Nov. 1, 1999
Nonetheless, it is rental business, estimated at about $4 billion by some studies, and it reaches into almost every industry, including traditional rental

Nonetheless, it is rental business, estimated at about $4 billion by some studies, and it reaches into almost every industry, including traditional rental markets such as construction sites and industrial plants to more specialized applications in the mining, petrochemical, medical and entertainment fields. Tools of the trade start at 20-kilowatt generators and get big in a hurry: multi-megawatt generator sets, air conditioners up to 50 tons and chillers up to 1,000 tons. The accessories - transformers, switchers and cable connectors - won't be found on most rental counters, either.

It is not a segment one dabbles in, then, and for some time now, it has been served predominantly by two major players - Aggreko and Caterpillar - and a host of niche operations, including a few RER 100 firms, that aren't household names outside their customer base. That's all about to change in a big way. In a GE way.

"They operate at a level that is unknown by the competition," says Dan Kaplan, former president of Hertz Equipment Rental Corp. and a leading industry consultant. "They're going to be a brand to this business that doesn't exist today. Their product offering goes from small equipment to equipment larger than anybody offers today. They will impact the industry. This is a game-changer."

Step Up Legendary GE chairman Jack Welch gave the go ahead to change the game in March 1999, via his $10 billion GE Power Systems unit run by president and CEO Robert Nardelli. In three months, GE Energy Rentals was launched with Nardelli's general manager of business development, Marty Moore, as president. Since then, Moore has been very busy.

GE Energy Rentals is already up and running in eight major markets: Atlanta, Chicago, Houston, Los Angeles, Miami, Philadelphia, Baton Rouge, La., and North Bergen, N.J. GE's newest business unit will soon enter Cincinnati and Albany, N.Y., near its headquarters in Schenectady.

"In the first year, we originally planned to open seven locations," says Moore. "'The Chairman' [as Welch is known throughout GE land] felt that was a little timid and that we needed to take some bolder steps. We've stepped up to 10 locations, maybe more, and we're doubling the number of employees."

GE Energy Rentals is also surveying the acquisition horizon to accelerate its growth and could announce several deals by the end of the year, according to sources. That could mean more locations, instant sales and seasoned staff.

In the meantime, GE Energy Rentals is calling on the resources of a tight-knit, $100 billion family to help get on its feet. The first rental operations have set up shop in existing GE service centers, which form a global network of 75 locations that repair GE heavy equipment, including gas and steam turbines, large motors and generators.

"We're going to leverage those assets - and it's not just the buildings," Moore says. "It's the people; the environmental, health and safety resources; the computers; the sharing of conference rooms, forklifts, cranes. In addition, during the summer peak when we need the most help, the service centers' labor force experiences a drop in activity providing a labor synergy opportunity."

GE Energy Rentals isn't an unwelcome partner at GE service centers since it puts "a couple hundred thousand dollars" into every location to create new offices and make other renovations. "They come out with better locations," Moore says, "but there is a negotiation that has to go on, which takes some time, making sure we understand the environmental, health and safety issues, the union implications, etc."

It should come as no surprise that to reap the rewards of the lucrative power rental segment there is a price to pay. Customers are always demanding, sometimes desperate, but that also means they can be less price sensitive than the average contractor, which translates into attractive profit margins to the companies that deliver the goods, industry analysts say. But at the same time, there are major investments and potential risks, which few providers can look straight in the eyes.

"GE doesn't wink or blink at environmental, health and safety issues, or business practices," Moore says. "GE understands the implications of less than flawless execution. The bar is set much higher for us and is a cost that some competitors don't incur. Our customers can rely on us and feel comfortable that they're not violating any local laws or ordinances, or that our equipment is going to contaminate their land."

For Moore, it's the value-added stuff that is the core business. "We don't want to be just renting hardware; we want to be selling our services. The hardware is just an enabler; it enables us to provide the value-added service. What the customers really want is someone who can do the planning and logistics, arrange for the fuel, make sure the unit is sized correctly, install it, provide technical advice, and in some cases, operate the equipment. We can reduce the customer's risk by providing experts who work with the equipment every day.

"If it was just putting the hardware out there, it becomes a commodity business. But we're selling the service capability, the technology, the risk management, not just the hardware."

It takes 13 people, on average, to run a rental facility on all cylinders, according to the GE model: a depot manager, two outside salespeople, two inside salespeople, a rental coordinator, four technicians, a yard person, and two administrative people. Finding and fitting the right people into that model, however, is more difficult than putting it on paper, and more than one ambitious rental company has felt the growing pains inflicted by a shortage of qualified candidates. The GE name - the career path it promises, the global reach, the history of market dominance - is helping Moore meet the challenge.

