Weekly Update: Ashtead & Equipment Rental: A More Resilient Business
Quality Primary Research on Quality Companies
inpractise.com/articles/newsletter-20220616
Content Published Last Week
1. United Rentals: Specialty Division Growth & M&A Strategy
2. Burford Capital, Harbour Litigation, IRR's, & Asset Recovery
3. Illumina: GRAIL's Clinical Trials
4. Wix: Partner Program Developments
Ashtead & Equipment Rental: A More Resilient Business
Ashtead (AHT) is a UK-listed equipment rental company that generates ~90% of its earnings in the US through Sunbelt Rentals, the second largest US player after United Rentals (URI).
Historically, equipment rental has been described as a deeply cyclical, commoditized business that struggled to earn its cost of capital throughout the cycle.
It’s a highly fragmented industry with relatively low barriers to entry for independent players to acquire equipment from OEM’s and rent out for a profit. In a downturn, customers run their owned equipment for longer and competitors heavily discount rental rates which destroys margins. Add leverage, and the combination of these factors has led us to steer clear of this industry.
However, after reading AHT’s recent CMD presentation, it seems like the company is now far more robust and potentially less cyclical compared to the previous decade. This is due to a few reasons:
1. Industry structure: rental penetration and consolidation
2. Pricing discipline
3. Specialty market growth
4. Proven FCF to self finance growth
Industry structure: rental penetration and consolidation
According to the ARA, the US equipment rental penetration has increased from 40% in 2005 to nearly 60% today. The UK rental penetration is over 75%. Historically, in a downturn, customers would save money by running their owned equipment longer rather than renting new equipment. Since the GFC, companies have been tidying their balance sheets and switching fixed costs into variable costs which has driven the rental penetration. Over time, AHT believes the US rental penetration can reach UK levels.
Equipment rental could also been seen as an interesting ESG play: renting equipment is an effective way for customers to reduce their carbon footprint. AHT gives the example below of a customer replacing 10 owned assets with 1 rented JCB to save 32,500kg of carbon emissions. This trend could also accelerate rental penetration.
In the rental business, scale begets scale; AHT and URI receive 25-30% discounts on OEM equipment, have greater fleet density, and can offer customers cheaper prices and higher availability. This has led to the market share of both AHT and URI to treble in the last 12 years. More importantly, the relative market share of URI / AHT and competitors has widened in the last decade.
AHT has taken a slower but more methodical approach to scaling by acquiring smaller, cheaper independent rental companies and opening greenfield sites to fill in the network; URI on the other hand has made several $bn+ acquisitions to take market share.
Both companies are over 3x the size of the nearest single competitor and there is no reason why the two cannot continue to win share.
We believe the combination of higher rental penetration driven by ESG trends and continued consolidation is likely to reduce the cyclicality of AHT’s earnings over time.
Pricing discipline
Greater consolidation has also led to greater price discipline. In 2008, when the market was far more fragmented, as demand fell, companies reduced rental rates by ~20%. This led to a 30% peak-to-trough decline in AHT’s revenue that took 4 years to recover.
On the earnings call this week, management explained the robustness of the company today versus in 08:
Notice our positioning during the great financial crisis, where the top 2 rental companies had less than 10% market share. A consequence of which was a lack of pricing discipline, which led to a 20% decline in rental rates in the matter of months. Contrast with -- that with today, where the top 2 have greater than 25% market share and demonstrated not only discipline in pricing during the pandemic, but also the technology and massively advanced capabilities through delivering a better overall alternative to ownership. Further, once you take into account the size and proportionality of our Specialty business today, accounting for 30% of our revenue, very different than during the great financial crisis. Finally, our financial position is wildly different from the 3.2x net debt to EBITDA we found ourselves in then to today's 1.5x. - Ashtead CEO, June 2022, FY22 earnings
Over the last two years during the pandemic, both AHT and URI have maintained price discipline and margins were stable. AHT’s revenue declined 1% in FY21 and grew 22% in FY22. URI’s revenue declined 9% in 2020 but grew 14% in FY 21 and is estimated to be 20% above FY19 this year.
Greater consolidation, higher rental rates, and a higher specialty mix increases the durability of AHT’s earning power.
Specialty Mix
The increase in specialty revenue is one of the main differences of both AHT and URI relative to the previous cycle. In 2008, AHT’s specialty mix was 13% vs 30% today. Management reports only 50% of revenue is directly exposed to non-residential construction compared to 90%+ in 2008.
We interviewed a Former Director of URI’s Specialty Business to understand the growth and profitability of the segment.
Specialty rental is mainly non-residential construction products that have a low rental penetration but in which AHT can offer an attractive alternative to ownership. It includes segments such as Power & HVAC, Lighting, Pumps, and Floor Solutions.
On average, the dollar utilization (rental revenue as % of original equipment cost) of specialty rental is 70-80% vs ~50% for general tools. Adding specialty to the selection also drives utilization in general tool rental. It’s the perfect cross-selling opportunity; it enables AHT and URI to take a greater share of wallet and deepen the relationship in core equipment rental.
