The Appleton Column – Market or private?
By Kevin Appleton and Steve Ducker24 March 2015
The recent arrival on the stock exchange of HSS received a fair bit of coverage in the rental media. It joins a number of listed rental companies on a variety of stock markets most of whom are relatively small in the context of their native exchanges.
HSS had been in the hands of private equity for well over a decade by my reckoning, prompting the question, “what is the best financial ownership model for rental companies”?
As with many other questions the answer, it seems to me, is “it depends”. The single biggest variable is where a company might be in its maturity curve and, consequently, what its cash and growth characteristics are.
Rental businesses, in their growth years, are pretty cash hungry. If the business is growing very rapidly in proportion to its size (high percentage growth rates) then it will be investing in fleet to support that growth and/or in the fit out or acquisition of new locations to penetrate new geographic areas.
The natural cash flow of the business will be insufficient to support these investments and so injections of debt, equity or both will need to be substantial in comparison to the perceived present value of the business.
For rental businesses with larger assets (construction equipment or aerials, for example) that are achieving high growth, it has not been uncommon to see negative or neutral cash flows through several years.
The reason is obvious – you build the fleet to achieve the market position you desire and that costs a lot of cash, provided through debt and equity.
Once that market position is achieved, you throttle back investment in the fleet to replacement levels (often below depreciation levels) and, as a consequence, free cash generation becomes substantial, and potentially significant enough to generate a >20% annual cash return on the original equity investment that got you there.
And there’s the problem. Especially in rental markets where equipment life is 10 to 15 years (heavy equipment) the cash payback period is unlikely to arrive much before five to seven years of following a growth strategy.
Most private equity houses want to hold investments for not more than five years. When they come to sell the investment at the end of that time (via a public flotation or sale to another private owner) they are, if they’ve been successful, pointing to a business that has consumed a lot of their cash (to drive growth) but asking a future owner to believe that this will all be different and therefore it’s worth paying a high price to acquire the business. It sounds too good to be true, even though it probably is true!
On the public markets things are much the same. If we think back to how Ashtead was valued back in 2008 (extremely low), this was partly a reflection of the fact that Ashtead had invested a lot of cash in growth but hadn’t yet got to the scale where they had a track record of generating substantial free cash flow.
Some analysts and investors expected the business to struggle through the recession and that nervousness was reflected in the (then) share price. However, Ashtead carried on investing, made that breakthrough into being a rental business of scale and its debt now looks a lot more manageable. The massive growth in the share price underlines that the markets now have a different view of the business.
If we understand where a rental business is in its maturity curve and the likely rate of investment required in its fleet we can make judgements about the best form of financial ownership.
Rental businesses with a serious growth agenda (and substantial cash generation capability at the end of that journey) require a five to seven year commitment, minimum.
While that certainly doesn’t make it impossible for PE houses to make money from rental companies, it is an investment that needs time and a strong nerve.
The same is true for public investors. In truth, if you have belief and enough cash try and own your business yourself – because it’s likely to produce a great long-term income.
Kevin Appleton is former CEO of Lavendon Group plc and former divisional chairman of Travis Perkins plc. He is currently managing director of Yusen Logistics UK, non-executive chairman of Horizon Platforms, non-executive director at Ramirent Oyj and non-executive director of the Freight Transport Association. To comment on these articles please email: IRNfeedback@khl.com
This is a feature from the March issue of IRN. To read The Appleton Column every issue, or to see other features from the March issue, please subscribe to the magazine at http://www.khl.com/subscriptions