HERC Holdings Non-Economic Selling And Temporary Oversupply Sets Up 80% Upside

HERC Holdings: Non-Economic Selling
And Temporary Oversupply Sets Up
80% Upside
|Must Read Aug. 30, 2016 9:00 AM ET
by: Lester Goh
Summary
• Likely mispriced due to non-economic selling.
• Oversupply situation likely to clear over the next few quarters.
• The market appears to have priced in the 'worst-case' scenario,
despite continued health in ex-oil & gas markets.
• Fair value of ~$60, representing ~80% upside. Downside is well-
covered by assets on the balance sheet and a highly depressed
valuation.
HERC Holdings: Non-Economic Selling And Temporary Oversupply Sets Up 8… Page 1 of 19
http://seekingalpha.com/article/4002854-herc-holdings-non-economic-selling-tem… 31/8/2016

In my view, HERC Holdings (NYSE:HRI) ("HRI", "HERC", or "the Company")
represents a compelling opportunity to initiate a long position in a firm which
has been a victim of non-economic selling as a result of traditional spin-off
dynamics. Non-economic selling appears to have abated, but cyclical oil &
gas woes have pressured rental rates and resulted in a guidance cut. I believe
these concerns are temporary and likely to be solved over the next few
quarters. My target price of ~$60 represents ~80% upside potential. Downside
protection is solid, courtesy of assets on the balance sheet along with a highly
depressed valuation which appears to have priced in a 'worst-case' scenario
despite many indications to the contrary.
1. Spin-off dynamics led to non-economic selling, creating a compelling
entry point
Small Portion Of Hertz's Business: HERC is a recent spin-off from Hertz
Global Holdings (NYSE:HTZ), a name that should be familiar to most readers.
Prior to the spin-off, HTZ had two main business lines - car rental and
equipment rental. It also owns the Donlen business, which primarily provides
fleet leasing and fleet management services.
The car rental business is operated through well-known brands such as Hertz,
Dollar, Thrifty, and Firefly. The equipment rental business is simply branded
Hertz Equipment Rental and was spun off from HTZ earlier this July. As
evidence of its small size, HERC comprised of ~14% of HTZ's 2015 sales and
~18% of adjusted pre-tax income (adjusted for one-time charges as detailed in
the 10-K). This suggests investors likely bought shares of HTZ to gain
exposure to the car rental business, not the equipment rental business.
Arguably Worse Business Relative To Hertz Car Rental: Many investors, as
well as Wall Street, view the equipment rental business as lower quality. This
is because HERC requires immense CapEx to grow whereas HTZ has
relatively lower CapEx needs. In addition, industry structure favors the car
rental business.

The domestic and international car rental business of HTZ spends ~$2b in
annual CapEx, which works out to ~24% of sales on ~$8.4b in 2015 revenue.
The equipment rental business generates ~$1.6b in 2015 revenue but
requires ~$500m annual CapEx, or ~31% of sales.
In recent years, the car rental industry has consolidated down to three major
players (Hertz, Avis, Enterprise) owning ~90% of the U.S. market. Such a high
degree of market share concentration has allowed for sustained pricing power
and rational supply. In contrast, the equipment rental industry is highly
fragmented, with the three largest players accounting for ~25% of the North
American market. While a highly fragmented industry suggests considerable
runway for growth, it exposes players to periods of oversupply.
Post-Spin Trading Volume Trends Imply Substantial Non-Economic Selling:
According to Yahoo Finance, daily trading volume in the weeks following the
spin-off started off at ~2.5m, falling to ~230k as of Aug 19. I'm guessing here -
to me, this suggests shares were likely sold due to non-fundamental reasons,
preventing HRI from repricing to fair value. Current daily trading volume is
small compared to the volume of shares traded immediately post-spin,
suggesting most market participants may not be paying attention. The
combination of these factors have created a compelling entry point for longs.
Screens Poorly On Value Metrics: As identified by a fellow Seeking Alpha
author, the roles of the parent and spin-off are reversed on an accounting
basis; HERC is treated as the parent and HTZ the spin-off. This role reversal
has resulted in major data providers such as Yahoo Finance listing incorrectly
calculated valuation metrics. Yahoo lists HERC's EV/EBITDA as ~17x, while it
is actually closer to ~5.6x.
2. HERC enjoys an attractive competitive position and benefits from
secular trends in equipment rental
Attractive Competitive Position: HERC is the #3 equipment rental player with
~4% market share in North America, behind Sunbelt (owned by the Ashtead
Group) at ~7% and United Rentals (NYSE:URI) at ~13%. Apart from the
aforementioned companies (and Home Depot, who has ~1% share), no other

