Description

Investment Overview: We believe the shares of United Rentals (URI) represent good value for long-term contrarian type investors and have used recent periods of volatility in the share price to initiate a position in the shares. While clearly a cyclical company, URI is a best-in-class industry leader with a large TAM that has established an excellent track record of execution, growth and improving shareholder value across the cycle for more than a decade and is benefiting from a couple of powerful secular tailwinds.

The shares have been neglected and are unloved by both investors and sell-side analysts and have underperformed the general market, due to the common wisdom mentality (unsupported by economic and trade data) that the industry is in the last innings of an economic expansion coupled with concerns associated with the price and integration of major acquisitions that URI made in 2017/18. During this time, management has been focused on continuing to evolve the business model into a stronger more resilient company, successfully integrating recent acquisitions and delivering strong profitability and cash flow, which has increased URI’s intrinsic value.

Noteworthy, the shares are trading at roughly the same level as in mid-2014, despite the fact that profitability, FCF, returns, KPI’s and recently leverage have improved significantly in the interim. By comparison, URI’s major competitor (Ashtead Group), who has a very similar business model and operates in the same industry, has about doubled in the same time period. Additionally, in about the last year, since March 2018, the shares have declined about 30%, compared with a slight increase of 2%-3% for both the S&P 500 and competitor Ashtead. Noteworthy, during this time period, URI reported four quarters that met or exceed expectations and raised future earnings and cash flow guidance.

Currently, URI is valued at an EV/EBITDA and P/E multiple of 4.9x and 6.6x consensus FY19 forecasts respectively. Notably, despite URI’s best-in-class industry standing, the shares EBITDA multiple is modestly below the group average of 5.3x, while its P/E multiple is significantly below the group average of 11.6x. Additionally, when viewing URI’s EV/EBITDA multiple across the cycle from 2006 to present, the valuation is at the lower end of the historical range. This suggests that investors are already somewhat discounting the risk of an economic downturn on the business despite the fact that most industry leading indicators and barometers suggest favorable market conditions looking out at least 12-18 months. Furthermore, there is evidence to support the belief that both URI and the industry in general are better prepared, compared with 2008/09, to weather a downturn in the cycle. Thus, for longer-term contrarian value investors, we believe the shares will offer good value thru the cycle over the next 3+ years.

Consensus EPS and adjusted EBITDA forecasts are ~$25/share and $4.9 billion for FY21. Assuming a re-rating of the P/E multiple to 9x (still below the group average) shows upside to roughly $225/share while assuming an increase in the EV/EBITDA multiple to 6x (on 2.5x leverage), shows a valuation of about $220/share; both implying upside of ~80% during the period. Noteworthy, some possible catalysts on the horizon in the future which could increase investment sentiment and support a rerating include management reducing its leverage ratio targets and the passing of a proposed $1.5 trillion infrastructure bill.

Key Investment Points: The following are some key factors that support our recommendation. Some of these have been discussed in past write-ups (and recommend interested investors review them), given that a number of years have passed since these reports, we felt it would be helpful to update them and provide a base for anyone new to the story.

Three Favorable Secular Trends Fueling Rental Industry Growth: As illustrated below, over the last 20 years the industry has grown at a 5.3% CAGR across the cycle and a 6.6% CAGR coming out of the recession since 2009.

The latest five-year forecast from the American Rental Association (ARA) calls for equipment revenues in North America to surpass $61.5 billion in 2019, up 5.3% compared to 2018. The industry is expected to grow 4.8% in 2020, 5.0% in 2021 and 4.8% in 2022 to reach $64.4 billion. Other market forecasters also call for continued healthy growth over the next few years.

                                                                                                                                                      Source: ARA / IHS Global Insight as of February 2019

Over the last 20 years there have been two favorable secular trends in the equipment rental industry that favor URI, which are: a shift from owning equipment to renting and the consolidation in the industry where the big are getting bigger. More recently, the increased availability of specialty products offered via rental has helped fuel growth, enhanced margins and helped reduce the cyclical nature of the industry.

Shift To Rentals vs. Purchases: A multi-decade industry trend is the move by customers to rent equipment versus purchasing. Renting offers the opportunity to free up capital, control costs and access the right equipment, when and where it is needed. It also doesn't require additional staff to maintain the equipment, spare parts on hand or storage of the equipment. Data from the American Rental Association shows that within the US, renting has increased from about 40% of equipment usage to 53.5% currently. Note, this still trails Europe and Asia, where rental constitute about 70%-80% of equipment usage. Moreover, drilling down into the data shows that in more general purpose categories (as opposed to large equipment categories), the number is meaningfully lower. As a result, it is expected that the rental mix of all equipment usage will continue to increase in the future. In addition to pure economics, where it only makes sense to purchase if the equipment will be utilized for most of its life, other factors driving this trend include the increased availability of equipment for rent as well as the broader diversity of product available for rent. As illustrated below, this trend has and will continue to help the equipment rental industry to grow in excess of the overall market.

