Morgan Stanley's 7th Annual Laguna Conference

Sep 12, 2019

Slides

Summary

H1 adjusted EBITDA rose ~15% YoY, while Q2 rental rates increased 4.6%; the margin target is the high-40% range within 2-3 years. Cash flow is being directed to debt reduction, alongside measured urban expansion and fleet optimization.

Next up, we have Herc Holdings, North America's third-largest rental equipment company that separated from the car rental business of Hertz back in July 2016. We are pleased to welcome to the stage Larry Silber and Mark Irion, CEO and CFO. Larry, I believe you have a few comments if you'd like to- Sure kick off. Thank you, Courtney. Good morning, everybody, and thanks for attending the conference here this morning. Before I get started, I just wanted to tell everybody, if you go to our investor relations page, you can see some presentation material that we prepared for this conference that is posted under www.hercrentals.com under investor relations. As Courtney mentioned, we separated from Hertz July 1, 2016, so we are 3-plus years down the road from separation as an independent public company, third-largest rental company in North America, with about 50 years of experience behind us, primarily from the time dating back to Hertz ownership. We have about 3% market share. We operate out of 265 locations in 39 states and 7 provinces in Canada. Over the last 3 and a half years or so, we have been implementing strategic initiatives that have closed the gap in terms of EBITDA margin and operating results relative to our peers. We have been very successful in completing the heavy lifting and focused on now operational excellence and internal activities that will close that gap. We have been making great progress against that plan. In calendar year 2018, we ended at nearly $2 billion in revenue and $685 million in EBITDA. As of the end of the second quarter, we had $3.86 billion in fleet. That is in great shape and operating at about 44 months of age. We continue to operate primarily an organic growth strategy, adding 4 to 6 locations on an annual basis, focused in highly dense urban markets. We are focused on the top 100 MSAs, and we are building out that network of branches. As I said, we have 265 locations that all have ample opportunity to put more volume through. Really, this is a volume growth game and a self-help game that we're involved in. For the past six months, ended June 30th, we increased our adjusted EBITDA by about 15%, and we improved the margin by 550 basis points over the prior year. We have about 4,900 Herc employees and associates, and we continue to focus on being the employer of choice, the supplier of choice, and the investment of choice. With that, Courtney, we'll open it up to you for some questions. Great. Thanks, Larry. Maybe if we could just start out a little bit on the macro. Last quarter, you talked about having a very positive outlook on the overall market and that your customers have a lot of confidence in still spending. Obviously, we've gotten a couple more data points more recently that have suggested there could be some type of deceleration. I'd just be curious what your conversations with customers are like and how you would characterize your view on the macro right now. Yeah, look, I would tell you that we are very bullish, very positive on the environment. We continue to operate with very strong markets. We've recently been out this week here in Southern California, which is just an example of the continued optimism and continued strength of our business. As you know, we're a late-cycle business, so we don't see anything on our horizon. We're very confident in 2019, and we're firming up confidence in 2020. We're seeing a lot of projects develop, and we're seeing the activity that our team is experiencing and feeling good about. We're constantly touching the ground with our people, our regions, and our districts, and our branches, so we have excellent visibility on what's going on, and we touch that on a daily, weekly basis. We're feeling pretty good about the end markets. Is there any particular pockets of strength or weakness that you'd call out, either geographically or across your different customer bases? Yeah, look, I wouldn't say there's any pockets of weakness anywhere across the North American markets that we serve. I would say the West Coast has historically, over the last 2 or 3 years, been a strong area for us, continues to be strong, but there are no areas that I'd say that are ringing of any weakness. Obviously, in Q1 and Q2, there were some weather issues around the country, but that's all dried up now, and we're back to a really positive environment. Great. Maybe switching onto the rental rate outlook then, how would you characterize how big Herc's rental rate opportunity is? You've obviously been able to price much more aggressively than some of your peers have, and maybe what's been driving that outperformance. Yeah. There is an opportunity for us to get rate in the current market, and obviously, the 4.6% that we generated in Q2 indicates that the end markets are favorable for us. We've got some excellent tools, an Optimus pricing tool that's been developed in-house and just gets better and better each year. There's market data that we take in and sort of factor around, and there are so many pricing opportunities every month in terms of the way we go to market with our customers that there is an opportunity to sort of move rate, I think at this sort of current pace for the near to medium-term. Great. How should we be thinking about how much of that 4.6% is being really driven by the pricing tools versus