Custom Truck One Source, Inc. (CTOS) Earnings Call Transcript & Summary

Welcome, everyone, to this fireside chat with Custom Truck One Source. My name is Tami Zakaria. I'm the machinery analyst here at JPMorgan. And it is my pleasure to host Ryan McMonagle, President and COO; and Chris Eperjesy, CFO of Custom Truck One. Ryan, I'll pass it on to you.

Great. Thank you for having us, and thank you, all, for giving us a chance to talk about Custom Truck One Source. So, we love to tell the story. So we thought, we'd have a few just prepared slides to talk about the business, and then we'll get into Q&A with Tami. But love to talk about CTOS or Custom Truck, and talk about how it truly is kind of the leading integrated provider of specialty equipment. And so for us, it means that we're a true one-stop shop platform, which means we love to take care of our customers, however they want to consume equipment. And we'll talk about the different ways that we do that, but it's primarily through our rental fleet, which is a big part of our business and our sales organization as well. What makes us unique, are a few things: one, the favorable end markets that we serve. We'll spend a minute talking about the 4 primary end markets, which we think continue to have great tailwinds and great demand drivers in them. And then we'll talk about where the growth opportunity is. But just from setting up the business, for fiscal year '22, we were $1.57 billion of revenue, right at $393 million of adjusted EBITDA. And I said, the rental fleet is a big part of our business. We've got -- we have about 10,000 pieces in our rental fleet or just under $1.5 billion of capital tied up. And there are 4 primary end markets that we serve. You'll see them in the first chart on the bottom. T&D or transmission and distribution or the utility end market is the largest end market we serve. It's about 65% of our revenue. It's about 70% of our rental fleet today, so it's our largest. We'll talk about, why we like that. Infrastructure is our second largest, and then rail and telecom are a big part of our business. You can see the mix of revenue that we show about 2/3 of revenue, 60% of revenue comes from the sales business or the TES segment that we talk about, and then about 30% of revenue comes from the ERS segment, or the rental fleet in particular. I always love to start talking about Custom Truck, and start with the end markets. And as I said, T&D is about 65% of revenue. And we have a very bullish view on all 4 of the end markets we serve. So T&D right now, both transmission and distribution, are seeing strong growth. We're seeing good CapEx forecast from the IOUs and power producers. We're seeing really strong backlog from the public utility contractors as well. And so, feel like T&D continues to have very good demand drivers in it. And then, I think -- we think the federal stimulus, both the IIJA and the IRA both will support all 4 of the end markets but T&D, in particular. So T&D is the core end market and the end market that we are the most bullish on, right now. Telecom and rail are each about 5% of revenue, and we think there are good demand drivers on both of those. Telecom, we're seeing some continued rollout of 5G, and we see some opportunity for Custom Truck to grow share in that segment as well. And so we think, there's good demand for us in telecom. Rail is kind of that steady plotter for us. There are good CapEx projections for most of the major railroads. We serve not only the Class I railroads but commuter and short-line rail as well. And so again, it's less than 5% of revenue. So for us, it's a good area to continue to grow share. And then infrastructure more broadly, there is a ton of federal stimulus. We think there is good demand for infrastructure, right now as well. We primarily participate in 2 pieces. First is refuse, so that's a part of our business where we sell and rent roll-off trucks, and then kind of more broadly in roads and bridges is a part of our work as well. So, I think, understanding that there are 4 really strong end markets, I think, is important to understanding the overall Custom Truck story. And then for us, it really is about offering what we call the one-stop shop business model. And so, that means to the customer that we'll take care of the customer however they want to consume the equipment, whether it's through the rental fleet, whether it's selling new and used equipment, or it's the aftermarket parts and service business. But for us, that all starts with what we call our integrated production capabilities. So different than a pure rental company, or a sales organization, we're buying the individual pieces. So we're buying chassis directly from a Peterbilt or Freightliner or a Ford or a Dodge, and then we're buying attachments, whether that's going to be a bucket truck or a digger derrick, which are the primary 2 trucks that are used in the utility segment from somebody like Terex, who's our primary partner there, or Versalift, who we buy from some in utility and more on the telecom side of the business. And then, we put those trucks together, so we have several hundred thousand square feet of space, where we are taking bare chassis, taking the body that we bought specifically for that application, and the attachment and putting those units together. And it gives us a real cost advantage. So, we will sell some of our trucks to other rental providers, so we know that we have a 10- or 15-point margin advantage over where other pure rental houses are buying equipment. So we know that we have a unit economic advantage, when it comes to putting assets into our rental fleet. And then we also have the ability to pivot. As markets move, as perhaps utility heats up, we can add more assets to the rental fleet or if transmission gets stronger, we can do that, or if there's demand to sell equipment, we can take our inventory and turn around and sell it. And then we also like that on the back end, when it's time to dispose of an asset, that we can sell those assets directly. So, when an asset comes out of the rental fleet, we have an organization of about 130 sales and rental account executives, account managers, who can then sell assets directly to their customers. So it's the one-stop shop of taking care of customers, however they want to consume equipment, but it's really built on that integrated production capability. So strong end markets in a one-stop shop and what we think is a really loyal customer base. And you'll see there's a lot of diversification in the customer base. So, no customer is more than 4% of revenue today, and our top 15 customers are about 25% of revenue. So good diversification, and you'll see really high-quality names in terms of customers that we serve, and that we've had very long-standing relationships with. The last piece I'll talk about, and then I'll turn it over to Chris, is really the branch network. So today, we operate out of 35 locations across the U.S. and Canada, 32 in the U.S., 3 in Canada today. We have about 300 of our -- just over 2,100 employees, we have about 350 technicians who are keeping the rental fleet up and running, which is really the backbone of what we're doing out of our branch facilities. And I think, the point I'll highlight here is there's still plenty of room to grow. So there's -- the Northwest for us is certainly an area where we don't have locations today. We've called out the Southwest or Arizona, in particular, and then the Carolinas and the New York and New Jersey metro area. So we see good growth, which we'll talk about but good organic growth from just continuing to grow the rental fleet, and then some M&A opportunities as well as we continue to expand the footprint. So with that, I'll turn it over to Chris.

