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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning and welcome to the Herc Holdings Third Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note today's event is being recorded.
I would now like to turn the conference over to Elizabeth Higashi. Please go ahead.
Thank you, Rocco, and thank you all for joining us this morning. Welcome everyone to our third quarter 2021 earnings conference call. Earlier today, our press release presentation slides and 10-Q were filed with the SEC and all of them are posted on the Events page of our IR website at ir.hercrentals.com.
This morning, I'm joined by, Larry Silber, President and Chief Executive Officer; Aaron Birnbaum, Senior Vice President and Chief Operating Officer; and Mark Irion, Senior Vice President and Chief Financial Officer. We'll review our third quarter and year-to-date results, with comments in operations and our financials, including our view of the industry and our strategic outlook. The prepared remarks will be followed by an open Q&A.
Before we begin our formal remarks, I'd like to remind you to review our Safe Harbor statements on Slide 3. Today's call will include forward-looking statements. These statements are based on the environment as we see it today, and therefore involve risks and uncertainties. I would caution you that our actual results could differ materially from the forward-looking statements made on this call. You should also refer to the Risk Factors section of our Annual Report on Form 10-K for the year-ended December 31, 2020.
In addition to the financial results presented on a GAAP basis, we will be discussing non-GAAP information that we believe is useful in evaluating the company's operating performance. Reconciliations for these non-GAAP measures to the closest GAAP equivalent can be found in the conference call materials.
Finally, a replay of this call can be accessed via dial-in or through a webcast on our website. Replay instructions are included in our earnings release this morning. We have not given permission for any other recording of this call and do not approve or sanction any transcribing of the call.
I'll now turn the call over to Larry.
Thank you, Elizabeth, and good morning everyone.
Please turn to Slide number 4. Our third quarter results continue to demonstrate outstanding operational execution and reflect new records in many of our financial metrics.
Slide 4 shows the third quarter results over the last three years. Given the unusual performance in 2020, due to the impact of COVID-19, we share a comparison with not only 2020, but 2019. As you can see, our performance in 2021 clearly accelerated our growth trajectory. Equipment rental revenue was $519.6 million in the third quarter, an increase of 29.2% or $117.3 million compared to the prior-year and 13.1% over 2019. This increase was driven by solid performance in our core business and growing market share from our specialty businesses, both of which continue to outpace our pre-pandemic performance in 2019.
Adjusted EBITDA grew by 25% over prior-year and 17.4% over 2019. Our focus on operating leverage improved year-over-year adjusted EBITDA margin by 160 basis points to 44.7% in the third quarter of 2021.
We reported net income of $72.3 million, or $2.37 per diluted share in the third quarter, compared with $39.9 million or $1.35 per diluted share last year. We're on our way to a record 2021.
This is an exciting time for Team Herc. And as you know from our growth goals we presented at our recent Investor Day, we have the appetite and desire to achieve greater success.
Our industry-leading rate management delivered strong results in a favorable operating environment which benefited from tight equipment supply and steady rental demand. Given the indications for the rest of the year, we're affirming the full-year adjusted adjusted EBITDA guidance range we provided at our Investor Day of $870 million to $890 million, which was the third time we raised guidance.
Now please turn to Slide number 5. 2021 has turned out to be a pivotal year for the equipment rental industry. Tight supplies of equipment and steady demand have created an optimal environment for us. We increased dollar utilization year-over-year by 840 basis points to 46% in the third quarter, reflecting improved volume, mix, and rates.
Our focus on the top MSAs in North America and filling out our urban density in select locations is driving both our Greenfield and acquisition targets. Since December 2020, we completed five acquisitions for a cumulative total purchase price of $280 million and announced our sixth acquisition Rapid Equipment Rental of Toronto earlier this month. We also recently announced the declaration of our first quarterly dividend of $0.50 per share to shareholders of record as of October 20th, and payable on November 4th. Our strong year-to-date performance is clearly providing the momentum and growth that we expect going forward.
