; and we have solid operating momentum to carry into the second half of the year, due to our strong core utilization and large volume of containers committed to lease.

I would now like to open up the discussion for questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question is from Jon Langenfeld of Robert W. Baird. Please go ahead, Mr. Langenfeld.

Ben Hartford - Robert W. Baird

Good morning, gentlemen, this is [Ben Hartford] standing in for Jon this morning. Nice quarter. If I could start just first off, I know you guys don't like to look at the business this way, but when we look at the profitability breaking down between leasing and equipment trading gains, it does, it looks like -- I guess, can you explain to me why we shouldn't look at leasing profitability year-over-year as flattish and with the bulk of the profit coming from equipment trading in this quarter?

Brian Sondey

Yes, sure. As I think we've talked before, in general, we view that the disposal of the container is integral to the way that we manage the life cycle value of the container. And so I would agree with your -- that you can separate the business to some extent between, say, leasing and container trading, but in that separation, I would include the gain on sale of our existing assets in the leasing portion of the equation for us. Just because -- again, when we look at how we structure our leases with our customers and how we run our business, we're really trying to maximize the net present value of the combination of the leasing streams and disposal of the container.

And quite frankly, some of the actions we have taken recently in particular, agreeing with customers over the years to accept lease revenue reductions in return for lease extensions, has the effect of shifting income from the lease revenue line into the gain on sale line. But again, we tend to look at that as one equation.

In addition, the other thing you need to be mindful of is that, say, second quarter '07 compared to second quarter '08, our SG&A expenses is up fairly significantly. But a lot of that increase in SG&A expense is because we have higher bonus accruals in 2008, partially or in fact a lot of it, are related to the high gains on sale we're taking in the high trading margins, which are leading to EPS growth, and our bonus plans are primarily oriented around EPS performance.

And so there's a bit of a -- the SG&A line kind of has to be split between the -- the change in that line needs to be split between the trading business and the lease revenue business.

The other thing that I think Chand alluded to a little bit is that I think we talked about that our revenue earning assets are growing in the range of 20%, and as well our ownership expense in terms of interest and depreciation combined, are growing in that 20% range, where our lease revenue is growing -- I think grew perhaps like 13% or so quarter two '07 compared to quarter two '08.

And one of the things that you see in an operating lease business is that the accounting profitability in the early years of a long-term lease is relatively low. Because the revenue straight line over the long duration of that lease while interest expense is very high, because the unit is new and it's a high carrying value.

And for example, for, say, on average, our long-term leases are probably six to seven years from inception, and the accounting return on equity in year one of that lease is less than 5%; while by the time you get to the end of the lease, it's 20% or more. And so just given the very large purchases we have made in the last two years, it is significant I think probably 40% or more of the book value of our fleet is less than 18 months old. So it has a relatively low accounting return associated with it. But again, as those units age and the portion of our fleet that's in that kind of 0 to 18 month old timeframe is reduced, we expect that the growth in lease revenue will get closer to the growth in our assets and you will see more contribution coming from the net of revenue less depreciation and interest.

Ben Hartford - Robert W. Baird

Okay. Understood. Great color. I appreciate it. If I could just back up -- if I look at the line items on the expense side, the equipment trading, direct operating and administrative -- the restatements, what drove those restatements? The adjustments prior-year?

Chand Khan

What we were trying to do is make sure that in the trading financial statements, we include all the costs associated with the purchase, which includes storage in some cases, SG&A to sell those equipments and the actual cost of that equipment. So all we've done is sort of grossed up the equipment trading expense line.

Brian Sondey

Right. So basically, as we've -- I think in the last quarter, we created a separate segment for equipment trading. And so we've gotten more detailed in terms of how we allocate our operating expenses like container storage and repairs, between the leasing business and the trading business.

And so for example, historically, before we had the trading segment, we would include storage on trading containers and repairs that we spent on trading containers in the general operating expense line. And so now I think going forward, and I guess we adjusted retroactively, we've taken out the storage expenses and repair expenses on the trading containers and put them into the cost of the trading containers.

Ben Hartford - Robert W. Baird

Okay. That makes sense. It looks like on your outlook you talked about a drop in disposal volumes. Can you talk about the trends over recent quarters? Maybe the distribution between the gains, breaking it down between volumes and price -- how should we think about that moving forward, as volumes trend down and how has it looked in recent quarters?

