Description

Overview

Shares in United Rentals, Inc. (URI) afford investors the opportunity to own an underappreciated, high-quality business with a strong balance sheet run by an outstanding leadership team for an outstanding price. URI is (literally!) a “picks and shovels” way to play some of today’s hottest trends, like electric vehicles (EVs) and the energy transition, US onshoring of manufacturing, and the modernization of critical infrastructure: 

URI Investor Day slides, 5/31/23.

 

Despite its strong qualitative and financial characteristics, the market does not give URI much love. We underwrite a mid-teens annual return on investment over the next five years.

 

URI is the leading North American lessor of construction equipment (aerial lifts, forklifts, dirt moving, etc.). It competes with only two other (smaller) players of any size in a highly fragmented industry where the benefits of scale accrue to the biggest players. URI and its main competitors have been growing market share both organically through branch expansion and better branch productivity and inorganically by rolling up smaller players. With scale also comes the ability to better service the larger national customers that stand behind most of the mega construction projects. As URI’s scale has improved so have their financial characteristics, including high margins and returns on capital. Management has proven adept at operations and capital allocation, including intelligent M&A and timely stock buybacks. They are culture leaders and run a lean business with a solid balance sheet. Though cyclical, the nonresidential and industrial construction market where URI plays benefits from several tailwinds, including massive future investment from government and private enterprise around infrastructure, onshoring, and energy transition, and a secular shift from ownership to rental among construction companies. Despite these attractive characteristics, URI trades at a low multiple.

 

Note that URI has a December fiscal year end and references to the latest twelve-month (LTM) period are for the year through March 2023. Note that throughout this document, when we refer to EBITDA, we have already deducted for depreciation related to equipment as if it were a cash expense unless otherwise noted.

 

 

The Business

URI is the largest equipment rental company in the world, operating throughout the US and Canada and with a small presence in several other countries that they established through the acquisition of BakerCorp in 2018 (Europe, 14 branches) and General Finance in 2021 (Australia, 27 branches, and New Zealand, 19 branches). North America represents around 90% of total revenues with 1,319 branches in the US (with concentrations in TX, CA, FL, LA and GA) and 146 in Canada. The company estimates their North American market share at approximately 17% in 2022 (pro forma for the recent acquisition of Ahern Rentals): 

 

URI Q1 2023 earnings slides.

 

URI serves two main end-markets, nonresidential and industrial construction:  

 

URI Q1 2023 earnings slides.

 

This gives some sense of the exposure by vertical: 

 

URI Q1 2023 earnings slides.

 

URI rents equipment out on an hourly, daily, weekly, or monthly basis, though ~80% are typically on monthly contracts (source: URI Q4 2022 earnings call). In addition to basic rent, the company charges for equipment delivery and pickup (8% of equipment rental revenue in 2022), protection against liability for damage to equipment while on rent, fuel, and environmental costs (collectively another 8% of equipment rental revenue in 2022). Equipment rentals represent the bulk of revenues at 86% of total revenue in the LTM, with sales of used equipment making up most of the rest. Gross margins on rentals tend to run around 40%.

 

URI sells equipment into the used market when it is no longer economic to rent it out, typically after around 7-8 years (source: HRI Q1 2023 earnings slides) (average fleet age was 54 months, or about 4.5 years, as of yearend 2022). Used equipment sales were around 9% of LTM revenues. The weighted average salvage value was 12% of cost as of yearend 2022. The associated depreciation policy is likely conservative, as URI typically generates a 45-55% gross margin on used equipment sales. The company depreciates equipment whether or not it is on rent. 

 

The equipment fleet totaled nearly $20 billion at original cost as of yearend 2022, with over 1 million units. 

• The General Rentals (GenRent) segment includes construction and industrial equipment (backhoes, skid-steer loaders, forklifts, earthmoving equipment, material handling equipment), aerial work platforms (boom lifts, scissor lifts), general tools and light equipment (pressure washers, water pumps, power tools), and related services. GenRent was 74% of LTM revenue and 68% of LTM equipment rentals gross profit and had 983 locations. 

• The Specialty segment includes specialty construction equipment for uses like trench safety (trench shields, aluminum hydraulic shoring systems, slide rails, crossing plates, construction lasers and line testing equipment for underground work), power and HVAC (portable diesel generators, electrical distribution equipment, temperature control equipment), fluid solutions (fluid containment, transfer, and treatment), mobile storage, and modular office space. Specialty was 26% of LTM revenue and 32% of LTM equipment gross profit and had 482 locations. This gives a sense of equipment breadth: 

 

 

URI Investor Day slides, 5/31/23.

