Ashtead: On The Ground

Investors in TSMC, the world’s largest independent semiconductor foundry, know it is expanding outside of Taiwan to diversify its production footprint, including a USD 40 billion commitment to build a leading-edge foundry in the American state of Arizona. President Biden personally opened the site in December 2022 to promote the CHIPS and Science Act, a legislative package which promises USD 50 billion in subsidies, loans and incentives to promote investment in America’s onshore semiconductor capacity.

The CHIPS and Science Act joins the USD 550 billion Infrastructure Investment and Jobs Act and the USD 394 billion Inflation Reduction Act to spur what Biden described that day as “the biggest investment in American infrastructure since Eisenhower’s Interstate Highway System”. Nowhere is this more apparent than in Manufacturing, where monthly construction spending has more than doubled since 2021 as firms invest in onshoring supply chains or in new fields like clean energy.

This boom has lifted Total Non-Residential Construction Spending to new highs, supporting the US economy and labour market even as higher interest rates bite into other sectors, like Residential and Commercial Construction. A wave of infrastructure projects will follow from this year onwards, with construction activity expected to stay at a high level for the remainder of the decade.

Enter Ashtead:

Ashtead Group plc (“Ashtead”) is a UK-listed equipment rental company operating in Britain, the USA and Canada. It would be an interesting business even without the tailwinds described above. Founded in 1947 in the eponymous town south of London, Ashtead was ‘bought out’ by management in 1984 when it had just five sites and GBP 1 million in revenue. Since listing on the London Stock Exchange in 1986, its revenue has grown from USD 5.3 million to USD 9.7 billion through organic growth and acquisitions. Earnings have grown even faster as scale improved margins: once a location is in place, the cost of incremental growth is relatively low.

Since 1984, Ashtead has had just three CEOs. George Burnett (1984-2006) and his partner Chairman Peter Lewis drove a consolidation of the UK market and then replicated their playbook in the United States, beginning with the acquisition of Sunbelt Rentals in 1990. Geoff Drabble (2007-2019) saw the company through the Global Financial Crisis and then expanded into Canada by acquiring GWG Rentals in 2014. The United States has been an enormous success for Ashtead: from just a few sites in North Carolina, Sunbelt USA has grown to comprise 85 per cent of Ashtead’s FY23 revenue and 90 per cent of its EBITDA. Brendan Horgan (2019-present) is 49 years old and the company’s first American leader. He joined Sunbelt in 1996, beginning as a salesman immediately after graduating from College.

There are many players and many pretenders in the equipment rental space. And the high fixed costs involved make earnings cyclical, a feature I will return to later. Still, Ashtead stands out for its longevity and profitability: over the last twenty years - a period which included several booms and busts - Ashtead has earned an average return on equity of 17 per cent, paid USD 2.0 billion in dividends and repurchased USD 2.4 billion in stock.

The Business:

Ashtead trades under the name ‘Sunbelt Rentals’ (“Sunbelt”) and has a straightforward business model:

It buys new equipment from manufacturers like Caterpillar, Komatsu, JCB, JLG Industries, John Deere and DeWalt, usually at a discount.
It maintains that equipment so that it is available for rent.
It sells old equipment, usually at a profit.

On top of this, Ashtead applies long-term, non-recourse leverage to raise its return on equity.

Sunbelt served more than 800,000 customers in FY22. All 900,000+ pieces of Sunbelt equipment are painted a bright, sunny green to let everyone know where they came from. They can be rented and paid for online for delivery to a job site or collection from one of Ashtead’s ~1,400 locations (approximately 1,200 in the USA, 200 in the UK and 100 in Canada). As of FY22, Sunbelt’s US fleet composition was 33% mobile elevating work platforms, 20% forklifts, 13% earth moving and 34% other. Its fleets in Canada and the UK are similar but with slightly different skews.

