Ashtead and the power of compound interest

Compound interest is the main reason why Warren Buffett has become one of the world’s richest men. His investments have earned high returns for decades and his wealth has compounded like a snowball being rolled across the snow. 

This all sounds very straightforward, but it is not easy. When it comes to investing in shares you have to try to find outstanding businesses that can utilise the power of compound interest and own them for a long period of time. These businesses are by their very nature scarce, and identifying and buying them at the right price is the difficult bit of investing. 

Investors in quality businesses often seek out those making high returns on capital employed (ROCE) – where trading profits are a high percentage of the money invested in the business. This on its own is unlikely to deliver good long-term investment results.  

Without the ability and opportunity to reinvest money at high rates of return going forward, the company and its shares are unlikely to become more valuable. This reinvestment opportunity is arguably one of the biggest challenges facing the large established quality businesses that are owned by many investors. 

My view is that many so-called mega-cap shares could struggle to meet this challenge and investors should turn their attention to smaller companies – not necessarily small-cap shares – instead. 

For me, one of the best recent examples of a company becoming more valuable through the power of reinvestment and compound interest is equipment hire company Ashtead (AHT). Its journey may not be over yet. 

The business 

Ashtead makes its money by buying equipment and renting it out to construction companies, special events, facilities maintenance, local authorities and emergency services – things like aerial platforms, forklift trucks, tools, diggers, cranes, power generators, fencing, barriers and pumps. It makes most of its profits via its North American subsiduary (Sunbelt) but also has an established business in the UK (A-Plant). 

Ashtead typically owns the equipment for seven years before selling it. At the end of July 2018, its equipment fleet had a value of £7.3bn. 

The company has thrived over the past few years in the US. It has done so due to a recovering and growing US economy, taking market share from competitors and buying up businesses. Arguably the biggest driver of growth has been the shift to renting rather than owning assets amongst its customers – a trend that is expected to continue.  

As you can see from the chart below it has ploughed huge amounts of cash into its business in recent years in order to grow. 

This money has earned lots of profits in return. Profits have also increased at a much faster rate than the growth in money invested and are shown in a rising and very respectable ROCE. This largely explains why Ashtead’s share price has gone up so much.  

What might put people off Ashtead if they are just glancing at the business is that it has not produced huge amounts of free cash flow with this impressive rate of growth in its profits. Free cash flow last year was £411m, compared with post-tax profits of £632m. 

To grow profits, it needs to spend a lot of cash buying new additional equipment (growth capex). This consumes cash flow. If we just consider money spent on replacing existing assets then you can see Ashtead tends to throw off lots of underlying free cash flow and that this number has increased significantly during the past five years, hitting £1.1bn last year. 

This cash flow performance is flattered by Ashtead’s investment cycle at the moment. Low replacement capital expenditure (capex) reflects the low amount of new assets bought between 2010 and 2012 when the economy was weak or recovering. I would expect replacement capex to increase over the next few years. 

Ashtead History (£m)

Note that Ashtead completely stopped investing in additional equipment (growth capex) during the weak economic backdrop of 2009-11 and slashed replacement capex in 2009 to protect the company’s financial position. This shows the flexibility of the business model when times get tough. 

Sunbelt is the key driver of profits and value  

The bulk of Ashtead’s profits come from its US business, which trades under the name Sunbelt. It is the second-biggest equipment rental business in North America, with around 8 per cent of the market (NYS-listed United Rentals is the biggest with 12 per cent). Sunbelt has 686 stores in the US as well as 61 stores in Canada.  

Sunbelt (£m)

We can easily see the rapid growth in sales, profits, average fleet value and capex (spending on new equipment assets).  

Physical utilisation measures the amount of time a piece of rental equipment is out on hire. Ashtead targets a physical utilisation rate of between 60 and 70 per cent. 100 per cent utilisation is not possible due to issues such as maintenance and seasonal demand.  

If utilisation falls below 60 per cent then the yield on equipment tends to fall as prices have to be cut to stimulate demand. With utilisation above 70 per cent the company may not have enough equipment to manage demand. This has been the case since 2013. 

The business is very profitable with high margins. The return on assets (earnings before interest and tax, or EBIT, as a percentage of average fleet value) is also very respectable.  