Thanks, Ryan. And so maybe just to start with, this year was really a year of 2 halves. So, as we entered this year, we were somewhat constrained on the supply chain side, entered the year with less inventory, than we would have liked. So, we ended the year at about $410 million of inventory. We finished the year just under $600 million. So as the year progressed, we did see improvement in the supply chain and ultimately, it culminated in what was a record fourth quarter for us. So whether that's new equipment sales on the TES side, where we had $247 million in sales in the quarter, or it was on the ERS side, our rental business, where we had record utilization, record rate and then also we achieved record OEC, so rental fleet. And so if you look on the top left there, overall revenue for the quarter, you'll see it was up 37%, driven again by really good growth, 12% in the rental business, 53% in our new equipment sales. And then for the full year, given some of the constraints we faced in the first half of the year, we're up roughly 6%. Top right, you see our gross profit, which again was up pretty significant, 35% adjusted gross profit for the quarter. You'll see there for the year, just under $100 million increase. And then, in terms of our pro forma adjusted EBITDA, on the bottom there, up roughly $25 million -- sorry, $30 million in the quarter and then just under $60 million for the full year. So overall, just a great year, great strong fourth quarter. We set records in terms of new equipment sales, as well as on our rental business side in terms of our overall utilization and our overall rate. Looking at the balance sheet, we continued to delever, which is one of our focuses. As we look at capital allocation, continuing to invest in our fleet because we think there's demand and there's opportunity there, as one of the priorities but also deleveraging. And so you'll see here, since the deal back in April of 2021, we're just a little over 1x turn down on leverage in the quarter, a little over 0.25x turn down, so we finished at 3.5x. We've given guidance that for this year, our goal is to get below 3x, assuming we don't have any significant M&A activity. On the top right, you'll see we continue to have a lot of availability and liquidity, so roughly $324 million, which was flat to the last quarter. But you'll also see there was significant investment in inventory, as well as significant investment in the overall rental fleet. So we're able to maintain that availability with that significant investment. Below the chart on the top right there, you'll see suppressed ABL availability, which has continued to grow another $60 million versus the end of last quarter. So we have about $190 million of additional suppressed availability on our ABL. And bottom left was just what I was talking about in terms of the significant investment we've continued to make throughout the year and the last 2 quarters, gross additions of just under $100 million and just over $100 million in the fourth quarter, and net CapEx in the last 2 quarters of roughly $100 million, so continuing to focus on that. We've given guidance for next year that we expect to see pretty significant growth, both in revenue and in EBITDA. And our range on our outlook for revenue was $1.61 billion to $1.73 billion and on the EBITDA of $415 million to $435 million, which represents 6% to 11% growth. So, we still think we're going to continue to see significant demand in 2023 and continue to invest heavily in our rental fleet. With that, I'll turn it back to Ryan for closing comments.

