HEES - H&E Equipment Services' Aggressive Growth Plans Are Justified

2023-10-12 06:00:14 ET

Summary

• H&E Equipment Services has seen strong stock performance, with shares rising 45% in the past year.
• The company is engaged in aggressive growth and expansion, due to strength in the nonresidential construction industry.
• While H&E's free cash flow deficit is a perceived risk, its fundamentals and growth strategy make it an attractive investment for those with a higher risk tolerance.

Shares of H&E Equipment Services (HEES) have been a stellar performer over the past twelve months rising about 45%, though most of these gains occurred late in 2022 with shares about 20% below their February peak. While the company is engaged in a very aggressive growth strategy, shares are cheap. I do view the fundamentals as justifying its growth spending, but its free cash flow deficit is a perceived risk. I view shares as attractive for investors with a higher risk tolerance; for others, United Rentals (URI) may be a superior choice.

H&E is an equipment rental company. For many construction projects, contractors will rent equipment rather than own it outright as their needs are constantly changing. H&E buys and maintains a fleet of equipment that it can rent out. As you can see, H&E operates across much of the country but the Southeast and Gulf Coast account for about half of its business. H&E has been aggressively expanding its presence, adding six locations this past quarter.

H&E primarily serves the nonresidential construction industry with that accounting for over 2/3 of its business. Industrial, oil & gas, and residential are much smaller pieces of its revenue. I see reasons to be secularly bullish on nonresidential investment, even if you have some concerns about the economy, which I will discuss further below.

In the company's second quarter , EPS rose by 50% to $1.14 as rental revenue 28.1% to $291.5 million. EBITDA was up 36.6% to $166.5 million as price increases helped to boost gross margins 180bp to 46.7%. As the business increases scale, SG&A as a share of revenue is coming down, last quarter by 50bp to 27.6%.

The primary driver of the company's growth is its aggressive fleet expansion. Its fleet is up 30% or $601.6 million based on original purchase cost. It has invested $375 million in gross cap-ex this year. Management expects the heavy pace of investment to continue as it raised its full year target to $600-650 million/yr. Alongside this larger fleet, its number of branches has risen by 19%.

With its fleet having grown so aggressively, physical utilization (how often equipment is being rented) has dropped, falling 390bp to 69.3%. Last year, utilization was arguably too high-if all of your equipment is being rented because demand exceeds supply, it could be a sign your fleet is too small relative to your opportunity, and you are leaving potential business on the table. That said, if utilization falls too quickly, the company is left with product it paid for that is not generating any revenue, dragging down margins.

Declines in utilization are a sign to pay attention to, but given a 30% rise in the size of its fleet, a 390bp drop in utilization is quite small proportionately. This is consistent with the fleet being right-sized higher for elevated demand rather than being overbuilt. Importantly, management has said during Q3, H&E is seeing a seasonal uptick in utilization above 70% but still below last year's levels.

Further to this point, we are seeing H&E continue to have pricing power-a sign that lower utilization is a normalization and not a sign of weak demand. Rental rates rose 1.1% sequentially and 7.1% from last year. While rental rates, like many other forms of inflation, have passed their peak, it was encouraging to see rental rates accelerate from Q1. I expect year over year rental rate growth to slow as 2022 falls out of the calculation but remain in the mid-single digits.

Because H&E is purchasing so much new equipment to grow its fleet, the age of its equipment has been falling. The average age of its fleet is 42.5 months from 43.7 last quarter and below the 50.3 month industry norm. A fleet with more modern equipment should lead to higher rental rates than peers and make its product offerings more attractive. Additionally, this means H&E can afford in the future to slow cap-ex, in the face of a downturn to let its fleet age a bit back towards the industry average.

It is important to note that because H&E is growing its business so aggressively, it is running a free cash flow shortfall. This is inevitable-there are few, if any businesses, that could grow their capital base by 30% solely out of operating cash flows. Last year, free cash flow was a negative -$233 million, and it will likely end this year wider than -$250 million.

This free cash flow deficit is primarily financed through debt as H&E has a 75% debt to capitalization ratio. Importantly, its $1.25 billion unsecured notes do not mature until 2028, meaning it will not need to refinance them in the current rate environment. With just $47 million in cash, near term deficits are financed through its $750 million asset-based lending facility. With $611 million available, H&E has more than enough liquidity to finance its growth plans, this facility is costly, running at about 6.7% at today's fed funds rate.

