For Equipment Rental Players, Intelligent Capex Planning Can Mitigate The Effects Of Cyclical Demand

Demand in the European rental equipment sector is correlated to nonresidential construction and industrial manufacturing, which we consider as cyclical. In a downturn, capital expenditure (capex) and fleet investment flexibility is the main way for management to reduce pressure on cash flow generation. However, during growth periods, we estimate the need to invest a high percentage of sales to keep the average fleet age in a five-to-seven-year range. Companies' aims to diversify fleets with more hybrid assets will also play a part in capex levels.

From a credit metrics view, for these companies we focus on S&P Global Ratings-adjusted debt to EBITDA, free operating cash flow (FOCF) as a percentage of debt, and EBITDA margin. Given the flexibility the rental equipment companies have, in favorable market conditions we expect them to generate strong profits with the possibility of a weaker FOCF-to-debt ratio due to the capital spending required to support growth. However, during a downturn, we would expect to see positive FOCF since management would have decided to cut capex and would focus on maintenance spending together with equipment sales in order to reduce debt and offset the revenue reduction.

Despite The Pandemic, Our Rated Issuers Outperformed Their Own Forecasts, Reduced Their Capex, And Generated Positive FOCF

Like in many sectors, companies were dependent on government decisions at the height of the pandemic. In March 2020, most groups were forecasting a fall in revenue and profitability erosion. However, different countries in Europe employed varied lockdown policies, with differing effects. We observed that it was only the initial, most severe, lockdowns (for example, that in France) that significantly affected companies because of forced branch closures. At the end of 2020, rental equipment companies had outperformed their initial budget from March 2020.

The peer group demonstrated flexibility by reducing capex at the beginning of the pandemic (charts 1 and 2). Together with cost-cutting measures and good cost control, this allowed them to outperform their own forecasts from the beginning of the pandemic and generate positive FOCF, ending a two-year cycle of negative FOCF for Boels and Kiloutou (table 1) where prioritizing fleet investment was symptomatic of issuers investing heavily to chase rising volumes/demand. We forecast Loxam's FOCF will fall in 2022 as it reignites investment plans and increases capex, but that FOCF will remain positive. We expect Loxam and Kiloutou will remain acquisitive and use future cash flows to fund bolt-on acquisitions. Likewise, we forecast continued positive FOCF for Kiloutou in 2022. Boels' increased capex in 2021 will support both continued integration of Cramo and renewal of the fleet.

We believe all peers will maintain cost discipline in 2021 and benefit from cost-cutting efforts undertaken in 2020 as sales start to recover in all countries, thereby keeping adjusted EBITDA margins above 35% (chart 3).

Our forecasts are unchanged after mid-year 2021 results, as detailed in our latest Research Updates on Loxam, Kiloutou, and Boels (see "Related Research" section).

Table 1

Chart 1

Chart 2

Chart 3

After a period of consolidation and geographic expansion, the bigger players in the European equipment rental industry are now better prepared to deal with a challenging operating environment. These companies are familiar with extreme ebbs and flows in demand for their products and services and therefore focus intently on their cost base and fleet investment in order to adapt quickly if market conditions weaken. In S&P Global Ratings' view, the industry leaders have the flexibility during downturns to reduce capex and let their fleet age somewhat, in order to continue generating FOCF and protect credit metrics. Some larger players are also willing to halt dividends and share repurchases to preserve cash flows.

Large Scale Mergers And Acquisitions (M&A) And Changing Geographic Diversity Meant That The Top Players Were All Positioned Slightly Differently When COVID-19 Arrived In Europe

Each of our rated issuers was uniquely affected by the various actions that governments took to contain the virus and protect their economies, given the differences in the breadth of each issuer's operational footprint and the relative strength of balance sheets and liquidity positions. Our rating actions over the past 18 months reflected this (chart 4). We note that all of these issuers reacted swiftly to cut costs and scale back on fleet capex to preserve cash flows. The recovery thus far has been robust, with long-term trends supporting rising demand for rental equipment.

