While equity investors look for upside to cash flows, credit investors just need to know that firms have the means to pay them back.
With its consistent, above cost-of-capital returns, this firm seems to be a creditors’ dream. But its bonds currently trade at an elevated level, suggesting that creditors may be concerned about its leverage or interest coverage ratios.
However, when looking at its credit term structure, it becomes apparent that the firm’s stability is not an illusion and the market is overstating its credit risk.
Below, we show how Uniform Accounting restates financials for a clear credit profile.
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When equity investors pick securities, they’re largely looking for upside to cash flows. They hope to find a company that will generate more money than the market expects, thus rewarding shareholders through increases in stock price and dividends.
Credit investors, on the other hand, care less about potential upside to a firm’s cash flows. Instead, they just need the company to have sufficient cash flows to pay them back.
In the fixed income market, there isn’t the same high-risk, high-return mindset as in equities. Massive swings in cash generating capabilities are generally detrimental for credit investors, even though they can be incredibly lucrative for stockholders.
For creditors, boring is better.
Credit investors are looking for firms with stable cash flows and little volatility. As such, creditors will be quick to discount any perceived business risk when considering an investment.
We’ve talked in the past about United Rentals (URI) and how “boring” the firm has become since acquiring construction and industrial equipment renter RSC Holdings in 2012.
As seen below, the firm has had incredibly stable, above cost-of-capital returns since the acquisition.
On paper, this firm seems to be a creditor’s dream. It has adequate profitability and low volatility in its cash flows.
However, yields of the firm’s bonds are trading at elevated levels, above 4%, suggesting that markets are clearly pricing in material risk to the name.
Perhaps the market is spooked by the firm’s high debt/equity ratios that eclipse 3x. Maybe the firm’s falling coverage interest ratios, even before the coronavirus pandemic, are causing some investors to be cautious. These signals may show that the firm has taken on too much leverage.
Yet despite these potential concerns, investors seem to be missing one of the most important factors of a company’s credit: its term structure.
When looking at United Rental’s term structure, it becomes apparent that the firm faces no near-term debt obstacles and does not seem to be an elevated credit risk. In fact, the firm has no material debt headwall until 2024.
Meanwhile, even when the firm’s cash flows dip this year, as a result of coronavirus-driven disruptions, it’s remaining cash flows still should be sufficient to cover all operating obligations.
Moreover, United Rentals will have ample time to see a recovery in its cash flows. With its operational sustainability and expected cash build over the next four years, the firm should have little difficulty servicing its debt obligations. It likely will not even need to refinance to pay off its debt.
This examination of the firm’s term structure using Uniform Accounting shows that the firm’s current bond yields are much too high. Its credit is much safer than the market currently recognizes, giving investors an opportunity to buy a bond trading lower than actually warranted.
URI’s Healthy Debt Repayment Capacity Calls for Ratings Upgrade
Cash bond markets are grossly overstating credit risk with a cash bond YTW of 5.021% relative to an Intrinsic YTW of 2.041%, while CDS markets are accurately stating credit risk with a CDS of 201bps relative to an Intrinsic CDS of 172bps. Meanwhile, Moody’s is overstating credit risk with its Ba2 rating three notches lower than Valens’ IG4 (Baa2) rating.
Fundamental analysis highlights that URI’s cash flows should comfortably exceed operating obligations in each year going forward. Moreover, the combination of the firm’s cash flows and expected cash build would be sufficient to handle all obligations including debt maturities through 2026.
Furthermore, with a healthy expected cash build and material capex flexibility, the firm should be able to comfortably navigate debt headwalls even if cash flows were to weaken in out years. Additionally, URI’s sizable market capitalization and robust 90% recovery rate should facilitate access to credit markets to refinance, if necessary.
Incentives Dictate Behavior™ analysis highlights mostly positive signals for credit holders. URI’s management compensation framework should drive management to focus on all three value drivers: asset utilization, margin expansion, and top-line growth, leading to Uniform ROA expansion and increased cash flows available for servicing obligations.
Moreover, although most management members are not material holders of the company’s equity relative to their average annual compensation, CEO Flannery’s high equity multiple indicates that he may influence other NEOs to align with shareholders for long-term value creation.
However, although most management members are not well-compensated in a change-in-control scenario, CEO Flannery’s significant change-in-control compensation may be enough to influence them to accept a takeover or sale of the company, increasing event risk.
Earnings Call Forensics™ analysis of the firm’s Q1 2020 earnings call (4/30) highlights that management is confident their proceeds as a percentage of original equipment cost was healthy ay 53% and that they have had a procure-to-pay, seamless, and touchless system for a couple of years.
However, they may be exaggerating their liquidity in the most challenging end-market scenario and their capex flexibility. Moreover, they may be concerned about declines in owned equipment rental, and they may lack confidence in their ability to adapt to the coronavirus and add more resources to their specialty businesses.
URI’s strong cash flows, healthy expected cash build, and robust recovery rate indicate that cash bond markets and Moody’s are overstating credit risk. As such, both a ratings improvement and a tightening of cash bond market spreads are likely going forward.
SUMMARY and United Rentals, Inc. Tearsheet
As the Uniform Accounting tearsheet for United Rentals, Inc. (URI:USA) highlights, the company trades at a 19.2x Uniform P/E, which is below global corporate average valuation levels, but around its historical average valuations.
Low P/Es only require low EPS growth to sustain them. That said, in the case of United Rentals, the company has recently shown a 43% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, United Rentals’ Wall Street analyst-driven forecast projects a 53% shrinkage in earnings in 2020, followed by 26% growth in 2021.
Based on current stock market valuations, we can back into the required earnings growth rate that would justify $161 per share. These are often referred to as market embedded expectations.
The company can have Uniform earnings shrink by 9% each year over the next three years and still justify current prices. Wall Street analyst expectations for United Rentals’ earnings growth are below what the current stock market valuation requires in 2020, but above that requirement in 2021.
Meanwhile, the company’s earnings power is 2x corporate averages. Also, total obligations—including debt maturities, maintenance capex, and dividends—are above total cash flows, and intrinsic credit risk is 140bps above the risk-free rate, signaling a fairly low risk to its dividend and operations.
To summarize, United Rentals is currently seeing below average Uniform earnings growth, but this performance is not expected to continue going forward. Therefore, as is warranted, the company is trading below peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research