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Essex Rental Corp: A Very Cheap Way To Play Increasing Construction Activity

|Includes:Essex Rental Corp. (ESSX), HEES, URI

Essex Rental Corp (NASDAQ:ESSX) is an asset rich equipment rental company that is has massive earnings leverage to an improvement in construction activity. ESSX's business is similar to United Rentals (NYSE:URI) or H&E Equipment (NASDAQ:HEES) Essex's recent results are showing that a new cycle in construction activity is well underway, which will continue to benefit ESSX in 2013 and 2014. There is also a large margin of safety in this investment since at $3.03/shr ESSX trades below its orderly liquidation value (OLV) of $5.87/shr. OLV is a measure of what ESSX's lenders think their assets would be worth if they were sold.

Essex is currently under selling pressure as its legacy private equity owner has distributed shares to its LPs. This has happened twice before this year and both times have represented an attractive entry point for ESSX.

As demand continues to return, driven by a new 2 yr highway bill passed in July and an increase in non-residential construction activity, ESSX can rise to $8/shr by the end of next year, more than double today's price.

Company Background:

Essex Rental Corp is one of North America's largest rental companies focusing just on heavy lifting equipment. Essex has a rental fleet of over 1000 pieces of lifting equipment and attachments. Around 70% of the value of their fleet is composed of crawler cranes, which are the largest category of cranes and are primarily used in large infrastructure and industrial projects. The remainder of their fleet is comprised of rough terrain, tower and boom truck cranes.

Essex was brought public in 2007 as a blank check company, completing the acquisition of Essex Crane Rental Corp in 2008. Essex Crane Rental focused exclusively on renting crawler cranes and was founded in 1960.

In November 2010 Essex bought Coast Crane Company out of bankruptcy for ~$92mln. Coast's assets are focused on smaller cranes such as rough terrain, tower and boom trucks in the west coast. Coast also has a new crane distribution business and a parts and service business.

These two businesses do not have any asset overlap and the merger allows Essex to participate in a broader portion of the rental cycle, as the Coast assets are earlier cycle compared to Essex's assets. The parts and service business will also provide some diversification to their legacy crawler crane business. At its peak Coast generated around $25mln of EBITDA annually, while ESSX generated $45mln.

Recent Operational Results & Industry Trends:

Essex's business experienced a fall off in demand during 2009-10 as commercial construction and large industrial projects wound down. Monthly rental and utilization rates fell to ~$15K and ~40% in 2011 from $21K and 77% during 2008. This resulted in EBITDA margins falling from ~50% in 2008 to ~6% in 2011. The business is now showing signs of recovering, utilization rates in the last quarter rose 400bps y/y, and improved every month in the quarter. Rates also rose, improving 10.7% y/y. Rates have a long way to go, they are still 35% off their highs and 92 cents of every dollar of price drops to EBITDA. EBITDA margins improved to 20% in Q3 from 14% last quarter and 10% last year, though still way off their high of 50% in 2008.

Essex's end markets are driven by large project work such as bridges, power plants, and refineries. Their largest end market is transportation at 28% of sales, followed by industrial at 22%. The two year bill passed in July 2012 will help large highway construction projects going forward even though it is not a typically 5 year bill. In addition an increase in general construction activity will benefit the acquired Coast Crane assets which are earlier cycle relative to Essex's legacy crawler cranes.

Essex's management team believes that their asset base lags the asset base of diversified rental equipment companies such as H&E equipment and United Rentals by 6-12 months. Given the improvement that both of those companies are currently experiencing in demand for light construction equipment and the improvement in Essex's bookings 2013 will continue to see utilization and rate improvement across Essex's fleet.

Earnings potential:

Essex is currently under earning due to its depressed end markets. To get an idea of what the company is capable of earnings in a recovery, in the last cycle Essex had EBITDA margins in the high 40% range. EBITDA peaked in 2008 at ~$45mln (53% EBITDA margin). Coast Crane had average EBITDA of ~$17mln thru the last cycle, and peaked at $25mln. In a continued economic recovery I believe that Essex could earn ~$72mln in EBITDA by 2014. This estimate reflects a recovery in the legacy crawler crane rental business and the earnings from the ~$20mln in new fleet investments Essex made in Coast's fleet in 2011. The $20mln in new Rough Terrain Cranes are currently experiencing a higher utilization rate compared to Essex's legacy crawler fleet (~60% vs. 40%) and will contribute more quickly to earnings recovering.

Significant Free Cash Flow Generation:

Unlike most rental companies that have to put significant capital into their fleets as activity rises, Essex will not have to make large capital investments in an up-cycle. This is due to the long asset life (~50yrs for crawler cranes) and the newer fleet that Coast has. Essex also will be able to continue to generate cash from the $20mln worth of excess crane capacity that they have targeted for sale over the next few years. This will result in minimal net capital expenditures. I believe Essex could generate ~$1.26 of FCF in 2013 and ~$2.43 of FCF in 2014 due to the strong conversion on EBITDA to FCF.

Essex will also not pay any cash taxes at the Federal level for many years due to the $113mln Federal NOL the company had at the end of 2011.

Stable Asset Base:

Essex's asset base is appraised by its bank group every quarter to determine the amount of revolver capacity that they can have. They create a value based on what they think the fleet would be worth if it were sold in an orderly manner today (Orderly Liquidation Value). Today Essex has an OLV that works out to $5.80/shr once you subtract debt and add the cash they have. I believe this is a conservative valuation of what the company is worth because it was done by a bank group who should be naturally conservative. The company also has historically sold assets around ~120% of OLV, indicating that OLV is a conservative valuation relative to market values. OLV should also be stable given the long economic life of the asset base. Thru Q312, they have sold $15.8mln of excess fleet inventory at 109% of OLV. Crawler cranes also have a very high steel content (70% of value) which provides another layer of stability to the asset's value. Simply put the functionality of what Essex's assets do (lift heavy stuff) has not changed over the last few decades but the cost of making a new crane has. This input cost inflation helps support the valuation of used cranes and thus Essex's fleet.

Price Target:

There are three ways to look at Essex's valuation, OLV, EV/EBITDA and P/FCF.

I believe Essex could trade at 5.5X 2014 EBITDA given where companies in the rental industry currently trade. This results in an $11.64/shr target by the end of 2014 on 2014's capital structure. Discounting that target back at 15% for 2 years yields an $8.80 target.

If Essex would simply trade at its OLV the stock would be at $5.80/shr right now. I view this as a floor valuation for the company given its historic ability to realize fleet sales in excess of OLV. Replacement cost for the assets is estimated to be around $600mln or $15.50/shr. As a base for comparison URI and RRR have traded between 120%-200% or OLV over the past 10 years, so it is not unreasonable to have the company trade at a premium to OLV.

On free cash flow of $2.37/shr in 2014, Essex could trade at 4X that (HEES & URI are 3-4x 2014 FCF). Discounting back ($9.74) two years at 15% arrives at a $7.36 price target.

Variant view:

I believe investors are currently overlooking this company due to its small size and current low level of earnings. Investors have fully embraced the recovery in the shorter cycle equipment rental companies, but haven't looked far enough out to care about this company. This has created the opportunity to a free option on the continued recovery in construction spending while having a large margin of safety due to the price being below OLV.

Disclosure: I am long ESSX, URI.