Description

Thesis

Construction Equipment rental stocks have performed poorly since November 26, 2014 (the day before oil’s infamous Black Friday). Since then, the share prices of the US’s three publically listed construction equipment rental companies, United Rentals Inc., H&E Equipment Services Inc., and newly public Neff Corp., have fallen 25.7%, 48.2% and 32.7% respectively, as investors attempted to discount the impact of a 53% decline in WTI oil prices since June 2014. Interestingly, over that same period, the share price of Ashtead Group PLC, the owner of Sunbelt Rentals Inc. (#2 US market share behind URI), has actually increased 8.8%. This outperformance is ironic, in that Ashtead, although listed in the UK, is almost entirely a US construction equipment rental company, with Sunbelt contributing 83.2% of AHT’s revenues, 86.8% of EBITDA and comprising 83.7% of AHT’s rental fleet (during FY1H15). 

I believe this significant outperformance versus peers, a historically high valuation, combined with the real vulnerability to AHT’s near-term fundamentals, leads to a short opportunity in AHT. I see a risk to consensus to FY2016 centered on lower EBITDA margins, stemming from weaker industry pricing, rather than a substantial drop off in end-user demand. I derive my price target through expected value, stressing earnings model assumptions for a more challenging operating environment, and valuation multiples reverting to historical averages. My price target of £777.12 offers 27.9% total return (incl. dividends) from the current price.

The Business

AHT’s is a construction equipment rental company based in London and trading on the London Stock Exchange. It operates two primary business lines: 1) Sunbelt Rentals Inc, the #2 US construction equipment leasing company, with an estimated 6% market share; and 2) A-Plant, the #2 UK equipment lessor, with an estimated 9% market share. A-Plant contributes 16.3% of group revenue, 13.2% of EBITDA, and comprises 16.3% of group fleet (during FY1H15). A-Plant is a slower growth, profitability improvement situation, and not a big driver of the AHT story. Management has a good reputation with investors for solid execution in recent years.

Fleet/distribution/Industry fragmentation. AHT’s customers are mainly smaller contractors and commercial, non-residential construction companies. AHT acquires and maintains a diverse “fleet” of construction equipment, renting that fleet out through 493 branch locations in the US and 129 in the UK. 22% of these locations were opened in the last two years: both greenfields (45%) or acquired (55%). Nearly all of the branch growth is in the US. The fleet is comprised of: 37% aerial work platforms; 20% forklifts; 16% earth moving; 13% diverse smaller equipment; 9% pump and power; and 4% scaffold (at 9/30/14).

In both the US and Great Britain, construction equipment rental is a very fragmented industry, consisting of a few national players, many OEM captive dealers, and hardware retailers. The barriers to entry are capital intensity and distribution. Growth is dependent on cyclical demand but also can be achieved through acquisitions (both AHT and URI have grown aggressively via acquisitions), greenfield store expansion, and through partnerships with retailers, such as Sunbelt’s 30 store partnership with Lowe’s Companies, Inc. A trend towards consolidation has allowed URI and AHT to grow much faster than the construction industry. AHT has chosen to grow through both greenfield branch expansion as well as bolt-on acquisitions, eschewing the kind of larger, transformational deals, pursued by URI. Over time, AHT believes it can more than triple its market share to 20%. It is thought that leasing’s penetration of construction equipment spending is also a secular growth tailwind (the American Rental Association says that leasing has grown to 53% penetration versus only 40% in 2005). AHT management believes leasing penetration of construction equipment spending can reach 60% in the US in the next few years, versus the 75% share it has enjoyed in the UK for years.