Sure. Actually, we'll just go to take Tami and jump into questions.

Sure. Yes, thanks so much for the presentation. I've been asking this question to all the companies that have presented with me so far. So the first question is, what are some of the near- and long-term opportunities, you see from the big 3 stimulus packages in the U.S., IIJA, CHIPS and IRA? And are you seeing any benefits of these already, or do you think the bulk of it is yet to come?

I'll start with the second half. We think the bulk of it is yet to come. So I think, the numbers that we quote in this presentation are kind of the direct spend that we see from the IIJA, so we're not including anything from the IRA or from the CHIPS bill. Those are less kind of direct spend that would affect us, but I think there are macro good tailwinds for some of the electrification that's happening and some of just the more broad manufacturing investment that's being made. So we haven't seen any of those yet. We think we're starting to see some of it in the infrastructure -- in our infrastructure category start to come into backlog. So there are certain projects that we're starting to hear about that are IIJA projects that are starting to come into backlog, but we don't think any of it yet is kind of in our performance on the utility side, in particular. But, we think it will be -- the way we describe it, though, is we think it will just extend the duration of good demand. And so there was already really strong demand out there. Certainly, as we move towards electrification, I think that is a great tailwind for our business. And then now, with the federal stimulus to help accelerate some of that, we just think it will extend the duration of demand for us.

Great. And so you're a specialty rental company, right? How do you -- can you give us a sense of like how quickly the specialty rental market penetrates per year? Like what is the growth like? Because I know I've seen your presentation, like the penetration is really low. I think you called it at about 25%-ish. Where do you see that going, and over what time frame?

That's a good question. We think it will be gradual penetration. If you look at more general rental, right, you'll see that penetration is kind of 55% to 60% or depending on kind of what metric you look at. And so we think it's -- again, it's another good tailwind. For us, the dynamic that seems to be driving that is as utility contractors perform more of the work for IOUs, utility contractors have a higher propensity to rent than the IOUs do themselves. So IOUs have typically historically purchased kind of their fleet. So, as utility contractors perform more of the work, we think that will mean that more of the universal fleet will be rented. We say that utility contractors typically rent between 30% and 50% of their fleet. And so I think, as they continue to perform more work, that will drive kind of more penetration of kind of that universal specialty rental fleet.

And what do you think could the rate be like? Is it like 100 basis points every year, or like 10% every 5 years?

Yes, it's a good question. I don't know that we've -- I think it will be gradual, so it's somewhere in there, a couple of points a year, I think, makes sense. We see it as just another -- in addition to good macro demand from the 4 end markets, we see that as just another driver of why we feel good about demand and deploying capital into our specialty rental fleet.

Great. And while we are on this topic, for those who are relatively new to the story, can you sort of walk us through how you are different from, let's say, one of the -- like [ URI ] or one of the national rental change? Like what is your differentiation versus them?

Sure. I think there's a couple of things, that I would highlight that make our story, we think, unique. The first is the end markets. So, we would say that the end markets that we've chosen have been largely recession-resistant. So, if you look at utility and telecom and rail and infrastructure, a lot less volatility in those end markets. So one, I think the end markets have been intentional. Two, because of that, I think you see a lot less volatility in the rental operating metrics. So, if you look at utilization, in Q4, we reported 86% utilization, which is even above what we'd call kind of theoretical max from a utilization standpoint. And then really the troughs of utilization, that we've seen have been in the low 70 percentages for a quarter, the high 60 percentages for a month. And so, a much tighter band between 70% and kind of the 86% number. So we see a lot less volatility on utilization. You see a lot longer duration contracts. So a piece of equipment in our rental fleet typically stays out -- now it's over 12 months, getting close to 13 months that a piece of equipment stays out when it goes out on rent, which is, I think, very different than general rental. And then the last piece is the residual value. We are -- as we've sold assets in the financials in 2022, we had about $200 million of rental asset sales, in there. And we're seeing residual values that are 70% to 80% of the original cost of the equipment, and that's after holding them for 5 years to 8 years in some cases. So we're seeing really strong residual values. All of that layers into really good, what we call, unlevered ROIC. So when we look at adding an asset into the fleet over its 5-year or 8-year life, we're generating 20 to 25 points of kind of annual return on an unlevered basis. So we think, it's just -- it's a great way to continue to deploy assets with a good collateral base in what we think are recession-resistant end markets as well.