Now please turn to Slide number 6. With a history of over 56 years in the equipment rental industry, our 5,100 plus team members works hard to ensure our customers achieved optimal performance safely, efficiently and effectively every day. Everything we do is built on our promise and commitment to help our customers and communities build a brighter future. As of today, we are now operating approximately 295 locations across the United States and Canada in 39 states and five provinces. We're excited about the momentum we are generating and in developing our M&A pipeline.
Please turn to Slide number 7. We introduced our strategy shifting into high gear at our Investor Day last month. The business model is simple yet it takes experience and commitment to truly capitalize on the opportunities we have in an expanding addressable equipment market and truly fragmented industry. Our team is hungry to take advantage of the exceptional opportunity before us.
Now for more details about our operations in the quarter and our outlook here's Aaron Birnbaum, our Chief Operating Officer.
Thank you, Larry.
The third quarter and year-to-date results reflect the contributions of our outstanding Herc Rentals field management and team. Every day our team demonstrates their dedication to serve our customers with their level of professionalism and commitment unparalleled in the industry. Coming off a really tough 2020, we challenged the organization to exceed our 2019 performance. They've stepped up the challenge and not only are they exceeding our pre-pandemic results, they're delivering exceptional performance throughout North America. We greatly appreciate the contributions of each and every one of our team members. Congratulations, teamwork for job well done.
Now please turn to Slide 9. Our Q3 results showed exceptional performance compared to 2020 and compared to a strong third quarter in 2019. Equipment rental revenue in the quarter was $520 million and rose nearly 30% compared with 2020 and 13% higher than the comparable periods in 2019. Business activity was solid and all of our end markets are showing positive momentum.
Our ProSolutions business continued to increase year-over-year by approximately 30% in the third quarter of 2021, as we continue to expand our market share. Our focus on the power generation climate control and remediation needs of our customers has contributed to the double-digit revenue growth in ProSolutions over the last four years. The strategic investments we made to diversify our customer base and industry verticals provided a solid foundation for growth, as we successfully built upon our urban market strategy and deepened and widened our market segments throughout North America.
Our core business showed the normal upturn in demand in the third quarter, we benefited from solid operating performance in our regional operations. The integration of the acquisitions we made to-date is on track and we are actively pursuing other acquisitions in targeted markets.
Our Herc operating model continues to drive operational performance and fleet efficiencies and margin improvement offsetting increases in year-over-year personnel related costs in the quarter. Our scale and leverage will support further margin improvement over the next few years as our revenue remains robust.
Please turn to Slide 10. Our fleet composition at OEC is on the left hand side of this slide. Total fleet was $4.1 billion as of the end of the third quarter, about 9.4% higher than OEC at the end of Q3 2020.
We continue to invest in our specialty fleet, which includes ProSolutions and ProContractor and accounted for about 23% of our total fleet as of the end of Q3 2021. We also continued to improve dollar utilization each quarter in 2021 and achieved a record 46% in the third quarter.
On the right hand chart, you can see OEC fleet expenditures in Q3 2021 were $210 million, an increase from our third quarter in 2020. Fleet disposals were $44 million in the third quarter of 2021, compared to $124 million of OEC sold in last year's comparable period. Our fleet department has done a great job getting in front of a tight market for new equipment purchases from the OEMs. We ordered early for 2021, and while we have experienced delays of certain equipment, we have largely received fleet from our initial orders. You may recall that in the second quarter, we announced that we were ordering an additional $100 million in fleet in 2021 and we expect delivery this year. Our equipment cost increases have not been material this year, but as shortages inflation and labor costs impact the industry, we anticipate that industry fleet costs will continue to rise in 2022. Fortunately, we had most of our 2022 orders in by September, some of them at 2021 pricing, so the inflationary impact for our 2022 orders will remain muted.
Given the current operating demand for our rental fleet, we reduced third quarter disposals in 2021 year-over-year by $80 million. Even as equipment sales proceeds as a percentage of OEC rose from 37% last year to 42% this year. The average age of our disposals was 86 months in the third quarter and fleet age is now about 48 months.
Please turn to Slide 11. Our diverse customer mix with our base of large national customers operating in the essential business sectors, and our expanded specialty business continues to drive our sales strategy. Specialty is expected to continue to be a growth driver, as we focus on the expanded addressable markets of climate control, remediation and entertainment.