Cyclicality. Construction equipment rental is a highly cyclical industry. Historically, both revenues and margins have been subject to volatility due to sudden changes in contractor demand (the average lease term is only 1-3 months, depending on equipment type, meaning pricing changes are felt quickly) and the supply of equipment available to meet localized demand. Operating conditions can vary significantly by equipment type, and geography. Such localized disparities give large national operators like URI, AHT and HERC (Hertz Equipment Rental Corp., “HERC” a division of Hertz Global Holdings, Inc., that is a rumored acquisition target of URI) a distinct competitive advantage over more locally focused players, due to large lessors’ ability to leverage sophisticated logistics to redeploy equipment into markets where the supply and demand characteristics are more favorable. Additionally, the large national accounts (those managed from a single point of contact) have a greater concentration at URI’s (nearly 68% of its total), while AHT’s is less than half that level (which should theoretically give AHT more pricing leverage). Upturns and downturns in cyclical profit margins are determined by fleet utilization and price. During this period of its aggressive capex expansion, AHT was fortunate to enjoy improving utilization and price. However, even as end user demand remains strong, AHT is already experiencing some diminution of pricing performance (to only 2.0% rate growth), perhaps in a bid to gain market share. This is in contrast to URI, which posted 4.5% price improvement for the full year 2014, but is guiding lower to 3.5% for 2015e. URI’s cautionary view, combined with expectations for a large amount of capex from competitors, make us concerned about pricing. Our expectation is that, because of AHT’s big capex push, any hit to AHT’s profit margins is likely to come from failure to achieve price rather than a big fall of in demand from customers.

Source: Company filings.

US market leader, URI, and some of the captive OEM dealers, have a competitive advantage in asset disposition, in that they view the sale of used equipment as a profit center, as opposed to other companies (including AHT) that primarily rely on third-party auction companies (such as Ritchie Bros. Auctioneers Incorporated) for asset disposal. Given a robust market for used equipment, margins have improved recently. URI’s margins on asset disposals ran at 42.0% in 2014, cyclically improving from only 31.3% as recently as 2012. AHT, however, only generated margins of 19.6% on used equipment sales in FY2014.

Geographic/energy exposure. Although AHT management claims its exposure to energy-related lessees is only 10% of the total portfolio, a careful look at its US geographical footprint shows large market shares in some important energy-sensitive areas, including an 11-12% share in Texas’ Permian Basin and more than 15% in the Houston-Galveston region, 10% market share throughout most of Colorado and Oklahoma, +15% share in Wyoming’s Niobrara Basin, Louisiana’s Deep Tuscaloosa, Pennsylvania’s Marcellus, and Texas’ Eagle Ford Basin south of San Antonio, as well as +15% share in most of Kentucky and West Virginia’s depressed coal country (coal prices have fallen 56% since January 2013). Importantly, AHT has zero presence in rapidly decelerating North Dakota, and only a token presence in Canada, a market which accounts for 6% of URI’s branches.

Source: Company filings.

Valuation

My short investment thesis centers on the premium valuation relative to peers and the increased risks posed to the fundamentals from a potentially serious slowdown in construction spending in the oil patch. My price target of £777.12 is derived from expected return analysis offering a one year IRR of 27.9% including the dividend:

AHT is Expensive Relative to Peers on every valuation measure. I believe that the explanation for the magnitude of this gap has more to do with the nature of its shareholder base rather than any deserved premium for superior execution/profitability or lower earnings volatility.

EV/EBITDA. The most commonly used methodology to value construction equipment rental companies is EV/EBITDA (next four quarters). Based on this measure, AHT is expensive relative its peers, a premium that has widened since 2013.

Source: Bloomberg.

Perhaps, the company’s inclusion in the FTSE 100 Index on December 23, 2013 offers some explanation for this premium. An evaluation of the shareholder base shows that some 56% of the shareholder base were UK institutions, 20% US (many large indexers), and only 5% hedge funds. As the 75^th weighted member of the index, AHT presents an interesting overweight opportunity for active manager, as AHT is at the top of the index rankings for both share price and earnings momentum, offers a uniquely heavy play on the US recovery (with only 15% exposure to the UK), and an implicit long dollar bet in the earnings translation. While AHT investors are likely asking more questions about the energy exposure, the issue has only recently come up, it has not yet impacted AHT’s earnings, and the buyside seems to have a high level of confidence in management given their track record of execution.