Brian Sondey

Yes, it's unfortunately a fairly complicated response to that question. I think we've been talking for a while now in our 10-Q's and 10-K's about how we expect ultimately our disposal volumes to go up, just due to the age profile of our fleet and the relatively large number of containers that we have that are 11, 12 years and older.

However, due to some of the actions we've taken in structuring our lease portfolio and just due right now to the very high demand for lease containers, we're actually not seeing disposal volumes really change very much. I think we've been around -- if you sort of look at the percentage of containers we are selling every year compared to the number of containers we had at the beginning of the year, it's kind of been around the 7% range on an annualized basis for the last three years or so.

I think it was a little higher, probably towards 8% in the second quarter on an annualized basis, of 2008. And all we wanted to highlight in the outlook is that we're seeing -- because of the high container prices and the constrained volume by our customers -- we're seeing our customers holding onto units even more than we thought. And our available inventory for selling containers that are owned by us -- and not the trading containers -- is dwindling, and went down fairly significantly in the second quarter. So we have a very low inventory of our own containers that we're going to sell in the third quarter, at least to start the third quarter.

And so we expect in the near-term, perhaps, that our disposal volumes will be down, below that kind of 7% annualized rate. But over time, eventually it's going to go up above that level, once our customers start to bring back those older containers.

Ben Hartford - Robert W. Baird

Okay, great. A couple of quick ones -- the 120,000 TEUs of containers, the generated lease commitments to date -- what was that number last year, for comparison's sake?

Brian Sondey

In total, in terms of newly purchased containers by the end of the year, I think it was right around 140,000 to 150,000 TEU over the course of the year.

Ben Hartford - Robert W. Baird

Okay.

Brian Sondey

And quite frankly, I don't have the number right now as of where we were in early August last year. But my guess is we're probably a little bit ahead of where we were last year but not sort of tremendously different.

Ben Hartford - Robert W. Baird

Okay. And then I think you gave ending utilization, ex-new off hire at 95.4. Do you have the average utilization for the quarter and the ending utilization as well?

Brian Sondey

Yes. So I mean, it's going to be -- all that stuff will be in the 10-Q that's going to come out at the end of the week. I'm just going to flip to that page for you --

Ben Hartford - Robert W. Baird

Sure.

Brian Sondey

If you exclude new units as we said, the ending utilization was 95.4% as of June 30 and the beginning utilization was 94.0. And so the average I'm sure is somewhere right around the average of those two numbers.

If you include the new units, you're now even higher, the average utilization for the quarter was 90.7% and the ending was 91.7%.

Ben Hartford - Robert W. Baird

Okay. Great. I think that's all I have. Thanks for the time. Great quarter.

Brian Sondey

Thanks.

Operator

Our next question comes from Art Hatfield of Morgan Keegan. Please go ahead, Mr. Hatfield.

Art Hatfield - Morgan Keegan

Thank you. Good morning, everybody. Most of my questions have been answered. And Brian, I missed the first part of your commentary and I may have missed this, but one of the issues that I think people have concern with is people are starting to see Europe slow down and obviously the U.S. has slowed down. I think that's brought a lot of concern into potential demand for containers. Can you talk a little bit about that and how you're actually seeing demand come into your business?

Brian Sondey

Yes, I say overall we've seen demand being quite strong this year. Trade growth, I think even given the actual problems in the U.S. and I guess the concern about problems in Europe so far, growth is still projected to be over 8% this year on a volume basis, which I think is pretty good for most industries.

In addition, as I mentioned in the prepared remarks, that we've -- one of the responses that the shipping lines have had to the increase in fuel costs is to basically slow steam their vessels. And for the Asia to Europe in particular, but also I think some trans-Pacific services, adding a ship to the strings and the combination of the slower steaming and reduced velocity of containers and more than sitting on the water, creates demand for containers above just the volume growth rate of containerized trade.

And the final thing we've seen that's supporting demand is that customers have been reluctant to buy large batches of new containers. I think the combination of the very high container prices and the operating guys not wanting to look foolish by buying at those prices if they fall, combined with the tighter capital markets, have constrained the buying behavior of our customers. And so we are seeing more of the demand go to leasing on a proportional basis, than we would have over the last couple of years.

And so the combination of the fairly still substantial volume growth plus the lower velocity of container turns plus the constrained buying of our customers have led to really strong leasing demand. We continue to see it today -- a lot of demand for our leased containers.

In terms of the recent feelings about Europe, there has been certainly a lot of talk in the financial press and so on about a slowdown of the major European economies. I'd say in talking with our customers, we get -- I wouldn't say people are very worried so far about the growth of the Asia/Europe trade, but perhaps an increased anxiety level right now than there was six to 12 months ago about the European growth.

