Description

Investment Thesis

Trading at ~2 standard deviations above a particularly flawed metric for this type of company (EV/EBITDA), URI is a short given that supply in the rental equipment industry is growing faster than demand while the entire street is only focused on accelerating non-residential demand. This is akin to saying buy pressure pumpers in the oil patch in mid 2011 because the outlook for demand (i.e. in this case wells drilled or stages frac’d) are exploding higher. The market is missing supply and the best evidence is the current cadence of rental rate as reported and guided to by URI.  I think URI may have ~10% upside in a good case and otherwise 30-50% downside.

"You were very polite in how you characterized the industry. In the history, the industry has spent like drunken sailors when times get good." - Bill Plummer - United Rentals, Inc. CFO, RBC Global Industrials - 9/9/14

Business Description:

URI purchases construction equipment (with a scale advantage), rents it to customers making a spread between the rental rate and the cost of financing and depreciation and SGA, and then sells the equipment in the used market. This is a very fragmented industry with no barriers to entry suggesting the economics here should be capped either by competition or by customers choosing to buy instead of rent.

This is a deep cyclical, capital-intensive, commodity business which has failed to earn its cost of capital through prior cycles yet is now trading at 1.7x invested capital and 6x book value. Tangible book is negative…

Some salient points:

• The company has a whopping 11% ROIC target which in their own slide is driven by volume growth and/or fleet utilization and not price. Price/cost is actually negative in their forecast to this ROIC target.

• At this target ROIC, the earnings power is roughly $10-11/share suggesting the stock is north of 10x a peak number that we don’t think will happen.

• Even with the 11% ROIC target, the company is trading north of 2x its original equipment cost (undepreciated) suggesting the replacement cost here is literally a fraction of where stock is trading.

• The company is implicitly guiding to rental rate growth of 3.5% and inflation of 2.5-3% yet insists on incremental margins north or 60% which only happens if utilization goes higher which begs 2 questions: (1) if utilization, already at very high levels and at levels most industry participants say are at the upper limit, then what is upside here without impairing revenue opportunities and therefore market share, and (2) why not invest more in the business if the outlook is so good? Peers such as Ashtead et al are doing so.

• Many on the street use EV/EBITDA as the valuation metric which makes no sense considering D&A is actually COGS here. Why should URI trade at a premium to HON or UTX on EV/EBIT?

• The street got excited about free cash flow but guidance here was actually below recent models. The company is effectively buying back stock when the rental rate has eclipsed prior peaks. These will prove to be dilutive purchases.

• URI’s own investor presentation shows a 40% incremental return on a hypothetical asset. Bulls have to believe that this cycle is different and that the thousands of competitors don’t have appetite this times…

• The multiyear stack on rental rates is wobbly at best and suggest the days of price > cost are done or very late stage for the industry in this cycle. This is also evident in gross margin progression.

Some background information.

• URI has been a tremendous outperformer since 1/1/13

  • Up 147% vs SPX up 45%

  • This is despite very minimal revisions to earnings. In fact the vast majority of the revision has been due to a $780mm purchase for an oil and gas levered pump rental business at 3x the original equipment cost of the business…!!

• The primary explanations for the outperformance include the following:

  • Exposure to commercial construction an end-market where acceleration is expected

  • Increasing penetration of equipment rental vs ownership

  • Increasing rental rates

  • Improving used equipment values

  • Lack of growth elsewhere in machinery, making URI a more appealing pitch to PMs looking for longs in the group

  • Increasing end market demand for equipment rental is likely to push utilization rates to new AT highs for URI & the industry

  • A changing portfolio mix away from larger / lower dollar utilization equipment classes towards more favorable equipment classes should improve returns

• While all of the aforementioned points are valid, these arguments are mostly backwards looking (i.e. rental rates have seen tremendous improvement off the bottom, utilization has improved very meaningfully, rental penetration has improved by 1,000bps over the past 10 years, used equipment values are at unprecedented high levels)

