Thursday, April 07, 2005

Case Study: Expensing vs. Capitalizing at Mobile Mini (MINI) (I)

In any capital-intensive business, such as in the telecom industry (think Worldcom) and real estate (e.g., REITs), management must decide how to allocate costs between current expenses and capital improvements. New fiber optics cables and new office towers, of course, are capitalized and become assets on the balance sheet, while repairs are expensed through the income statement.

The distinction between what constitutes a "repair" and what qualifies as an "improvement" often requires a judgment call on the part of a company's CFO and accountants. Sometimes, too, this discretionary power leads to outright fraud or "cooking the books," as was the case with certain "line items" that Worldcom improperly capitalized rather than expensed, in order to boost net income to meet pre-determined earnings targets and keep the stock price high--inevitably precipitating Worldcom's inglorious collapse. When REITs report quarterly earnings, management provides information on funds from operations (FFO) and capital expenditures, which may be either recurring or non-recurring. As the terminology itself indicates, there is plenty of room for obfuscation and connivery--since, strictly speaking, shouldn't the term "expenditures" mean an expense item that really should not be capitalized, and, particularly if a "capital expenditure" is "recurring," shouldn't it really be expensed rather than capitalized?

I bother to introduce this expensing vs. capitalizing debate because it has become a key issue in the trading of small-cap stock, Mobile Mini (MINI) (Disclosure: I am long this stock and considering taking profit on part of my position). Short-sellers have pushed Mobile Mini's short ratio up (see my March 7, 2005 post, "Waiting for the Short Squeeze"), even while the stock has risen over the past few years from a low of $10 (Oct-2002) to its all-time high around $40 today, on improving fundamentals in the portable storage container leasing market.

The company's basic reported financials for the past six years are:

(Dollar figures in millions)

Year: 1999, 2000, 2001, 2002, 2003, 2004

Income Statement
Revenues ($ mil.): 67, 90, 115, 133, 147, 168
Net Income ($ mil.): 9, 13, 19, 18, 6, 21
Diluted EPS ($): 0.85, 1.11, 1.34, 1.26, 0.41, 1.40

Lease Fleet (mostly steel containers)
Utilization (%): 86, 85, 83, 79, 79, 81
Units (thous.): 37, 55, 70, 84, 89, 101
Net Book Value ($ mil.): 121, 196, 277, 337, 383, 452
Net Book Value/Unit ($ thous.): 3.27, 3.53, 3.95, 4.03, 4.28, 4.49
YOY Change in Net Book Value/Unit: ---, 7.9%, 11.9%, 1.9%, 6.1%, 5.0%

Longs argue that Mobile Mini is a growth company with improving margins, whose business is now powering through a recovery following the recession that depressed fleet utilization and earnings in 2002 and 2003. In support of this view, management just last week raised guidance (to $1.80, from prior guidance of $1.72 for 2005 EPS), lifting the stock to a new high.

Shorts have a different view, claiming that earnings are being inflated through management's nefarious practice of capitalizing lease container-related "refurbishing" costs that really should be expensed each year through the income statement. The result, the short-sellers contend, is a lease fleet that is grossly overvalued on the books.

To resolve this dispute, we really need to understand the market value of the storage containers that comprise Mobile Mini's lease fleet. However, historical market price information for customized storage containers is not readily available (as least I do not know where to find it), and the variety of containers in Mobile Mini's lease fleet makes valuation difficult without having more specific inventory information.

Fortunately, since Mobile Mini also sells a number of storage units each year, it is possible to gauge the approximate market value of their lease fleet based on actual sales figures for the units that are sold. Using cumulative data that the company provides for sales from 1997 through each reporting year in their annual reports (10-K) for 2002, 2003 and 2004, I am able to back out average unit sales prices for 2003 and 2004:

For Lease Fleet Units Sold During Period: 1997-2002, 1997-2003, 1997-2004; 2003, 2004

Sales Revenue ($ mil.): 25.2, 28.6, 33.9; 3.4, 5.3
Net Book Value ($ mil.): 16.6, 18.9, 22.4; 2.3, 3.5

Number of Units Sold (thous.): 6.89, 7.93, 9.02; 1.04, 1.09

Average Sales Revenue/Unit ($ thous.): 3.65, 3.61, 3.76; 3.29, 4.86
Average Net Book Value/Unit ($ thous.): 2.41, 2.38, 2.48; 2.16, 3.21

Average Sales Revenue/Net Book Value: 1.52, 1.52, 1.52; 1.52, 1.51

During 2003 and 2004, the average sales prices for lease fleet units were $3,290 and $4,860, respectively. These units carried average net book values of $2,160 and $3,210, respectively, indicating average sales prices about 1.5 times net book value in both years. With year-end 2003 and 2004 average net book values of the company's entire lease fleet being $4,280 and $4,490 (vs. the lower figures of $2,160 and $3,210 for lease fleet units sold during these years), respectively, we can infer that during the past two years the company happened to sell units from its lease fleet sitting towards the lower end of the price spectrum. (Skeptics might doubt how the company just "happened to sell" units carried on the books at lower prices, pointing out how this raises the prospect that the company could be "cherry-picking" by selectively assigning sales to units with low, as opposed to representative, book prices, in order to realize gains and boost earnings. If this is the case, then the market value of the company's lease fleet might actually be quite a bit less than the 1.5 times net book value that the lease fleet sales data otherwise indicate.)

To summarize our evidence: According to the figures in the annual reports, units that the company sold consistently fetched prices much higher than (i.e., 1.5 times) net book value. Also, the company's 2002 annual report cites an appraisal dated January 2002, that assessed the fair market value of the entire lease fleet to be "in excess of 120% of net book value" (the company mentions that "An appraisal of orderly liquidation value was completed in September 2002" but does not detail the results). Further, last year's sharp run-up in steel prices only works to enhance container prices and the value of the lease fleet. The preponderance of evidence, then, absent intentional false reporting by the company, indicates that the lease fleet carries a net book value that, instead of being overvalued, could be conservatively low.

Frankly, I think that the shorts are wrong. It is possible that management has a practice capitalizing certain items that really should be expensed, but one could also argue that, if management were to mark the value of their lease fleet to market, they would more than recoup whatever net income they would lose through expensing rather than capitalizing certain lease fleet costs.

Unless steel and container prices collapse, or the margins that the company realizes on its lease fleet sales relative to net book value begin to fall, or it becomes evident that management has improperly reported their financials--none of which I see as imminent--my educated bet is that the longs will win the war (just as they have been consistently winning battles on the way up from $10 per share). Given the rumor that a single hedge fund is behind more than 85% of the outstanding short of 1.7 million shares (12% of float), the fireworks at the longs' victory party will commence if (or when?) continued improvement in Mobile Mini's earnings force this lone hedge fund, ever so humbly, to run for cover.


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