We don't see exactly where the containers are going, but the one thing we do hear from our customers at least is that one reason why Asia to Europe trade has been so strong isn't necessarily just the growth of the economies in the U.K. and France and Germany; it is also because of the emerging consumer societies in Eastern Europe and the eastern Mediterranean, and also the Middle East, obviously, which have been -- it's really supporting the growth of that trade. And I don't think those things aren't necessarily directly related to economic cycles; they're more sort of fundamental changes in those societies.

Art Hatfield - Morgan Keegan

Thank you for that but when we think about the decreased velocity of ships, is there -- if we think about that going forward, is there a level that you know of or that your customers talk about oil getting to, where they'd start taking ships out of rotation. And if that is the case, does that potentially create kind of an imbalance between supply and demand down the road for containers?

Brian Sondey

Yes, I mean, it's a good question. I think when I first started hearing about the customers doing this, it was really probably toward the end of last year. I think oil at that point -- again, I'm not an oil trader, so don't quote me on this, but --

Art Hatfield - Morgan Keegan

Right.

Brian Sondey

I think oil at that point was below $100 a barrel. So I don't think -- the slow steaming wasn't a $140 a barrel kind of activity; it was -- it kicked in well below that. And I think, if I recall correctly, below where it is today.

In addition, I think one of the challenges for the shipping lines over the next couple of years is that the vessel capacity additions are likely to be -- are scheduled to grow at, say, 12% to 13% relative to, say, the volume growth of 9% or so.

And so I think the shipping lines in addition to getting a benefit perhaps on fuel economy also benefit by reducing effective capacity, if they kind of collectively all slow steam their vessels. And again, a lot of these guys are in alliances and to the extent that the alliance agrees to do things on a coordinated basis, that does also help them take capacity out of the market.

And so, again, we're not operating the vessels and it's hard for us to say exactly what the impact of this is, but I'd say very consistently, all of our customers are talking about it and they're still talking about it.

Art Hatfield - Morgan Keegan

Does that worry you, though, that if that changes direction, that there could be a significant imbalance of containers in the market?

Brian Sondey

It does happen from time to time. For example, in 2004, we got a lot of benefit from the congestion that was occurring in the ports in the U.S. and in Europe, and the land side, rail congestions in the U.S. And so in 2004, the shipping lines kept having to lease more and more containers because they couldn't get the containers through the domestic side of the trip and back to Asia.

And in 2005, the shipping lines were able to fairly effectively de-bottleneck and you did see, for awhile, an imbalance of containers. But I'll tell you, one of the things I like about the business overall is that we never see those imbalances in terms of absolute numbers last terribly long. That, I think we've discussed before, that the ordering cycle for containers is only a few months long.

And given the 5% or so annual disposal rate of the containers coupled with the minimum growth we have seen and the -- or at least the growth expectations in the 8%, 9% range, that even if we had a period where all of a sudden everyone decided to stop slow steaming the vessels and container turns accelerated, that would be absorbed pretty quickly, given the growth in disposals, and bringing the market back into balance.

And in '05, for example, we probably saw an imbalance of no more than, I don't know, two quarters.

Art Hatfield - Morgan Keegan

Okay. Have you heard anything -- any disruptions or anything more on the West Coast labor situation?

Brian Sondey

I don't follow it incredibly closely, but you read obviously what's said out there. And I guess my only impression is that maybe it's not going quite as smoothly as everybody hoped; that obviously the contract wasn't renewed by the deadline or expiration of the first. And there's some talk of -- if not a work stoppage, productivity decreases.

But that said, the growth in our market right now isn't really coming from the trans-Pacific route. In fact, from what I see, the volume are down at the West Coast ports. And so I don't think it's going to have a big impact for us unless it's quite a dramatic stoppage.

Art Hatfield - Morgan Keegan

Thank you. Hey, I appreciated your comments on the GAAP earnings impact on new containers. As you look at that, and I know you've addressed this but is it a slow progression on the impact on GAAP earnings throughout the life of the lease contract? Or is there an inflection point, say, in year three or year two, where the earnings step up?

Brian Sondey

It's pretty steady, because what makes it happen is, again, the lease revenue is straight-lined across the duration of the initial lease. And probably on average for us, again, that's six to seven years for new containers.

And so let's say if the average ROE we see in the initial six, seven-year period on a GAAP basis is -- I don't know -- 12% or something like that.

Art Hatfield - Morgan Keegan

Right.

