United Rentals: Look Beyond The Cycle To The Secular Opportunity
Summary
- United Rentals is a market share leader in the North American equipment rental market with only 13% share. The opportunity for both organic and acquired share gains is significant.
- Equipment rental is in the midst of a long-term secular growth story. Rental penetration is consistently increasing, providing United Rentals with a steady base of growth.
- Management has done an excellent job, leading the industry away from a history of poor returns to a future focused on return on capital and free cash flow generation.
- This year will be a bad one for earnings, but the market has already wrestled with this risk and is now attempting to value the recovery in 2021 and beyond. This has created an opportunity to buy the shares ahead of an economic expansion.
- Valuations are near the low end of historical ranges. The rebound in the shares since the March lows has eroded an outsized opportunity for investors. But the shares still offer attractive returns for investors. Buy United Rentals.
Another stock that popped out of one of my thematic screens is United Rentals (NYSE:URI), as outlined in my earlier report "Turning Over Rocks - Hunting For New Ideas."
The company is one that fits into my theme "Why own when you can rent," which in my view includes the likes of software-as-a-service companies. URI, however, is of particular interest to me as it is optically very cheap and I would argue ticks the box for "counter-cyclicality" due to the nature of its cash flows - a point I will touch on in more detail later in the report.
I believe that URI represents a compelling long-term investment opportunity, supported by the following key drivers:
- Strong management team and culture, leading the industry forward with a move away from an ill-disciplined focus on price alone, to a focus on profitability and returns.
- Solid and steady growth driven by a consistent shift from equipment ownership to equipment rental.
- Capital is being allocated towards higher margin, higher returning specialty rental businesses.
- Prodigious FCF generation, and the somewhat counter-cyclical nature of FCF conversion, supports the target leverage ratio of 2.0-3.0x net debt/ EBITDA. The business generates significant capital through the cycle.
- Excess capital is used to shrink the share count. Since 2016, share count has declined by 4% per year, or a cumulative reduction of 15%.
- Valuation is extremely compelling when considering forward earnings potential of the business. The stock is on less than 10x earnings from FY2021 onwards, with a levered FCF yield in the teens.
And while the company is cyclical and the shares have a tendency to react aggressively to cyclical up- and down-swings, pullbacks have generally presented great buying opportunities. Typical corrections in the shares have ranged from 45% to 65%, and the most recent correction amounted to close to 65%. URI shares have rebounded sharply from the lows.
Source: Koyfin
As such, while volatile, the shares have delivered solid returns for investors over time.
Data by YCharts
URI is an attractive long-term investment that should benefit in the medium-term from cyclical tailwinds as we continue to emerge from the COVID-19 pandemic. Over the long term, the shares should benefit from the more sustainable drivers outlined above.
The shares have rebounded strongly from the March 2020 lows, but still remain below pre-COVID-19 levels.
Data by YCharts
Secular Growth and Cyclical Kicker
URI is the market share leading industrial equipment rental company in the US. The company has 13% market share in North America, followed by #2 player Sunbelt, a subsidiary of Ashtead Group (OTCPK:ASHTF) (OTCPK:ASHTY) in the UK, with 7% market share.
The equipment rental industry in North America is highly fragmented with the top 3 players owning only 23% market share, and the remaining 77% largely distributed across local and regional chains (and "mom & pops"). URI's share has increased from around 12% in early 2015, implying a share gain per year of around 20bp.
Source: URI 1Q20 earnings presentation
The company rents equipment for all sorts of industrial and construction needs, as demonstrated by the following graphic on its website:
Source: unitedrentals
The business is driven by asset utilisation, pricing and general productivity of fleet across a highly diverse and fragmented client base. End-markets are primarily industrial and non-residential construction, making URI almost a pure-play on general infrastructure spending and industrial activity in North America.
Source: URI 1Q20 earnings presentation
The benefits of renting for customers range from easier expense and inventory control to the removal of maintenance requirements, and of course includes better capital management. The latter is clearly an advantage for smaller businesses that lack the expertise, scale and access to capital that larger businesses enjoy.