"I've been able to attract experienced industry people to help us get up and running," he says. "We want to shorten that learning curve as much as possible, so we're looking to bring people on board who can bring with them an understanding of the rental business and the customer base. They hit the ground running."

In exchange, Moore says, the new employees have the opportunity to get in on the ground floor of an enterprise with huge growth potential and the resources, appetite and commitment to become the market leader.

Power Moves In the world according to Welch, three's a crowd: GE isn't interested in markets where it can't be No. 1 or a close second. Considering that Aggreko and Caterpillar make three in the temp power game, someone may have to take its ball and go home.

Moore cuts to the chase: "When you've invested billions of dollars in a plant, would you rather have the $100 billion General Electric company standing by you with all the depth and breadth of its resources, or do you want Joe's Generator Rentals? The competition doesn't have the capability to manage large- scale issues."

GE is big and bold, indeed, and its leaders are bullish. But there is no bull in the strategy. GE Energy Rentals wants to take out the competition by taking what they have and relentlessly showing them what they don't: a synergy so devastatingly far-reaching that other companies should be embarrassed to use the word.

It all starts with a GE-owned global distribution network that can move assets around in large blocks, Moore says. "For most of the competition, this becomes a problem because they can't direct their distribution network on how to price the product, or tell them where to move the assets."

GE will be moving its assets just about everywhere and anywhere, he says. Into plants, for scheduled or emergency maintenance and shutdowns. Into utilities, for their peak power periods. At concerts, conventions and film locations. After natural disasters and so on.

Temporary power and climate-control applications are growing and seemingly limitless. Moore rattles off a few: refrigerated trailers for shipping food products in the South; providing power to the living quarters on drilling rigs and the remote-controlled underwater exploration vehicles in the Gulf; and chilling river water used by process plants in the Northeast.

"Industry in general wants to become more flexible, so rather than add capacity and tie up assets, they can rent capacity," says Moore. "Why keep a staff to run and maintain equipment when the equipment isn't being used all the time? Why not bring experts into the business with new equipment that is properly maintained? You don't have to worry about the costs, the obsolescence of equipment, the training, the risks of damaging equipment and even hurting people.

"Those are the rental drivers. That is what is driving the growth in this segment - it's a drive toward productivity."

Generator X Beyond the broader rental trends, the mere fact of GE Energy Rentals can be counted on to drive rental growth, to enlarge the very concept of what rental can be. "They're going to expand and grow the traditional marketplace in a way that only GE can do it," says Kaplan. "They have the resources, the relationships and an incredible brand name."

First and foremost, GE Energy Rentals wants to rent big, bigger and biggest. That, after all, is where the big money is. "When the Ford plant blew up, they needed 40 megawatts of power," Moore says. "When a tornado hit Oklahoma, they were looking for 30 megawatts of power. We want to be able to provide large blocks of power offering, so we'll be making a significant investment in our fleet and looking at new products."

Early next year, GE Energy Rentals will unveil an unprecedented power offering. Says Moore: "Rather than sending 20 1,250-kW units, GE will offer a trailer-mounted 22-megawatt turbine generator that will be fueled by diesel or natural gas and installed in three days."

And further down the road, the gap may widen between what is now available and what GE will make available. "We'll have the capability to add larger and smaller turbines, micro turbines, fuel cells, gas reciprocating generator sets, excitation systems, specialized HVAC and more into our rental fleet," Moore says. "All of these products are potential candidates for this rental market."

But it doesn't end there. How about factory rentals? "There's potential for us to develop rental programs for a 40-megawatt plant," Moore says. "No reason not to have a rent-to-purchase option for a plant. The difficulty is that you can't remove a fixed-installation product. I suspect in the not-too-distant future, we'll have some packaging capability to modify the equipment more precisely for the rental market."

And while the GE strategy is to focus on the power, heating and chilling market, Moore says some other products could be a natural extension, including air compression, dehumidification, perhaps even lighting towers.

That's a hint that GE Energy Rentals, far from thinking exclusively about multi-megawatts, is peeking into corners where general rental customers reside.

"Utility, commercial and industrial [markets] are our bread and butter," Moore says, "but there is a residential segment that is significant and we need to develop that opportunity as well."

Sounds like all the things GE brings to rental life have yet to be seen.

As the rental equipment industry continues its rapid consolidation, company owners are being approached frequently with proposals to purchase their companies.

A recent Wall Street survey indicates that two out of three owners of companies with revenues in excess of $2 million received unsolicited offers to buy their businesses. Regardless of whether owners are contemplating a sale, the valuations being offered by acquirers raise the question: What's it worth?

