United Rentals: Cerberus Backs Out, Not Us

| About: United Rentals, (URI)

URI primarily operates 700 equipment rental locations throughout the U.S. The company offers for rent approximately 20,000 classes of rental equipment, such as backhoes, compressors, scissor lifts, and water pumps, among other equipment. URI also sells new and used equipment. In the interest of background, URI shares are down nearly 35% since Wednesday, November 14th 2007, as private equity giant Cerberus backed out of its planned purchase of the company on uncertainty in the credit and financing markets and despite no material adverse change in the underlying business. URI has filed a lawsuit seeking to force Cerberus to complete the deal.

Given the recent correction, we believe the current price for URI shares offers a good entry point for investors willing to deal with high near-term volatility. In the near-term, merger-related news will likely be the key driver of the shares. Longer-term and even if the Cerberus deal is not re-negotiated, we like the URI story, given the attractiveness of the equipment rental industry and current valuation as well as the opportunity for URI to improve margins, pursue other strategic alternatives, and / or pay a special dividend. The largest risk is a material slow-down in the commercial construction sector.

Cerberus Backs Out

On Wednesday November 14th, Cerberus backed out of its proposed purchase of URI at $34.50 per share, prompting the significant decline in the shares. Importantly, no material adverse change in URI's business was cited; rather, a diminishing appetite for LBO debt is to blame. Cerberus is willing to negotiate a lower price, something URI probably won't consider. Instead, URI is now suing Cerberus stating that it violated the merger agreement terms in an attempt to force the deal, as only a material adverse change can be used to abandon the deal. Moreover, URI noted that Cerberus has binding commitment letters that should be used to force the lenders to complete the deal. All told, the legal uncertainty is keeping many investors from the shares. And the significant share price decline was probably extraordinarily affected by the merger arbitrageurs headed for the hills.

Near Term Scenarios

In the near term, assuming URI can't force the deal under the current terms in court, a new deal could be consummated with Cerberus or another emerging player. The terms will likely not be as favorable given the credit environment, but an offer in the $27 to $32 range can't be ruled out, especially considering URI was trading at $27 prior to the Cerberus deal and that URI had a good 3Q beating the Street's forecast. In addition, URI will receive the $100 million break-up fee plus costs, which could be used to pay a special dividend to URI shareholders. If URI distributed the entire $100 million, URI shareholders would receive approximately $1.17 per share, implying a 5% yield.


Assuming no deal is consummated and URI remains public, we still like the URI story due to the attractive equipment rental industry and the ability to improve margins. Analysts believe URI is in the fourth year of a seven to nine year expansionary cycle in the commercial construction sector. Specifically, nonresidential construction spending is expected to remain strong in the near term on spending on new big box restaurants, hotels, retail locations, malls, manufacturing sites, hospitals, schools, aging national infrastructure, nursing homes, airports, power plants, etc. The end market opportunities are talked about at length here.

In additional to industry growth, URI should continue to benefit from secular trends that point to increased adoption of rental versus owning. Rental offers convenience, flexibility, and cost benefits to construction companies. We also believe URI is more insulated during an economic downturn since it can effectively manage its fleet given its size and construction companies are more likely to rent than invest in new equipment during a down cycle. Finally, URI is in a position to improve margins, especially on the S,G&A line where URI lags its peers. According to analysts, URI's S,G&A costs are nearly double the percent of the company's two largest competitors.

Attractive Current Valuation

URI has generally traded at 4.5x to 6.0x EBITDA. URI shares are currently trading at 4.0x EBITDA, which is the lowest level since 2002 and below the Cerberus offer of around 5.0x EBITDA. URI's two major competitors, H&E Equipment Services and RSC Holdings, are currently trading at 4.8x and 5.0x EBITDA. Finally, deals in the equipment rental industry have garnered an average multiple of 6.0x EBITDA over the last two years. Therefore, we believe URI should trade at a multiple of 4.5x EBITDA, in light of the legal uncertainties. As such, we see roughly 15% upside even under a 'no deal' scenario. Interestingly, many analysts had $30 price targets before the deal was announced in July 2007. Therefore, we believe investors with an appetite for high near-term volatility should be buyers at the current low-$20 level.

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