Brian Sondey

It starts off at less than 5%, probably -- I don't know what it is, 3%, 4%, and grows to over 20%, and it's pretty much of a straight line from the beginning to the end.

Art Hatfield - Morgan Keegan

Okay. And so in essence, I mean, you're telling us that as you bring new containers in, you're locking in and improving GAAP earnings stream over the next five to seven years, depending on obviously, the life of that lease. Is there anything that can disrupt that improvement in the GAAP earnings over the life of that lease contract?

Brian Sondey

The reason we're seeing it is because we have an age profile of containers that's not even.

Art Hatfield - Morgan Keegan

Right.

Brian Sondey

And we went through a number of periods before we went public, when we were owned by [Aegon] and they weren't really investing, where we don't have a lot of containers that are in the four to eight-year age range. And so right now we have a disproportionate number of containers that are in the early stage of their life.

And so as the -- I think what I mentioned before is that something like 40% or so of our containers in terms of book value were purchased in the last 18 months. And as that portion of containers that are in that initial period decreases, just as we buy more containers over time and our age profile becomes more even, that will have the effect of improving the GAAP ROE on the leasing portion of the business.

Art Hatfield - Morgan Keegan

Okay. Thank you. That's all I have. Thanks.

Operator

The next question is from Greg Lewis of Credit Suisse. Please go ahead Mr. Lewis.

Greg Lewis - Credit Suisse

Thank you and good morning. Congratulations on a good quarter, guys. My first question is regarding -- and you touched on it briefly -- the bad debt expense was up quarter-over-quarter, and you mentioned that it's going to be clarified a little bit more in the 10-Q. Could you expand on that and provide a little color now?

Brian Sondey

Yeah. The bad debt expense was still pretty small; it was under $200,000 for the second quarter. In addition to that, though, we do talk in the 10-Q that there was an additional $300,000 or $400,000 of operating expenses that was included in the operating expense line, related to a recovery for a small customer. We had a small customer with, I think, like 600 TEU on-hire, something like that, that basically went under. And it's a pretty small customer. Again, we still had a very good quarter with all we think the economic hit from that customer fully reflected in the second quarter.

But it's just kind of is an example of something that we are worried about a little bit, that mostly our customers, I think probably 80%, 85% or more of our containers, are on-hire to the top 25 shipping lines. And these guys made a ton of money from really '03 to '07. And starting perhaps -- if this year is going to be more difficult or next year -- in very good financial shape. But we do have a tail of customers, like any business, that are smaller. And we do see perhaps a challenging market environment for them out there, with the combination of high fuel costs and then perhaps a difficult environment for them to try to pass that cost on, due to the large vessel additions that the big guys have made. And we haven't seen other customers talking about it. Our payment performance has been great. We haven't seen our DSOs trend out at all or anything like that. And so we haven't really seen a financial impact from this. It is just something we were concerned about. And so we just wanted to pass our concern along.

Greg Lewis - Credit Suisse

Okay, great. And then I am just to touch a little bit on the -- given the fact that container pricing, new container pricing is on the rise, and even your interest financing costs are on the rise, what sort of upward pressure, if any, have we seen on per diem rates?

Brian Sondey

Well, per diem rates have gone up a lot. I mentioned in the call, container prices are up, say, for example 35% compared to the middle of the fourth quarter last year. And our leasing rates are up over 40%, in terms of market leasing rates on new container transactions that are being done today. And it's a combination of the more expensive containers and the higher financing costs of the containers that are driving the leasing rates up. Over time though -- so far, though, we haven't seen a huge impact on our average lease rates because the number of container deals that we have done at the very high rates today is fairly small, compared to our overall fleet. And plus a lot of those containers that we've contracted for in the last couple of months haven't yet been picked up by the customers.

That said, we are very confident that if container prices stay where they are for an extended period, that you will begin to see our average lease rates begin to move up toward the market rate.

Greg Lewis - Credit Suisse

Okay, great. And then just lastly if you could touch on the debt a little bit on, I guess at the end of Q1, you had about $125 million of undrawn facilities for containers. At this point, how much is undrawn available to buy containers?

Brian Sondey

Yeah, we have, I think as Chand mentioned, right now we've got commitments to purchase containers that weren't reflected in the June 30th number, something around $100 million. And we have undrawn facilities to cover those containers, which will cover a lot of the balance of what we need for 2008.

As we look into 2009, though, we are going to have to raise new facilities to fund our 2009 growth. And actually, quite frankly, we are embarking on that process right now.