Despite a relative premium to the group, on an absolute basis 6.9x EV/EBITDA (2015e) might not sound excessive for a company with expectations of strong earnings momentum, and a 12.4% return on invested capital. The question is whether it is the right metric in the first place. It’s hard to see why this valuation approach is widely used. Depreciation is essentially AHT’s COGS. Without the equipment expense, there is no business. Looking at AHT on EBIT, AHT’s still much more expensive 13.2X versus 10.0x for URI and the group at 9.5x. And interest expense, too, is a critical cost of operations; all of the companies in the business need to deploy leverage to generate acceptable returns. Thus, we may be better off looking at simplistic forward P/E ratios, ignoring some tax and forex issues, by which AHT also screens very expensive at 17.3x, versus 11.1x for URI and 11.8x for the group.

EV/Replacement Cost. One way to sort of strip through these differences is to simply look at the price the market is valuing AHT’s gross, un-depreciated equipment as a proxy for replacement cost. The following graph shows the EV/replacement cost valuation metric has just come off an all-time high (2.75x), and stands at 30% premium to URI (1.93x). AHT’s current valuation is slightly below two standard deviations above its five year mean (1.49x), while URI stands at 1.06 standard deviations above its mean. AHT’s premium exists despite the equipment being largely similar types, rented the same way, to the same types of customers in the same markets. With both companies’ profit margins being nearly identical, it’s hard to see why such a large divergence should exist. My expectation is that, during times of stressed earnings, the market will revert to valuing the businesses on the more certain asset value versus less visible earnings expectations.

Source: Bloomberg.

Expected Value Derived Price Target. I considered, and probability weighted, three potential scenarios to derive our price target.

1)    Upside scenario. AHT meets 2016e expectations for EBITDA and trades at 8.0x EV/EBITDA, a significant premium to its five year group average. (20% probability)

2)    Base Case scenario. AHT’s 2016e EBITDA margins return to 2012-2013 levels on identical revenue estimates, without significant capex cuts, leading to EBITDA 16% below consensus, and an EV/EBITDA valuation equal to its five year historical average. (60% probability)

3)    Downside scenario. AHT delivers the same stressed earnings as the base case, however, based negative sentiment in the group reverts to valuation based on replacement cost, wherein AHT trades at its historical average (1.38x) as a percent of 2015e undepreciated rental equipment (20% probability).

AHT may face significant cyclical earnings risk by CY2H15, perhaps more than peers, due to a few key factors:

AHT has enjoyed a very strong cyclically-driven profitability expansion (1,140bps EBITDA margin expansion) since 2012, coincident with a decision to increase fleet growth to several times the industry average during an economic recovery.

Massive Increases in Capex Accompanied Profitability Improvement and led to Market Share Gains. Big increases capex resulted in a near doubling of the gross un-depreciated equipment base since 2010 (when capex was only a mere £36mm). The decision to ramp up investment was well-timed. Over the past five years, AHT has generated higher revenue as a percent of gross equipment, and higher EBITDA as a percent of gross equipment and revenue. The following table details the cyclical improvement in AHT’s profitability since 2010:

Source: Company filings.

As such, AHT benefitted from a virtuous cycle of a growing equipment base, leased at a greater level of utilization and higher prices. This phenomenon can only exist in a cyclically improving economy. Yet, as AHT’s fleet age has declined (now 24 months), the average un-depreciated cost of the newer rental fleet should logically be at higher prices (URI’s is 45 months), exposing AHT to greater risk if equipment values were to decline.

