U.S. equipment rental companies are well positioned to deal with the lingering effects of the pandemic.   Commercial construction generally operates with a lag to the general economy, so U.S. equipment rental companies are by no means out of the woods. That said, S&P Global Ratings believes the ability to manage the cost base and rapidly reduce capital expenditures (capex) to protect cash flows, as well as secular demand trends in the industry, position these companies well. We believe the impact of the 2020 recession on equipment rental companies will be less than that of the great recession of 2008-2009.

The bigger players in the equipment rental industry seem especially well-armed to deal with a turbulent macro landscape versus prior recessions. These companies are familiar with the extreme ebbs and flows in commercial construction, and their cash flows tend to be countercyclical. In our view, the industry leaders have the flexibility to reduce capex and let their fleet age somewhat, and also focus on cost containment through developing in-house capabilities rather than outsourcing, in order to generate free operating cash flow (FOCF). Some larger players are also able and willing to halt dividends and share repurchases to preserve cash flows.

We were already expecting 2020 to be a difficult year, even prior to COVID. The onset of the pandemic threw the industry a curveball. We revised the outlook on the highest rated equipment rental company, Ashtead Group PLC, to negative in March 2020 and then revised back to stable in December after the company exhibited stronger than expected operating performance through the peak of the pandemic. The other ratings, including United Rentals Inc. (URI), HERC Rentals Inc., and H&E Equipment Services Inc., were stable in early 2020 due to strong balance sheets for the ratings. On March 5, 2021, we upgraded United Rentals to 'BB+' and Herc to 'BB-' on their respective resilience during the pandemic. We do not expect 2019 levels of operating performance until 2022 at the earliest, but we believe the impact will not be nearly as severe as during the 2007-2009 period.

According to the American Rental Association, the overall North American Rental equipment industry declined 13% in 2020. The trade group is expecting a relatively flat 2021 before conditions begin to improve materially in 2022 and beyond. We believe the equipment rental companies we rate will be able to hold some of the cost savings they took in 2020 and that their specialty businesses and relationships with national accounts should drive reasonable leverage metrics.

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The COVID downturn appears to be less stressful to construction levels than that of the great recession.

Our macroeconomic forecast suggests there won't be a quick bounce back for equipment rental companies, but it doesn't paint a dire picture. Demand is heavily tied to the macroeconomic environment, particularly to nonresidential construction activity, which we forecast will grow just 0.2% in 2021 after falling by 10.3% during 2020. In 2009 and 2010, total nonresidential construction dropped by 22% (-8.2% and -14.7%, respectively) according to the Federal Reserve Bank of St. Louis. Furthermore, the American Rental Association is expecting 2021 to be similar to 2020 before rebounding to close to pre-pandemic levels by 2022. The Architectural Billings Index, which dropped to 29.5 in the first half of 2020, climbed steadily through October to 47.5, ending the year at 42.6 (where below 50 indicates a decline and above 50 indicates expansion). That said, we believe the commercial construction space is heavily bifurcated and that retail, office space, and hospitality will be significantly challenged while health care, warehouses, infrastructure, and data centers could benefit from recent secular trends.

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The ability to reduce costs will help these companies clear a path through the pandemic.   During the second quarter, which we expected to be the demand trough, URI and HERC's year-over-year (YoY) revenue declines were 15.3% and 22.5%, respectively. The declines were largely driven by lower utilization. However, by managing operating expenses, mostly outsourced costs and direct labor, both companies were able to increase EBITDA margin. These industry leaders also benefit from exposure to large national accounts, which are likely to be in a stronger financial position than local and regional clients. National accounts represent 44% and more than 50% of revenue for HERC and URI, respectively.

The secular trend in favor of equipment rental vs. owning will likely remain a tailwind.

S&P Global Ratings expects the prospects for the rental equipment industry to remain generally favorable over the next 12-24 months. We believe the modest economic expansion and underinvestment in infrastructure bode well for the industry. More importantly, we believe industry clients will seek to rent vs. own given lower capital investments and greater flexibility. Since the financial crisis, the U.S. equipment rental market has outgrown total U.S. construction spending by a wide margin, and that gap is only growing.