player has the scale to compete nationally; the rest of competition typically
competes in regional markets. National scale not only allows HERC to
redeploy equipment to other regional markets when one is experiencing a
downturn, but also offers the Company purchasing power when ordering new
equipment which smaller competitors do not have. This purchasing power
allows HERC to pass on a portion of its cost savings to customers. In addition,
HERC also possesses a wide offering of equipment which make it (along with
Sunbelt and United Rentals) the few one-stop shops for large customers.
Secular Trends In Equipment Rental: Customers are increasingly turning to
renting equipment for their operational needs. There are strong reasons to do.
One reason is flexibility. As the recent oil & gas industry downturn has shown,
demand can take a major step down over a short period of time. Instead of
owning equipment outright, renting allows a customer to dispose off unneeded
capacity easily. Renting also frees up capital as it entails a much smaller
economic commitment as compared to ownership. Getting caught with excess
capacity in a downturn can be ugly; lower revenue on high fixed costs is not a
fun combination, and renting largely eliminates this problem. Hence, it should
come as no surprise that rental penetration in North America have been
growing for years - it was ~41% in 2003, ~48% in 2008, and ~53% in 2015.
While ownership risk is passed on to the equipment rental companies, HERC
and its peers are better suited to managing such a risk given the Company
can redeploy unneeded equipment in a struggling market (i.e. oil & gas) to a
relatively healthier market (i.e. non-residential construction), severely
mitigating "re-rental" risk. This is something most of its customers are unable
to do.
3. Oversupply situation as a result of oil & gas woes likely to clear
Exposure To Oil & Gas Significantly Reduced: Oil & gas prices have been
depressed for much of the past 2 years. The reduction of prices of these
commodities have forced major industry players to cut billions in CapEx as
new projects became severely uneconomic at spot prices. At $100 oil/bbl,
Exxon Mobil (NYSE:XOM) was spending $33-$34b annually in CapEx. At the
XOM 2016 annual meeting, management guided for ~$23b in CapEx, while
YTD 2Q '16 is at ~$10b. Similarly massive reductions in CapEx can be seen

at other major firms. Suffice to say, this drastic drop in capital spending has
cratered demand for upstream oil & gas equipment rentals. HERC's exposure
to the upstream oil & gas industry has been significantly reduced. Upstream
oil & gas revenues have fallen from ~25% of equipment rental sales in 2014-
2015 to ~19% as of 1Q '16, and ~16% as of 2Q '16. Thus, upstream oil & gas
performance will be less of a driver going forward.
Oversupply Situation Likely To Clear Over Next Few Quarters: As a result of
the huge reduction in demand for equipment rentals for the upstream oil & gas
industry, equipment rental firms have responded by redeploying said
equipment in other markets (i.e. non-residential construction and industrials).
This redeployment of equipment has resulted in an oversupply situation in the
past few quarters.

Source: Rouse Rental Report June 2016
The mismatch between supply and demand is evident by examining pricing
trends. The Rental Rate Index provided by Rouse Services, a leading data
provider for the equipment rental industry, plateaued in mid-2014 after years
of steady increases, and have began seeing y/y declines beginning in late
2016, as seen above. As a result, the Company cut 2016 EBITDA guidance
from $560m-$610m to $520m-$560m, or ~7.7% at the mid-point.
Despite volume trends remaining relatively stable (especially when viewed on
an ex-oil & gas basis), the more pressing issue, and likely what market
participants are laser-focused on, is that of pricing. This is because,
unlike volume, changes in pricing results in an outsized impact on profitability
as it carries no variable costs; declines in volumes can be mitigated by
reducing related variable costs, but the same cannot be said for pricing. In
short, the market appears to be extrapolating recent industry-wide
pricing trends into the foreseeable future, an assessment I strongly
disagree with.
Reason being, fleet additions in the equipment rental industry have been
significantly curtailed. Said another way, incremental supply is falling rapidly.
Additionally, demand in non-oil & gas markets continues to grow.

HRI spent $435m-$520m annually over the 2013-2015 period on net fleet
CapEx (net being acquisitions of new equipment - disposals of old
equipment), a time-frame which coincides with oil trading at materially higher
prices as compared to the present. The Company is now guiding for
$375m-$400m in net fleet CapEx for 2016.
The situation is similar at United Rentals, the largest equipment rental firm in
North America with ~13% market share. United spent ~$1b-$1.2b in net rental
CapEx (similar definition as HRI) over the 2013-2015 period, and is guiding for
a mere $650m-$750m in 2016.
To get a feel for the rest of the equipment rental industry, I believe it is
instructive to look at Caterpillar's (NYSE:CAT) sales trends. Caterpillar is
primarily a seller of equipment to many industries that HRI and United serves.
Sales of such equipment has declined ~22% y/y as of YTD 2Q '16 from
~$23.5b to ~$18.4b. Total sales, which includes revenue from its finance arm,
is about ~$19.8b as of YTD 2Q '16. Management at Caterpillar is forecasting
full-year 2016 sales near the bottom-end of the $40b-$42b range, a large
decrease from ~$47b-$55b over the 2013-2015 period.
This massive reduction in fleet additions is beginning to bear fruit. HRI cited in
its earnings presentation that worldwide pricing saw a 0.5% increase y/y in 2Q
'16, suggesting pricing is beginning to stabilize. Monthly sequential pricing
trends have also turned positive for United Rentals, with prior-month declines
decreasing over time, as seen below.

