|Shares Out. (in M):||503||P/E||19.1||17.3|
|Market Cap (in M):||5,507||P/FCF||0||0|
|Net Debt (in M):||1,571||EBIT||522||553|
|Borrow Cost:||General Collateral|
Construction Equipment rental stocks have performed poorly since November 26, 2014 (the day before oil’s infamous Black Friday). Since then, the share prices of the US’s three publically listed construction equipment rental companies, United Rentals Inc., H&E Equipment Services Inc., and newly public Neff Corp., have fallen 25.7%, 48.2% and 32.7% respectively, as investors attempted to discount the impact of a 53% decline in WTI oil prices since June 2014. Interestingly, over that same period, the share price of Ashtead Group PLC, the owner of Sunbelt Rentals Inc. (#2 US market share behind URI), has actually increased 8.8%. This outperformance is ironic, in that Ashtead, although listed in the UK, is almost entirely a US construction equipment rental company, with Sunbelt contributing 83.2% of AHT’s revenues, 86.8% of EBITDA and comprising 83.7% of AHT’s rental fleet (during FY1H15).
I believe this significant outperformance versus peers, a historically high valuation, combined with the real vulnerability to AHT’s near-term fundamentals, leads to a short opportunity in AHT. I see a risk to consensus to FY2016 centered on lower EBITDA margins, stemming from weaker industry pricing, rather than a substantial drop off in end-user demand. I derive my price target through expected value, stressing earnings model assumptions for a more challenging operating environment, and valuation multiples reverting to historical averages. My price target of £777.12 offers 27.9% total return (incl. dividends) from the current price.
AHT’s is a construction equipment rental company based in London and trading on the London Stock Exchange. It operates two primary business lines: 1) Sunbelt Rentals Inc, the #2 US construction equipment leasing company, with an estimated 6% market share; and 2) A-Plant, the #2 UK equipment lessor, with an estimated 9% market share. A-Plant contributes 16.3% of group revenue, 13.2% of EBITDA, and comprises 16.3% of group fleet (during FY1H15). A-Plant is a slower growth, profitability improvement situation, and not a big driver of the AHT story. Management has a good reputation with investors for solid execution in recent years.
Fleet/distribution/Industry fragmentation. AHT’s customers are mainly smaller contractors and commercial, non-residential construction companies. AHT acquires and maintains a diverse “fleet” of construction equipment, renting that fleet out through 493 branch locations in the US and 129 in the UK. 22% of these locations were opened in the last two years: both greenfields (45%) or acquired (55%). Nearly all of the branch growth is in the US. The fleet is comprised of: 37% aerial work platforms; 20% forklifts; 16% earth moving; 13% diverse smaller equipment; 9% pump and power; and 4% scaffold (at 9/30/14).
In both the US and Great Britain, construction equipment rental is a very fragmented industry, consisting of a few national players, many OEM captive dealers, and hardware retailers. The barriers to entry are capital intensity and distribution. Growth is dependent on cyclical demand but also can be achieved through acquisitions (both AHT and URI have grown aggressively via acquisitions), greenfield store expansion, and through partnerships with retailers, such as Sunbelt’s 30 store partnership with Lowe’s Companies, Inc. A trend towards consolidation has allowed URI and AHT to grow much faster than the construction industry. AHT has chosen to grow through both greenfield branch expansion as well as bolt-on acquisitions, eschewing the kind of larger, transformational deals, pursued by URI. Over time, AHT believes it can more than triple its market share to 20%. It is thought that leasing’s penetration of construction equipment spending is also a secular growth tailwind (the American Rental Association says that leasing has grown to 53% penetration versus only 40% in 2005). AHT management believes leasing penetration of construction equipment spending can reach 60% in the US in the next few years, versus the 75% share it has enjoyed in the UK for years.
Cyclicality. Construction equipment rental is a highly cyclical industry. Historically, both revenues and margins have been subject to volatility due to sudden changes in contractor demand (the average lease term is only 1-3 months, depending on equipment type, meaning pricing changes are felt quickly) and the supply of equipment available to meet localized demand. Operating conditions can vary significantly by equipment type, and geography. Such localized disparities give large national operators like URI, AHT and HERC (Hertz Equipment Rental Corp., “HERC” a division of Hertz Global Holdings, Inc., that is a rumored acquisition target of URI) a distinct competitive advantage over more locally focused players, due to large lessors’ ability to leverage sophisticated logistics to redeploy equipment into markets where the supply and demand characteristics are more favorable. Additionally, the large national accounts (those managed from a single point of contact) have a greater concentration at URI’s (nearly 68% of its total), while AHT’s is less than half that level (which should theoretically give AHT more pricing leverage). Upturns and downturns in cyclical profit margins are determined by fleet utilization and price. During this period of its aggressive capex expansion, AHT was fortunate to enjoy improving utilization and price. However, even as end user demand remains strong, AHT is already experiencing some diminution of pricing performance (to only 2.0% rate growth), perhaps in a bid to gain market share. This is in contrast to URI, which posted 4.5% price improvement for the full year 2014, but is guiding lower to 3.5% for 2015e. URI’s cautionary view, combined with expectations for a large amount of capex from competitors, make us concerned about pricing. Our expectation is that, because of AHT’s big capex push, any hit to AHT’s profit margins is likely to come from failure to achieve price rather than a big fall of in demand from customers.
Source: Company filings.