Great. So, I wanted to understand your one-stop shop business model a bit better. Does that have an impact on customer acquisition or does it mostly drive higher retention? And more broadly, what do your customers care about the most? Like what is the usual first conversation like with a prospective customer?

I think that it -- I think there's a couple of things. One, I think it gives us more initial touch points to get to work with a customer. I think, it's a much easier purchase decision to rent a truck for a month and spend a few thousand dollars to rent it than to purchase a truck for several hundred thousand dollars. So I think there's -- I think it's much broader from our ability to acquire new customers. I think it's a much easier purchase decision for the customers. At the end of the day, the majority of our customers need equipment to do their job. And so they care about kind of the quality of the equipment and the uptime of the equipment. And that's why, I think, making decisions to reinvest in our fleet and have a young fleet is important. And it's why we continue to invest in our service organization to be able to continue to keep the equipment up and running. Because at the end of the day, our customers care about uptime to keep that equipment running.

Perfect. So you just reported your fourth quarter earnings. I do want to ask a few sort of near-term questions, if that's okay. Supply chain was a big issue last year. You've had to sort of lower guidance for one of your segments twice. And so looking into fiscal 2023, how are you thinking about supply chain? Is the current guidance predicated on supply chain sort of staying at these levels, or do you expect some improvement?

Yes. I think one of the challenges we had this year, I alluded to in my portion of the presentation, which is, we entered the year light on inventory. We are probably a little more optimistic in terms of what was going to happen with the supply chain. I think, we feel very good with where we are today, both in terms of an inventory level and what we see in terms of visibility when it comes to chassis and attachments and inventory. So, as you look at 2022, as a company, we came in within the guidance range for EBITDA, so I think we were able to really pull it out at the end of the year. And, I think that really does go to the one-stop shop business model that Ryan was talking about. There's different levers we can pull and our customers can pull. And so to answer your question directly, we're not expecting any significant further improvement in the supply chain in our numbers. But we feel like we're in a really good position to deliver within that range.

So could supply chain be a source of upside if, let's say, it improves from here on?

Yes. I'd answer that yes, if it does improve. If it continues to improve, I think it can be upside, right, to how we provide the guidance.

And if supply chain wasn't an issue last year, where do you think your TES segment revenues could have been?

Yes, that's -- it would be -- we think it would be several hundred million dollars more, that we would have sold last year. And the way we think about it is, we look at backlog. So backlog finished the year, we reported backlog at $754 million. So that's 10 or 11 months of sales, right, when you take kind of the midpoint of what we're talking about this year. And historically, that number has been closer to 4 or 5 months of sales. So kind of the delta there, if supply chain had been open last year or closer to normal last year in '22, we think that there would have been several hundred million dollars that we would have sold additionally, in the TES segment. And we think we would have been able to put another $50 million to $100 million into the rental fleet last year, given how strong demand was kind of throughout the year.

And you had a record 86% fleet utilization, right, if I remember correctly in the fourth quarter. How do you think that would look like this year? Does it stay at those levels or tick down a bit?

We -- it was a record. 86% was a record. And historically, 2 years ago, we said that our theoretical max was 85%. So we're proving that we can operate above 85%. As we come into January of this year, we're about 200 basis points where we were last year. So last January, we were in the 81s. This January, we're coming in at kind of the 83% area. And so we think, that we're trending ahead from a utilization standpoint. There's two reasons. The team has done a great job of replacing CapEx. So as we put in new CapEx, there's less R&M costs associated with it. And then the ops team has done a great job of focusing on how quickly they can turn equipment. And so, I think those two things will allow us to continue to operate at a higher utilization level. From a guidance standpoint, we wanted to be hesitant to say that we're going to run at all-time highs, for the full year. So we've assumed that we'll revert a little bit back to where we historically have operated, which has been in the low 80s, but we think that there can be some upside there for sure.