There is, however, no simple answer to that question. Valuation is a function of many factors, including:

* The quality of the existing management team.

* Historical profitability adjusted for non-recurring and owner items.

* Type and age of fleet.

* Location.

* Customer base and market share.

Acquirers will look at these and other factors in forming a view on a company's future prospects. Historical operating profitability is studied in order to better understand the future earnings outlook. The "high valuations" being paid for companies need to be evaluated in the context of prospective earnings.

To the extent that an acquirer can increase cash flow through purchasing scale, access to lower cost capital and enhancing future revenue streams, the price paid for a strategic acquisition may be quite reasonable. (See Chart A, page 38.)

However, before an owner can evaluate whether an acquirer's proposal constitutes a fair valuation or not, it is useful to be familiar with the various methodologies used by corporate acquirers.

On Wall Street, there are three commonly used methods for determining a company's value: discounted cash flow, "multiples" analysis, and liquidation or adjusted net worth analysis. Acquirers will typically review each of these valuation methods, in addition to other subjective factors such as those in Chart A, to determine the price they are willing to pay for a rental equipment company.

Discounted cash flow Discounted cash flow analysis, although more complex than other valuation techniques, is the most analytically rigorous method used by financial and strategic acquirers.

In DCF valuation, acquirers value the projected future stream of cash payments, net of income taxes, working capital investments and capital expenditures. By ignoring how a company is capitalized (debt versus equity), the DCF analysis allows acquirers to calculate the present value of all future, unleveraged cash flows. The discount rate at which the future payments are calculated reflects an appropriate weighted average cost of capital.

In order for a DCF valuation to be meaningful, an acquirer must have access to realistically developed five-year financial projections. Typically, the target company's management team prepares the cash-flow projections. It is important that these projections be developed, as much as possible, from the bottom up.

Ideally, a five-year projection incorporates sales by customer or customer type; fleet utilization rates; rental/sale mix and rates; detailed operating expenses and business cycles.

Of course, through due diligence, an acquirer will test the assumptions underlying the target company's "management forecast." To the extent that certain assumptions appear overly optimistic, an acquirer will modify the projections to reflect a "base-case scenario."

Any prospective cost savings or revenue enhancements that an acquirer may have should be reflected in this analysis. While the acquirer's DCF incorporates all these benefits, what an acquirer will propose to pay for a business is also a function of the selling process, transaction structure (see "Seller Beware!" page 42) and form of purchase consideration.

One way acquirers may build a margin of error into their base-case projections is to increase the rate used to discount the projected cash flows. In other words, the higher the discount rate used in the calculation, the lower the enterprise value - and, accordingly, the lower the residual equity value. Acquirers calculate this rate differently, but in each case the discount rate reflects an acquirer's view of the risks related to securing future cash flows, weighted to reflect how the company will be capitalized using debt and equity.

By applying the discount rate to "base-case" free cash flows, an acquirer can calculate the unleveraged present value of a future cash-flow stream. Additionally, the acquirer needs to calculate a "terminal value" to reflect the enterprise value in excess of the initial annual cash flows. In many cases, acquirers will determine the terminal value based on applying a multiple to the terminal year projected base-case operating earnings. The terminal value is discounted back to the present and added to the present value of the annual cash flows to calculate the total "unleveraged" enterprise value. By subtracting any funded net debt from the enterprise value, an acquirer arrives at a change-of-control value for the firm's equity.

While the DCF is the most analytically defensible valuation methodology, it is also an approach that is not always viable. In order to be meaningful, a DCF valuation typically requires not less than a reasonable five-year forecast.Given the uncertainty of business cycles and lack of reliable forecasts, DCF valuations in the rental equipment industry are not common.

Earnings multiples Given the limitations of the DCF analysis, many acquirers estimate value using multiples of operating earnings (earnings before interest and taxes, or EBIT) or operating cash flow (earnings before interest, taxes, depreciation and amortization, or EBITDA).

Simply stated, multiple analysis applies a number or range of numbers to a relevant financial operating figure. The multiple range reflects an acquirer's overall assessment of the various factors that affect valuation. For an acquirer, the valuation derived from these earnings multiples is tied to achieving certain target financial hurdle rates, including:

* Expected return on invested capital (adjusted operating income divided by total invested capital).

* Return on equity (net income divided by total equity).

* Cash-on-cash returns (expected cash flow after fleet replenishment investment divided by total invested capital).

