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Summary:

We believe TAL's stock price is set to decline significantly because earnings will fall at least 20% short of consensus estimates for structural reasons.

Additionally, the Company could also face a credit crunch forcing it to cut its dividend if global trade growth is weak.

Thesis:

• Revenue disappointments:
  • Revenue and earnings will decline as TAL's boom-time leases (for containers 2010/2011) reset significantly lower over the next 6-36 months.
  • CAPEX spent is generating less EBITDA than it did historically, exacerbating the rent-roll issue.
  • Compounded by margin pressures
    • Accounting changes are turning into headwinds & legacy accounting benefits are depleted

What we find most compelling about this thesis is the structural nature of these issues.

Kickers:

If global trade slows, TAL will face falling revenues with inversely related costs (storage and refurb), need to cut or elimiinate the dividend, and will likely breach covenants. Even without a recession, we believe TAL needs to issue equity to sustain their dividend. If TAL doesn't get in front of this problem, they will lack the capital needed to continue deferring taxes and face a $336m tax bill.

Basics:

Stock Price: $57  

Mkt Cap / EV: $1.92B / $4.67B

Net Debt: 2.82B net debt (includes cash, fv of deriv asset/liab, and equip purch payable)

Leverage Metrics: 5.6x gross leverage; 5.2x net leverage

Avg Daily Volume:  372K shares (~$20.5m)

What's it worth?

• P/E valuation: $32.50
  • $3.25 2014E (detailed below)
  • 10x (historical range is 7-13x)
  • Replacement Value: $22.75
    • Tangible book + 50% of DTL
    • EBITDA: $30
      • $520 Adj EBITDA (detailed below)
      • 7.5x multiple (historical range is 6-8x)

Background:

TAL International owns dry, refrigerated, and "special" containers that it leases to global liners on leases with initial terms of 3-6 years. The dry freight containers are used for general cargo, refrigerated containers are used for perishable items, and special containers are used for heavy and oversized cargo. Global liners typically own 40-60% of their fleet and lease swing capacity from TAL and its competitors.

This is a classic commoditized boom-bust business where orders can be delivered in 1-3 months but last for 12-15 years. Despite the risk, container lessors haven't suffered a sustained period of difficultty since 1997-2002[1]. However, container leasing companies are starting to feel the hangover effects after the boom time the enjoyed from 2010-1q12.

Why 2010-1h12 was so good to container lessors:

(1)   Trade rebounded sharply to absorb their excess containers

(2)   Excess of containerships prompted slow-steaming, effectively reducing the supply of containers

(3)   Container manufacturers were offline, so supply took some time to catch up to demand

(4)   TAL's customers were capital constrained from containership orders and couldn't tap debt markets, but didn't default

(5)   Steel prices rose meaningfully, effectively increasing the replacement value of containers

Why now is a terrible time for container lessors:

(1)   Trade growth is tepid, but there has not been any rationalization of supply

(2)   the full effects of slow steaming have been felt and acceleration of ship speeds is a risk to TAL

(3)   Manufacturers caught up to demand, added capacity, and can deliver containers in less time than ever

(4)   TAL's larger customers have recovered, allowing them to borrow more cheaply (CMA CGM and Maersk bonds)

(5)   HRC Steel prices in China (the primary input for containers) are down 30% from the 2011 peak.

Below is the Shanghai container throughput growth (SHPSCYOY on Bloomberg) which clearly shows the strong rebound in 2010 and 2011, followed by more tepid growth since early 2012.  See appendix for additional details and charts.

Key Issues:

1. 1.                  Revenue (and earnings) will decline as TAL's above-market leases are reset

Key point: When TAL's high-priced leases expire, they will reset to significantly lower levels.

TAL disclosed that their leases were above market in the 10K:

"New container prices were exceptionally high during 2011 and market leasing rates reached recent historical peak levels in the first half of the year. In 2012, lower new container prices and very low interest rates for financing structures used by leasing companies to fund new container purchases caused market lease rates to decrease from peak 2011 levels, and our average dry container lease rates held fairly steady in 2012, excluding the impact of sale-leaseback transactions. Lower new container prices and widespread availability of attractively priced financing for container leasing companies continue to pressure market lease rates, and market lease rates for dry containers are currently below our portfolio average. Because of this, we expect our average dry container lease rates to decrease slightly in the first part of 2013 as new units are picked up on lease." (TAL 2012 10K, page 41)

...and lease rates have only gotten worse with average per diem rates falling approximately 5% year over year in each of the last five quarters. However, a 5% decline understates the decline in rates because only a portion of TAL's leases roll-over each year. The incremental revenue per incremental CEU is more indicative and by that measure, TAL's rates have fallen by more than half:

What's especially concerning about TAL's decline in incremental rates is that the Company's high priced leases have only just started to expire. The lower incremental per diem is mostly a function of the company adding lower per diem leases than it was able to in 2011. When the high priced leases begin to roll, we could actually see declines in revenue despite additions to the fleet.

