Description

Situation Overview

Over the last year, equipment rental companies have sold off significantly on oil & gas concerns. Although oil & gas accounts for <10% of industry revenues, the transfer of O&G equipment to general rental markets led to short-term over-supply conditions that pressured rates. Feeding the momentum on energy and commodity fears, sell-side analysts downgraded baskets of loosely-defined industrial stocks and contributed to mass sell-offs. One recent example was the 20% price decline in industry leader United Rentals’ (URI) stock after Caterpillar cut guidance in September 2015. Although ostensibly in the same industry, United Rentals has virtually no exposure to the drivers behind Caterpillar’s revision – China, Brazil, and mining.

While sentiment in early 2016 is worse than ever, the oil & gas impact on equipment rentals actually hit a max sometime in 2H 2015, setting up easier comps for 2016. URI has redeployed almost all of its original O&G equipment into new markets and significantly reduced its revenue exposure. The over-supply conditions of 2015 also appear to have been short-lived, as most rental companies have sensibly reduced capex. Rouse data indicates that small and mid-sized players have reduced fleet additions by 50% y/y in September, in a marked shift from the prior 8 months.

Nevertheless, the market seems to believe that the industry has peaked and is headed for a long down cycle comparable to 2007/2008; URI’s EBIT and EBITDA multiples today are at the lowest levels seen since 2008. But construction KMIs actually indicate healthy end markets (more on that below). With its scale advantages and prudent management team, URI offers an opportunity to profit from the market’s excessive pessimism. To get a sense for the relative opportunity, United Rentals (URI) brought down its 2015 revenue guidance 3% in July 2015 while holding FCF guidance flat. Its stock price has fallen 33% in the last 12 months and 45% from its 52 week high. URI’s stock is now trading at price levels last seen in early 2013, despite having a 25% larger rental fleet today and >300 bps of improvement in operating margins (a mix of structural efficiencies and favorable industry conditions).

Industry Background

United Rentals’ revenues come from non-residential construction (~50%); industrial MRO spend and infrastructure projects (45%); and residential construction (5%).

Through the up and down cycles, two macro trends have quietly continued:

1. The US rental equipment market has taken share from purchases, growing from 5% of the industry in 1993 to >50% today as companies adapted their capex budgets for economic uncertainty. Rental penetration in developed economies such as the UK and Japan range from 60% to 80%, so there is at least still room for increased penetration. This is also the view held competitor Ashtead’s management team.

1. The industry favors scale and financial stability, and the number of rental companies has continually declined. In 2010, the top 3 players had 14% market share and the top 10 had 25%. In 2015, these had increased to 23% and 33%, respectively (Source: Ashtead management estimates, IHS Global Insights).

Still, 45% of remaining players are regional operators with <1% market share, leaving considerable room for further consolidation. The current environment can be characterized by rising equipment costs (e.g. Tier 4 engine requirements) and tighter rental rates increases, both of which disproportionately affect mom-and-pop shops and position scale players to win market share.

Moat / Competition

Only three US players have the scale and capital to compete nationally: URI (13% market share), Ashtead / Sunbelt (7%), and Hertz Equipment (3%). Smaller players lack the capital to invest in a broad array of equipment and upgrades to meet regulatory standards such as the new Tier 4 emissions requirements. Larger competitors also benefit from software investments that allow them to track and move their fleets dynamically to maximize utilization.

Finally, #3 player Hertz’ mismanagement over the past two years has led the company to forfeit market share. This may change with the spin-off of Hertz Equipment expected in 2016, and one possible outcome is a merger with another top 10 competitor. But for now, this means that there are only two viable competitors of scale.

Industry Cycles

Cycles are 7-8 years in length, with peaks and troughs that lag general construction activity. For less disciplined management teams, this means a psychological tug-of-war battle between the dual fears of over-investing at peaks and losing customers from under-investing. In the past, this can lead to over-spending at exactly the right times.