Among the most common multiples relied on by investors are price-to-earnings multiples, or P/Es. For example, an investor may contemplate buying a certain stock because its P/E multiple is less than a comparable market peer or relevant market index multiple.

Assuming comparable growth pros-pects, investors might conclude the lower multiple stock is undervalued. In the rental equipment industry, investors seem to prefer using EBIT or EBITDA, in part because it offers operating earnings, which are less vulnerable to variations as a result of differences in tax rates, leverage and depreciation policies. Chart B (below) reviews current public "going concern" multiples of after-tax earnings, EBIT and EBITDA.

At any given time, earnings multiples of publicly traded rental equipment firms may be higher or lower than multiples paid in private "change-of-control" transactions.

The current high valuation levels of many of the publicly traded rental equipment companies, fueled in part by the market's expectations for future growth rates in excess of 20 percent per year, should not lead owners to assume that such high valuation levels are achievable.

However, these valuations indicate that public investors have a favorable view of the industry's prospects. In light of the ongoing consolidation, certain of these companies will be able to grow rapidly over the next few years and improve profit margins with increased purchasing scale.

It should be noted that applying a multiple to any of the pre-interest operating figures (EBIT or EBITDA) in Chart B results in an estimated business value or "total enterprise value" (TEV). In order to derive an equity value, it is necessary to subtract existing debt from the enterprise value.

Lastly, acquirers will evaluate various "non-financial" characteristics of a business. Rental equipment companies with higher "strategic value" - such as those viewed as platform companies - and higher revenues, particularly those with significant rental revenue, are more likely to command valuation multiples toward the high end of the range.

Certain change-of-control valuation data is available from the active consolidators that are publicly traded and are required to disclose financial information to the Securities and Exchange Commission. For a company growing rapidly, a trailing, unadjusted 12-month multiple may lead to the impression of an unreasonably high price; whereas a trailing, adjusted multiple is less susceptible to distortion. Chart C (page 42) summarizes selected recent transactions and estimated multiples paid, based on audited trailing earnings.

Any owner-related adjustments factored into a buyers' valuation are not typically disclosed in publicly available financial statements. Accordingly, the "true" multiple of trailing EBITDA may differ significantly from the multiple that may be derived from publicly available information.

Additionally, other acquirers will evaluate a target's operating earnings over the course of an economic cycle (three to fiveyears), particularly in a cyclical industry such as equipment rental. Any analysis that relies too heavily on simple multiples of trailing financial performance are subject to substantial distortion resulting in misleading information. Chart D (page 42) summarizes multiple ranges that we have found to be a reasonable guide to mid-sized rental equipment companies.

Notwithstanding the limitations of relying on after-tax earnings, many acquirers will evaluate acquisitions based partially on multiples of net income adjusted for any non-recurring owner-related items or accelerated depreciation on the fleet. A modified approach to the net income multiple analysis is to calculate "pro forma" adjusted after-tax earnings, taking into consideration the pro forma target debt levels and income tax rates. By subtracting estimated interest expense and taxes from adjusted EBIT, an acquirer can calculate the residual equity value assuming a range of P/E multiples.

This calculation is helpful because it adjusts operating income, or EBIT, by interest being paid on debt that is presumably being used to purchase additional fleet equipment and earnings growth. Moreover, public acquirers, sensitive to earnings dilution, are unlikely to consider paying a higher multiple of earnings than the market assigns to its own shares. Earnings dilution is a primary concern of publicly traded companies issuing new shares to make acquisitions.

With competition to acquire both RER 100 firms as well as smaller rental centers increasing, multiple ranges have trended upwards. Among the largest completed deals, Atlas Copco's $1.2 billion acquisition of Prime last July was about 11 times trailing EBITDA, and eight times analysts' expected 1997 EBITDA. It's hard to know all the synergies and other benefits that may have been factored into this valuation, but based on publicly available information, the price paid significantly exceeds our simplified pricing matrix.

A final shorthand valuation method that some acquirers use in developing preliminary bids is based on applying multiple ranges to rental and sales revenues. In cases where there is limited (if any) information on profitability, acquirers may estimate enterprise value as up to three times rental revenues and up to one times new equipment sales revenues. While subject to important refinement, the method reflects the higher margins and recurring revenue associated with rental revenue streams.

Adjusted net worth The adjusted net worth calculation uses the net assets of the company, as reflected in its most recent balance sheet, adjusted for variances between the book value of the assets and "fair market value." However, valuations analyzing the underlying assets do not consider future earnings potential and, therefore, are not appropriate for valuing a "going concern." Instead, an underlying asset valuation is more appropriate in a liquidation scenario.