Despite the tremors, AHT is doubling down on capex. Ignoring rising concerns about the sustainability of the US energy investment binge, AHT’s huge $1.4B capex plan for 2015 (28% increase versus 2014, and 37% of AHT’s 2014 ending gross fleet) could exceed 12% of total industry investment, nearly double its existing market share. On the other hand, URI, twice AHT’s size, is planning on holding capex flat in 2015; a year in which AHT’s capex could actually exceed URI’s. Additionally, several of AHT’s other large competitors, HEES, NEFF, Sunstate Equipment Rental, and BlueLine Rental, have all recently been growing at double-digit percentages above the industry average. This investment splurge raises the risk of a glut of certain equipment types in the market, if demand were to decline, impacting both pricing on new rentals as well as gains on the disposition of assets. Importantly, the short-cycle of AHT’s lease portfolio (which averages around 14 days vs. URI’s, which is measured in months) means the impact of any incremental pricing weakness is felt sooner at AHT in terms of margins.

Investment in the Energy Sector Provided the Tailwind. During the past four years, the strength of energy-related construction spending in the oil patch was a big contributor to rebound of non-residential commercial construction activity. According to the US Census Bureau, oil & gas related spending rose from about 4% of total private non-residential construction spending in 2009 to 11% through November 2014, from about $15B to $24B (after averaging only $6B annually from 1993 to 2006). Oil-related construction spending alone rose 97% in 2012 and 93% in 2013. Total US capital spending in the oil & gas sector totals $135B, or nearly 1% of GDP, with most of it concentrated in just six states. However, according to Baker Hughes, as of January 31,2015, US oil rig counts, which had doubled from early 2011 to a peak of 1,609 in October, 2014 have already fallen 24%, including 20% in AHT’s critical Permian Basin, which accounts for 37% of total US oil rigs. Despite this rapid deceleration in this critical driver, the recent IHS Global Insight forecast for 2015 still expects an 8.1% increase in constructional/industrial rental revenue, versus a 10.5% forecast for 2015 a year ago, as it expects strength elsewhere in the economy to pick-up the slack. This assumption belies AHT’s decision to raise its total capex forecast of to £925-975mm.

AHT’s tactical options if pricing or demand were to weaken. Management can at any time tap the brakes on capex. They will not hesitate to do so if they see diminishing returns on invested capital on new equipment deployed. From an earnings standpoint, however, given the recent massive ramp up in capex, the result of slowing down would be an increase in depreciation expense of the larger equipment base, without as large a resulting increase in revenues, which would hit the bottom line. Lower time and dollar utilization would lead to lower revenues and an erosion in profit margins. However, if AHT were to slow down, its free cash flow (including capex) which is currently running at more than -£200mm, could swing positive, giving AHT significant tactical options to continue creating value for shareholders.

Potential offsets management could employ if capex opportunities look less fruitful is to buy back more shares or grow by acquiring distressed competitors. AHT’s strategic aversion to large share repurchases (in favor of maintaining low leverage) and big transformational acquisition opportunities (which are more likely to help URI) reduce the likelihood of AHT taking advantage of these positive offsets in the short run, with the most likely alternative pursued being further deleveraging (AHT has the lowest debt/EBITDA in the sector).

Risks

• Strong demand for construction equipment outside the oil patch offsets energy-related weakness in the oil patch.
• Used construction equipment prices hold up despite oil patch weakness.
• A 2H15 capitulation on capex plans leads to higher free cash flow and more aggressive share buyback plans.
• Industry profitability declines lead to accretive acquisition opportunities for AHT.
• Tailwinds from lower fuel prices (used in transportation of equipment, a £40mm benefit to AHT in 2016e, already in my numbers) and further weakness in the GBP (a 1% change in USD/GBP adds/subtracts £4mm of PBT) resulting in higher than expected GBP earnings.

Catalyst

• Demand falls due to declines in construction spending within the oil patch hurting revenues and margins.
• Supply-driven pricing weakness emanates from the marginal drag from O&G construction.
• Used construction equipment prices decline due to glut of off-lease equipment leading to a reduction in AHT’s pricing and gross margins (most likely through lower rate rather than time utilization).
• High capex spending plans prove to be mistimed hurting pricing.
• A cut in AHT’s capex budget by spring 2015 could signal a capitulation on earnings expectations.
• High consensus earnings expectations stemming from strong financial performance in recent years lead to consensus earnings shortfalls by calendar 2H15.