The last bear ended dramatically around 2008. After a period of aggressive capex, URI’s prior management wrote off $1Bn of goodwill and sold assets at steep discounts. In 2008, the company also received a federal indictment for securities fraud and insider trading, and the then-CFO was imprisoned. Both URI and its closest competitor Ashtead came under new management around this time.

As discussed below, there is reason to believe that United Rentals’ current management team has learned from its predecessors’ mistakes.

Business Economics

A frequent criticism by bears is that the end product is commoditized, which therefore means that participants must struggle to achieve acceptable returns. In practice, major rental companies benefit from pricing power over a fragmented customer base (no individual customer makes up >1% of URI’s total sales), and regional companies lack the geographic presence to compete effectively.

In most rental cases, customers require equipment for a period days or weeks, and often with as little as 1-2 days’ notice. Within these short duration cases, renting is more attractive than spending additional capex, and allows companies to off-load maintenance, transport, and disposal responsibilities. Given the time-sensitive nature of demand and specificity of equipment required (e.g. a 60 foot manlift has different applications from an 80 foot manlift), rental companies are positioned to charge rates imputing high ROI, as long as they keep utilization rates up.

Rental players have generally been profitable through downcycles, with normalized operating margins in the high teens. During the trough of 2009, URI’s operating margins reached a low of 8%, but recovered to 18% by 2011. CFFO margins reached a low of 19% in 2009 and were 32% for the 12 months ended September 2015.

One source of confusion is the fact that sell-side analysts focus on EBITDA, even though the metric ignores several cash flow characteristics of the business. Capex spend is counter-cyclical because rental companies reserve cash during periods of weak demand. Second, book depreciation routinely over-states cash losses while creating a tax shield.

An example of the latter: even in the current environment, URI is getting $0.50 on the dollar for 7-year old equipment that is ostensibly near the end of its (book) useful life. Depending on the cycle, URI recognizes 40-50% gains on the sale of its used equipment, and this is a yearly “source of cash”. The company is able maximize value by selling directly to customers, thanks to its scale and relationship with larger national customers. Smaller players including Ashtead and Neff Corp rely on auctioneers and brokers, and realize only ~20% gains on used equipment sales.

Macro indicators point to healthy activity

Conventional wisdom states that the rental industry as a whole has peaked and is early innings of a multi-year down-turn. But industry indicators imply otherwise.

• Changes in the Architectural Billings Index (ABI) precede non-res construction activity by ~12 months, where a score above 50 indicates increasing activity for architectural firms. The ABI was 53.7 in September 2015 and has stayed within the same range of 50-55 since 2011, albeit with monthly fluctuations. Current ABI levels remains below 2005’s peak.  

• Indicators for US Construction employment and spend remained near 7-year highs. US non-residential construction spend through September 2015 was up 9% y/y, while construction employment was up 3.3%.

One could say that anything could happen, and these indicators could all come crashing down tomorrow. Industry indicators themselves are not a buy signal…the point is that despite the anxiety around oil and gas, the numbers actually point to a healthy non-res market continuing into 2016.

Current management has demonstrated capex discipline

The importance of a conservative and disciplined management team in a cyclical and capital intensive industry is almost impossible to overstate.

Current management was largely responsible for a 30% reduction in retail locations between 2007 and 2010, targeting branch overlaps that had sprung up through the company’s acquisition history. Then in 2012 against a more forgiving backdrop of increasing rental demand, URI acquired then-#2 competitor, RSC. The acquisition immediately grew revenues ~60% and nearly doubled URI’s exposure to less-cyclical industrial customers.

In recent quarters, URI has demonstrated capex conservatism. Despite URI roughly double the fleet of Ashtead, the two companies had roughly the same capex spend in 2015, as Ashtead spent disproportionately on fleet growth. In shareholder calls, the operating philosophies of the two CEOs is marked:

Michael Kneeland, URI CEO, October 22nd 2015 earnings call:

“We already know that we'll spend significantly less CapEx in the first quarter of 2016 than in Q1 of [2015]. And we'll be watching demand very closely, and we'll make sure we continue to meet our customer needs as the year unfolds….Our goal is and always has been to drive higher returns, and we have tremendous flexibility in the path we take to meet that goal.”

