United Rentals Stock: Great Pick For High-Inflation Environment

I’ve written a pair of articles outlining why I think United Rentals (NYSE:URI) is a great long-term investment; in this article I want to focus on why I think the company will be successful in a high-inflation environment. I’m on the record as being skeptical that inflation will be a problem in the long term, but in the current economic climate it is an important factor to consider. URI is well-insulated from the problems associated with high inflation and stands to benefit from the positive aspects because:

URI’s Services Provide Value to Customers

The ability to raise prices without losing significant sales volume is critical to surviving high inflation. URI can do this because its services are mostly non-discretionary and provide a clear value proposition to their customers. The company’s customer base is evenly split between industrial and commercial construction and notably includes sectors such as energy, healthcare, utilities, railroads, and other infrastructure. Many of the projects are directly or indirectly funded by government spending or by companies in sectors that can remain active during inflationary periods; URI’s customers are not dependent on the whims of the retail consumer. I expect to see increased demand for URI’s services as the $550b infrastructure bill passed by Congress begins to turn into actual projects later this year. These are non-discretionary projects that give URI’s customers negotiating leverage, which in turn allows URI to more easily pass along input cost increases.

Most importantly, URI provides great value to its customers. No one likes paying higher prices, but customers are more willing to do so if your services offer them a clear value proposition. In a period of rising prices, buying equipment becomes more expensive and rising interest rates make new debt to buy that equipment more costly; 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 on offer, and a better customer service network than its competitors. In a high-inflation environment it makes the most sense for customers to rent equipment, and it makes the most sense to rent from URI rather than from their smaller competitors.

URI posted strong Q3 and Q4 results in 2021 when compared to both 2019 and 2020. Inflation was highest in these quarters, and URI’s revenue, operating income, net income, and operating cash flow were all up significantly over 2020 (which was impacted by pandemic lockdowns) and modestly over 2019. URI was able to profitably grow their business in a high-inflation environment and I expect them to continue to do so in the future.

URI Has Control Over its Input Costs

It is important to be able to limit or absorb rising input costs during periods of high inflation. URI isn’t immune to higher input costs, but it has flexibility in tackling the problem. The company already owns a large inventory of equipment in reasonably good condition. URI has over 780k items in its fleet, with an average equipment age of 54 months. 77% of their inventory is within the manufacturer’s recommended maintenance schedule, which is on par with historical levels. The company invested nearly $3b to increase the size and quality of their fleet in 2021. This was more than triple the amount spent in 2020 and 50% more than in 2019. URI’s inventory is in good shape so there is less need to buy new equipment when prices are high. URI has guided another $2b in equipment purchases for 2022, but this number can be flexible if equipment prices get too high in the short term.

URI will need to manage rising labor and transportation costs. The company has over 20k employees and must balance and transport their inventory across 1,300 rental locations. So far URI has been able to handle these increased costs without hurting their profitability or cash flow. In fact, URI expanded aggressively in this environment; the company added 200 rental locations and over 2,000 employees in 2021.

URI’s Balance Sheet Benefits from Inflation

URI’s balance sheet will benefit in two ways if inflation stays high. First, URI owns significant tangible assets via their inventory of rental equipment. As prices rise, the value of the equipment goes up proportionally. The increase is “hidden,” in that these assets continue to be depreciated following normal schedules, but management has touted rising margins on their used equipment sales. URI posted net gains of $431mm from used equipment sales in 2021.

Second, URI carries significant debt on its balance sheet. The debt in aggregate is long-dated and carries a blended interest rate below 5%; the total debt liability is just under $10b. Rising interest rates usually accompany rising inflation, so long-term debt at low interest rates becomes more valuable (or at least less burdensome to repay). The debt repayment schedule is flexible and spread out over the next ten years; no senior notes are due to be redeemed until 2027 and the company’s $3.75b ABL facility doesn’t expire until 2024. In addition, URI generates significant cash flow from operations ($3.6b in 2021) and has had meaningful free cash flow every year since 2015. Cash flow gives URI flexibility to borrow less if interest rates become unacceptably 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 Valuation

In my previous article on URI I went through a variety of valuation scenarios for the company and made the case that URI will be a multi-bagger over the next five years. I believe the market is valuing URI as an “average” business when it is actually an exceptional business. The company generates ample free cash flow, can reinvest that cash at a high rate of return, and has management that treats shareholders as partners. URI’s free cash flow was $1.5b in 2021 and is projected to be as high as $1.7b in 2022, meaning the company is currently trading at ~15x forward free cash flow. URI’s return on invested capital is consistently above 10% and the company is planning $1b in share buybacks in the year ahead. Modeling out 10% annual FCF growth (approx. their ROIC), 5% annual share buybacks, and a more appropriate P/FCF ratio of 20 results in an expected share price of ~$720 in 5 years. This translates to a 16% compound annual return for shareholders.

Risks and Concerns

URI can thrive in a high-inflation environment, but they are not completely immune from the risks of a prolonged period of inflation (3-5 years). The company has tens of thousands of employees, so they are particularly vulnerable to sustained wage inflation. 75% of their workforce is hourly and these wages are more sensitive to overall labor market trends. URI needs to continue to buy new equipment and manage lines of credit with lenders. URI can easily manage these needs in the short term, but it will get harder to buy new equipment and finance new debt in the long term if inflation remains elevated. Finally, while I expect the overall volume of construction and infrastructure work in the United States to grow as government spending ramps up, some of URI’s commercial construction customers might see diminished demand and delayed project timelines if inflation stays high.

Conclusion

URI will continue to thrive in a high-inflation environment. URI has control over its input costs, can raise prices while still adding value to customers, and has a robust balance sheet that will only get stronger if inflation remains high. URI is a great pick in a high-inflation environment, but it is also a great pick if inflation slows. The company generates ample free cash flow and has a long runway for reinvestment to grow the business. URI is one of my top five holdings and I plan to hold the company for the long term.