just end market strength, which Larry had talked about? There's a mix. We've got 40% of our business in national accounts, if you like. They're big customers which we renegotiate with on an annual basis, sometimes biannually or rarely every 3 years. That's about 40%. That's a fixed contract rate that we renegotiate as they come up. We've been getting lift from those as well. We are a service business. Customers don't deal with us just over rate. They do value the quality of our business, and we expect to get a return from that. Then in the local account business, about 80% of our pricing comes off the Optimus tool. There's the opportunity within that to move a big volume of our actual transactions in the local account business. Great. On fleet management, can you just talk a little bit about some of the adjustments that you're making to your fleet to really improve utilization? Well, I'd say, a majority of the fleet adjustments have already been made. All the heavy lifting is behind us. When we got here, we had a fair amount of cleanup to do, but that's all been done. We have the type of gear, the brands of gear in our fleet today, and we're now more of on a rotational basis and an added product category basis. But fleet's in great shape. We brought our age down to about 44 months. That might fluctuate 1 or 2 months either way over the foreseeable future. But we're really happy with our fleet. When we came, we said we wanted to bring up our specialty gear to be about 25%-30% of our fleet. We're currently sitting at about 21% of our fleet is specialty gear. You'll see us slowly add some more specialty gear over the next couple of years. But by and large, our fleet is in great shape and right where we want it to be. Can you remind us a little bit more about how the composition did change from when you originally started targeting these changes? Yeah, I think, unfortunately, the fleet that we inherited was in a poor state of repair, was bought perhaps on a low bid basis, not necessarily what I would call rental rugged gear or rental industry type gear, and not necessarily all premium brands. We had a fair amount of work to do in the first couple of years to clean out some of that, to get some of that equipment back repaired and on a ready line, and then focus on narrowing the number of manufacturers and focus on just premium brands. We have eliminated all what I will call the ancillary brands, secondary, tertiary brands, and we really have just a premium brand fleet that is well managed today and well maintained today. Can you maybe give us an update on some of your strategic initiatives, and how those are progressing and how they have helped to reduce the cyclicality of your business? Well, in terms of our margin improvement strategy, there is some costs which we are focusing on in terms of logistics and just becoming more efficient. The fleet is in place, like Larry said, so it is a matter of just optimizing the utilization of that fleet and just getting the whole branch network up to speed. The short-term costs, which have been coming out from 2018 in terms of the separation, some consulting fees, and some IT costs. There is efficiency in our logistics business that we are focused on at the moment, and that is generating some cost savings. Then over the short to medium term, the strategy is just generating more revenue and putting that on top of the existing branch network and flowing through 60%-70% of our EBITDA to enhance our margins there. Great. So obviously, you spoke to the macro outlook being fairly positive right now, but how should we be thinking about if there was some type of downturn coming, what the playbook for Herc would look like? Yeah, look, I think if there were a downturn, which we're not experiencing, Herc would put in the appropriate controls and adjustments to our business. We'd reduce fleet, we'd reduce CapEx. We'd make the necessary adjustments to continue to operate at the levels. Hopefully, we'll never see a 2009 again, right? But we are certainly better prepared today than ever for this business in the event of that. But we still think the way we're positioning the company around major metropolitan markets, which is the top 100 MSAs, those become recession-resistant markets. Nothing's recession-proof, but those become recession resistant because they're still going to do infrastructure work. They're still going to do upgrading of airports and hotels and hospitals and public facilities. Any projects that would've started are going to generally carry through what would be a more traditional downturn period of 18 months to 2 years, and we'd be well-positioned to operate through that. On EBITDA margins, can you just talk a little bit about what your longer-term goals are? You've obviously been showing a solid improvement, but how much more runway is there, and do you think that you can get well above your peers? Well, the initial target is to get up to within our peers. It looks like a well-run rental company runs in the high 40s, low 50s in terms of EBITDA margin. Q2, we did 42% in REBITDA and improved that by 550 basis points. We are making some real traction. The strategy we have in place and the execution is taking shape. Our goal is to be up into that high 40s zone within the next two to three years and improve by a couple of hundred basis points each year. Switching on to the urban market growth strategy, which you alluded to those being some more recession-resistant areas. You are planning four to six greenfield locations this year. Can you talk a little bit about where those locations are, and how we should think about the