Our other verticals on major industrial customers in utilities and energy, healthcare, warehousing and manufacturing and general construction are gearing up and look to support growth in 2022 and beyond. We're also focused on high-growth segments of the economy and our end markets are showing momentum to continue a strong recovery in 2022. We expect to drive additional fleet efficiencies and operate a lean cost structure to drive margin improvement.
Turning now to Slide 12. We shared the cumulative values of our acquisitions we have made to-date on the right-hand side of this slide at our Investor Day on September 20th. Since then we also announced the signing of a purchase agreement with Rapid Equipment Rental with 110 employees in seven locations in the Greater Toronto area. The transaction is subject to the customary closing conditions is expected to be completed in the fourth quarter. So we'll start 2022 with 13 locations in the GTA, more than double our current capital.
The EBITDA contribution from the acquisitions we've made so far in 2021 isn't material to our reported results. But our M&A pipeline is quite robust, and we are aggressively seeking additional targeted markets in the top MSAs to help us enhance our urban density and improve our operating leverage and scale.
Please turn to Slide 13. There has been a fair amount of media coverage regarding labor shortages particularly for truck drivers and mechanics in our industry. As we have said repeatedly, we intend to be the employer of choice in the industry, and have made specific strides to offer competitive salaries and benefits to enhance retention and attract talent to team Herc.
We also intend to be the acquirer of choice, and we've been busy integrating our new team Herc members and focusing on Herc career development, job opportunities and training. With the spate of climate-related events this year, we are also supporting the Herc families impacted by Hurricane Ida. Our team Herc members contribute donations and the company matches their contributions to assist our team members in need.
Our employee resource groups, Women in Action, and the Veterans Employee Resource Group, also are active in offering career-related programs, networking opportunities, and support. Safety is the foundation of everything we do and exemplifying that belief, we start every day across our branches with these safety huddle. As you've heard us talk in the past about various safety initiatives, one of our major internal safety programs focuses on perfect days. That is days with no OSHA reportable incidents, no at-fault motor vehicle accidents, and no DOT violations. In the third quarter on a branch-by-branch measurement, all of our branch operations achieved at least 98% of days as perfect. We're always striving for 100% perfect days and our commitment to safety means continuous focus through communications and training. It also means supplying the team with the equipment that will help them perform efficiently and safely, particularly in their driving and daily equipment servicing and maintenance activities at all of our branches. Our rental days are best when they are done safely seven days a week.
Now I'll pass the call on to Mark.
Thanks, Aaron, and good morning everyone.
We continue to be really pleased with our performance and have delivered another excellent quarter in Q3. It's a great environment for the rental industry with strong demand although supply is constrained like it is in a lot of other industries at the moment. Our fleet team has done a great job with getting our orders in early this year, so that our new fleet arrived steadily throughout the quarter.
Our operations team have also done a great job with managing record utilization, getting the fleet to the right customers in the right jobs, managing peak demands with strong response, and by integrating new team members, customers and fleet into the Herc model. This consistent execution has led to a record quarter and is maintaining strong momentum into Q4 and 2022.
Slide 15 shows the summary of our third quarter results compared with 2020 and 2019. Q3 was a record quarter for many key metrics including rental revenues, net income, adjusted EBITDA, adjusted EBITDA margin, and dollar utilization.
Equipment rental revenue increased 29.2% from $402.3 million in 2020 to $519.6 million in the third quarter of 2021, primarily due to improved volume and continued momentum in pricing. Compared with 2019, equipment rental revenue increased 13.1%.
We continue to deliver solid profitability with adjusted net income in the third quarter of 2021 of $72.7 million or $2.38 per diluted share, compared with adjusted net income of $43.2 million or $1.48 per diluted share in 2019.
Adjusted EBITDA increased 25% in comparison to Q3 2020 and was up by 17.4% in comparison to our previous peak cycle in the third quarter of 2019.
Adjusted EBITDA margins were also a record for the third quarter at 44.7% in 2021 improving from 43.1% in 2020 and by 350 basis points from 41.2% in 2019.
