Herc Stock: Growth Built On Little Working Capital, Increasing Value Intrinsically (HRI)

Investment briefing

Selective opportunities within the industrials sector continue to present us with an attractive risk reward profile in our opinion. Nearing the end of Q4 2024 earnings season FactSet analysis estimates that the earnings growth rate for the S&P 500 index is 1.5% so far. For the industrials sector, the blended earnings growth rate has increased to 1.4%, in line with the broad index.

Meanwhile, bottom-up EPS estimates for the index are calling for $242/share in CY’24, looking at growth to $274/share beyond this. Call this optimistic, but it at least implies contribution from fundamentals this year in our estimation.

Figure 1.

Turning back to the sector, the industrials group posted 19% YoY earnings growth in FY’23 according to FactSet, 3rd in the pack from consumer discretionary and communication services. I would refer readers to our composite in Figure 3 that was posted at the end of Q3 2023 earnings. Back then we had identified the industrial sector held just 8% notional value of the market weighted index, but was projected to deliver 16% of the forecasted earnings growth over the coming 12 months (avid readers of mine will have seen the graphic in Figure 3 quite extensively). Point is that there continues to present compelling evidence of risk unlock in the sector this year.

Figure 2.

Figure 3.

Our investment mandate permits us to buy and sell the marketable securities of companies that have attractive business economics. Without making it too complicated, the simple process is to check any – if at all– companies are growing at high rates of return, or are growing with little capital requirements, to gush free cash flow. Then, all that’s needed is a quick check to see if the market is valuing this correctly according to our paradigms.

This process to top-down security selection has led us to the common stock of Herc Holdings (NYSE:HRI). HRI is in the rental and equipment supply business, with differentiated offerings in heavy vehicle solutions, earthmoving and transport. It also sales various supplies to arrange contractors and has a footprint in the petrochemical and aerospace industries, along with adjacent industries in agriculture, morning, and the food and beverage industry.

We have noted the following key drivers of investment return and multiple re-rating:

1. Little working capital required to produce $3Bn in TTM sales and $700mm in pre-tax earnings.
2. Selling at 12x forward earnings, 13x forward EBIT, both steep discounts to the sector, and attractive in absolute terms.
3. Compounding earnings with little incremental capital investment, meaning it can throw off FCF to shareholders without jeopardising growth, and vice versa.

Conclusions derived from factors raised in this report are encouraging for those investors seeking long-term compounders who grow earnings with little volatility in multiples. We are constructive on HRI and rate the company a buy with initial price objectives of $164/share.

Brief commentary on upcoming earnings

The company is set to report its Q4 2024 earnings next week. In my opinion, the company is well positioned to deliver a solid result. For one, management are constructive on HRI’s growth for the next 2 years (discussed later). It is calling for CAGR 10 – 14% annualized revenue growth in this time. To me this is a bullish sign, but a high watermark for the company to beat come earnings time.

The second thing is the consensus estimates. Wall Street is eyeing 11% YoY growth at the bottom line, which isn’t an unreasonable number. A downside surprise from this number could be remarkable, however. We’ve seen the market react violently to earnings misses already this year, so unlikely HRI would be different in this respect.

One must also consider the ‘established’ earnings of the company thus far:

(1). 37% trailing gross margin,

(2). 21% trailing EBIT margin,

(3). Return on equity of 31% over the last 12 months.

These are compelling numbers that signal earnings momentum in our view. Based on these rudimentary insights, our posture is HRI is set to come in with a strong set of numbers. Alas, the risk is that it surprises to the downside, and investors should be well aware of this.

Critical investment findings

Based on our analysis, the following set of data points form the crux of the bull thesis:

(1). Short-term and medium-term catalysts:

• Top and bottom line growth forecasts
• Starting valuations

(2). Long-term catalysts:

• Capital allocation
• Growth in earnings attributable to shareholders

Short and mid-term catalysts

One catalyst that immediately stood out is a recent announcement by the company in November last year, targeting “organic rental revenue of 10% to 14% CAGR from 2024 through 2026, and established an organic adjusted EBITDA CAGR of 11% to 16% over the same period.”

If the company hit these kind of growth rates, it would be c.4 percentage points higher than its 5-year average revenue growth rate, and another 3 percentage points higher than its 5-year growth in pretax income.

Management’s view is supported by the fact that consensus estimates project a waterfall growth schedule for HRI out to 2025. The median of analyst estimates expects 11% to 15% earnings growth over the next 2 years along with single digit top line growth of average during this period.

Figure 4.

Equally as compelling for near-term returns is the starting valuations at which the company can be bought today. As seen in Figure 5, is currently trades at 12.2x forward earnings and around 12.6x forward EBIT. These are steep discounts to the sector of more than 30% and 22% respectively.

What’s important here is that starting evaluations heavily determine the first 12 months investment returns for any public investment security. Buying stocks at relative discounts– provided there is the quality assets underlying the business–does provide a statistical advantage especially for near term gains to the equity portfolio.

Keep in mind we are paying 12x for a company that:

• Has grown free cash flow per share from $2.60 in Q2 2022 two $8.65 in the last period on a rolling TTM basis.
• Post-tax earnings, measured here as net of rating profit after tax, have also crept higher in near linear fashion. The company has grown its tax adjusted operating income per share from $6.17 in 2021 up to $11 at the same time in 2022 $17 pressure in 2023 and printed $18 per share in TTM NOPAT last period (Figure 6).

Figure 5.

By the best estimation these are not the hallmarks of a company that should be heavily discounted to a growth sector. The company is also methodically turning earnings into free cash flow at the rate of around 35 to 40% on average in the last 18 months, as seen in Figure 6.

