Investment Recommendation: I recommend a long position in United Rentals (“URI” or “The Company”) with an estimated price target ~$55 (~45% higher than current levels). The Company is misunderstood as a purely cyclical business and the market underappreciates changes the Company has made to position themselves in a secular sweetspot. In particular, the trend towards renting equipment rather than purchasing it has yet to play itself out and will continue to progress, despite any potential cyclical setbacks in the economy.  Beyond that, URI will continue to leverage their scale to take share within the equipment rental category. Finally, any rebound in domestic construction, industrial production or manufacturing will only serve to further benefit the Company. The recent acquisition of RSC has reinforced URI’s position as the market leader (they now have ~3x the market share of their next largest peer) and leaves them the logical beneficiary of industry growth. Additionally, the merger will provide meaningful synergies and a substantial boost to EBITDA over the next 12-18 months.

Investment Thesis:

• The equipment industry is undergoing a secular shift towards equipment rental away from equipment purchase. As customers remain uncertain about the economic environment and are conscious of capital allocation, renting equipment is a more compelling proposition for most customers.
  • Shift currently underway has seen the equipment rental industry increase penetration from mid single digits in 90’s to ~25% in ’00 and is now ~40% on its way to 50%+ within the next few years). This is a secular dynamic that dampens any cyclical factors.
  • § The US construction equipment market is actually relatively immature compared to other counties like UK and Australia which have equipment rental penetration ~80% and 60% respectively while continental Europe and Japan are in the 70% range. There are no structural reasons why the US market should not be composed similarly.
  • § The equipment rental industry has performed better than the overall construction industry for 7 of the past 8 years and this is expected to continue.
    • Additionally, new changes in emissions standards being implemented now will increase the price of certain new equipment 10-15% and creates a catalyst for companies that currently own their own equipment to begin renting.
• Recent acquisition of their largest competitor has reinforced URI’s position as the dominant company in the space (~3x market share of next largest peer).  The Company now has a more compelling value proposition for customers as they can utilize broader equipment portfolios to meet customer needs.
  • URI is the only equipment rental company that can effectively service national industrial customers
  • Total EBITDA synergies could be in the range of $250-300+MM (12-15%+ improvement from a ~$2Bn PF EBITDA base)
• Exposure to tailwinds of US industrial production and potential onshoring of energy/chemical production and processing. No international exposure also helps limit broader macro risks.
• Modest leverage leads to enhanced equity returns as the thesis is realized.

Company Description:

United Rentals is the largest equipment rental company in the world. ~84% of total revenue comes from rental of construction and maintenance equipment. The remaining 16% of revenue is derived from sales of used equipment, service revenue, sale of new equipment and supplies.

Equipment rental (~84% of revenue, ~80% of EBITDA) is the core of URI’s business.

• This business has been undergoing a shift away from the more volatile construction segment towards a more stable industrial/non-construction customer base. This shift was cemented with the RSC acquisition which moved industrial/non-construction from ~22% to ~50% of revenue.
  • Industrial customers rent equipment for longer periods of time. URI has on-site depots at industrial locations (chemicals, refining, manufacturing etc) that have more continuous equipment rental needs. In some cases, their customers are essentially outsourcing their equipment needs to URI to maintain flexibility (industrial customers have rental terms +2.5x the duration of other customers which reduces transaction and repositioning costs and increases margins as well as improves ROIC)

• Industrial customers-the Company’s emerging niche-are particularly well served by scale which URI can uniquely provide. Large industrial companies need a broad array of equipment, often at different locations, and URI can leverage their scale to serve these accounts with a single point of contact that smaller operators cannot effectively address.
• § During the recent recession, RSC (which skewed industrial) maintained higher utilization levels than peers and saw shallower declines in pricing than many of their peers which points to the resilience of industrial/non-construction customers.
  • The remainder of URI’s business is related to construction (~46% non-residential construction and ~5% residential construction).
  • § This construction related business will be more sensitive to broader construction activity trends than the industrial segment, but is well positioned as commercial construction is set to increase double digits over the next three years ⁱⁱ.
    • Greater scale makes URI the largest equipment purchaser in the industry and provides them better pricing power with OEMs.
    • The business is fairly diversified in terms of cyclical exposure with forklifts and earthmoving equipment (~41% of rental revenue), aerial work platforms (~39% of rental revenue), general tools and equipment (~8% of rental revenue),trench safety equipment (~6% of rental revenue), and power and HVAC systems (~6% of rental revenue). 

Non-equipment rental (~16% of revenue, ~20% of EBITDA).

• This consists of sales of used equipment (~9% of total revenue), sales of new equipment (~2% of revenue), services (~2% of revenue) and contractor supply sales (~2% of revenue).
  • Sale of used equipment is an important avenue for the Company to actively manage their equipment profile. Used equipment prices have been robust[i] and are expected to continue to remain strong which will provide support to the segment.
  • The implementation of new fuel economy standards which is expected to raise new equipment prices ~10% will help sustain used equipment pricing. Note, in ’10, similar changes in regulation that impacted trucks went into effect which helped drive a 30% increase in used truck prices despite weak macro environment.

Industry Dynamics:

The equipment rental market is undergoing structural changes which provide tailwinds to URI. These structural changes will increase the sustainable margin profile and make the Company less cyclically exposed. As this process has progressed, the Company has been able to achieve record margins with rental rates still ~5-8% below previous peaks. 