Source: United Rentals 2Q '16 Earnings Call Presentation
Management commentary at United also indicates the firm has mostly finished
redeploying its original oil & gas equipment to other industries and that the
supply/demand situation has improved significantly (emphasis mine):

Joe J. O'Dea - Vertical Research Partners LLC
That's helpful. Thanks. And then just one more on
with what we've seen at some of the Rouse supply-
demand data recently, I think on the demand side,
some of that's explained with heavy equipment
trends and some weather effects. But when you
think about it on the supply side, outside of your
own decisions, is your general sense that the
industry is behaving rationally with the supply
growth that we continue to see. And then related
to that, do you think that we have now fully
moved beyond some of the equipment
redeployment related to oil?
Michael J. Kneeland - President, Chief Executive
Officer & Director
So there are several answers there. So in my
estimation, I think we have moved beyond the oil
and I think that has been fully absorbed...

...Number two, I think by order of magnitude when
you ask is everyone playing safe or playing right, I
think that one of the things that I took away from
the Rouse report, I believe, it was in May, the
report actually saw where the supply was below
the demand. The demand was higher. So that
would tell me that their people are being good
stewards in understanding of the industry
trends."
Source: United Rentals 2Q '16 Earnings Call
Transcript
HERC Holdings: Non-Economic Selling And Temporary Oversupply Sets Up… Page 10 of 19

Source: United Rentals 2Q '16 Earnings Call Presentation
As seen above, United also provides an exceedingly helpful chart suggesting
supply is beginning to match demand, a stark contrast to 2015 where supply
growth largely outpaced demand growth.
Collectively, the data and commentary provided by HERC, United Rentals,
Rouse, and Caterpillar serves as strong indications the supply situation, at the
very least, is not getting worse. While I am not concluding that pricing has
bottomed, it appears tremendously difficult to make a strong argument
for pricing continuing to deteriorate significantly going forward; the
opposite scenario seems far more likely, something that is a huge positive for
HERC over the next few quarters.

4. Market is pricing in 'worst-case' scenario, despite continued strength
excl. oil & gas
2008-Style Recession Scenario Appears Priced In: With net debt of ~$2.1b,
the equity trading at ~$930m, and the Company guiding $520m-$560m in
2016 EBITDA, shares of HERC trade at ~5.6x EV/2016E EBITDA at the mid-
point of guidance. Such a multiple implies unsustainable fundamentals
stemming from a cyclical peak. Yet, HERC still seems to be trading at a cheap
valuation even if we assumed a 2008-style recession is around the corner.
Throughout 2007-2010, sales at HERC dropped ~40% while EBITDA halved
from peak to trough, as seen below. Applying this scenario would result in HRI
trading at an undemanding valuation of ~11.2x trough EV/EBITDA (~$3.04b in
EV / $270m in EBITDA).

Source: HERC Investor Presentation
No Indication 2008-Style Recession Is Around The Corner: Excluding
upstream oil & gas revenue, HERC is performing very well. In 2Q '16, rental
revenue grew ~8% in non-upstream oil & gas markets, which is a continuation
of trends in prior quarters, as seen below.
Although sequential ex-oil & gas rental revenue trends appear to be
worsening, this is likely due to the oversupply situation I discussed earlier,
which should iron itself out over the next few quarters as the equipment rental
industry continues to be disciplined about fleet additions.
Macro indicators also point to healthy growth ex-oil & gas going forward, as
seen below.

Source: HERC 2Q '16 Earnings Call Presentation
As a result, it appears difficult to make a solid argument as to why the near
future will be as bleak as HERC's current valuation implies. Again, the
opposite appears far more likely.
5. Valuation & Asymmetry
Fair Value Of ~$60 Representing ~80% Upside: Given HERC operates in a
highly cyclical industry, it is hard to argue for high (low-to-mid teens)
EV/EBITDA valuation multiples at potentially mid-cycle earnings. Fortunately
for longs, conservative assumptions still imply material upside from current
levels. In my view, a 7x EV/2016E EBITDA on a highly cyclical business such

