McGrath RentCorp Resoundingly Busted Its Trend
Summary
- When my investment club researched McGrath RentCorp last summer, we were drawn to many things but were not impressed at all with its dividend growth rate.
- As transforming DGI investors, we consider valuation, yield and a clear potential for dividends to grow in our GRAVY model.
- Though McGrath had not been growing its dividend at a healthy rate, we saw there was indeed clear potential for its five-year trend of just 2.1% to be broken.
- Between its focus and performance on ROIC, tax reform and improving industry outlooks, McGrath resoundingly busted the trend.
In November, I embarrassingly confessed my investment club had “chased” an investment in McGrath RentCorp (NASDAQ:MGRC) in September 2017. In hindsight, our interest in the business-to-business rental equipment provider emerged just in time. Its share price has not dropped below the $40 mark since we invested. Furthermore, McGrath reported healthy full-year results on February 27th as well as optimistic projections for 2018.
Recent Results
Typically, McGrath experiences a seasonal impact in the fourth quarter. But, the last quarters in 2016 and 2017 did not follow suit. Rental revenue sequentially increased quarter to quarter in both years with the most recent quarter hitting $77.7 million. Based on information provided in the third quarter, full-year revenue was expected to top $460 million and EPS approach the $2.00 range. Full-year revenue totaled $462 million and earnings per share, exclusive of the tax reform impact, barreled through the $2.00 range.
The impact of tax reform was significant for McGrath. The following table details several views for consideration.
Actuals Reported YE 2017 | Based on 2017 effective tax rate | Based on 2018 effective tax rate | Projected 2018 | |
Income before provision of income taxes | $83.45M | $83.45M | $83.45M | $90M - $92M |
Effective tax rate | -84.40% | 38.70% | 27.00% | 27.00% |
Tax Provision | $(70.47)M | $32.3M | $22.53M | $24.3M - $24.9M |
Net income | $153.92M | $51.15M | $60.92M | $65.7M - $67.3M |
EPS per diluted share | $6.34 | $2.11 | $2.51 | $2.68 - $2.75 |
Outstanding Share Count | 24.27M | 24.27M | 24.27M | Midpoint 24.5M |
Source: Author-created from company data
While tax reform was an external contributor, the company's focus on ROIC was well within its control. Efforts began in early 2016 when the key performance metric fell below 5% at year-end 2015. Results from the first year would take time to flow through the business but were expected to have long-term impact. By year-end 2017, the ROIC metric had, indeed, improved 139 basis points.
| Operating Profit (less Taxes) | Total Assets | Cash | Total Liabilities | Long-term Liabilities | ROIC | |
2015 | $66,377 | $1,152,549 | $1,103 | $772,862 | $381,281 | 4.30% |
2016 | $66,931 | $1,128,276 | $852 | $733,989 | $326,266 | 4.36% |
Proj 2017 | $83,452 | $1,147,854 | $2,501 | $623,670 | $303,414 | 5.69% |
Source: Author-created from company data
“Our ability to grow operating profit 20% for the year with fleet growth of 2% shows that our efforts in improving the financial returns on our invested capital base were a solid success.”
The Investment Thesis
Initially, McGrath RentCorp bubbled through my investment club's DGI filter. Our strategy is based on our self-defined GRAVY criteria for dividend growth investing - “GR” owth “A”bility, “V”aluation and “Y”ield. We strive to invest in healthy, fairly-valued dividend-payers with clear potential for dividend growth.
McGrath Rentcorp operates a fairly simple business model - invest, rent then sell or dispose. Approximately 63% of McGrath's revenue is derived from rental agreements. The company also sells used equipment and provides services associated with rentals for the remaining portion of revenue. It operates three primary businesses – Mobile Modular & Portable Storage, TRS-Ren Telco and Adler Tank Rentals.
Mobile Modular & Portable Storage provides temporary office buildings, temporary classrooms and portable storage units. The segment contributed half of McGrath's revenue in 2017. TRS-Ren Telco contributed 23.4% of the company's revenue in 2017. It rents general purpose test equipment and communications test equipment. Adler Tank Rentals contributed the remaining revenue. Adler provides both solid and liquid containment solutions.
Because the company invests in equipment other companies are hesitant to purchase or have no need for long-term, it relies on credit to operate. As of year-end 2017, McGrath had invested $1.35 billion in rental equipment. After depreciation, the book value on this equipment is $862 million. Yet, the company's long-term debt obligation totals just $303.4 million. McGrath still has the ability to borrow $248.5 million based on its lines of credit to improve or maintain its fleets. The company's debt level is an important factor to my club because it could impact McGrath's ability to grow its dividend rate.
In February 2017, McGrath officially joined the ranks of Dividend Champions by bumping its dividend for the 25th year. My investment club's DGI criteria encompasses more than just a growing dividend. We consider the rate of growth.
Since 2010, McGrath had bumped its dividend rate by just $0.02 per year. Even after 2011, when results exceeded expectations and hopes for 2012 were running high, it maintained a $0.02 increase. This proved to be beneficial as turbulent times ensued shortly thereafter. Still, when we considered investing in McGrath in 2017, we fully expected it was time for the company to bust its five-year average growth rate of a measly 2.1%.
Hope Fulfilled
Busting that five-year growth trend on the dividend rate is exactly what happened. With its reporting of full-year results, McGrath boosted its annual dividend rate 31%, marking the 26th consecutive annual increase.
“The improved company performance and anticipated earnings and cash flow benefits from Tax Reform support the 31% dividend increase announced.”
At $0.34 per share per quarter, the annual rate increases to $1.36. Based on projected earnings for 2018, the rate should equate to a payout ratio of approximately 50%. McGrath's five-year average payout ratio is closer to 57%. Thus, the stability of this rate could be deemed solid.
Long-Term Outlook
The Mobile Modular segment's continued growth prospects should be supported by a robust construction environment. Infrastructure spending should also support the need for modular building rentals. As well, demand in the segment's primary market for temporary classrooms and educational space should continue. In 2017, 26% of the company's consolidated revenue was comprised of rentals and sales to this market. Geographically, McGrath is the primary supplier of modular buildings in California and a top supplier in both Florida and Texas.
TRS-RenTelco's general purpose equipment is used in high-growth industries such as aerospace, defense, electronics, industrial, research and semiconductors. The build-out of 4G networks and eventually 5G networks fuels the need for its communications test equipment.
Adler Tank Rentals' containment solutions are notoriously associated with the oil and gas industry though there is demand from other industries. In the past few years, pressures in the oil and gas industry found E&P firms stalling drilling and completions while upstream, midstream and downstream players cut costs by renegotiating contracts and tightly managing rental equipment. Recovery in this industry should eventually favor Adler Tank Rentals.
Summary
Outrageous growth is not likely on the horizon for McGrath RentCorp so it would be ludicrous to expect dividend growth of 31% annually going forward. Rather, this bump should be considered in context – as the result of a) the company's focus on ROIC and improved performance, b) the benefits of tax reform and c) the stability of potential growth opportunities in the markets served by the company's rental equipment.
As well, should McGrath return to a steady dividend growth rate for the next few years, it should not be construed as failure or fear. This most recent increase is a testament to the company's intent to reward shareholders when circumstances permit.
This article was written by
Analyst’s Disclosure: I am/we are long MGRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
I belong to an investment club that owns shares in MGRC.
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