With more than 200 rental companies acquired in 1998, it was hard enough just keeping up with the deals - let alone analyzing what they meant for the consolidators, for the sellers and for the industry as a whole.
But what did the continued flurry of deals mean? Can the rental industry continue its steady double-digit annual growth? How will consolidation be affected if the economy slows? What impact does Wall Street have on the actions of consolidators?
RER recently asked several high-level rental executives, a securities analyst, an M&A specialist and an industry consultant to ponder those and other questions at our virtual roundtable. In the electronic-roundtable forum, respondents replied to questions via e-mail and fax without the benefit of knowing what other participants said.
BRUCE DRESSEL: There is great potential for continued expansion of the rental market in all sectors. The rental market has and will continue to become much more competitive in regard to price and level of service. This will only help speed our customers' conversion from ownership to the rental option.
SHAUN FLANAGAN: There is growth in the rental market - the big guys' shouting this on Wall Street has helped it grow; because if you hear it and believe it, it sometimes happens. More and more customers are outsourcing work than they used to do. I see more industrial market growth, followed by the contractor end.
WAYLAND HICKS: We believe the rental market will continue to expand at a rapid pace primarily because of the compelling economic advantages of renting equipment instead of purchasing it. This powerful, fundamental trend of increasing rentals will continue.
This is particularly true in the contractor and industrial markets, where currently only a very small percentage of the equipment being used today is rented. Until recently, there have not been large, national firms that could provide these customers a diverse fleet of reliable equipment. As these strong national and regional firms evolve, we anticipate that large and small commercial, industrial, governmental and educational customers will increasingly recognize the benefits of renting.
DAN KAPLAN: On the contractor side, I see good potential for growth, perhaps 8 to 10 percent per year. Contractors will continue to rent versus own; today, only 15 percent of contractors' equipment is actually rented. There is excellent potential in commercial firms, such as warehouses, where they traditionally own their forklift fleets.
I see a more limited potential in the industrial area - perhaps 5 percent growth per year. With all this talk about the untapped industrial potential, one must recognize industrial firms have historically rented their equipment from thousands of local rental companies. What we are about to witness is consolidators taking over these national accounts at the expense of the thousands of local firms.
I see very little growth potential from homeowners. There is, however, opportunity if a rental company could provide a consistent quality rental offering across the country.
KEVIN RODGERS: One of the difficulties in forecasting future growth is trying to get a handle on just how much equipment is presently rented versus owned on jobs and in factories.
The estimate most often cited is about 15 percent of the equipment on construction jobs and some significantly lesser figure for industrial applications. Assuming that's the case, there should be double-digit growth for several more years. The rate of growth shouldn't really slow down significantly until we at least begin approaching a 50 percent market penetration.
DAN PERLIN: With no more than 20 percent of the equipment utilized in the construction industry rented, there appears to be an enormous opportunity. The industrial market offers, without a doubt, the best potential for outsourcing. That market represents the greatest opportunity, followed by commercial construction and then the homeowner market.
JOHN MOLNER: One of the most attractive aspects of the rental equipment market is the enormous potential for future expansion. Industry sources indicate that rental equipment still satisfies only 15 percent or so of overall construction industry equipment demands. By contrast, in Europe rentals comprise up to 75 percent of total equipment demands. Clearly, growth in the rental industry will be generated from an increasing percentage of equipment needs being outsourced. This trend leads us to believe that - if the economy holds - the industry should be able to grow at 20 percent per annum for some time.
To put this growth into perspective, if equipment outsourcing grows 1 percent, from, say, 15 percent to 16 percent, about $1.3 billion in revenue is added for rental equipment companies. So, clearly, there is quite a bit of upside potential.
In our view, the contractor and industrial sectors have attracted the most attention, primarily because of the size and nature of these markets. In most industries, customer preferences drive consolidation, and equipment rental is no exception. Industrial concerns, general contractors, subcontractors and municipal customers want to deal with a reduced number of suppliers. They want to take costs out of the total supply chain and are seeking a broader range of value-added services from a limited number of vendors. Customers with a regional or national presence prefer suppliers with similar service capabilities.
The homeowner market has not, to date, been as attractive to the consolidators. The primary drivers, however, for all sectors will continue to be favorable economic growth, low interest rates, and ongoing migration from equipment ownership to more cost-efficient rental contracts.
RER: How much internal growth can be reasonably expected from the consolidating companies?
FLANAGAN: Assuming the consolidators stop acquisitions and focus on internal growth, they can capture a huge market share. What will stop them is the people issue, and they will never get enough to become the only players in the market. There will always be this people issue. They are losing people now, and it's probable that some of the consolidators' competition in the next few years will come from their old people.
