McGrath RentCorp (MGRC) 2006 Q2 法說會逐字稿

Ladies and Gentlemen, thank you for standing by, and welcome to the McGrath Rentcorp second quarter 2006 earnings conference call. At this time, all participants are in listen-only mode. Following today's presentation, instructions will be given for the question-and-answer session. If anyone needs assistance at any time during the conference, please press the star followed by the zero. As a reminder, this conference is being recorded today, Thursday, August 3, 2006. I would now like to turn the conference to Geoffrey Buscher with SBG Investor Relations. Please go ahead.

Thank you, operator. Good afternoon. I'm investor relations advisor to McGrath Rentcorp and will be acting as moderator of the conference call today. On the call today from McGrath Rentcorp are Dennis Kakures, President and CEO, and Keith Pratt, Vice President and CFO. Please note that this call is being recorded and will be available for telephone replay for up to 48 hours following the call by dialing 1-800-405-2236 for domestic callers and 1-303-590-3000 for international callers. The pass-code for the call replay is 11064495. This call is also being broadcast live over the internet and will be available for replay.

We encourage you to visit the Investor Relations section of the company's website at MGRC.com. Our press release was sent out today at approximately 4.05 Eastern time or 1.05 Pacific. If you did not receive a copy, but would like one, it is available online in the Investor Relations section of our website. Or, you may call 1-206-652-9704, and one will be sent to you.

Before getting started, let me remind everyone that matters we will be discussing today that are not truly historical are forward-looking statements within the meaning of section 21E of the Securities and Exchange Act of 1934, including statements regarding the McGrath Rentcorp's expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements are based upon information currently available to McGrath Rentcorp. And McGrath Rentcorp assumes no obligation to update any such forward-looking statements. Forward-looking statements involve risks and uncertainties which could cause actual results to differ materially from those projected. These and other risks relating to McGrath Rentcorp's business are set forth in the documents filed by McGrath Rentcorp with the Securities and Exchange Commission. Including the company's most recent form 10-K and form 10-Q.

I would now like to turn the call over to Keith Pratt.

Thank you Jeff. In addition to the press release issued today, the company also filed with the SEC the earnings release on Form 8-K and a second quarter 2006 Form 10-Q.

For the second quarter 2006 total revenues decreased 5% from $63.9 million in 2005 to $60.7 million in 2006. And net income decreased 8% from $9.5 million, or $0.38 per diluted share, in 2005 to $8.7 million, or $0.34 per diluted share, in 2006. Second quarter 2006 results included $0.7 million of non-cash stock compensation expense required under FAS 123R, reducing net income by $0.4 million or $0.02 per diluted share.

Reviewing the second quarter results for the company's Mobile Modular division, Mobile Modular total revenues decreased $0.9 million or 2% to $35.9 million over the same period in 2005 due to $3.9 million lower sales revenue offset by higher rental and rental-related services revenues during the quarter.

Gross profit on rents decreased $0.3 million or 2% to $11.9 million from $12.2 million in 2005, as higher rental revenues were offset by lower rental margins. Rental revenues increased $2 million, or 10%, over 2005, but rental margins decreased to 55% in 2006 compared to 62% in 2005. The decrease in rental margin was primarily caused by $1.9 million higher inventory center labor and material cost to prepare a higher volume of equipment for shipment and higher than customary fields repairs.

Selling and administrative expenses increased $1.1 million or 23% to $5.9 million from $4.8 million in the same period in 2005, primarily due to higher personnel and employee benefits costs to support higher rental activity levels, which included $0.5 million non-cash stock compensation expense related to the adoption of FAS 123R. The combined effect of the revenue decrease, increased operating and administrative expenses and higher allocated interest expense with a decrease in pretax income of $2.2 million or 21% to $8.3 million for the second quarter 2006 from $10.5 million for the same period in 2005.

Finally, average Modular rental equipment for the quarter was $372 million, an increase of $43 million from the second quarter of 2005. Average utilization for the second quarter declined from 85.6% in 2005 to 82.7% in 2006.

