United Rentals: Expect Future Returns To Moderate (Rating Downgrade) (NYSE:URI)

The current year is gearing up to be yet another strong one for United Rentals, Inc. (NYSE:URI). The stock has delivered a total return of nearly 40% year-to-date and 34% since I laid out my investment thesis in March. Although 2023 is likely to go as a very strong year for equities more broadly, the total return of S&P 500 (SP500) is roughly half during the period.

What’s even more impressive is the fact that the rally in equities was largely driven by large tech stocks which are among the major holdings of Technology Select Sector SPDR® Fund ETF (XLK), Communication Services Select Sector SPDR® Fund ETF (XLC), and Consumer Discretionary Select Sector SPDR® Fund ETF (XLY).

Without the contribution of these names, the total return of S&P 500 would have been far lower during the year. That is why the Industrial Select Sector SPDR® Fund ETF (XLI), the sector of which United Rentals is part of, has delivered less than 11% since the beginning of the year.

All that is a very strong indication that United Rentals continues to execute well on its strategy and the market has finally begun to price in the improving business fundamentals.

That is why, even though URI remains very strong positioned to continue to outperform the market in the long run, the mispricing opportunity over the short term no longer exists. What investors should also be mindful of is the market tends to overshoot both on the upside as well as on the downside, which in my view creates an additional risk for URI at current levels.

Reinvesting At High Returns

Over the course of 2023, United Rentals was able to fully capitalize on its large size and leading market share in the highly fragmented industry of equipment rentals. Thus, the company’s return on invested capital reached 13.7% during the last reported quarter, which is nearly twice the return it had in FY 2013.

The acquisition-led strategy has allowed the company to achieve very high equipment utilization rates and at the same time to benefit from significant economies of scale, which drove the share of fixed costs to revenue at record low levels.

As we will see in the next section of this article, the strong economic growth in certain sectors in 2023 has made all that possible and also allowed for a smooth transition to one of the company’s largest M&A deals so far – that of Ahern Rentals.

In this process, free cash flow is now expected to achieve record-high levels and to be within the range of $2.3bn to $2.5bn for the full fiscal year of 2023.

Having said that, we should note that the midpoint of the guidance would still be below the 2020 free cash flow level, but this time around URI did not cut its purchases of rental equipment as it did back then.

As a matter of fact, the annual spend on rental equipment relative to the depreciation expense currently stands at one of its highest levels at 180%. As I mentioned before, this is a very strong indication of the growth potential ahead and highlights the heavy reinvestment rates within the business.

The Multiple Repricing Opportunity

In addition to the strong competitive positioning of United Rentals and the higher than the industry average return on capital, a key pillar in my initial investment thesis was the opportunity for a multiple repricing. As I noted in March, based on the high equipment utilization rates, URI was likely to trade at much higher multiples before the end of 2023.

Equipment utilization rate is one of the most important metrics behind the record high asset turnover and margins. That is why, United Rentals Price-to-Book multiple is related to the rental equipment dollar utilization on a historical basis.

Having said that, we are likely to see a multiple repricing if utilization rates remain high in 2023 and URI continues to extend its footprint.

Source: Seeking Alpha (emphasis added)

This is now a fact, and United Rentals’ stock experienced a multiple repricing with its Price/Book multiple now standing at around 4.3, which is significantly higher than the multiple it had at the beginning of the year.

This alone was one of the most important drivers of URI’s returns in 2023 and the opportunity for encourage upward multiple repricing is now gone. The reason is equipment utilization rates have reached a cyclical high, and with that, URI also trades at a cyclical high based on its Enterprise Value to Tangible Assets multiple.

As we see from the graph above, rental equipment dollar utilization could potentially improve encourage and achieve 60% as it did back in 2014, but this would take a significant pick-up in economic activity. Certain areas of the economy, such as semiconductors, automotive, and infrastructure, have noticed a significant uplift in spending in recent years, and this has been a significant tailwind for United Rentals’ equipment utilization.

Non-res construction grew 9% year over year, and within this, our customers kicked off new projects across the board, including numerous EV and semiconductor related jobs, solar power facilities, infrastructure projects, data centers and healthcare.

Source: United Rentals Q3 2023 Earnings Transcript (emphasis added)

Although spending on large projects in these areas will be a multi-year tailwind for United Rentals, it will take a notable pickup in economic activity for United Rentals’ equipment utilization rates to go beyond their current levels.

In the near term, this is highly unlikely, given the deterioration of the Leading Economic Index (LEI) and the elevated risk of a worse-than-expected recession in 2024.

Conclusion

United Rentals’ stock is on track to record yet another strong year by outperforming both the broader equity market and the industrials sector. The company remains an attractive long-term buy opportunity, however, the recent multiple repricing will weigh on returns in the coming months.

As I said before, trying to anticipate a recession is a futile exercise when trying to forecast future returns. Nonetheless, investors should be mindful of short-term risks and the high probability of an economic slowdown in 2024. That is why, even though United Rentals, Inc. remains on a strong footing with solid competitive advantages, investors should keep enough dry powder in case investor sentiment turns south in 2024.