 

The business rents and services equipment and customers out of an extensive branch network that includes over 1,500 locations as of yearend 2022. Each regional office (which includes ~25-125 branches) has its own management team. URI uses a decentralized management system whereby it empowers branch managers to make day-to-day decisions concerning branch matters (within budgetary guidelines). 

 

The main competitors are Sunbelt (owned by London-listed Ashtead Group plc, or AHT) and Herc Rentals (HRI). 

• AHT: AHT’s US and Canadian businesses had $4.4 billion in revenue in 2022 out of a total $4.8 billion, so they are largely defined by the segment that directly competes with URI. AHT looks quite like URI in most respects, including its financial characteristics and strategic approach. 

• Herc: HRI is a pureplay but considerably smaller at only $2.6 billion in 2022 revenue. HRI also looks much like URI, except that HRI has significantly lower margins due to its materially smaller scale and owns an ancillary studio entertainment business. HRI also seems to have more of what they call “spot” business (presumably daily rentals) at 35% of their mix (source: HRI Q1 2023 earnings call.). 

 

Management

Management, led by CEO Matt Flannery, has overseen a disciplined strategy focused on organic and inorganic revenue growth and margin expansion. 

 

In the boom period leading up to the great financial crisis (GFC) of 2008/2009, adjusted operating margins peaked at 18% (in 2007). In 2022, they were 30%, an increase of 1,200 bps. The gains have come from both gross margin (800 bps) and leverage over SG&A (400 bps). Management achieved this impressive result by focusing on customer segmentation, customer service differentiation, rate management, fleet management, and operational efficiency. Here is how management presents their evolution: 

URI Q1 2023 earnings slides.

 

A slide from AHT provides some further historical industry context: 

AHT Q3 2023 earnings slides.

 

Much of URI’s performance comes down to management approaching the basics with thoughtfulness. For instance, management drills down to the unit-level return to understand whether they should be making changes. This shows their framework: 

 

URI Investor Day slides, 5/31/23.

 

They make the initial quantitative buy decision on equipment based on the lowest total cost of ownership (that is, they look at factors like maintenance costs in labor and parts, resale value, etc., not just acquisition cost). 

 

Leadership at URI talk the talk and walk the walk on culture. Their corporate decks are tuned towards “people” and “customers,” and while that’s easy to show as marketing/promotional propaganda, their authenticity does seem to be supported by the evidence. For instance, they quantify and claim to be a top decile performer across performance categories like safety, DEI, engagement, and health and wellbeing (source: URI Investor Day, 5/31/23). Voluntary turnover is low at around 13%, a retention rate that far exceeds the industry norm. Here is how they represent their value creation framework, which ties together their people focus and corporate values with operations and financial goals: 

URI Investor Day slides, 5/31/23.

 

They maintain close relationships, frequently training customers  in equipment usage and looking to achieve a consistently superior standard of service to customers (often through a single lead contact who can coordinate across the network). They accomplish this by utilizing a proprietary software application that enables customers to monitor and manage all their equipment needs. 

 

Management’s focus on technology is apparent in many areas, many of which are true competitive differentiators:

• Rental fleet management platform: real-time account and equipment telematics  information

  • Open and close rental contracts

  • View invoices and pay bills

  • Locate GPS enabled equipment

  • Customize alerts to proactively manage utilization

  • Customize reports and KPIs

  • Estimate greenhouse gas and engine emissions

  • Performance monitoring and service alerts

  • Efficient location and pick-up

  • Overtime and revenue recovery

  • Fuel alerts

  • Self-serve digital actions 

  • Desktop and mobile access

• Field Automation Systems and Technologies (FAST)

  • Driver and dispatcher productivity

  • Fleet efficiency

  • Fuel consumption

  • Safety

  • Environmental

• Digital marketplace 

 

This slide captures some of the day-to-day applications of URI’s technology, which smaller competitors can’t afford to develop: 

 

URI Investor Day slides, 5/31/23.

 

They leverage the data from this technology to improve and automate decisions around sourcing, assignment, pricing, and maintenance: 

URI Investor Day slides, 5/31/23.