pace of those unit growth going forward? Could it accelerate from here? Yeah. Look, this has always been an organic growth strategy since we separated from Hertz, and we will continue along that, looking at a four to six branch location growth, which is a 2%-3% number on an annual basis. If you look at our map today, which is contained in the material that we provided, we are looking to build out the markets that we do not have a lot of dots on. Some of our bigger markets, like in L.A., like in New York, like in Atlanta, we probably have ample capacity and would not be looking to add. If you look at, just as a case in point here, we are close to San Diego. We were just there the other day. We have one location in San Diego. That is a location that we might look to add another two or three dots on over the next few years. Maybe some of the secondary markets of the top 30 MSAs is where we will probably look to add additional facilities and branch locations to improve that density. As you improve that density and you have more fleet in the market, you are better able to utilize that fleet and trade that fleet around and better service that customer base. Can you talk a little bit more about why you prefer the greenfield organic growth strategy, and also just how we should think about the unit economics of opening a new store, and what determines the success of a location? Yeah, look, we prefer at the moment. We're not opposed to looking at an M&A opportunity. But to me, that's really a make or buy decision, right? That we evaluate when we're looking to open a branch in a particular market, who might be available, what the cost might be, what the integration complications are when you buy a company versus opening a greenfield. That has about an 18- to 24-month drag on it. But the benefits are we bring existing people and culture into a new facility. We're able to ramp that up. We're able to give opportunity for our people for growth and development. We plan those so that they get supported by surrounding locations and have ample supervision and ample capability to grow in the market and mature in that short period of time. Great. Moving on to customer mix. You've obviously taken some steps to diversify it. Mark, you spoke a little bit earlier about the mix of nationals. Can you just talk a little bit about how ProSolutions and ProContractor have helped some of your mix shift and how different the margins are between your different customer groups? The ProContractor, it's a specialty business. The ProContractor's a small tool offering that's on each of our branches. The ProSolutions is a specialty mix focused on climate control and heat and other sort of niche markets. The margins tend to be the same once they're mature. There's a little bit of difference in terms of the capital sort of commitment. So the specialty business runs a lower time utilization, a higher dollar utilization, and uses less capital that tends to sort of last a lot longer and not have the same sort of replacement cycle. Gen rent will run the same margins when it's a mature business, but it's a little bit more of a change. The time utilization's higher and the dollar utilization is lower. Gotcha. Have you seen a substantial difference in how your different customer groups are using equipment? I think it is pretty standard over the years. A lot of these applications is a much broader offering now. I think as we alluded to with the specialty lines, is that as the rental industry becomes better and provides a steady, consistent offering to our customers, they are looking to rent more and more of their offerings. The rental industry, I think, over the medium term, continues to expand, and that is where the secular shift comes from. The long term is different categories that we would not have considered renting 20 years ago is now a standard offering for a lot of these customers. Maybe switching to capital allocation. Obviously, you have mentioned your EBITDA targets and your growth targets. If you meet them, you should be generating some substantial cash flows. How should we think about what your capital allocation priorities would be? Right. We are going to generate substantial cash flow this year. I think we have got $125 million worth of free cash flow through the first six months. In June, our leverage is down to 2.8 times. Our stated goal is somewhere between 2.5 and 3.5 times, and we will be heading towards the lower end of that range by the end of this year and into next year, and we will revisit our goals at that stage. But we are going to be paying the free cash flow down and just paying off debt and taking our leverage down for the medium term. Great. I think you also did a refinancing in July. Are there any other opportunities on the balance sheet right now for some type of refinancing? I think we completely refinanced the balance sheet in July. We've extended the maturity out on our senior notes through 2027. We redid the ABL out through 2026. The balance sheet's pretty much done for the next four or five years, and we're in really good shape in terms of just managing that through the rest of the cycle. On market consolidation, obviously you mentioned it's not a focus of your strategy right now, but obviously there's a lot going on in the broader rental market. Can you just talk a little bit about how that's had an impact on your business? Yeah, look, generally, I think consolidation is good for the industry. It firms up the industry. It makes it more disciplined. It certainly eliminates what I'll call some of the second-tier and third-tier players, and it has been good, and I think will