For the company's TRS-RenTelco division, total revenues decreased $1.7 million or 7% to $23.6 million compared to the same period in 2005 due to $3.9 million lower sales revenue offset by higher rental revenues during the quarter. Gross profit on rents increased $1.8 million or 29% to $8.2 million as compared to the same period in 2005. Rental revenues increased $2.4 million or 14% as compared to 2005, and rental margins increased to 42% in 2006 from 37% in 2005. Despite the decrease in total revenues, pretax income remained at $4.7 million for the second quarter, 2006 and 2005, primarily due to higher gross profit on rental revenues.

Finally, average Electronics rental equipment for the quarter was $167 million, an increase of $18 million from the second quarter of 2005. Average utilization for the second quarter improved from 64.3% in 2005 to 71.1% in 2006. On a consolidated basis, interest expense for the second quarter 2006 increased 45% to $2.8 million from $1.9 million for the same period in 2005 as a result of the company's higher average interest rates and higher average debt levels to support higher rental equipment purchases in 2006.

Provision for income taxes was reduced $0.9 million during the second quarter 2006 to record the impact to the company's deferred tax liability from a franchise tax law change enacted by the state of Texas in May, 2006. As a result, the company's effective tax rate for the second quarter was 32.1% compared with 38% during the same period in 2005. This reduction in deferred tax liability is a one-time adjustment caused by the tax law change. And it increased second-quarter earnings per share by $0.03. For the remainder of 2006, we estimate the tax rate to be 39%.

Next, I'd like to review our year-to-date 2006 cash flows. We continue to generate strong cash flows to invest in our business and return value to our shareholders. For the six months ended June 30, 2006, highlights in our cash flows included net cash provided by operating activities increased $16.7 million over 2005, a 65% increase to $42.3 million. We invested $71 million for rental equipment purchases, partly offset by $9.5 million in proceeds from used equipment sales. Dividend payments to shareholders were $7.5 million and net borrowing's increased $23.6 million year-to-date from $163.2 million to $189.5 million.

We continue to have solid low-average balance sheet. For 2006 second quarter, EBITDA decreased $0.5 million, or 2%, to $28 million, compared to $28.5 million in 2005. We consolidated EBITDA margin at 46%. Our definition of EBITDA and a reconciliation of EBITDA to net income are included in our Form 10-Q for the quarter.

With respect to 2006 earnings calls guidance, although both our Modular and Electronics businesses have experienced rental revenue growth, sales of new and used equipment have not materialized as we had anticipated entering 2006. In addition, we have experienced increased expenses due to a higher than anticipated volume and complexity of Modular buildings being processed through our inventory centers during the first half of the year.

Based on our results to date and our current forecast for the remainder of the year, we are revising our full year EPS guidance range to $1.42 to $1.49 per diluted share. At this point, I would like to turn the call over to Dennis.

Thank you, Keith. Let me first acknowledge that our second quarter EPS results were below our expectations. As Keith mentioned a moment ago, our results reflected a reduction in both Modular and Electronics equipment sales -- the most difficult element in our businesses to forecast and a reduction in gross profit on rents from Modulars due to higher inventory center expenses mostly related to increased business activity levels.

While we are disappointed in our sales shortfall year-to-date and the need to reduce guidance for the year, quite frankly, when you look more closely at our results, there are quite a few key indicators that speak very positively towards longer-term revenue and EPS growth.

In my prepared comments over the next few minutes, I'll do my best to identify these key items. Let me start with the overall 12% increase in rental revenues for the company, which is the key revenue metric of our business. Keep in mind that rental revenues carry one-and-a-half to two times the margin of sales and have historically been a more stable, predictable and enduring revenue line.

For Modulars, rental revenues increased 10% to $21.6 million for the second quarter 2006 from a year ago. The rental revenue increase was primarily related to classroom shipments in the third and fourth quarters of 2005 from the educational markets we serve. We should experience a full 12 months of rental revenues in 2006 on a great majority of the classroom orders shipped in the second half of 2005. Our focus on educational rental markets continues to provide us with long-term occurring rental revenue streams.

