We recommend a long position in United Rentals (URI).  We estimate the Company’s recurring cash earnings power to be ~$10/share (based on “maintenance free cash flow” or cash EPS), which very few investors or analysts are focusing on.  At the midpoint of our valuation range of 10x – 12x cash EPS, URI should be worth $110 / share today, representing a 72% premium to the recent market price of $64 / share.

URI was written up on VIC in October 2012 and we would encourage investors to read the earlier writeup for background.  We like URI for many of the same reasons previously articulated (attractive point in non-res construction cycle, secular penetration growth as users increasingly choose to rent equipment over buying, synergies and scale advantages from RSC acquisition which created a dominant industry player, favorable capital structure, and attractive valuation).  However, we would like to re-focus the discussion on a concept that is not widely understood about this Company – its copious maintenance free cash flow generation.

While many investors and analysts value URI on an EBITDA multiple basis, we believe the best way to look at the Company is on a cash P/E basis.  At its core, this is a leasing business – it buys equipment, using financing, and leases it out to customers, hoping to make a spread over and above its depreciation and interest costs.  As such, depreciation and interest are core expenses of the business model.  What really matters is the spread the Company is able to earn, which is captured as the net income available to equity holders.  Like a leasing company, bank, or any finco, the most relevant valuation metric for this Company is its P/E multiple.  We think that, like a finco or bank, URI should probably trade at a 10x – 12x normalized (ie, mid-cycle) P/E multiple.

Optically, URI does appear to trade at a reasonable P/E multiple.  Consensus estimates are for $4.53 of EPS in 2013 and $5.95 in 2014, so at a $64 stock price, it looks like it trades at 14.1x 2013E EPS and 10.8x 2014E EPS.  However, this approach misses the fact that cash earnings are materially higher than GAAP earnings.  We estimate cash earnings are closer to $10 / share today, implying URI is trading around only ~6.4x cash earnings.

This became especially evident when, at its Q3 earnings release, URI added a slide to its investor presentation which, for the first time, broke out CapEx between maintenance CapEx and growth CapEx.  URI’s guidance for 2013 calls for $400 – 500m of free cash flow, after spending $1.6bn of gross CapEx.    This CapEx is broken out between $1,055 of maintenance CapEx (ie, CapEx needed to maintain the fleet at the same size and age), and $545m of growth CapEx (ie, CapEx spent to actually grow the size of the fleet).  This implies that free cash flow this year on a purely maintenance CapEx basis would be roughly $1bn (based on $400 – 500 of FCF, and adding back $545m of growth CapEx).  This means URI is currently trading at a >15% FCF yield, or ~6.6x maintenance free cash flow.

This raises the question: why is maintenance free cash flow, which should approximate cash net income, so much higher than actual, reported net income?  Why does URI appear to be trading at 14.1x 2013E earnings, but only 6.6x 2013E cash earnings?  What is the difference between cash earnings and GAAP earnings?  There are 4 separate reasons:

-          GAAP vs Cash Interest – There is ~$55m of non-cash interest running through URI’s income statement.  This is an accounting fiction that unfairly depresses GAAP net income, relative to true cash net income.

-          GAAP vs Cash Taxes – URI is currently paying a low-teens % cash tax rate, as opposed to a 37% GAAP tax rate, leading to significantly lower cash taxes than GAAP taxes.  This is partially due to NOLs, which will run out in 2015, but is partially due to a structural tax advantage which will persist forever.  Every year, URI sells its oldest fleet (roughly 1/7 of the fleet / year), and replaces it with new equipment – this is the maintenance CapEx mentioned above.  This fleet recycling is treated as a like-kind exchange under Section 1031 of the internal revenue code, and so even when its NOLs run out in 2015, URI’s cash tax rate will be ~25%, significantly lower than the 37% on its income statement.