 

URI’s annual “Customer Day,” where they invite 1,200 customers for one-on-one conversations at each URI branch, shows that customers value fleet quality and availability (45%), and responsiveness and on-time customer service (42%) as far and away the most important factors in their choice of lessor.  Pricing (10%) and other factors are much further down the list. URI’s customer focus through service, technology, and data has led to a best-in-class net promoter score (75 in 2022), comparable to or better than leading consumer product and retail companies (source: URI Investor Day, 5/31/23). 

 

The company uses lean management techniques, including kaizen processes focused on continuous improvement. The branch network employs kaizen to reduce cycle times for rentals, improve accuracy and service, reduce elapsed time for equipment pickup and delivery, and improve the efficiency of repair and maintenance operations. They hold about 800 kaizen events per year. These efforts have resulted in a meaningful increase in how much equipment each branch can offer: 

 

This has occurred despite significant growth in the branch count: 

 

They have been able to accomplish the higher branch productivity without a material change in employees per location:

 

This improved capacity and efficiency has led to dramatically improved profitability per branch:

 

They’ve also done a good job expanding the attractive Specialty footprint. From 2012 to 2022, Specialty revenues grew at a 26% compound annual growth rate (CAGR), increasing from 7% to 26% of revenues. Specialty’s higher equipment rentals gross margin (44% vs. 33% for GenRent in the LTM) and equipment rentals gross profit return on segment assets (30% vs. 15% for GenRent in the LTM) lead to an outsized profit and returns impact from Specialty revenue growth. 

 

Furthermore, management has proven to be thoughtful acquirers of smaller competitors, staying squarely in the core equipment rental business to benefit from scale economics. Management has completed around 300 transactions over 25 years, leveraging scale and removing duplicative branch and overhead expenses to drive margin enhancement. They have created a core competency in integrating deals – for instance, they had recent target Ahern operating on URI’s systems within 10 days of closing the acquisition. URI has spent around $13 billion on cash deals since 2000, which compares to free cash flow (FCF) of almost $17 billion over that time. Sustained high returns on invested capital (ROIC) and returns on equity (ROE) argue this has been a good use of capital. The industry remains highly fragmented, providing a long runway for continued consolidation before risking DOJ concerns. 

 

In addition to its thoughtful M&A approach, management is not shy about retiring stock. Since 2012 they have bought back $5.0 billion worth of stock, reducing the outstanding share count by 40%. They claim to have earned over a 20% IRR on these purchases (source: URI Investor Day, 5/31/23). They expect to buy back $1 billion of stock in 2023. 

 

Management compensation is reasonable, with adj. EBITDA and “economic profit improvement” (a proxy for returns) driving annual bonuses and revenue growth and ROIC driving long-term comp. They make occasional all-company stock grants to incentivize rank and file to think like owners (2014, 2017, 2020, 2022).

 

Management oversees a solid balance sheet, with $11.4 billion of gross debt that works out to 3.0x LTM EBITDA. The ratio is better than it might appear, as we have already deducted depreciation on rental equipment as a “cash” expense. So, debt to operating profit is not much different and a healthy level. The optics around the leverage ratios can change quickly though given the cyclicality of the business. This makes asset-based credit metrics an arguably more useful perspective. Debt is currently 47% of assets and 86% of rental equipment net book value. These are both comfortable levels and considerably lower than historical averages (62% and 125%, respectively, since 2000).

 

URI’s debt consists primarily of secured and unsecured senior notes with well-staggered maturities from 2027 to 2032. They also have $1.5 billion drawn under an ABL facility that expires in 2027 ($4.25 billion capacity), and $1 billion each in an accounts receivable securitization facility that expires in 2024 and a term loan facility that expires in 2025:  

URI Q1 2023 earnings slides.

 

The term loan facility has no financial covenants. The only financial covenant under the ABL facility is a fixed charge coverage ratio, and it only applies if availability under the facility falls below 10% of the maximum revolver amount. Their smaller accounts receivable securitization facility refers to the same covenant under the same circumstances, plus a few more specific to the receivables collateral (default ratio, delinquency ratio, dilution ratio, and days sales outstanding). Just under 30% of URI’s debt is variable rate, exposing them to some interest rate risk.

 

 

Business Quality

URI sports attractive returns on capital, with pretax returns on tangible capital running around 25-30%, pretax ROIC around 15-20%, and after-tax ROEs in the 25-40% range. Here is ROIC:

 

Margins are solid and stable, with operating margins fluctuating between 25% and 30% since the GFC:

 

Both the margin profile and the return profile speak to a high-quality business.

 

As the largest player in the market, URI benefits from significant economies of scale. These include:

• Branches within a region can share equipment located elsewhere in the region. This increases utilization and availability and allows for more disciplined capital spending.