The company has two categories of rental equipment: General Tools and Specialty. General Tools include equipment for general construction, aerial work, earth moving, concrete and masonry, lawn care, floor care and more. Specialty focuses on predominantly non-construction activities where renting has historically not been viable because no third party has invested in a rental fleet. Sunbelt currently offers Specialty rentals in ten niches: Power and HVAC; Climate Control and Air Quality; Scaffold Services; Flooring Solutions; Pump Solutions; Lighting, Grip & Lens; Ground Protection; Industrial Tool; Shoring Solutions; and Temporary Structures.

Why Rent?

Customers face a simple choice with their equipment: to buy or to rent. The advantages of buying are ownership and availability, but the disadvantages are the costs of redundancy, idle time, maintenance and obsolescence.

Ashtead’s proposition is to ensure a huge breadth of new, well-maintained equipment is available whenever and wherever customers need it. Renting turns a high upfront cost into a lower variable cost, helping to manage cash flow. Having well-maintained equipment reduces downtime. Ashtead will even provide safety and facilities management training so that customers comply with their own regulatory and union obligations. And a younger fleet is better for the environment because it produces less emissions.

As the supply side of the rental market has grown and availability has improved, the nature of demand has changed. Customers initially used rentals to ‘top up’ their own equipment. Then rentals became a viable alternative to ownership. Today, for the reasons given above, rentals are most often a superior choice.

Former Ashtead CEO Geoff Drabble explained it this way:

People say we’re an old-fashioned construction business but they’re missing what’s happening structurally. The reason people didn’t rent much ten years ago was because the rental industry was crap. What we brought in faster than anybody else was that it was all about the service. Increasingly what product we put through the platform is less relevant than the robustness of the platform itself.

It’s hard to imagine this trend reversing given the convenience and value renting offers. An expert explained to primary research firm In Practise:

The trends are clearly going in the direction of end users being happy renting their equipment, which goes all the way back to the global financial crisis. For the past 12 years, I have seen a distinct trend of sophisticated financial professionals willing to take a slightly lower margin on a smaller balance sheet, to get better returns on equity by shrinking their balance sheet. They would rather variablize their equipment expense and pay slightly more. This is the math the unsophisticated buyer does. United will rent this to them for $ 2,000 a month but they can buy it new for $ 10,000, so after five months they should have bought it and then they save money. That is the quick back of the envelope math everybody does, but that's not the real trade-off. If you buy this equipment yourself, you commit to buying two of them so you have a spare. You will have to employ mechanics to maintain and a yard to store it. It is not as simple as dividing the purchase price by your rental price.

In contrast, if you work with Sunbelt or United, they give you technology to help you manage your fleet, so you can see what your utilization is. You can click a button, that equipment shows up and the bill starts running. More importantly, when you are done with it, you simply push the button and that expense goes away when you don't have a job. United and Sunbelt are very good at moving assets around and creating a shared pool of well-maintained relatively new assets anybody can tap into when they need it.

Rental penetration of General Tools is ~80% in the UK and ~60% in the USA, although the levels vary widely across categories. Because penetration in Specialty is lower (by Ashtead’s own definition), it has been growing materially faster than General Tools. Ashtead sees enormous potential to keep growing this category, as illustrated in the slide below from its 2021 Capital Markets Day.

SUNBELT’S ECONOMICS:

The economic variables which matter in equipment rentals are:

Cost of the fleet: the recorded value of rental assets before depreciation.
Useful life: how many years a piece of equipment can be rented.
Rental rates: what is charged to clients.
Physical Utilisation: the percentage of the fleet out on rent during a given period.
Dollar utilisation: rental revenues in a given period divided by the average cost of the fleet. This measure gets closer than physical utilisation to a proxy for return on investment.
EBITDA margins, which incorporate operating costs.
Disposal values: what the company will likely receive from selling old equipment.

Putting this together, here is an analysis of Ashtead’s unit economics using assumptions gleaned from its annual report. The result is an unleveraged IRR of 12 per cent. Note, though, that dollar utilisation is more applicable for assessing a fleet of equipment rather than an individual piece. In this case, it smooths revenues out over the equipment’s useful life, rather than front-loading them as is more likely in practice. Ceteris paribus, this means I am probably underestimating the true IRR.

