United Rentals' Private Equities Loss is an Investor's Gain

| About: United Rentals, (URI)

United Rentals (NYSE:URI) is the first company many commercial, industrial, utilities, municipalities, and homeowners think of when they have large projects and need equipment and supplies to complete the job. URI has rental/retail locations in the US, Canada, and Mexico with nearly 700 locations. If you need to rent or purchase equipment such as backhoes, forklifts, compressors, pumps, generators, scissor lifts, boom lifts, pressure washers, water pumps, heaters, hand tools and trench safety equipment, then URI is where you go. It offers over 20K classes of rental equipment and services equipment.

URI also trains customers in specialized work, and offers an entire line of convenient supplies to its customers for their specific needs on the job. Commercial business is 75% of their revenue, while industrial is 15% and homeowners round out the last 10%. URI was a start-up business 10 years ago (founded in 1997) and has grown to a $3.6B+ per year business through acquisitions and internal growth. They compete in a highly fragmented business and have the #1 market share in North America with only 7% (This means lots of opportunity for growth).

Key Information

  • Current Stock Price $18.84
  • Intrinsic Value $32 today (5 year estimate $65)
  • TTM FCF (Trailing Twelve Months Free Cash Flow) $228M
  • Market Cap = $1.6B
  • Private Equity offered $34.50/share in ’07 and pulled out after credit crisis in broad market prohibited the ability to raise capital
  • World’s largest equipment rental company giving it scale and purchasing power to more cost effectively compete
  • Increasing ROIC, currently at an impressive 15% vs. 12% three years ago
  • Highly leveraged, but multiple year trend of paying down debt ratios
  • Business in US/Canada/Mexico with 7% market share in North America (Competing in a highly fragmented industry with opportunity to consolidate)

SWOT Analysis

For those of you new to the SWOT analysis this is a tool to help review a company’s internal Strengths and Weaknesses as well as the external Opportunities and Threats to gauge how competitive URI truly is versus the rest of the industry.

Strengths: While researching URI I have uncovered quite a few strengths that help give them an edge in a highly competitive market place. Since URI is the world’s largest equipment rental provider, they create a size advantage that gives it economies of scale that smaller mom and pop shops do not have. URI has $4.0B of rental equipment, which means they are buying in bulk (i.e. they get a volume discount). It has also leveraged the use of IT wisely and networked their 700+ branch locations so it can act like one large rental outlet. If a customer is at location A and needs to rent a piece of equipment in location B, then URI will move the equipment around to improve utilization and delight their customers. URI has been continuously improving their dollar equipment utilization (average rental revenue/average equipment fleet cost) over the past few years from 55% to 62% thru ’06. These utilization improvements have translated into record margin improvements (net income as % of revenue was 6.8% in ’06 versus negative 2.7% in ’04). Management has added new services like training certification for equipment to help tie their customers closer to URI in order to become less of a commodity and more of a specialized service provider. These services should help differentiate URI from their competition and allow for superior pricing and margins.

Weakness: In my mind there is one large concern that warrants the most amount of scrutiny by investors, which is the large amount of leverage (i.e. debt) that URI uses. The good news is that URI has been paying down debt over the past few years as shown in graph 1 below. The debt to capitalization ratio is also lower, but still sits north of 50%, which creates more risk than the average company (especially moving into a slower economy). This massive amount of debt is what has allowed it to be successful and expand so rapidly over the course of ten years and I’m glad to see URI is reducing these ratios to lower their risk exposure a bit. As debt has dropped and EBITDA has risen URI has reduced their chances in breaking their covenants with the banks (i.e. URI has to abide by certain rules set by the lenders like net income versus interest rate expense and if broken could cause a liquidity issue if the banks call their loans).

