H&E Equipment (NASDAQ:HEES) is a company that is flying under the radar for many retail and institutional investors, due to its sizable insider ownership and relatively smaller size in an industry that many would describe as mundane. A market cap of $1.6bn is certainly not a small number, however, HEES is eclipsed by the behemoth in the industry - United Rentals (URI), which has a market capitalization of $27bn.
In spite of all that, the much smaller peer of URI that is also at a significant disadvantage due to its size has achieved at par returns. Since my first bullish thesis on the company almost a year ago, HEES' total return amounted to 55%, which also leaves the broader market in the dust.
Investment Thesis
My investment thesis is based on a narrowing size gap between the leaders in the space, such as URI, and smaller players as the industry consolidates.
Source: Ashtead Group Annual Report 2021
At present, the construction equipment rental industry is still highly fragmented, but the trend towards consolidation is ongoing. United Rentals has been leading the way for the past 10 years or so, on the back of its aggressive M&A strategy, that made it by far the largest player in the space, and with that the market awarded it with a much higher valuation multiple (see below).
So why is consolidation so important?
Larger size not only results in significant economies of scale in the sector, but is also in my view a necessary condition for survival since over the recent years, sophistication in the industry has increased significantly.
Another key feature of the rental market, says the ERA (European Rental Association), is the increasing size and sophistication of rental companies. Consolidation has played a role in the overall efficiency and promotion of the rental industry.
Source: Hitachi Construction equipment rental
By offering the full range of construction equipment, alongside specialty equipment solutions, across a wide geographical region creates a significant competitive advantage that the smaller players can't match.
Source: United Rentals Investor Presentation 2021
I covered in detail the impact of size on fixed costs and utilization rates in my last thought piece on H&E Equipment, called '. If you haven't read it already, I recommend doing so before proceeding.
With all that in mind, URI will likely continue to dominate the industry for the foreseeable future. However, in my view, the opportunity for smaller players to slowly catch up with the leader is far more attractive. H&E Equipment is on track to do just that and as management is focused on transforming the company into a pure-play rental business, it sets up the stage for more aggressive expansion and margin improvement.
Industry Tailwinds
Favorable industry tailwinds will likely provide a tide that lifts all boats and such an environment will create the necessary conditions for further consolidation in the sector.
As of today, construction investment in the U.S. still remains below the long-term average (see below) and recent supply chain disruptions created significant incentives for more domestic production.
Source: United Rentals Investor Presentation 2021
In addition, the construction industry is also feeling the impacts of the shared economy. Being less capital intensive is a feature that more businesses are actively seeking as it improves efficiency.
According to the ERA’s Equipment Rental Industry Report, 2019 [2], one of the reasons behind this growth is that customers have a better understanding of the advantages of using rental equipment. They can save money by using rental services and have access to modern and technologically advanced equipment. It also provides flexibility and implies less capital expenditure.
Source: Hitachi Construction equipment rental
Finally, construction contractors also benefit from a more consolidated rental equipment industry, because it allows them to compete more easily across the country.
Another benefit to contractors: They get better geographic coverage from larger rental companies that have stores spread over the nation. A contractor can bid and obtain work in territory that is new to him, based on the fact that his existing rental company – or another one – will have one or more stores in the new area.
Source: stormh2o.com
That is why, HEES' branch growth is essential for winning new and retaining old customers. Just a year ago, the company's branch network consisted of 94 locations, compared to 101 today.
Source: H&E Equipment Q3 2021 Earnings Presentation
This branch growth comes at a time when the company divested its crane business just last month. Following the deal and the strong performance over the recent quarters, HEES management is now committed to an even more aggressive expansion strategy next year.
As evidence of the company's growing confidence in expansion of our primary markets, H&E expects to disclose strong fleet growth plans for 2022 with a growth investment -- gross invest that is expected to significantly exceed our total expenditures of any of the previous years of our 60-year history.
Brad Barber - Chief Executive Officer
Source: HEES Q3 2021 Earnings Transcript
Closing the Gap
With larger size and a stronger focus on rental equipment, HEES is also positioned to significantly improve its margins and asset turnover, thus achieving much higher return on capital and valuation.
Historically, HEES relied heavily on equipment and parts sales, which just 10 years ago were the main revenue source for the company (see below).