In its accounts, Ashtead helpfully provides a split of its capital spending between replacement or maintenance capex (the cost of replacing worn out equipment) and spending on new assets. What this allows the investor to do is to get a feel for the underlying cash generation of a business. This can be done by taking away capex from earnings before interest, tax, depreciation and amortisation (Ebitda) to get a pre-interest, pre-tax cash flow figure (ignoring changes in working capital as well).  

What we can see here is that Sunbelt is generating a lot of cash flow at the moment (for the reasons explained above). Ebitda less replacement capex was over £1.3bn in 2017-18 compared with EBIT of £983m.  

I have highlighted 2010 to show you what happens to the business in a recession. Capex tends to be slashed – as evidenced by the sharp fall in the capex to sales ratio – and cash flow increases on the back of weak profits. The age of the rental fleet is allowed to increase and the company focuses on cash flow to protect its financial position.  

UK business 

Ashtead’s UK business is known as A-Plant. It is the UK market leader with a share of around 8 per cent. Companies such as Speedy Hire and HSS are close behind, with estimated market shares of 6 per cent.  

A-Plant's financial performance is not as impressive as Sunbelt’s  

Profit margins and return on assets are not as good – they are reasonable rather than very good and perhaps reflect the more competitive nature of the market compared with North America.  

Free cash flow had been negative, but as with Sunbelt the underlying cash generation is solid. Note how badly profits were hit during the last recession and the slashing of capex to cope with this as in the US.

Checking the quality of rental company profits  

Rental companies have historically been treated with suspicion due to the scope to manipulate their profits. The easiest way to do this is to under-depreciate the equipment assets – one of the biggest costs of the business – and report higher profits.  

Fortunately, there is an easy way to spot if this has been going on. The clear sign is consistent losses on disposals of fixed assets. If a company has been under-depreciating an asset, its balance sheet value will be more than its resale value. The low depreciation boosts trading profits when it is in use, but the company still pays the bill when it comes to sell the asset by making a loss on disposal.  

There’s nothing to worry about in Ashtead’s case. 

The chart shows that it has made profits consistently over the last economic cycle – a sign that its depreciation policy and profits are prudently stated. This is very reassuring. 

Can Ashtead keep growing its profits?  

The company has ambitious plans to grow its market share in the US to 15 per cent, with sales of over $5bn by 2021. The US market is less mature than the UK, with the rental concept still growing in popularity. Rental only makes up 55 per cent of the US market compared with around 70 per cent in the UK. The US market is also highly fragmented with lots of small independent local operators. These companies do not have the scale to compete with Sunbelt or United Rentals and it is expected that many will be acquired over the next few years.  

The company also intends to grow in Canada and increase its market share in the UK.  

Ashtead’s track record suggests that it has a good chance of achieving these aims. However, the economy will turn down again in the future and history suggests that profits will be hit hard when this happens.  

Is cyclicality Ashtead’s Achilles heel? 

The fact that demand for Ashtead’s products moves up and down with the economic cycle makes its shares quite difficult to value. Over the economic cycle I would expect Ashtead to be able to keep on growing its profits. The timing and size of those profits does have a reasonable degree of uncertainty attached to them, though.  

The shares have derated in recent months despite 2019 profit forecasts consistently moving up.  

They currently trade on a one-year forecast rolling PE ratio of 13.4 times at a share price of 2,340p and have traded at more than 16 times during this year. 

It seems that some nervousness about the future of the US economy is being baked into the share price. This is despite the fact that there is a backlog of US infrastructure spending, a continued shift to renting equipment and the considerable scope for Ashtead to take a much bigger slice of the US market.  

Unless there is a sudden collapse in trading, Ashtead looks to be well placed to continue compounding its current high returns. Analysts’ forecasts should always be taken with a pinch of salt, but Ashtead’s earnings per share is expected to increase by 61 per cent between 2018 and 2021, according to current consensus estimates. 

Yet, the valuation of Ashtead’s shares on a PE basis is at a considerable discount to more stable consumer focused businesses with similar rates of profitability (ROCE) but much lower immediate growth prospects such as Diageo or Unilever.  

I think this makes sense to an extent as investors are right to put a high price tag on the dependability of profits that these companies have. In fact, this is the case why some investors believe that they are still undervalued. 

Ashtead is a riskier investment proposition for sure. Time will tell, but I feel that its profits and maybe its share price have not peaked yet.