Some thoughts on Hertz

A lot of egos at play here, and the new CEO, Mr. John Tague, seems to have drummed up some interest. I wouldn’t call it unwarranted – after all, we are talking about some of the smarter investors and a man who ran complex airlines & logistics companies; but I am not entirely convinced that HTZ is a good investment – the bottomline is that, post the run-up, corporate EBITDA stands at 9.5-10x based on my assumptions, and the fix on pricing will take some time – long enough that the cycle might be over when they finally decide to collude. As I have said in twitter, if there’s one thing you can bank on, it’s that these guys go into crises with too many cars and too much debt; and that’s aside from driverless cars potentially disrupting the entire industry.

Some of my math 1st.

There are 3 key drivers to a car rental business’s economics:

-          Revenue / day (pricing)

-          Utilization % and operational cost (efficiency + volume)

-          And residual car value upon disposal 12-24 months out.

-          The other factors (ABS financing, interest, etc) are just minute details.

Assuming a $20,000 car that’s being driven 65 miles per day, 23 days out of a month (75% utilization), this car will hit the 25k mile mark and approach $14-15k in resale value (or ~70% residual) after 18 months. With a $45 / day rental charge, the rental firm’s cash & cash flow profile on that car is:

I.e. pay for the car upfront w/ debt financing, have the rental income slowly accrue to the disposal mark, then sell the car at residual, pay back the debt, take a loss on invested capital, but overall come out ahead thanks to the rental income.

It is then fairly evident where the risk lies: (1) if the company charges too little, the rental fee won’t cover the loss upon sale, (2) if the company sucks at operating and the utilization is too low or operating cost too high, same fate, (3) if the company can’t sell the car at a high enough price, the project is also NPV-negative.

Factor (2) is somewhat internal and can be improved by management style. Enterprise is the best in the business in that regards, but factor (1) and (3) – pricing and resale value, are only partially within the control of competing car companies. Let’s look at an example of a 10% hit on pricing & residual value:

10% hit on price ($45 to $40.5)

 

10 pt hit on residual value ($14k to 12k, or 70% residual to 60%)

 

In fact, the 1^st key observation is that 10%+ in price cancels out 10% decrease in residual value very well. The implication are both ways: (1) a little pricing goes a long way to offset a lot of flaws, (2) but when residual price really falls, when company is unable to raise price, and when it also has to refresh its fleet to compete in the market, the cash-flow profile can get very nasty.

 

The next nuance, also important, is that if a car is 10% more expensive, to achieve the same return on capital w/ ~60% leverage, the company will need to raise its rental price by4-5%. Hence a price increase in a rising car price environment is not voluntary – it’s necessary.

Hence, in Hertz’ case, there are 3 questions to be answered:

(1)   Will a new CEO make HTZ a better operated company, as its utilization will trend better, cost down, and fleets reaping more residual value?

(2)   Will / Can HTZ be more disciplined and “collude” with the industry to drive pricing?

(3)   Will used car prices continue to trend down, thus offsetting the price increases?

The 1^st point should be simpler to tackle. A few issues that had been miring HTZ’s performance had been (1) the off-airport push into corporate / insurance accounts that drag down margin, (2) slow integration of Dollar Thrifty fleet & systems, leading to poor allocation of resources / utilization / pricing, and (3) having old cars that are 40k + miles and 3 years+ in age that really hinders their utilization and pricing. It’s gonna take some pain and dollars to get through all these, and most likely 1+ year under good management, but it is largely a fate within the company’s control. I think the time-line here will be a bit dragged out and the cycle may be over before they get to a satisfactory point, but this point seems like something one can bank on.

Then I want to talk about the 3^rd point second. I think used car prices have very good chance of going flat to down over the next 1-2 years. The root cause goes back to supply/demand: Looking into the next 2 years, major US car OEMs are ramping CapEx:

As the supply of cars increase (potentially at higher price points), the demand for new cars is likely to stay put as economy grinds along, subject to slight increases due to high used car prices. So the volume of new cars will likely go to 17 mm SAAR while the prices stay flat to down:

 

As this happens, the 1-6 year of new-turned-used car supply finally comes back to the used market. So supply of used car increases. While the demand curve for used car will likely to improve slightly too due to economic strength, the anticipation of price drop and substitution effect of cheaper new cars will likely overshadow such strength – resulting in increased used car sales volume and flat-to-down prices.

 

In fact, the Manheim index (used car prices) is already showing some signs of weakness. Everyone kind of knows this price issue, and that’s why Avis and Hertz are both moving back to program vehicles vs. risk (to lock in residual) and the fleet age is going higher to slow down the pace of unloading in order to stabilize price. I’m not Adam Jonas berish, but I do think used car has another 10-15% to go, and that does not help car rental firms’ case at all.