The marginal cost of revenue (adding equipment to an existing location, raising rates or increasing utilisation) is trivial, resulting in large incremental profits and high returns on invested capital. Management likes to measure this in terms of the “drop-through rate”, the EBITDA margin earned on incremental revenue. On examination, however, incremental revenue has not always been margin accretive (when the orange line is above the blue line). I suspect this is because new locations take time to mature and reach their revenue potential.

Management explains as much, saying:

The maturity of our stores has a big impact on RoI. As stores mature, and the size and range of fleet increases, there is natural margin and returns progression. Stores that were greenfield sites only two years ago are now already adding same-store growth. We are always focused on moving new and young stores up the maturity curve as there is scope for higher returns as they progress. This also means that we are now at a very different stage in our evolution in the current economic cycle relative to where we were in the last cycle. We have more stores and they are larger and more mature than at the peak of the last cycle, and are well placed to take advantage of growth opportunities and much better placed to weather downturns, when they arise, as we have seen over the last two years.

Note that EBITDA is a relatively good proxy for Ashtead’s cash flow from operations: the weighted average ratio of the two over FY05-FY23 was 96%. In reality, however, EBITDA has historically overstated owners’ earnings by about one-third because it does not incorporate replacement capex, interest or taxes.

BIGGER IS BETTER:

Sunbelt holds an estimated 13 per cent market share in the USA, up from just 4 per cent in 2010. The market is highly fragmented, with the top ten players accounting for just 42 per cent. As of FY22, Sunbelt’s market share was 8 per cent in Canada and 10 per cent in the UK.

Over the last decade, Sunbelt has dramatically expanded its geographic footprint into new locations and to make its presence in existing markets denser. From FY16 to FY21, the years of Ashtead’s “Project 2021”, 29% of Ashtead’s USD 3.4 billion revenue growth came from existing sites, while the remaining 71% came from greenfield expansion and bolt-on acquisitions.

You can see from the maps below that the United States should be thought of as an agglomeration of small markets, naturally fragmented due to the friction of moving equipment across long distances. Sunbelt’s nationwide market share is an average which masks its dominance in certain areas and opportunity in others.

Sunbelt has become a better business for customers (and shareholders) as it has grown and gotten bigger:

A larger footprint makes Sunbelt more convenient and accessible to customers.
It has a bigger fleet, which means more equipment is available.
Its fleet has a wider selection, making rental viable for a wider range of jobs.
When equipment a customer needs is unavailable in their area, Sunbelt can tap into its nationwide fleet to bring it in from elsewhere (for a price, of course). For the company, this optimises rates and improves utilisation.
Greater purchasing volumes (thanks to scale and standardisation) give Sunbelt more heft with suppliers. This translates into discounts on new equipment orders, which can be passed on as lower rates. During COVID, when supply chains were disrupted, being a large customer also gave Sunbelt priority access to supply. OEMs also offer large accounts better and longer warranty terms.
Sunbelt’s fleet is large enough to bid on mega-projects that might need hundreds of different pieces of equipment available at different stages. United Rentals is probably the only competitor to match Sunbelt at this level.
It has the resources to invest in its internal and customer-facing IT.
It has an unfair advantage in M&A, given that it can afford a dedicated M&A team and now enjoys a lower cost of debt.

Two other factors improve Sunbelt’s service and accelerate its growth: clustering and cross-selling.

CLUSTERING:

As the name implies, “Clustering” involves densely grouping stores in a particular region. The image below illustrates the sixteen-store cluster in the South Florida District and its mix of General Tool and Specialty locations.

Ashtead explains its clustering strategy as follows (emphasis mine):

Our cluster approach is an important aspect of our strategy. Our greenfield sites are chosen to enhance our existing business. We focus on building clusters of stores because, as they mature, they access a broader range of markets unrelated to construction leading to better margins and RoI. The size and composition of a cluster depends on the market size based on Designated Market Areas.

A top 25 market cluster in the US has more than 15 stores, a top 26-50 market cluster more than ten stores and a top 51-100 market more than four stores. We also include the smaller 101-210 markets within our cluster analysis. We have found that these smaller markets, while performing less well than others overall, often prove more resilient when times are less good. Our definition of a cluster in these markets is two or more stores… The more customers get to know and trust us, the faster we are able to grow.