Rental penetration continues to rise in the US, reaching 56.7% in 2019, according to the American Rental Association (ARA). This rate is up 80bp from 2018, and compares to under 55% in 2016.
The secular trends in the industry are clearly outlined in another slide from the company's 1Q20 presentation:
It is hard to know how much higher penetration rates will reach in the next decade or so before hitting a peak, but my belief is that the penetration rate can continue rising at a 50bp annual rate of increase for a long time yet. This view is predicated on the fragmentation of the construction industry. A preference for renting assets versus owning can be seen across all segments these days, and I see the construction industry continuing to benefit from those same trends.
Underlying construction spending has generally grown at a 9-11% annual pace during times of expansion. If the secular trend in renting continues as described, and the industry continues to consolidate with URI gaining 20bp of market share per year, then during periods of expansion URI rental revenues should have a base-line growth rate of around 12-13% per annum in the US (The US represents the vast majority of rental revenues)! Cyclicality aside, URI should benefit from this steady long-term baseline growth rate.
And in another 20 years URI would still only have 15% market share in this scenario.
Further upside to growth could be due, however, given how "below-trend" construction spending per capita has been since the global financial crisis. A return to historical averages would accelerate the growth of the industry beyond the normal trend for several years.
Source: URI 1Q20 earnings presentation
Of course, near-term growth is largely influenced by economic activity in the US. My calculations show a high correlation between organic or pro-forma growth rates of URI and the level of the US ISM Manufacturing Activity Index. The US ISM Manufacturing Activity Index is a measure of manufacturing activity (>50 implies expansion, <50 implies contraction). In fact, the correlation since 1Q17 on a quarterly basis has an R-squared of around 78%.
Source: own models
And given the latest reading, which unsurprisingly shows a magnitude of contraction not seen since the global financial crisis, that doesn't bode well for near-term organic growth at URI. But this is "old news" to some extent. I will look at near-term forecasts later in the article.
Source: US ISM Manufacturing Index (PMI) chart from www.tradingeconomics.com
Returns and Technology
At its heart, I see URI as a logistics business where optimal deployment of its fleet assets is the key to growth, future returns, and of course customer satisfaction. Experience matters, as does scale. But technology is increasingly a key factor behind the company's success, with digital technologies and innovations enhancing its fleet management capabilities.
URI's approach to technology and innovation is driven by management's singular focus on returns on invested capital. It has resulted in its offering of a service called "Total Control," that rather ingeniously provides technological tools for customers to manage their rental fleet and their owned equipment fleet. URI says that this service product helps customers cut their rental costs each year by "up to a third". What is clever about this offering - something that only those with scale and investment capital can offer - is that it builds customer trust (by not discriminating against customers that don't rent all their equipment, and by saving them significant costs) and it creates a longer-standing relationship. Total Control customers now account for nearly 25% of total revenues, across 13k accounts, and those customers are benefiting from faster growth.
source: URI 1Q20 earnings presentation
The use of Telematics and Field Automation Systems & Technologies (FAST) have helped URI generate significant internal benefits, as well as some additional customer benefits. URI is able to leverage these technologies to improve its performance monitoring and servicing of fleet; the efficiency in fleet location and pick-up; the overtime and revenue recovery; driver and dispatch productivity; fuel consumption; and safety, among other things. Customers also benefit from better visibility into fleet utilisation, easier location of equipment, better account access and management, and fuel alerts.
What this should mean, in my view, is sustainably higher return on capital outside of severe economic contractions. This is something the company has been achieving in the last several years, despite significant headwinds from the energy sector since 2015, for example. In fact, until the recent deterioration in URI's returns (which actually started late in 2019) which follows the deterioration in the ISM Manufacturing Index, the company had been maintaining return on capital in a range above the prior cycle peaks.
source: Koyfin
Of course, these are hardly market-leading returns on capital (~10% through the cycle), but they are above the cost of capital and certainly are a vast improvement on levels seen in prior cycles.