as HERC is quite reasonable. At the mid-point of 2016 EBITDA guidance, this
implies ~$3.78b in EV. Subtracting ~$2.1b in net debt and dividing the result
by ~28m shares outstanding gets me to a ~$60 stock price.
Note the Company is likely under-earning significantly and therefore 2016E
EBITDA does not fully represent HERC's potential. HERC is currently
generating ~33% adj. EBITDA margins as compared to ~48% at United
Rentals. While some of the difference can be explained by scale (United
Rentals has ~3x the market share of HERC) and different add-backs, HERC's
management believes the margin differential can be reduced significantly.
To achieve this, management is focusing on consolidating its supplier base;
the number of suppliers has been reduced by ~40% from 2Q '15 to 1Q '16. In
addition, the Company is also decreasing its Fleet Unavailable for Rent
("FUR") to open up additional rental opportunities. FUR has declined from
~18.6% in 2013 to ~12.6% in 2Q '16. The Company is targeting 10% FUR;
each 100bp improvement results in an incremental $35m in equipment
available for rent. Moreover, HERC is also looking to expand its products and
services to higher-margin offerings such as ProSolutions and ProContractor
Tools.
More information on these initiatives can be seen from the Company's
presentations. Needless to say, excluding the benefits from these potentially
large margin improvements incorporates a significant margin of safety in my
estimates. Notably, these margin improvements do not appear to be priced
into the stock at the current valuation.
Significant Downside Protection Sets Up Asymmetric Risk/Reward: With
tangible assets at HERC currently valued near the Company's EV and a low
current valuation of ~5.6x EV/2016E EBITDA, there appears to be material
protection on the downside for longs.

As seen above, the value of the Company's tangible assets is around ~$2.9b
(fleet OLV is appraised by Rouse, a third-party) while EV is roughly ~$3b.
Note the numbers are as of 1Q '16; the 2Q '16 numbers are slightly higher.
Moreover, the Company's current valuation appears to have already priced in
a 2008-style recession scenario as discussed, suggesting further downside is

likely limited. Couple the fact tangible assets nearly covers the Company's
current EV with significant upside potential, shares of HERC represent a
highly asymmetric long opportunity.
6. Catalysts
Pricing Trends Improve Over The Next Few Quarters: As the oversupply
situation corrects, the Company should be able to increase both pricing and
volume. This should improve operating results going forward.
Deleveraging Of The Balance Sheet: Some investors are worried about the
Company's leverage. However, HERC is still significantly free cash flow
positive. This cash flow can be used to be pay down debt. In addition,
management is confident EBITDA margins can be improved considerably
going forward, as discussed. Increases in EBITDA margins would reduce the
net debt/EBITDA ratio. If we want to be draconian, in a hypothetical orderly
liquidation, tangible assets would more than cover outstanding debt, and
would still leave sufficient equity for longs to recoup their investment at the
current share price, as discussed.
Oil & Gas Markets Improve Significantly: Admittedly, this is more of a macro
call. Oil prices have recovered significantly from their lows and appear to be
stabilizing. This could lead to increased confidence by oil & gas industry
participants to increase CapEx, a scenario which bodes well for HERC. That
said, I wouldn't base a long position in HERC solely on this.
7. Risks
Demand From Non-Upstream Oil & Gas Markets Decline: While certainly a
possibility, current macro indicators do not suggest any near-term decline, as
discussed. An easy push-back to this is that macro indicators are not always
accurate and may change for the worse in short order. However, even if a
2008-style recession scenario materializes and HERC's revenue and EBITDA
fall ~40% and ~50% respectively, similar to what occurred over the 2007-2010
period, the Company's valuation would arguably still be cheap on trough
EBITDA.

Equipment Rental Players Significantly Increases CapEx: A large increase in
fleet additions would worsen the current oversupply situation and likely result
in further drops in pricing and likely some degree of volume pressure, which
would lead to outsized EBITDA declines at HERC. This risk is mitigated by the
fact the industry, despite being highly fragmented, appears to be very rational
in reducing fleet additions, as discussed. Anecdotally, it appears many of the
smaller equipment rental firms are family-owned, which could explain the high
degree of rationality.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours.
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: Disclaimer: The author's reports contain factual
statements and opinions. He derives factual statements from sources which
he believes are accurate, but neither they nor the author represent that the
facts presented are accurate or complete. Opinions are those of the the
author and are subject to change without notice. His reports are for
informational purposes only and do not offer securities or solicit the offer of
securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever
for any direct or consequential loss or damage arising from any use of his
reports or their content. Lester advises readers to conduct their own due
diligence before investing in any companies covered by him. He does not
know of each individual's investment objectives, risk appetite, and time
horizon. His reports do not constitute as investment advice and are meant for
general public consumption. Past performance is not indicative of future
performance.

HERC Holdings Non-Economic Selling And Temporary Oversupply Sets Up 80% Upside

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