continue to be good. I think at this point in time, there's not many big regional players to sort of be rolled up anymore. There's just more, what I'll call small regional mom and pops and others. I think you'll probably see a slowing a bit of that activity at the top level. There'll be fill-ins, but I don't think you're going to see a lot of big deals like you saw over the last 30 months happen. Are you able to tell whether some of the share gains that you guys are making are coming from some of those mom and pops versus some of the national players? Well, look, I think the share gains, I don't even know if it's share gains, it's volume gains that we're getting, are really coming from new product offerings that we're putting into our business and focusing on those markets. Whenever there's consolidation, there is some opportunities to pick up customers that may not want to go to one of the consolidators that happened, and that'll happen on a sort of a normal basis. But I don't see that as being a big gain opportunity for us. The bigger gain is by continuing to focus on our customers through operational excellence, providing them type of service and the technology improvements that we've been putting in the business, and also offering them a broader product line where, as you see this secular shift from ownership to rental, and as we offer more products that may have not been rented in the past and become a reliable source of rental, that's really where the opportunities for growth and gains are coming out of. Can you talk a little bit about what the right metrics to measure your business are? What you guys are focused on, whether it's rate, dollar utilization, or time utilization? Yeah, sure. I think it's a combination of those three rates. Obviously, a very important metric in terms of sort of our success in providing quality service to our customers and getting return from that. It flows through the balance, the income statement, 95%. So it really helps our margin improvement. Time utilization's important for the efficiency that we're managing our fleet, and those two wrap up into dollar utilization and sort of provide the return of our capital investments in those fleet. EBITDA margin, important in terms of how efficient we are with the income statement and sort of getting the revenues through, and ROIC, I guess, at the end of the day, sort of brings those four metrics together in terms of the capital that we've got invested. So we're going to continue to report out on our rate and our dollar utilization like we always have. We think it's an important sort of communication with our investors and sort of reflects how we look at the business ourselves. Great. Larry, you mentioned that there really aren't any pockets of weakness that you're seeing. What are you guys seeing in oil and gas right now? Yeah. As you know, we've been diligent about reducing our exposure to oil and gas since we got here four years ago. I think we were at a high of about 35% of our business at one point was from upstream oil and gas. We're now down around 11% or 12% of our revenue comes from upstream oil and gas. But that's been, for the areas that we're participating in, been very strong. It's mostly around the Permian Basin activity, which has been very healthy for us. Certainly, the oil sands has been solid. I wouldn't say it's been extra strong. It's been solid because it's primarily maintenance capital that we're putting in there. There hasn't been a lot of new capacity put in the oil sands. In the oil shale, we're very solid in oil shale in Western Pennsylvania, Lower New York, that area. All of the markets that we are in and where we choose to participate are solid to strong. Can you give us a brief overview of your digital offering and maybe how you think that compares to some of the offerings that your competitors have? Mm-hmm. Yeah, I think we are on par with the larger sort of offerings from the major rental players. We have ProControl, which gives our customers visibility into their equipment, if they need it, see how that is operating and getting the returns from there. OnTheGo is a logistics offering which lets customers see what the delivery times and the expected arrivals of the equipment. Optimus is our rate tool, which we utilize ourselves in terms of communicating and getting the sort of right negotiations, conversations going with the customers. We have a broader range of digital tools. We continue to invest and improve in them. But we are on par, I think, with the standard offerings that are available out there in the market. Yeah. We are also heavily involved in growing our capability with Salesforce in terms of a customer relationship management tool and utilizing that across a broad spectrum of capability. When did you roll out a lot of these tools, and have you seen any notable changes in customer behavior, especially on the customer-facing ones? I think it's all been coming out over the last sort of three or four years. A lot of these things have been developed and continue to be enhanced. It's not a huge demand from some of the bigger customers want it if they've got a lot of fleet, but it's still kind of a, Larry likes to say, a belly-to-belly business in terms of the communications with the customers. So it, I think, becomes more important over the sort of coming years. But at the moment, it's not a huge sort of commitment from the customers in terms of these digital offerings. Mark, you spoke a little bit earlier about how we're seeing a trend towards renting more types of equipment standard than we had in the past. Obviously, there's different penetration