We focus on ensuring our clusters meet the multiple needs of local customers even if that means some stores may appear superficially to perform less well than others. The interaction of the stores in a cluster is what gives us real competitive advantage. We find that having a blend of locations is highly desirable and we like to mix up the large equipment locations with smaller General Tool stores. The addition of Specialty stores serves to really differentiate us from competitors in the area. This enables us to broaden and diversify our customer base and our end markets, as we extend our reach within a market. Average revenue per store is not a relevant measure with which to evaluate the success of individual clusters or even the business as a whole. The value is in the mix.

An expert interviewed by In Practise explained how clustering helps Sunbelt dominate a local market:

In diversified, hot markets that aren't solely driven by construction, it makes sense to have a strong presence. These markets have expanded and grown economically, attracting industries and jobs. It's not just about being in the city center anymore; it's about serving the entire metro area, which may cover 60 miles around the market. These companies have surrounded themselves within the market and its outskirts, offering specialty trench, power, pump, office trailers, and general equipment. They are renting anything from a two-inch pump, to an 80,000-pound escalator, to a 185-foot manlift. They provide a one-stop-shop for customers, who don't necessarily know where the equipment is coming from but can rely on the company to deliver it on time.

Ashtead shared data for its ‘Cluster Economics’ at its 2021 Capital Markets Day: clusters enjoy 2.2x more customers, 15 per cent more revenue per customer, and a 160 basis point improvement to EBITA margins. As of that time, 49 of Ashtead’s Top 100 US markets were ‘clustered’, as were 4 of its Top 10 Canadian markets.

As mentioned above, new stores are initially a drag on margins but eventually make the whole greater than the sum of its parts. Investor Tom Russo cites Ashtead’s willingness to trade short-term pressure for long-term gain as evidence of its “capacity to suffer”, a strength he seeks in all his investments.

CROSS-SELLING:

The second accelerant is cross-selling, with Specialty rentals driving increased General Tools rentals as it brings new customers into the rental market. The company calls this “the Power of Sunbelt”. Management explained at the 2021 Capital Markets Day:

[72%] of rental revenue from our organization over the trailing 12 months [came from customers renting] from a general tool location and one or more of our specialty businesses. To take that down a level, [39% of revenue comes from] renting from a general tool location and 3 or more of our specialty businesses. And I can assure you that 39% is increasing every day. The incredibly powerful stat… for every $ 100 spent with our general tool business, the same customer spends $ 47 across the rest of the Power of Sunbelt. Now that is cluster economics. As Brad described earlier, this can't be done unless you're advancing clustered markets. This can't be accomplished unless you amplify the specialty businesses and enter white space.

This is only achievable by incentivising salespeople to leverage the whole organisation, as management explained:

one thing remains core to any plan that we roll out. And it's that idea of making sure that we incentivize our sellers to cross-sell. We not only compensate the seller that comes forward with the lead, but we also share that commission with the seller that actually closes the lead. And this really engages the sales force. And we think who wins in this is the customer. It really enriches the customer experience, full stop.

CASHFLOW & THE CYCLE:

The high fixed costs Ashtead needs to maintain its platform give it operating leverage: small changes in revenue create large changes in earnings. This amplifies the impact of the natural cycle underlying demand for its services, both for the better and the worse.

The charts below illustrate the volatility and magnitude of Ashtead’s year-on-year changes in revenue and normalised net profit before tax through the four major down-cycles Ashtead has experienced since listing: the recession which followed the Savings & Loan crisis in the early 1990s; the recession which followed the Dot.Com collapse; the recession which followed the US Sub-Prime Housing crisis; and COVID.