In Florida, student population growth, class-size reduction, our hybrid classroom product and the fading out of older model portable classrooms have supported another strong first half of the year in classroom rental order activity. Also, during the first half of the year, we have expanded our base of school district customers in Florida very favorably.

We have now done some form of either rental or sale business with over 55% of the public school districts in Florida in just over two years in the market. With respect to class-size reduction in Florida, it's important to repeat a few comments from our first quarter conference call.

For the 2006-2007 school year, under the class-size reduction statute in Florida, school districts are required to meet class-size limits based on the average number of students per class at the school level, as compared to the district level, which had been the standard since the program was implemented in the 2003-2004 school year. Furthermore, in the 2008-2009 school year, school districts will be required to meet the average class-size at the individual classroom level. These requirements could have a very favorable impact on our business levels. We are buying significant quantities of classrooms to support demand for additional educational space in Florida.

In California, we had satisfactory classroom rental booking levels during the first half of the year. However, as expected, they were not up to the levels of the past two years due to the limited availability of state bond monies for school modernization projects. But the passage of a statewide facility bond measure in November, 2006, we should see increased educational rental opportunities beginning in early 2007. The need to modernize schools in California continues to be very high, and we are positioning ourselves to take full advantage of the anticipated increase opportunity levels in 2007.

Additionally, in the second quarter, we experienced a considerably higher level of commercial rental opportunities mainly driven by increased business activity in residential and commercial construction. If higher commercial rental business activity levels have continued into the third quarter, we should see favorable rental revenue growth in the third quarter as a result of classroom shipment and the increased level of commercial rental activity.

As Keith spoke to earlier, gross profit on rents for Modulars declined 2% to $11.9 million for the quarter despite the 10% increase in rental revenues. This is primarily attributable to a significant increase in inventory center material and labor costs directly related to preparing a higher volume of buildings. This included both higher levels of pre-prepped standard classrooms and commercial inventory. Also contributing to the increased costs were higher levels of customized buildings for commercial applications. We believe that our broad inventory and ability to customize buildings within our inventory centers to meet a wide variety of different customer applications enables us to book higher levels of these types of orders as compared to our competitors.

It's important to point out that the great majority of the higher inventory center costs associated with the current equipment for both educational and commercial needs were fully expensed during the second quarter. However, we will benefit favorably from the rental stream created from these orders in the quarters ahead. Additionally, many of the commercial orders in the second quarter will provide a full year's income stream in 2007. With the strong increase in commercial business activity in the second quarter, period ending utilization increased to 83.3% as compared to 82.1% at the end of the first quarter.

Keep in mind that the majority of classroom rentals shift beginning in the third quarter. Thus, we are expecting to see a favorable increase in equipment utilization during the third quarter. Also contributing to the higher inventory centered labor costs during the quarter were a larger than normal number of subcontractors within our inventory centers at higher labor rates compared to our in-house staff to support the increased levels of equipment preparation.

Finally, we also experienced higher than customary field service expenses during the quarter. While field service issues occur from time to time, this was a larger than normal effort. We do not expect a reoccurrence of this issue and the related higher expenses going forward.

In summary, when you break down the increase in inventory-centered expenses during the second quarter, the great majority relates to actual or anticipated business activity levels and our need to process equipment to meet those needs. In turn, we end up absorbing a disproportionate share of expenses during the quarter, with the revenue to come later this year and next year. This dynamic should impact our profitability favorably going forward.

Sales and gross profit on sales for mobile Modular for the quarter were down 34% to $7.3 million and 26% to $1.8 million, respectively, compared to the second quarter of 2005. This is a quarter wherein the normal course of our Modular business, the number and size of equipment sales opportunities that we would consider pursuing were short of our expectations. We do not believe this presents any significant concern for our Modular business or the health of the markets in which we operate.