As expected, rolling over the low base effect of the cost side of the business in the COVID impacted quarters of 2020 was likely to impact our ability to maintain our historic flow through and will temporarily slow our margin expansion.
EBITDA margins of Q3 2021 remained strong at 45.9% down by 240 basis points from 2020 and an increase of 100 basis points from 44.9% in 2019. There are all sorts of quick temporary cost anomalies in the Q3 2020 results, and we did not expect to be able to replicate those margins this year.
Adjusted EBITDA flow through of 37.5% was in line with our expectations and should return to our targeted range of 60% to 70% in 2022.
On the cost side, we have some operating expenses coming back into the business, along with record rental revenues we incurred delivery, re-rent, payroll and commissions in order to provide superior customer service and supply to our customers.
In order to be the employer of choice in the industry, we also have to provide competitive compensation and benefits. We have been adjusting our operating team's compensation to strategically stay ahead of wage inflation and to build our platform for growth.
All of this is manageable within the context of double-digit growth in rental revenues. We can invest in our business and in our people and continue to improve our margins and investor returns.
The 2020 COVID impacted base effects will run out over the next couple of quarters and we will focus on returning to our targeted flow through range of 60% to 70% in 2022 and beyond.
On Slide 16, we highlight pricing and utilization trends by quarter. The graph on the upper left illustrates our success in managing price over the last couple of years and is a testimony to our ability to manage rates. The latest quarter reflects average rates up 280 basis points compared to last year. Q3 2020 highlights how well we managed rates in the COVID downturn down only 80 basis points despite all of the challenges we faced last year. In Q3 2019, our rates were up 4.5% in a much less inflationary environment, we are currently in.
Our track record of executing on price in all sorts of operating environments is clear, and our rates are up by 6.5% over the last three years. The right momentum we've built in 2021 is also clear and we will maintain this momentum into 2022.
The current market environment of tight equipment supplies and steady demand continues to support our focus on rate and we continue to benefit from our excellent pricing tools, and the discipline and professionalism of our sales team. The industry seems to have gotten price momentum back and we intend to continue leading the industry on rate. Rate, record time utilization, and continued momentum in our specialty businesses drove another quarter of record dollar utilization. At 46% we continue to close in on our goal of industry-leading dollar use. This positive momentum changes our fleet efficiency going forward and has a powerful impact on our return on assets.
We managed to get our change in fleet size back into positive territory in Q3 which is exciting. A combination of savvy purchasing and early ordering saw us receiving most of our fleet orders during the quarter and we supplemented those orders with some fleet integrated in conjunction with our acquisition activity. Volume growth in the quarter was almost four times the growth in fleet size as we've managed an excellent operating environment with record time utilization and efficiency.
On Slide 17, with no near-term maturities, we have ample liquidity to fund the growth goals we laid out at our recent Investor Day for 2022 and into the future, as we commit capital to invest in our business to drive fleet growth under the new cycle. We generated $115 million of free cash flow before acquisitions in the nine months ended September 30, 2021. After funding $225.2 million of acquisitions year-to-date, our net debt increased approximately $140 million to $1.8 billion as of September 30. We have ample liquidity to fund our growth plans, and our leverage at 2.1 times is at the lower end of our target range of two to three times.
On Slide 18, we share the latest industry forecasts. ARA growth forecasts continue to be in the mid-single-digit range this year, accelerating into 2022. Our rental revenues are up year-to-date over 2020 by 22.5% and are up year-to-date on 2019 by 9.9%. So we clearly have much more momentum than the broader industry and are probably taking shifts.
This is consistent with past experience. Rental companies of scale with broad rental fleets and a well-diversified customer base are consistently growing faster than the rental industry in general and as we have seen in 2021, Herc is a company of scale with a large well diversified mix of customers. We're clearly in the early stages of the next construction upcycle with steady demand even before we get into any potential benefits from the proposed future boosts to infrastructure spending.
Equipment supplies are tight with our OEMs struggling to manufacture and deliver new equipment to worldwide supply chain bottlenecks. This is a very favorable environment to own $4.1 billion of rental fleet as our customers really appreciate our fleet availability and commitments to service. It should remain a favorable environment for increasing rates as everyone is facing cost inflation to a certain extent.