Chart 4

Consolidation Of The European Equipment Market (Prior To The Pandemic) Fundamentally Changed The Size, Scale, And Geographic Footprint Of The Top Players

The European leader, Loxam, acquired Ramirent (former No. 3), while Boels (former No. 6) acquired Cramo (former No. 4). Kiloutou (former No. 2) planned to operate several bolt-on acquisitions before the pandemic hit, but paused this strategy. We expect to see the group refocus on that strategy in the coming years in order to reduce the gap with Boels and Loxam. In three years, Loxam increased its size significantly and strengthened its footprint in the Nordics, mainly with the acquisition of Ramirent in 2018-2019 (charts 5 and 6). Loxam's strategy is to be the top player in each country where it is present. In March 2020, Boels acquired Cramo, doubling the group's size and taking it to the No. 2 position in the European rental equipment market. Kiloutou, which was a strong No. 2, behind Loxam, is now in third position. However, despite the consolidation and in a fragmented European market where even the top three-players hold only 16% of the total market, our rated issuers continue to exhibit notably different geographic footprints.

Chart 5

Chart 6

In A Fragmented European Market, We Continue To Differentiate The Top Three Players Mainly By Their Geographic Diversification

Loxam, Boels, and Kiloutou together represent about 16% of the European equipment rental market. We consider the rest of the market as highly fragmented. In terms of revenue generation these three players exhibit different geographic concentrations (chart 7). Following the acquisitions it has undertaken, Loxam now generates about 60% of its revenue internationally (versus 41% in 2018) while revenue generated in its home market of France represents about 40%. Boels, by acquiring Cramo, continued to diversify its geographic risk, with no country now accounting for more than 30% of revenue. This geographic spread enabled Loxam and Boels to weather the weak economic momentum and pandemic effects such as lockdowns or closure of branches in some European countries. In contrast, Kiloutou generates about 84% of revenue in France, and is therefore still highly dependent on the French economy. We saw a huge impact on revenue during the second quarter of 2020 when French branches had to be closed because of French government lockdown measures. The relative size, scale, and diversification of these peers is what drives us to assess Loxam's and Boels' business risk profiles as fair and Kiloutou's business risk profile as weak.

Chart 7

Companies Followed Different Treasury And Financing Strategies During The Pandemic

While Boels did not request support from the government, the French groups Loxam and Kiloutou contracted government loans during 2020. Loxam decided to amortize this loan (€260 million) whereas Kiloutou took the decision to repay the full amount (€125 million) directly in 2021. Meanwhile, the rental equipment companies followed the same strategy by anticipating any potential COVID 19 developments and any related liquidity needs and drew their available revolving credit facilities (RCF) in March and April 2020. They all repaid the full amount of RCF in the same year, highlighting the comfortable liquidity situation (all assessed as adequate) and the flexibility from which the groups benefit.

The market consolidation between 2019 and 2020, together with the measures taken by the companies to face the pandemic (capex reduction, cost discipline, loan support from the government) complicate a peer comparison of the adjusted debt-to-EBITDA ratio. The acquisition of Ramirent by Loxam in 2019 and Boels' structure change in 2020 after the Cramo acquisition prevent data comparison with 2019 and 2020. Nevertheless, we expect all three peers will reduce their leverage in 2021 (chart 8).

Chart 8

Environmental, Social, And Governance (ESG) Requirements And Demand For Hybrid-Fuel Products Continue To Gather Pace, But Issuers Are Adapting Quickly

The share of the hybrid fleet is increasing each year as clients such as governments and original equipment manufacturers aim to reduce their carbon impact. We expect this trend will increase in the coming years, which could give companies with the most advanced hybrid fleets a competitive advantage. All players have enough capex to fund this shift.

Furthermore, we view positively that ESG considerations are increasing in the sector. Kiloutou contracted its first sustainability linked loan in June 2021 including corporate social responsibility commitments. It takes into account one external rating and four internal indicators reflecting "the group's environmental and social ambitions in terms of its vehicle fleet, investments in equipment powered by alternative energy systems, representation of women in its management and promotion of employee share ownership" (Kiloutou Group press release dated June 15, 2021; kiloutou-group.com). Meanwhile, Loxam contracted a new five-year €345 million RCF in July 2021, with the possibility to include ESG-linked provisions within 12 months from signing.

