How Depreciating Assets CAN Rise in Book Value (IV)
One of the concerns that bears raise about Mobile Mini's balance sheet is that the net book value per unit (i.e., average net book value per container) of the company's lease fleet keeps on RISING in value, even though the lease fleet consists of depreciable portable storage containers whose net book value instead should be FALLING over time. The implication, according to the short-sellers, is that the company is capitalizing costs that really should be expensed.
To understand how the lease fleet can both depreciate AND rise in book value, we need to look carefully at period-to-period changes in the composition of the fleet. Referring to the 10-Ks for 2002, 2003 and 2004, I summarize cumulative changes in the lease fleet over the past three years:
Item: Book Value = Number of Units x $/Unit
Lease Fleet at Dec. 31, 2001: $277.0 mil. = 70,070 units x $3,953/unit
Purchases: $23.9 mil. = 14,764 units x $1,616/unit
-Steel: $92.1 mil. = 12,408 units x $7,420/unit
-Wood: $46.1 mil. = 2,267 units x $20,351/unit
Refurbishment and Customization:
$46.0 mil. = $29.4 mil. + 6,291 units x $2,639/unit *
Other: ($1.2 mil.) = (358 units) x $3,366/unit
Sales: ($12.6 mil.) = (4,813 units) x $2,624/unit
Depreciation: ($19.5 mil.)
Lease Fleet at Dec. 31, 2004: $451.8 mil. = 100,629 units x $4,490/unit
[* I allocated the $46.0 mil. total cost as follows: $29.4 mil. for refurbishment and customization of 28,769 units (at $1,023/unit), plus $16.6 mil. for the 6,291 additional units (at $2,639/unit) resulting from splitting containers into shorter ones and moving units from finished goods to lease fleet. I select this allocation to achieve self-consistency on an average per-unit basis: cost of purchased units ($1,616) plus refurbishment cost ($1,023) equals cost of additional unit ($2,639) from refurbishment process.]
During the past three years, the company's lease fleet has increased from about 70,000 units at year-end 2001 to about 101,000 at year-end 2004. The additional 31,000 units are accounted for as follows:
1. Purchases and Sales: The company purchased about 15,000 units for $24 mil. ($1,616/unit) and sold about 5,000 units for $13 mil. ($2,624/unit).
(Net: 10,000 additional units)
2. Manufactured Units: The company added two types of manufactured units:
a) steel containers, storage-office combo units and security offices ($92 mil. spent on 12,400 units, at $7,420/unit), and
b) new wood mobile offices ($46 mil. spent on 2,300 units, at $20,351/unit).
(Net: About 15,000 additional units)
Note that these new manufactured units are considerably more expensive than the generic used ISO shipping containers that the company purchases.
3. Refurbishment and Customization: The company refurbished about 29,000 units already in its fleet, a process that generated about 6,000 additional units.
(Net: 6,000 additional units)
Now, having detailed all of the sources of additional lease fleet units, we can examine how the various components have contributed to changes in net book value per unit:
Year-End 2001: $3,953/unit
Component: 3-Year Change in Net Book Value (% annual change)
Depreciation: -$278/unit (-2.4%)
Refurbishment and customization: +$277/unit (+2.3%)
Purchases, sales, other: -$350/unit (-3.0%)
Manufactured units: $946/unit (+7.4%)
Year-End 2004: $4,490/unit (+4.3% annual)
This component analysis shows that:
1. For a hypothetical "static" fleet (i.e., no additions, subtractions or refurbishment of units), the net book value per unit would have fallen from depreciation by about 2% per year;
2. Refurbishment and customization have contributed about 2% per year to net book value per unit, essentially offsetting the impact of depreciation;
3. Driven by purchases of containers occurring at prices ($1,616/unit) below the average net book value per unit (around $4,000/unit), the impact of actual purchases and sales has been to reduce net book value per unit by about 3% per year; and
4. Manufactured units (costing about $7,000/unit for steel units and $20,000/unit for wood units) contribute an increase of about 7% per year to net book value per unit.
The overall result has been an increase in net book value of 4.3% annually for the past three years.
To conclude, the answer to the question of how a depreciating asset can increase in book value is:
If the size of Mobile Mini's leasing fleet were static, with no refurbishment and customization, no generic ISO additions and no new manufactured units, the net book value per unit would gradually fall about 2% per year through depreciation. However, the fleet is not static--instead it is dynamic, reflecting the growth of the company. As a strategic initiative, management has been adding expensive manufactured units ($7,000 for steel units and $20,000 for wood units) to its fleet, thereby driving up the average net book value per unit. The net result is an approximate 4% annual increase in net book value per unit (between 2002 and 2004).
As mentioned in the company's 2003 annual report, "Product differentiation is a critical competitive advantage for us and the reason why we can and do stay on the sidelines when our competitors battle for commodity-driven, low margin, price sensitive storage business." The 10-K lists certain products introduced over recent years:
1998: 10-foot wide storage unit ("proven to be a popular product with our customers")
1999: Records storage unit, for "highly secure, on-site, easily accessible storage"
2000: Wood mobile offices (which are purchased from third parties) as a "complementary product" that "helps make Mobile Mini the single source for storage and office units"
2001: Improved security locking system (patented)
2002: 10-by-30-foot steel combination storage/office unit
"Currently, the 10-foot-wide unit, the record storage unit and the 10-by-30-foot steel combination storage/office unit are exclusively offered by Mobile Mini." (2004 10-K)
Given that we now know where the increase in net book value is coming from, the remaining question is: How effective is the company's capital-intensive spending on product differentiation and customization in driving profits? I will address this topic in my next post.