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HERC Holdings Non-Economic Selling And Temporary Oversupply Sets Up 80% Upside

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HERC Holdings: Non-Economic Selling And Temporary Oversupply Sets Up 80% Upside | Must Read Aug. 30, 2016 9:00 AM ET by: Lester Goh Summary Likely mispriced due to non-economic selling. Oversupply situation likely to clear over the next few quarters. The market appears to have priced in the 'worst-case' scenario, despite continued health in ex-oil & gas markets. Fair value of ~$60, representing ~80% upside. Downside is well- covered by assets on the balance sheet and a highly depressed valuation. HERC Holdings: Non-Economic Selling And Temporary Oversupply Sets Up 8… Page 1 of 19 http://seekingalpha.com/article/4002854-herc-holdings-non-economic-selling-tem… 31/8/2016
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HERC Holdings: Non-Economic Selling And Temporary Oversupply Sets Up 80% Upside|Must Read Aug. 30, 2016 9:00 AM ET

by: Lester Goh

Summary• Likely mispriced due to non-economic selling. • Oversupply situation likely to clear over the next few quarters. • The market appears to have priced in the 'worst-case' scenario,

despite continued health in ex-oil & gas markets. • Fair value of ~$60, representing ~80% upside. Downside is well-

covered by assets on the balance sheet and a highly depressed valuation.

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In my view, HERC Holdings (NYSE:HRI) ("HRI", "HERC", or "the Company") represents a compelling opportunity to initiate a long position in a firm which has been a victim of non-economic selling as a result of traditional spin-off dynamics. Non-economic selling appears to have abated, but cyclical oil & gas woes have pressured rental rates and resulted in a guidance cut. I believe these concerns are temporary and likely to be solved over the next few quarters. My target price of ~$60 represents ~80% upside potential. Downside protection is solid, courtesy of assets on the balance sheet along with a highly depressed valuation which appears to have priced in a 'worst-case' scenario despite many indications to the contrary.1. Spin-off dynamics led to non-economic selling, creating a compelling entry pointSmall Portion Of Hertz's Business: HERC is a recent spin-off from Hertz Global Holdings (NYSE:HTZ), a name that should be familiar to most readers. Prior to the spin-off, HTZ had two main business lines - car rental and equipment rental. It also owns the Donlen business, which primarily provides fleet leasing and fleet management services.The car rental business is operated through well-known brands such as Hertz, Dollar, Thrifty, and Firefly. The equipment rental business is simply branded Hertz Equipment Rental and was spun off from HTZ earlier this July. As evidence of its small size, HERC comprised of ~14% of HTZ's 2015 sales and ~18% of adjusted pre-tax income (adjusted for one-time charges as detailed in the 10-K). This suggests investors likely bought shares of HTZ to gain exposure to the car rental business, not the equipment rental business.Arguably Worse Business Relative To Hertz Car Rental: Many investors, as well as Wall Street, view the equipment rental business as lower quality. This is because HERC requires immense CapEx to grow whereas HTZ has relatively lower CapEx needs. In addition, industry structure favors the car rental business.

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The domestic and international car rental business of HTZ spends ~$2b in annual CapEx, which works out to ~24% of sales on ~$8.4b in 2015 revenue. The equipment rental business generates ~$1.6b in 2015 revenue but requires ~$500m annual CapEx, or ~31% of sales.In recent years, the car rental industry has consolidated down to three major players (Hertz, Avis, Enterprise) owning ~90% of the U.S. market. Such a high degree of market share concentration has allowed for sustained pricing power and rational supply. In contrast, the equipment rental industry is highly fragmented, with the three largest players accounting for ~25% of the North American market. While a highly fragmented industry suggests considerable runway for growth, it exposes players to periods of oversupply.Post-Spin Trading Volume Trends Imply Substantial Non-Economic Selling:According to Yahoo Finance, daily trading volume in the weeks following the spin-off started off at ~2.5m, falling to ~230k as of Aug 19. I'm guessing here - to me, this suggests shares were likely sold due to non-fundamental reasons, preventing HRI from repricing to fair value. Current daily trading volume is small compared to the volume of shares traded immediately post-spin, suggesting most market participants may not be paying attention. The combination of these factors have created a compelling entry point for longs.Screens Poorly On Value Metrics: As identified by a fellow Seeking Alpha author, the roles of the parent and spin-off are reversed on an accounting basis; HERC is treated as the parent and HTZ the spin-off. This role reversal has resulted in major data providers such as Yahoo Finance listing incorrectly calculated valuation metrics. Yahoo lists HERC's EV/EBITDA as ~17x, while it is actually closer to ~5.6x.2. HERC enjoys an attractive competitive position and benefits from secular trends in equipment rentalAttractive Competitive Position: HERC is the #3 equipment rental player with ~4% market share in North America, behind Sunbelt (owned by the Ashtead Group) at ~7% and United Rentals (NYSE:URI) at ~13%. Apart from the aforementioned companies (and Home Depot, who has ~1% share), no other