We view sales as a byproduct of being in the rental business and although we are actively engaged in selling both new and used equipment, we focus our sales force on rentals for the reasons mentioned earlier. Rental revenue growth is truly our economic engine. That's not to say that we don't expect to have favorable sales levels going forward. Sales just tend to be much less consistent on a quarter-to-quarter or year-to-year basis then rent.

In summary, when it comes to the pick and shovel work of getting more opportunities, we'd rather have our sales force focus on digging up and working hard on rental opportunities, and at the same time, we will gladly work on sale opportunities that we encounter in the normal course of building our rental business.

Now, let's take a closer look at TRS-RenTelco, our test equipment rental division. TRS-RenTelco had a very strong increase in rental revenues of 14% to $19.6 million from $17.2 million a year ago. This is reflective of a continuing improved marketing condition that we spoke to during our first quarter conference call. We are continuing to see favorable market conditions in the third quarter. It's important to note that the increase in rental business activity levels is across a broad range of product segments and markets for both our general purpose and communications test equipment.

We believe this reflects an increasingly positive outlook for the long-term health of our test equipment rental business. We are pro-actively purchasing the latest technology test equipment to support the increased demand we are seeing. With the continuing strong business activity levels, second quarter ending utilization increased to 71.3% compared to 70.6% at the end of the first quarter.

Our test equipment business also had a very strong increase in gross profit on rent in the second quarter of 2006 at 29% $8.2 million from $6.4 million a year ago. This was our highest quarter since the merger of TRS and RenTelco in mid 2004. The 14% increase in rental revenues associated with only a 2% increase in depreciation expense and direct cost of rental operations other expense of 16% enabled gross margin rents to increase to 42% for the quarter, with the month of June reaching 46%.

Sales revenue and gross margin sales were down approximately 55% and 48%, respectively, from last year's second quarter results, mainly due lower levels of under-utilized inventory available for sale and fewer installment sales of new equipment.

The increase in rental revenues offset by the reduction in sales income and higher interest expense of $0.3 million, or 44% over last year, combined to make quarter-over-quarter pre-tax profit flat at $4.7 million.

Although there was lower than expected sales income during the quarter, our results reflect an improving domestic rental market and an increasingly profitable TRS-RenTelco rental engine.

A few closing comments -- while it was necessary to reduce guidance for the year following our second quarter results, due to primarily to a shortfall in sales levels for both Modulars and Electronics, I want to emphasize that both of our rental businesses are very well positioned for long-term earnings growth. Let me summarize for you why.

First, our Modular rental business -- we've had an 11% rental revenue growth year-to-date. We've added approximately 14% or $31 million in original cost of rental assets thus far in 2006. Utilization increased to 83.3% at the end of the second quarter compared to 82.1% at the end of the first quarter.

We have seen a strong increase in the level of commercial rental activity in California. We had another strong year in rental bookings in the Florida market. The great majority of the inventory expenditures incurred in the second quarter results are for rental transactions that will provide rental revenues for many quarters ahead. We expect our gross profit in rents to increase to the low 60% range beginning in the third quarter.

Finally, with passage of the November state-wide facilities bond measure in California, we should see a very healthy increase in classroom rental opportunities beginning in early 2007.

For our Electronics business -- we had a 14% increase in rental revenues in the second quarter and have increased revenues each month thus far in 2006. We've added approximately $21 million in original cost of rental outfits thus far this year. Utilization increased to 71.3% at the end of the second quarter compared to 70.6% at the end of the first quarter. Our increase in rental revenues thus far in 2006 has resulted from increased business activity from a broad range of products, segments and markets.

And finally, gross profit and rents increased quarter-over-quarter to $8.2 million or 29%, our highest quarter yet for TRS-RenTelco. What matters most to produce sustainable long-term earnings and share value growth is our focus on improving rental revenue growth, growing our level of rental assets, increasing rental margins, increasing utilization and growing our base of both educational and commercial customers.

We remain steadfast in these efforts, and now Keith and I are pleased to address any of your questions.

[OPERATOR INSTRUCTIONS]

One moment for our first question.

[OPERATOR INSTRUCTIONS]

Our first question comes from Cliff Walsh with Sidoti and Company. Please go ahead.

