Markets & Finance

A Rental Firm Worth Owning


By Markos Kaminis With the stimulus provided by four Federal Reserve half-point cuts of the Fed funds target rate since January, we at S&P believe investors will increasingly anticipate an economic recovery and look to consumer cyclical issues for new investment. In that regard, we believe we've uncovered a company that is poised to outperform the other stocks in its peer group: United Rentals, Inc. (URI). This week's S&P Focus Stock of the Week, United was recently added to coverage with S&P's highest investment ranking of 5

STARS (buy).

The company offers a wide array of equipment, over 600 different types, to more than 1.2 million customers, including construction and industrial companies, manufacturers, utilities, municipalities and homeowners. Through a heavy acquisition program (United has snapped up 245 companies in the last four years), United has quickly amassed the industry's leading market share.

The company services its customers through 750 locations in 47 states, Canada and Mexico. Rental equipment ranges from light to heavy construction and industrial to general tools and equipment. Construction and industrial equipment consists primarily of aerial lifts, air compressors, backhoes, boom lifts, bulldozers, cranes, ditching equipment, forklifts, generators, high reach equipment, pumps, scissor lifts, and tractors. General tools and equipment include mainly garden and landscaping equipment, hand tools, high-pressure washers, paint sprayers, power tools, and roto tillers.

Rental revenues as generated per customer type are: commercial construction (48%), residential construction (2%), industrial North America (25%), infrastructure or traffic control (15%), and homeowners 10%.

ONE-STOP SHOP. United routinely sells used equipment as well, and is generally able to achieve favorable prices, due to its preventive maintenance program and its national salesforce that can access resale markets across North America. In an attempt to be a "one-stop-shop", it also sells new equipment and related merchandise and parts, such as saw blades, fasteners, drill bits, hard hats and other safety equipment often used in conjunction with its rental fleet.

Recently, the company began an effort to capitalize on opportunities arising from increased federal and state transportation spending brought about by the Transportation Equity Act for the Twenty-First Century (TEA-21). United has acquired companies that offer traffic control equipment, such as barricades, cones, warning lights, message boards and pavement marking systems. The traffic control business now represents 15% of revenue, and is providing a stabilizing effect due to the noncyclical nature of government funding for these projects.

The company's management team saw an opportunity in 1997, when it entered the industry. The U.S. equipment rental industry has grown at a compound annual growth rate of 14.5% since 1990, according to data reported by Manfredi & Associates, Inc. This growth has not been driven by general economic expansion alone, and likely reflects an increasing degree of market share gains from equipment sales suppliers. At present, the $25 billion equipment rental market represents just one-fifth of the construction equipment pie, and the industrial market is large and still greatly untapped.

The company emphasizes advantages to renting versus owning, such as the avoidance of large capital investment, the ability to select the equipment best suited for each individual job, a reduction in storage and maintenance costs, and access to the latest technology without a purchase outlay. In addition, industrial companies, utilities and municipalities can realize the advantage of outsourcing yet another noncore function.

BIGGER IS BETTER. Penetration of the equipment for purchase market is not the only factor working in United Rental's favor. The industry is highly fragmented, as evidenced by URI's leading market share at just 8%, which is twice that of the company's nearest competitor. Competition ranges from small, independent businesses with one or two rental locations, to regional competitors operating in a few states, to public companies and equipment vendors and dealers.

As the largest member of a fragmented industry, United enjoys several advantages born from economies of scale. Owing to a high degree of equipment purchases, the company enjoys significant purchasing power. Recently, the company has taken initiative to increase purchasing power by reducing the amount of vendors it buys from, cutting the number of primary suppliers from 111 to 28 in 2000. The company estimates that it saved approximately $150 million in doing so, and anticipates further savings in 2001.

United also benefits from economies of scale and scope in its dealings with customers. Through the building of brand value and a national footprint, the company is increasingly winning national accounts with large companies. At year end, the company had about 1,300 national account customers, with 700 added in 2000. Evidence of its strengthening brand value:: United was recently able to raise rental rates (1.25% on a sequential quarter basis) without significant consequences. Equipment utilization rates were only slightly lower on a year-to-year basis in the first quarter of 2001, likely due to decelerated economic growth.

As the economy slows in 2001, we see United's revenue growth rate decelerating to about 3%. However, rental revenues should rise about 15%, driven by higher rental rates and growth in national accounts. In 2002, we expect economic recovery to restore revenue growth of 9%. Benefiting from its increasing purchasing, pricing and operating leverage, margins should widen over the long-term. We expect EPS to increase to $1.94 in 2001, and rise 16% to $2.25 in 2002.

Although the company's debt to capital ratio of 60% is high, S&P does not believe this is particularly onerous, for three reasons. First, the company's EBITDA-to-interest expense coverage ratio for the trailing twelve months is 3.7, a level we view as adequate. Second, the company is decreasing its new equipment purchases and delaying its old equipment sales, which will help it to generate free cash flow of approximately $390 million in 2001. Of this cash flow, $350 million has been budgeted for use to retire debt; the company expects to reduce its debt to capital ratio to 55% by year-end. Now, the age of United's rental fleet will increase to 32 months from 28 at the end of the first quarter as a result, but this still represents a relatively young fleet. And third, we expect the economy to respond to the aggressive stimulus that the Federal Reserve is providing through its actions to lower interest rates. This should stave off a prolonged economic downturn, and rejuvenate growth at the company's operations.

UPSIDE POTENTIAL. Following a decline of 22% in 2000, the shares are up over 60% in 2001, in contrast to a 5.4% decline in the S&P 500. S&P believes the relative outperformance of the shares is due to the cyclical nature of United's business, which should benefit from lower interest rates and a potentially restored economy. With a price-to-earnings (p-e) multiple of 11 times S&P's 2001 EPS estimate, the shares are well discounted to the 23 multiple of the S&P 500 and the 21 multiple of the company's commercial and consumer services peers in the S&P Super 1500 Index.

In addition, the shares are 26% discounted to the 15% long-term growth we project in a conservative economic scenario. Analysts' consensus long-term growth rate expectations of 20%, indicate further undervaluation. Historically, the shares' p-e multiple has ranged from 6 to 23.

In S&P's opinion, the shares are likely to reach the high-end of the p-e range in the early stages of economic recovery. Applying a more conservative target multiple of 15 times our 2001 EPS estimate, S&P has set a target price of $29 for the shares. This implies capital appreciation potential of 38% from URI's recent market price of $21.

The S&P Focus Stock of the Week just celebrated its second anniversary. How's the performance been? Pretty remarkable. See A Focus Stock Report Card for more details. Kaminis follows small-cap and emerging growth stocks for Standard & Poor's


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