Geoffrey Drabble, Ashtead CEO, June 16th 2015 earnings call:

“If a customer calls us up and says, "Have you got a new location?" Is it more important to say yes? Or is it more important to say, "No, I haven't got it, but guess what, I've got 72% physical utilization?" Okay? So -- and the answer is, as you establish your presence in a new market, you have to be able to say yes.”

Importantly, URI’s management is financially aligned with minority shareholders. CEO Michael Kneeland holds 345K of URI shares that are worth $19M at the currently stock price of $55. His compensation is heavily weighted toward stock awards, 80% of which are paid out as performance-based stock units.

Valuation - Multiples

A look at industry comps tells us how the market views individual companies. With the exception of Ashtead (which trades on the London Stock Exchange but derives nearly all of its revenues from its US rental operations via Sunbelt), companies are trading down 20-40% y/y:

URI is trading in line with much smaller competitors on EV/ EBIT and EV/ fleet replacement multiples, which tells us that the market is not assigning any premium to scale advantages or growth track record.

URI and Neff (a recent IPO) have seen the steepest y/y price declines. Ashtead trades at a substantially premium to the group, at multiples that seem to more than fully reflect its recent growth.

Notes:

1. Valuation multiples are N/A for Hertz in its current form where Hertz Equipment and Car Rentals are lumped together. Estimated segment EBITDA margins are likely lower than the 21% reported, which excludes corporate overhead.

2. As Ashtead reports under IFRS, CFFO margins shown above are adjusted to exclude CapEx for an apples-to-apples comparison

3. Revenue CAGR includes acquisitions

Valuation: Model

Based on a 10-year DCF, I get a fair value range of between $53 in the downside case and $96 in the base case. The DCF model assumes a 10% cost of capital - above the high end of management’s 8-9.5% estimated cost of capital range - and long-term growth equal to the historic rate of equipment inflation, or 3%. The key drivers are EBIT margin and growth capex as a % of beginning PP&E.

Downside

The downside case assumes revenue growth drops to <2% in 2016 and continues in the low-single digits, as net capex remains depressed at near-replacement levels. Operating margins decline from current 25-26% levels to 20% by 2016, and remains there. A 20% margin would be the lowest profitability level that URI has seen since integrating with RSC. What this means as O&G is no longer a meaningful driver, is that commercial construction pulls back substantially by 2016 and puts continued downward pressure on rates.

In this scenario, operating profit declines from ~$1.6Bn in 2015 to $1.2Bn by 2016. The fair value of $53 is 9% below current trading price.

Base Case

The base case projects a more moderate future in which operating margins decline 350 bps to 23% by 2017 and remain flat, while net capex spend returns to URI’s historic capex spend, approximating book depreciation. Here, revenue growth returns to mid/ high-single digits after 2016, driven by more normalized capex spend.

The fair value of $96 implies 67% upside.

Optionality Value

Neither case ascribes value to management’s targeted $100M in structural cost reductions by end of 2016. In addition, URI has an untapped $1Bn share repurchase authorization that is roughly 18% of its current market cap.

On top of this, the company is generating $700M of net free cash per year that creates further optionality to invest in strategic M&A, an expanded share buy-back program, or greenfield opportunities.

Catalyst

Catalysts

• Supply side rationalization comes into focus. This is already happening with small and mid-sized competitors as of Q3 2015.

• Stronger than expected Q4-2015 results

• Accretive acquisition of Hertz Equipment Rentals

Risks:

• Non-residential construction markets tank.

• Management overpays for major acquisitions in the near future

• Equipment companies reverse course on capex reductions and over-spend to create depressed utilization levels