United Rentals is a great business with attractive secular growth prospects that has more than 100% upside to fair value. URI is commonly perceived as cyclical, but investors miss the strong resiliency of the business.
URI is trading at under 5x my estimate of 2020 free cash flow and has a healthy balance sheet. URI is resilient because it has flexible capex. URI is expected to cut capex by more than half this year, just as it did in 2009. This will result in capex that is under 50% of depreciation and thus significantly higher free cash flow than earnings for 2020. I expect free cash flow to increase nearly 25% to more than $25 per share, despite an expected 38% expected decline in 2020 EPS. These countercyclical cash flows under-appreciated by the market.
United Rentals is a High-Quality Business
United Rentals is the largest rental equipment company in North America. The company has 1,200 locations and an inventory of 665,000 pieces of equipment, including aerial lifts, earth moving machines, forklifts, and many more.
United Rentals is a good business with double-digit returns on tangible capital. As the #1 market participant nearly equal in size to its next three competitors combined, URI enjoys many competitive advantages. Its dense network provides a cost advantage over smaller, regional players because URI can more efficiently spread out overhead costs. It also has purchasing power, allowing it to obtain equipment at up to a 10%-20% discount to its peers. URI’s focus on larger customers is another differentiator; national accounts have a single point of contact and can return rentals to any of the company’s locations.
United Rentals Durability
A key reason to own United Rentals is its financial flexibility and how it should perform in an economic recession. Rental equipment is an economically sensitive business, and in 2009 EBITDA declined by 41%. Despite this drop, free cash flow increased by 10% that year. As demand falls, United Rentals needs less equipment in its fleet and can cut capital spending. For new equipment, the company can cancel its orders with as little as 30-45 days’ notice – this is a critical option that the company enjoys. If necessary, the company can also sell old equipment from the fleet. Values for old equipment have been solid even in weak economic times. In fact, in 2008 and 2009 United Rentals was able to sell equipment above book value and record a gain on the sales (partly due to aggressive depreciation methods as well).
From 2008 to 2009, net capex declined from $440 million (13.5% of sales) to $82 million (3.5%), allowing free cash flow to expand. In 2019, net capex was $1.48 billion (15.8% of sales), so there is meaningful room for the company to adapt. Entering 2020, URI expected to spend about $2 billion (net) on new equipment. Now, just a few months later, the company expects to spend under $1 billion and to exit 2020 at an even lower run-rate.
United Rentals is currently levered at 2.5x 2019 EBITDA. If I use 2009’s 41% EBITDA decline as a proxy, United Rentals would be expected to end this year under 4x levered, as the company should be able to pay down debt with the benefit of reduced capex. United Rentals has no debt maturities until 2025 and its loans are covenant-light. In short, United Rental’s financial health is very strong.
URI is Stronger and More Diverse than During the Great Financial Crisis
The equipment rental industry has always been healthy, but it is even healthier today. The industry is more consolidated with the top 10 rental companies making up 30% of the market now, compared with 20% in 2010. I expect United Rentals to continue gaining share, as smaller, independently owned companies under stress either go out of business or sell out to United Rentals.
Longer term, the current, uncertain environment should create an even greater opportunity for United Rentals. There should continue to be a secular shift towards renting equipment instead of owning. Rental penetration is 53% now versus 40% in 2005, as customers realize many benefits from renting. Customers prefer renting because they receive 24-hour customer care and support, they have reduced downtime and increased reliability, and renting conserves capital.
Lastly, I believe URI’s business has improved beyond industry dynamics as it has shifted away from non-residential construction to less volatile end markets. Non-residential construction is <50% of sales now, down from ~75% in 2008. Today, a higher portion of sales are from specialty rental equipment, a more stable segment. These services include Power & HVAC (used in disaster recovery, for example), port-a-potties, and trench excavation equipment, each of which is less cyclical. Specialty rental accounted for 23% of sales in 2019, up from just 7% in 2012 and less than that in 2009.
Specialty Rentals should hold up much better in this environment. Ashtead, United Rentals top competitor, recently announced that its specialty rentals business was running +9% y/y in April 2020, compared with -18% y/y for its general tool rental business. And, most importantly, Ashtead and United Rentals are not cutting price.
These trends were echoed by United Rentals last week, who showed a chart that equipment on rent has been increasing since early April. While many job sites have been shut down, there are also new sources of demand for URI’s services. For example, COVID-19 testing sites or other related medical demand (like the temporary hospital that was set up in NYC at the Jacob Javits Center) utilize URI equipment. And, many of URI’s end-markets, like road construction, are perfectly suited for social-distancing work environments.
Long-Term Growth and Upside to Fair Value
From 2006 through 2019, United Rentals grew its EPS from $2.28 to $19.52 (an annualized rate of 18%), through a combination of organic growth, M&A, and buybacks. URI is a great operator and a great capital allocator in an industry with secular tailwinds. Once the environment stabilizes, I expect double-digit EPS (and free cash flow) growth to resume. With the stock trading for less than 5x 2020 free cash flow, I think fair value is at least 100% higher than the current stock price.
I do not hold a position with the issuer such as employment, directorship, or consultancy. I and/or others I advise hold a material investment in the issuer's securities.