The company is, of course, well aware of its inherent cyclicality. It described the five phases of a cycle and its ‘playbook’ in the FY10 annual report:

Phase One: when the economy is expanding, we utilise free cash flow to increase investment in our rental fleet to support revenue, EBITDA and earnings growth and reduce the age of our rental fleet. We are also able to take advantage of the many growth opportunities available. We enjoy high utilisation at good rates thereby generating strong margins. Capital expenditure will be strong and debt broadly flat whilst leverage will tend to reduce as earnings grow.
Phase Two: In this phase markets are still strong but we recognise this will not last forever. We begin to make preparations for the coming downturn, in particular preparing the balance sheet for the lower levels of income expected when the cycle turns. All debt is committed for the long term and structured to remain covenant free, enabling us to get on with running the business unimpeded through the cycle. We start to reduce the rate at which we invest in new equipment and begin gently increasing the age of our rental fleet. This in turn increases cash flow.
Phase Three: At the beginning of the downturn we may also rightsize the business to ensure that it is best positioned to withstand the worsening economy. In this way we have, in the latest cycle, sustained our EBITDA margin above 30%.
Phase Four: Once in recession we focus on running a tight business, reducing capital expenditure to around half the level of depreciation, further reducing the fleet if required and, as a result, entering our most cash generative phase. Typically, we apply this cash to pay down debt, sustaining our leverage at close to our target despite lower earnings. At all times, however, we take care to maintain the optimal flexibility to ensure that we can bounce back aggressively once the upturn arrives. The focus is on cost efficiency while at the same time positioning the business for the recovery to come.
Phase Five: Once the recovery is under way, we look for our preparations to pay off. Rental rates begin to recover as does our utilisation and consequently we can anticipate strong earnings growth. Capital expenditure necessarily increases as the business expands again. Leverage decreases as earnings recover and, once again, we start to invest for organic growth. At the same time we may look for opportunities amongst those in the industry who have struggled to survive the recession and are in a weaker position than ourselves. Again the flexibility of our business model enables us to upgrade and expand quickly to service increased demand.

The crucial point is that Ashtead can manage its free cash flow by dialling up or down replacement and growth capex. In FY09-11, for example, there were literally zero dollars spent on growth capex. In FY21, which included the eight months of COVID during calendar 2020, management slashed growth capex from USD 906 million to USD 63 million.

The divergence between reported earnings and levered free cash flow confirms this practice works: despite the volatility in earnings, Ashtead has been FCF-positive every year from FY08 onwards.

Naturally, this begs the question: what changed after FY08 to improve Ashtead’s profile so radically? I suspect the following factors played an important role:

Rental equipment changed from ‘top up’ to ‘must have’, making demand itself less cyclical.
Market concentration increased, giving more bargaining power to the largest players.
As the relative size and breadth of the largest players grew versus the rest of the pack, the more attractive their fleet and services became. They are, therefore, most likely the last suppliers to be cut when times are tough. And as it becomes more and more expensive for smaller players to keep up, the larger players probably have more and more leeway to allow their fleets to age when necessary.
Ashtead’s Specialty business became a larger part of its mix, reducing its dependence on the more cyclical construction sector.
Ashtead paid down debt and reduced its gearing.

DEBT & LEVERAGE:

On this last point, Ashtead runs a leveraged balance sheet, and that is a risk. In fact, the company was almost bankrupted in 2003 in a freak occurrence when it discovered a GBP 11 million accounting error the day before rolling over a large banking facility. The CFO could not certify the accounts, and the company went into technical default, leading its share price to drop from 30 pence to 5 pence. It was only through management’s deft handling of the crisis that the company survived.

Ashtead’s leverage peaked in FY03 due to a combination of debt taken on to finance an acquisition and cyclically low earnings. In the years since the Global Financial Crisis, it has reduced its leverage ratio from ~3.0x to ~2.0x Net Debt to EBITDA.

(Note that these figures include operating leases, which were brought on-balance sheet following the introduction of IFRS 16. Ashtead excludes IFRS 16 and reports a ratio of 1.6x, towards the bottom of its 1.5-2.0x target range.)

Ashtead has constructed a good debt maturity profile, as seen below. The USD 550 million notes due in 2026 will almost certainly be repriced higher, though this should not adversely impact the company’s interest expense.