Greg Lewis - Credit Suisse

Okay. And when I look at, say, a net debt to capital ratio, right now it looks like it's towards the high end of where it's been for the last couple of years at around 76%, 77% net debt to cap ratio. What sort of level are you comfortable going up to?

Brian Sondey

I mean, I think -- our ratio has been right around 75%, 76%, I think for the last couple of years. I think that level is pretty comfortable for us. We've been -- if you look through our investor presentations that we do, we typically think of our business and our cash flow at growth rates in the sort of 10%, a little more than that range. And obviously we have been growing more like 20%. And that's had the effect I think of moving that debt to asset level up a little bit.

But at our sort of target growth rate and even at a little more than that, we see it being pretty stable and we're pretty comfortable where it is.

Greg Lewis - Credit Suisse

Okay, great. That's all for me. Thank you.

Operator

The next question is from Rick Shane of Jefferies. Please go ahead Mr. Shane.

Rick Shane - Jefferies & Company

Hey Brian. Thanks for taking my questions. A couple of things here, first of all, we have seen over the last three or four weeks a pretty sharp decline in terms of steel prices. Is that having any impact on new container prices at this point? Or how should we think about that going forward?

Brian Sondey

Yeah, there certainly is a pretty direct connection between steel prices and new container prices. And so if we see steel prices fall significantly, there's no doubt that that will ripple through to container prices. We've seen, for example -- I don't want to get into specific to the dollar, but -- we saw container prices in maybe late June, early July peak probably near $2,650. And they've -- our understanding is they've come down from there toward $2,500, I think reflecting a little bit of the backing off of steel prices over the last couple of weeks.

But they're still pretty high. And as far as we can see in terms of the price of core tin steel in China that it hasn't dramatically fallen yet, but obviously if it does, that would have an impact.

Rick Shane - Jefferies & Company

Got it. Next sort of conceptual question, then I have a couple just modeling details -- you've talked about the increase -- the 40% increase in lease rates and the relationship between container prices. We followed you guys since the beginning and the one thing that's sort of never been -- never come into place, utilization has improved; you've seen good portfolio growth; you've seen good demand -- there has historically, over the last three or four years, not been a ton of pricing power by the leasing companies. And now that seems to be developing. What do you think has changed that has caused that?

Brian Sondey

Well, I think what we've seen historically is the container prices kind of bounced around. And so if you go all the way back to '05, we were seeing basically container prices started going up in, I think, late '03 and were pretty firm all the way through the end of '05. And during '05, we were getting quarter-over-quarter average rate increases.

Unfortunately, at the end of '05 and into early '06, container prices fell significantly. And then they kind of bounced around, really, from early '06 they got to as low as maybe $1,600 and they kind of then bounced around -- they moved up from there fairly quickly, but perhaps varied between $1,800 and $2,000 between first quarter of '06 right through the end of last year.

And the fact that container prices didn't stabilize at a high level made it difficult for us to translate when container prices were high. If they're only high for a brief period of time, it's hard to translate that into our existing container lease portfolio. Because we can't really go to our customers and -- container prices have just peaked for just over the last few weeks -- we can't get them to accept that for our renegotiations.

On the other hand, container prices have been moving strongly and steadily up this year, and so there is more of an acceptance in the market that container price increases are not necessarily a short-term peak, but are more here to stay, at least for this year.

If we were to see a situation where container prices stay high from now all the way to next year, I think we'd have considerable pricing power, both in our new leases which we are seeing today, but as well as in our existing fleet of containers.

Rick Shane - Jefferies & Company

Okay, great. From a housekeeping perspective, can we just get the total number of containers in the fleet by units and by TEU at quarter-end?

Brian Sondey

Yeah, we'll have a detailed table in the Q showing that, breaking out between container type, by unit and TEU. But just the highlight number -- as of June 30, 2008, we had total numbers of containers of 711,000. Of that, 96% were owned and 4% were managed. In terms of TEU, we had 1.165 million as of June 30th with about 50,000 TEU managed and the balance owned.

Rick Shane - Jefferies & Company

Great. Thank you. That's very helpful.

Operator

(Operator Instructions). The next question is from Bob Napoli of Piper Jaffray. Please go ahead sir.

Bob Napoli - Piper Jaffray

Good morning, good morning Brian and nice job on the quarter. A couple of questions on your strategy around purchasing containers. As prices have moved up, your customers have pulled back for that reason and several others that you laid out very clearly. But I just wondered, are you pulling back on purchasing or is it your thought that we're in this industry, prices go up and we've got to continue to buy supply for our customers? Or are you pulling back some? What are your thoughts? How are you balancing your acquisition of containers as prices have moved up sharply?

