United Rentals is pretty cheap if you’re willing to think about the economics of the business a little differently than GAAP accounting portrays it.  Despite the rapid run-up in the stock price over the last year I think URI still trades for 8.5x maintenance free cash flow.  I think a more normalized level of commercial construction is perhaps 20% higher than the current level, which could provide a continued cyclical tailwind in volumes and pricing for a few more years.  There is also a secular tailwind from the continued preference for contractors to lease equipment on an as-needed basis rather than own it.

URI leases construction equipment.  The leases are generally weekly or monthly.  The advantage of leasing equipment is that leased equipment has a much higher utilization rate than owned equipment.  Also leased equipment tends to be newer and customers are assured that the equipment is maintained and conforms to current emissions standards.  Customers also benefit from a broader fleet.  URI also has greater purchasing leverage than any of its customers would have.  Unlike a lot of leasing business models, credit risk is minimal for URI because leases are very short term and so there is no risk of getting back a machine that has depreciated to below what the customer owes.  The model benefits everyone: it lowers the cost of equipment ownership and URI is able to earn a good ROA.

Looking at the 2013 cash flow statement you’ll see that URI produced $1.55 billion of operating cash flow (working capital was a slight cash outflow) and spent $1.2 billion on capital expenditures.  If a restaurant company spends all of their operating cash flow to open new restaurants, the company isn’t worth zero because they produce no free cash flow.  New restaurants potentially have positive value.  In the same way, when URI grows its fleet those machines likely have positive value.  So my belief is that the relevant measure of free cash flow is one that adds back money spent to grow the business. 

In 2013 URI sold equipment from its fleet that had an original cost of $941 million.  URI adjusts this $941 million cost by a compounded inflation rate of 2.0% to estimate what it would cost to replace the disposed equipment at today’s prices - $1.07 billion in 2013.  The result is what URI estimates is maintenance capex.  This is a reasonable methodology, especially compared to URI’s peer Ashtead who does not adjust original equipment cost for inflation when estimating their maintenance capex.  It’s also interesting to point out that both URI and Ashtead believe that equipment inflation over the last seven years has been less than 2%.  But over the long term it seems like a reasonable assumption.

Something that this exercise doesn’t adjust for is fleet aging or de-aging.  If URI dials back their equipment disposals, they can make maintenance capex appear lower.  So I perform a sanity check to test the believability.  In 2013 the average age of equipment sold was 85 months, which is a touch over seven years.  This seven years is probably a good estimate of what URI thinks is the useful life of their equipment, otherwise there’s no reason to sell it.  The average age of URI’s fleet at 12/31/13 was 45.2 months.  The average age of the fleet at 12/31/12 was 47.2 months.  This indicates that URI is deaging their fleet, which means that if anything the maintenance capex estimate is currently higher than if the fleet age was in a steady state.  So I feel good about URI’s maintenance capex methodology.

Note that rental equipment depreciation is quite a bit higher than maintenance capex.  At the beginning of 2013, URI had $6.82 billion of gross rental equipment on its balance sheet.  They depreciated this asset by $852 million in 2013.  This implies that at the end of eight years these machines are depreciated to zero.  This is clearly unrealistically conservative given that in 2013 URI sold $941 million of seven year-old equipment for $490 million, or 52% of cost.  I think when potential investors glance at GAAP numbers it’s difficult to see the cash generation potential.

So if URI produced $1.55 billion of operating cash flow, spent $1.07 billion on (gross) maintenance capex, and received $490 million of proceeds from equipment sales (per the cash flows from investing section of the cash flow statement), then maintenance free cash flow (subtracting non-equipment capex of $68m) in 2013 was $890 million.  The current market cap is $10.5 billion.  URI trades for 11.8x 2013 maintenance free cash flow. 

Non-residential construction spending in 2013 was 6% above the 2011 average monthly level which was the post-crisis low point in construction.  2013 non-residential construction spending was still more than 20% below the peak levels.  By no stretch was 2013 construction peak-like, so this is what gives me some comfort about the downside protection.  Additionally, rental penetration has increased from 40% in 2008 to almost 50% in 2013, so adjusted for market penetration, rental spend may be as much as 35% below peak levels. 

Moving on to 2014 expectations.  Year to date, non-residential construction spending is up about 6%.  Assuming rental equipment is taking 1-2% points of share per year, I think 6-8% volume growth is a reasonable assumption for 2014.  In Q1 URI’s average rental rate (pricing) was up 4.3% year over year.  Ashtead’s US rental business Sunbelt reported a similar 4.0% growth in pricing in their April 2014 quarter.  If we assume rates can sustain at this level, 10-12% revenue growth is possible in 2014.  Management believes that based on their view of the market and the projects planned for 2014, the construction spending rate of growth may accelerate in 2015.

In Q1, 83% of URI’s revenue growth dropped through to EBITDA.  The company maintains its guidance for 60% incremental margins in 2014, but I am using a 70% assumption.

Below is a simplified model.  Note that revenue grows more than the 10% organic rate in 2014 due to $180 million of revenue from owning the acquired National Pump for nine months.

                                             2014      2013

Revenue                             5,632     4,955

Organic Growth                10%

EBITDA                                2,705     2,231

Incr. Margin                       70%

Depreciation                      992        920

Amortization                     194        178

EBIT                                     1,519     1,133

Interest Expense               420        475

EBT                                      1,099     658

Taxes                                   363        217

Net Income                        736        441

Add: D&A                            1,186     1,098

Less: Net Maint. Capex   620        584

Less: Other Capex            72           68

Maintenance FCF              1,230     887

Additionally, if URI spends $600 million on growth capex and they want to maintain their current level of leverage, they may have the ability to repurchase $1 billion of stock this year.  If URI spent $1 billion on stock buybacks, the current multiple on maintenance free cash flow per share might be less than 8x.  I think this business deserves a multiple of maybe 14x on maintenance free cash flow, a three-turn discount to the S&P due to cyclicality, offset by secular tailwinds and the ability to reinvest at ROAs of 20%+.  Essentially I think URI should trade at a multiple comparable to a well-run bank.