CAPITAL ALLOCATION:

Management has a clear ranking for capital allocation: organic growth > bolt-on M&A > capital returns. This is illustrated in the waterfall chart below, which shows where the company’s cash came from and how it was spent over FY05-FY23. It brought in USD 38 billion cash, the lion’s share of which was from operations (a very good thing). It spent approximately USD 17 billion to sustain itself (45%), USD 10 billion on organic growth (27%), USD 6 billion on M&A (17%) and USD 4 billion on capital returns (11%).

COMPARISON WITH UNITED RENTALS:

Based on its forward PE and EV/EBITDA multiples, Ashtead trades at an ~40% and ~20% premium to its closest peer, United Rentals.

The two companies share a similar history, with ambitious management driving rapid market share gains. Both are also investing heavily in their Specialty businesses to leverage their platform and drive further rental penetration. Today, United Rentals commands a 17 per cent market share in the United States, some four percentage points higher than Ashtead. Because of their size, these two companies are the leading contenders to bid for the mega-projects, which will drive non-residential construction over the coming years.

However, as can be seen in the numbers below, there are some subtle differences in their profile which point to Ashtead being the superior business:

Ashtead has higher asset turnover and EBITDA margins, suggesting its investments are more productive.
While both companies have a similar return on equity, United Rentals employs more leverage to achieve this.
Higher leverage results in a higher interest expense, which means United Rentals earns materially less levered free cash flow.

One explanation for the difference between the two companies is Ashtead’s focus on dominating local markets. An anecdote from In Practise is illustrative (emphasis mine):

a lot of this equipment is such that, if you need the equipment, you need the equipment. That is what Ashtead really specialize in. They don’t do as many nationwide contracts as URI does where, on average, you probably get lower rates. If you need an extra piece of equipment, Ashtead will have it, when you need it, at the place you need it and that is where you can get the premiums; it’s kind of like Sherwin-Williams paint. They are embedded in the processes, where they are a small percentage of the overall project.

Ashtead’s preference for organic growth (investment into clusters) and small, bolt-on acquisitions is borne out in the numbers: in the fifteen years since 2008, it has invested some USD 22.5 billion into replacement capex, growth capex and M&A. Of this, 20 per cent went on M&A. United Rentals has invested USD 27.9 billion over the same time, of which M&A has comprised 42 per cent. As can be seen in the slide below, over the period FY11-FY21, Ashtead made 103 acquisitions at an average price of USD 28 million. Over time, it has driven tremendous revenue growth from these acquisitions, most likely thanks to how they accelerate the development of clusters.

Valuation:

Ashtead’s shares were priced during the Global Financial Crisis as if it was going bankrupt. They appear to have normalised into a range with an average of about 15x forward PE. As I have explained, earnings are not necessarily the best heuristic for the company’s true earnings power. In FY23, it had a steady-state cash flow of USD 3.3 billion. This would imply a trailing multiple of 12x enterprise value. Of course, if we are closer to the top of the cycle than I think, these may be peak earnings and true multiples may be a lot higher.

Wrapping IT up:

I’ve noticed two common traits across great companies: they are good at explaining what they do and care deeply about returns on capital. Ashtead is no exception, and you will learn a great deal from reading one or two annual reports - far more than I can hope to summarise here.

Ashtead is classified as an Industrial company due to its end markets, but I consider it a specialty finance company. It is highly profitable and earns an attractive return with modest leverage. Most compelling is its opportunity to re-invest almost everything it makes into the large, growing but still fragmented American market. I haven’t gone into detail on the company’s opportunity to grow in Canada or its turnaround in the UK, but those offer potential too.

Nonetheless, Ashtead is a cyclical business - albeit a superior one. As I described at the beginning of this write-up, things are going well for the company, and the odds seem good that this will continue for some time. But what happens when the cycle turns? Perhaps the key when considering an investment is to size the position to a level where one can comfortably add more in the event of a large decline.

Disclosure: Longriver Investment Partners Limited manages the Longriver Partners Fund and separately managed accounts. These portfolios may hold or trade securities discussed in this article, and their holdings may change without notice.