H&E Equipment Services Outperforming The Peer Group (NASDAQ:HEES) (2024)

In the equipment rental industry, most investors recognize scale leader United Rentals (NYSE:URI) as one of the best-managed companies. I think the reputation is, on the whole, well-deserved - but even after adjusting for geographic exposure, I have to say that I continue to be impressed with how well H&E Equipment Services (NASDAQ:NASDAQ:HEES) is executing.

In retrospect, I probably should have picked up some shares during the early part of this year, when H&E was trading at around the value of its original equipment cost (OEC). Back up at $20, the investment case isn't a slam-dunk from a fundamental perspective, although it's not bad if you're bullish on construction. Nonetheless, the company's good execution, flexible fleet, exposure to seemingly robust end-markets, and clean balance sheet relative to the sector make it one of the more interesting construction momentum/sentiment plays.

Industry Outperformance Continuing In Q1

Taken on its own, you might look at H&E's recent results and shrug your shoulders. Utilization of 66.3% is fine, but not spectacular, rental revenues increasing 1.4% year on year is certainly not enough to get excited over, and flat rates signal an end to (or at least a pause in) the dramatic march upward in margins over the past half a decade.

This isn't a company you can analyze in a vacuum, though, and relative to both United and Neff Corp. (NYSE:NEFF), H&E is delivering solid results. Time utilization was better than either United or Neff, and perhaps most impressively, H&E seems to be holding its rates while United (which likes to be a price leader) is expecting 200 bps of decline in the United States. This continues the trend of strong results relative to the peer group. H&E hasn't seen as much impact from reallocating fleet from branch to branch as others.

Distribution sales were also up significantly in the first quarter, as H&E took market share from competitors. This is likely not replicable, as oil has put a damper on new equipment sales for the whole industry - but it continues to substantiate H&E's good execution amidst challenging times.

From a macro perspective, while the decline in oil-related revenues has offset strong non-res performance, leading the company to pull back significantly on growth capex, I think there will be opportunities for modest fleet growth in 2017 and beyond.

Could Oil Actually Become A Tailwind?

Amidst all of investors' questions about the potential downside risks associated with the oil patch, it might pay to remember that there's another side to the story, too. H&E can actually be viewed as a stealth oil recovery play. Oil comprised 13% of revenues prior to the downcycle, and now only comprises 5%. That's a pretty material drop, and yet, as discussed previously, H&E has driven solid fleet absorption and rental revenues. To put it another way, if not for the decline in oil, H&E would be generating nicely higher revenues and EBITDA in the current period.

While I'm not going to sit here and call for a dramatic upswing in the price of oil anytime soon, based on historical perspective, it certainly seems like there's a better chance of the rig count going up by 50% rather than down by another 50% over the next two to three years.

This would provide H&E with incremental opportunities to complement the strength in non-res and industrial. In particular, despite the generally strong rental rate environment for most classes of equipment, cranes have been lagging behind coming out of the crisis. The dollar utilization graph from H&E's first quarter presentation provides a nice visual:

While cranes have substantially longer useful lives than earthmoving or AWP equipment - and thus will not have the same dollar utilization - crane rates still have room to move meaningfully higher, and a recovery in the oil patch would go a long way towards making this possible, as well as boosting H&E's distribution business. With non-res doing well, they don't absolutely need it to drive growth, but it would certainly be a nice tailwind were it to materialize.

Industrial "Contagion" - A Nuanced Issue

The knock against H&E beyond its modest direct oil exposure is concern about oil-related "contagion" effects on both the broader Gulf Coast economies (which could pressure non-residential construction activity) as well as the company's exposure to major industrial projects. Current results make me believe the first of those two is significantly overblown; the second issue is more interesting.

On the one hand, from talking to dozens of companies and management teams with exposure to this trend, the general takeaway is that most of the major Gulf Coast industrial projects are underpinned by the U.S./rest-of-world arbitrage in natural gas (which serves as both a fuel and a feedstock for many process industries). To the extent that the arbitrage continues to exist - which, given the ever-more-powerful fracking techniques being developed and the seeming ocean of gas trapped in U.S. shale - this seems like it will be a relatively durable phenomenon over the next decade, or potentially much longer.

On the other hand, while the standalone economics of most of the projects aren't materially adversely impacted by the recent decline in oil prices, the fact remains that many project sponsors (such as integrated oil companies) are facing pressures elsewhere in their business that constrain their capital budgets and/or willingness to make big investments. Sasol, for example, is slowing construction at its $8 billion ethane cracker complex in Lake Charles.

As it relates to H&E specifically, I don't see this as being a major negative to the fundamentals (or the investment story) over the next few years. First, while the rate of growth in projects may slow, all indications are that it will still continue to be a strong market. Second, H&E's fleet is heavily weighted towards aerial work platforms, a versatile category of equipment that can be used in many applications (including routine ongoing maintenance of the facilities once they're built, unlike, say, earthmoving or super-duty cranes). Third, a longer plateau of industrial work versus a few-year bump is actually easier to deal with (and probably less risky) from a fleet management perspective.

Valuation: Strong On The Intangibles

I find cash flow modeling to be rather besides the point with equipment rental companies given the inherent uncertainty in the construction cycle, not to mention variables like fleet growth and rates on top of that. While many analysts (both buyside and sellside) use EBITDA, I find that to be a bit of a lousy metric for an industry where depreciation is a very real and salient expense. Ultimately, my preferred approach is to look at the business on the basis of how much ongoing steady-state cash flow it throws off - i.e. EBITDA less maintenance capex.

From that perspective, at the current price around ~$20, H&E seems neither expensive nor cheap at a little shy of ~11x my estimates (which are roughly flat EBITDA to 2015 and maintenance capex around $170-$180 million).

Where H&E scores highly is on their intangibles, starting with their young fleet. Then comes geography: I view the Gulf Coast as a good place to be over the medium term, and think that their current results relative to United are at least partly attributable to this geographic focus (although results relative to Neff suggest a good deal of execution as well).

H&E also has a strong parts and service business (mid-teens percentage of revenue), which has very good returns on capital and provides a modest hedge against the cyclicality of distribution and rental. Finally, the significant insider ownership by CEO John Engquist is probably a positive - I do have a few concerns about related-party issues here, but the big risk with equipment rental companies is imprudent leverage in the good times leading to heartache in the bad times, which is the primary flaw I see with Neff.

Wrapping It Up

Ultimately, equipment rental companies are and always will be derivatives of construction sentiment more so than actual construction fundamentals, as evidenced by the wild divergence in stock price vs. underlying business trends over the past few years. I really should have bought in during the February rout, but there were a lot of cheap stocks on my plate at the time - and this one, much to my chagrin, slipped by me even though it was on my watchlist.

Going forward, beyond the obvious construction-cycle concerns, the major risk factor here is that H&E is eventually dragged down by the same challenges facing United. This is still an industry fragmented enough for undisciplined local mom-and-pops - who aren't able to move fleet around like the big players - to chase market share at the expense of industry-wide rates and profitability. So far, H&E's execution has held up pretty well amidst a challenging environment, but this is an issue that bears close monitoring.

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