Description

HERC

Pair trade: Long HRI/Short URI

We see HRI as undervalued relative to its peers. There is a reasonable short thesis on equipment rental names in general – top of the cycle, swing capacity providers, exposure to energy and a possible fall in construction activity – so we seek to hedge the industry risk with a short in one of the other rental names. We chose URI, other possible shorts include Ashtead, which is more expensive but has a better balance sheet, or NEFF, which is more levered but small cap, lower multiple and has different market exposures. If HRI can approach URI’s return on assets, we could see a double or better.

Company Background

HERC Holdings, Inc., a recent spin-off from Hertz Global, is the third largest equipment rental company in North America.  Herc operates 280 branches in the US and Canada, and has another 10 company-managed and 13 franchised locations overseas.  The Company operates under the name “Hertz Equipment Rental Corporation,” but expects to rename itself to “Herc Rentals Inc.” soon.  Herc’s largest customer concentration is in the commercial and residential construction industries (38% of 2015 revenues), but also includes various industrial, chemical and energy customers (around 23%), as well as “other” such as government, railroad and specialized entertainment and event production companies (39% of revenues).  Herc has been in the equipment rental business since 1965 and has about 4% of the North American market.  The Company rents a broad range of equipment, broadly similar in mix to its largest peers, the main categories of which are aerial equipment at 27%, earthmoving equipment at 19%, material handling at 17%, trucks at 11%, electrical at 9% and other at 17%.

Herc was recently spun out of Hertz (HTZ), where it was a secondary concern to the main car rental business and as a result was quite undermanaged (EBITDA margins are over 10% below publicly-traded peers) and has lost share to competitors in recent years.  The initial reaction to the spinoff has not been positive, with a lukewarm reception from the sell-side community and an underwhelming trading debut.  As the smaller of the two Hertz business, some selling was probably due to technical factors – Herc’s market cap, at just below $1bn is less than 20% of the total equity cap of the combined company, and, in addition, it may be too small for some funds to hold. 

Looking past these issues, we see a company with a new management team, executing on a turnaround using the competitors’ playbook.  Herc trades at the same EV/EBITDA ratio as its peers but a significant discount on an asset valuation basis, despite having significant upside opportunity in both asset utilization and profit margins.  If Herc can achieve peer-level returns on capital employed, there could be 50-60% upside in enterprise value and the potential for the equity to more than double from current levels.  Should management’s execution stall, Herc is an acquisition candidate, a fact that may not have escaped the attention of Carl Icahn, its largest shareholder. 

Industry Dynamics

Equipment rental is still a relatively fragmented industry and in North America, the three largest competitors only account for around 24% of the market.  United Rentals (ticker:URI) ("URI") is the largest player at 13% and Sunbelt (owned by Ashtead, ticker: AHT LN) is next at 7%, followed by Herc at 4%. There are two other pure-play publicly traded competitors of size – Neff (ticker: NEFF) with about 1% of the market, concentrated in the south with high exposure to earthmoving equipment, and H&E (ticker: HEES) which is focused on cranes and lifting equipment.  Other competitors include independents, subsidiaries of other businesses often with a very specific customer or equipment niche such as Home Depot rental (fourth largest player, less than half the size of Herc), or retailers of construction equipment and numerous smaller independent players.

Scale is a benefit to larger players such as Herc who are able to service national accounts, move equipment around to track geographical shifts in demand, have greater purchasing power to get discounts from OEMs, can spread maintenance and parts around multiple locations, and can invest in better systems and pricing tools. While Herc may be smaller than URI or Ashtead, we believe that it should eventually be able to achieve comparable results. NEFF, at around a quarter Herc’s size is able to produce utilization rates and EBITDA margins comparable to URI.

There is a secular trend towards increased penetration for the equipment rental industry, with share increasing from 40% to 53% from 2003 to 2015, while still a long way short of the levels of other developed countries such as the United Kingdom and Japan, which are over 80% rental equipment.  Customers are able to reduce capital investment, outsource repair and maintenance and achieve flexibility in operations, while rental companies can achieve higher utilization rates and lower operating costs through scale.  Industry research from IHS Global projects growth in the North American market of over 5% per year through 2019.

There are valid reasons for concern though. Equipment rental is a cyclical business, as many businesses use rental equipment as “flex capacity” during increases in demand, particularly in the non-residential and industrial construction cycles.  As such, rental businesses are considered to be “early-cycle” plays and there are concerns that the current construction cycle has already peaked.  Rental pricing, measured by the Rouse index, has been flattish over the last several months, affected by a slower pickup in non-residential construction and reallocation of equipment from the recent bust in the energy industry.  Herc has more exposure to upstream oil and gas than peers (10% of Herc’s 2015 revenues compared to around 5% for URI) but firms have aggressively relocated equipment away from the oil patch, and the commentary from all the major players indicate that the markets are stabilizing after two years of decline.