  • This means 1) risk on many of these factors is skewed lower not higher – especially for rental rates, rental penetration rates (proving more counter-cyclical), used equipment values (later in cycle) 2) Most of the bullish arguments approach the industry assuming that demand growth is increasing much faster than supply. A contention that I will strongly disagree with. 3) A very bullish case on rental rate growth, utilization improvement, and volume growth is already priced into estimates. 4) Given that the stock trades at an AT high multiple of “EBITDA” (the reason why it’s in quotations is that it is incredibly misleading vs. any other industry/company that I’ve come across. Most companies have D&A % Sales between 3%-5%. URI has D&A % Equipment Rental Revenue ~35% Sales) I argue that what is being priced into the stock are big beats and 3-5 years of solid growth. I believe that the odds of this scenario coming true is very low. In light of 1) big risk from accelerating competition and 2) increasing risk for used equipment value declines

• Gauging Increased Competition Risk (Review Exhibit Below)

• Rental Equipment Register data provides one of (if not the most) comprehensive historical data sets

  • It captures historical rental revenues from the top 100 US rental companies (including a sprinkling of crane rental operators – who have under-grown the general rental peer set)

• Putting Sunbelt’s Growth CapEx in context

  • Since URI has grown several hundred basis points slower than the industry over the last 2 years as per company estimates and RER figures, we should assume that Growth CapEx of 500m ~10% of total industry growth capital

  • This implies that while Sunbelt is 6% of industry revenues in 2013 vs URI’s 12%, Sunbelt is spending the equivalent of 18% of industry growth CapEx / 80% more than URI

  • Since the lag between growth CapEx spend and rental revenues is pretty short <1month, Sunbelt’s growth plans are disruptive to URI and the whole industry

• Other Players who are taking share include:

  • H&E Equipment Services $340m Rental Revenue (growing 10% faster than industry over 2011-2013)

  • NEFF Rental $281m (growing 5%-10% faster than industry)

  • Sunstate Equipment Rental $300m (growing 15%-20% faster than the industry)

  • BlueLine Rental (Former Volvo Rents) $425m (growing 10%-15% faster than the industry)

    • Combined the 4 players listed above equate to 1.345bn of rental revenue (32% of URI), yet are expected to generate almost as much growth as URI

      • Basically Ashtead + these 4 players =1.6x Ashtead’s disruptive power

• Good Quote from NES Rentals:

  • “We feel more comfortable increasing fleet purchases today than at any other point in the cycle”

    • I think that this type of emboldened behavior by many discrete rental players acting in their own best interest is likely to lead to an over-supplied rental market in the near future

      • Especially when combined with flattening penetration rates and

• Supply Growth

  • The top 10 players on RER 100 list are collectively growing 400bps faster than the market as a whole

  • This assumes that URI grows in-line with the market, HERC grows in-line with the market, Aggrekko & NES grow in line with with the market and Home Depot Rentals grows at ½ the market rate

  • Sunbelt, H&E, NEFF, Sunstate and Blueline (Volvo) are collectively growing 1500bps faster than the market

  • While, it is not being captured here. An additional supply-side risk that is cited by both OSK (independents growing aerial purchase volume by ~15% (HDD growth rate net of 4%-5% YoY price inflation), while national rental companies are closer to flat. And Rental Equipment Register – “Most companies are predicting similar increases for 2014. Plans are being made to increase fleet and open new branches. Unlike three years ago, when rental companies were pulling in their horns, cutting expenses, reducing the size of their fleets, and closing branches, now the horses are back out of the barn and the reverse is taking place. Although many of the steps forward are cautious, nonetheless they are movements in the direction of growth and expansion.”

  • So, while we generally assume that the large companies collectively will maintain / slightly increase share, comments like those by OSK. Suggest the opposite dynamic is the more likely scenario.

  • Basically, supply is growing rapidly and in accelerating fashion from 5 of the top 10 and from the smaller side of the market. This is generally not conducive of 3 or more additional years of 4%-5% rental rate increases

• Rental Demand Growth

  • Rental revenue growth consists of the following variables:

    • Underlying Demand Growth ( ~50/50 split between industrial MRO and Non-Residential Construction) * (1+ ∆ Rental Penetration)

      • Ashtead has acknowledged as have many others in the industry that rental penetration is likely to stabilize and not play much of a role in driving demand higher over the next several years

      • I believe that industrial MRO is growing at ~4%

      • And non-res construction is growing at ~10%

      • Together this blends to 7% demand growth

      • To the extent that non-residential construction accelerates vs. this assumption I estimate that each additional 1,000bps of growth would have a .5 coefficient on additional rental demand growth in the non-res vertical

      • So 1,000bps of additional construction growth would equal 500bps of additional volume growth in the non-res slice * 50% Non-Res Weighting = 250bps of additional rental revenue growth