Brian Sondey

Well, certainly when container prices are high, it increases the risk of buying. And what we do is when container prices are high, we focus very much on the leasing structure to make sure that we're getting as much back end protection as possible. And we always look whether container prices are low or container prices are high, we always have a life cycle model that we use to estimate the returns on our investments and lease transactions, that models in the first lease specifically and then has generalized assumptions for the re-lease and resale performance of the container.

And we tend to leave those as back end assumptions relatively constant, so that we're not -- say, when container prices are high, assuming that they're going to be worth more in 13 years, than we assume when container prices are low. And so by leaving those back end assumptions constant, we think, at least, where we're kind of making sure that we get the return we need as much as possible during the first lease.

And what that's meant for us this year in terms of structuring is that we've done a lot of our containers on very long-term leases, probably I'd say close to half are on leases that we expect to go for eight or more years. As well as we've been very disciplined on the logistics, making sure that if we do get these containers back at the end of the lease without a lease extension, that they're going to come back in our highest demand areas. And that really tends to win the day when it comes to releasing containers at any value.

And so we've just been really trying to manage our exposure like that. I think the difference for us is that we're in the business as a leasing company of wanting to invest and grow in our fleet. And so to some extent, as long as we're getting the returns that we need on our high container price investments, they're actually in some ways better because you're building your asset base and revenue more quickly.

I think the challenge for the shipping lines is that they don't look at containers necessarily as strategic assets. That's more of a cost of doing business. And I think just for the guys in charge of the operations, they run the risk of sort of looking foolish by buying containers at a very high price if the container prices happen to fall later. And while it's true that even if they lease containers at high prices, that we're fully capturing the value of that high price, but I think still, it's a safer bet for the operating guys to shift toward renting when container prices are very high, just from a perception's management standpoint.

Bob Napoli - Piper Jaffray

And the lease term, the average lease term, Brian, on new leases, is that -- where is that? And were you below five years before?

Brian Sondey

No, we've always been -- we've always had a philosophy that we want to be one of the easiest to pick-up, and relatively cheap to hold and have long durations and tight logistics and be hard to get out. And so I think our average lease durations are always probably well north of five years for new containers.

That said, I didn't calculate it specifically. But I'm just thinking the top of my head of several very large leases that we've done, where we expect the initial on-hire time to be eight years or more.

Bob Napoli - Piper Jaffray

The last question on the cycle, if you look at this industry in the last economic cycle, the last recession that we had here in the U.S. -- and I think it was more of a global recession than we've seen so far today -- but this industry did not do real well. What is different this time around? And what gives you confidence that in an economic slowdown, the industry will do much better than it did last cycle?

Brian Sondey

Well, I think the last cycle you're probably referring to is 2001 --

Bob Napoli - Piper Jaffray

Right.

Brian Sondey

Where we saw relatively slow growth in containerized trade. For the leasing industry, 2001 was a tough year. But it wasn't really because of the slowdown in trade growth. I think our trade growth was still, I don't know, plus 5% or so in that year. It had to do with I think the aftereffects of the Asia crisis, that -- with the Asian crisis in the late '90s, global logistics changed. And where containers had flowed fairly evenly around the world, after the Asia crisis, trade became highly imbalanced coming from Asia to the U.S. and Europe. And us, as well as a lot of other leasing companies, ended up with a huge portion of our containers sitting on the ground in the U.S. and Europe. And that was really not something that happened in '01, but happened in the late '90s. In 2001, we were still kind of digging out of that problem. We don't think -- I mean, despite, I think, the depreciation of the dollar and so on, we don't think the trade flows are going to reverse to the point where, say, our lease structures that are oriented around keeping containers in Asia are going to become inappropriate.

And so our view is, as long as trade continues to grow, as long as it continues to flow from Asia to elsewhere, that we're going to be in pretty good shape utilization-wise, regardless of what happens to trade growth, as long as it doesn't go significantly negative.

Bob Napoli - Piper Jaffray

Great. Thank you.

Operator

There are no more questions at this time. I would like to turn the conference back over to Brian Sondey for closing remarks.

Brian Sondey

Well, I'd just like to thank everybody for your continued interest in TAL. We look forward to talking with you soon. Thanks very much.

Operator

Thank you all very much for participating in the TAL results conference call. This concludes today's events. You may now disconnect.

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