Rental companies constantly sell older equipment to keep their fleet fresh, maintain high availability and manage exposures.  While not a primary profit source, equipment sales are about 10% of revenues.   Recent pricing in the secondary market has been weak, but this is a minor driver of profitability that we think is priced in.

We recognize these concerns and believe that they are already reflected in current stock prices, but we also see several mitigants.  Energy exposure has shrunk and seems to be stabilizing, non-residential construction continues to grow and there has been talk of much-needed infrastructure stimulus during the current election campaign.  Competitors have acted rationally and reduced capital expenditures, which should reduce pressure on rental rates and resale pricing.  Regardless, end-market risk can be hedged by shorting competitors such as URI.

The Turnaround

Herc had seen falling margins and asset utilization over the last several years.  The business was undermanaged as the “junior” part of Hertz, which itself was itself a holding of Ford Motor Company for nearly twenty years.  EBITDA margins have fallen to 36% vs peers at 47-49% and utilization rates are around 75% of peer levels. Until recently, some branches did not have their own manager, pricing was below industry, purchasing was not properly coordinated and sales incentives favored volume over returns.  A new management team was recruited in 2015 and has begun to address these shortcomings.  The two key names from our perspective are Larry Silber, CEO and Bruce Dressel, COO.  Mr. Silber spent 30 years at Ingersoll Rand at various groups including equipment rental and remarketing, as well as recently serving as an advisor to Private Equity and a turnaround CEO.  Mr. Dressel has significant rental industry experience, including as President and CEO of Sunbelt Rentals Inc. from 1997-2003.

The turnaround is focused on a couple of key areas.  The goal for sales is to broaden the customer base and improve the mix of business.  This will be achieved changing the sales force incentives to focus on higher return customers, increasing penetration of smaller local customers, and shifting towards a greater mix of specialty ProSolutions (specialty equipment and support such as HVAC, power, pumps etc.) and Contractor Tools, which in spite of being smaller dollar items, offer a greater profit margin and return on investment.  Fleet dollar utilization (rental revenue per dollar of capital invested) will improve by addressing fleet unavailable for rent, which is already down from 19% to 13%, with a target of 10%, and by changing fleet mix to include more specialty and contractor tools.  In addition, improved pricing technology offers some low hanging fruit for margin improvement.

Improved purchasing coordination has reduced the number of suppliers by 40% to better leverage pricing power and lower operating expenses.  The Company has also been investing in technology and systems – algorithmic pricing tools, customer mobile phone app, management and sales incentive structures.

None of this sounds ground-breaking, nor should it.  Herc is a business very similar to URI and Sunbelt, renting similar equipment, and simply copying best practices should be enough to close most of the gap in systems and operations with its peers. Herc should be able to achieve similar utilization, rental yields and profit margins, (indeed, Herc’s EBITDA margins were in the mid 40% range a decade ago).  Management agrees with this assessment and has set a long term target for EBITDA to meet or exceed peer metrics.

Capital Allocation

Herc is relatively levered – around 3.6x debt to EBITDA, above URI at 2.8x but comparable to NEFF at 3.75x.  We expect the leverage ratio to fall as operational improvements increase the Company’s EBITDA, and the company target is 2.5-3.5x.  There will be some modest green-field expansion but management has ruled out major M&A as a use of cash.  We take comfort in the presence of an experienced CFO, a CEO with a background in private equity, and the heavy hand of Carl Icahn as the single largest shareholder at 15%.

Valuation

Herc currently trades at 5.12x management guidance for 2016 EBITDA, vs URI at 5x and Ashtead (Sunbelt) at 5.6x 2017 ests (Ashtead FY ends in April).  On this metric, the Company appears to be roughly fairly valued relative to its peers.  The upside potential becomes apparent when we compare dollar utilization and profit margins with peers. Herc’s peers operate in a tight band of utilization (measured as rental revenue to rental assets) EBITDA margin, or return on assets (measured as EBITDA / average tangible assets).

If Herc can achieve the same operating return on tangible assets that URI does, EBITDA would increase by over 80%.  That’s a best-case outcome, and differences in fleet composition, energy exposures, scale etc. should be accounted for, but those shouldn’t be huge if management can execute – it’s broadly the same equipment after all. If we say that structural differences justify 15% discount on ROC to URI, that would still indicate a possible 55% increase from current levels and a stock price of over $80. Reasonable people can come up with different estimates, but our point is that there’s a lot of value to be captured if that gap narrows. In short, we see a potentially large upside and a lot of ways to win.

Risks

There is clearly a lot of execution risk, which is partly mitigated by management’s experience. There is cycle risk, which can be hedged by shorting the stocks of peers.  We also have the comfort of Carl Icahn as a 15%+ shareholder who we assume will be monitoring progress closely.  On the upside, the industry has seen a lot of consolidation over the last decade and Herc would be a natural target once any tax issues post-spin are no longer in play.

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author or affiliated funds  presently has a long position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

Catalyst

Execution on turnaround plan, improved dollar utilization, strengthening of construction end markets