The U.S. And European Rental Markets Have Strong Similarities, But Some Nuances

At $40 billion-$45 billion, the total addressable U.S. market is roughly twice the size of the European one (about €25 million-€27 million). For both markets, we expect a recovery in 2021, at a single-digit level, followed by stronger 2022 growth (chart 9).

Chart 9

In the U.S., we measure geographic diversity on a state-by-state basis, rather than by country. Both markets are very fragmented and highly competitive with a handful of much larger players dominating the top end. In the U.S., we estimate United Rentals is the leader, with about 13% market share (No.1 worldwide), followed by Ashtead with 10% (No.2 worldwide), and HERC with 3%. Most of the U.S. competitors run their businesses domestically, with only a small proportion of group revenue generated outside the U.S. (chart 7). In the U.S., the top 10 players hold about 30% of the market, while in Europe we estimate Loxam, Boels, and Kiloutou hold 8%, 5%, and 3% of the market, respectively. We note that in the U.S., the market is much more linked to residential and nonresidential construction and that, due to the availability of fundamental trackable data like housing starts, revenue visibility is better. Finally, we note that the U.S. market tends to experience far more extreme weather patterns and one off natural events that result in sudden spikes in demand for rental equipment, for example power, pumps, and heating, air conditioning and ventilation.

M&A will remain a feature in both markets. In the U.S. we expect United Rentals to continue to be a consolidator within its industry, as evidenced by its 2018 acquisitions of BlueLine and BakerCorp., which comes with some integration risk, and the acquisition in April 2021 of U.S.-based portable storage and mobile offices provider General Finance Corp. for $996 million. Over time, acquisitions and greenfield development could strengthen the competitive advantage of smaller peers like H&E Equipment Services over local competitors as the companies increase their presence in their existing geographic markets, allowing them to provide better value and more comprehensive services to customers. However, absent a transformational acquisition, we believe small peers will maintain modest market shares in the large and highly fragmented equipment rental industry.

Like in Europe, we see as positive the flexibility of U.S. peers to decrease their capex to protect their liquidity during downturns. Long-term demand trends for the equipment rental industry in North America are generally positive due to relatively lower rental penetration rates in the U.S. compared with other developed markets. The economics of renting continue to compare favorably with those of owning, since renting allows customers to adjust their fleet to match cyclical end market demand. The rental companies therefore have to deal with the cyclical risks linked to some end markets such as construction (United Rentals, Ashtead, HERC, H&E), nonresidential construction, and the oil and gas sector. United Rentals is exposed to highly cyclical end markets (such as construction, industrial, and infrastructure), which we believe can limit customer loyalty and pricing power, particularly during periods of stress. Still, we believe United Rental's scale and broad range of products and services gives it some ability to match cyclical end market demand, as well as enhance its purchasing power with suppliers. Ashtead is somewhat concentrated in nonresidential construction, partly moderated by the increasing presence in the specialty business, which helps mitigate the negative impact during downturns. As a partial offset, H&E's parts and service business lines provide a more stable revenue stream, which many of the company's peers do not have. This moderately decreases cyclicality relative to smaller peers. Finally, European peers typically carry higher leverage compared with the U.S. companies (charts 10 and 11). This can be explained partly by higher EBITDA margins, given higher volume transactions (bigger size market). Also many management teams have the view that the next sudden downturn is not that far away (equipment rental management teams tend to have long memories and an investor base that supports moderate leverage). On the path of market recovery, we expect the average leverage of our peers will decrease in 2021 and 2022, despite potential market consolidation.

Chart 10

Chart 11

Table 2

Related Research

• Research Update: Dutch Equipment Rental Group Boels Outlook Revised To Stable On Resilient Operating Performance Through COVID-19, May 18, 2021
• Research Update: French Rental Equipment Group Kiloutou Outlook Revised To Positive On Resilient Operating Performance Through COVID-19, May 18, 2021
• Research Update: Loxam SAS Upgraded To 'B+' From 'B' On Resilient Operating Performance Through The COVID-19 Pandemic; Outlook Positive, May 7, 2021
• Cost Discipline And Secular Tailwinds Will Help U.S. Equipment Rental Companies Clear A Path Through Difficult Terrain, March 19, 2021