Click HERE to register for our Annual Virtual Conference!

Key Takeaways

• We wanted to cover a company that will benefit from the recent passage of the Infrastrucutre bill. As the largest member of a fragmented market, we thought United Rentals was perfect.
  
• The term “Picks and Shovels” play refers to the Gold Rush in 1849. While many looked for gold, a more lucrative business tended to be selling the tools do so given the long odds of striking.
  
• We believe there has been so much underinvestment in infrastructure over the last decades and lower than average long-term construction spending that the current tailwind from the passage of the bill is just the beginning.
  
• The specialty rentals segment has been growing at a rapid clip and we believe it will continue to. The company has a clear path toward margin expansion, greater earnings power and bolstering its dominant position in its chosen industry.
  
• As construction needs exist all over the country, we believe the company will benefit an added tailwind as construction operators attempt to reduce costs in response to labor shortages.

“During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue jeans made a nice profit.” – Peter Lynch

There are a lot of overused analogies in financial discourse and one of them that is used often is calling something a “picks and shovels” play. The concept comes from the California Gold Rush in 1849 when folks from across the country and world flocked to the Golden State to seek their fortunes by trying to literally strike it rich.

If you think what you do for your job today is hard, try searching for a producing gold mine with amateur equipment in the late 1840’s. Not an easy task and it is no wonder why most people who came to search for gold didn’t find it.

However, many people were nonetheless able to capitalize on the influx of would-be miners by selling them essential equipment for their task, like picks and shovels. While this is only one of the most obvious tools there we many businesses that benefitted from the rapid influx of people into a previously sparsely populated and remote land.

Many of the most successful businesses in the same region nearly 175 years later have operationalized the concept and learned from the early days of commerce in their home-state. Cloud companies, for example, could definitely be said to be a “picks and shovels” play to the digital transformation. However, this is not an analogy or a metaphor in this case even really.

We literally are picking this company to take advantage of a coming boom in infrastructure and construction spending. They rent the picks and shovels of modern construction. The size, breadth and financial condition of this company all suggest that it will be a primary beneficiary of a coming boom in the spending on what it rents to companies who need it. The company has a larger footprint in North America in its industry.

Eureka! Infrastructure Passage Likely Early Days For Increased Construction Spending

After months of debate and legislative chicken, the House of Representatives finally passed a $1.2 trillion infrastructure bill last week with a 228-206 vote. Usually, in less acrimonious times, infrastructure is one of the most popular and bi-partisan issues as every member loves to bring the bacon home to their district if they can.

Unfortunately, we live in uniquely polarized times which in no small part is encouraged by our surreptitious and sinister autocratic adversaries. By many measure the US is a laggard in the quality of our infrastructure and it has long been recognized that infrastructure spending has a positive multiplier effect on the economy.

The American Society of Civil Engineers has estimated that the country underspends on infrastructure estimates that there is shortfall of $2.6 trillion in needed infrastructure spending every decade. What are the economic consequences of this? By 2039, the group estimates that underspending will cost the American economy about $10 trillion in lost GDP.

It’s not just public projects either, many companies may have differing needs and changes they need to implement because of COVID-19 to offices and facilities. A massive boom in construction was likely already on its way as the economy begins its post-COVID comeback, but the added catalyst of government sponsored infrastructure projects certainly makes this name look all the more appealing to us. We’d also venture to say that as company’s competitively bid for projects the savings provided by renting could be a key way to reduce costs and still effectively deliver on their end.

As you can see, over the course of the last decades, construction spending per capita has tended to exceed long-term averages during cyclical expansions. We believe the coming cyclical expansion given several macro trends will likely ultimately make construction spending per capita approach the levels achieved in the runup to the Global Financial Crisis. We’d suggest that there are a lot of reasons for new construction given the accelerated changes brought on by COVID-19.

An Old-Economy Company Meets the Digital Transformation

Phillip Fisher wrote a famous book on investing called Common Stocks and Uncommon Profits. In this book, he mentioned that cyclical companies like those involved in constructions are often beneficiaries of up-cycles, just like the one that followed that baby-boom and American victory in the Second World War.

The boom in spending causes cyclically inclined companies to experience above-market growth. That appears to already be happening with United Rentals, but we believe the idiosyncratic situations from which we are emerging is probably most similar to the Herculean tasks and spending levels that occurred in wartime. This company has also been improving its financial condition and business model over the past decade and we think it will be quite lucrative when these efforts collide with what could be a major super-cycle in construction spending bolstered by US government efforts.

Impressively, this company which you may associate with anything, but the digital transformation is finding impressive ways to benefit from digital technology and, given the sprawling physical network of locations needed for this business model, the potential benefits for the business model are significant.