Also, the majority of our business is not directly connected to non-residential construction. Our ProSolutions business is a real strategic benefit and we will look to continue to gain share and grow that business. There is pent-up demand for maintenance and turnarounds in a lot of industrial plants and this segment should also rebound. There's plenty of demand in most growing markets to support growth into 2022 and we have the balance sheet and liquidity to be able to fuel that growth by investing in our fleet and our market share and that is what we intend to do.
Looking at the left side of Slide 19, you can see the momentum in our results through 2021, and our expectations to maintain double-digit top-line growth momentum for 2022 through 2024. We've raised 2021 guidance three times this year to our current range of $870 million to $890 million of EBITDA. We're focused not only on top-line growth, but profitable top-line growth and have improved our margins in 2021 and have seem to continue to improve our margins with a goal in the high 40% range by 2024.
On Slide 20, as we laid out at our Investor Day last month, we're affirming fiscal year 2021 guidance from adjusted EBITDA range of $870 million to $890 million. For those of you who have not had a chance to review, a video of the Investor Day is posted on the Investor Relations section of our website. We're very excited with the growth momentum we currently have in our business, and are also affirming our EBITDA guidance for 2022 of $1.05 billion to $1.15 billion, net fleet rental -- net fleet capital expenditures of 820 million to $1.12 million.
On Slide 21, we also want to highlight the growth goals we laid out at the Investor Day. We're a leader in an industry that is beginning to grow into a new upcycle and that continues to benefit from a secular shift from ownership to rental. Rental industry leaders can grow at two to three times the growth rate of the broader industry; we see our rental revenue CAGR at 12% to 15% for 2024 and our adjusted EBITDA CAGR at 17% to 20%. We're focused on profitable growth and our goal for adjusted EBITDA margins was to improve to a range of 45% to 50% by 2024. We're an exciting industry upcycle and are excited about performance we anticipate over the next couple of years, as we look to take advantage of a hot start.
With that, I'll turn the call back to Larry.
Thanks Mark.
Now please turn to Slide number 22. Before we move to Q&A, I wanted to point out the vision, mission and values we developed when we became a public company five-plus-years ago. We frequently talk about our vision and mission. But today, I also want to focus on the values we hold their particularly given the commitment we are making to investors about our growth goals over the next several years. We want you to know that we manage our business by these values, which are we do what is right. We're in this together. We take responsibility. We achieve results. We prove ourselves every day and we are committed to investing in our communities.
And now operator, please open the lines for questions.
Thank you. We'll now begin the question-and-answer session. [Operator Instructions].
Today's first question comes from Ross Gilardi at BOA. Please go ahead.
Just had a question on your capital spending, I mean you guys are getting your deliveries this year from the sounds of it have managed that well but and you're obviously out there with big capital spending growth projections for next year. We've all seen what at least JLG has said about the short-term for now and they're obviously got to be a big supplier. So my understanding you've got the orders in for next year but explain again what gives you the confidence that your suppliers can actually produce at the level necessary to deliver that fleet and do you have to take bigger cost increases to ensure that your prioritized buyer suppliers next year? Thanks.
Yes, Ross great question and certainly there has been obvious news that Riwal [ph] and JLG announced and certainly with your strike that has potential to impact as well not as great for us but certainly the impact supply chain for others in the industry. But generally we have received confirmation from all of our major suppliers where we have placed orders for 2022 that our order and production slots are intact and for the most part we will receive everything according to the schedules that we have agreed to with them and we work very closely with them to do things to make sure that our gear is delivered on time.
As far as your question about rate, we have been able to do very well in negotiating our rates for next year and we're in the low-single-digits relative to inflationary pressures on net gear. And for now I don't foresee any issues relative to us receiving net gear in an orderly manner or fashion as we've negotiated with our suppliers. Aaron, maybe you want to comment more?
Larry, I think you've covered it very well. When you look back to this year, we did receive all of our fleet supplies that we planned when we initially started 2021 and I think that because we started early planning forward and then so as you look into 2022 we started early planning for that well. So we fully expect to receive the fleet we planned for, I expect disruptions to an extent, maybe some delays, but I do expect to receive the fleet we planned for.