HICKS: We expect that increased demand for rentals, combined with new investment in fleet, can support same-store increases of 15 to 20 percent over the next several years, with acquisitions and cold-starts being additional growth opportunities.
KAPLAN: There is significant internal growth potential once the consolidators integrate their fleets from their many acquisitions. This is beginning to happen today. One would be surprised how much revenue growth potential is possible from a well-managed, highly utilized fleet.
MOLNER: During 1998, the equipment consolidators as a group achieved very favorable internal or same-store growth. Most of the reporting companies have internal rental growth rates of 20 percent or higher. Investors are interested in this trend because it highlights the inherent ability of a business to grow without "paying for growth" through possibly expensive acquisitions.
Of course, a great deal of the high internal growth rate is directly tied to substantial increases in fleet expenditures. Consolidators are investing millions of dollars into new equipment purchases in markets that were previously controlled by more capital-constrained private company owners.
In the near term, provided the U.S. economy remains strong, internal growth should continue. However, to enjoy 20 percent-plus growth in the future, we believe these public consolidators will need to enter new, under-capitalized markets through strategic acquisitions as well as benefit from the ongoing rental trends. As such, a disciplined acquisition strategy will remain a key element for any of the surviving consolidators going forward.
PERLIN: We believe the internal growth rate numbers will be more like 10 to 15 percent going forward.
RODGERS: With lack of access to capital being the biggest obstacle to internal growth for most rental companies, I'd expect to see the public companies growing internally at a rate equal to about 150 percent of the overall rental market. If the market in general is growing at 10 percent, then I'd expect to see the public companies, with their greater access to capital, growing at about 15 percent.
DRESSEL: Internal growth for the consolidators will depend on their ability to integrate the businesses they have purchased. If they fail to properly integrate these businesses, continued internal growth will be difficult.
RER: With many of the so-called platform rental companies purchased, will distributors become more sought-after acquisition targets?
HICKS: We don't think so. Our 25-member acquisition team continues to see a very strong pipeline of quality rental companies that are potential acquisitions. Because of the strong industry growth rate, new platforms are being created each year, and with such a fragmented industry and such a limited number of potential acquirers, there will likely be many, many more large and small rental companies to acquire in the foreseeable future.
KAPLAN: I see the distributors buying small rental companies and adding rental operations to their dealership sales locations, just as one major manufacturer is doing today. It is a matter of survival for the distributor.
MOLNER: We don't expect equipment dealers to catch the eye of the consolidators any time soon. The fact of the matter is that distribution and rental are different businesses with very different operating and financial characteristics.
The operating differences are well understood. Dealers are focused on parts sales and follow-up maintenance services. From a financial perspective, dealers typically have gross margins under 20 percent. In contrast, even small rental firms can enjoy gross margins of 70 percent and EBITDA margins of 45 percent or higher. Clearly, there is a very large profit gap between rental and sales, or "rent-to-own." Accordingly, we're doubtful that pure distribution companies will become sought-after targets.
On the other hand, there are a number of regional distributors with substantial recurring rental revenues. These hybrid dealers/rental firms are attractive to the consolidators.
PERLIN: The days of simply cherry-picking good acquisitions are over. However, we believe there are still some good acquisition candidates left in the dedicated rental business.
RODGERS: They may be promoting the same products, but the typical equipment distributor is in a very different business as compared to the typical rental company (defined as a company deriving at least 60 percent of its total revenue from rental). If there wasn't an acquisition opportunity that made sense, we'd be more likely to do a start-up than acquire an equipment distributor that earned less than 50 percent of its revenues from rentals.
DRESSEL: The culture of a distributor and a rental company are so fundamentally different. By definition, rentals and sales are two completely different approaches to equipment distribution. I do believe that more and more distributors will offer the rental option, which will once again help speed the conversion from ownership to rental.
FLANAGAN: Distributors are the best kept secret in the business. If you have great product support, you can always throw money at rental equipment and sales reps. That is the easier part to make happen.
RER: What's your opinion of where rates are headed in both the short and long term?
KAPLAN: I see rates headed down for two years or so. Then there will be ongoing rate increases as the consolidation process matures and a few large consolidators with market share in excess of 30 percent drive rental rates up.
PERLIN: In the short term, rental rates will remain flat with isolated areas of rising rates. Long term, as the national rental companies continue to grow, we believe that rental rates will slowly rise.
RODGERS: While individual markets can vary significantly, our rates companywide - as measured by taking the annual rental revenue over the historical cost of the fleet - have been fairly consistent over the past two years. Over the long term, we expect rates, but not necessarily returns, to trend downward.
