2023-07-04 23:10:31 ET
Summary
- United Rentals continues to perform well as the risk of a recession grows.
- The share price is not expensive as profitability and utilization rates remain strong.
- Near-term risks should not be ignored, but United Rentals remains a sold long-term opportunity.
As consolidation in equipment rental space accelerated, Untied Rentals ( URI ) continues to perform well among the rising fears of an upcoming recession.
Although the company won't be immune to a potential economic slowdown, URI remains among my top picks within the Industrials sector. In a bit more than 3 months , URI delivered nearly 21% total return thus outperforming both the S&P 500 and the Industrial Select Sector SPDR® Fund ETF ( XLI ) on an absolute basis.
Having said all that, investors should remain cautious of any short-term reversals in United Rentals' share price due to changes in macroeconomic and liquidity conditions and retain their long-term focus on the business itself.
Not Worried About The Share Price
The Conference Board Leading Economic Index® [LEI] has continued falling in recent months and is signalling a potential slowdown in economic activity and with that cyclical and high beta names, such as United Rentals, are at much higher risk in relation to defensive stocks.
The downside risk for URI, however, remains significantly lower due to the conservative pricing of the company's shares.
After returning nearly 21% over the past few months, United Rentals' forward P/E ratio is still well-below the sector median and very close to falling down to single digits again.
Seeking Alpha
On a price-to-book basis, United Rentals trades at 4.3 times its current book value of equity which is significantly higher than the sector median of 2.7. Having said that, we should take into account the company's rental equipment utilization, which is a major driver of the company's premium over book value.
As we see in the graph below, in fiscal year 2022 URI was trading at a much lower multiple to what its dollar utilization rate would suggest as the market was anticipating a drop in utilization rates following the Ahern deal. At the moment, however, the company is priced in-line with the current rates.
prepared by the author, using data from SEC Filings and Seeking Alpha
As Ahern is integrated into the business and the combined entity benefits from economies of scale, utilization rates are likely to return to their previous highs.
If you think about the amount of capital that Ahern had that we're adding to the base year, and the amount of revenue -- rent revenue they generated on it, it was about 40%, about $0.40 on every dollar. When you roll that into our experience, which is more like 60% on the dollar, that's that dilutive effect.
Source: United Rentals Q1 2023 Earnings Transcript
Lastly, free cash flow yield has also fallen dramatically over the recent years and now stands at 1.5% if we include purchases of rental equipment within our capital expenditures calculation.
prepared by the author, using data from SEC Filings and Seeking Alpha
The reason for this low yield is the fact that United Rentals has been very aggressive in its expansion strategy in recent years. The amount spent on purchases of rental equipment has skyrocketed during fiscal year 2021 and stayed at around 35% of equipment rentals revenue since then.
Growth in rental equipment also continued into the current fiscal year with original equipment cost [OEC] increasing by nearly 26% following the Ahern deal and the increased spent on capex.
Equipment rentals represented 83 percent of total revenues for the three months ended March 31, 2023. For the three months ended March 31, 2023, equipment rentals of $2.740 billion increased $565, or 26.0 percent, as compared to the same period in 2022, primarily due to a 25.6 percent increase in average OEC . The increase in average OEC includes the impact of the acquisition of Ahern Rentals that is discussed in note 3 to the condensed consolidated financial statements, as well as increased capital expenditures .
Source: United Rentals Q1 2023 10-Q SEC Filing
Improving Return On Capital
While pricing of United Rentals shares remains in-line with its fundamentals, the business positioning is gradually improving and the company is retaining its current leadership.
With a leading market share in a very fragmented industry, where economies of scale create significant competitive advantages, URI is in a very good spot to continue improving utilization rates, profitability and return on capital.
United Rentals Investor Presentation
As we saw in one of the graphs above, the current period of high spend on rental equipment relative to sales resembles the 2011-14 one, when the ratio of capex to sales once again stood at 35% or above.
In the latter period, URI gross margin in equipment rentals also experienced a major headwind, improving from 34% in 2011 to 43% 2014.
Although profitability has recently rebounded from its 2020 lows, gross margins have not experienced a similar improvement this time around due to United Rentals' more aggressive M&A strategy.
While this might sound disappointing to shareholders, the more aggressive approach towards inorganic growth has very important implications for long-term investors.
To begin with, it puts the company in a very good position to compete for large construction projects in infrastructure, electric vehicles, semiconductors and energy.
In the meantime, it also provides a major tailwind for operating profitability as economies of scale kick in. To illustrate that, in the graph below we could see how United Rentals SG&A expenses to sales ratio has recently reached one of its lowest points ever.
In combination with the higher utilization rates, this has resulted in a major increase in the company's return on invested capital.
Be Mindful Of The Short-Term Risks
Even though URI is conservatively priced and well-positioned to remain a leader in the sector, the short-term risks for the share price should not be ignored.
As of late, sell-side analysts have been becoming increasingly optimistic about the stock which attracts momentum trades and more speculative investors, who are chasing short-term results. On itself, this only intensifies the downside risk in the near-term, if the economy goes into recession.
Although URI's 6-month beta is still near its lowest levels since 2011, the company is still heavily exposed to market-wide movements and near-term expectations about the business cycle.
Conclusion
In spite of the short-term risks related to the equity market and the economy, United Rentals offers significant downside protection due to its conservative valuation and leading positioning in the sector. In the meantime, the company is very well-positioned to capitalize on profitable growth opportunities as the management takes all the right steps towards securing sustainable competitive advantages in the sector.
For further details see:
United Rentals: Be Mindful Of Short-Term Risks, But Don't Lose The Long-Term Focus