-          Maintenance CapEx vs. D&A – URI’s D&A on its income statement (excluding amortization from the RSC merger) will be ~$1.0 bn this year, versus ~$630m of net maintenance CapEx (which we calculate as the gross maintenance CapEx mentioned above of $1,055m, net of $500m of proceeds from selling old equipment this year, plus a small amount of non-fleet CapEx).  This is a huge GAAP vs. cash difference of ~$370m, but it is partially offset by the non-cash gains on sale that URI books into its income statement when it sells old equipment – we estimate roughly $180m this year.  Still, the net surplus of cash earnings over GAAP earnings of all of this accounting is a sizable ~$190m this year.  Why the large discrepancy?  Some portion of it is due to URI arguably depreciating its fleet for accounting purposes faster than its true economic useful life, although that delta should theoretically be made back up when URI sells its used equipment at a premium to book value and books the gain on the sale into its income statement.  Arguably, some of the discrepancy may potentially be due to URI underspending on maintenance CapEx this year (they are replacing closer to 1/8 of the fleet this year as opposed to a more standard 1/7, as demand is strong and they can afford to let the fleet age a bit given its current young age relative to history).  However a large portion of the discrepancy (roughly $80m) is due to non-cash amortization of intangibles from prior acquisitions (the Company does itself a bit of a disservice by adding back RSC-related amortization to calculate an “adjusted EPS,” but not adding back amortization related to any of the other many acquisitions it has done through the years).

-          Other – In our model, stock comp (~$50m), additional one-time restructuring/merger expenses (~$20m), and working capital source of cash (~$50m) all provide additional reasons why, in 2013, we are getting to maintenance free cash flow of >$1bn (ie, cash EPS of $10/share) as opposed to GAAP EPS of ~$4.50 / share.

We would note that, while GAAP EPS should ramp significantly over the next few years (consensus estimates of $4.53 in 2013, $5.95 in 2014, and $7.35 in 2015), we estimate maintenance free cash flow (or cash EPS) to stay around the ~$1bn level (or ~$10 / share) over that time frame, as the NOLs burn off, maintenance CapEx increases to a more typical 1/7 of the fleet / year, the used equipment prices that URI collects come down to historical averages which they are currently above (perhaps a conservative modeling assumption), working capital is no longer a source of cash, and one-time restructuring/merger costs go away.  These headwinds to cash EPS should be offset by actual earnings growth of the business itself through 2015 as we enter into a more normalized environment for the Company’s construction and industrial end-markets, such that cash EPS will stay around $10 / share.  All of these effects will help close the delta between GAAP EPS and cash EPS from ~$5 / share in 2013 to ~$2.50 / share in 2015, but that is still a large discrepancy which will persist, mainly due to the ~$55m of non-cash interest, the ~$80m of non-cash intangible amortization, and ~$100m of non-cash taxes (due to the like-kind exchange tax benefit) that will continue running through the income statement for the foreseeable future.  Stock comp will also continue to cause a ~$50 – 60m delta between GAAP and cash earnings, but we acknowledge that that should be treated as a true economic expense.

Thus we expect $10 / share of true cash earnings power to persist at URI, and would value the Company based on 10x – 12x that, or $110 / share at the mid-point, representing 72% upside to the recent price of $64 / share.

Finally, we would note that, for the next few years, actual free cash flow will continue to be lower than the maintenance free cash flow (or cash EPS) number we are focusing on, as the Company will continue spending on growth CapEx to grow its fleet as the non-res construction cycle continues to recover.  We think the Company did itself a disservice recently when it took its cumulative 2013 – 2015 FCF guidance down from $2bn to $1.5bn, but failed to distinguish that the majority of that delta was due to a discretionary decision to spend more on growth CapEx (and not due to any deterioration in its core business).  We acknowledge that actual free cash flow matters, and URI has historically had trouble earning its cost of capital, and so, in order to like the stock, you must have a view on the growth CapEx the Company will certainly be spending, and just how attractive of a use of capital it is.  URI claims that the incremental growth CapEx will have a high return, with every $1 of CapEx translating to 37.5 cents of EBITDA (based on 50% dollar utilization and a 75% EBITDA flow through), as returns on incremental invested capital are higher than overall corporate returns on invested capital.  It is believable that this CapEx will generate an attractive return relative to history, given 1) the Company is operating at record high margins due to an improved cost structure, which should continue to increase over the next few years as revenue growth comes with very high incremental margins due to the high fixed cost nature of the business, 2) we are still in the early innings of the non-res construction recovery, with increasing demand, utilization, and pricing likely over the coming years, and 3) most of the CapEx is being spent on the specialty rental business (HVAC/power and trench), which does indeed generate higher ROICs. 

Moreover, the Company’s recently announced $500m share repurchase commitment guarantees that a large portion of the Company’s cash flow will be returned to shareholders, and ensures that they simply cannot increase growth CapEx much higher than current levels.  Or, if they do, they will have to debt-finance it, and since the Company has historically generated a very attractive return on equity (in spite of its inconsistent ROIC), debt-financing new fleet additions can end well for equity holders.

Earnings growth

Share repurchases

Investors re-focusing on URI’s copious maintenance free cash flow (cash EPS)