• Branches can leverage URI’s national customer care center in North Carolina. This frees up resources at the branches and allows for a more uniform customer experience.

• URI can serve national accounts (those with more than $500k in revenue) with multiple locations.

• URI can devote significant resources towards developing top-of-class technology to better serve customers and manage assets.

• URI can leverage their scale for better purchasing power, including negotiating better prices for new and used equipment purchases and sales, and to access more locations across the country for used equipment sales.

• Corporate HQ consolidates common branch functions like AP, payroll, benefits and risk management, IT, and credit and collection. 

Goldman Sachs has attempted to quantify the scale advantage in terms of IRRs on equipment purchases, though we don’t know the methodology they used to arrive at these conclusions:

 

URI’s equipment is also a relatively small but important part of a customer’s operations. The cost of rental equipment is around 2-3% of total project cost as per management (source: URI at Evercore conference, 3/7/23), but it can have a large impact on the speed with which a project can be completed. Completing a project on time can dramatically improve the economics for builders. 

 

One of management’s key performance indicators (KPIs) is “fleet productivity,” which is a comprehensive measure of the combined impact of changes in rental rates, time utilization, and mix that contribute to the variance in owned equipment rental revenue. URI’s investment in technology plays a big role here, as management has indicated their data advantage leads to significantly better time utilization vs. the competition. Unfortunately, we only have fleet productivity data from 2018. The following chart goes back further with two of the major components, time utilization and pricing: 

 

 

The advantages of URI’s scale are on display in these results. 

 

A conversation on business quality would not be complete without acknowledging the downsides of URI’s business. There are two primary ones: cyclicality and capital intensity. We address the cyclicality issue throughout this document, with a devoted discussion in the Risks section. As for capital intensity, it goes without saying that to operate a leasing business, one must buy a lot of equipment. This also makes growth expensive: for URI to grow, it must invest in new equipment (and, to a much lesser extent, branches). This investment is evident on the capex line, with net rental capex running about 15-20% of sales in a normal year. The good news is that URI has proven to have considerable flexibility in terms of when it needs to ramp up capital intensity. They can dial net purchases back basically to zero when cash flow is scarcer. We discuss this dynamic in more detail in the Risks section as well.

 

Growth

At the recent Investor Day, management put forth new “aspirational” targets for 2028. Among them was a forecast for $20 billion in revenue (including $7 billion in Specialty revenue). This guidance implies an 8% CAGR from 2022 (pro forma for Ahern). For Specialty the implied revenue CAGR is 15% from 2022. From this we can calculate a 5% implied CAGR for GenRent (pro forma for Ahern). The forecast includes some assumed M&A activity, but management says the bulk of their goal can be achieved organically. 

 

By comparison, the GenRent goal of 5% annual growth compares to an average growth rate of 9% since 2013 and 8% since 2002 (both of which include M&A). For another benchmark, over the past 10 and 25 years, the industry in the US grew at a ~5% CAGR: 

  

URI Q1 2023 earnings slides, citing company reports, American Rental Association (ARA), RER, and US Census Bureau data.

 

Management expects the industry to grow by 4% in North America in 2023, consistent with the ARA forecast (HRI management notes this is likely conservative, as all the data are robust. Source: HRI Q1 2023 earnings call). This follows a historically strong year in 2022, when the industry grew about 12-13%. 

 

Increasing rental penetration has been a major driver of revenue growth and is expected to continue to be so. The end-user advantages to renting rather than owning equipment are numerous (source: URI Q1 2023 earnings slides): 

• Conserve capital / focus on core business

• Ensure the right equipment is available for any job

• Reduce downtime / improve reliability

• Control expenses and inventory

• Outsource maintenance (labor)

• Outsource pick-up and delivery (labor)

• Save on storage and warehousing

• Receive 24/7 customer care and support

• Save on disposable costs

• Manage risks like regulatory and obsolescence

 

The data supports management’s assertions: URI claims to have higher utilization (20%), newer equipment (4-5 years younger), and better emissions (5-10% higher electric/hybrid share) than non-lessor equipment owners (source: URI Investor Day slides, 5/31/23). This all has the added advantage of providing significant benefits to the environment, which is important both for Mother Nature and for customers that need to achieve certain “green” building certifications.

 

Though not a totally clean comparison, we can see hints of the increasing penetration of rental in the data: 

URI Q1 2023 earnings slides, citing company reports, ARA, RER, and US Census Bureau data.

