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United Rentals’ (URI) shares have rebounded this year from their lows seen at the end of last year. Along with many stocks, the shares sold down to very cheap levels at which I was lucky enough to add some. After seeing it do a run-up to $140 before pulling back to $110, I was once again able to add more. However, this time I learned to sell on the run-up back to $130 and take a slight profit. I do continue to maintain a core position due to the long-run opportunity the company has within its operating markets. I also keep the position small due to my primary focus on DGI companies. Management continues to reaffirm guidance for the year and is proving the business is still on solid ground. Because of this, the shares continue to appear cheap despite the run-up. The most recently reported Q3 results continue to prove the company is executing. In time the market will recognize this value and push the value of the shares higher.

A quick overview of the company and its industry can be seen below.

Source: Earnings Slides

United Rentals continues to capture more and more market share while growing its location base. The company operates in a cyclical manner, and demand for its products is very related to the demand in construction. The company has also diversified its offerings to ensure more stable revenue streams in times of economic weakness. As fears of a recession loom, the shares could pull back again, but it’s evident the shares are already too cheap. Despite massive cash flow, the company has a massive debt load relative to its size and could be pressured by rising rates. We take a deeper look at the potential catalysts and headwinds for United Rentals.

Performance

United Rentals recently reported an excellent quarter, beating estimates on both the top and bottom lines.

Source: Seeking Alpha

Revenue rose by almost 18% due to acquisitions. Once adjusted, the company still saw a 4.2% rise in revenue which is evidence enough that there is no weakness in its business. Despite this beat, shares trade right where they were when they reported. Free cash flow so far this year increased over 101% to $1.082 billion, giving the company flexibility to continue to grow the business. The company even raised the bottom portion of its free cash flow guidance for the year which is a positive as well. More impressively, the company saw a 10.7% ROI so far for the year, which was decently higher than cost of capital, which is around 8%. While this is flat compared to last year, it is nice to see that the company is not expanding and sacrificing a decline on ROI in the name of growth.

Management reaffirmed the strong guidance it gave earlier, seeing revenue of $9.25 billion to $9.35 billion and adjusted EBITDA of $4.35 billion to $4.4 billion. While this is narrowed down from the top end, it is also higher than the bottom end estimated and puts the company right in the middle of its guidance. The company guided for $1.45 billion to $1.55 billion in free cash flow for the remainder of the year as well. This means the shares trade with a free cash flow as a percentage of market cap of 15%.

Taking a look at the income statement, we see some great results.

Source: 10-Q

Total revenue increased 17.5% and net income grew about the same. The revenue increase was due in part to higher rental rates, acquisitions, new locations and the rest from higher demand and increased fleet size. A very important factor looked upon by many investors is the time utilization rate. Though typically a better measure of return is dollar utilization, the company does not provide this figure for us. Time utilization, a measure of how much time the equipment is actually being rented out, decreased in the quarter but was mostly due to acquisitions lowering the combined rate.

Taking a look at the balance sheet, of concern is the cash levels versus debt.

Source: 10-Q

During the first quarter, the company reduced debt by $150 million relative to year-end 2018 levels. Management expects to end the year with a net leverage ratio of 2.6x compared to 2.7x at September 30, 2019 and 3.1x at the end of 2018. Management’s focus on reducing this leverage ratio is nice to see as the company is viewed as very cyclical. With a lower debt profile, the stock can be viewed by investors as less risky and perhaps demand a higher multiple. Year to date, the company has repurchased $630 million of common stock under its current $1.25 billion repurchase program, reducing its share count by 3.1%. It will be interesting to see if the company has continued to do so in the current quarter. Hopefully, the company really starts leveraging its cash flow to reduce debt.

So let’s take a look at when the debt is due.

Source: 10-Q

As we can see, it is all fixed rate debt; however, in the coming years, a lot of it is due. The company can renew its credit facilities, of course, enabling it to be extend out the due date on them. While the company certainly has strong cash flows right now, about $1.4-$1.5 billion this year, this is not that strong when considering the possibility of recession.

As the company keeps acquiring smaller competitors, it is increasing its stream of cash but also increasing its debt, as none of the acquisitions are being made with cash on hand but rather the issuance of senior notes or use of credit lines. Typically, acquisitions are made during times of strength which the United States is currently experiencing. However, many times it has been seen that companies make too many acquisitions right before the end of a cycle. When the cycle ends the company is unable to refinance debt in an affordable manner, cash flows go down making it even harder to be approved for better rates due to credit rating drops.

At the rate in which United Rentals is growing its debt pile, it could become an issue very soon. As it stands, the company has a current ratio of less than 1 which means it is unable to cover its debt obligations with cash on hand. The amount of debt due between 2024 and 2028 could put significant pressure on the company if not reduced before hand. This would require a significant portion of the company’s cash flow each year. In the past 5 years, the company has quadrupled debt, so ensuring the trend is broken is imperative for a higher stock price. The focus on reducing this debt effectively should be a positive catalyst.