Price Obsession Vs. Fleet Productivity
Prior to the focus on returns by this management team, the industry was largely focused on rate (price) as the primary lever for growth. Effectively, the industry leveraged rate to drive market share gains and utilisation. This made for exaggerated cyclicality and drove poor returns through the cycle - something the current management team seem hell bent on changing.
The problem for management has been in the communication of this change in focus to a market long obsessed by the correlation between earnings and price.
The reality is that earnings will be more correlated to fleet productivity and margins, as pricing is only one factor behind returns (returns are driven by price, utilisation, customer and revenue mix, customer churn etc...). Management finally made the break in 2019 from reporting pricing rates, moving to a more encompassing measure called fleet productivity, which captures rental rates, time utilisation and changes in mix. But it still remains to be seen if the market can accept that price is not the be all and end all for this business.
Nonetheless, this metric is much more aligned with how management actually manages the business, separated from the company's more cyclical aspects.
Source: URI 1Q20 earnings presentation
The reported fleet productivity metric is impacted by acquisitions, but fortunately the company provides transparency in its earnings reports to help tease out the organic performance. The following chart shows the progression in fleet productivity since 1Q17, both on a pro-forma basis and on a reported basis - and we can see the deterioration that began in trends from mid-2018/early-2019:
Source: own models, URI financial reports
Not surprisingly, the deceleration began around the same time that the US ISM Manufacturing Index (PMI) began to fall. So far in 2Q20, the ISM Index has fallen sharply to a low of 41.50, so we can naturally expect a relatively sharp fall in fleet productivity driven by volumes.
Fleet productivity, like overall organic growth, is unsurprisingly relatively correlated too to the ISM Manufacturing Index with an R-squared of 56%:
Source: own models, URI financial reports
If an ISM Index reading of 41.50 in April is sustained through 2Q20, this relationship would suggest a fleet productivity number of -1.8% for the June quarter, supporting a -3.0% to -3.2% number based on recent divergences from trend.
We are clearly in an economic downtrend, which has now been compounded by the COVID-19 pandemic. Management has given some colour on recent trends, which I will touch on in a later segment of this report when I review my forecasts.
Free Cash Machine
Traditionally, a rental equipment business would be expected to have relatively weak FCF generation relative to earnings during times of economic strength with much better conversion during downturns. This is because, when in expansionary mode, the industry spends capital to expand fleet - chewing up FCF immediately whereas the fleet investments earn their returns over time. On the flip side, during downturns, fleet tends to be liquidated, freeing up more capital and resulting in much greater conversion of earnings to cash flows.
The best way I can demonstrate this is through the following graph showing levered FCF margins of URI over the last 20 years. We can see that cycle peaks in FCF margins were achieved in 2009 and 2016, both years following a global recession and a US industrial recession, respectively.
Source: Tikr.com
Looking at absolute FCF, we can see this pattern as well, although here we can see a step-change in FCF generation for the business since 2012. This is partly driven by acquisitions, but I also argue that management's successful refocusing on returns has played an important part in this trend.
Source: Koyfin
Over the last 4 years, URI has generated an average of $1.2 billion in FCF per year for a total of $4.7 billion. This FCF has been used for bolt-on acquisitions ($5.6 billion) and buybacks ($2.3 billion), with the company funding the shortfall through debt and maintaining a leverage ratio of 2.0-3.0x. I would expect more of the same.
As mentioned above, the share count has been falling at a 4% pace per year.
For investors, this business is capable of generating sustainable normalised FCF of $1.2-1.3 billion each year. Relative to a market cap of about $10.3 billion today, which will be shrinking thanks to buybacks (all else being equal), this represents a forward mid-cycle FCF yield of around 13% or more! That is extremely enticing in my book.
Over the next 5 years, the company could generate nearly $7 billion of FCF, or 70% of its current market capitalisation. This creates significant opportunities for accelerating industry consolidation, shrinking the share count, international expansion, or even entertaining a dividend (though I think that is unlikely).
Management Quality and Alignment
I have had the pleasure of engaging with former CEO Mike Kneeland over the last decade, interacting with his team of executives, and even having the opportunity to visit some of the company's larger sites in the US to witness their productivity and opportunities firsthand. I have built up a strong admiration for him and his team in this time, and while I'm sorry to see him retire, his successor Matthew Flannery has been groomed well through his operational roles, and seems well-qualified to continue Mike's good work.
