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Electro Rent: Borrowing to Pay Special Dividend Raises Concerns
Posted by: Mark Lin (IP Logged)
Date: January 29, 2013 10:31AM
Electro Rent Corporation (ELRC) is one of the largest global organizations devoted to the rental, lease and sale of new and used electronic test and measurement equipment. ELRC purchases equipment from leading manufacturers such as Agilent Technologies Inc. and Tektronix Inc. primarily for use by its customers in the aerospace, defense, telecommunications, electronics, industrial and semiconductor industries. Also, its data products division is one of the largest rental companies in the U.S. for personal computers and servers from manufacturers including Dell, HP/Compaq, IBM and Toshiba, even though it represented only approximately 7% of fiscal 2012 revenues. ELRC has also recently expanded its efforts in the rental, lease and sale of industrial equipment such as electrical test equipment and inspection equipment.
Valuation and Financial Analysis
ELRC currently trades at a trailing 12 months P/E of 15.6 and a trailing 12 months EV/EBITDA of 3.7. Its current P/E valuations are at a 10% discount to its five-year average P/E of 17.3. ELRC achieved a trailing 12 months ROE of 9.7% and a five-year average ROE of 7.8%. From the chart below, it is interesting to note that this is only the second time in its 10-year history that ELRC's P/E is so close to its ROE, suggesting potential undervaluation.
ELRC PE-ROE Comparison
ELRC was profitable in 9 of the last 10 years and delivered positive operating cash flow positive in every single year in the past decade. Free cash flow is consistently negative, as ELRC had to make significant equipment purchases to meet rental demand, support areas of potential growth and keep its equipment pool technologically up-to-date. Between fiscal 2010 and 2012, ELRC purchased approximately $287 million of equipment, creating what management believes to be the most comprehensive and newest inventory in the test and measurement equipment industry. Since fiscal 2010, ELRC's gross profit margins have fallen over a cliff, dropping from 80% to 60%. Management has grown revenue and EPS by a 10-year CAGR of 5.3% and 7.3%, respectively.
ELRC Earnings-Cash Flow Comparison
ELRC Profit Margins Analysis
Financial and Business Risks
ELRC has a strong balance sheet with no long-term debt on its books.
ELRC Cash-Debt-Market Capitalization Comparison
In September 2012, Faruqi & Faruqi LLP, a leading national securities firm headquartered in New York City, announced that it was investigating the Board of Directors of ELRC for potential breaches of fiduciary duties in connection with their conduct of seeking shareholders’ approval of the compensation for the company’s named executive officers. The terms of the compensation to be awarded to the company’s executive officers are outlined in the Proxy Statement on Form Schedule 14A that the company filed with the Securities and Exchange Commission on Aug. 31, 2012. Key executive compensation in 2012 amounted to $2.74 million, slightly more than 10% of 2012 net income of $26 million.
ELRC makes money by acquiring new and used equipment at attractive prices, from which it assess that it can make a profit as a result of a combination of renting and/or selling that equipment. It is highly dependent on management's ability to successfully control the timing, pricing and mix of purchases and sales of equipment, and manage its equipment pool. If management fails in this aspect, ELRC will see its sales drop and may not be able to adjust its inventory quickly enough to compensate for lower demand for one or more of its products or sell any of its excess equipment at favorable prices.
About 92% of ELRC's equipment portfolio at acquisition cost consists of general purpose test and measurement instruments purchased from leading manufacturers such as Agilent and Tektronix, while the remainder of its equipment pool consists of personal computers and workstations, which include personal computers from Dell, Apple, and Toshiba and workstations primarily from Hewlett Packard. ELRC's continued profitability is dependent on its ability to obtain equipment from these manufacturers and suppliers at favorable rates. In fiscal 2012, ELRC received a two-year renewal of its reseller program with Agilent Technologies.
ELRC's customers in the aerospace and defense industry derive a significant amount of revenue from the U.S. government, and could cut back on the rental or purchase of equipment, if the federal government reduces government spending.
Business Quality and Capital Allocation
ELRC has close to 100 people for its new and used electronic test and measurement equipment sales team, making it possibly the largest among its key competitors. This is largely attributed to its resale channel for Agilent test and measurement equipment, for the U.S. and Canada, which enabled it to substantially expand the number and technical expertise of electronic test and measurement equipment sales force. In addition, ELRC has been adding new equipment sales channels to its rental, leasing and used equipment sales offerings since fiscal 2007, spreading costs over multiple channels, allowing it to maintain a large sales force, which in turn broadens and deepens its customer contacts.
As possibly one of the only companies in the world with a global platform and key locations in the U.S., Canada, China and Europe, ELRC's size and reach appeals to its multinational customers in the aerospace and defense, semiconductor, electronics and telecommunications industries. Also, the global platform maximizes its equipment utilization and inventory management across different geographic markets.
ELRC has paid dividends in every single year since 2007 and currently sports a dividend yield of 5.3% (excluding special dividends). Dividends are paid quarterly. On Nov. 29, 2012, ELRC announced that its board of directors has declared a special year-end cash dividend of $1.00 per common share, in addition to its regular quarterly cash dividend of $0.20 per common share. However, it must be noted that the total cost of the dividend was $29.1 million, of which $6.1 million was funded from ELRC's cash on hand and $23,000 was funded by borrowing from its line of credit pursuant to the Commercial Credit Agreement with Union Bank.
ELRC Dividend Yield-DPS Analysis
Borrowing to pay dividends definitely raises concerns, especially considering that ELRC has little excess cash on the books and is consistently free cash flow negative.
The author does not have a position in any of the stocks mentioned.
Stocks Discussed: ELRC,
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