click to enlarge all images

Graph 1

Opportunities: Equipment rental is a positive trend as more companies prefer to rent versus buy equipment to reduce capital costs, use equipment only when needed, remove the costly storage and maintenance requirements and have an inventory of equipment around the world at any given time. URI has been heavily investing in new and replacement equipment to expand their business (i.e. Capital investments of $800M-$1000M/yr). About 20% of their capital spent is for expanding the equipment versus the 80% to replace retired equipment. URI has been acquiring small companies ($10-$30M) to add to their existing base as they are in a highly fragmented business that is ripe for consolidation. It can bring in a smaller business to it’s network and get better utilization and strategically source supplies and equipment at a lower cost realizing higher margins. URI recently was offered $34.50/share by a private equity firm (Cerberus Capital), but due to the collapse of the credit market the deal fell thru. I believe Cerberus Capital is a well run company and only made this bid after getting a rare insiders look at the books. A bid for $34.50 would have meant Cerberus felt this price was under valued and worth much more since Cerberus Capital focuses on buying under valued companies for a strategic investment. URI is likely still taking bids if any are out there so there may be an opportunity for a second bid (likely at a lower price) once the market decides to settle down (hopefully in the 2nd half ’08). Lastly, I believe since URI only has a 7% market share in the North American they have plenty of room to grow in their current market plus have ample opportunity to pursue Europe, Asia, and South America.

Threats: The largest threat in the near-term is if the US enters into a recession and construction gets weaker than it already has. This will not bode well for URI’s utilization rates and result in much lower revenue and margin in the short-term. Fortunately 90% of URI’s business comes from commercial and industrial segments, which has held up very well compared to residential. Competition is everywhere and there are some large players in the field like Hertz and Home Depot, but I believe URI has positioned itself to compete based on much broader product offering and specialization such as training and heavy customer support to offer complete solutions for their end customers.


The competition in the equipment rental/sales business is very broad ranging from small mom and pop shops to large corporations like Home Depot and Hertz that have a very large presence. As mentioned above I believe URI is uniquely positioned and thru scale, diverse product mix, locations all over North America, services, and specialized training they offer a one shop stop that few competitors can match. They have market leading margins as one would expect from the market share leader (ah…isn’t scale a beautiful thing). They also yield the highest owners earnings yield of 17% (CFO/Enterprise Value). I like this metric as it shows how much cash a business generates in a given year without new CapEx versus the enterprise value (market capitalization value of the company plus the incurred debt and minus any cash/short-term investments on their balance sheet).

Table 1


URI has worked diligently to improve their financials over the past few years and their score card reflects it below:

  • Net margins have improved significantly from negative 8% to positive 7%
  • CFO (Cash Flow from Operations) growth of 43% per year (5 year avg.)
  • FCF (Free Cash Flow) is -6% driven by CapEx in new equipment to grow the business (I think CFO is the better indicator here because of their growth)
  • ROE (Return on Equity) at 17-18% the last two year
  • ROIC (Return on Invested Capital) increased 300 basis points in the past three years to 15%

Graph 2

Graph 2 above is illustrative of how much management has been able to improve URI’s financials in a few short years. Wayland Hicks was appointed CEO in Dec ’03, which is when this company started its turn around. He retired in the summer of ’07, but maintains a chair on the board of directors (This is a common practice that allows the prior CEO to groom the new CEO). Michael Kneeland was promoted to CEO and previously served as the COO (He’ no stranger to URI). To be fair the construction boom played a large role in demand for equipment, but management definitely deserves credit too. The purple bar CFO (Cash Flow from Operations) is the most impressive bar on this chart as they grew it from ~$150M/year in ’01-’03 to $700M+ in ’06. The 2007 year is shaping up to generate $800M.

I am also very attracted to the orange line (Net income as % of revenue) as it too has shown impressive growth from negative 8% in ‘01 to positive 7% in ’06 and ’07. The green bar shows FCF (Free Cash Flow) which has been positive every year going back to ’01. This is impressive because management has demonstrated success in adjusting capital spending in down years so FCF is still positive. This helps comfort any worries about the size of their $2.7B in long-term debt. Management is projecting FCF of $300M plus in ’08 as they slow their capital investments down. URI has been very successful at modulating capital expenditures as the economy slows so that FCF does not decline significantly and more importantly turn negative. This is a major factor in my reduced concern over their large debt position.

Graph 3

Graph 3 depicts a ratio I like to look at called Owner’s Earnings Yield (Cash Flow from Operations/Enterprise Value). This ratio in a nut shell shows how much cash this business generates based on the current cost to out right purchase the company (Current Market Capitalization + Debt – Cash). This ratio is at its highest level ever over the past 4 years (currently 17%). This is a signal that this stock is extremely undervalued (No surprise Cerberus Capital was interested). Historically this ratio has traded on the low side of 3-10% (red line) and on the high side of 4-15% (green line). The main driver of this improvement over the past few years is that URI has been actively paying down debt (reducing their enterprise value from a debt perspective) all while growing CFO.