Okay, great. So you would say that, so you're baking in low-single-digit type cost inflation into your CapEx outlook for 2022, is that right? And just, can you remind everybody how the accounting works on equipment in inflation? Do your rental gross margins get squeezed next year a bit due to the inflation or does the impact get smoothed out just because of the depreciation accounting over the life of the fleet?
Yes, I think Ross, so yes, we are looking at low-single-digit cost increases next year for the broad spend and accounting. I mean, it gets smoothed out. So I mean, that fleet comes in and is depreciated over seven, eight years. So the increase has smoothed out with no real immediate appreciation and pay.
Right, okay. That's what I thought, all right. I'll hand it over and get back to you. Thank you guys.
Our next question today comes from Steven Ramsey at Thompson Research Group. Please go ahead.
Hi, good morning. Maybe wanted to get into the rate environment clearly the things that won't change your discipline on getting strong rates, but do you feel like this rate environment is pretty favorable into the first half of next year, or if this tight supply environment gets incrementally less tight, do you think this pressures rates for the industry and what you could get in FY 2022?
Yes, no -- we -- there is rate momentum in this environment, Steven, and we don't see that disappearing, you sort of get a flywheel effect rate, so that sort of tends to build in a positive environment. And we see rate momentum running into 2032 and 2022 being a favorable rate environment for us also.
Okay, great. And then in the other customers group seeing growth of 70% plus again in Q3 after Q2, is the strength in that purely entertainment sector coming back off the bottom last year or what other areas are driving that strength?
In the other categories would be some of the government activity as well.
Yes, that's the local portion there, Steven, and that's not really entertainment at all. So that's a swing back from COVID that market was more volatile last year, and is coming back sort of stronger this year. So starting to sort of reflect the normal mix we see in local customers versus national accounts.
Excellent. And then last one to clarify on operating expenses being normalized. Are both SG&A and DOE kind of running it back at normalized levels? And if not, what elements are coming in place in the next few months to normalize into next year? Thanks.
Yes, now we are back at normalized levels. So, I mean, we're running at sort of record levels of revenue. So the normal levels of operating expense and SG&A are -- there's no real -- none of the COVID cost reductions are in place since [ph] last year. So we're back at normal levels, and we'll continue sort of operating with those levels through Q4 and into 2022.
Our next question today comes from Jerry Revich with Goldman Sachs. Please go ahead.
Can you talk about the acquisitions that you closed on over $200 million in fleet? How much room do you have to grow that fleet with your specialty business and other areas, and now that you have the additional branch locations, can you step us through the plan? So we can think about what it might look like as you make additional acquisitions?
Well, the ones that we have done so far, Jerry what's exciting about them is that it gives us a lot of the urban density that we want in some of the big MSA markets. Only one of them was what we would call is a specialty business, which was a trench business in California. The rest of them are just core general rental businesses. So we have lots of opportunity to drive our specialty synergies through those business and we began that right away working on that with the sales teams.
And can you comment on order of magnitude, is it an extra $50 million in fleet, $100 million in fleet, just to get of us a rough context?
Well, I think if you just took the revenues that we acquired from those acquisitions and then assume that there's no specialty business running through them, there's probably extrapolate our 25% specialty number on that that's the fleet that we could push through there to grow that, specialty segment side business through that.
Very interesting. And from a utilization standpoint, you folks have worked hard to get fleet availability up. Was the third quarter essentially full out for you folks or as we think about third quarter 2022 might look like and the comps, is there room to take utilization higher? And what's your seasonally strongest quarter? How would you frame that opportunity?
I would say. This is Aaron, I would say that there's still some room for us to run at a higher time than what we did through Q3 this year.
And lastly, Mark, can I get you to expand on the flywheel comments on this type of environment, spot rates are well above rates that you charge your monthly and national account customers. If you were to mark-to-market your monthly and national account customers through quarter end, how much higher would the rate be? And can you talk about what's the timing of those annual agreements, just so we can get an appreciation for the cadence?
