marchmeena29/iStock via Getty Images

marchmeena29/iStock via Getty Images

It's almost a year ago since I wrote my most recent article covering rental and leasing giant United Rentals (NYSE:URI ). The reason why I'm digging the ticker up again is based on the abysmal performance of the stock market. The S&P 500 is close to a bear market (-20%) as investors have de-risked their portfolios to incorporate slower economic growth, an aggressive Fed hiking cycle, ongoing supply chain issues, and high inflation into their portfolios. While sell-offs aren't fun, they offer opportunities to buy new companies or to add to existing positions. In the past few months, I've talked a lot about construction companies like Cummins ( CMI) that offer dividend growth opportunities at good prices. United Rentals does not pay a dividend, but it does repurchase a lot of shares using its massive stream of free cash flow. The company has high margins, a rapidly growing business, and a terrific valuation thanks to the sell-off. Investors who don't care for a dividend may consider buying United Rentals, which I consider to be more than a trading opportunity at a good price. It's a promising long-term investment with a high likelihood to outperform the S&P 500.

Let's look at the details!

In general, when I buy dividend growth investments, I like to buy companies with as little competition as possible in an industry with high entry barriers for new entrants. However, there are benefits that come with buying companies in highly fragmented markets. Strong performers who are able to stand out thanks to good services or products can use their ability to acquire competition to expand their way of doing things on a large scale. This is possible in, i.e., car dealerships, barbers, retail, and construction (and so many more).

With a market cap of $20.3 billion, United Rentals is the world's largest equipment rental company, with 90% exposure in the United States.

Founded in 1997, the company has grown to more than 1,300 locations in North America, covering 49 states. United Rentals owns $16.0 billion worth of fleet assets covering 805,000 units of various construction and related tools, machines, and whatnot. This gives the company a 15% market share, which is 400 basis points above its largest competitor, Sunbelt.

The company's customer mix is incredibly well diversified. The company services every industry, segment, and niche that is in need of machinery.

In general, United Rentals benefits from a trend towards low-CapEx businesses. By renting equipment, i.e., construction companies achieve very high utilization rates as they use equipment only when it's needed. This shifts the utilization risk to United Rentals. Moreover, smaller construction companies can do a big variety of jobs, as they don't need to buy a machine for every special situation.

Needless to say, this industry has grown a lot. Over the past 24 years, the compounded annual growth rate of the rental and construction industry has been 4.9%. This has not slowed as the number is 5.0% on a 10-year basis.

With that said, while rental companies bear a lot of "utilization rate" risks, URI has benefited from its digital tools. The company has an advanced rental fleet management platform that allows it to easily open and close contracts, view data, locate equipment, and track and analyze data. It allows the company to use advanced pricing tools and to create services that other, traditional, rental companies simply cannot compete with.

On top of that, the company has other competitive advantages. For example, it has a huge and diverse fleet, which offers machines for all jobs imaginable. Also, because the company has so much equipment, it can buy machines cheaper, hence supporting margins.

Moreover, its scale allows the company to benefit from its National Account Program, aimed at big-ticket relationships:

Our national account sales force is dedicated to establishing and expanding relationships with large companies, particularly those with a national or multi-regional presence. National accounts are generally defined as customers with potential annual equipment rental spend of at least $500,000 or customers doing business in multiple states. We offer our national account customers the benefits of a consistent level of service across North America, a wide selection of equipment and a single point of contact for all their equipment needs.

And, needless to say, there's strong brand recognition because of its size and customer satisfaction.

All of this has resulted in significant outperformance. Despite having two 60% sell-offs in the past 10 years (2016 and 2020), United Rentals is up more than 550% since 2012, outperforming Caterpillar (CAT) and the industrial ETF (XLI) by a mile. Caterpillar isn't a competitor as it's a supplier of equipment, but it's also considered to be a construction play.

This outperformance is based on the fantastic financials that come from its stellar business model, and I expect that outperformance continues.

