Introduction
H&E Equipment Services, Inc. (NASDAQ:HEES) is a $1.6 billion integrated equipment services company that caught my eye when I was scrolling down some recent reports by Bank of America.
That particular report you see above is listing the most likely stock market outperformers for January 2023 based on different factors that statistically worked in the past at a year's beginning - the bank's analysts found out that in the current Late Cycle, investors need to look for high-quality stocks that have a:
- high beta;
- consistent FCF & margin expansion (high FCF/EV, operating cash flow);
- dividend;
- strong profitability (ROIC, ROCE, etc.);
- good solvency (deleveraging process, Net Debt/EBITDA, etc.);
- relatively cheap valuation amid solid growth prospects (low PEG amid EPS upward revisions).
The list sounds like it should work in all "Cycles", not just the "Late" one, right? In practice, relatively more robust performance [compared to the S&P 500 Index] will be explained by completely different factors depending on where you are on the cycle curve:
Since HEES is on the BofA list, it certainly meets all the criteria for a fundamentally strong company that can outperform the S&P 500 Index in 2023 but is unfairly under covered here on Seeking Alpha. I say "unfairly" because unlike (SPY), HEES has actually delivered a slight, but positive total return this year [approaching its multiyear highs]:
So I think it's time to correct the injustice created and answer the question - does H&P Equipment Services stock really have the potential to outperform in 2023, as BofA analysts claim?
Business Overview & Financials
According to the most recent 10-Q filing, H&E Equipment Services was founded by a business combination of Head & Engquist [founded in 1961] and ICM that took place back in 1971. The company went public in February 2006 as a Delaware corporation, though it's headquartered in Baton Rouge, Louisiana. As of September 30, 2022, the company operated 110 branch locations across 26 states throughout the United States - Pacific Northwest, West Coast, Intermountain, Southwest, Gulf Coast, Southeast, Midwest, and Mid-Atlantic regions.
HEES is engaged in 5 principal business activities:
- Equipment rentals (78.2% of total sales) - renting the core types of construction and industrial equipment, actively managing the size, quality, age, and composition of the company's rental fleet;
- Used equipment sales (6.26%) - sales from the company's rental fleet, as well as from sales of inventoried equipment that HEES acquires through trade-ins from our equipment customers;
- New equipment sales (7.24%) - sale of new equipment across all of HEES's core categories of equipment, primarily in the earthmoving product; category;
- Parts sales (5.16%) - provides parts to HEES's own rental fleet and sells parts for the equipment the company sells;
- Repair and maintenance services (3.1%) - provides maintenance and repair services to HEES's own rental fleet and for its customers' equipment at its facilities as well as at its customers' locations.
The lion's share of the company's operating activity is in the non-residential market, while the fleet mix looks quite diversified:
HEES has more than 120 locations across the U.S., with the largest presence in the South. This is the region where the company is expanding the most - on Oct. 1, 2022, it completed the acquisition of One Source Equipment Rentals, Inc. (transaction of $130 million in cash], which added 10 new locations. In the last 2 years alone, the company has expanded the number of locations by more than 30% and by ~3.44% (4 new locations) in the last reporting quarter. Pretty fast growth for a 61-year-old company in my opinion.
Based on the most recent IR presentation, HEES achieved its best rental rate in recent years in Q3 FY2022, as well as dollar and time utilization rates, driving the company's rental gross margins to a record 55.6%, up from 50.9% in Q3 2021:
Only 0.1% of the company's total revenue is dependent on non-US sales, so strength in the USD (DXY) YTD had no negative effect on the bottom line this year.
In Q3 FY2022, the company increased its net income by 55.2% (YoY), without any one-off items over the quarter. Good operating leverage allowed HEES to smoothly convert revenue growth into net income growth as margins improved across all key metrics.
Cash and cash equivalents have fallen from 17% of total assets to about 10% over the last 9 months, but do not forget the operational growth and the purchases I mentioned above. In general, the company looks quite stable relative to existing current liabilities, with a current ratio of over 2.6x and a quick ratio of almost 2x:
The company is very profitable not only in terms of paper profit (net income from the P&L statement), but also in terms of cash flow - in the 9 months of 2022, HEES generated cash flow from operations of >$211M (+4.5% year-on-year), and this against the backdrop of rapid growth in inventories and receivables, which, without deteriorating the quality of liquidity of the company's balance sheet (judging by the above metrics), tells me that HEES is preparing for increased demand for its services in the coming quarters. This assumption coincides with the words of the CEO, Bradley Barber:
We continue to experience a steady backlog of projects in the non-residential, construction and Industrial end markets. Feedback from our customer base remains reassuring with projects proceeding as planned.
Also, with the continuation of a robust demand, global supply chains remain challenge limiting the immediate availability of equipment, these factors reinforce a strong business environment and apart from traditional seasonality, or are expected to sustain a set of underlying fundamentals characterized by strong fleet utilization and favorable pricing trends into 2023.