The investments on the digital front have been paying major dividends so far. The company, like many Epicenter companies, used a tough situation in order to increase efficiencies in an industry that seemed decidedly boring compared to the Technology darlings of the market. Sometimes a strong business with enduring competitive advantage is just exactly that. We think the combination of a massive physical footprint with the increased efficiencies and increased desirability of a digitally enabled platform has repeatedly proved a winning equation across various sectors of the economy.

Culture, Culture, Culture

We’ve definitely heard the saying location, location, location. We’d suggest that for companies like this one a winning culture is an enormously important ingredient to continued success. This firm’s management team has a clear plan for rewarding shareholders made even more plausible by their execution and pro-shareholder bent over the past decades. These guys know how to deliver, and we think they will be able to capitalize effectively on this moment because of years of preparation.

The company has consistently outgrown its peers likely because of structural advantages that will only likely increase in the current environment. The dedication to innovation and a strong culture is ingrained in every company decision and this allows agility enabled by capital discipline and opens multiple pathways to continued above-market growth. For example, the revenue so far generated through digital channels is pretty small but growing two to three times faster than the top line.

Company culture is not valued by everybody, but based on this column’s winners, we believe it is an essential and crucial component to an enduring competitive advantage. Temporary boons and advantages are able to be spun into enduring positives for shareholders by a management team that fosters an effective culture centered on innovation and one that is aligned with the needs of customers. As qualitative as this is, we believe it is a very crucial ingredient to commercial success.

The Courage To Change Is Crucial For Survival

This is a great example of an Epicenter company. Our Head of Research, Tom Lee, has highlighted companies that pivot and effectively adapt to a post-COVID as having a good risk adjusted return because they have an increase capacity to surprise consensus. This name has also been flagged by Brian Rauscher’s Earnings Revision Model which has a demonstrated track record of selecting companies that will outperform consensus earnings expectations.

As you can see, this company has significantly outperformed both the market and its’ peers over the past decade. This is not an accident as we said, and we think it is likely directly attributable to a superior culture and structural advantages that show no sign of abating. The company’s considerable efforts to increase FCF have paid off handsomely and enabled to also have the firepower and credit profile to benefit from accretive acquisitions.

In addition to these key advantages, the company has a very diverse clientele across virtually the entire industrial economic system and across geographies as well. The company’s industry-leading position is likely just beginning as the benefits of scale, scope and diversification will take a while to make themselves fully apparent. For example, one weakness of the construction rental business would be high cyclicality. The company has made great strides reducing its own cyclicality by dramatically increasing its specialty rentals business. The gains in free-cash flow also speak for themselves.

The company’s ability to deliver and follow through on past initiatives to change give us faith that their recent positive strides and continued innovative efforts will pay off, just as they have in the past.

We think that the particulars on the demand-side are extremely favorable and that both construction and government infrastructure spending will continue increasing over the medium term. For example, wage pressures in the construction industry likely increase the relative benefit of renting equipment in many cases.

These forces combined with a proven management team, strong balance sheet and plausible strategy seems like a winning formula. You’ll want to let the story play out so it’s a longer-term name, not a trade. This is a time-tested name with a proven management team shareholders should continue benefitting from.

Risks And Where We Could Be Wrong

Given that this company has such a diverse clientele and multiple paths to continued growth and efficiency, we think that any headwinds that effect economic growth on a wide level could be problematic for the company. Similarly, inflation and rising material costs could slow the projected levels of demand.

Though the light at the end of the tunnel seems near on COVID-19, any new variant or lockdown issues in the United States would definitely be problematic. The infrastructure passage was a major positive for the name. However, supply-chain issues could definitely slow demand and hurt the company’s ability to be customer-centric and timely, one of the major reasons businesses use it.

We do acknowledge that the stock is priced pretty high, but we believe it’s early innings and see multiple paths to continued growth. We believe, on a relative basis compared to peers and other stocks on the market with less promising prospects for growth, the risk-adjusted return is pretty good. Particularly when you factor in the positive readings from the Earnings Revision Model our team has found. However, this name could definitely be victim if inflation pressures run out of control.

There have been favorable developments in anticipated levels of U.S. nonresidential construction. Anything that derails the favorable projections will obviously derail consensus growth projections for the company as well. The company’s above-market growth in the specialty segment is a key part of why we like this name and think growth can continue at levels justifying the valuation.

There’s always a chance that management messes up the strategy or makes a bad acquisition that complicates or undermines operation efficiency. We’d say this risk is mitigated given the solid track record of this management team and the straight forward nature of the business model.