Hi, guys.

Hi Cliff.

Can you guys talk a little bit about what you're hearing about the support for the bond issue in November? I know that there was some polling data that came out in June, which seemed to support it. Have you seen anything recently or your lobbyists heard anything to suggest any which way the public is leaning on this?

Let me give you the latest update here. First of all, Cliff's referring -- in June there were two polls that were done. One was done by the Public Policy Institute of California, which showed a mid-60% approval rating. And I might mention that the bond measure needs 50% plus one vote to pass. The other poll at the time was a field poll, which showed about 48% support at that time. So, for where that was at in the process in June, that's quite favorable.

The most recent poll that I've seen, again, is a field poll, which still shows 48%. I haven't seen an update in the public opinion poll group, but it's still at 48% in the field poll, but there's 15% in the undecided category. All that we need to do is pull 3% from the undecided, it passes. And remember also that the governor and the legislative leadership has not really gotten out and campaigned yet for this. So that's to come here. And November, quite frankly, is a long ways off for a lot of people.

And one other just comment on why the difference in the mid-60% range verses 48%, our point of view is that it's the way in which they ask the question. And if you were to look at how the public opinion poll asks the question, it was very definitive as to what the money would be spent for. In the field poll, it's more of just, it's not defined, it just talks in a general case of spending roughly $10 billion per facility for schools, but it doesn't really get into the details.

So, last item would be in the past 20 years there's only been one statewide bond measure that's failed. So we feel is the outlook is very positive for passage.

Okay. In terms of the cost issues that you saw in the inventory centers and on maintenance, how much did that differ from your expectations? And maybe you could just kind of touch on where things were below your expectations.

Yeah. Phil, I'm sorry, Cliff, I'll make a couple of comments. If you look on a year-over-year basis, our inventory center costs a year ago for the Modular business were $5.2 million, and what we just experienced in the second quarter of this year was $7.1 million. As we look at what caused the increase, we mentioned the field repair issue and that caused about $0.4 million of an increase and as we noted in the prepared remarks, that's really a unusual spike for that kind of work. We also experienced some overall increase in materials used at our centers, which probably contributed about $0.2 million.

The balance, or somewhere close to $1.3 million, really relates to a volume and also complexity of the work being done in the centers. I think going into the quarter, we expected a somewhat higher than a year ago but not to the extent we experienced. And we did not expect quite the level of the field repair costs.

Cliff, I might add -- to the extent we're spending a lot of dollars in our inventory centers, although it's actually a very positive item that means that there's a lot of demand, and we have not realized the revenue streams from that real pent-up demand that we saw in Q2 that's continue into Q3. So I know the numbers probably, certainly -- it was startling to us as well. But when you know that the great majority is tied to putting product out, and -- it's just, it's very positive.

Okay. And in terms of TRS-RenTelco, it seems like things are definitely turning around there. What did you -- what were your expectations for the quarter? Or maybe you could talk about how you viewed the performance in the quarter.

Well, what I was very pleased to see was that it's broad based, the growth. When you have it coming from General Purpose and Communications and, within those two product segments, a lot of different areas, that's always very nice to see. There's good momentum for that business. We have a strong leadership position. It took us some time to put those two businesses together. We articulated in those days, as the markets begin to recover, we should benefit favorably, having the biggest shipment in the sea. And we certainly saw a very strong quarter in Q2. And our expectation is that we're going to continue to grow that business and have greater profitability in the future.

Okay. Can you update us on how activity was in July?

It -- for the Electronics business?

Yeah, I mean for both if you could.

Well, let's start with Electronics because we're on the subject. It was -- it continued in a very favorable manner. So we saw very good activity continuing an opportunity flow. And then the goal there is to book as much as you can. And hopefully that continues through the end of the quarter and into the fourth quarter. And just know, there is some seasonality of that business as you get into the fourth quarter there. But everything we've seen in our year-to-date has been very positive, even through today's date of August 30 or so.