We also think that recession-driven capital and budget constraints provide an opportunity for equipment rental penetration in end markets that historically have been relatively lower penetrated, such as government and auto manufacturing. This should support stable or increasing overall penetration of the equipment rental industry in the U.S. and benefit all industry participants, particularly the largest players with greater resources and marketing capabilities.

Traditional credit metrics apply to equipment rental companies, but we expect them to behave differently than typical industrial companies.

As with other industrial sectors, in the equipment rental sector we focus on S&P Global Ratings-adjusted debt to EBITDA, free operating cash flow as a percentage of debt, and EBITDA margin. However, the nature of the equipment rental industry causes some of these measures to behave differently through a business cycle. We generally expect equipment rental companies to maintain a debt to EBITDA cushion during periods of strong economic activity because we believe leverage will increase 1x-3x during periods of stress. Equipment rental assets are primarily used in nonresidential construction and, to a lesser degree, in multifamily construction and industrial manufacturing. Demand is highly correlated to output in these cyclical sectors as a result.

Countercyclical cash flow generation only partially mitigates the procyclicality of credit metrics. Fleet management is one of the main ways equipment rental companies can mitigate cash flow pressure in a downturn. We generally expect equipment rental companies to require high amounts of capital investment as a percent of revenues to grow its fleet. We expect that, in favorable market conditions, equipment rental companies will typically generate strong profits but their FOCF to debt ratio can weaken because of the capital spending required to support growth. Conversely, we expect the companies would curtail capex, letting their fleet age somewhat, and sell equipment to reduce debt as an offset to lower earnings in cyclical downturns. In a downturn, we expect to see FOCF turn positive.

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Therefore, the ability to anticipate upcoming downturns and upturns is crucial given the cyclical nature of most end markets. As equipment companies typically put in orders for equipment purchasing at the end of the year for the following year (in bulk for the best price), the ability to correctly anticipate demand is critical. Equipment that is not used is associated with increased costs and lower utilization rates, while lack of equipment for the growing end-market means lost opportunities. We believe larger entities, such as URI, have better ability to match cyclical end market demand given their scale and broad range of products and services, as well as enhanced purchasing power with suppliers given larger order sizes, while smaller or niche equipment rental entities are more vulnerable to softness in demand.

Equipment rental companies generally must earn high EBITDA margins (30%-40% on average) because they fund high levels of gross maintenance capex, which we view as the level of new equipment purchases required to keep the fleet size and age constant (typically about 10%-20% of fleet net book value or 20%-30% of rental revenue). Net maintenance capex is generally lower, offset by sales of rental equipment.

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In addition to traditional credit and profitability metrics, we focus on industry-specific measures such as equipment utilization rates, rental rates, and rental equipment fleet age. These provide insights into the companies' ability to manage their fleets during recessions.

Industry-Specific Metrics

We also analyze the following operating metrics, and bigger isn't always better. For instance, an extremely high time utilization might indicate that the company is not investing properly in the fleet and customers might seek out competitors.

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How Long Did The Recovery Take In Prior Recessions?

Equipment rental companies can only defer capex for so long. Maintenance on older machines becomes expensive and less attractive to customers.

So how long did it take post-Great Recession to return to 2007 levels? For United Rentals, revenue declined in 2008, 2009, and 2010, and didn't reach 2007 levels until 2012, when they topped the $4 billion mark on the top line. H&E, on the other hand, grew slightly in sales from 2007-2008 (to $1.068 billion from $1.003 billion), but did not top the $1 billion mark in sales again until 2014!

The financial crisis did result in a couple of equipment rental company defaults, including Neff Rental Inc. and Ahern Rentals Inc. Prior to the Great Recession, Anthony Crane Rental Holdings L.P. made a distressed exchange and Maxim Crane Works L.P. defaulted in 2004. Some of these companies actually turned free cash flow positive heading into the periods prior to their defaults.