I’ve written two articles explaining why I think United Rentals (NYSE: URI) is an excellent long-term investment; in this article i want to focus on why i think the business will be successful in a high inflation environment. I am on the file as being skeptical that inflation will be a long-term problem, but in the current economic climate, it’s an important factor to consider. URI is well protected from the problems associated with high inflation and should benefit from the positive aspects because:
URI services bring value to customers
The ability to raise prices without losing significant sales volume is critical to surviving high inflation. URI can do this because their services are mostly non-discretionary and offer a clear value proposition to their clients. The company’s customer base is evenly split between industrial and commercial construction and includes sectors such as energy, healthcare, utilities, railways and other infrastructure, among others. Many projects are financed directly or indirectly by public spending or by companies in sectors that can remain active during periods of inflation; URI’s customers are not dependent on the whims of the retail consumer. I expect to see increased demand for URI services as the $550 billion infrastructure bill passed by Congress begins to turn into real projects later this year. These are non-discretionary projects that give URI’s customers bargaining power, which in turn makes it easier for URI to pass on increases in input costs.
More importantly, URI provides great value to its customers. No one likes to pay higher prices, but customers are more willing to do so if your services offer them a clear value proposition. In times of rising prices, the purchase of equipment becomes more expensive and the increase in interest rates makes it more expensive to borrow again to buy this equipment; renting equipment makes more sense in the short term. As the largest equipment rental service in the United States, URI has more warehouse locations, more products offered, and a better customer service network than its competitors. In a high inflation environment, it makes more sense for customers to lease hardware, and it makes more sense to lease from URI rather than their smaller competitors.
URI posted strong third and fourth quarter results in 2021 compared to 2019 and 2020. Inflation was highest in these quarters, and revenue, operating profit, net profit and cash flow URI’s operating cash flow all increased significantly from 2020 (which was impacted by the pandemic lockdowns) and modestly in 2019. URI was able to grow its business profitably in an environment of high inflation and i expect it to continue to do so in the future.
The URI controls its entry costs
It is important to be able to limit or absorb rising input costs during periods of high inflation. The URI is not immune to higher entry costs, but it has the flexibility to tackle the problem. The company already has a large inventory of equipment in fairly good condition. URI has over 780,000 items in its fleet, with an average equipment age of 54 months. 77% of their inventory meets the manufacturer’s recommended maintenance schedule, which is consistent with historical levels. The company has invested nearly $3 billion to increase the size and quality of its fleet in 2021. This is more than triple the amount spent in 2020 and 50% more than in 2019. URI’s inventory is in good condition, so there is less need to buy new equipment when prices are high. The URI has guided an additional $2 billion in equipment purchases for 2022, but that number may be flexible if equipment prices get too high in the short term.
The URI will have to manage rising labor and transportation costs. The company has more than 20,000 employees and must balance and transport its inventory to 1,300 rental locations. So far, URI has been able to manage these increased costs without hurting its profitability or cash flow. In fact, the URI grew aggressively in this environment; the company added 200 rental locations and more than 2,000 employees in 2021.
URI’s balance sheet benefits from inflation
URI’s balance sheet will benefit in two ways if inflation remains high. First, URI owns significant tangible assets through its inventory of rental equipment. When prices increase, the value of equipment increases proportionally. The increase is “hidden”, as these assets continue to be depreciated on normal schedules, but management has touted rising margins on their used equipment sales. URI recorded net gains of $431 million on used equipment sales in 2021.
Second, URI carries significant debt on its balance sheet. The debt as a whole is long-term and bears a blended interest rate of less than 5%; total debt liabilities are just under $10 billion. Rising interest rates usually accompany rising inflation, so long-term, low-interest debt becomes more valuable (or at least less burdensome to pay off). The debt repayment schedule is flexible and spread over the next ten years; no senior bonds are due to be repaid until 2027 and the company’s $3.75 billion ABL facility does not expire until 2024. 2015. The cash flows give URI the flexibility to borrow less if the interest rates become too high. URI’s debt is easy to manage in the short term and will become easier to repay in the long term if inflation remains high.
Thoughts on evaluation
In my previous article on URI, I reviewed a variety of business evaluation scenarios and argued that URI will be a multi-bagger over the next five years. I believe the market views URI as an “average” company when in fact it is an exceptional company. The company generates abundant free cash flow, can reinvest that money at a high rate of return, and has management that treats shareholders as partners. URI’s free cash flow was $1.5 billion in 2021 and is expected to reach $1.7 billion in 2022, meaning the company is currently trading at approximately 15 times forward free cash flow. . URI’s return on invested capital is consistently above 10% and the company expects $1 billion in share buybacks in the coming year. Modeling an annual FCF growth of 10% (approximately their return on investment), annual share buybacks of 5% and a more appropriate P/FCF ratio of 20 yields an expected stock price of about $720 in 5 years. This translates to a 16% compound annual return to shareholders.
Risks and Concerns
URIs can thrive in a high inflation environment, but they are not completely immune to the risks of a prolonged period of inflation (3-5 years). The company has tens of thousands of employees, who are therefore particularly vulnerable to sustained wage inflation. 75% of their workforce is paid by the hour and these wages are more sensitive to general labor market trends. URI must continue to purchase new equipment and manage lines of credit with lenders. URI can easily handle these short-term needs, but it will become more difficult to purchase new equipment and finance new long-term debt if inflation remains high. Finally, while I expect the overall volume of construction and infrastructure work in the United States to increase as government spending increases, some of URI’s commercial construction clients may see a decline in demand and delayed project timelines if inflation remains high.
URI will continue to thrive in a high inflation environment. URI controls its input costs, can raise prices while adding value to customers, and has a strong balance sheet that will only get stronger if inflation stays high. The URI is a great choice in a high inflation environment, but it’s also a great choice if inflation is slowing. The company generates sufficient free cash flow and has a long reinvestment track to grow the business. URI is one of my top five holdings and I intend to hold the company for the long term.