So yes, I mean, you've got it right. There's a lot more momentum in the spot market as those rates sort of cycle in every 45 days, if you like. So the rate growth that we're seeing in the spot is probably two to three times what we've got going in national accounts at the moment. We do have positive momentum in the national accounts, it just takes longer to sort of get going, as they sort of cycle every 12 months. And they're relatively evenly spread throughout the year. So we've got a monthly cadence of renewals within those national accounts and we continue to focus on getting right to left as they come up for renewal.
And our next question today comes from Rob Wertheimer with Melius Research. Please go ahead.
Hey, good morning, everyone. I wonder if you could just remind us or talk through the dynamics of the drop that you expect in the next couple of years. Is it largely just SG&A leverage that will become more evident as you've now done a reset? Is it how much is price versus rental rate versus cost inflation, et cetera. Maybe just some background around that? Thank you.
It's probably mostly operating cost leverage, it's the bigger portion of the cost spend in the P&L, but it's a combination of the two, obviously SG&A, there's a lot more fixed than operating expenses. So most of it really comes from just putting more fleet on existing locations. So as you add fleet, there is a step function in the cost that comes along with that, so you don't need to add drivers and mechanics straightaway. You do as those sort of fleet increase gets more substantial, but there's a step function to the cost and the OpEx and as that you just sort of work your way through that there's a pretty steady flow through and that sort of 60% to 70% time. Most of our branches can handle existing fleet and a big part of the strategy over the next couple of years is just really accelerating the fleet growth on those existing locations.
Okay. That was very helpful. And then just can I ask you a question about IT. Larry, we chatted about this at the Investor Day, but just what's your feeling on whether IT spend goes up materially or not where you're positioned on your sort of technology base and maybe the opportunity from IT as well? And I'll stop there. Thank you.
Look, I think when we were at Investor Day, and presented our plans. Our IT spend is baked into everything that we're doing, and that planning and spending is sort of baked into what we're looking out over the next three years. So I don't think there's any kind of a step function, or any kind of incremental spend that you'll see that's not already baked in.
And then just the opportunity and separation versus smaller competitors as you use your scale?
Look, I think the market as you know, is extremely fragmented. The top three or four players have roughly a third or more of the market. So, there's a great amount of opportunity, due to the fragmentation in the industry and I think where the separation comes is, the ability to spend the kind of capital that we spend, both in fleet, in IT and in overall structure, in the business that gives us as well as a few other of our peers a distinct advantage over smaller independent rental companies. So, that'll continue to happen, there'll be fragmentation that will -- there will be further consolidation due to that fragmentation and will be a part of that.
[Operator Instructions].
Today’s next question comes from Ken Newman at KeyBanc. Please go ahead.
Sorry, if I missed this, but can you please just quantify the impacts of the personnel costs that you incurred in a quarter and just on how should we think about labor costs, that maybe we should be aware of in coming quarters into 2022?
So I mean, part of it is just returning to normal on that sort of basis that comes from 2020. So, obviously commissions were low last year, and there was some furlough actions still going on and the entertainment business was effectively shut down. And then part of it's just return to normal and the sort of inflationary pressures that are touching into sort of 2022. So the payroll costs as a percentage of revenues has been huge, we're looking at maybe 5% to 10% ish increases in costs across that sort of spend, and that's manageable in the context of double-digit sort of revenue growth. So with drivers and mechanics are hard to find these days, we're focused on staying competitive in the market on all of our lines. And, there’s adjustments being made on a sort of regular basis to sort of do that. So it's manageable. It's something that we can deal with and still maintain margins and improve margins as we go forward.
Right. I guess kind of just sticking with labor, but taking I guess a bit of a different route. I mean, luckily it seems that we were able to avert a strike in Hollywood earlier this week, which potentially could have been an impact to your entertainment business. But, I am curious how you view potential labor headwinds or challenges across your customers or the end-markets that you serve? Is there anything that you are seeing in terms of things that are keeping you awake at night, or even potential opportunities going forward?