 

In addition, we’ve seen data showing that renting in the US increased from 40% in 2005 to 54% today (source: ARA, Value Investors Club URI write-up 5/20/19). Despite the growth, renting in the US still trails Europe and Asia at 70-80%.

 

AHT and HRI provide some forecasts out to 2026, based on Dodge and IHS Markit data (the AHT data is from December 2022 and the HRI data is from January-March 2023): 

 

AHT Q3 2023 earnings slides (top), HRI Q1 2023 earnings slides (bottom).

 

Despite a slowing economy, both show industry growth in the near- and medium-term.

 

In addition to the favorable industry backdrop, the bigger players have been aggressively consolidating the space, with URI chief among them:

 

 URI Q1 2023 earnings slides, citing company reports, ARA, RER, and US Census Bureau data (top), AHT Q2 2023 earnings slides (bottom).

 

While we’ve discussed the broader scale benefits at length, another key driver behind consolidation is to achieve local density: 

 

AHT Q2 2023 earnings slides.

 

URI’s most recent major effort at consolidation was the November 2022 announcement to acquire the #8 player in the US industry, Ahern Rentals (closed December 7). Ahern is a sizeable GenRent player with 106 locations and LTM revenue and adjusted EBITDA (URI looks at EBITDA before all depreciation; we have adjusted the figures to match our treatment of fleet-related depreciation as a “cash” operating cost that reduces EBITDA) through September 2022 of $887 million and $218 million, respectively. Ahern’s focus is on aerial and material handling equipment like forklifts. URI paid $2 billion, though this is offset by tax benefits totaling $426 million and expected cost synergies of $40 million (mainly SG&A but also some branch consolidation and rental purchasing) plus $60 million in Specialty revenue cross-sell opportunities. This works out to 9.2x trailing EBITDA and 6.1x net of cost synergies and tax benefits. By comparison, URI traded for roughly 11x trailing EBITDA at the time of the announcement, making the acquisition highly accretive to the trading multiple. They funded the deal through debt, but this impacted leverage ratios only slightly. Ahern’s 24.6% EBITDA margin compares to URI’s at 30.1%, a 554 bps spread. The $40 million of expected cost synergies would capture 451 bps, indicating either some conservatism from management or the presence of some minor structural comparative deficiencies in Ahern’s business. Absent synergies, we would expect mixing Ahern’s lower margin business with URI’s would reduce overall EBITDA margins by around 40 bps. 

 

While M&A is all well and good, the major macro growth impetus for the next decade will come from government legislation, energy transition, and secular shifts towards onshoring:

 

 

 

 

 

URI Investor Day slides, 5/31/23 (top), AHT Q2 2023 earnings slides (middle), HRI Q1 2023 earnings slides (bottom). 

 

 

In October 2022, the CEO said, “In my 33 years of business, we have never seen this amount of mega projects. And specifically, in the infrastructure and commercial space on the books. The manufacturing is an added bonus that we really didn't expect to see” (source: URI Q3 2022 earnings call). These larger projects are weighted more towards GenRent than Specialty. The margin should be comparable to typical GenRent margins as increased project scale offsets bulk price concessions.

 

Infrastructure legislation totaling $550 billion was finalized in 2022 and will show benefit this year as projects break ground. This includes a diverse mix of new, expansion and remodel work for roads and bridges, water control, harbors and ports, airports, and power grid projects. Management believes about $510 billion is within their addressable market, spent over five years (source: URI at Evercore conference, 3/7/23).  

 

The Inflation Reduction Act also provides $370 billion of relevant federal tax incentives for clean energy and plant upgrades. This should translate to over $1 trillion of investment, which should play out over the next decade (source: URI at Evercore conference, 3/7/23).  

 

On the manufacturing front, there are huge projects announced every day for automotive electrification (including battery plants), semiconductor fabs (CHIPS Act), and various onshoring initiatives driven by desire to have domestic supply chains. In addition to manufacturing, we expect near- and long-term investment in data centers, distribution centers, petrochem, LNG, and power / renewable energy. Management talked about $200-$250 billion of funds activated for semiconductor work, with $300-$400 billion for the EV auto transition, and $100+ billion for LNG in North America (source: URI at Evercore conference, 3/7/23). 

 

To put this spending in perspective, the over $2 trillion of spending anticipated over the next five to ten years should add at least $200 billion to the annual nonresidential construction market in the US. That compares to a market size of $900 billion, or roughly 22% upside all else equal.