Also, just as Domino’s and Basic Fit fortress units to increase market share, AHT is ‘clustering’ rental branches to increase its share. Clustering branches is proven to increase the market size by adding new specialty lines to existing general tool customers which drives higher utilization, rates and overall unit economics.
Over time, AHT believes it can achieve specialty rental revenue equivalent to the total revenue of the group today. In FY22, Specialty revenue grew 34%, double the growth rate of the general tools market and ahead of management’s forecasts.
In the earnings call yesterday, management explained the resiliency of specialty revenue even in this uncertain, high inflationary period:
The Barclays Center in Brooklyn, New York. There's a team called the Brooklyn Nets. Regardless of what's happening economically, they will play their games. They played their games even during the pandemic. And in that building, there's a janitorial contractor who is a very big target in terms of our Specialty customer we're looking for, they need sweepers and scrubbers in order to do their job. So in these conditions, when you're faced with those 3 things everyone is worried about: Supply chain, inflation and the lack of availability when it comes to labor, are you going to choose more often to rent than you had previously or you're going to buy more? We know for sure you're going to choose more often rentals. So we think, in almost any circumstance, our Specialty business continues to grow. - Ashtead CEO, June 2022, FY22 earnings
Given the size and growth in specialty, the non-residential construction market would have to decline ~5%+ for AHT not to grow. Both AHT and URI have been passing through rental rate increases to combat inflation and demand hasn't been impacted. Yet.
Self-financing growth
Historically, the misalignment between IFRS earnings and FCF has been an overhang for AHT's equity. Depreciation is effectively COGS for rental companies; they pay $100 for equipment which depreciates over 3-4 years before being sold and the cash is recycled into new equipment.
AHT spends cash each year to replenish old equipment and add to the existing fleet. The chart below shows how although EBIT has grown consistently, FCF has been lagging behind as AHT has been adding to the fleet to grow. This growth capex causes a mismatch between reported EBIT and FCF.
However, this has changed over the last two years; in FY 2021, growth capex declined by 93% and FCF grew to £1.2bn. COVID was a chance for AHT to prove its ability to generate FCF at scale.
If we net out growth capex, we can see the steady-state FCF before acquisitions has been steadily growing since 2014. The cash flow has always been there; it has just been aggressively reinvested into growing the fleet.
In FY22, AHT spent $2.2bn on equipment, both replacement and growth capex, and still generated $1.1bn before the spend on acquisitions.
This FCF generation has de-levered AHT; in 2010, AHT had net leverage over 3x versus 1.5x today and it's now an investment grade issuer. Pre-GFC, URI had 4x+ leverage and is now running at ~2.2x levered.
By the end of 2009, AHT and URI both traded at the replacement value of equipment. Today, they both trade at 2.5-3x replacement value and ~10x EBIT. If we include all growth capex and exclude the bolt-on acquisitions, AHT FCF yield is ~5%.
Both trade at a premium to replacement cost but the net ROI both companies earn is higher than in previous cycles due to the moat; higher discounts from OEM's, greater density, higher margin, less cyclical specialty mix. This looks cheap for a company that earns a sustainable 20% return on tangible assets and 25%+ ROE.
The market is pricing in the cyclicality that we’re used to seeing hurt AHT.
After listening to the earnings call on Wednesday, management is not convinced that the expected upcoming recession is going to impact them.
AHT plans to grow rental fleet capex 50% year-on-year and expects revenue growth of 15% in the year to April 2023. Any capacity they’ve added in May and June is being absorbed:
You've seen what we've guided to in terms of CapEx. We landed $200 million in new rental fleet in North America in the month of May, and we are on pace to land $300 million in June, and that is being absorbed incredibly quickly. So the demand is there. - Ashtead CEO, June 2022, FY22 earnings
The non-resi construction market forecast is also boosted by the Federal Infrastructure Project that begins later this year. Mega projects, those over $400m, account for 30% of AHT’s revenue compared to 13% in 2009.
There is little doubt AHT is a more robust entity today; ~50% non-construction mix, higher margins driven by specialty growth, lower net leverage, proven FCF, and greater market share in a more rational market.
A 5% FCF yield for a business growing 15% py suggests the market doesn't necessarily believe in the resiliency of AHT. Management clearly disagrees.
Related Content
Copyright Notice
This document may not be reproduced, distributed, or transmitted in any form or by any means including resale of any part, unauthorised distribution to a third party or other electronic methods, without the prior written permission of IP 1 Ltd.
IP 1 Ltd, trading as In Practise (herein referred to as "IP") is a company registered in England and Wales and is not a registered investment advisor or broker-dealer, and is not licensed nor qualified to provide investment advice.
In Practise reserves all copyright, intellectual and other property rights in the Content. The information published in this transcript (“Content”) is for information purposes only and should not be used as the sole basis for making any investment decision. Information provided by IP is to be used as an educational tool and nothing in this Content shall be construed as an offer, recommendation or solicitation regarding any financial product, service or management of investments or securities.
© 2024 IP 1 Ltd. All rights reserved.