As illustrated in the below comments, management believes there are further opportunities for rental penetration to grow in the future:

“I think there's still more opportunity for penetration in North America when you think about right here in the U.K., where penetrations are reported at over 80%; or in Japan, similar. You think about North America. ARA, as quoted in January at the annual show, that it was about 53% penetration. That number would have been in the high 30s when I started in 1990. So when we think about the opportunities, there are some specific end markets that we think really not penetrated at all, whether it's government, manufacturing. So there's actual whole segments that have not been penetrated yet, and we think there's a lot of opportunity. And then the continued penetration in some of the plants that we operate in, we continue to find new ways to get customers to realize the value of rental. And there are very few times where the rental opportunity and the math doesn't paper out, where then a customer would try rental and then go back to purchasing. Unless you're going to use a piece of equipment for a consistent amount of time, doing a consistent task for multiple years, you're never going to get the utilization opportunity out of it worth the paper. And I think what we've proven as a rental industry, not just United Rentals, is that we are a real trusted and reliable option. And pre '09, people may not have believed that. They may not have believed that the access to the fleet was going to be quick enough or the reliability of the fleet was going to be at the same level, and I think the penetrations occurred because they've been pleasantly surprised.”

Matthew J. Flannery President & COO

BofA Merrill Lynch Conference March 20, 2019

Industry Consolidation: The second secular trend is the consolidation in the industry, where the largest companies, both individually and as a group, are gaining market share. As illustrated in the chart below, the top 10 rental companies have increased their combined share of market from 10% in 2010 to 30% in 2017.

There are a number of reasons for this trend, similar to other asset-heavy industries, scale and financial benefits play a major role. In addition to brand and reputation, having a large and broad asset base of equipment (including specialty products) and locations, combined with investments in software, enables equipment to be deployed from one location to another when critically needed. These factors create high barriers, which is especially true as you move up in scale to the largest infrastructure jobs, which makes it hard for all but the largest companies to be competitive. Also, given the asset heavy nature of the industry and the large capital requirements needed for new purchases, the financial strength of the leading players gives them an advantage. The growth in market share is occurring both organically as well as thru acquisitions. Thus, financial strength provides capital to make market share expanding accretive acquisitions. URI is the market leader and as a result of these factors, URI has been able to increase its market share from about 9% in 2010 to about 13.3% currently and is larger than its next 2-3 competitors combined.

The highly fragmented nature of the industry creates a large TAM for URI to continue to gain significant market share through both organic growth and via acquisitions. As illustrated below, in the last few years URI has used its robust cash flow to make a number of large acquisitions, which has helped it share grow. We believe that URI will continue to look for accretive acquisition to complement its organic growth in the future (especially in specialty products), in the near-term any will be more bolt-on type deals as it continues to digest recent larger deals.

The Increased Availability Of Specialty Products Provides Stronger Growth, Higher Margins & Less Cyclicality: A trend in the industry that appears to have accelerated since the 2008/09 downturn is the move to offer greater availability of specialty products. As illustrated below, these products include trench support/safety, power & HVAC, fluid solutions and other specialty products.

These product categories offer superior growth, higher margins and have attributes that make them less cyclical in nature. Given that these non-mainstream products require healthy capital investments, they are not broadly carried across the rental industry. Thus, they offer higher margin opportunities and better returns for those larger companies, like URI, that have the financial resources and network size to provide them to customers. The less cyclical applications that these products address has makes them attractive as well. URI has increased its revenue mix of specialty products from 7.2% in FY12 to 21.4%, including the run rate from the recent acquisition of Baker Corp. in 2018.

We believe that specialty products will be a major focus of URI’s acquisition efforts in the future. Additionally, we believe the growth in specialty products has made URI a stronger more resilient company thru the cycle, which may not be fully appreciated by investors, and should bode well for the company be accorded a higher multiple.

URI Has A Healthy & Improved Business Model And A Solid Track Record Of Execution Thru The Cycle: Over the cycle from pre-recession years to the recent period, URI has created an excellent track record of execution and improved its business model. Over the last 15 years, through the cycle, URI has grown adjusted EPS by a 25% CAGR. As illustrated below, the 10-year track record shows a CAGR in revenues of 9.4%, adjusted EBITDA of 13.7% & adjusted EPS of 18.6% CAGR.

