Trade-in: why do big rental companies buy their own shares?

In the last few months the equipment rental industry has seen the prices of shares of publicly traded companies decline significantly, often 50 to 65% (see article in March 08 IRN). This is despite record profits and strong cash flow by both rental companies and equipment manufacturers.

Whether or not the investors who are selling the shares are right will be shown by what happens in the near future, whether markets get hit by a serious recession, or if this will be remembered as a period of temporary uncertainty and hesitation.

Companies tend to repurchase their own shares only in certain situations. In recent times we have seen share repurchases proposed or implemented by United Rentals, Ramirent, Maxim Crane, John Deere, Terex and others. To understand these, let's examine why companies issued the shares in the first place.

Companies issue shares on stock markets to raise cash. The cash is used primarily for:

• Buying shares from previous owners

• Investing in business activities (which may be by organic growth, such as opening rental depots and buying equipment, or acquisition of competitors)

• Reducing debt

• Generally reinforcing the balance sheet (for example, to build or replace reserves, as many of the biggest banks are doing)

Publicly traded companies usually talk about profit numbers to investors in terms of Earnings Per Share (EPS). Earnings per share is calculated by taking the total profits of the company and dividing them by the total number of shares. A company is considered under or over valued depending on the ratio of its Share Price to Earnings ratio (or P/E ratio). As discussed in September 2006 IRN, rental companies often have P/E ratios of 15/1 or even above 20/1, when times are good and prospects are even better.

If you hold earnings constant, and decrease the amount of shares, then Earnings Per Share increases. The same profit is distributed over fewer shares.

Taking a theoretical example, if a rental company has revenues as below, its P/E would be 5x. Its EPS would be € 0.10 per share, which means that for every share of the company an investor owns, the forecast profit is 20% of that value; reflecting quite a low share price compared to typical rental company share values a year ago.

Annual Revenue €200m
Profit €16m
Market Cap €80m
Shares in circulation 160m
Jan 1 Share Price €0.50 per share
EPS €0.10 per share (€16m/160m shares)

Now, let's say the company has an extra €40m of cash lying around, and investors and analysts won't worry that the company's health would be compromised if this money is spent repurchasing shares; nor does the company have a more compelling investment possibility for that cash (more on this below). The company goes to the open market and repurchases half of all the shares in the market, which should, if the markets are stable and work correctly, result in a doubling of the share price of the remaining shares.

The day after the share purchase the company would look like this:

Annual Revenue €200m
Profit €16m
Market Cap €80m
Shares in circulation 80m
Jan 2 Share Price €1.00 per share
EPS €0.20 per share (€16m/80m shares)

All things being equal, the share price for the remaining shareholders should double, with the same Earnings spread over half the shares, assuming the P/E ratio (determined by the market) remains constant. Earnings per share are now €0.20, which will be even more exciting when they rise.

Repurchasing shares is compelling when:

• The shares are "cheap" (remember, United Rentals shares have traded at 15x+ P/E in recent years, and are now at 5.75x (July 7).

• No other exciting growth opportunities are apparent to the company management (including investing in rental fleet, facilities, new business lines, including acquiring other rental companies)

• The company has enough cash to do this without worrying anyone.

Limits to share purchases

Whenever you hear "all things being equal", remember, they never are. Does the company repurchasing its shares actually have that much cash, or is it borrowing money to do this, in the middle of a credit crisis?

It's unusual that a company will repurchase more than a small portion of its own shares. So, in a business climate where more than 50% of many rental company market capitalisation values have disappeared, a share repurchase of 10% of a company's own shares may simply not be a big deal.

Psychology of share purchases - can it be overdone?

Company management can demonstrate that it thinks the stock market is overly pessimistic when it buys its own shares, so this optimism alone is an attempt to reduce downward pressure on share prices.

United Rentals often comes up in analysis of rental companies, especially where extremes are discussed. United announced in June that it would repurchase around 30% (over US$1 billion) of its own shares by using debt. Remember, United's debt is also traded on bond exchanges in the US, so United bonds will increase or decrease in value depending on its perceived risk of default.

An extra US$1 billion plus of debt for United - which has been raised despite the credit runch - had bond analysts using strong language like "This share buyback coupled with the weakness in the economy are a one-two punch to credit quality [of United's bonds]." Remember, this debt used for repurchasing shares does not produce extra profitability or cash flow, as investing in equipment or acquisitions hopefully would.

In conclusion, I believe that today's doom and gloom about rental company stocks is over-rated, so share buybacks will be appreciated by the investors in years to come, after solid growth returns to the larger economies. Remember, however, that every £, $ or € spent on share repurchases is one that was not spent on investing in new equipment!

=== BOX STORY ===
The author: Jeff Eisenberg has spent 12 years in the rental industry. He started and led Genie Financial Services in Europe, providing finance for large and small rental companies all over the world. Since 2000 he has held senior positions in a number of European rental companies, as well as running his own consultancy for rental companies, financial institutions and equipment manufacturers. In July 2008 he joined Netherlands-based rental company Riwal as Director of Acquisitions and Investments. Contact tel: +44 (0)7900 916933.