It’s been almost a year since I last wrote my article on the rental and leasing giant United rentals (NYSE: URI). The reason I’m digging the ticker again is based on the abysmal performance of the stock market. The S&P 500 is close to a bear market (-20%) as investors have de-risked their portfolios to price in slower economic growth, an aggressive Fed hike cycle, ongoing supply chain issues and high inflation in their portfolios. Although sales are no fun, they provide opportunities to buy new businesses or add to existing positions. Over the past few months, I’ve talked a lot about construction companies like Cummins (CMI) that offer opportunities for dividend growth at good prices. United Rentals does not pay a dividend, but buys back a large number of shares using its huge free cash flow. The company has high margins, a rapidly growing business and a terrific valuation from the sale. Investors who don’t care about a dividend can consider buying United Rentals, which I see as more than a business opportunity at a good price. It is a promising long-term investment with a high probability of outperforming the S&P 500.
Let’s look at the details!
What is United Rentals?
In general, when buying dividend growth investments, I like to buy companies with as little competition as possible in an industry where entry barriers are high for new entrants. However, there are advantages to buying companies in highly fragmented markets. High achievers who are able to stand out through good services or products can use their ability to gain competition to scale their way of doing things. This is possible, i.e. in car dealerships, barbers, retail and construction (and many more).
With a market capitalization of $20.3 billion, United Rentals is the largest equipment rental company in the world, with 90% exposure in the United States.
Founded in 1997, the company has more than 1,300 locations in North America, spanning 49 states. United Rentals has $16.0 billion in fleet assets covering 805,000 units of various construction and related tools, machinery, etc. That gives the company a 15% market share, or 400 basis points above its biggest competitor, Sunbelt.
The company’s customer base is incredibly well-diversified. The company serves all sectors, segments and niches that need machines.
In general, United Rentals benefits from a trend toward companies with low investment capital. By leasing equipment i.e. construction companies achieve very high utilization rates because they only use the equipment when needed. This transfers the risk of use to United Rentals. Also, small construction companies can do a wide variety of jobs because they don’t need to buy a machine for every particular situation.
Needless to say, this industry has grown a lot. Over the past 24 years, the compound annual growth rate of the rental and construction industry has been 4.9%. This has not slowed down as the number is 5.0% on a 10 year basis.
That said, while rental companies bear many “use rate” risks, URI has benefited from its digital tools. The company has an advanced rental fleet management platform that allows it to easily open and close contracts, view data, locate equipment, track and analyze data. It allows the company to use advanced pricing tools and create services that other traditional rental companies simply cannot compete with.
In addition to this, the company has other competitive advantages. For example, it has a huge and diverse fleet, which offers machines for every job imaginable. Also, because the company has so much equipment, it can buy less expensive machines, which helps support its margins.
In addition, its scale allows the company to benefit from its national accounts program, intended for large budget relationships:
Our national account sales force is dedicated to building and expanding relationships with large companies, especially those with a national or multi-regional presence. National accounts are generally defined as customers with potential annual equipment rental spend of at least $500,000 or customers doing business in multiple states. We offer our National Account customers the benefits of a consistent level of service across North America, a wide selection of equipment, and a single point of contact for all of their equipment needs.
And, needless to say, there is strong brand recognition due to its size and customer satisfaction.
All of this resulted in a significant outperformance. Despite two 60% sales in the past 10 years (2016 and 2020), United Rentals has grown more than 550% since 2012, outperforming Caterpillar (CAT) and the Industrial ETF (XLI) by a mile. Caterpillar is not a competitor because it is an equipment supplier, but it is also considered a construction player.
This outperformance is based on the fantastic financials that come from its stellar business model, and I expect this outperformance to continue.
United Rentals generates high value
United Rentals is a mix of organic growth and aggressive mergers and acquisitions. Over the past four years, the company has purchased businesses worth approximately $4.0 billion.
Over the past five years, the company has achieved the following compound annual growth rates:
- Total revenue: 11.0%
- Adjusted EBITDA: 9.9%
- Non-GAAP EPS: 20.6%
By becoming a more mature company with adjusted EBITDA margins close to 50%, United Rentals has become a cash machine. This year, the company is looking to generate $1.8 billion in free cash flow. Free cash flow is cash flow from operations minus capital expenditures. It is the money a company can spend on dividends, share buybacks or (net) debt reduction.
Although URI does not pay a dividend, it buys back a large number of shares. It’s based on two things. First, a high implied free cash flow yield. $1.8 billion in expected free cash flow represents approximately 8.9% of the company’s $20.3 billion market capitalization. It really is a wild number. Say the company were to spend it all on buybacks, it could buy back 8.9% of its outstanding shares without needing additional funding or hurting its existing business. Or pay an 8.9% dividend with no redemption. It won’t, but you get the idea.
In addition, the company’s balance sheet is very healthy. This year, net debt (gross debt less cash) is expected to fall to $9.0 billion. It’s the same as 2017, except EBITDA is much higher now. Therefore, the net leverage ratio should fall to just 1.7x. Even with redemptions, this ratio could fall into the low 1.0x range in the coming years. Keep in mind this is the case despite millions of M&As and a long-term decline in shares outstanding (the company hasn’t diluted shares to buy growth).
With that in mind, the chart below shows what the company has spent over the past 10 years. In this case, I’ve included cash acquisitions, share buybacks, and debt issued/repaid.
Almost needless to say, as we just looked at net debt, debt issued and debt repaid have moved from higher volume of debt issued to higher volume of debt repaid. On April 21, the company announced the redemption of $500 million of the $1.0 billion outstanding 5.5% Senior Notes due 2027.
Cash acquisitions have a major impact on debt issued, as URI primarily uses cash for these transactions. The last time the company used stock to acquire a company was in 2012.
Note that since the acquisition of RSC in 2012, the number of outstanding shares has imploded. In 2014, the company had approximately 105 million shares outstanding. Currently, it is 73 million.
Between 2017 and 2021, the company repurchased 3.1% of its outstanding shares – per year.
So what about valuation?
Using the company’s market cap of $20.3 billion and projected net debt of $8.0 billion for 2023, we get an enterprise value of $28.3 billion. This is only 5.0 times the expected EBITDA of $5.7 billion for next year.
This valuation is too cheap and the result of an overreaction from traders and investors, as the past few weeks have been difficult. The same goes for the implied free cash flow yield of almost 10%, which is close to the upper end of the historical range, as shown in the lower part of the graph above.
This year, de-risking (selling) has been aggressive as investors feared slowing economic growth, an aggressive Fed, related high inflation, ongoing supply chain issues, war in Ukraine and Chinese shutdowns. .
The good news is that a lot of the weakness has been baked in. The URI is around 30% below its all-time high, meaning negative manufacturing growth has been priced in – using the chart below. I have extended URI’s year-over-year performance into the next few months (based on an unchanged stock price). If growth rebounds in the second half of this year (likely through 2023), we are dealing with a seriously undervalued company here.
To wrap up this article, here are the takeaways.
United Rentals does not pay a dividend – which is what I normally look for in a stock. However, URI has other qualities that make it an excellent long-term investment. The company is very effectively expanding its footprint in a highly fragmented industry using both organic and earned growth. The company’s balance sheet is incredibly healthy, free cash flow is strong, and aggressive buybacks are driving long-term capital gains and outperformance.
The most recent sell-off in the stock market has pushed URI down to a very favorable valuation, and I view this stock as a long-term “buy”.
(Disagree? Let me know in the comments!