We are constantly striving to lower the costs of our rental equipment: by buying better, but, just as importantly, by improving maintenance procedures to get more life out of the equipment; by rebuilding rather than replacing equipment with long, useful lives and lowering our cost of replacement parts. For example, this year we will rebuild equipment that would represent approximately $40 million at current dealer net prices. With a lower capital investment, we can continue to generate outstanding returns despite lower rental rates.
FLANAGAN: Rates will go up. Wall Street will demand profits, and rates are the best way to get them. We do see them inching up now and predict they will stay up, but not to where they were in 1989.
DRESSEL: Will you please let me know where these markets with increasing rental rates are? We are all faced with one fact: Rates will continue to come down. There may be a market here or there that might see short periods of rate increases, but, long term, rates will continue to come down.
We are at the beginning of what will be a very competitive marketplace. But the bright side to it is that this trend will speed the conversion from ownership to the rental option.
HICKS: We very closely monitor rental rates and utilization in all of our 400-plus branch locations. Pricing in the aggregate is stable although some areas are experiencing increases and others decreases.
As the industry evolves, we anticipate that the larger companies will begin to offer more value with each rental, and rates should rise. Customers understand that offering a broader fleet selection; having deeply ingrained safety and training procedures that will make them more profitable and more efficient; and having equipment that is newer, better-maintained and less likely to break down - these are all valuable attributes that should appropriately be reflected in rental rates.
One of the big advantages of having locations in 38 states, Canada and Mexico is that we can expand the fleet in those areas that have the best environment for rental rates, and be less aggressive in places with less favorable trends.
RER: There have been some reports of layoffs and branch consolidations after acquisitions. Can you describe what efficiencies have been realized and how levels of service are maintained?
MOLNER: One point of agreement between independent company owners and the leaders of the public consolidators is that experienced labor - general managers, equipment mechanics and salespeople - is a scarce resource in this industry. Attracting and retaining experienced people is certainly among the most significant challenges for any of these entities. So we need to be careful when we speak about layoffs in the consolidation.
Layoffs are occurring in a number of redundant functions such as purchasing, accounting, A/R billing, payroll and credit. In some cases, a CEO or CFO of a private company may decide, after selling to one of the consolidators, that they are not comfortable with a new role as a branch manager. These individuals, after a transition period, may decide to leave. More often, however, the consolidators rely on these entrepreneurs, going forward to manage the acquired locations.
PERLIN:In the case of a branch that was operating as an independent, almost all back-office operations will be consolidated to the headquarters. Economies of scale are a key to increasing operating efficiencies at individual locations. Some benefits are: 1) purchasing leverage with equipment suppliers; 2) lower cost of capital; 3) MIS integration; and 4) access to capital for fleet expansion.
RODGERS: To date, we have completed 19 acquisitions and haven't laid off a single person. In most cases, we've added people following the sale. Over this same period, we have achieved the highest operating margins of any of the public rental companies.
Our strategy is based on improving profitability and expanding margins primarily through top line or revenue growth coupled with a lower capital cost of the rental fleet. Everybody essentially has access to the same equipment - the difference is the people. As a consolidator, there is nothing any more important than buying the right companies in the first place. We focus on companies that are successful and have a very strong management team and employee group in place. To generate revenue growth significantly above the industry average, you better have great people. The last thing we are interested in is laying off employees at the companies we have acquired.
DRESSEL: Because we have not been involved in acquisitions anywhere near as much as others, I am not sure exactly how to answer. I can say that, over the last 24 months, Sunbelt has opened 31 greenfield locations and employs an additional 345 people.
FLANAGAN: From the outside looking in, the layoffs have been owners or high-level managers that they needed to get rid of. Even if they have to pay them for a year or two, they had too many chiefs. I don't know if the efficiencies have been realized yet, or if they will. The service has declined, mostly from a personal standpoint [i.e., interacting with the customer]. The combination of eventual efficiencies and rate increases will be the key to the big guys' making the return.
HICKS: We've completed 87 acquisitions since United Rentals was founded. We often realize significant savings by combining some functions where there are several branch locations in proximity. For example, accounts receivable, payables, purchasing and major maintenance usually benefit from consolidation by delivering better services at lower costs.
In some cases, it makes sense to combine a smaller location that may have a cramped rental yard with a larger location that has room to expand, provided that customers from both locations can still be effectively served. We also see instances where a company we acquire is simply overstaffed.
RER: The stocks of several public rental companies have traded below their initial public offering prices for significant periods of time. Is Wall Street making a statement about the industry?
PERLIN: Wall Street is still trying to understand the industry. Keep in mind that, at the time of the NationsRent, Neff and National Equipment Services IPOs, the capital markets were essentially closing and concerns of a recession were looming.
RODGERS: Wall Street is still trying to figure out and gain a better understanding of the industry. There's not a lot of history to rely on since four of the five pure public equipment rental companies all went public over the last year or so, and the oldest, RSC, goes back to only September 1996.
