United Rentals stock: limited upside in the short term (NYSE: URI)

Untied rentals' (NYSE:URI) the stock has continued to outperform the broader stock market over the past 12 months. The stock is up 63% during that time, more than twice the return of the broader stock index.

As good as this looks to shareholders, the returns achieved this time around are much less sustainable than those of previous years. Although URI remains one of the best-positioned companies in the highly attractive construction equipment rental sector, investors should be cautious as the stock reached all-time highs a few months ago.

For starters, recent returns have been primarily driven by multiple expansion. The stock's sales multiple, for example, has reached all-time highs in recent months, and while it has cooled somewhat since March, it remains near record highs.

But the most important thing is the fact that the stock has skyrocketed since early November. This coincided with the release of third quarter results in late October, but a more important driver of returns has been the decline in the term premium since the start of October. US Treasury Quarterly Announcement in November. The latter phenomenon has had profound implications for growth stocks and pushed valuations to unsustainable levels.

With all of this in mind, shareholders should be aware of the downside risks for URI, even if the company continues to do well.

Slowing Free Cash Flow

It's no secret that United Rentals has benefited from a number of ongoing trends. From the strong US economy (compared to other developed markets) and the relocation of a number of strategic industries, to increased infrastructure spending and, last but not least, consolidation within the manufacturing sector. equipment rental.

As a result, URI's free cash flow has skyrocketed over the past decade, from $574 million in 2014 to $2,314 million in fiscal 2023. fiscal 2020 (when the company cut a record amount of capital spending to preserve cash). ), over the years, free cash flow growth has also been fairly consistent.

However, after experiencing several years of strong growth, free cash flow for 2024 is now expected to be significantly lower than in 2023.

The lower figure also reflects recently upgraded guidance for the full year, with the upper end of management's estimate still expected to be lower than the 2023 figure.

On the fleet side, we increased our gross and net capital expenditure guidance from $100 million to $3.5 billion to $3.8 billion and from $2 billion to $2.3 billion. dollars, respectively. And finally, we have raised our free cash flow forecast of $50 million to reach a range of $2.05 to $2.25 billion after growth financing.

Source: United Rentals First Quarter 2024 Results Transcript

Annual capital spending is also expected to be lower in 2024, as the total amount spent on rental equipment purchases in fiscal 2023 was a record $3.7 billion, which which is higher than the average of current forecasts.

Given the rapid growth in the size of URIs in recent years, one would expect that investments would continue to increase each year, but this is no longer the case. More importantly, the share of rental equipment purchase expenses in the annual depreciation expense will decrease for the second year in a row. The current ratio of 145% is already below the average of 158% for the period 2011-2023.

Advantages of bundling

Although URI will continue to reap the rewards of its industry leadership position in the years to come, it appears the market is far too optimistic about the company's more immediate prospects.

As we saw above, URI is trading near an all-time high at a time when its revenue and free cash flow growth is likely slowing.

After several years of strong organic growth and several significant acquisitions, United Rentals increased its market share from 12% in 2018 to 15% in 2023.

The same was true for the No. 2 and No. 3 players in the United States and the three largest companies now hold a combined market share of 30%, compared to just 23% in 2018. Although this may not seem like much . Firstly, this is significant progress for a very fragmented industry.

URI shareholders should be aware, however, that this rapid growth in the market share of the major players is likely to result in the following developments over the coming years:

• Big players are likely to compromise more on future acquisitions as the low-hanging fruit has been picked.

URI's latest acquisition appears to confirm this as the target company, Yak Access, serves an adjacent product segment and is a way for United Rentals to diversify its operations.

• It would be increasingly difficult to further increase its market share through acquisitions, without moving into residential construction, an area less attractive to large players like URI.

Based on all of this, it's concerning that United Rentals' gross margin is already at an all-time high. This suggests that at its current size, management may be forced to expand into areas of the equipment rental market where its pricing power is weaker.

Historically, this has been offset by significant economies of scale, which have reduced the share of fixed costs in sales from 15.6% in 2011 to 10.7% in 2023.

However, going forward, it is unlikely that this trendline will continue to decline at such rates. Especially if the company needs to expand into adjacent markets where economies of scale would be more difficult to achieve. In combination with gross margin pressures, such a development could have negative implications on United Rentals' profitability and valuation multiples.

Takeaways for investors

United Rentals' strategy has made the stock a huge hit with investors in recent years. Extrapolating recent returns into the future could be a big mistake, however, as stocks trade at record multiples at a time when growth and margins are under pressure. United Rentals will continue to enjoy the benefits of its industry leadership, but shareholder returns are expected to moderate in the coming years.