rates for different types of equipment. I think overall, U.S. rental penetration is now over 50%. Can you talk about where you think that could go longer term? Could it get anywhere close to some levels that we see in places like the U.K. where it's over 80%? Right. The secular shift has been a gentle tide, I think, that's been certainly supporting the industry over the last 30 or 40 years. I think it's going to continue over the next 20 years. Some lines are kind of fully penetrated, like the Japanese or the U.K. model. But earthmoving's maybe 50% penetrated. That's going to continue to expand. Then some of these specialty lines, we've really only just started. So I think the general trend will move. I don't know that we'll get to 80%, but certainly over the next 10, 20 years, there's plenty of opportunity for us to continue to move through that secular shift. Great. I just want to take a chance to open the floor for questions from the audience. Hey. I think it's no secret that two of your largest competitors in the U.S. are moving away from reporting a firm rate metric going forward. I think you mentioned it's your intention to keep doing so. Is there any level of concern out there that that's removing a layer of accountability in terms of the cycle over cycle rate discipline, or that is not really a concern? Look, you'd have to ask them what their motivation is. We view that as a key important metric and something that is really indicative of how well we're performing and our people are performing in the marketplace. We'll continue to report that. I can't comment on what their motivation was or what they're doing. They're around the conference here, at least one of them. You might want to ask them. Maybe shifting over to CapEx. You guys are planning a 20% decrease this year relative to 2018. Can you talk a little bit about why you have the step down in CapEx and maybe how we should think about the run rate going forward and whether that should re-accelerate, or is this more of a permanent change? I think the strategic fleet changes that Larry has mentioned have taken place. There was quite a lot of fleet growth in the 2018 number, so it was not a run rate that we were really committed to for the long term. As we move through this margin improvement strategy, we are focused on optimizing the fleet that we have got in place. So we have got the right fleet. The new investments have been made in our specialty business. It is a matter of just optimizing the return of those and getting the utilization up. This net $400 million spend level, I think, is going to be pretty consistent over the next couple of years, just as we assess market demand. We can turn it up, we can turn it down as necessary. It will give us a 1%-3% fleet growth, which feels about right, and we can continue to supplement our revenue growth with rate and improve utilization off the fleet. Great. Obviously, the cost of equipment has seen a lot of pressure because of some of the tariffs and whatnot. Can you just talk a little bit, well, I guess, A, what impact tariffs and trade have had on your business, both on the cost side and perhaps on the top line? Secondly, how your view on commodity pricing and cost is heading into next year. Yeah, look, for 2019, we had very little inflation on our cost of material. We were sub 2% on the inflationary index. We expect more of that to continue, although we are just entering negotiations now with our vendors for next year. So we will see where that goes. We did hear at one of the conferences yesterday that a vendor no longer has the tariff, so we may look for a reduction in price as a result of that. So we will see where that goes. But I would say we will probably end up similar to where we have been. Gotcha. Maybe just shifting over to weather. Can you just talk a little bit, I think you alluded to this a little bit earlier, but can you quantify how much of an impact weather had on your business this year and relative to prior years? Yeah. We try not to use weather either as an excuse or as a benefit. Weather's weather. You're going to have weather in every business that we participate in on an annual basis, and you just need to adjust for that. Sure, there was a bit of a slow start in some of the markets, Pacific Northwest, Carolinas, due to weather during the first and second quarter, and that just delayed some projects and work. But all of that's dried up, and we're in the peak demand season. When you think about Hurricane Dorian, I think when that's all said and done, that'll be a wash. As much equipment probably came off rent in preparation or fear of a storm as went on rent in preparation of disaster recovery and relief efforts. I think that'll be a wash when it's all said and done at the end of this year. Great. Finally, we have about a minute left. You had mentioned earlier that you'd brought your fleet age down to about 44 to 42 months. Is that the right level that you're targeting at this point? Maybe how should we expect that range to move over time? I think the ideal range is in the 40-to-50-month zone. We're comfortable with it at the 44. With the CapEx spend that we've got going on, it might move a couple of months up, a couple of months down, but we're in the middle of the range that we're targeting and are comfortable with that. Great. Awesome. Well, thank you guys so much for the time. Yeah, just great. Elizabeth Higashi, our Vice President of Investor Relations, is here at the meeting with us in the front of the room. If anybody has any questions or would like to contact us for more dialogue, please get ahold of Elizabeth. Thank you.