Description

Ashtead (“Sunbelt”) is the second largest equipment rental company in the States, and cyclical fears plus a few minor operational missteps have created an attractive entry point into a secular winner. I also believe Sunbelt is under-earning to a larger degree than peers because of the organic nature of recent growth. 

Business Overview

I'll keep this short because this and other equipment rental companies have been covered on VIC. Sunbelt buys and maintains a fleet of equipment including aerial work platforms (30% of fleet), forklifts (20%), earthmoving (14%), power and HVAC (11%) and more. Equipment is depreciated over 10 years (chosen to make equipment disposals breakeven at the low point of a cycle) and Sunbelt typically keeps it around for 7 years, getting more than 50% of original cost ("OEC" or original equipment cost) in rental revenue per year. After 7 years, equipment is disposed of at 40 cents on the dollar. Non-resi construction end markets are less than half of the business, and the rest is industrial, MRO and more.

Renting equipment lets you get the exact right piece of equipment for a job. As an example, you used to find backhoes on jobsites much more, because a backhoe is the swiss army knife of earthmoving. That user might now prefer to rent either an excavator or a bucket loader, each of which peform half the function of the backhoe but in a more efficient manner. 

Rental also conserves capital, reduces the need for equipment yards/storage, solves logistics/ eliminates the need for vehicles that can move equipment, and solves the difficulty of maintaining owned equipment. 

Secular Trends

The secular tailwinds come from both increased rental penetration as well as market share gains by the largest players. The use of rented equipment accounts for about 55% of the equipment market today and I expect it to hit at least 65% over time. Penetration is up from the low 40% range pre-GFC and single-digits in the 1990s. 

The top two players URI and Sunbelt have 15% and 11% share, respectively, and players smaller than the top 100 have 44% of the market. The top 10 players have grown market share from 20% in 2010 to about 45% today. 

The largest rental company businesses have improved over time. Scale gives purchasing economies with OEM suppliers, efficiencies in logistics and maintenance, and higher equipment utilization. 

URI and Sunbelt purchase equipment 15-20% cheaper than mom & pop operators. Moving heavy equipment to and from job sites requires a large fleet of dedicated vehicles. Equipment maintenance benefits from having expertise by equipment type, mechanic sharing and better utilization of parts and spares. In a typical branch, 6 out of 20 total employees might be mechanics. 

Utilization is measured both by time/physical utilization, which is just the amount of time the equipment is on rent, or by dollar utilization, which is measured by the rental revenue divided by the cost of the equipment (basically, asset turns). Dollar utilization is perhaps the most important metric, because it combines the time on rent and the rental rate. Dollar utilization is higher at the scale players for a large variety of reasons. 

More locations give larger players density and a higher likelihood that a given piece of equipment is needed by someone in that geography. It also lowers transportation costs and time and most importantly allows locations to share equipment. A better repair function means machines are on rent for longer and means that there is more equipment available to rent. A wider variety of equipment on rent also leads to higher rates. Sunbelt frequently mentions that they are not the lowest price, but they win business because of breadth, availability and service. 

The factors I’ve outlined above have led to stable dollar utilization, rising margins and thus rising returns on capital over time:

Specialty rental equipment has become a larger part of Sunbelt’s mix over time. Specialty is a catch-all for equipment that can have more of a service component or more of a temporary, emergency, or one-off use case. When looking at historical results, note that specialty carries lower physical utilization but higher margins. Specialty equipment also depreciates more slowly and is generally less cyclical than general tool (i.e. non-specialty). 

Cyclical Factors

Equipment rental is a cyclical business. Sunbelt will tell you that because equipment rental is now an essential part of customer’s businesses, rather than used as a top-up, future cycles will be more muted than the past. I mostly believe this for a few reasons. 

First, the large players are larger and more sophisticated. CEO Brendan Horgan likes to say that in the GFC they almost blindly lowered prices by 20% across the board without any pricing tools or great reason to do so. 

Second, the top 10 players are less leveraged. In the GFC, you not only had more leveraged companies, but some companies actually had covenants tied to time utilization. You can imagine what incentives that creates. Leverage at all the large players has decreased steadily over time.

Finally, 70% of the industry contributes and subscribes to Rouse data (owned by RB Global), which provides detailed rate and utilization data by equipment type and geography. This was not the case in the GFC, and even a decade ago large players including Sunbelt did not contribute. 

