HERC Holdings: Undervalued Spin-Off Opportunity in the Growing North American Equipment Rental Market.

Founded in 1965, Hertz Equipment Rental Corporation (“Herc Holdings”) is a leading equipment rental company in North America operating a diversified fleet of equipment with a total Original Equipment Cost (OEC) of $3.5 billion. The company serves a broad range of customers across the construction, industrial, governmental, agricultural and entertainment sectors.

Herc Holdings was separated from the Hertz Rental Car (“Hertz”) business in a spin-off on 30th June 2016 spearheaded by Carl Icahn who owns 15% of the firm. The company believes the following benefits will result from operating as an independent company.

  1. Greater Strategic Focus: management will be able to prioritise their own growth initiatives to develop the business, make decisions more quickly, deploy resources more rapidly and efficiently, and operate with more agility as a smaller, independent firm.
  2. Direct Access to Capital Markets: the company will be able to access capital markets directly to issue debt or equity to finance expansion, growth opportunities and debt repayment.
  3. Strategic Acquisitions: management will have more freedom to pursue strategic acquisitions, joint ventures and investments to develop the business.
  4. Simpler Business: the business will be more easily understood by investors thereby releasing the underlying business value that has been unrecognized to date.

This article examines the significant opportunities available to Herc Holdings to improve its operating performance to being more in line with its peer group and to realize sizeable shareholder value as a result.


An Overview of the North American Equipment Rental Industry

The North American equipment rental industry serves a diverse range of customers from individuals to small local contractors to national and industrial accounts encompassing a wide variety of rental equipment including heavy equipment, specialty equipment and contractor tools.

The growth of the North American equipment rental industry is driven by a number of factors including economic trends, non-residential construction activity, capital investment in the industrial sector, repair and overhaul spending, government spending and general demand for construction and other rental equipment. Companies are increasingly looking to the equipment rental market to manage their capital needs, with many firms relying on equipment rental to allow them to partake in their respective markets without incurring the significant acquisition costs and maintenance expense associated with owning their own equipment fleet. The North American equipment rental industry is forecasted to grow at 5.3% per annum between 2016-2019.

The industry is highly fragmented with few national competitors and many regional operators offering a subset of potential equipment and services. Herc Holdings is one of the leading companies in the North American equipment rental industry with approximately 4% market share.

Top 8 Equipment Rental Companies in North America by Sales

Company Sales ($m)
United Rentals $4,949m
Sunbelt Rentals $2,790m
Herc Rentals $1,411m
BlueLine Rentals $599m
Maxim Crane Rental $550m
Substate Equipment $450m
H&E Equipment Service $443m
Ahern Rentals $442m

An Overview of Herc Holdings

Herc Holdings is the third largest equipment rental business in North America offering a broad portfolio of equipment for rent, including aerial, earthmoving, material handling and specialty equipment such as air compressors, compaction equipment, construction-related trucks, electrical equipment, power generation, contractor tools, pumps, and lighting, studio and production equipment. As of 31st March 2016, their equipment rental fleet portfolio consisted of equipment with a total Original Equipment Cost (OEC) of $3.5 billion. The Company generates almost all of its equipment rental revenue in North America with approximately 1% of revenue coming from their international operations.

The company has longstanding relationships with large and small companies in the construction and industrial industries alongside customers in smaller industries such as government entities and contractors, disaster recovery, remediation firms, railroads, utility operators, individual homeowners, entertainment production companies, agricultural producers and special event management firms.

  • Construction: Herc Holdings principally serves the non-residential construction industry which consists primarily of private sector rentals relating to the construction, maintenance and remodeling of commercial facilities. Construction represents approximately 38% of revenues.
  • Industrial: consists of large industrial plants, refineries and petrochemical operations, industrial manufacturing, power, pulp, paper and wood and other industrial verticals. Industrial contributes approximately 23% of revenue.
  • Other: consists primarily of government entities and entertainment production. Government related revenue is principally rentals to government entities and contractors working directly on government projects. While entertainment production consists of equipment rented to the motion picture and television production industries. Other represent approximately 39% of total sales.

Herc is focused on continuing to diversify their rental portfolio to expand their offerings in higher margin niche and specialty markets through both organic growth and acquisitions. Strategic acquisitions provide the business with a more balance portfolio of equipment by diversifying the company away from their historical reliance on the more seasonal and cyclical construction industries and towards industries that vary in intensity and duration to the general economy. Specialty markets typically grow faster than the general economy and are less cyclical. In addition, a diversified portfolio differentiates Herc Holdings from their competition and positions them to take advantage of the increase in demand for more specialized rental solutions.


Performance Overview of Herc Holdings (2012-2015)

2012 2013 2014 2015
Sales $1,608m $1,736m $1,770m $1,608m
Gross Profit $678m $800m $785m $752m
Gross Margin 42.16% 46.08% 44.35% 42.82%
Operating Profit $87m $153m $145m $157m
Operating Margin 5.41% 8.81% 8.19% 9.36%
Net Income $61m $98m $90m $111m
Net Margin 3.79% 5.65% 5.08% 6.62%
Total Assets $3,710m $4.132m $3,611m $3,407m
Return on Assets 1.64% 2.37% 2.49% 3.26%
Total Debt $1,072m $674m $866m $137m
Shareholder Equity $1,285m $1,877m $1,705m $2,312m
Return on Equity 4.75% 5.22% 5.28% 4.80%
Invested Capital $2,357m $2,551m $2,571m $2,449m
Return on Invested Capital 2.59% 3.84% 3.50% 4.53%

The company’s underlying performance has improved in recent years. Sales grew consistently in 2013 and 2014 while a slight drop in sales in 2015 was driven by a significant slow down in Oil & Gas equipment rentals. In fact, excluding Oil & Gas equipment rentals the company had a very strong year in 2015 as demonstrated in the table below.