US market leader, URI, and some of the captive OEM dealers, have a competitive advantage in asset disposition, in that they view the sale of used equipment as a profit center, as opposed to other companies (including AHT) that primarily rely on third-party auction companies (such as Ritchie Bros. Auctioneers Incorporated) for asset disposal. Given a robust market for used equipment, margins have improved recently. URI’s margins on asset disposals ran at 42.0% in 2014, cyclically improving from only 31.3% as recently as 2012. AHT, however, only generated margins of 19.6% on used equipment sales in FY2014.
Geographic/energy exposure. Although AHT management claims its exposure to energy-related lessees is only 10% of the total portfolio, a careful look at its US geographical footprint shows large market shares in some important energy-sensitive areas, including an 11-12% share in Texas’ Permian Basin and more than 15% in the Houston-Galveston region, 10% market share throughout most of Colorado and Oklahoma, +15% share in Wyoming’s Niobrara Basin, Louisiana’s Deep Tuscaloosa, Pennsylvania’s Marcellus, and Texas’ Eagle Ford Basin south of San Antonio, as well as +15% share in most of Kentucky and West Virginia’s depressed coal country (coal prices have fallen 56% since January 2013). Importantly, AHT has zero presence in rapidly decelerating North Dakota, and only a token presence in Canada, a market which accounts for 6% of URI’s branches.
Source: Company filings.
My short investment thesis centers on the premium valuation relative to peers and the increased risks posed to the fundamentals from a potentially serious slowdown in construction spending in the oil patch. My price target of £777.12 is derived from expected return analysis offering a one year IRR of 27.9% including the dividend:
AHT is Expensive Relative to Peers on every valuation measure. I believe that the explanation for the magnitude of this gap has more to do with the nature of its shareholder base rather than any deserved premium for superior execution/profitability or lower earnings volatility.
EV/EBITDA. The most commonly used methodology to value construction equipment rental companies is EV/EBITDA (next four quarters). Based on this measure, AHT is expensive relative its peers, a premium that has widened since 2013.
Perhaps, the company’s inclusion in the FTSE 100 Index on December 23, 2013 offers some explanation for this premium. An evaluation of the shareholder base shows that some 56% of the shareholder base were UK institutions, 20% US (many large indexers), and only 5% hedge funds. As the 75th weighted member of the index, AHT presents an interesting overweight opportunity for active manager, as AHT is at the top of the index rankings for both share price and earnings momentum, offers a uniquely heavy play on the US recovery (with only 15% exposure to the UK), and an implicit long dollar bet in the earnings translation. While AHT investors are likely asking more questions about the energy exposure, the issue has only recently come up, it has not yet impacted AHT’s earnings, and the buyside seems to have a high level of confidence in management given their track record of execution.
Despite a relative premium to the group, on an absolute basis 6.9x EV/EBITDA (2015e) might not sound excessive for a company with expectations of strong earnings momentum, and a 12.4% return on invested capital. The question is whether it is the right metric in the first place. It’s hard to see why this valuation approach is widely used. Depreciation is essentially AHT’s COGS. Without the equipment expense, there is no business. Looking at AHT on EBIT, AHT’s still much more expensive 13.2X versus 10.0x for URI and the group at 9.5x. And interest expense, too, is a critical cost of operations; all of the companies in the business need to deploy leverage to generate acceptable returns. Thus, we may be better off looking at simplistic forward P/E ratios, ignoring some tax and forex issues, by which AHT also screens very expensive at 17.3x, versus 11.1x for URI and 11.8x for the group.
EV/Replacement Cost. One way to sort of strip through these differences is to simply look at the price the market is valuing AHT’s gross, un-depreciated equipment as a proxy for replacement cost. The following graph shows the EV/replacement cost valuation metric has just come off an all-time high (2.75x), and stands at 30% premium to URI (1.93x). AHT’s current valuation is slightly below two standard deviations above its five year mean (1.49x), while URI stands at 1.06 standard deviations above its mean. AHT’s premium exists despite the equipment being largely similar types, rented the same way, to the same types of customers in the same markets. With both companies’ profit margins being nearly identical, it’s hard to see why such a large divergence should exist. My expectation is that, during times of stressed earnings, the market will revert to valuing the businesses on the more certain asset value versus less visible earnings expectations.
Expected Value Derived Price Target. I considered, and probability weighted, three potential scenarios to derive our price target.
1) Upside scenario. AHT meets 2016e expectations for EBITDA and trades at 8.0x EV/EBITDA, a significant premium to its five year group average. (20% probability)
2) Base Case scenario. AHT’s 2016e EBITDA margins return to 2012-2013 levels on identical revenue estimates, without significant capex cuts, leading to EBITDA 16% below consensus, and an EV/EBITDA valuation equal to its five year historical average. (60% probability)
3) Downside scenario. AHT delivers the same stressed earnings as the base case, however, based negative sentiment in the group reverts to valuation based on replacement cost, wherein AHT trades at its historical average (1.38x) as a percent of 2015e undepreciated rental equipment (20% probability).
AHT may face significant cyclical earnings risk by CY2H15, perhaps more than peers, due to a few key factors:
AHT has enjoyed a very strong cyclically-driven profitability expansion (1,140bps EBITDA margin expansion) since 2012, coincident with a decision to increase fleet growth to several times the industry average during an economic recovery.
Massive Increases in Capex Accompanied Profitability Improvement and led to Market Share Gains. Big increases capex resulted in a near doubling of the gross un-depreciated equipment base since 2010 (when capex was only a mere £36mm). The decision to ramp up investment was well-timed. Over the past five years, AHT has generated higher revenue as a percent of gross equipment, and higher EBITDA as a percent of gross equipment and revenue. The following table details the cyclical improvement in AHT’s profitability since 2010:
Source: Company filings.