Source: Prepared by the author, using data from annual and quarterly reports
Today, HEES is much closer to becoming a pure play equipment rental company as its main peer United Rentals is.
Source: Prepared by the author, using data from annual and quarterly reports
In addition to fixed cost efficiencies, becoming a pure equipment rentals company will also benefit HEES gross margins. This is due to the fact that equipment and parts sales are far less profitable when compared to equipment rentals and additional services.
Source: Prepared by the author, using data from annual and quarterly reports
Higher utilization is another key target for HEES management as the company transitions into a pure rental equipment company and expands its geographical reach. The dollar utilization has been relatively steady over the past decade at around 35%, but has taken a hit during the recent pandemic.
Source: Prepared by the author, using data from HEES Earnings Presentations
As bad as 2020 was, HEES utilization did not experience a sharp fall as it did back in the 2009-10 period. This illustrates the more stable nature of the business today and is encouraging for future return on capital.
Dollar utilization is by far the most important driver of operating margins. On an annual basis, utilization explains the vast majority of variations in the company's margins.
* annually for the period 2004-2020
Source: Prepared by the author, using data from HEES Earnings Presentations & Annual Reports
Additionally, utilization rates also influence overall asset turnover, which is another key driver of return on capital.
* Annually for the period 2004-2020
Source: Prepared by the author, using data from HEES Earnings Presentations & Annual Reports
For the past twelve months, HEES' operating margin stood at 11%, while asset turnover is 0.6. Both of these values are not materially different from the ones recorded for the fiscal year 2020 shown above. However, quarterly dollar utilization rates have skyrocketed over the past two quarters and are significantly higher than those recorded a year earlier.
Source: Prepared by the author, using data from HEES Earnings Presentations
These utilization rates will most likely cool off over the coming months, but the overall setup for 2022 remains exceptionally strong.
The combination of higher physical utilization and strengthening rental rates contributed significantly to the quarter's performance gains, which included a 600 basis point increase in dollar utilization to 38.9% compared to the year ago quarter.
(...)
Since the close of the third quarter, our physical utilization continued to reflect outstanding operational execution and strong customer demand, reaching a peak of just over 75% in October. While we're enjoying the momentum continue -- coming into the final quarter this year, we still expect to see utilization levels moderate as seasonal factors emerge during the second half of the quarter.
Brad Barber - Chief Executive Officer
Source: HEES Q3 2021 Earnings Transcript
Therefore, HEES' rental equipment turnover (equipment rentals revenue / rental equipment assets) could soon close the gap with the leader - United Rentals. The gap has been narrowing since 2015 and could also result HEES' margins catching up with those of URI.
Source: Prepared by the author, using data from annual and quarterly reports
At the same time, the gap between the two companies in terms of their Price-to-Sales multiples has widened even year to date.
Source: Prepared by the author, using data from annual and quarterly reports & Yahoo! Finance
That is why I expect HEES to outperform its larger peer in the coming years, and given the industry tailwinds, it would most likely continue to outperform the broader equity market.
Conclusion
With a beta of 2.2, H&E Equipment remains a risky company from an overall market exposure that operates in a highly cyclical industry. Over the long term, however, tailwinds for the U.S. equipment rental industry remain strong and HEES is uniquely positioned to succeed in this environment. The management is about to embark on a more ambitious growth program that so far relies heavily on organic growth. Given the currently high utilization rates, HEES could benefit from both higher margins and expanded top line, which is at odds with the wide valuation gap with the current leader - United Rentals. As a result, HEES is well-positioned to outperform both the overall market and the current leader in the industry.
Vladimir Dimitrov, CFA
Vladimir Dimitrov, CFA is a former strategy consultant within the field of brand and intangible assets valuation. During his career in the City of London he has been working with some of the largest global brands within the technology, telecom and banking sectors.
He graduated from the London School of Economics and is interested in finding reasonably priced businesses with sustainable long-term competitive advantages.
Vladimir is the leader of the investing group The Roundabout Investor where he teaches the process of evaluating roundabout investments; defined by potential high capital return, growth in free cash flow, safe dividends and conservative capital allocation. He offers weekly investment ideas, a model portfolio, a watchlist, macro outlooks, and sector deep dives. Learn more.
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