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Welcome, everyone. This episode focuses on Ashtead, a UK-listed equipment rental business. It owns Sunbelt Rentals in the US and competes with United Rentals. We've been studying this intriguing company for the past few years. In this episode, we'll discuss, among other things, the favorable market structure, the history of consolidation in the industry, the favorable unit economics, primarily from specialty, but also from the general tool business, and then the potential risks in rate, pricing, and cyclicality. Please enjoy, and as always, conduct your own research. Nothing here is investment advice.

Hello, we're discussing Ashtead today. I'm curious as to why you've been studying this business. In a recent piece you wrote, you described equipment rental as a deeply cyclical, commoditized business that has historically struggled to earn its cost of capital throughout the cycle. So, what's the interest in Ashtead?

That's the key question. I first came across this business through United Rentals, which I used to cover on the credit side. These businesses have typically been highly leveraged, using debt to finance the acquisition of equipment for rental. I used to cover United Rentals and another one, Loxam, a French PE-owned company, and used Ashtead as a comparison. That was when I was mainly working with credit, and I realized that this was a much better business, structurally advantaged.

A couple of key takeaways from studying Ashtead specifically are that it benefits from significant economies of scale, from the density of equipment within geographies. Their business model is simple. They acquire equipment from Original Equipment Manufacturers (OEMs) like Caterpillar and JCB. They purchase large quantities of machinery, aerial forklifts, and various platforms, mainly for construction, but also for power and other uses. They buy more equipment than a single manufacturing customer would need, and because of the scale of their purchases, they get a discount.

They then rent this equipment out to customers. With the scale they have compared to a small business, they achieve better scale, better density, meaning more equipment per kilometer. This results in better availability, which leads to better turns on the equipment and better returns in terms of dollar utilization and return on invested capital. This structural advantage over smaller independents has been playing out for decades now, and they've been gaining market share. I believe it was pre-crisis, but I can't recall the exact details from my notes.

United and Ashtead initially held around a 10% market share, which has now doubled or tripled. The market is rapidly consolidating towards the larger players. It's a simple business, but it's tied to the cycle and often bundled with cyclicals. As an industrial analyst, you would model out construction demand and expenditure, and sell Ashtead and United when it dips. This business has been grouped with highly cyclical businesses. However, considering the changes in the market structure over the past decade, the solid returns on invested capital, and higher ROEs, we are exploring if this is a structurally growing business or just a long cycle that we've benefited from over the last 15 years.

They've been taking market share and growing organically at a high single-digit rate, in addition to acquiring assets. This suggests a long runway of growth in a large market with a favorable structure and good economic unit economics. The business trades relatively cheaply if you believe it has a structural advantage. It generated significant free cash flow during Covid when spending was halted. They buy equipment from companies like JCB and Caterpillar at a discount to book value, rent it out to customers, and then sell it in the secondary market at or near book value. They make money on the trading and disposal of the equipment, and then reinvest that into new equipment.

The key question is how stable is the free cash flow we saw during Covid when they stopped replenishing their equipment. During Covid, we saw consistent replenishment spending, but a significant decline in growth capex, resulting in a large amount of free cash flow. This gave us an insight into how much cash the business generates. Over the past six months, we've been exploring key questions about the business's cyclicality and resilience. Why has the history of equipment rental been plagued with bankruptcies in Europe and the US, and why is this business able to consistently earn 20 plus ROEs in such a large market?

We believe the business is more durable today than it was before the crisis. This is due to several factors we've been exploring in more detail. The first is the market structure, where these players now hold a much larger market share. Equipment rental has increased from 40% to nearly 60% in the last 15 to 16 years. Customers are more reliant on renting. United Rentals and Ashtead, or Sunbelt in the US, had a combined market share of 9% in 2010. By 2020, they held 25%. The market has become two and a half times more concentrated, resulting in scale benefits and increased customer reliance on rental. This provides a better market structure, more sustainable demand, and a more significant part of the value chain that these companies cater to.

What has happened to OEMs during this period?

The OEMs. essentially, don't have a choice. They're spending two billion pounds sterling annually on equipment. No manufacturer spends that every year on buying JCBs or aerial platforms. They recognize that they have a crucial customer in Ashtead and United, which gives them more bargaining power in the value chain. This power doesn't seem to be decreasing at all.

They're gaining market share by acquiring smaller businesses, which can't compete with their scale and equipment replenishment capabilities. This market structure is highly favorable for Sunbelt and United to continue gaining share.