TAL's November 2013 investor presentation directionally confirms the decline in average rates (including sale-leasebacks, the decline would be more severe):

TAL's initial lease terms are typically 3-7 years, so the "historical peak " leases struck during 2010/11 will start to expire in 2014 and continue to cause problems for several years. Based on checks with private market operators, lease rates have been ~40-50c/TEU over the last year and remain towards the low end of that range. However, this is not because the container market is depressed and poised for a rebound. As TGH (TAL's largest competitor) is quick to say, there isn't necessarily a glut of containers. Rather, the decline in rates is really just a normalization from the 2010-1H12 boom, so rates should remain low.

As such, we don't think there is a much risk of rates returning to the ~75c/TEU per diem. Those leases will steadily expire over the next three years causing TAL cumulative revenue headwinds of ~23% on it's existing assets (57% of fleet * 40% decline in rates). These declines won't occur all at once, but the headwinds build on one another year after year as more high-priced leases expire.

1. 2.      Cap Ex is not packing the punch it once did

Key point: TAL's CAPEX is translating into less EBITDA than before, making estimates difficult to achieve.

Sell-side analysts get excited about TAL's ability to add revenue/ebitda/earnings via fleet CAPEX, but if those analysts looked at whether the CAPEX translated into EBITDA and cash flow, they would be much less excited.

The table below shows TAL's EBITDA growth as a function of CAPEX. As you can see, TAL is having to spend increasing amounts to get the same EBITDA contribution. This makes consensus earnings difficult to achieve, even if TAL had the balance sheet capacity to make the investments (which we question).

1. 3.      Recent accounting changes are turning into headwinds & legacy accounting benefits are depleted

Key point: Accounting changes reduced depreciation. Since TAL is also recognizing gains on sale, the company is effectively double-dipping. Those tailwinds are nearly gone though and create headwinds for 2014 and beyond.

TAL pulled multiple accounting levers, the most glaring being changing the residual value estimate. TAL depreciates its leasing equipment over 12-20 years on a straight-line basis. When an estimate changes, the remaining depreciation (to the new residual) is straight-lined over the remaining life. Below the table TAL put in their 10K to summarize the changes:

Two examples highlight the benefit:

• Example 1: 20' dry container purchased for $1400 on October 1, 1999
  • Total depreciation expected at purchase date: $650 (1400 - 750), or 50/yr
  • On Oct 1, 2010, this container had a carrying value of $900 and remaining depreciation (before the change in estimates) of $150.
  • Beyond October 1, 2010 accounting change, there is no longer any remaining depreciation and TAL will operate the asset for two more years without any depreciation costs.
  • So by making the estimate change, TAL was able to create $50/year of earnings from this container.
  • Example 2: 20' dry container purchased for $2050 on October 1, 2001
    • Total depreciation expected at the purchase date: $1300, or 100/year
    • On Oct 1, 2010, this container had a carrying value of $1150, remaining life of four years, and remaining depreciation (to the original estimate) of $400.
    • Starting Oct 1, 2010, depreciation declined to $62.50/year (1150-900=250 / 4 years)
    • On Oct 1, 2012, the container had a carrying value of $1025, remaining life of two years and remaining depreciation of $125 (before the second change).
    • From Oct 1, 2012 to Oct 1, 2014, this container will have depreciation of $12.50/year.
    • By making the first change, TAL "earned" $37.50 more from 4q10-4q12 on this container than it would have without the change. Then from 4q12-3q14, TAL "earned" $50/year more than it would have otherwise.

The magnitude of these changes is substantial. Taking the two residual value changes together, we see that TAL increased pre-tax earnings by approximately $37.8m:

On a related note, TAL recognizes gains on the sale of leasing equipment as on-going operations (negative operating expenses).  TAL has historically generated significant gains on sale because they purchased the initial fleet in 2004 and made additional purchases when box and steel prices were lower than in 2008 or 2010 and beyond.

By increasing the residual value, TAL is taking potential gains away from future periods in the form of lower depreciation today.  However, since TAL is recognizing gains on sale while not replenishing that reserve for future periods, they are "double-dipping".

TAL's double-dipping days are numbered on both fronts though. First, the depreciation is most impacted right after the accounting change. As the company sells fully depreciated assets and adds un-depreciated ones, the rate reverts (partially) back to the rate before the change in assumptions.