While the leverage is improving, this is due to the larger cash flows it has been recognizing from its acquisitions.

Source: Earnings slides

The important note investors should keep in mind is that if the company experienced a 30-40% drop in revenue due to a mild economic recession, would it be able to cover its obligations? In a recession, the company would not only see its rental rates decline, it would see utilization decrease, asset value decrease, and a host of other negative factors leading to write downs or losses. The company should start to be more mindful of how far along this cycle is and take into account leverage.

What’s Plaguing The Shares?

So besides debt, what else could be hampering shares?

The company is highly tied to many industries seeing pressure. Currently, oil has been rapidly declining in price. This has led to underperformance in shares before. The pulp and paper industry is starting to see pressure from a huge increase in supply as well. Additionally, the company doesn’t give its exposure to home building, but we have seen a recent increase in housing starts.

Source: Trading Economics

It does appear to have reached a peak, however, and it’s safe to say there could be more downside risk than upside potential. As this becomes a steady rate and not an increasing one, URI could see a slowdown in growth of utilization. This would further increase the dependence on the company to gain growth inorganically.

While the company forecasts growth through 2020, visibility thereafter is low.

Source: Earnings Slides

Being in one of the longest economically positive cycles in history, it has been hard to predict what or when it may end. It is important to note that we are already seeing the signs of an end, with mortgage applications falling, auto sales declining, and rising rates. These pressures tend to lead to less economic activity and eventually a decline in sales for companies like URI.

As we discussed before, the oil industry has become an area of concern.

Source: Earnings slides

As the company diversified into which industries provided revenue to the total, it added the highly commodity price dependent fluid solutions segment. This is now a rather large piece of the business and can be affected by a swing in consumption, pricing, and demand for oil. However, the company is focusing on the opportunities listed below to be a total service provider.

Source: Earnings Slides

The market is forward looking, as investors see headwinds from varying sectors they analyze who is exposed. So far, United Rentals, while having a strong forecast now, has been mute to address these concerns. With a slowdown in many of the sectors it provides equipment to, we can see why the selloff in shares may be happening. Investors are getting ahead of the potential revision of guidance downward in the following quarters. Although as of now all appears to be fine, investors don’t tend to wait until it’s too late.

The company continues to benefit from the further adoption of equipment rental over owning.

Source: Earnings Slides

For many businesses and government entities, owning equipment comes with maintenance and storage expenses. Additionally, it requires massive amounts of upfront capital and or financing. Renting when the job needs the equipment has turned out to be more realistic and offers opportunity for both URI and their customers. As the company continues to have more offerings and locations, customers can continue to depend on URI which is why large players are capturing share in the market.

Valuation

Taking a look at valuation, we can see where the company lies versus its historical value.

Source: Morningstar

The company currently trades at a historically low P/S, P/E, P/CF, P/B, and PEG ratio. Pretty much every metric shows the company is trading lower than it typically has in the past. This may mean it’s an opportunity to purchase shares.

However, as we stated before, the market is forward looking. These metrics can quickly change if revenue were to decline significantly. Additionally, the company could see more pressure than it has in the last 5 years due to the increased debt load and now increasing rates. Future acquisitions and refinancing will become costlier and tax cash flows at a higher rate.

For investors looking to add an industrial company at a lower than average valuation, now may be the time to add URI. However, those who prefer to be risk adverse may want to wait as a recession is not a matter of if but when. Should the company continue its acquisition spree and add to its debt pile, there will be a significant valuation change for the stock.

Conclusion

United Rentals is not exposed to the global economic conditions that many other international corporations are. This makes it a great domestic play; however, many of its customers and their businesses could be exposed to the global economy in some manner. This could become a headwind in the coming quarters for URI. As it stands, management expects strong results, but this can often change quickly should business confidence decline. Investors should expect stabilization in share price after the mid-terms as it could lead to a shift in which direction the market believes the country is headed. This often has been a turbulent time for the market.

Investors who prefer a company more prudent with capital would be advised to look elsewhere as the debt pile continues to grow. Fixed rate or not the company is continuing to look for ways to spend money. The recently announced share repurchase program, while a nice return of capital for shareholders, could be used to increase cash on the balance sheet. In fact, while rates are still low, instead of borrowing to buy shares back, it should be borrowing to add cash to its balance sheet.

Hopefully, management recognizes the cycle is sooner to be over than it is to continue to expand and it will not be acquiring into the peak further. The best time to acquire and have capacity to acquire is when valuations are low due to underperformance, typically during a recession. Investors have room for safety due to current valuation, but be advised that shares may continue to be pressured until investor sentiment becomes more positive. A further pullback to $110-$115 per share would see me add more shares again. An increase to $140-$150 would see me reduce my trading position and maintain my core position.

Disclosure: I am/we are long URI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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2019-10-20