An important aspect of URI’s financial performance has been the improvements it has made in the last decade since the last downturn in 2008 to become a stronger, more resilient company. These factors include building a more diverse customer base (less exposure to oil & gas and residential construction), increasing its mix of specialty products and improving its asset management and utilization in the field. The following comments from management highlight some of the transitions that have taken place over the last decade:

“I think what it boils down to is, all of those structural changes which give us a very different starting point should the downside come or should the downturn come from where we were before. And with that, the flexibility that we have now and the choices we have now that we didn't have before. So you know Matt mentioned, our capital structure, we have a much stronger balance sheet at this point. The next closest is maturity is in 2023. We generate full -- free cash flow full cycle in years where we were also investing significant amounts in CapEx. And so while we can't pin a timing, tell you how long it will last, how severe it will be, we believe that we have strength across the business now, that we just didn't have before, that makes us much better positioned. We talked about the structural changes from the last cycle to where we are now, I mean, there's been over 1,600 basis points of improvement in margin, right? So again, when you think about where you're starting from and when the downturn comes is just a very different place……… I think I just want to put an exclamation point on one thing Jess said, we've been generating free cash flow here in the growth cycle. That has not been the history of this company or this industry. It's always been that you can generate robust free cash flow once you turn off that capital spigot as you get into a down cycle or a delay or whatever you want to call it. So I think that's a significant change in how the company will look through any part of the cycle.”

Matthew J. Flannery President & COO and Jessica T. Graziano Executive VP & CFO

Citigroup February 21, 2019

As a result of the improvements to URI’s business model, profitability, returns and cash flow dynamics have all improved notably from pre-recession levels. Adjusted EBITDA margins have improved from 31.5% in 2007 (prior to the cyclical downturn) to about 48% currently. As part of this improvement, gross margins have grown from 35.3% to 42.5%, which provides great downside protection in another downturn. Additionally, as illustrated below the increased profitability has helped improve cash flow dynamics over this period.

Despite the improved cash flow, unlike prior upcycles where management injudiciously just reinvested most dollars back into cap-ex to grow the business (assets and locations) without concern for a turn in the cycle, current management appears to be more managed and thoughtful in its capital utilization to try to match cap-ex spending to its visibility. Managements priorities for its cash flow are accretive acquisitions, reducing leverage and share repurchases. While management has been using the increased cash flow in recent years to make significant acquisitions to grow the business and expand into new areas, they have also initiated aggressive share repurchase programs. Since FY14, the share count has been reduced by about 22%, which has proven accretive to EPS growth.

The Current Cycle Still Looks Healthy: While recognizing that we are nearing a decade in the life of the current upcycle in the industry, which has been longer than most prior cycles, most barometers show healthy readings, suggesting the current cycle looks to have further life.

US Construction Starts Are Below Their 20 & 30 Year Averages……

……And Forecasts Look Healthy

US Housing Starts Are Still Below The Long-Term Average

Other Leading Industry Barometers Also Look Positive

Recent comment from the top three industry players (United, Ashtead and Herc Rentals) have also been very bullish relative to current favorable industry factors, suggesting good visibility at least thru 2019 and into 20120. The following are comments from management of all three companies.

“We remain optimistic. We think that 2019 continues to be a growth opportunity for us. We really have been very, very bullish in the face of a lot of other folks saying something else, and it's really more external, the investment community. I -- sometimes, we feel like we're shouting into the wind. We were here last year as well. And I wasn't sure -- when you get out of Q1, sometimes you wonder, "Are we seeing this clearly?" So we spent an inordinate amount of time polling our team, making sure that everybody feels good about the -- our internal team as well as our customers, and not just through our customer confidence index, but using our network of a few thousand salespeople managing our key accounts to say, "What does the pipeline look like? What's the backlog? What's the bid board look like?" These are the things that we have access to through our 1,200 locations that give us a good feeling about 2019. We don't pretend to have more than 12 months visibility, but we do think we have good visibility into 2019, and that remains our feeling.”

Matthew J. Flannery President & COO

BofA Merrill Lynch Conference March 20, 2019

“Just about every piece of macro data that you can look at in our end market show positive whether it's ISM, Dodge Momentum, ABI, non-res construction growth, even ARA projected growth. But additionally, we have these 1,200 locations across the U.S. and Canada, where we have managers and strategic sales teams that are focused on staying engaged with the customers. And our internal customer confidence index is strong and remains at a very high level with no deceleration, by the way, from the past few years where that remained strong. And I believe -- we believe that our customers have a good 12- to 18-month window based on their backlog and their pipeline. We don't pretend to be able to forecast out further than that, but we feel very good about 2019 and our -- and that's really born from our touches of 1,200 branches with their ears to the ground, and getting feedback from our customers.”

