On May 19, Bill Simpson wrote an analysis of RSC Equipment Rental (NYSE:RRR-OLD). On May 23, the company sold 20.8 million shares at $19 per share, below the expected range of $23 to $25 per share. The stock closed on June 1 at $19.85.
The text of Mr. Simpson's original writeup follows:
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RSC Equipment Rental plans on offering 24 million shares (assuming over-allotments) at a range of $23-$25. Note that 11.5 million shares in this deal are being offered by insiders. Deutsche Bank, Lehman and Moran Stanley are lead managing the deal, five firms co-managing.
Post-ipo RRR will have 103.1 million shares outstanding for a market cap of $2.47 billion on a $24 pricing. IPO proceeds will be used to repay debt as well as $25 million going to terminate a 'monitoring' fee. This $25 million is heading into insiders pockets.
Ripplewood and Oak Hill will each own approximately 32% of RRR post-ipo. Combined they'll own 64% of RRR. Recently RRR recapitalized its operation resulting in the Ripplewood and Oak Hill majority ownership. As is the norm these days with this sort of deals, Ripplewood and Oak Hill funded their recap investment primarily by laying on substantial debt to the back of RRR.
RRR operates in a business in which it will have debt on the books as it is. It finances equipment purchases and then enters into leasing agreements with customers for said equipment. However, the recapitalization more then doubles RRR's debt on the books, and did so without generating any future revenues as RRR's business related debt would. Even by paying off debt on ipo, RRR will have $2.7 billion in debt on the books post-ipo. This is simply too much for my taste, especially with RRR's type of operation.
By laying more debt onto RRR, Ripplewood and Oak Hill slow RRR's ability post-ipo to grow via laying on debt to finance greater number of equipment to then lease. RRR is a large established successful operation. However, the balance sheet here stands in direct contrast to the recent ACM ipo, whose balance sheet post-ipo is pristine. Different businesses yes, but all in all I'll go with a cleaner balance sheet ipo every time.
Not only will the 'un-natural' debt laid on in the recap potentially slow growth, this substantial debt level will also eat into operating profits. As usual, I dislike seeing third parties come in and finance company purchases (or majority ownerships) via laying debt onto the back of a solid cash flow generating operation. It really handicaps the newer public shareholders post-ipo. Oak Hill, Ripplewood and minority owner ACF are the selling shareholders in this deal. ACF was the owner that sold a % in the recap to Ripplewood and Oak Hill. These two private equity firms will do quite well on this deal with the ipo cash-out as well as shares held post-ipo. We've seen this sort of thing a number of times previously.
Contingent 'earn-out' notes - In addition to the debt outstanding, there is the potential for more due to something called a contingent 'earn out' notes deal. If RRR has combined EBITDA of $1.54 billion or better for the fiscal years 2006 and 2007 combined, RRR will owe the pre-ipo shareholders (primarily Oak Hill, Ripplewood and ACF), a $150+ million bonus. If EBITDA is $800+ million in FY '08, then an additional $250+ million bonus is due.
These bonuses would mature beginning in a decade or so and would go on the books, I believe, as new debt until then. There are a number of exceptions to this payout delay that would kick in principal payment earlier. It would appear RRR has a 50/50 or so chance of hitting the $1.54 combined 2006/2007 EBITDA number which would kick in the 'earn out' notes deal.
From the prospectus:
We are one of the largest equipment rental providers in North America. As of March 31, 2007, we operate through a network of 459 rental locations across 10 regions in 39 U.S. states and four Canadian provinces.
RRR believes it's the #1 or #2 equipment rental provider in the majority of regions in which it operates. Customers are primarily non-residential construction and industrial markets. Equipment ranges from large equipment such as backhoes, forklifts, air compressors, scissor lifts, booms and skid-steer loaders to smaller items such as pumps, generators, welders and electric hand tools.
85% of revenues are derived from equipment rentals, 15% from sales of used equipment. Average fleet age is 25 months, which RRR believes is one of the youngest in the industry. Original equipment cost of the fleet was $2.5 billion. RRR has invested $2.2 billion in its fleet over the past four years.
Fleet utilization was 70% over the 15 months concluding 3/31/07. Over the period, RRR has had over 470,000 customers with the top 10 customers representing 7% of overall revenues.
Business has been strong the past 4 years, as RRR has achieved 15 consecutive quarters of positive 'same store sales' growth. This would mesh with the strong nature of the non-residential real estate construction sector since 2003. The equipment rental market was $34.8 billion business in 2006 and is expected to grow 8%-9% overall in 2007. The top 10 companies in the sector accounted for 30% of overall revenues in 2006. Interestingly, while this is a fairly fragmented sector, RRR has grown exclusively organically and not via acquisitions.
Competition - National competitors include United Rentals (NYSE:URI), Hertz Equipment Rental Corporation (NYSE:HTZ) and Sunbelt Rentals. Regional competitors are Neff Rental, Ahern Rentals, and Sunstate Equipment Co. A number of individual Caterpillar (NYSE:CAT) dealers also participate in the equipment rental market in the United States and Canada.