For Modulars, the July has continued to be very strong on the commercial side. We haven't - there hasn't been any reduction there in the opportunity flow. So that feels very good. And what's interesting to date is -- we did a little analysis this morning. We looked at our booked not billed at this point in time, and we actually, if you compare ourselves to last year through the end of June, that we have only -- even though we've booked about the same amount last year in rental stream in floors, that as of the end of June, we've only billed about two-thirds of what we had booked up to -- for the year, comparatively.

So we've got a lot of billing that's still in the pipeline that hasn't billed yet. And again, we have the, obviously, still increasing opportunities here in the third quarter thus far.

Okay, and just, can I back up to TRS-RenTelco a minute and talk about, maybe, where you saw the most strength? Was there a particular geographic area and market user that really drove the results? Or was it pretty widespread?

It's pretty widespread, and for competitive reasons, I really try not to get too low an altitude there with respect to product areas. And this one, John, wireless continues to be a very strong area for us.

Okay. All right, great. Thanks, guys.

[OPERATOR INSTRUCTIONS]

Our next question comes from [John Gibbons with Oden Partners]. Please go ahead.

Hi, Dennis.

Hey, John, how are you?

Good, good. I think I understand over the last couple of months that you were giving us some caution about this quarter because of the investment spending you're doing for the future. I guess I'm a little puzzled by the felling of disconnect between the lower guidance and your very positive comments. I don't quite understand how you can expect improved profitability going forward, etcetera, etcetera and then want to reduce your guidance. So maybe you can give me a little help on understanding that.

Because I understand how you have to investment spend for late-'06 and '07, but you just said a minute ago, you only booked two-thirds of what you -- you just said you only billed two-thirds of what you booked to be where you were last year. So it sounds like the last part of this year is, indeed, as strong as you told us, let's see, when you were back to see us this spring. Are you saying, 'Well, there's not going to be any hurricane effect, and we're not going to get any sales going forward,' things that are unpredictable? Or are you just trying to be very cautious about [technical difficulty]? Or is there something more serious we don't understand here?

John, great question, and let me respond to that. It really centers mostly around the sale side of things, in that the sale side did not materialize in the first half of the year. And when we sat down and looked at our projections for the remainder of 2006, we just don't see, at this point in time, anything picking up the slack that we lost in the first half or where we were looking at for the second half. So that's not to say that we can't have something come along and be impacted very favorably. But we're not counting on a hurricane. We're not counting on any special events there. So sales are the biggest component of that.

The other piece, also, is the fact of the matter is that the amount of money that we're spending in the second quarter and in the third quarter in preparing a lot of the commercial assets, we're not getting a full year's worth of income this year. So when you're doing a lot of large complexes, and you're spending a lot of money to reconfigure them and put them into the appropriate application for an end-user, it's a multi-year lease. But in -- so we're going to spend a lot of money this year. We're going to get some rental revenue. But you're really not going to get the true benefit of that until next year.

And it's one of those dynamics with inventory center labor and material costs where we have to incur those expenses as they hit, even though the rental stream is over a two to three year period. So we have -- that's important towards the guidance piece as well.

Right. And you expense everything rather than capitalizing anything.

That is correct. The great, great majority of everything that occurred the quarter got expensed. So it's not spread. We take -- in effect, take the hit in the second quarter. We get the benefit of the revenue in the quarters to come. So those two items are the -- that's really why we're sitting here saying guidance $142 to $149. I mean, if things went right, we could still almost hit the low end of our original guidance range. But we want to be prudent in our approach here without greater visibility on -- especially on the sales side.

So all things being equal, you're saying you'll [inaudible] for a very good '07. Well, I mean, you never can be perfect on this kind of stuff, but since sales are very low this year, anything that got sold next year would be a plus. More Florida's a plus, and more California's a plus.

Exactly. And I think what the key takeaways from this call are look at the acid growth thus far this year in our rental fleets.

Right.

Look at our increase in rents year-to-date, and we've still got a lot of billing that's not even online yet, and we haven't -- and that includes shipments in the third quarter for both educational and commercial. The health of the rental markets for both businesses are very good. And, again, when we looked at 2007, assuming a bond measure of assets in November of $3 billion, well, that's a very big positive. So the rental markets are strong. Our results are showing that.