If the rental companies as a group continue to outperform analysts' expectations, Wall Street will begin to take more notice and the stock prices should reflect that in a very positive way.
DRESSEL: Because not all publicly traded rental companies are trading below their IPO price, investors are making comments about individual companies, not the industry as a whole. Investors in the rental industry are looking for operating results - in other words, profits. If you do not show positive results, lower trading prices are inevitable.
FLANAGAN: One week, United Rentals' [Brad Jacobs] states that consolidators are a dirty word on Wall Street. The next week, the stocks of consolidators rise. That shows that Wall Street is too fickle to make a lasting statement about a blue-collar industry.
HICKS: Stockholders in United Rentals have realized a gain of about 130 percent since our IPO in December 1997. So, from our point of view, both Wall Street and Main Street are making strong positive statements about United Rentals and the rental industry in general.
We think our stock performance reflects investors' confidence in the company's growth prospects, our deep and experienced management team, and our strong balance sheet.
KAPLAN: Wall Street is waiting to see the positive effects of consolidation, namely improved earnings. The consolidators have excellent management teams. Wall Street needs to give these management teams time to operate, and the earnings should be there along with higher share prices.
MOLNER: Wall Street is making less of a statement about the industry and more of a statement on individual companies.
Last year, Wall Street certainly soured on roll-ups in general and on some of the rental equipment consolidators in particular. Roll-ups are predicated on a consolidator's ability to make redundant acquisitions at favorable prices - using its own stock to at least partly finance the purchase - and subsequently benefit from advantages including purchasing scale, pricing and access to capital.
If you look at the individual companies, some are trading substantially above their IPO price of a year or so ago, while others are off. United's current stock price, for example, while only 60 percent of its 1998 high of $48 per share, is trading at more than twice its initial offer price. And Apollo Capital's willingness to invest $300 million at $25 per share is a great vote of confidence from a sophisticated institutional investor.
There is certainly some skepticism regarding some of the publicly traded rental stocks. To begin, Wall Street investors have difficulty differentiating among some of these relatively new issues. A few companies are also leveraged and, accordingly, may suffer in the event of a cyclical downturn. Furthermore, smaller public companies suffer from a lack of liquidity in their stocks.
RER: Do you believe that the equipment rental industry is recession-proof?
RODGERS: Overall, I'd say recession-resistant rather than recession-proof. With the relatively low level of market penetration by rental equipment, I'd expect to see the industry continue to grow, albeit at a single-digit rate, through the next recession, assuming it's no worse than what occurred in 1990-1991.
DRESSEL: It is recession-resistant. During a recession, there is a natural tendency of more users to look for rentals for their equipment needs. They look to take advantage of lower rental rates in order to preserve cash for things they cannot rent. Consolidation will also move to the next level in a downturn as more rental companies are bought and sold because of financial strains brought on by a recession-tightened market.
FLANAGAN: It is not recession-proof, but if you can find a business that is, call me. The one to suffer the most during a recession will be the manufacturer because demand for new equipment will really fall.
HICKS: We believe the rental industry will not perform as well in a recession as it does during a period of strong economic growth. While it is logical to think that equipment users would be even more inclined to rent rather than buy during a period of uncertainty, the overall amount of money spent on equipment in general clearly will be less when the country goes through a recession.
We are positioning United Rentals to perform whatever direction the economy goes in, including a recession. Most recessions develop regionally, and our national network of over 400 locations, tied together by a state-of-the-art management information system, gives us the ability to re-allocate fleet across all of North America, moving it from areas of low utilization to areas of high demand.
Most important, we have a very strong team of managers and other rental professionals who have accumulated over 10,000 years of combined industry experience and who know how to successfully manage the business in booms and busts.
KAPLAN: The rental industry has grown as an industry throughout the 1990s regardless of the economy. In the recession of 1990-1991, the rental industry grew by 5 percent. Nevertheless, the industry is subject to recession. The sizes of the rental fleets today are huge. Compound this by the fact that currently many dealers also have large rental fleets. In the past, dealers were essentially in the rent-to-sell business; today, dealers are in the rent-to-rent business with large fleets. Contrary to past experiences, in the next recession, I predict that supply will exceed demand.
MOLNER: The equipment rental industry is certainly vulnerable to a recession. Companies that are substantially leveraged would face a challenging scenario - depreciation and cash interest expense are two substantial fixed costs for most equipment companies that will continue as revenues decline.
Certainly, customer mix or geographic diversity can mitigate an equipment company's vulnerability in a downturn. But the consolidator stocks are trading on Wall Street's expectation of 20 percent growth or better. You can bet that if the economy turns, investors' expectations will be quickly revised downward and so will the current share prices of these companies.