Substantial debt of $2.7 billion post-ipo is the issue here. The nature of RRR's business is going to mean there will be debt on the books. Prior to the recapitalization however, RRR was doing a very nice job of maintaining level debt levels of $1.2 billion in 2004, 2005 and into 2006 while expanding its equipment fleet. It was adding a lot of new equipment through cash flows while keeping debt levels stable. Sign of a strong business and solid management. My issue here (and it is a big one) is that the substantial additional debt added recently due to the recapitalization did nothing to help grow the business. All it did was help the private equity interests make money.
As RRR states, 'Our revenues and operating results are driven in large part by activities in the non-residential construction and industrial markets. These markets are cyclical with activity levels that tend to increase in line with growth in gross domestic product and decline during times of economic weakness.'
Debt servicing costs will now eat up roughly 50% of RRR's operating profits post-ipo. While business is strong currently, RRR will still have nice cash flows even at these debt levels. However its business is highly dependent on overall non-residential construction. We saw this segment of the economy slow substantially in 2001-2002. While a similar future slowdown most likely would not mean difficulty in servicing its debt, it could easily mean servicing debt wipes away cash flows and bottom line net profits.
My issue here is not RRR's debt as it's going to have debt in its line of business. My issue is the substantial debt laid on during the recap that does nothing to assist the business. The newer debt is debt that is dragging the business, not debt in which it's making a profit by leasing equipment financed. Big difference. THE difference maker for me when it comes to this RRR ipo.
Business has been strong: Same store sales increases were 12% in 2004, 18% in 2005, 19% in 2006 and 13% the first quarter of 2007. Keep in mind this sector is not apples to apples comparison to retail and restaurant same store sales growth. While the latter two tend to have a finite selling space, RRR is able to add equipment and overall rental capacity annually much easier in a strong demand environment. This is not really a 'finite selling space' type business. Still the same store sales do indicate an overall healthy operating climate for RRR the past few years.
Note that 2006/2007 numbers include a look at the company as if both the recapitalization and the ipo had closed 12/31/05. In other words a look at operations as the company will be structured post-ipo.
2006 - Revenues were strong at $1.65 billion, a 14% increase over 2005. Reasons for the increase were additional rental equipment added as well as higher purchase and rental rates on equipment. Gross margins are rather strong here at 36%. RRR is in many ways a 'middle man' type operation. These are impressive margins for this type of business. Operating expenses were 11% of revenues. RRR has held operating expenses in this 10%-11% range over the years. Operating margins were 26%. Pre-recapitalization, net margins would have been 12% with earnings per share of nearly $2. Without the recap debt, RRR would be dirt cheap in range and strong recommend. However that isn't the case. Including the recap debt, 2006 net margins were 7% with earnings per share of $1.17. Huge difference, all into the pockets of the Oak Hill and Ripplewood. 2007 - RRR had a solid first quarter, even though equipment sales were down a bit. It appears in 2006 RRR cleared out a lot of old equipment via sales and replaced rental fleet with newer stuff. Overall revenues look as if they may grow by 10% in '07 to $1.82 billion. Gross margins should again be in the 36% range. As RRR has managed operating expenses to that 10%-11% area for years now, I would expect similar in 2007, meaning operating margins should again come in around that 25%-26% number. Debt servicing will 'eat' up approximately 50% of all operating profits in 2007. Again a chunk of this debt is recap related and not debt RRR will be making money off of, through equipment purchases and then renting out said equipment. Net margins should be 7 1/2% - 8%. Earnings per share should be in the $1.30 range. On a pricing of $24, RRR would trade 18 x's '07 earnings.
RRR's closest public comparable is United Rentals. A quick look at each.
URI - $2.83 billion market cap, currently trades 0.72 X's '07 revenues and 13 X's 07 earnings estimates. URI is heavily leveraged with $2.7 billion in debt. Revenue growth estimates are in the 5%-7% range.
RRR - $2.47 billion market cap on a $24 pricing. Would trade 1.4 X's '07 revenues and 18 x's '07 earnings estimates. RRR is heavily leveraged post-ipo with $2.7 billion in debt. Revenue growth estimates for '07 in the 10% ballpark.
Conclusion - If not for the recap debt laid onto RRR, this would be an easy recommend. As it is, the multiple here seems a bit steep in relation to both URI and the amount of debt on the books post-ipo. RRR is a solid company that has booked strong cash flows and earnings the past four years. This is a good company that appears to have managed growth very well. However I can't recommend this deal, due to the debt laid on here to directly benefit Ripplewood and Oak Hill (and not the company and public shareholders). In solid economic climate, I would expect RRR operationally to continue to do well. Neutral overall here on this deal. Strong business and sector leadership with a private equity related drag on the bottom line.