I always like to see how a company fares on Glassdoor.co.uk as a measure of quality and culture, and URI looks very strong.
The other aspect to touch on is executive compensation - I want to feel that a company's management team has its interests aligned with shareholders, and the best way for this is to have executive compensation linked to performance metrics that matter. In this case, URI's executives are paid 50% on economic or return metrics in their annual and long-term compensation formulae:
Source: URI 2020 Proxy Statement
And with the majority of CEO pay coming from these performance-related schemes, it clearly says to me that Matthew Flannery's interests are aligned with those of his investors.
Source: URI 2020 proxy Statement
Shift to Specialty
The other aspect of the strategy that will drive better returns and growth going forward is the shift towards specialty rental services. These are higher growth niches that carry higher margins and are thus accretive to returns.
Specialty services fall under the following categories:
Source: URI 1Q20 earnings presentation
While these revenues are not broken out explicitly in the company's financial statements and reports (Trench, Power and Fluid Solutions make up most of the specialty revenues), management does provide a break-out of these revenues in its presentations. Specialty revenues accounted for $2.2 billion of revenue in 2019, representing 23% of the mix. This has increased from 17.7% in 2016 and only 7.2% in 2012. The growth has not been entirely organic, but the category has grown faster than general rentals even on an organic basis.
Management has not provided a detailed breakdown of the actual margin difference between general rental and specialty rental. But we can use the segment breakdown in the financial statements to give an indication of the margin differential - though clearly the revenues here don't represent the entire specialty offering at URI. Trench, Power and Fluid Solutions has carried a consistent gross margin premium to general rental of 600-900bp each year for the past 4 years.
With mix shifting towards specialty business, it doesn't take much to see the margin tailwind URI has on the gross margin line. While gross margins are not the full story, this positive variance must ultimately feed through to better margins (all else being equal).
The following chart shows the mix of revenues from Trench, Power and Fluid Solutions. Note that specialty revenues also includes Tools and Onsite Solutions, which are actually under General Rental Revenues.
Source: own models
This trend will continue as more capital is deliberately targeted at specialty services.
The Numbers
The Near-Term
Clearly, it is important to try to understand the potential impact to revenues and earnings from the COVID-19 pandemic and lockdown. As mentioned earlier in this report, the historical relationship between organic growth and fleet productivity with the US ISM Manufacturing Index suggests that 2Q20 could see fleet productivity fall as much as -3.2% in 2Q20. Similarly, organic growth in rental revenues could fall by up to -6% (based on the current ISM reading of 41.5, and the implied historical correlation with the ISM).
It was clear from the earnings call that visibility is very, very poor for URI - as it is for many industrial companies. However, management provided some useful colour and information on its earnings call on April 30, 2020:
- All US and Canadian branches were open at the time of the call, and I haven't seen anything to suggest that any of these have since closed.
- Levers are being pulled to preserve cash flows, such as: working with suppliers to reduce the flow of equipment; a significant reduction in CAPEX is now anticipated (quite rightly); Focus on costs, with a large portion considered variable; Liquidity is solid at $3 billion with around $513 million of cash on the balance sheet.
- URI expects to generate "substantially positive" FCF in 2020
- OEC-on-Rent growth was tracking about flat in the first 2 months of 1Q20, but in March fell 15% from the quarter's peak. This metric is a measure of industry volumes, and since April, the 15% decline has stabilised.
The last point is depicted in the following graphic from the earnings presentation:
Source: URI 1Q20 earnings presentation
Feeding these inputs into my model, combining a 15% decline in OEC and a 4.3% decline in fleet productivity (more than implied by the ISM reading), I arrive at rental equipment organic growth of -21.3% in 2Q20. I then fade the declines through 2020 as recovery comes back at a gradual pace. The result is a FY2020 organic rental revenue growth of -12.7%. At the same time, I am assuming that the other line items fall significantly in 2Q20, with declines improving through the year.