This is an aberration in terms of the sales piece this year. We don't have a better explanation for it other than we stay highly focused on our rental business, and we let those fall as they do. And key to the long-term success is continue to do what we're doing with the rental business. And we'll be fine on sales over the long run. It's just that 2006, we've been a bit challenged.

Well, and you've had some nonrecurring -- if you want to call them that -- hurricane benefits and stuff late '05.

That is correct. And in all fairness, everybody, that was baked into our guidance to pull that out. So I want to be fair on the other side as well and say, even with that adjustment, those sales pieces have not materialized to date.

The second half of last year included approximately $14 million in revenue related to Modular sales that were a result of the hurricane and contributed about $0.09 to earnings. But as Dennis said, we did factor that in as we looked at our forecast for the year. But it will make some of the Q3 and Q4 year-over-year comparisons look a little different.

Yeah. Well, that's what I figured, from $160 to $150; you're saying that was $0.09.

Right.

Okay, good luck. You know, the stock's not going to like this in the morning.

We need to just keep pushing forward with the growing of the rental business.

Good luck, Dennis. I know you'll work it out.

Thanks, John.

Our next question comes from [technical difficulty] [Graff with Capital Management]. Go ahead.

Hi, guys. I just wondered if you could talk a little bit about what's behind your assumption that gross margins go back to. And I think I heard you right -- they go back to the low-60s in the third quarter for the Modular business.

Well, I think what's behind that is the fact we should inventory center expenses reduced. And we should see rental revenues increase nicely. So it's the combination of those two items that should return us to the low-60% range.

Can you just go a little bit more in detail about what expenses will be reduced? I mean, I would imagine your labor's pretty stable.

No, actually, there's two items. Keith spoke to them a minute ago. We have the additional outside service piece, which he talked about $0.4 million --

Right, the field service work.

…for field service work, which was a one-time event in the second quarter. And then we also have the fact that, from a subcontractor standpoint, a lot of the subcontractors we brought in at higher rates are being phased out. Those are two significant items. Plus the commercial activity in Q2, the amount of customization and, in effect, the touching of large complexes and, perhaps, some of our inventory that has sat a little bit longer. We had some higher expenses associated with getting a lot of that equipment ready.

And what we expect in the third quarter is, although commercial activity will continue to be strong, we don't expect the spend to be consistent with the second quarter in preparing those types of assets.

Okay, that makes a lot more sense. And then, if you could -- you may not have more detail on this, but any thoughts on why customers are not making purchases? Are they preferring to rent instead? Is that part of the really great growth that you've seen in rental income?

That's a great question. You know what, I just think it's just what you come across. I don't think there's a dynamic of -- you know, you could argue the fact that if interest rates are going higher that people may want to not use capital that way, and they'll go ahead and rent. You could argue that. I don't have any empirical data to support that at this time. That's not unreasonable. But I just think, at this point, I don't have a good response to that. We're seven months through the year at this point, and it's just been a lower sales year. And I wish I had a better answer for that, and I don't at this point. We may get some better [visibility] later in the year.

Certainly, on the Electronics side, we have less equipment available to sell, so it's less of a demand issue and more the fact that our equipment pool is very well utilized. When we reach a utilization rate around 70%, that's a very good rate for the Electronics business.

And then I think, on the Modular side, it's worth keeping in mind that we operate in select geographies. And so those geographies may have, in any particular year, more or less sales activity. And we always caution that it is one of the harder parts of the business to forecast.

Okay, so it sounds like the disappointment was more on the Modular side rather than -- because you would have known your equipment was fairly highly utilized on the Electronics side.

Well, again, in all fairness, we made adjustments in our planning for the year on the fact that we had less equipment available for sale because we had done such a good job in 2005 of moving it. But even at that, we were -- we are lower. And, again, we'll see how the year finishes with Electronics. But those are -- that's the present state.