Quarter Total Sales Growth Sales Growth (ex. Oil & Gas Equipment) Oil & Gas Equipment Sales Growth
2016 Q1 -1% 12% -33%
2015 Q4 -1% 13% -33%
2015 Q3 2% 14% -25%
2015 Q2 2% 12% -24%
2015 Q1 4% 12% -12%

While sales have grown consistently, operating profit has improved significantly from 5.41% in 2012 to 9.36% in 2015. This has been driven by an improvement in overall Gross Profit Margin and a reduction in operating costs. As a result, the company is now achieving an improved Return on Invested Capital of 4.53% vs. 2.59% in 2012.


Performance Overview of Herc Holdings (2012-2015)

As a condition of the spin-off, Herc Holdings was required to transfer $1.9 billion to Hertz Car Rental to settle intercompany account balances. As a result, Herc Holdings issued $2 billion of debt including $1.235 billion of 7.50% and 7.75% Senior Secured Priority Notes due 2022 and 2024. In addition, Herc Holdings has obtained commitments for a $1.75 billion ABL Revolving Credit Facility at an expected initial rate of Libor plus 1.75% with certain lenders.

The recapitalized balance sheet as of 30th June 2016 is below.

Balance Sheet Amount ($m)
Cash $43m
Total Assets $3,397m
Total Debt $2,130m
Shareholder Equity $347m

As a result, Herc Holdings is currently significantly more leveraged than in recent years.


Strategic Opportunities

While Herc Holdings has performed reasonably in recent years there is significant potential for the company to continue to improve its performance in the years ahead.

  1. Attractive Long Term Industry Fundamentals to drive Organic Revenue Growth: market dynamics favor the continuation of the growing trend of companies renting equipment instead of owning it in order to free up their capital, provide great flexibility to adjust their operations and cost base, enable third parties to fulfill the fleet lifecycle management and to outsource fleet repair and maintenance. North American rental penetration has increased from 41% (2003) to 48% (2008) to 53% (2015). Herc Holdings is positioned to gain market share as a result of its brand recognition and reputation, scale advantage and the fragmented nature of the North American equipment rental industry.
  2. Fragmented Equipment Rental Industry provides Platform for Strategic Acquisitions: the equipment rental industry is highly fragmented with the Top 5 companies accounting for less than 30% of the market. By acquiring selected bolt-on businesses, Herc Holdings has the opportunity to expend their existing geographic footprint and improve their mix of rental revenue to create a customer profile that is less susceptible to industry-specific cycles, is more geographical diverse and is better positioned to facilitate sustainable earnings growth.
  3. Opportunities for driving Margin Expansion and Optimizing Operations: in addition to driving top line growth, Herc Holdings has identified a number of opportunities to drive margin efficiency including gaining better buying leverage by reducing the number of equipment suppliers by c. 40% and simplifying buying processes, increasing fleet availability, increasing sales density in urban areas and expanding the range of products and services towards higher revenue and margin equipment. For example, a One-Wheel Loader costs $136,000 and generates annual revenue of $37,800 whereas 13 Floor Scrubbers also cost $136,000 but can generate annual revenue of $149,760.

When compared to its peers, there is a significant opportunity for Herc Holdings to improve its EBITDA margins by c. 15%+. The company aims to meet or exceed its peer’s EBITDA margins in the long term.

EBITDA Margins 2012 2013 2014 2015
Herc Holdings 23.45% 27.53% 27.40% 29.86%
United Rentals 33.55% 36.14% 43.92% 45.47%
Ashstead Group 33.48% 38.11% 42.14% 44.53%

Valuation

Let us assume that the company makes reasonable headway at improving their operating performance and underlying profitability such that their Operating Profit Margin increases from c. 8% to c. 14%. While this may seem a sizeable increase it remains significantly behind the firm’s peers whose Operating Profit Margins are c. 25%. Given Herc Holding’s long term objective of achieving EBITDA parity this estimate may even prove conservative.

An Operating Profit Margin of 14% would result in average net earnings of c. $113m per annum at the current level of sales and after the current level of interest and tax is accounted for.

Ashtead Group and United Rentals currently have PE ratios of 17 and 13.50 respectively. Given the level of uncertainty regarding Herc Holding’s ability to improve its profitability as planned and assuming only a moderate growth in sales of c. 3%, a conservative PE ratio for the company of 12 would give a share price of $47.80. The current share price of c. $35.00 provides a 36.50% upside and an adequate margin of safety for what might be a long-term growth opportunity.


Legal Information and Disclosures

This memorandum expresses the views of the author(s) as of the date indicated and such views are subject to change without notice. Elenchus Capital Management Limited has no duty or obligation to update the information contained herein. Further, Elenchus Capital Management Limited makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.

This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elenchus Capital Management Limited believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.

This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elenchus Capital Management Limited.

Leave a Reply