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player has the scale to compete nationally; the rest of competition typically competes in regional markets. National scale not only allows HERC to redeploy equipment to other regional markets when one is experiencing a downturn, but also offers the Company purchasing power when ordering new equipment which smaller competitors do not have. This purchasing power allows HERC to pass on a portion of its cost savings to customers. In addition, HERC also possesses a wide offering of equipment which make it (along with Sunbelt and United Rentals) the few one-stop shops for large customers.Secular Trends In Equipment Rental: Customers are increasingly turning to renting equipment for their operational needs. There are strong reasons to do. One reason is flexibility. As the recent oil & gas industry downturn has shown, demand can take a major step down over a short period of time. Instead of owning equipment outright, renting allows a customer to dispose off unneeded capacity easily. Renting also frees up capital as it entails a much smaller economic commitment as compared to ownership. Getting caught with excess capacity in a downturn can be ugly; lower revenue on high fixed costs is not a fun combination, and renting largely eliminates this problem. Hence, it should come as no surprise that rental penetration in North America have been growing for years - it was ~41% in 2003, ~48% in 2008, and ~53% in 2015. While ownership risk is passed on to the equipment rental companies, HERC and its peers are better suited to managing such a risk given the Company can redeploy unneeded equipment in a struggling market (i.e. oil & gas) to a relatively healthier market (i.e. non-residential construction), severely mitigating "re-rental" risk. This is something most of its customers are unable to do.3. Oversupply situation as a result of oil & gas woes likely to clearExposure To Oil & Gas Significantly Reduced: Oil & gas prices have been depressed for much of the past 2 years. The reduction of prices of these commodities have forced major industry players to cut billions in CapEx as new projects became severely uneconomic at spot prices. At $100 oil/bbl, Exxon Mobil (NYSE:XOM) was spending $33-$34b annually in CapEx. At the XOM 2016 annual meeting, management guided for ~$23b in CapEx, while YTD 2Q '16 is at ~$10b. Similarly massive reductions in CapEx can be seen

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at other major firms. Suffice to say, this drastic drop in capital spending has cratered demand for upstream oil & gas equipment rentals. HERC's exposure to the upstream oil & gas industry has been significantly reduced. Upstream oil & gas revenues have fallen from ~25% of equipment rental sales in 2014-2015 to ~19% as of 1Q '16, and ~16% as of 2Q '16. Thus, upstream oil & gas performance will be less of a driver going forward.Oversupply Situation Likely To Clear Over Next Few Quarters: As a result of the huge reduction in demand for equipment rentals for the upstream oil & gas industry, equipment rental firms have responded by redeploying said equipment in other markets (i.e. non-residential construction and industrials). This redeployment of equipment has resulted in an oversupply situation in the past few quarters.

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Source: Rouse Rental Report June 2016The mismatch between supply and demand is evident by examining pricing trends. The Rental Rate Index provided by Rouse Services, a leading data provider for the equipment rental industry, plateaued in mid-2014 after years of steady increases, and have began seeing y/y declines beginning in late 2016, as seen above. As a result, the Company cut 2016 EBITDA guidance from $560m-$610m to $520m-$560m, or ~7.7% at the mid-point.Despite volume trends remaining relatively stable (especially when viewed on an ex-oil & gas basis), the more pressing issue, and likely what market participants are laser-focused on, is that of pricing. This is because, unlike volume, changes in pricing results in an outsized impact on profitability as it carries no variable costs; declines in volumes can be mitigated by reducing related variable costs, but the same cannot be said for pricing. In short, the market appears to be extrapolating recent industry-wide pricing trends into the foreseeable future, an assessment I strongly disagree with.Reason being, fleet additions in the equipment rental industry have been significantly curtailed. Said another way, incremental supply is falling rapidly. Additionally, demand in non-oil & gas markets continues to grow.