Well, thanks. And you guys really have done a good job growing the rental income. It's nice to see that.

Well, that's what should be most enduring over time and much more stable. That's not to say that we won't be successful in sales as well.

Thanks a lot.

Okay, thank you.

[OPERATOR INSTRUCTIONS]

Our next question comes from Les Bryant with UBS Financial. Please go ahead.

Hello. Dennis, I have something that might help clarify, but are you on?

Yes, sir. How are you, Les?

Okay. I am doing fine, doing fine.

Wonderful.

As you know, I've been with the company for a long time, as a broker and also as a shareholder.

And we're very appreciative of that; thank you.

I appreciate what you guys do very much. By the way, if I had not visited Mira Loma, I would be having the same questions a number of these people are having in regards to sales. I happened to go by Mira Loma not too, well, a year ago. And then I drove by not too long ago. And you really depleted your inventory, it appeared to me. I don't know if it was that way in all your other locations, but didn't you make a large sale last year that depleted the inventory over there pretty substantially?

You know what, there may have been a large sale last year that maybe --

Well, was that the hurricane sale?

That actually was new equipment from Florida --

Was that new equipment -- okay.

And that would've impacted that Mira Loma facility. Probably what you saw is the fact that if you drove by and saw less inventory, it means more was out on rent, which is great also. And from the sales camp where we've actually -- when you look at our sales component for Modulars new sales, used sales out of the inventory center and also the purchase off rent quarter-over-quarter, all of the areas are down some.

So it's across the spectrum there and that's, as I said a moment ago, that is what it is today and we'll continue -- again, we actively sell and pursue new and used inventory and we'll --

You remodel over there, the old facilities, and rent them out like new?

That is correct.

And you expense the remodeling as you do it?

For the most part, you get the expense. Occasionally we'll have buildings that will, if they're a certain age, or there's a certain value-add to them that will capitalize, but when you look at our second quarter numbers, by virtue all of that effort was expensed during the quarter.

Okay. That was the point that I was going to have you bring up because it would appear that there's a lot of value-added that will be -- that you will be getting rent on, from those remodels in the future.

That is absolutely correct and --

I know you've been saying it.

That's an important take-away from this call, that we spent a lot of money in the second quarter, but the income strain for that money spent is to be recognized in the quarters ahead.

Okay. I have just one more little comment and observation and question. Okay. I also own Modtech. That's another public company that -- and I understand they're doing less customization and more of their modules and are you seeing any extra business customizing? Because Mr. Buckley, the President who's recently resigned, but he was bringing the company back to just building the boxes rather than doing the custom jobs. Are you getting more custom business?

Well, Les, the way I would respond to that -

I know you buy from them.

Modtech is a manufacturer, and they sell directly to school districts. I think that relates to the highly customized school projects, more permanent Modular construction for schools and their direction more towards doing more standard portable classrooms. So I think that's what they're speaking to. That hasn't really -- that's not an impact to our business. It's different dynamic, just on the sales side to schools.

Yeah. When we use the term customization, you can almost think of it as kind of improvement, if you will, more the finish and feel of the way the building is equipped.

And in rental.

Uh-huh.

For the most part.

Yeah. Okay. Thank you very much.

Les, thanks so much and for your continued support as well.

Yeah.

Our next question is a follow up question from [technical difficulty].

Yes, that's my question that I was -- been answered. I'm sorry. Thank you.

Thanks, Cliff.

[OPERATOR INSTRUCTIONS]

Management, at this time there are no further question. Do you have any comments?

We would love to thank everybody for joining us on today's call and we look forward to chatting with everyone in early November for our Q3 call. Thank you all very much.

Thank you. Ladies and gentlemen, this concludes McGrath Rentcorp's second quarter 2006 earnings conference call. If you'd like to listen to a replay of today's call, please dial 1-800-405-2236, entering a passcode of 11064495, followed by the pound sign. Again, if you'd like to listen to a replay, dial 1-800-405-2236, entering a passcode of 11046695, followed by the pound key. Thank you for your participation. You may now disconnect.