Cycles will still happen, but the cash flow characteristics of the business blunt the impact. Rental equipment is typically sold and replaced after seven years, and you can see below that in past downturns capex can effectively be turned off for a time even as aged equipment is still sold. Sunbelt has a young fleet, partly because organic growth necessitates it, and so aging the equipment a year by turning off capex can easily be done in future downturns. Replacing a seventh of your capital every year is actually helpful in downturns because not replacing it means that equilibrium can be reached faster versus having something like a factory running at low levels of utilization. 

[a note on Sunbelt's fleet age: historically Sunbelt weighted age by net book value, versus gross book value at URI and other US based peers, and this flattered Sunbelt. Sunbelt's fleet is still younger, but this is because they've grown by adding brand new fleet versus M&A/acquiring fleet as URI has done]

It’s worth noting that in the Oil & Gas Downturn and during Covid that rates did not fall despite used equipment values falling. Historically this was not the case.

Current Conditions

The pandemic was characterized by a quick and steep decline in (all) business activity, followed by a scramble to get new equipment. Lead times doubled and tripled and large companies like Sunbelt found themselves waiting almost a year for new equipment, while smaller companies had trouble getting it at all. In recent quarters, equipment availability normalized and Ashtead found itself with slightly more equipment than it would have liked. 

Inflation is a double edged sword here. Rates need to keep pace with inflation to maintain returns, but Sunbelt and other large players are relatively better off than others. Equipment prices are 20%+ higher than pre-pandemic levels, and Sunbelt has replaced a lot of the fleet at these higher levels, whereas mom & pop players were not able to because of availability. Rates will benefit as these small players replace aged fleet with new fleet at significantly higher prices. 

Megaprojects, roughly defined as those projects with more than $400mm of value, provide additional opportunities and challenges. The trio of the Jobs Act, the IRA, and the CHIPs act have created a large backlog of megaprojects that will (probably) offset any weakness in commercial construction. Megaprojects favor the larger players. Sunbelt claims 30% market share in these projects, i.e. almost triple their national share. Only the largest players can serve these projects. Sunbelt has examples where they have over $100mm of fleet on a single project. 

Pandemic related shortages and megaprojects have contributed to recent disappointments in the stock. Both of these factors make it difficult to perfectly plan equipment needs, and ordering equipment early because you’re worried about availability or because you’re staging it for a megaproject can hurt utilization. I view these challenges as easily surmountable.

Construction, which is 40% of the customer mix, is rate sensitive, and recently Sunbelt has seen customers delay projects as they wait for clarity on rates. Most of the slack has been taken up by megaprojects ramping. We’re coming off good times, so I think of mid-cycle as normalizing utilization and margin while also accounting for maturing greenfield locations. I think the most likely scenario in the near term is that softness in construction continues to be mostly offset by megaprojects driven by the desire to re-shore and fix our crumbling infrastructure. 

Valuation

As I mentioned earlier, I believe Sunbelt is under-earning. Sunbelt has grown organically to a much larger degree than URI, and they’ve done it by putting new equipment in greenfield locations. These locations take a while to scale from both a fleet and margin perspective. Locations 10+ years old have 56% EBITDA margins. Locations 0-2 years old have 46% margins and locations 2-5 years old have 53% margins. If you apply this to the current store base, mature margins would be three points higher. Margins will also be helped by what Sunbelt calls “cluster economics,” which is just increasing density in markets. Clustered markets carry a few more points of margin and return. 

I value the business by assuming continued rental penetration, further share gains, and higher returns/margins (note below that I have market share at 13%, but recently an industry publication changed their methodology to include more specialty lines in the market definition and thus share is now said to be 11%). 

I think about valuation in a few ways. First is a multiple of mid-cycle, which puts the stock at about 15x earnings and 16x NOPAT using the Key KPIs I outline above. The second way is through a two stage DCF, where I grow the business to terminal rental penetration and market share followed by low growth into perpetuity. In that method, I get Sunbelt as an 80c dollar. 

The long term inevitability of this business appeals to me. It’s cyclical, but with countercyclical cash flows. It is not capital light, but incremental returns are quite good. And most importantly, it's hard to imagine scenarios where further rental penetration and market share gains don’t come to pass. There is no technological risk either. 

I'll end by noting that CEO Brendan Horgan is highly regarded, and I share that sentiment, but this is not a jockey bet. This is mostly a bet on the inevitability of rental growth and market share gains at attractive incremental returns. 

 Risks

The shorter term concern here is that I'm wrong about the depth of the cycle we might be headed into. A longer term concern is that increased rental penetration does not necessarily come with better economics. In the UK rental penetration is higher but Ashtead's UK business is far worse. I believe that is due to customer concentration and low levels of profitability, but its something to think about. 

Catalyst

rental penetration, marke share gains