 

In addition to these secular drivers, URI claims to be taking market share. The data below supports this claim but is bolstered by M&A activity: 

URI Investor Day slides, 5/31/23.

 

URI says that organic growth through this period was around 6% per year, well above the 4% growth of the market. Management attributes the share gain in large part to URI’s positioning as a one-stop shop (management discusses how important site security and safety are for national account customers, and having dozens of suppliers on site supporting a project creates risk; URI’s ability to invest in technology to manage safety becomes a competitive advantage in this regard), as its combination of scale, job site solutions, superior service, and technology (like telematics) all contribute to customer productivity and make URI unique in the industry. 

 

In addition, the vast bulk of investment dollars for the large manufacturing, industrial, and infrastructure projects discussed above will come from large companies that are typically national accounts. Only the biggest rental companies like URI can competitively service these larger customers. This should provide another significant tailwind for market share gains as national account spending outpaces overall industry spending.

 

We’ve mentioned earlier that URI is also making a push to expand its Specialty business, opening 30-45 Specialty branches a year. Specialty is less penetrated by rentals and is higher margin, providing an attractive segment to pursue: 

AHT Q3 2023 earnings slides.

 

Furthermore, Specialty has a better return profile, with the segment producing a gross profit to segment assets of around 30% in the LTM vs. only 15% for GenRent.

The revenue growth drivers outlined above coupled with the mix shift towards higher margin Specialty business, lean operating initiatives, fixed cost leverage, and capital allocation (M&A and share buybacks) should produce continuing strong EPS growth. 

 

Recent Results

In recent quarters URI reported growth across the board in all verticals, geographies, and product lines. Rental revenue grew 17% in Q1 2023 pro forma for the Ahern acquisition, with pro forma fleet productivity up 5.9%. The big guys are all outperforming the market. For instance, HRI said that in Q1 2023 their organic core and specialty rental revenue grew more than 3x the industry’s 6% rate (source: HRI Q1 2023 earnings call). They attributed this to revenue from national and mega projects, which accrues to the largest players, though they noted that local infrastructure work remains robust. Signs for continued growth are solid. Nonresidential construction starts increased 30% in March and the Dodge Momentum Index was up 24% year-over-year. URI expects pro forma revenue growth of 12% in 2023. 

 

Margins on used equipment have been strong due to lack of inventory in recent periods, with management restricting sales almost exclusively to the retail channel. Management expects to sell more equipment in 2023, including through broker channels, with margins returning to more normal levels as supply chain issues improve throughout the year.

 

Higher commissions and a normalization of discretionary costs like travel post-Covid have led to higher SG&A costs in recent periods, though strong revenue growth has provided operating leverage despite the higher SG&A spending.

Overall, management expects pro forma EBITDA margins (using their definition: management’s definition of EBITDA is before rental equipment depreciation and stock-based compensation; this is unlike our treatment, where we deduct these expenses to calculate EBITDA) to increase by 80 bps.

 

On the Q1 2023 call, management had difficulty clearly explaining the impact of the Ahern acquisition on results, as the headline numbers spooked investors. For instance, they reported fleet productivity of 2% vs. pro forma 6%. This is because Ahern as a standalone business earned about 40 cents for every dollar of rental equipment it owned. For URI, the comparable figure would be around 60 cents. This dynamic creates a dilutive effect on productivity when combining the two balance sheets. There were similar issues on display in reported vs. pro forma gross margins and EBIT margins. We expect dilution effects to become less of an issue going forward, in large part because Q1 is the seasonally weakest quarter and therefore the one in which Ahern benefits least from economies of scale. For instance, in Q1 2022 Ahern only made $6 million in EBIT, or a 3% margin. By comparison, URI made over 25% margin in the same period. The pro forma would have reduced the URI standalone margin by 167 bps, whereas the pro forma for the twelve months ended September 2022 would have reduced the URI standalone margin by only 52 bps. In addition, URI will gradually improve Ahern’s operations so they look more like standalone URI’s. 

Valuation

 

By any measure, URI trades at low multiples (based on today’s closing price of $360):

 

URI trades favorably to HRI (an inferior business) but cheap to AHT (source: SeekingAlpha, 6/1/23):

• AHT: 17.2x LTM earnings, 14.2x forward earnings, 8.8x LTM EBITDA, 7.9x forward EBITDA 

• HRI: 9.0x LTM earnings, 7.3x forward earnings, 9.8x LTM EBITDA, 4.5x forward EBITDA 

 

We note that HRI’s ancillary studio entertainment business is weighing on its current results and likely drags down the multiple somewhat.