In addition, we remain encouraged by the indicators for future construction activity. Recent measures from Dodge Momentum Index and the Architectural Billing Index, and the Associated Builders and Contractors continue to signal the likelihood of further expansion well into 2023 as additional construction projects into the planning stages.
Source: HEES's Q3 FY2022 Earnings Call Transcript
The management also expects further construction expansion through 2023 based on the positive signals from the Dodge Momentum Index, the Architectural Billing Index, and the Associated Builders and Contractors. In addition, the start of various infrastructure and construction projects in 2023, including those that expand U.S. manufacturing and renewable energy, may increase the company's profits in the coming years.
Valuation & Expectations
Trading at a forward price-to-earnings multiple of around 14x, HEES is ~20% undervalued to the whole Industrials sector, according to Seeking Alpha data. However, compared to its closest peers, HEES appears to be a fairly average company in terms of P/E ratio (FWD), but significantly undervalued in terms of EV/EBITDA forward multiple:
It cannot be said that HEES has significant upside potential compared to its peers due to its rather low EV/EBITDA multiple - in any case, this becomes clear by comparing the multiples with the forecast EBITDA growth rates and margins of the corresponding indicators:
However, this is only a relative-based assessment. In my opinion, a more important factor in evaluating growth potential is identifying discrepancies between consensus forecasts and what is likely to occur.
Analysts expect Q4 2022 earnings per share to decline 5.6% quarter-over-quarter - apparently blaming existing seasonality as the main factor behind the decline in rental rates and thus the decline in earnings.
When we look at Q4 of last year, the seasonal impacts were not typical, it was not nearly as impactful as it has been in past years. So, with that being said, I think it is fair to say that we could achieve double digit exit rate between 8.5% to 10% ranges [vs. 10.1% in Q3], is where we feel comfortable.
Source: John Engquist, Q3 FY2022 Earnings Call Transcript [emphasis and notes added by the author]
The midpoint of the forecasted exit rate range gives 9.25%, which is almost two times more than in Q4 last year (4.7%). In addition, we are likely to see a positive sales and EPS impact from the acquisition of One Source in Q4 2022:
It [the One Source merger] contributed nothing to the [third] quarter, we actually closed the beginning of October. So it will be embedded into Q4. They're not performing at quite the same levels of H&E. But $130 million a fleet, bringing a very motivated, capable team a board and they're going to be a positive contributor here in Q4, and going forward.
Source: Bradley Barber, Q3 FY2022 Earnings Call Transcript [emphasis added by the author]
The last two times the company has reported a revenue decline in the last quarter averaging 4.2%. Now the consensus is for a 4.64% QoQ increase in revenue, but a 5.66% QoQ decrease in EPS - I think this discrepancy is too high, as the number of shares is unlikely to dilute over the indicated period.
For some reason, analysts forecast a 30% quarter-over-quarter decline for Q1 FY2023 EPS. Yes, in YoY terms that's +55.8%, but still - over the last 3 years the average seasonal decline has been only -10.4%, and that's taking into account the COVID -year effect.
Things should be much better at the start of 2023 judging by management's comments on the end markets' strength.
Risks & Summary Thesis
It should be clear that the company is trying to cope with many risks, especially on the eve of the new year, which does not bode well according to many leading macro indicators. By providing rental services of key construction equipment, the company is effectively dependent on the construction industry's business cycle, which seems to have peaked recently - the biggest risk I see for H&E Equipment today.
To be fair, the 10% of the company's revenue that is most exposed to this kind of risk comes from customers who build multifamily housing, which is a more sustainable type of housing in terms of demand, as opposed to single-family residences:
Steven Ramsay
Excellent. Then last quick one, for me, residential vertical is 10% of trailing 12-month revenue that is slowing, clearly in the coming months. How much of that is multifamily and therefore may have more durability? And should it slow meaningfully? How could this impact utilization rates and the need to redeploy that fleet?
Bradley Barber
It will have no impact. And we're almost entirely multifamily. It would be rare to see an H&E Equipment machine on a single family residence.
Source: HEES's Q3 FY2022 Earnings Call Transcript
Another risk for the company is its rather average growth and margins at the current valuation level. For example, HEES's forward revenue growth rate is 6.64%, while the average of the [above listed] peer group is 26.1% - and this at a P/B (TTM) of 4.52x, which is 35% above the average of the group (3.35x).
On the other hand, we observe that HEES appears undervalued in absolute terms compared to the average valuation multiples of the group. Additionally, relatively modest growth projections may be underestimated, leading the stock to beat the consensus estimates as it has in recent quarters:
So despite the above-listed risks, I conclude, that even if we forget the BofA's factor analysis, HEES also appears attractive due to:
a) "cash flow generosity" - TTM-based CFO of 16.6% to market cap;
b) rapid, high-quality growth (30% growth in sites in the past 2 years); and:
c) low EPS consensus expectations that are likely to be beaten again.
This is my summary thesis.
I rate the company as a contender for outperformance in 2023, at least relative to the broader market and its sector.
Thank you for reading!
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