URI - United Rentals: This Capital Intensive Business Deserves Attention

2023-03-17 13:14:30 ET

Summary

• The leader in rental equipment industry offers attractive returns, in spite of short-term risk of recession.
• United Rentals' well thought out growth strategy has created an important competitive advantage.
• High free cash flow allows the management to increase shareholder distributions, while also reinvesting back into the business.

Untied Rentals ( URI ) is a leader in an industry that seems to have fallen out of favour with most investors. Even though it is a high growth stock with competitive advantages that are hard to replicate, it rarely makes the news and trades at low double digit multiple on forward earnings.

From a historical point of view, United Rentals has been a gem for investors, delivering more than 500% return over the past 5-year period and thus outperforming its major peers by a very wide margin.

Looking ahead, URI is well-positioned to deliver superior shareholder returns for a number of reasons. As a starting point, the rental equipment sector is experiencing strong secular tailwinds.

Reverting To The Mean

The equipment rental space is still a very fragmented sector, where achieving high economies of scale is crucial for success. In that regard, United Rentals growth strategy has made the company the absolute leader in the highly attractive market of the United States.

Although the risk of a recession over the short-term is real, investors with a longer investment horizon look favourably at the deglobalizaiton trends, which are bringing more industrial production onshore.

The graph below clearly illustrates how construction spending per capita has fallen below its long-term trend over the past 10 years or so.

This, however, is rapidly changing as more industrial capacity is being brought back in the United States. Although this already sounds like a cliche, onshoring within energy, automotive and semiconductors industry is happening as you are reading this.

The government plays a key role in this process and has already provided a highly supportive environment for more mega projects in these and other areas.

As the largest company in the rental equipment space, United Rentals is among the best-positioned companies in the sector to win larger projects due to the breadth of its portfolio and wide geographical reach.

Moreover, United Rentals customer mix is already heavily shifted toward industrials and non-residential construction.

As a result, the company has already provided a revenue guidance for this fiscal year that assumes roughly 20% growth. Although the recent acquisition of Ahern Rentals also plays a role, organic growth remains high.

Free Cash Flow is also expected to improve considerably over this year, even as the company spends a record amount on capex (more on that later).

Large Scale Matters

The equipment rental industry relies heavily on scale. On one hand, the companies could significantly increase utilization rates and the share of fixed cost expenses with larger size. On the other, they could also differentiate by also servicing more niche areas of the market.

With that larger size results in a major competitive advantage that also drives higher margins and higher return on capital.

Therefore, one would expect that United Rentals' return on equity would have skyrocketed in recent years as the company more than doubled in size since 2013. Unfortunately, however, this was not the case and ROE now stands within the company's historical average.

Once we look at the main drivers of ROE, we notice that operating margin is now at record highs while asset turnover is also at its highest levels since 2013. Leverage, however, has come down rapidly in recent years which has largely offset the outstanding operational performance.

Equipment utilization rate is one of the most important metrics behind the record high asset turnover and margins. That is why, United Rentals Price-to-Book multiple is related to the rental equipment dollar utilization on a historical basis.

Having said that, we are likely to see a multiple repricing if utilization rates remain high in 2023 and URI continues to expand its footprint.

Cash Flow Machine

The last piece of the puzzle on what makes United Rentals so attractive is the company's focus on free cash flow and its capital allocation process.

Through its aggressive M&A and organic growth strategy, United Rentals grew in size very fast and with that accelerated its free cash flow.

Anyone who follows my work would know that the phrase "aggressive M&A strategy" is usually a major red flag for me. And United Rentals did just that over the past decade.

However, right off the bat we notice that the deals have not grown in size over the years which suggests that the company is not pursuing these deals just to inflate its short-term revenue growth.

In addition, United Rentals shareholders were not diluted in the process - quite the opposite and leverage has also come down over the past decade.

Already this is in stark contrast to other aggressive M&A strategies that I have been criticizing over the years and that ultimately led to shareholder value destruction (see here , here , here and here ).

Another advantage stemming from United Rentals' size is that the company could afford to outbid its smaller peers, without significantly overpaying. One such example is the acquisition of Neff where the smaller H&E Equipment ( HEES ) was outbid by URI.

In spite of the bidding process, the recorded goodwill was still a small proportion within the total net assets acquired.

A large share of goodwill and low amount of individually identified intangible assets following an M&A deal is usually an important red flag .

The prudent M&A strategy of United Rentals has allowed the company to now resume its share buyback program while also instituting quarterly dividend payments.

(...) we’re reactivating the $1.25 billion share repurchase program that we pause when we announce the Ahern deal. We plan to buy back $1 billion of stock this year. And we’ll also be instituting quarterly dividends for our shareholders, totaling $5.92 per share this year.

Source: United Rentals Q4 2022 Earnings Transcript

Not only is the management committed to returning cash to shareholders, but it also prioritizes organic revenue growth. This is proven by the company's record high amount spent on purchases of rental equipment relative to its cash flow from operations (capital expenditure).

Purchases of rental equipment relative to the annual depreciation and amortization expense stood at more than 150% in fiscal year 2022 which is by far the highest ratio over the past 10-year period.

Conclusion

United Rentals capital allocation strategy has been a master class on how to successfully execute on an aggressive M&A strategy. At the same time, management has also prioritized organic revenue growth and shareholder distributions. Most importantly, however, the company has secured a major competitive advantage that in my view would allow it to retain its industry leading profitability and return on capital. Last but not least, the stock is still trading at relatively conservative levels which creates a long-term opportunity for anyone willing to ride through short-term volatility in the markets.

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