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HRI spent $435m-$520m annually over the 2013-2015 period on net fleet CapEx (net being acquisitions of new equipment - disposals of old equipment), a time-frame which coincides with oil trading at materially higher prices as compared to the present. The Company is now guiding for $375m-$400m in net fleet CapEx for 2016.The situation is similar at United Rentals, the largest equipment rental firm in North America with ~13% market share. United spent ~$1b-$1.2b in net rental CapEx (similar definition as HRI) over the 2013-2015 period, and is guiding for a mere $650m-$750m in 2016.To get a feel for the rest of the equipment rental industry, I believe it is instructive to look at Caterpillar's (NYSE:CAT) sales trends. Caterpillar is primarily a seller of equipment to many industries that HRI and United serves. Sales of such equipment has declined ~22% y/y as of YTD 2Q '16 from ~$23.5b to ~$18.4b. Total sales, which includes revenue from its finance arm, is about ~$19.8b as of YTD 2Q '16. Management at Caterpillar is forecasting full-year 2016 sales near the bottom-end of the $40b-$42b range, a large decrease from ~$47b-$55b over the 2013-2015 period.This massive reduction in fleet additions is beginning to bear fruit. HRI cited in its earnings presentation that worldwide pricing saw a 0.5% increase y/y in 2Q '16, suggesting pricing is beginning to stabilize. Monthly sequential pricing trends have also turned positive for United Rentals, with prior-month declines decreasing over time, as seen below.

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Source: United Rentals 2Q '16 Earnings Call PresentationManagement commentary at United also indicates the firm has mostly finished redeploying its original oil & gas equipment to other industries and that the supply/demand situation has improved significantly (emphasis mine):

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Joe J. O'Dea - Vertical Research Partners LLCThat's helpful. Thanks. And then just one more on with what we've seen at some of the Rouse supply-demand data recently, I think on the demand side, some of that's explained with heavy equipment trends and some weather effects. But when you think about it on the supply side, outside of your own decisions, is your general sense that the industry is behaving rationally with the supply growth that we continue to see. And then related to that, do you think that we have now fully moved beyond some of the equipment redeployment related to oil?Michael J. Kneeland - President, Chief Executive Officer & DirectorSo there are several answers there. So in my estimation, I think we have moved beyond the oil and I think that has been fully absorbed...

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...Number two, I think by order of magnitude when you ask is everyone playing safe or playing right, I think that one of the things that I took away from the Rouse report, I believe, it was in May, the report actually saw where the supply was below the demand. The demand was higher. So that would tell me that their people are being good stewards in understanding of the industry trends."Source: United Rentals 2Q '16 Earnings Call Transcript

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Source: United Rentals 2Q '16 Earnings Call PresentationAs seen above, United also provides an exceedingly helpful chart suggesting supply is beginning to match demand, a stark contrast to 2015 where supply growth largely outpaced demand growth.Collectively, the data and commentary provided by HERC, United Rentals, Rouse, and Caterpillar serves as strong indications the supply situation, at the very least, is not getting worse. While I am not concluding that pricing has bottomed, it appears tremendously difficult to make a strong argument for pricing continuing to deteriorate significantly going forward; the opposite scenario seems far more likely, something that is a huge positive for HERC over the next few quarters.

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4. Market is pricing in 'worst-case' scenario, despite continued strength excl. oil & gas2008-Style Recession Scenario Appears Priced In: With net debt of ~$2.1b, the equity trading at ~$930m, and the Company guiding $520m-$560m in 2016 EBITDA, shares of HERC trade at ~5.6x EV/2016E EBITDA at the mid-point of guidance. Such a multiple implies unsustainable fundamentals stemming from a cyclical peak. Yet, HERC still seems to be trading at a cheap valuation even if we assumed a 2008-style recession is around the corner. Throughout 2007-2010, sales at HERC dropped ~40% while EBITDA halved from peak to trough, as seen below. Applying this scenario would result in HRI trading at an undemanding valuation of ~11.2x trough EV/EBITDA (~$3.04b in EV / $270m in EBITDA).

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Source: HERC Investor PresentationNo Indication 2008-Style Recession Is Around The Corner: Excluding upstream oil & gas revenue, HERC is performing very well. In 2Q '16, rental revenue grew ~8% in non-upstream oil & gas markets, which is a continuation of trends in prior quarters, as seen below.

Source: HERC Investor PresentationAlthough sequential ex-oil & gas rental revenue trends appear to be worsening, this is likely due to the oversupply situation I discussed earlier, which should iron itself out over the next few quarters as the equipment rental industry continues to be disciplined about fleet additions.Macro indicators also point to healthy growth ex-oil & gas going forward, as seen below.