Yes, look I think to try to predict that, beyond what you hear about every day, whether it could be a John Deere strike, or an averted strike in the entertainment business, I don't think we plan for that, we certainly understand it, and we react to it. And as we reacted last year to COVID-19 very quickly, we can react to any type of an abnormality in the market if we have resources that are applied to that. So I wouldn't view that as a big challenge. I certainly don't lose sleep over it. We have a quick relief valve and can deal with that. But I don't expect that there'll be a lot that we're going to have be challenged with because I think the general tone is, let’s keep people working, right. And I think the resolution in the entertainment industry is indicative of that type of thought process.
Right. I was curious if you just give some color on the growth in rental revenues between specialty and the core fleet that you saw in the quarter, and I'm trying to get a better sense of how you think about the momentum for rental revenue growth between those two fleets in coming quarters?
It was pretty balanced this quarter. So, with specialty been coming back, well specialty was strong through last year and of course coming back, just as the market normalizes. So always pretty balanced in terms of the growth contributions this quarter, and we anticipate that going forward. Specialty historically has grown faster; there is a smaller part of the business and now as we sort of focus on core growth, then the two of those levers should be relatively balanced.
Yes. And then just last one for me if you don't mind. Just going back to the supplier tightness, can you just provide on where are current delivery slippages in terms of the equipment across your fleet that you're seeing and any just additional color on how much more extension you're seeing in the slippage?
Yes, this is Aaron, Ken. The slippage from deliveries expectation hasn't changed much from the last time we had our Q2 earnings call or met some of you at the Investor Day is about the same. What I would say is, some OEMs really had struggled to deliver their goods, mostly the smaller ones, and then we would pivot and find another supplier or put that capital to somewhere else for a segment of our fleet that was growing. But the bigger ones are delivering our scheduled fleet although, a little bit late, like we've mentioned several times but it's kind of a mixed bag, it's hard to pinpoint, particular OEM, but they're all working really hard to satisfy us. I know that.
And our next question is a follow-up from Ross Gilardi of BOA. Please go ahead.
Good morning. Thanks, guys. Can you just touch on your energy exposure and what you're seeing there, what kind of pickup you're seeing there, if any? You had referenced, just pent-up demand for industrial maintenance is that we're tapping and just remind us of your exposure and roughly and how it's divided by upstream, midstream and downstream?
On the upstream part, I know the price of oil has accelerated pretty rapidly, the demand for rental gear into that segment hasn't really accelerated as fast as the price of the barrel of oil. We have our basket of customers up in the Permian area that we like to serve. And we stick with that play.
On the downstream part, we did mention that we continue to expect more turnaround activity or pent-up turnaround activity that was delayed. That's happening, and we've used some of our capital, some of our new fleet to move into that segment to satisfy our customers in that segment as well. And we continue that downstream improvement and activity to continue all the way through starting in the fourth quarter and continue all through next year.
And just, Aaron, what is your rough percentage of -- I don't know how you want to give it out percentage of fleet or percentage of sales to energy these days and just upstream versus downstream?
For us, the upstream is about 3% or 4% and the downstream is like 5% or 6%.
Thank you. And our next question today comes from Steven Fisher at UBS. Please go ahead.
Great. Thanks. Good morning. You guys mentioned that mechanics are hard to find. Curious how the availability of parts is, are you seeing any challenges there and how might that be affecting your ability to kind of turn equipment around and get it back out on rent?
This is Aaron. Yes, we have similar parts delays as the fleet delays. Although, we have a team here that specifically focuses on fulfilling the parts demands that our branches need and connecting with the OEMs and other secondary suppliers daily, I think what we -- the way we measure our fleet is in our operating model, and we can measure how much of our fleet got returned from a rental, how much of its down, waiting for parts. And the good news is that we really haven't had any degradation of our operating modeled during the last 15 months. So we are keeping our fleet running and although it's not as easy and efficient getting the parts, we are putting the resources in human capital towards it to move it along faster and the way we're running our business is very similar than we were before the pandemic.
And, ladies and gentlemen, this concludes the question-and-answer session. I would like to turn the conference back over to Elizabeth Higashi for any closing remarks.
Thank you all. We appreciate you participating today. And as always, if anybody has any further questions, please feel free to give me a call and we look forward to seeing you all soon. Thank you.
Thank you, ma'am. This concludes today’s conference call. We thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day.