Matthew J. Flannery President & COO

Citigroup February 21, 2019

“In December, I shared what were broad and positive market indicators. Now here we are 3 months later and these views hold true and are further solidified. The spring season, and indeed, 2019 are now in clear view. Industry forecasts are strong, and the latest positive ABI and Dodge Momentum Index only further support this. Our end markets are busy and signaling no change in course. No one market indicator or forecast tells the full story or should be overreacted to. However, what we are seeing today is a broad set of data, internal and external, pointing to ongoing positive times ahead.”

Brendan Horgan Group COO & Executive Director, Ashtead Group

Q3 FY19 Conference Call, March 5, 2019

“Key economic and industry metrics remain generally positive. While the Architecture Billing Index fell short of 50 in March, the Index was most affected by regional declines in the Northeast, West and Midwest regions of the United States. Industry observers expect the Index to resume to a 50-plus level later this spring. Industrial spending increased 6% in 2018 over 2017 and spending forecasts for 2019 are showing a slight increase of nearly 2% over 2018. Our conversations with industrial customers indicate their confidence for continued growth and spending over the next few years. Expectation for U.S. nonresidential construction spending for 2019 also continued to be healthy, with expectations of a year-over-year increase of 3%. Longer term, the North American American Rental Association forecast for equipment rental revenue growth remains robust, with compound annual growth rate projected at 5.4% for 2022.”

Lawrence H. Silber President, CEO & Director Herc Holdings

Q1 Conference Call, May 2, 2019

Leverage Is A Major Concern Of Investors & Is Depressing The Valuation Of The Shares: Clearly of the major issue surrounding the shares is the company’s leverage. With concern as to whether the industry may possibly be entering a cyclical downturn sometime in the future, this issue takes on added significance and we believe is one of the things depressing the multiple of the shares. The company’s stated leverage targets are 3.5x-2.5x.  As illustrated in the chart below, from a high of 4.8x in FY09 at the height of the financial recession, URI’s leverage ratio has been trending down due to the combination of growth in EBITDA and use of cash flow to reduce debt. However, it has bumped up in years tied to major acquisitions. Notably, the company’s leverage moved up in FY17/18 tied to four major acquisitions. In FY17 URI acquired NES and Neff Rentals in cash deals valued at $965 million and $1.3 billion respectively, while in FY18 the company acquired Baker Corp. and BlueLine Rentals in cash deals valued at $720 million and $2.1 billion respectively. Combined, the ~$5.1 billion transactions took the company’s leverage ratio towards the upper end of the targeted range. Exiting FY18 and into early FY19, management made progress on its goal of reducing the leverage ratio to the low end of its targeted rage at 2.5x.

Despite this progress, there has been a fair amount of concern in the investment community, worried about the potential for the cycle in the industry turning down, as to whether it is appropriate for management to reduce its targeted leverage below 2.5x. In our opinion, this is one of the issues that has been pressuring the shares multiple. For its part, management has stated that it is not interested in doing any large acquisitions in the near-term until recent deals are fully digested, which should give them greater flexibility to consider such an option. The following are recent comments from management:

“We've done 9 deals in the last 2 years. They've been very accretive. We think we've done a very good job integrating them. We're in a more of a digest and leverage those deals mode right now rather than M&A mode. There may be some tuck-ins like the Thompson deal that gave us the appropriate opportunity and wouldn't change leverage for the balance sheet too much anyway, but something small that we think can be additive for our customers that we go to. Outside of that, we're in a much more of an absorb-and deleverage focus right now from an M&A perspective.”

Matthew J. Flannery President & COO

Evercore ISI Conference March 5, 2019

The issue is somewhat of a balancing act that management has relative to growing the business, especially in certain niches when the cycle is favorable or be proactive ahead of a possible downturn in the cycle. While we do not have any special insight into managements thoughts on this issue, we believe suggestions by the company that they may be moving in this direction will likely be a catalyst to a multiple re-rating for the shares.

Another noteworthy point regarding the company’s leverage is that, as illustrated in the chart below, management has restructured its debt portfolio so that the next major obligation is not until 2023. This gives the company a fair amount of time to react to any sudden change in market conditions.

Attractive Valuation, An Unloved Stock: The shares of URI are trading at roughly the same level as in mid-2014, despite the fact that profitability, FCF, returns, KPI’s and recently leverage have improved significantly in the interim.