A related valuation method is to use the fair market value of the fleet and subtract funded debt, then add any cash and marketable securities that will remain with the company. The method also fails to consider the future earnings potential and is rarely used to determine the purchase price of a company.

PQs: A recent Wall Street survey indicates that two out of three owners of companies with revenues in excess of $2 million received unsolicited offers to buy their companies.

Atlas Copco's $1.2 billion acquisition of Prime last July was about 11 times trailing EBITDA, and eight times analysts' expected 1997 EBITDA.

Valuations are currently approaching levels well beyond values likely to be achieved under existing ownership.

The below charts have already been trxed to Mo. Additionally, they still need to be updated so they are included here for reference only. We will need to thoroughly edit them in lasers, however.

PQ: Tax issues are one of the most important factors that affect valuation.

Mo: Charts for reference only. Do not layout.

Why sell? Clearly, valuing a business is not a simple matter. Still, several methods - some more complex than others - help an owner understand how acquirers think about valuation.

While the DCF valuation is the most analytically defensible approach, it is subject to important limitations. Foremost, the DCF is predicated on an acquirer being able to evaluate a thoughtfully prepared five-year financial projection. To the extent that such projections are not available, or are not well-prepared, this analysis will be of limited value.

Similarly, if the only projections available are this year's expected earnings outlook, then an acquirer may be limited to using the multiple approach. Whether or not an acquirer will be at the low end of a multiple range or the high end is primarily a function of the issues that impact business valuation referred to in Chart A.

In the present environment of unprecedented, rapid corporate consolidation, it is useful to reflect on these measures of valuation. But, perhaps the most significant factor currently driving valuations is that demand for successful, well-managed rental equipment firms has not abated while acquirers continue to access public capital to fund growth through acquisitions.

With a number of aggressive corporate and financial acquirers targeting many of the same business owners, valuations are currently approaching levels well beyond values likely to be achieved under existing ownership. This suggests it may be a good time for certain owners to reflect on what their business is worth to them.

In the GE culture, if you have a new idea, you have a new responsibility. Title, seniority, alma mater and other resume filler become non-issues, according to the Welch way. So when GE managers identify opportunities in the marketplace, they usually get put in charge of dragging them into revenue-based reality.

Marty Moore had been managing M&A activity for GE Power Systems, including a $600 million gas turbine business and an $80 million energy management systems venture. That's how he learned about the potential demand for large portable power units.

And that's how Marty Moore found himself president of GE Energy Rentals, the new turnkey provider of temporary power and climate control solution for GE Power Systems.

"We look for people in our business development organization who have the skills to follow through on a deal from early identification through due diligence and closing," says GE Power Systems president Bob Nardelli. "We also want people who have relevant skills within the industry segment that the potential acquisition already serves."

In other words, look for Moore to do some M&A in the rental industry, sooner than later.

GE's reach is just about all-encompassing, and GE Energy Rentals will call on it to reach into every possible corner of the power and climate-control rental market. Because GE makes things easier for its start-up - from corporate travel discounts to its own telephone system - GE Energy Rentals will enjoy advantages in almost every aspect of business operations. It goes without saying that GE Power Systems is a one-of-a-kind resource for generating utility business. Here's a look at some of the other synergies:

GE Trailers. With a massive fleet of trailers and locations around the world, this unit can allow GE Energy Rentals to move equipment without having to arrange a local solution in every market. "They take care of the registration and maintenance, I do what I do best, and I don't have to worry about trailers," GE Energy Rentals president Marty Moore says. The trailer unit also does refrigerated container business with food shippers - a channel for GE Energy Rentals. This business also affords GE Energy Rentals an opportunity to park assets almost anywhere, creating fleet flexibility that keeps equipment near the action, rather than returning to a branch between jobs.

GE Modular Office. Not many construction sites operate without one of GE's modular offices. "This is an opportunity to rent our power and air conditioning with their offices. That's where Cat's strength is, but this is a way to penetrate that segment. And the sales guys are out there already selling that channel."

GE Medical Systems. Yet another channel to rent products. When hospitals do maintenance on a CAT scanner, for example, they frequently rent power for the down period. "It's only a 100-kilowatt unit," Moore says, "but we've got a huge sales force selling maintenance contracts to hospitals all over the world." It'll add up.

NBC. "The Chairman," Jack Welch, has asked GE Energy Rentals to support the needs of its "Friends" in the entertainment and special events division. Moore is working on a business plan.

GE Capital. Finally, the money guys. "Nobody in the world can borrow money cheaper than General Electric with its AAA credit rating," Moore says. "We're using GE Capital's balance sheet to finance our investment."- Ars