Management gave clear indications that it would not be selling fleet at bargain prices - URI does not need to do this and can wait for a better time to sell. I therefore expect asset sales to contribute significantly less than last year through the remainder of 2020.
The result is revenue in FY2020 of $7.8 billion, down 16% from last year.
On the cost side, management is clearly looking to mitigate any revenue pressure by managing its variable costs, though clearly it will have to take more severe cost containment measures as well. The CEO said the following on the 1Q20 earnings call:
On the operating side, our team is focused on aggressively managing costs. And while a portion of our costs flexed naturally with volume, others need to be driven by discrete actions, and we're taking those actions as well.
SG&A costs were down around 5% in the last quarter, and I am going to assume a similar pace through 2020 - which should likely prove conservative. Nonetheless, the severe drop in volumes puts pressure on my gross margin assumptions, and with the SG&A declines as modelled, the incremental drop-through to EBITDA from the revenue declines is higher - at around 72%+ for the next 3 quarters of the year.
My FY2020 EBITDA estimate is now $3.2 billion, back to 2017 levels, with a 520bp margin contraction from 2019. This is the trough EBITDA.
EPS comes out at $7.35 for the year, declining more than 60% from 2019.
While these look like painful numbers for FY2020, what happens on the cash flow side is most intriguing in my opinion. CAPEX will be slashed according to how bad demand is, and I am assuming URI lowers gross rental CAPEX to just $1 billion from last year's $1.3 billion. Net total CAPEX comes in at just $714 million for FY2020, down around $700 million from last year.
My operating cash flow estimate comes down by a similar amount to $2.3 billion, which means that FCF for the year remains roughly the same as for FY2019. This is impressive, and most importantly gives URI significant flexibility through the crisis to protect the downside and to capitalise on consolidation opportunities.
Relative to consensus, my estimates for FY2020 are as follows:
| Consensus | My Estimates | % Diff | |
Revenues | $8.2b | $7.8b | -4.9% |
EBITDA | $3.6b | $3.2b | -11.1% |
EPS | $12.14 | $7.35 | -39% |
FCF | $1.9b | $1.6b | -16% |
While I look to be wildly below consensus across the board, I don't find this surprising as the spread of estimates in each "consensus" number is likely to be very wide. I feel my estimates are sufficiently conservative.
Beyond 2020
After FY2020, I have the business rebounding with strength, along with general economic activity. However, I remain concerned around the risks of a virus resurgence until we have a widely available vaccine - which could mean waiting until 1Q or 2Q 2021.
My URI revenues take until FY2022 before they exceed 2019 levels, while I have assumed EBITDA takes another year to do the same.
CAPEX ramps up significantly as the company chases growth with some much-needed additional capacity. This pressures FCF lower in the first few years of expansion, though my annual FCF estimate does not dip below $1.2 billion.
My forward estimates are as follows:
Instead of acquisitions, I have modelled a more aggressive share buyback program, reducing share count by 5-6% per year. I assume that the company uses 65% of FCF to buy back stock each year.
The company targets net debt/ EBITDA in a range of 2.0-3.0x. I have the company straying slightly above the range, reaching 3.2x, in 2020. This doesn't bother me as the pace of deleverage is rapid in the recovery, even with the required fleet investment. I have net leverage declining to 2.6x in 2021, and then to 1.8x by 2024 - even with the company using 65% of its FCF to buy back stock from 2021 onwards. Without the buyback, URI's leverage ratio would reach 1.0x by 2024.
I end up with EBITDA growing to $4.7 billion in FY2024 and EPS of $23.58. While these estimates represent only 1.4% and 3.8% annualised growth from 2019, they also represent 10% and 34% annualised growth respectively from my (hopefully) conservative estimates for 2020.
Valuation
On my estimates, URI is trading on the following valuation multiples:
Source: own models
Historically, the shares have traded on the following forward P/E, forward EV/EBITDA and trailing P/FCF multiples:
Source: Koyfin, TIKR.com
The comparable multiples to these charts for URI are 8.6x 2021 earnings, 5.2x 2021 EBITDA, and 6.5x 2020 FCF (a FCF yield of 15.5% equates to a multiple of 6.5x). These are all near the lower end of historical ranges (and indeed, having rebounded off recent lows, trough multiples have already been visited by URI).