And here comes the last point, where will industry pricing go?

This is really the crux of the bull thesis, and the quick answer is I don’t know and need more time. Here are some interesting points relevant to the discussion:

• The supply of rental cars is rather local & fluid: Local because you rent cars at regional markets, fluid because while hauling cars from place A-to-B costs time and money, supply in a market can indeed be increased rather quickly should there be a demand w/ relatively little capital intensity. So when Avis raises price, Hertz can increase profit by (a) raising price as well or (b) doing nothing / bring in more cars – but regardless of what happens, my guess is that there will always be a time-lag (MKM cites 3-4 weeks lead time), and Avis in this case will lose some volume. This leads me to believe that we probably won’t see a crazy price-uptick scenario like DRAMs, but rather slow and steady creeps (1-3% per annum above new car price inflation) when “oligopoly pricing” does happen.
• Upon Avis’s attempt to take price up earlier this year, Enterprise followed-through within 3-4 weeks across markets, but Hertz shows no pattern of cooperating. One can either read it as Hertz is not playing ball, or one can interpret it as HTZ simply don’t have the ability to due to (1) aged fleet and (2) aged system that cannot accommodate the complexity associated with new cars, Dollar Thrifty + off-airport addition. In other words, oligopolistic pricing probably won’t happen until HTZ spends some CapEx after getting a new CEO.
• And to the point above, It seems unlikely that HTZ fixes this pricing mechanism in 4Q14 & 1Q15 given the activist & accounting problem + fleet renewal. It’s hard to do in 2&3Q15, so the fastest they can implement anything material may be 4Q15. So we might not  see real beef behind the sizzle for another year or so.
• Net-net, car cost is still a small part of travel and it is unlikely that $5 makes a big difference if it is an industry phenomenon. But as long as HTZ doesn’t get its act together, we probably won’t see it.

Some blurbs from a sell-side firm on the new CEO:

HTZ –we are all doing our own checks and will know more by the end of the day and not sure I can add all that much right now.  I’d say there is of course disappointment amongst us that respect and know Scott well but we were all prepared for this at this point.  Scott’s comments that just came out confirms all we already knew about him – what a class act.  The best.  Love that guy.  There is also optimism given the majority of checks have come back positive and what Tague did at UAL seems rather applicable and impressive.  His track record before and after needs further examination.    If you want to be bullish, you can be bullish on this stock and CEO.  If you want to be bearish on this stock and CEO you can be.  I enjoy debating it both ways.  I reiterate what we wrote in Where We Stand this weekend.  The patient is healing, the opportunity here is big, this stock can double but it may also very well be flat to down in 6 months from now.   Today is the first day of the next chapter.

The good

• We don’t have to play the mental gymnastics of who, when, why anymore.  Holders I’ve spoken to aren’t freaking out.
• United was a mess when Tague got involved; when they left major customer metrics had improved significantly.  They were #1 in on time arrival and customer satisfaction – everyone knows HTZ customer service is hurting.
• Tague was very involved with corporate accounts and led a change in strategy where UAL regained the upper hand – this must happen at HTZ
• Tague seems like the guy that first instituted ancillary fees like extra leg room, bag fees etc
• Has been in the leisure industry since birth – dad was a PanAm guy
• Early feedback from Greatwide investors (two of them) is that John was the best CEO they have seen and someone that “has his head very much on straight.”
• This has all the finger prints of a classic Icahn guy and Carl knows so much better than all of us.  Rough, no nonsense, to the point, gets things done.  I read somewhere he was described as someone that wouldn’t work at GS (I’m not sure how to take that personally but I get the point) and we know what Carl thinks of GS.  Also, this guy may not even have a college degree.  That would be cool.
• This hit me yesterday and has nothing to do with Tague.   There is around 40%-50% of this stock that from what I can tell that is pretty much locked up/ long term $.  For all the talk of this being an awful shareholder list historically, this I think is an interesting point.

The bad

• We all knew exactly what Scott would have done, we don’t know yet what John will do.  I do hear he may be meeting SHs next week.
• The problems here are deep and urgent; any time to get up to speed is not ideal.
• Doesn’t seem that Tague has relationships with the OEMs or Enterprise
• Doesn’t seem like he is going to make people dream a dream, like Sefi does.  
• Many of the senior guys that are left are Thompson/ DTG guys-  wonder if they will leave.  Probably need to hire someone to replace Scott Sider –ex  head of RAC
• My check in the logistics industry is that Greatwide isn’t very respected and has had a rough go of it – although I believe this is pre John getting there
•  ATA went bankrupt when John was running it (a very long time ago) but factual statement  

Finally, some historical valuation...