What is essential to recognize is that this free cash flow deficit is an active management choice. In the face of substantial demand for equipment rental, H&E is growing to meet that demand, and as long as rental demand remains strong, this will prove to be a wise investment. It is important to note though that its larger peer, United Rentals, is now generating free cash flow through the cycle, though it used to run deficits during fleet expansions when it was a less mature company. URI grows more slowly now, but its persistent free cash flow does provide a safety than H&E does not have.

Now, during a downturn, H&E can quickly shift its free cash flow profile by pulling back on equipment purchases-as you can see above, it actually generated cash in 2020 when the economy went into a recession. Even though demand for rental equipment tends to be cyclical, equipment rental companies' cash flows can be counter-cyclical, a reason I view the business as relatively resilient and am more accepting of aggressive growth plans.

First, H&E could simply stop its fleet expansion. In the first half of the year, it generated $250 million in operating cash flow excluding working capital movements. Over a full year, H&E, at today's fleet size has about $400-450 million in operating cash flow power, even if rental rates were to fall mid-single digits. To maintain the size of its fleet, it needs to spend about $300-325 million gross, or $250-275 million net per year on equipment, for sustaining free cash flow of ~$150 million.

Beyond this though, during a downturn, H&E can let its fleet age. Instead of replacing equipment after 5 years, it can wait 5.5 years, pushing off some cap-ex below sustaining levels for a period of time while maintaining the same amount of equipment. With its fleet 8 months below industry average (and industry average likely to age during a recession), it's true sustaining cap-ex in a recession is a bit under half of its "long-run level, or about $100-125 million. In a downturn, H&E could generate $300 million of free cash flow again, to pay down its revolver balances, etc. As equipment purchase contracts generally are within 6 months, the ability to flex up or down cap-ex spending is fairly quick. H&E can react and change course quickly if needed

Now of course if I felt demand were about to fall tomorrow, I would not want to see H&E growing into that recession, I'd rather see it begin to hunker down now. However, I believe its nonresidential construction exposure if a major positive. We generally think of construction as being very cyclical; however, there is secular growth occurring. As you can see below, nonresidential investment has soared over the past year.

Government policy is a major driver of this. The 2021 bipartisan infrastructure bill has begun to ramp up; these projects will take several years to complete. The CHIPS Act is providing significant funding for semiconductor factory construction, and the Inflation Reduction Act supports renewables construction as well as providing indirect incentivize for private construction of projects like battery plants for electric vehicles.

These projects are tied to government funds that have already been appropriated, which insulates them from broader economic activity. Many of these projects, like a semiconductor factory, take several years to complete, so this spending should be persistent. Now, I do not expect the recent pace of growth to continue, rather I expect the elevated absolute level of spending to continue, providing ample demand for rental equipment. The boom H&E is seeing is secular, not cyclical, in nature and should last for several years.

The company's reliance on debt financing in a period of high rates for cap-ex, in what has historically been a cyclical business, drives the narrative of H&E being a "risky" stock. And indeed, it is riskier than a peer like URI, which generates cash and can buy back stock. However, that safety premium means URI trades with about a 7.5% free cash flow yield. Conversely, H&E is trading at 10% sustaining free cash flow yield (using my $150 million level cited above). This is even as its near-term growth prospects are superior due to the magnitude of its fleet expansion.

Now, if we were to see an economic downturn occur, which brought nonresidential construction down despite the government tailwinds, I would expect H&E to exhibit more downside beta, given its smaller size and free cash flow deficits. However, given the ability of the company to cut cap-ex and flip cash flow positive quickly by letting its fleet age, I think the business is more resilient than the market may give it credit for. Still, that elevated share price volatility is something investors need to recognize.

With faster growth, thanks to its smaller current size and cap-ex program, one could argue HEES should trade at a more expensive multiple than URI as it should be able to grow into that multiple if I am correct that nonresidential construction remains strong. However, I expect HEES to continue to trade at a discount given its perception of being riskier, and while HEES is riskier than URI, I do not view it as excessively risky. For investors who can stomach volatility and be patient in letting the valuation gap close as H&E continues to build more scale and report 20+% revenue growth over the next 12-18 months, I think shares provide an attractive opportunity.

I believe shares should trade to no more than an 8% sustaining free cash flow yield, providing about 25% upside to $55 and back to 12-month highs. H&E is not as risky as its free cash flow deficit implies, and with demand for construction equipment likely to stay strong, we should see revenue continue to grow swiftly. I would take advantage of recent weakness to be a buyer.

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