Another aspect I've been examining, which I'm still trying to understand, is pricing. During the last crisis, pricing plummeted because everyone had surplus equipment and wanted to dispose of it. If you purchase $2 billion worth of equipment, it's on your balance sheet and depreciating every year. You need to get a return on that equipment and turn it over rapidly each year. So, what happens when demand drops? This is a significant question for Ashtead.

When demand drops, you have unused metal pieces. If no one wants them, people start dropping their prices. I think rates declined by around 30% during 2008 and 2009, which severely impacted the returns and earnings. Some companies went bankrupt and had to restructure. It was a challenging time due to the rates.

It's uncertain how they will react if the cycle turns again. However, we got a sense of why these companies might be more disciplined during Covid. Although Covid wasn't a proper recession, rates didn't change much. There's an argument that these companies might be more disciplined. A few factors contribute to this. First, there's transparency across the market in pricing and how to optimize pricing. There's an internal third-party business that provides almost daily rates transparently to the market. So, when everyone knows the rate in the market, they don't tend to discount heavily.

The second factor is the better market structure. The third factor, which we've explored a lot in our primary research over the last six months, is the new specialty business. This diversifies the bigger players a lot, accounting for 25 to 30% of their revenue, which significantly reduces the cyclicality.

They have the general tool business and the specialty business. The general tool business is typically linked to construction market growth, which is more cyclical. The specialty business is not as much linked and can include everything from HVAC, trench pumps, to portable toilets.

The specialty business also has significantly higher cash margins. These businesses look very different today than they did 15 years ago. If you can acquire these at a mid-teens multiple, and they're earning 20 plus return on equity with a huge runway and a massive market, it's quite interesting.

Is there anything in particular that surprised you from the insights you've gained from experts in this field during your calls?

The returns on specialty equipment are truly remarkable. Specialty is one segment, but it's actually comprised of 20 different segments. These are completely different businesses, including climate control and air quality, scaffolding, pump solutions, flooring solutions, lighting businesses, industrial tools, trenches, power, and more. These businesses are so differentiated that they're essentially in a league of their own. Some of these specialty businesses are running a 100% cash return on investment on the equipment per year. For instance, if they purchase equipment for a billion, they get a billion in cash back. Whether this is sustainable or not is another question. You can see the margin explosion for both Ashtead and United over the last seven years, which I believe is primarily driven by the specialty segment.

What growth rate do you think is realistic for this business and how sustainable is it? What assumptions are you making regarding its sustainability?

Over the next 10 to 20 years, I have no doubt that this market will become more consolidated. They're going to take market share. They have a huge runway in the specialty segment. The big question is, can you handle the potential volatility? Even if you can, the extent of that volatility could put the equity into question. This industry has seen numerous bankruptcies in the past. If the construction market comes to a halt, it might not be as severe as in 2008-2009, but if we start seeing a 5% to 10% decline in the construction market, no one's going to rent your equipment. You'll be left with a large amount of fixed assets, that is, equipment that's just sitting around.

So, it's about discipline; pricing discipline, management discipline, and quality of capital allocation. They have a natural arbitrage in the equipment because of their size. They buy at a discount, which is like free money. They buy at a 20% discount to book value from the OEM, and they mark it so the asset is effectively marked below book value. Then they monetize that asset and sell it in two to three years at book value. So they're making money on book, plus they're earning the cash return from renting it out. The question is, how will these businesses perform if we do see a big hiccup in the cycle? If they prove to be resilient when we do see a hiccup, then it's pretty interesting. Management keeps increasing guidance, which is quite incredible.

What have you learned about the quality of the people running the business?

I've never spoken to Brendan, but he seems like a lifer in the equipment rental industry. He's spent his entire career in it, and those who have spoken to him really like him. One person even said that everyone likes him. He's not a hired gun who doesn't know the business. He's really worked his way up.

He's been in the industry for more than 25 years, correct?

He is quite young, in his mid-forties, I believe. He's managing a fairly large business with a long runway. If he can continue this for another 10 to 15 years, it would be an interesting story.

What can our subscribers find in the library about the business?

Much of what we just discussed is available, but in greater detail. I have been focusing on a couple of key aspects. The first one is the cyclicality and why this business might differ from previous cycles.

There has been a lot of work going back and studying why United Rentals bought a couple of businesses from bankruptcy. We interviewed several people from there to understand why those businesses went bankrupt. Additionally, we have done a lot of work on pricing and specialty. We are trying to answer questions like, how durable is this business? How resilient is it to cyclical pressure? And are these cash returns real? It's all quite fascinating.