There is no doubt in my mind that URI is a cheap stock.
Using a DCF model with 0% long-term growth and a 9.75% WACC, I arrive at a fair value for URI in 2021 and 2022 of $169 and $190, respectively. This compares to the current share price of ~$140. Lift the long-term growth rate of FCF to 2% and we get prices of $233 and $264 respectively, both representing significant gains from today's price.
If I use a 5.5x multiple on EBITDA on FY2024 estimates, I get to a target price of $277 in 2024, which offers a 16% compounded annual return from today's price. Using a target return of 10-15% per annum, I get to a target price in 2021 $180-209, respectively. However, a 5.5x multiple is only the middle of the historical range. Prior cycle peaks have been at 6x EV/ EBITDA or more. Using 6.0x, I get to targets of $209-240.
Finally, if I assume that the company sticks to its average 2.5x leverage target by 2024, that would mean URI has an incremental $3 billion of capital to deploy - either on buybacks, or acquisitions, or both. By my calculations, buybacks are the most accretive use of capital (assuming only 10% after-tax ROIC on deals). Depending on the mix of buybacks or acquisitions, URI could see 20-30% accretion to my 2024 EPS number. Putting a 10x multiple on that and discounting back I get to a target of $185-211 in 2021. Using a more bullish 14x I get to $259-295.
I feel confident that there is material upside for URI. My analysis suggests a reasonable base case target price of around $200, with a bull-case upside target of $250 looking achievable if all things go smoothly beyond 2021.
The downside is to 4.5x EV/ EBITDA, which on my 2020 and 2021 estimates would point to $50 to $100. The $50 downside would be extreme, and would require sentiment to turn materially negative again about the prospects for the US economy - perhaps in response to a resurgence of the virus, a new lockdown, and with no vaccine in sight... This is still a possibility.
However, if I use a 4.5x EV/EBITDA multiple on my out-year projections, I still see an 8% compounded return for investors each year, which is not bad in my eyes as a bear case.
So in summary, from a valuation perspective, while I see risk to $50-100 on the downside, the upside for URI is to $200-250. This puts the risk at -64% to -28% in the near-term, with upside of +44% to +80% in the next 12-18 months.
My sense is that the probability of the upside is currently higher than that of the downside, with the probability of the extreme downside looking more minimal in my view. The market is already looking forwards and trying to discount the scale of recovery.
Conclusion
I like URI as a company. I think it is often misunderstood, with the quality of the management team and its approach to running the business typically overlooked by investors hypnotised by the company's sensitivity to economic cycles. As a long-term investor, I have the luxury of looking beyond near-term cyclicality towards the secular growth story and the quality of the company's strategy. In particular, I like the strength of the FCF story, which provides the company plenty of options to create value - particularly in down cycles.
Valuation is attractive, and while I see some downside risk, I think the scenarios that might lead to significant impairment of investors' capital have relatively low probabilities. More importantly, I believe they would be short-lived.
Longer-term, I see significant upside potential, and see the shares reaching $200-250 in the next 12-18 months as visibility into the US economic recovery improves.
URI is a long-term BUY at current levels, though I would be prepared to use any corrections in the share price to accumulate more - particularly below $130.
This article was written by
Analyst’s Disclosure: I am/we are long URI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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Comments (10)
You did not specifically discuss the capital structure and the impact on the investment thesis. I would be interested in your thoughts on total debt/equity in excess of ~300%. I understand that high leverage is characteristic of the industry. And, I acknowledge that URI is a very strong FCF generator. Both are mitigating factors. While it appears that URI can and has serviced the debt, the amount of leverage is a concern worth addressing. High leverage boosts returns on equity in the 'good times', but can quickly cripple a business in less favorable business conditions. FYI, I am long URI, but have been hesitant to increase my position because of the leverage overhang and no dividend return.