Second, TAL's gains on sale are rapidly declining for several reasons:

• the market for used containers has normalized
• the company has fewer units from its initial purchases that were depreciated to levels even lower than pre-4q10
• the cost basis continues to rise towards the new residual value assumption.

The gains will continue to diminish and very well could turn into losses because TAL is likely still selling units with $900 or lower basis (since older ones got to net values below the new estimate and older containers are usually sold first).

As a sanity check, we have looked at the historical rate of depreciation relative to gross PPE (below). This paints a clear picture -- depreciation took a step function down in 2010 and 2011 as a result of the change. When depreciation started to tick back up, the company again changed the assumption, but still faced a higher rate for 2012 than 2011.

Unless the company changes residual value assumptions again, we expect 2014 to be higher than 2013 and steadily work back to approximately 6-7% annualized (we only assume 5.25% for 2014). We do not think the company is likely to change residual value assumptions again because gains on sale are waning (and driven by legacy fleet that has a much lower carrying value.

We arrive at 6-6.5% with the calculations below:

What does it mean for earnings?

In the table below, we provide our estimates for 2013 and 2014. Relative to BAML's estimates, we differ primarily on:

• Operating lease revenue
  • We are $20m lower
  • We model the rate from the bottom-up based on current incrementals. We believe this is still generous because current incrementals do not yet capture the significant rent roll problem ahead.
  • Street analysts assume a yield (above actual) assume no decline in base ex-disposals 
  • Depreciation
    • We are $23m higher
    • Street doesn't understand how the residual value change aids the first year and then partially reverts
    • Gains on Sale
      • We are ~$30m lower
      • Street doesn't appear to realize that (1) ASPs have fallen and are likely to continue (per mgmt), (2) basis for the sales will be higher as a result of the higher residual value and (3) TAL has basically run out of very low basis units

1. 4.      TAL needs to issue equity to sustain their dividend.

Key point: TAL will not be able to cover their dividend at a 10% asset growth rate

While we disagree with TAL management and analysts that the tax liability should be ignored (addressed later), even if the deferred tax liability is ignored, we believe TAL is not able to cover their dividend under this scenario unless they issue equity. This is critical because the dividend is the crux of the bull case for TAL.

The table below is how TAL presents their cash flow incorporating our 2014 estimates:

We will write a follow-up discussing why TAL's DTL is a large and increasingly timely problem.

Valuation:

We laid out our assumptions and estimates above for 2014, so the metrics below should be self explanatory.

One important comment on valuation -- TAL's gross PPE is ~$2156/TEU which corresponds to current market prices.  Therefore, we believe tangible book value is a good approximation of replacement value. As you can see, even excluding the entire DTL (which we'll touch on in a follow-up), TAL is currently trading at 2x replacement value.

Catalysts:

• Missing revenue estimates
• Negative rent-roll
• CAPEX not generating the EBITDA that
• Missing EBITDA
• Estimates for gains on sale (recognized as negative opex) are too high and don't incorporate the higher residual value that will start going through as the basis.
• Missing EBIT by even more than EBITDA because:
• Container market softening - falling utilization and rates working into #s
• Customer defaults       
• TAL and peers have incurred losses as a result of customers defaulting.
• Given some high-priced leases and depressed shipping rates for the liners, we could see more defaults.
• Almost as important, TAL could lose the revenues from above market leases being reset even sooner than we expect.           
• Further out:
• Potential for DTL unwind (not near term)
• Dividend cut (if they don't raise equity)

Appendix

Average speed of containerships - no longer declining.

The slowdown of ships has been a boon to container lessors by reducing the number of turns a container can do in a given year. As such, more containers were needed to move the same amount of goods. The speed of ships is no longer declining however, and an acceleration would release a significant number of boxes.

Below is the domestic hot rolled steel sheet spot price in China. This and the cost of credit are by far the largest drivers of newbuild pricing and lease rates. Both input costs are low and indicate rates are unlikely to recover soon (particularly with excess inventories sitting at ports).

• Missing revenue estimates
• Negative rent-roll
• CAPEX not generating the EBITDA that
• Missing EBITDA
• Estimates for gains on sale (recognized as negative opex) are too high and don't incorporate the higher residual value that will start going through as the basis.
• Missing EBIT by even more than EBITDA because:
• Container market softening - falling utilization and rates working into #s
• Customer defaults       
• TAL and peers have incurred losses as a result of customers defaulting.
• Given some high-priced leases and depressed shipping rates for the liners, we could see more defaults.
• Almost as important, TAL could lose the revenues from above market leases being reset even sooner than we expect.           
• Further out:
• Potential for DTL unwind (not near term)
• Dividend cut (if they don't raise equity)