 

URI is a great business that has always been valued as a mediocre one. Such a discounted valuation may have made sense decades ago when the margins and returns were lower. But things have changed, especially since the GFC, and today’s URI is a top-notch performer on almost every financial metric. From revenue growth to EPS growth to operating margin to ROE to cash conversion, URI is in the top quartile (and often in the top decile) as compared to its S&P 500 Industrials peers (source: URI Investor Day, 5/31/23). Despite these strong characteristics, their profit multiples fall towards the very bottom of the peer group.

 

Even so, we don’t base our investment return expectations on a change in URI’s profit multiples. If that occurs, we’ll have an even nicer payday (plus the board will likely raise the dividend in such a scenario; note that URI recently initiated a dividend of $1.48 per quarter, producing a current dividend yield of around 1.7%). For smart allocators like URI who maintain a strong balance sheet, a low-priced stock is an asset. As we mentioned earlier, since 2014 they have bought back $5.4 billion worth of stock, reducing the outstanding diluted share count by 34%. The share shrink party will continue as they expect to buy back $1 billion of stock in 2023. 

 

In addition to its revenue outlook, management put forth new “aspirational” 2028 targets for profit at the recent Investor Day, forecasting $10 billion in EBITDA (per management’s definition), and a 15% after-tax ROIC (again per management’s definition). We have already put the revenue growth implications in perspective. The implied EBITDA margin of 50% compares to recent results around 48% and a 47% average since 2013 (using management’s definition of EBITDA). This seems reasonable if not conservative, especially given the increase of Specialty business in the mix (from 26% of revenues in 2022 to 35% in the 2028 forecast), operating leverage, and other initiatives. 

 

We ran a simple discounted cash flow (DCF) through 2028 that makes the following major assumptions:

• Sales grow at a CAGR of 4-9% from 2023 guidance levels (compares to long-term historical average growth rates of around 8%)

• EBITDA margin (per management definition) comes in at 45-52.5% (compares to medium-term historical average of 47%)

• Earnings approximates cash flow before growth investments that are required to meet revenue growth assumptions:

  • Growth capex at 60% of earnings (compares to long-term historical average of 60%, calculated as cumulative gross capex less depreciation divided by cumulative earnings) 

  • M&A investment at 25% of earnings (this is admittedly a thumb in the air guess as to what management modeled)

• Remaining cash flow used to retire stock at the current ~10x P/E (reduces shares outstanding by around 1.5% per year)

• Dividend payout ratio stays constant to current level (17% of earnings) 

This produces the following IRRs through 2028 assuming a purchase at today’s stock price of $360:

 

The DCF points to a low- to mid-teens expected return under reasonably cautious assumptions. 

 

 

Risks

Some of the more meaningful risks include:

 

Cyclicality

URI is exposed to cyclical end markets in construction and related activity. This cyclicality is evident in the industry data as we saw earlier: 

URI Q1 2023 earnings slides, citing company reports, ARA, RER, and US Census Bureau data.

 

While recent results suggest the cycle might be peaking, the data shows that non-residential construction spend per capita is in-line or perhaps even a bit below long-term average levels: 

URI Q1 2023 earnings slides, citing ENR and US Census Bureau data.

 

The company’s performance through the GFC is instructive. In 2009, EBITDA margins dropped by 800-1000 bps from recent prior years to only 9% on a revenue decline of 37% from 2007 to 2009. The Covid downturn in 2020 also provides a more recent (though less dramatic) insight. In 2020, EBITDA margins dropped 200-400 bps from recent years to 25% on a revenue decline of 9% from 2019. 

 

While profits fell quite a bit during both Covid (15% EBITDA decline from 2019) and the GFC (72% EBITDA decline from 2007 to 2009), a major positive is the company’s ability to dial back capex rapidly in a downturn. They are consistently able to sell used equipment above book value (even during the GFC!). For instance, in 2009 and 2020 they barely bought any new equipment, net of equipment sales: 

 

As we can see, this provides a massive cushion to cash flow, allowing URI to maintain positive FCF except briefly at cyclical bottoms during periods when URI was structurally much weaker (and even then, cash losses were kept to a manageable level):

 

It’s notable that the most recent downturn in Covid-impacted 2020, when sales dipped 9% and earnings dropped 23%, produced URI’s highest FCF year ever (since it rapidly pivoted to stop investing in new equipment).