    • In other words, I believe that it would take 20%+ non-res construction growth to get the industry to 10% volume growth

    • By way of reference. The industry (as measured by RER Top 100 has only achieved volume growth of 10% or better in 1 year out of the last 14 (2011) due to a meaningful improvement in rental penetration

      • Please refer to the paste-in several pages back that references historical volume growth rates for the top 100

• Percentage of rental companies that are looking to grow their aerial fleet (As per Access International) is highest in 2014 since 2007

• North American Access Equipment sales volumes were 59k units in are likely to approx. 66k-67k units in 2014. (i.e. the base off of which further growth is set to occur is at an elevated level)

  • Prior peak units = 80k (2007)

  • Average of 2006-2008 = 74k units

  • This suggests that the supply side spending of the market is already at very healthy levels.

    • As independents come back into the market and the market share gainers continue to exercise the capacity offered by their higher returns / cash flows, the overall volume of spending could well overwhelm the growth in demand.

Rental Penetration by Equipment Category:

• Anecdotally it sounds like aerial rental penetration today is marginally higher than 10 years ago (NES Guidepoint conversation)

Composition of URI’s rental fleet (56% - 59% of URI’s fleet is equipment that OSK and TEX are primary producers of):

• Forks = telehandlers

• The point here is that while it’s difficult for us to say with total confidence that independent rental companies (when growing “strong double digits”) that it’s all accelerating supply vs just delayed replacement spend, the point remains that much more new equipment in the hands of players who before were reluctant to spend and now are finally able to because of improved rental economics + greater access to financing is not positive for URI’s share / rental rates / utilization, etc

• Rental Penetration (To Rent or To Own ?)

  • Has increased by ~1200bps 40%-52% over the past decade

  • It represents the relative mix of rental vs ownership.

  • The debate between whether ownership or rental makes more sense is complex and nuanced

    • However, there’s pretty broad consensus Rouse, Ashtead, etc. that it’s unlikely to go up very much as the construction recovery starts to broaden

      • Some of the unwillingness to buy was driven by increased prominence/appeal of rental

      • But 2 other important drivers have been lack of confidence/visibility in backlog of work + reduced availability of financing for big-ticket purchase among contractors / small business owners

      • I just assume that penetration flat-lines for the next few years. If it backs up by even a couple hundred basis points it will further exaggerate the competitive pressures that are discussed throughout the document

• Used Equipment Disposition Gains / Orderly Liquidation Values are at all time highs

  • There is meaningful risk that over time they should trend lower

    • This will happen due to one of the following reasons

      • a) price war / need to de-fleet due to industry over-supply

      • b) recession

      • c) reduced used equipment demand from fewer Latin American buyers who have supposedly accounted for ~50% of the used equipment market

      • d) More used equipment being brought into US market over time due to Latin American recession

  • URI’s Gross Profit Margins on sale of used equipment are up 1,200bps from last cycle highs

    • Risk is likely skewed to the downside although no clear catalyst is evident to take margins lower yet.

  • Used equipment gross profits are 15% of the total company operating profit

Perception / Model Variation

• What’s imputed in estimates is something very, very close to this (left): / I believe that the stock is imputing something much more like what’s being captured on the right

Directionally: Top 2 public companies have admitted that rate growth is likely to decelerate from here:

• And the third, H&E has experienced noticeable deceleration in Q2

• URI – Q2 2014 Conference Call

Ashtead has acknowledged that rental rates are likely to decelerate moderately in the out years. But they also have more pricing power given the last-second / small customer mix of their business vs highly national account focus of URI.

• H&E has just shown 320bps of rental rate deceleration on a 2-year stack despite having the majority of their business in the Gulf.

  • The company received a lot of questions / concerns on Q2 rate development and generally answered them favorably. But the street was a bit surprised overall that the business did not see more rental rate improvement.

Risks

• Potenitally accretive acquisition of HERC

• Rental rates accelerate due to disciplined behavior from competitors – due to a sudden spurt in end-market demand

• Further multiple expansion to new AT high levels.

  • Remember that a 1.5 point reduction in multiple here (back to something close to the LT average) = 40% reduction in the share price

  • If the market starts to believe that we are near cycle highs

Catalyst

Rental rate disappointing

Earnings misses by 1H15

Reports of supply growth in industry