United Rentals is a mix of organic growth and aggressive M&A. Over the past four years, the company has bought companies worth roughly $4.0 billion.

Over the past five years, the company has achieved the following compounded annual growth rates:

As a result of becoming a more mature business with adjusted EBITDA margins close to 50%, United Rentals has become a cash machine. This year, the company is looking to do $1.8 billion in free cash flow. Free cash flow is operating cash flow minus capital expenditures. It's cash a company can spend on dividends, stock buybacks, or (net) debt reduction.

While URI does not pay a dividend, it does buy back a lot of shares. That's based on two things. First of all a high implied free cash flow yield. $1.8 billion in expected free cash flow is roughly 8.9% of the company's $20.3 billion market cap. That's truly a wild number. Let's say the company were to spend it all on buybacks, it could buy back 8.9% of its shares outstanding without needing additional funding or hurting its existing business. Or pay an 8.9% dividend with zero buybacks. It won't do that, but you get the idea.

Moreover, the company's balance sheet is very healthy. This year, net debt (gross debt minus cash) is expected to fall to $9.0 billion. It's the same as it was in 2017, except that EBITDA is much higher now. Hence, the net leverage ratio is expected to fall to just 1.7x. Even with buybacks, this ratio could fall to the low 1.0x range in the years ahead. Bear in mind that this is the case despite millions in M&A and a long-term decline in shares outstanding (the company didn't dilute shares to buy growth).

With that in mind, the graph below shows what the company has spent money on in the past 10 years. In this case, I included cash acquisitions, share repurchases, and debt issued/repaid.

Almost needless to say, as we just looked at net debt, debt issued and debt repaid have shifted from higher debt issued volume to higher debt repaid volume. On April 21, the company announced to redeem $500 million of the outstanding $1.0 billion of 5.5% senior notes due 2027.

Cash acquisitions have a major impact on issued debt, as URI mainly uses cash for these transactions. The last time the company used stock to acquire a company was back in 2012.

Note that since the 2012 acquisition of RSC, the number of shares outstanding has imploded. In 2014, the company had roughly 105 million shares outstanding. Currently, it's 73 million.

Between 2017 and 2021, the company has repurchased 3.1% of its shares outstanding - per year.

So, what about the valuation?

Using the company's $20.3 billion market cap and $8.0 billion in expected 2023 net debt, we get an enterprise value of $28.3 billion. This is just 5.0x next year's expected EBITDA of $5.7 billion.

This valuation is too cheap and a result of overreacting traders and investors, as the past few weeks have been tough. The same goes for the implied free cash flow yield of almost 10%, which is close to the upper bound of the historic range, as the lower part of the graph above shows.

This year, de-risking (selling) was aggressive as investors feared slower economic growth, an aggressive Fed, related high inflation, ongoing supply chain issues, the war in Ukraine, and Chinese lockdowns.

The good news is that a lot of weakness has been priced in. URI is roughly 30% below its all-time high, which means that negative manufacturing growth has been priced in - using the graph below. I extended the year-on-year performance of URI into the next few months (based on an unchanged stock price). If growth rebounds in the second half of this year (likely going into 2023), we're dealing with a seriously undervalued company here.

Author (Data source: New York Fed)

Author (Data source: New York Fed)

To conclude this article, here's the takeaway.

United Rentals does not pay a dividend - which I'm normally looking for in a stock. However, URI has other qualities that make it a great long-term investment. The company is very efficiently expanding its footprint in a highly fragmented industry using both organic and acquired growth. The company's balance sheet is incredibly healthy, free cash flow is high, and aggressive buybacks provide long-term capital gains and outperformance.

The most recent sell-off on the stock market has caused URI to drop to a very favorable valuation, and I do rate this stock as a long-term "buy".

(Dis)agree? Let me know in the comments!

This article was written by

Disclosure: I/we have a beneficial long position in the shares of CAT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.