• Fragmented market in the process of squeezing out the fat tail of mom and pop operators who constitute >50% of the industry (URI is 13% of industry, top 3 combined is only 22%, while the top 15% account for just ~32% of the industry)[ii]. URI’s target niche of industrial customers require scale to service and the majority of companies in the space lack sufficient scale.
  • Of note, the top three equipment rental companies accounted for ~30% of total industry capex in ’11 which is +1000 bps higher than the previous peak. This reduction in investment by smaller companies shows that smaller operators have simply been unable to compete with the advantages of scale.
  • Primary research with smaller operators ($1-5MM in revenue) indicate substantial difficulty in securing loans for rental equipment purchases. Some of these competitors are essentially seeing forced aging of their fleet which further impairs their ability to compete. Many of these operators will be squeezed out of the industry.
• Secular shift towards equipment rental as equipment rental can maximize capital efficiency and helps companies deal with uncertain economic environments. The domestic equipment rental business is actually relatively immature compared to other Western countries and rental share will continue to increase. Note UK and Australia have ~80% and ~60% rental penetration, respectively while most of Europe is in the 60-70% range. (this chart, in particular, didnt post, but the equipment rental industry is forecast to grow at an 8% CAGR over next four years. Even assuming no revenue synergies and no share increase within the rental category, URI should see ~$300MM in incremental revenue/year).

• Primary research with several large industrial customers suggest equipment rental is more attractive than purchasing because it allows them to focus on their core competencies.
• § Breadth of equipment cited as a major driver of equipment rental vendor choice. With a fleet >3x their next largest competitor, URI is the clear favorite.
• § Given uncertain economic environment, firms are placing greater emphasis on capital efficiency and many customers can’t justify purchasing construction equipment
• § Price not an especially important determinant. Some industrial customers are working in plants with >$10MM/day of throughput. A few hours of downtime is meaningful and they need rental companies that have a fleet on call-they are willing to pay an extra few thousand to have that.

Catalysts:

• Continued tailwind from rental share gains v buy
• Tier 4 fuel efficiency standards
  • Implementation of new fuel economy standards which is expected to raise new equipment prices ~10% will help sustain used equipment pricing. Note, in ’10, similar changes in regulation that impacted trucks went into effect which helped drive a 30% increase in used truck prices despite weak macro environment.
• Positive benefits of RSC integration.
  • Continuing cost synergies with RSC will drive an incremental $100MM in EBITDA in ’13 and $30-50MM in ’14.
• Rebound in construction activity.
  • US construction spending is forecast to grow in low teens in ’13 and high teens in ‘14[iii]. This will be especially driven by increased energy and chemical production enabled by shale gas development (energy and chemical companies are large customers in URI’s key industrial segment).
  • URI’s relatively high exposure to industrial markets positions the Company well to benefit from onshoring of energy and petrochemical production introduced by shale gas discoveries. Additionally, any potential relocation of manufacturing facilities domestically as a result of higher foreign labor costs will benefit the Company

Valuation:

The Company is in a sweet spot for growth with a secular shift towards renting, increased share for large companies within the renting category, and (possibly) rising US industrial production. The equipment rental industry is projected to grow at an 8% CAGR over the next three years.   

• The Company is trading roughly in-line with 10 year average trading multiples despite favorable changes to industry dynamics (5.2x LTM EV/EBITDA v 10 year average of 5.2x, 11.5x LTM EV/EBITDA-Capex v 10 year average of 11.2x).
• Just maintaining their share within the industry would provide ~$300MM in incremental revenue/year.
• Continuing cost synergies with RSC will drive an incremental $100MM in EBITDA in ’13 and $30-50MM in ’14.

Triangulating between several valuation methods suggest fair value for the stock ~$55. Importantly, the modest leverage on the Company accelerates shareholder stock appreciation, even absent multiple expansion.  

DCF Analysis:

Deleveraging Value Creation/EBITDA Multiple

Risks:

• Continued capital investment needs
  • This is at least partially mitigated by the fact that on a normalized basis, fleets have more room to age. Their fleet is ~46 months old and primary research with industry participants indicate they believe a more reasonable steady-state level is closer to 50 months.
  • Additionally, their increased purchasing power means future purchases may not be as expensive as in the past (on an apples to apples basis)
• Persistent decline in industrial activity
  • While the secular shift towards renting equipment will provide a tailwind for performance, they are still exposed to broader macro risks.

Catalysts:

• Continued tailwind from rental share gains v buy
• Tier 4 fuel efficiency standards
  • Implementation of new fuel economy standards which is expected to raise new equipment prices ~10% will help sustain used equipment pricing. Note, in ’10, similar changes in regulation that impacted trucks went into effect which helped drive a 30% increase in used truck prices despite weak macro environment.
• Positive benefits of RSC integration.
  • Continuing cost synergies with RSC will drive an incremental $100MM in EBITDA in ’13 and $30-50MM in ’14.
• Rebound in construction activity.
  • US construction spending is forecast to grow in low teens in ’13 and high teens in ‘14[iii]. This will be especially driven by increased energy and chemical production enabled by shale gas development (energy and chemical companies are large customers in URI’s key industrial segment).
  • URI’s relatively high exposure to industrial markets positions the Company well to benefit from onshoring of energy and petrochemical production introduced by shale gas discoveries. Additionally, any potential relocation of manufacturing facilities domestically as a result of higher foreign labor costs will benefit the Company