Moreover, as we’ll discuss later, it appears that growth can be engendered on very little allocation to working capital. In the last three years sales, growing at a compound in rate of 6%, required $0.10 for every new $1 of sales, compared to $0.40 on the dollar for fixed capital. We believe this is a constructive point and should be factored into the investment debate, because it adds bullish tilt to the risk reward calculus for the short term investment horizon.

Figure 6. Note: The undated Last bar is the estimate for Q4 2023.

Long-term catalysts

Long-term catalyst can be grouped into two buckets, (i) capital allocation and (ii )business returns. For the former, the company’s distribution of incremental capital is listed in Figure 7. From the three years to Q3 2023, the company grew sales at a 6% compounding rate.

For capital allocation:

• As mentioned earlier this growth was engendered on very little incremental working capital. The bulk of the company’s cash is tied up in its rental equipment. However these assets produce a lengthy tail of returns whereby cash is received upfront at the time of service delivery. Because payment is made up front, this reduces the company’s cash conversion cycle and there is less risk cash being inefficiently tied up in working capital.
• For every new $1 in sales since 2020, this required just $.10 investment in net working capital. The company also contributed $0.12 on the dollar to intangible assets along with $1.24 per $1 in new sales two acquisitions and the change in rental equipment which is booked on the balance sheet as such, but recorded as the change in M&A.

Should these trends continue it suggests that every new one dollar of sales would require around $2.10 of investments to grow, dropping to around $0.80 when stripping out the changes to the rental equipment on the asset side of the balance sheet. The key points being that we believe that company can produce a dollar with $0.80 investment, thereby unlocking shareholder value.

Figure 7.

For business returns:

The scope for HRI to trade higher of these multiples is bolstered by this growth outlook and the economic value that is creative to shareholders. Critically, findings show it is compounding the rate of earnings produced on incremental capital, thereby growing post-tax earnings off each new $1 put it back to work in the business. It is here where we see long-term value in the company:

• As seen in figure 8, the company has around $206 per share of capital at risk invested in its business assets. On this, it produced $19.20 per share of net operating profit after-tax in Q3 ’23, a 9.3% return on investment. This is in line with its historical averages and even 300 basis points higher than what it clipped in Q1 2021.
• However the incremental results are what is creating the momentum in our opinion, and what is yet to be fully appreciated by the market.
• The company has been successfully reinvesting a large portion of its after-tax earnings to engender future growth and maintain its competitive position. It has put >$250mm of capital to work each quarter at a minimum since 2021, indicating this stance.
• On these investments, the growth ramp on its earnings has steepened, having increased post-tax earnings per share from $6.70 in 2021 to $19.20 in the last report on a TTM basis. It has achieved this on an investment of $106 per share, otherwise 12.5% incremental return on investment.
• By all measures, we believe these returns – which are likely to mirror the company’s stock price returns – will continue.

This lays the bedrock for an investment thesis moving forward. We have here company that is continuously compounding earnings on each continuous use of capital. As a reminder capital is the lifeblood of any business and is simply the cash that is used for the purchase of assets or the means of production.

Figure 8.

Valuation

Economic value is created through the returns generates on incremental investments, and the amounts it reinvests at these rates. A firm can compound its intrinsic value at this function (ROIC x reinvestment). But it’s not enough for the markets, which itself looks also to dividend yield and the speculative return, or the changing price-earnings multiple – how much investors are willing to pay for $1 earnings. Combined, these three things for the markets return, all the total shareholder return.

As seen in Figure 9, our model has tracked the performance of HRI by compounding its implied intrinsic value by its market return each rolling TTM period. The data is shown in the table below the graph. Forward growth assumptions call for 5% – 6% earnings growth over the coming 12 months, with 1% dividend yield, along with 7% change in the implied P/E multiple, leading to a 13% growth in intrinsic value.

This could position HRI at a market value of $4.6Bn, otherwise $164/share or around 14x earnings if recognized by the market. Thus, paying 12.6x earnings implies the company is priced at fair value under our assumptions and therefore is warranted as buy by the best estimation. We are buying an excellent stream of earnings that adjusts to 0.84x when factored for growth.

Figure 9.

Discussion summary

After extensive analysis of the investment facts there is abundant support for allocating HRI to the equity risk budget by our estimation. The company presents with robust economics and recent price movements that are driven by fundamentals, along with attractive starting valuations of around 12.3x earnings.

The company’s growth is engendered on relatively little working capital requirements, with the bulk of capital tied up in its rental equipment, which produces a tale of cash flows. This is constructive in an asset-inflation environment.

This means into can be allocated with great efficiency to produce sales and earnings growth. In our opinion, this positions the company well to continue its growth pattern without jeopardising the earnings attributable to its owners, and/or it can increase earnings without jeopardising its growth pattern. Net-net rate buy eyeing initial price objective of $164/share.

The following risks are relevant to the investment thesis and must be understood before progressing any further as they balance the bullish outlook:(1). The projections for the industrials sector may not play out as we anticipated. This would have implications to our investment thesis and potentially reduce the size of the profit pool for HRI.

(2). If the company does not hit its projected earnings growth rates this would reduce the scope for valuation increase in our opinion. This is a risk to the thesis.

(3). Consideration should also be given to the macroeconomic landscape. The inflation/rates axis still exists, despite recent positive developments. The risk of rising real rates could spill over into broad equities, thereby hurting the scope for HRI’s valuation to increase as well.

These risks must be recognized in full.