Ashtead looks well equipped for further growth

Ashtead (AHT) is an international equipment rental company with operations spanning the UK, US and Canada through the Sunbelt brand. The group follows a relatively simple business model – it purchases equipment, rents it out to customers and then sells it to the second-hand market after around seven years. Catering to a wide variety of industries – such as construction, facilities maintenance and disaster response – Ashtead serves the individual DIYer all the way up to multinational businesses, hiring out everything from small hand-held tools to large excavators.

The US growth engine

The bulk of Ashtead’s earnings come from its US business, which accounted for 86 per cent of revenue and 95 per cent of adjusted operating profit in 2020. The US rental market is around six to seven times bigger than that of the UK and it is also less mature, with a rental penetration rate of 55 per cent versus 75 per cent in the UK.

This opportunity hasn’t gone unnoticed by fund managers. Royal London is Ashtead’s tenth largest shareholder and the asset manager holds the company across a few of its funds including the UK Opportunities Fund (GB00B5BRWC09) and UK Growth Trust (GB0001597979). Richard Marwood, senior fund manager at Royal London, points to Ashtead’s “tremendous growth due to a secular trend in the construction industry for companies to rent rather than own their equipment”. Indeed, amid rising costs and maintenance requirements, customers are increasingly coming to the conclusion that hiring is the more economical and easier option.

Ashtead is the number two player in the US behind United Rentals (US:URI), but still only has a 10 per cent market share – that’s up from 4 per cent in 2010. The US market remains fragmented, with many smaller independent operators that Ashtead can consolidate to bolster its position. It is difficult for the smaller players to catch up as they would need to deploy a lot of capital to achieve the same scale, regional density and efficient operations. The group is aiming to increase its US market share to 15 per cent in the medium term and eventually hit 20 per cent.

Ashtead has 840 stores across the US – more than double the 393 in 2010 – and growth has come through both M&A and expanding its own store network. After a brief pause due to pandemic uncertainty, Ashtead is once again opening new stores, adding 12 new greenfield sites in North America in the six months to 31 October, with plans to open 25 to 30 new greenfield sites in total this year.

New stores take around seven years to mature, providing a long runway for growth. Ashtead arranges its stores as clusters of depots within a local area – a mix of big and small general tool stores as well as specialty outlets. The idea is to create a competitive moat by increasing the product range and density within that area so that customers can find whatever equipment they need from Sunbelt without having to go somewhere else. Clusters are initially more weighted towards construction customers, but as they are built out and mature, non-construction customers become a larger part of the mix and economies of scale means margins and return on investment increase. Ashtead’s cluster approach has underpinned high adjusted operating profit margins – although these have come under pressure during the Covid-19 pandemic – as well as a return on investment above its cost of capital (see charts). There is still room to grow as only 28 of the top 100 US markets are currently clustered.

Less cyclical than you might think

The main concern with Ashtead is its cyclical vulnerability, particularly as a large fixed cost base means profits are more sensitive to a drop in sales. But the group is better placed to cope with an economic downturn than during the global financial crisis, with construction now accounting for 45 per cent of Ashtead’s US revenue versus 87 per cent in 2008.

“Cognisant of the cyclical nature of this business we have been impressed by the success of the ‘Specialty’ division,” says Clare Erskine-Murray, a director at Baillie Gifford, which holds the company in its UK Growth Fund (GB0007913485). “Management has looked increasingly to focus its efforts on diversifying away from construction into more defensive end markets with a much broader customer base and where the concept of rental is still relatively new.”

Specialty markets include the likes of portable power, disaster recovery and facilities maintenance, and Deutsche Bank reckons that rental penetration in these more niche areas is between just 10 and 20 per cent. The emergency response market, alone, is estimated to be worth $40bn (£29bn) and Ashtead is capitalising on the increasing frequency and severity of extreme weather events – it picked up $35m-$40m of revenue from hurricane response efforts in the US in the recent October quarter.

The specialty business now accounts for just under a quarter of US rental revenue – up from 16 per cent in 2011 – and Deutsche Bank predicts it will rise to around a third by 2024. It used to be lower margin – the adjusted operating profit margin was 25 per cent in 2016 versus 39 per cent for general tool – and while Ashtead hasn’t disclosed the break down of these margins recently, Deutsche Bank believes that as the scale of the specialty business has grown, margins are now at a similar level.