By comparison, URI’s major competitor (Ashtead Group), who has a very similar business model and operates in the same industry, has about doubled in the same time period while the S&P 500 is up about 42%.

In about the last year, since March 2018, the shares have declined about 32%, compared with a slight increase of 2%-3% for both the S&P 500 and competitor Ashtead.

Noteworthy, during this time period, URI reported four quarter that met or exceed expectations and raised future earnings and cash flow guidance. This underperformance appears to be tied to the large back-to-back acquisitions of Baker Corp. in July 2018 and Blueline Rental in September 2018 and the increase in leverage associated with funding the transactions, especially given concern that the industry is at the tail end of the current cycle. We note in this regard URI’s excellent track record of integrating many acquisitions over its history and recent remarks by management that things appear to be tracking as expected.

“BlueLine, we're through most of the structural integration. We closed them on October 31. Nine days later, we had them on our operating system. That's a core belief for us. And we think part of the success is moving quickly so that people can share the assets right away. And we're in the process of continuing to harmonize crossover customers, crossover territories with the sales reps. And largely, they're integrated into our organization. Most of the cost synergies will be achieved this year, if not all. We usually overachieve in the cost synergies, and they are easy to measure. So we're on track there. And then, within a couple of years and where the real value is, is how we can cross-sell into those customers. And that access to those customers that these integrations give us -- these acquisitions give us to help that business look more like United's business 2 years from now, that's our goal. That's what we do with it, and that's how you justify paying the multiple for the business.”

Matthew J. Flannery President & COO

BofA Merrill Lynch Conference March 20, 2019

Currently, URI is valued at an EV/EBITDA and P/E multiple of 4.9x and 6.6x consensus FY19 forecasts respectively. Notably, despite URI’s best-in-class industry standing, the shares EBITDA multiple is modestly below the group average of 5.3x, while its P/E multiple is significantly below the group average of 11.6x.

Additionally, when viewing URI’s EV/EBITDA multiple across the cycle from 2006 to present, the valuation is at the lower end of the range. This suggests that investors are already somewhat discounting the risk of an economic downturn on the business despite the fact that most industry leading indicators and barometers suggest favorable market conditions looking out at least 12-18 months.

Risk/Reward Ratio In The Shares Appears Favorable: Consensus EPS and adjusted EBITDA forecasts are ~$25/share and $4.9 billion for FY21. The underlying assumption behind these forecasts appear to be no major downturn in the cycle, no real benefit from possible future accretive acquisitions, little benefit from future share buybacks and management maintaining its leverage targets. While one could argue whether the cycle will continue and at what level of growth, we believe there is upside from the use of cash flow to make accretive acquisitions, new share repurchase programs or take the leverage ratio below the low end of its 3.5x-2.5x target. All of which would have a positive effect of the multiple of the shares or underlying profitability. Assuming a re-rating of the P/E multiple to 9x (still below the group average) shows upside of roughly $225/share while assuming an increase in the EV/EBITDA multiple to 6x (on 2.5x leverage), shows a valuation of about $220/share; both implying upside of ~80% during the period. Trying to forecast downside is tricky due to what call you want to make on the economy and its timing on the industry cycle. At this point visibility looks healthy thru FY19 into FY20. However, if you assume a modest downturn in the cycle in in FY21, with EPS declining 10%-15% from FY20 levels to roughly $18.50-$19.50 per share and a P/E of 5x, translates into a share price range of $92-$98 per share, or roughly 20%-25%. While we believe these are reasonable assumptions for gauging downside given current information, other investors with different assumptions could come up with a different number.

Risks:

• A downturn in the economy leading to constraints on overall construction spending, lower utilization, declining rates and a general downturn in the industry cycle.

• Given the highly leveraged nature of the business, a sharp and sustained decline in profitability could negatively impact the business.

• Challenges in integrating some of the company’s recent major acquisitions could have a negative impact on profitability.

   

   

Catalyst

• • Continued solid execution and growth in EBITDA& FCF.
• • Further reduction in leverage to the low end of the 3.5%-2.5% target that management has guided to by the end of FY19. Should management decide to lower their leverage target, we believe this will be a catalyst to a re-rating of the shares.
• • Should both sides of Congress get together (sometime miracles do happen!) and pass a badly needed infrastructure bill (estimated at $1.5 trillion dollars over a 10-year period), this would be viewed very favorably by investors and help offset investor concerns regarding a downturn in the cycle.
• • Potential rating upgrades from the sell-side community.