Perfect. And I've heard you talk about your tiered pricing strategy. Can you elaborate on that a little bit, the rationale? And what is like the purpose of that?

Yes. I'd simplify just saying that a customer who's running hundreds of pieces of equipment is paying a little less than a customer who comes in off the street, and is just renting one piece of equipment. So we operate with tiers kind of that way.

Got it. And I think, you've mentioned in the past that contractors are generally your customers. And how exposed are these contractors to a rising interest rate? Is that a part of the conversation now? Do you see them holding back on maybe purchases and renting more?

It's a discussion that we're having. At the end of the day, I think it starts with really strong demand, so they know that they need the equipment. And for a contractor, the cost of the equipment is not a significant component of their costs to go, do the work. So it's something that we're aware of and watching, but it's also where we feel like the one-stop shop model wins because we become relatively agnostic, to whether they buy the equipment or they rent the equipment from us. So, we think that there could be a little bit of a shift from purchasing equipment to renting equipment. But we're okay with that because we're okay with kind of the economics of either.

So going back to your business segments, you have 3, right? The biggest is TES followed by ERS and then parts and services. Let's say 5 years down the line, where do you see the mix of each going? Do you expect TES to remain the biggest chunk of your business? Or you want to focus on rent more?

I think our expectation is we see significant growth for both. And we're just talking about decisions that our customers are making based on interest rates. And so the -- obviously, there can be decisions that will be made. But even in this high interest rate environment, we're seeing record utilization. Ryan alluded to, Q4 was 86%, but we actually achieved 89% in quarter, in one of the months. The backlog, we had record TES shipments for the quarter, yet our backlog grew another $50 million versus last quarter. And so we expect to see good demand in both of those. And so there's probably not going to be a significant movement in the overall mix that we're going to see. But certainly, that can happen as some of those decisions get made.

Got it. And I think you mentioned you want to spend gross $400 million in rental fleet this year. Are you expanding into existing categories? Or is -- are you going into new adjacent categories as well?

It will be a little bit of both, so we will continue to grow in kind of the core -- utility is the core category for us. It's about 70% of the fleet, so we'll continue to grow the bucket and digger fleet. And then we're beginning to expand into some adjacent products that the same customers are using, so some of the other specialized vocational trucks, things like trailers and back trucks and roll-off trucks are all really interesting ways for us to continue to take care of the customer, to capture a greater share of the customer's wallet, and then are delivering comparable or, if not, improving kind of the ROIC profile of adding those assets to the fleet.

Got it. And switching to gross margin. The 3 segments you have, where do you see the most opportunity for organic gross margin expansion? And what would be the drivers of that?

This year, we achieved pretty significant gross margin expansion, both in TES and ERS. I think, Ryan has touched on TES. We wouldn't necessarily expect continued growth from where we were at the end of Q4, because we had achieved kind of a high watermark. I think going forward, the goal is to improve upon it, but I wouldn't expect meaningful improvement off of that. ERS, there's the different levers that Ryan talked about in terms of putting the new equipment in there. With that new equipment comes with lower repairs and maintenance costs. We have utilization. Obviously, we have rate. And so we think, in terms of production efficiencies, in terms of other opportunities as we see the age of that fleet go down, there could be some further expansion there. But, I think, really the growth story is just the volume that we're going to get and there'll be some marginal improvement on margin, including in APS.

Got it. And, when I think about your competition, I think, one of your largest competitors is a private company. So, can you help us understand, like what's your differentiation versus your biggest competitor? Is it geographic? Is it a product line? Is it something else that we don't know?

Sure, yes. It's -- and you're right, the largest competitor in the utility segment is Alltech, which is a privately owned company. They've taken an approach of vertically integrating in buckets and diggers, so they manufacture their own buckets and digger derricks, and are certainly a formidable competitor. We've taken a view of a bit of a broader product portfolio, so offering some of these adjacent products that our customers are looking for. So we think, that's been a competitive way to compete with them and then to also offer high quality in service as well. And so, we think customer service has been a big part of why we've been able to continue to grow.

Got it. And in terms of your relationship with chassis and adjustment OEMs, that your suppliers, have you looked to expand your supplier base, given the disruptions you've seen last year? Or do you think it's just a one-off, you don't really need to pivot?