In addition to diversifying its revenues, Ashtead is also able to protect itself during tougher times by curbing its investment and ageing its relatively young fleet to preserve cash. Between 2008 and 2010, the group only invested in replacing its existing fleet and reduced growth capex to zero. As a result, the average age of its US rental fleet increased from 34 to 46 months.

In response to Covid-19, Ashtead cut its gross capex by two-thirds in the six months to 31 October, to £343m, and again, only spent on replacement. The average age of its rental fleet has risen from 33 months to 39 months, which is still younger than industry average of 48-50 months.

An improving outlook

Classified as an 'essential’ business, Ashtead has been able to stay open throughout the pandemic and rental revenue only dipped by 4 per cent year on year at constant currencies in the six months to 31 October. In the UK, Ashtead has picked up work assisting the government’s Covid-19 response, providing the equipment needed to set up testing sites, and the Department of Health accounted for almost a fifth of the group's UK revenue during the first half of the year. Meanwhile, the US has benefited from the resilience of the specialty business, which saw rental revenue increase by 12 per cent year on year versus an 8 per cent decline in general tool.

The hit to profits was more pronounced, with adjusted operating profit falling by close to a fifth, to £646m, and the margin contracting by 4.6 percentage points to 25.3 per cent. This was partly down to lower demand for hire equipment, but also high fixed costs as it chose not to trim its workforce.

Still, as activity levels have improved, the fleet on rent at the end of October was roughly in line with the prior year in the US and Canada and higher in the UK. Encouragingly, rental rates have remained stable as the industry adopts a more disciplined approach to pricing. Nine months into the 2008 financial crisis, rental rates were down 20 per cent.

Ashtead has upgraded its full-year guidance and is now anticipating that rental revenue will fall by 3 to 7 per cent, up from previous expectations of a 5 to 9 per cent contraction. As a further sign of confidence, the group has also upgraded its full-year gross capex plans from £485m-£540m to £650m-£700m.

The improved guidance has prompted brokers to nudge up their forecasts and there could be further upgrades to come as analysts at JPMorgan are expecting an earnings beat when the group reports its third-quarter results in March.

Balance sheet firepower

Excluding lease liabilities, Ashtead was sitting on £3.6bn of net debt at the end of October, down 16 per cent from the April year-end. Equivalent to 1.7 times cash profits (Ebitda), this is within the group’s target multiple range of between 1.5 and 2. While net debt in absolute terms has been increasing in recent years as Ashtead invests in growth, leverage has been coming down.

Cutting capex enabled Ashtead to generate record free cash flow of £822m in the six months to 31 October and it is guiding to more than £1.2bn of free cash flow for the full year. But it’s worth noting that Ashtead has been free cash flow positive since 2017 during an upcycle when it has been investing in growth.

The strong balance sheet has also enabled the group to reward shareholders with share buybacks and supplement organic growth with acquisitions, although both M&A and share repurchasing activity have currently been paused due to the pandemic.

Worth the price tag?

Ashtead’s shares have bounced back strongly from the ‘Corona crunch’ and have risen by more than 50 per cent over the past year. Hovering around an all-time high, they are currently trading at 21 times consensus 2022 earnings – above the five-year average PE ratio of 14 – with an enterprise value-to-operating profit ratio of 18.

Some might baulk at that valuation given Ashtead’s cyclical exposure, but it has weathered the pandemic well thus far and earnings should bounce back relatively quickly once this crisis abates. This would be aided by any infrastructure stimulus in the US, and President Biden intends to push for his ‘Build Back Better Recovery Plan’ after a Covid relief bill is passed. Somewhat reassuringly, infrastructure spending tends to garner bipartisan support. In the meantime, the burgeoning specialty business is adding to the attractiveness of the long-term investment case amid the structural shift from buying to renting equipment. In that light, we think the shares have further to run.

Last IC View: Buy, 3,339p, 08 Dec 2020

Last IC View: Buy, 3,339p, 8 Dec 2020