 

Furthermore, margin recovery is quick due to a high flow through on growing revenue once the bottom is found:

 

 

The Q1 2020 earnings call provides some interesting insights into how management was thinking about the business’s ability to withstand a major downturn as they were looking into the unknown abyss of Covid (the call took place in April 2020). Management showed level-headed judgment and called out many of the strengths highlighted above (capex flexibility, low debt levels with ample liquidity, relevant experience from the GFC, improved technology, lower exposure to commercial construction, etc.) as well as a highly variable cost structure. They talked about how industry pricing has become more rational as the larger players consolidated and as technology improved real-time access to high quality information. They also pointed out how the GFC informed a large part of their strategy to focus on key accounts (accounts covered by a single point of contact) and national accounts (accounts with over $500k in revenue), which tend to be much more resilient in a downturn. By way of comparison, key accounts grew from 47% of revenue in 2009 to 72% by 2019 (just prior to Covid), while national accounts grew from 27% to 43% over the same period.

 

Many other things have changed since the GFC. URI’s fleet is about 5x bigger in terms of units and over 4x bigger in terms of dollars at original cost, branch locations have more than doubled, and North American market share grew from 9% in 2008 to 17% in 2022, all providing substantially greater scale. Increased scale and other improvements led to a much stronger margin profile, with 800 bps of increased gross margin and 400 bps of better SG&A leverage. ROEs are commensurately higher as well (35% in 2022 vs. 17% in 2007) despite a less leveraged balance sheet (86% debt to rental equipment in 2022 vs. 122% in 2008).

 

Several subcategories of commercial construction cause particular concern today, including office, retail, and hotel construction, as well as oil and gas activity. US Census data gives us some sense for how much spending is in these at-risk sectors. Office represented $97 billion of the $1 trillion in annualized nonresidential construction spending, or 10% in the March data. Lodging is another $22 billion, or 2%. Retail is buried in “commercial” spending, which totals 13% but includes many categories that are performing well. Energy does not have its own category, but management said that energy all-in represented about 10% of URI’s revenues, with more resilient downstream being about half of that and upstream only around 2-2.5% (source: URI Q1 2022 earnings call and URI Investor Day, 5/31/23). All told, it seems about 20-30% of URI’s revenue might be in the weaker categories, depending on how the company’s mix compares to the Census data. This is nothing to shrug at, but it should be more than offset by the strength in bigger categories, like manufacturing (15% of Census spending), highway and street (12%), and power (11%).

 

For what it’s worth, management and the board do not seem worried. Among other things, their decision in Q4 2022 to begin paying a quarterly dividend speaks to their confidence in the outlook and free cash flow generation capabilities of the business. It’s notable that HRI also increased their dividend by 10% in late April 2023, saying they see no indication of a slowdown.

 

While cyclicality is an inherent part of this business, we don’t see significant near-term concerns given the deep multi-year pipeline of infrastructure, industrial, and manufacturing projects. Even so, should a recession hit and prove stronger than expected, URI should be in a great position to benefit. While profits will turn down in such a scenario (and the stock will likely take a hit), the impact on smaller competitors will be much worse, putting many on the brink. We would expect to see URI capitalize on consolidation opportunities during an economic downturn and emerge much stronger.

 

Inventory Shortages

The recent outstanding results could be in part due to an inability for end users to be able to buy new or used equipment, forcing them to rely more on rental equipment. For instance, this chart shows used equipment inventory: 

 

 

The data we referenced earlier from HRI serves as a potential mitigant to this issue. That is to say, the market only grew 6% in the quarter. While still solid growth, it doesn’t show the type of double-digit growth we’ve seen from the major players. This is an indication that lack of inventory may be playing less of a role than the ramp-up of national and mega projects.

 

Price Sensitivity

Given the availability of similar equipment from multiple lessors and the pressures on large-scale construction budgets, rental industry customers are price sensitive, making it harder for lessors to develop pricing power. URI’s scale, however, allows it to trade off higher margins for market share through pricing – an option no other competitor besides AHT enjoys.

 

Competition

While URI has an advantage in scale and logistics capabilities, its competitive edge is not insurmountable. AHT is already pursuing a similar strategy with similar results, and there is no reason why another competitor with similar aspirations and access to capital might not choose to do the same. Still, we see URI’s head start as significant, and the advantages of scale should continue to accrue to its benefit for many years if not decades.

 

 

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information. 

 

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

 

The adviser, through accounts that it advises, may hold an investment in the issuer's securities.

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