Graph 4

Graph 4 is another strong indicator that URI is trading at a very low multiple. Their current P/E ratio is 8 and the lowest P/E URI has traded at over the past ten years is 6. If URI were in fact to trade at a P/E of 6 based on their current EPS (Earnings Per Share) of $2.37, then their stock would see a low of $14. On the contrary their average high P/E (red line) is 17 and would give URI a stock price of $40. This gets me pretty excited as the near-term down side risk ($14 versus $18) is ~20% versus an upside long-term potential of ~120% ($40 versus $18). As a note Graph 4 does not show data from ’02-’04 as EPS were negative so the P/E ratio was not applicable.

Graph 5

Since URI has such a large amount of debt, which leads to a large amount of interest expense I wanted to show their interest coverage ratio (CFO/Interest Expense) in graph 5. URI’s total debt has come down over the past couple of years and CFO has increased. This has allowed the interest coverage ratio to improve remarkably since the 2001-2003 lows. URI in ’06 generated enough CFO to pay their interest expenses 3.3 times. I really like this trend and feel URI is well positioned for the future. My opinion is that their debt levels should not overly concern an investor as URI has successfully used debt in the past to gain financial leverage, which has allowed them to grow their business. In Dec ’07 Moody’s raised URI’s debt rating and S&P reaffirmed it after the Cerberus private equity deal fell through and URI received a $100M break-up fee from Cerberus. This $100M cash infusion is a done deal and will allow for even lower debt levels than portrayed in Graph 5 (i.e. even lower risk).

URI Valuation

The valuation portion of the newsletter is the best part as it indicates what the potential rates of return one might achieve assuming company fundamentals stay in tact for the long-term.

The eighteen variables I used to score URI generated a score of 75 out of 100, which is a bit lower than last months pick AEO, but I feel this is a great opportunity with a higher potential risk and reward. The variables that I believe are most compelling for this stock idea are the fact that the financials have showed remarkable improvements over the past few years (CFO growth and expanding net margin as % of revenue). Management has put a large emphasis on increasing ROIC, which has paid off with the current rate of ~15%. URI has the largest market share and margins in a competitive industry that is ripe for consolidation. URI has proven they can acquire and successfully integrate businesses and are not afraid to sell under performing businesses like their traffic control business. I am also very attracted to the fact that Cerberus Capital offered $34.50 per share after getting an up close look at their financials. Now admittedly they pulled the plug on this deal, which is likely driven by the collapse of the credit markets (this is what Cerberus claimed). I assume that URI is worth at least 80% of what Cerberus offered, which would mean $28 per share.

As far as intrinsic value is concerned I believe this stock should be valued at $32 per share today (1.7X the current price) and in five years could be as high as $65 per share (3.4X the current price). This would create an average return over the next 5 years of ~28% based on today’s $18.84 price reaching $65 in 5 years. I am assuming a cash flow growth rate of 8% over the next 5 years and a slight net margin erosion (back to ~6%) as the economy is likely to slow and URI’s utilization rates will likely decline. I may be too pessimistic as URI recently came out and increased 2008 guidance to my surprise (11% higher EPS than the street expected and 280 basis points higher PM% than 2007). I believe the risks in URI are related primarily to a slowing economy and completely built into the stock. If commercial building and roadway projects have a continued decline this will hurt URI in the short-term. Most experts are calling for a construction bottom in mid ’08 in residential. Commercial building has not been impacted like residential, but if this were to change this would be a near-term risk.

I am convinced this is an opportune time to open a position in URI driven by it’s very low versus historical valuation. I like the long-term trend of this industry consolidating and more customers wanting to rent versus buy. If URI continues to pay down debt and maximize margins through better equipment utilization rates I think this will drive a much higher stock value. I feel most if not all the down side risk has been baked into the current price and the upside opportunity will be exposed once other analysts recognize the tremendous cash flow URI generates on a yearly basis versus the current price.

Disclosure: In the interest of fair disclosure the author of this newsletter currently holds a long position in this security as well as most investments he recommends.