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 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 segments.
 Fair value of ~$60, representing ~80% upside.
 Downside is well-covered by assets on the balance sheet and a highly
depressed valuation.

In my view, HERC Holdings (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.
Technical selling appears to have abated, but cyclical oil & gas concerns 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


point

Small Portion Of Hertz's Business: HERC is a recent spin-off from Hertz Global
Holdings (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 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.

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. 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. In my view, this suggests
shares were sold due to non-fundamental reasons; likely the reasons cited above.
It has also 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 rental

Attractive Competitive Position: HERC is the #3 equipment rental player with ~4%
market share in North America, behind Sunbelt at ~7% and United Rentals (URI)
at ~13%. Apart from the aforementioned companies, no other 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. 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
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.

3. Oversupply situation as a result of oil & gas woes likely to clear

Exposure 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 (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 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.

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.
Source: Rouse Rental Report June 2016

The 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 ~7.5% 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, change 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 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.
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 (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. Management at Caterpillar
is forecasting 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.
Source: United Rentals 2Q '16 Earnings Call Presentation

Management 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):

Joe J. O'Dea - Vertical Research Partners LLC

That'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 & Director

So 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...

...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

Source: United Rentals 2Q '16 Earnings Call Presentation

As 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.

4. Market is pricing in 'worst-case' scenario, despite continued strength excl.


oil & gas
2008-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.
Indeed, HERC only seems to be trading at a cheap valuation if we assumed a 2008-
style recession is around the corner. Throughout 2007-2010, sales at HERC dropped
~40% while EBITDA halved, as seen below. Applying this scenario would result in
HRI trading at an undemanding valuation of ~11.2x trough EV/EBITDA.

Source: HERC Investor Presentation

No 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 Presentation

Although sequential ex-oil & gas rental revenue trends appear to be worsening, this
is likely due to the oversupply situation I discussed later, which should iron itself
out over the next few quarters.

Macro indicators also point to healthy growth going forward, as seen below.

Source: HERC 2Q '16 Earnings Call Presentation

As 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 & Asymmetry


Fair 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. 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 as HERC is just right. 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) 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"). FUR has
declined from ~18.6% in 2013 to ~12.6% in 2Q '16. The Company is targeting 10%
FUR. 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.

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.
Source: HERC Investor Presentation

As 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 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. Catalysts

Pricing Trends Improve Over The Next Few Quarters: As the oversupply situation
corrects, the Company should be able to increase pricing. 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.
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.
However, 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. Risks

Demand 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 hardly good
predictors of recessions. 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 be cheap on trough EBITDA.

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, 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, as discussed. Anecdotally, it appears many equipment rental firms
are family-owned, which could explain the high degree of rationality.