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Source: HERC 2Q '16 Earnings Call PresentationAs a result, it appears difficult to make a solid argument as to why the near future will be as bleak as HERC's current valuation implies. Again, the opposite appears far more likely.5. Valuation & AsymmetryFair Value Of ~$60 Representing ~80% Upside: Given HERC operates in a highly cyclical industry, it is hard to argue for high (low-to-mid teens) EV/EBITDA valuation multiples at potentially mid-cycle earnings. Fortunately for longs, conservative assumptions still imply material upside from current levels. In my view, a 7x EV/2016E EBITDA on a highly cyclical business such

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as HERC is quite reasonable. At the mid-point of 2016 EBITDA guidance, this implies ~$3.78b in EV. Subtracting ~$2.1b in net debt and dividing the result by ~28m shares outstanding gets me to a ~$60 stock price.Note the Company is likely under-earning significantly and therefore 2016E EBITDA does not fully represent HERC's potential. HERC is currently generating ~33% adj. EBITDA margins as compared to ~48% at United Rentals. While some of the difference can be explained by scale (United Rentals has ~3x the market share of HERC) and different add-backs, HERC's management believes the margin differential can be reduced significantly.To achieve this, management is focusing on consolidating its supplier base; the number of suppliers has been reduced by ~40% from 2Q '15 to 1Q '16. In addition, the Company is also decreasing its Fleet Unavailable for Rent ("FUR") to open up additional rental opportunities. FUR has declined from ~18.6% in 2013 to ~12.6% in 2Q '16. The Company is targeting 10% FUR; each 100bp improvement results in an incremental $35m in equipment available for rent. Moreover, HERC is also looking to expand its products and services to higher-margin offerings such as ProSolutions and ProContractor Tools.More information on these initiatives can be seen from the Company's presentations. Needless to say, excluding the benefits from these potentially large margin improvements incorporates a significant margin of safety in my estimates. Notably, these margin improvements do not appear to be priced into the stock at the current valuation.Significant Downside Protection Sets Up Asymmetric Risk/Reward: With tangible assets at HERC currently valued near the Company's EV and a low current valuation of ~5.6x EV/2016E EBITDA, there appears to be material protection on the downside for longs.

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Source: HERC Investor PresentationAs seen above, the value of the Company's tangible assets is around ~$2.9b (fleet OLV is appraised by Rouse, a third-party) while EV is roughly ~$3b. Note the numbers are as of 1Q '16; the 2Q '16 numbers are slightly higher. Moreover, the Company's current valuation appears to have already priced in a 2008-style recession scenario as discussed, suggesting further downside is

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likely limited. Couple the fact tangible assets nearly covers the Company's current EV with significant upside potential, shares of HERC represent a highly asymmetric long opportunity.6. CatalystsPricing Trends Improve Over The Next Few Quarters: As the oversupply situation corrects, the Company should be able to increase both pricing and volume. This should improve operating results going forward.Deleveraging Of The Balance Sheet: Some investors are worried about the Company's leverage. However, HERC is still significantly free cash flow positive. This cash flow can be used to be pay down debt. In addition, management is confident EBITDA margins can be improved considerably going forward, as discussed. Increases in EBITDA margins would reduce the net debt/EBITDA ratio. If we want to be draconian, in a hypothetical orderly liquidation, tangible assets would more than cover outstanding debt, and would still leave sufficient equity for longs to recoup their investment at the current share price, as discussed.Oil & Gas Markets Improve Significantly: Admittedly, this is more of a macro call. Oil prices have recovered significantly from their lows and appear to be stabilizing. This could lead to increased confidence by oil & gas industry participants to increase CapEx, a scenario which bodes well for HERC. That said, I wouldn't base a long position in HERC solely on this.7. RisksDemand From Non-Upstream Oil & Gas Markets Decline: While certainly a possibility, current macro indicators do not suggest any near-term decline, as discussed. An easy push-back to this is that macro indicators are not always accurate and may change for the worse in short order. However, even if a 2008-style recession scenario materializes and HERC's revenue and EBITDA fall ~40% and ~50% respectively, similar to what occurred over the 2007-2010 period, the Company's valuation would arguably still be cheap on trough EBITDA.

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Equipment Rental Players Significantly Increases CapEx: A large increase in fleet additions would worsen the current oversupply situation and likely result in further drops in pricing and likely some degree of volume pressure, which would lead to outsized EBITDA declines at HERC. This risk is mitigated by the fact the industry, despite being highly fragmented, appears to be very rational in reducing fleet additions, as discussed. Anecdotally, it appears many of the smaller equipment rental firms are family-owned, which could explain the high degree of rationality.Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.Additional disclosure: Disclaimer: The author's reports contain factual statements and opinions. He derives factual statements from sources which he believes are accurate, but neither they nor the author represent that the facts presented are accurate or complete. Opinions are those of the the author and are subject to change without notice. His reports are for informational purposes only and do not offer securities or solicit the offer of securities of any company. Mr. Goh ("Lester") accepts no liability whatsoever for any direct or consequential loss or damage arising from any use of his reports or their content. Lester advises readers to conduct their own due diligence before investing in any companies covered by him. He does not know of each individual's investment objectives, risk appetite, and time horizon. His reports do not constitute as investment advice and are meant for general public consumption. Past performance is not indicative of future performance.

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