Before launching into an analysis of Hertz, it is important to understand the nature of Hertz's business. Largely, Hertz does not have a product but is rather a financing company. It borrows money (quite cheaply using ABS vehicles that are non-recourse to the parent) and acquires vehicles from OEMs like GM, Ford, Chrysler etc. It then leases out those vehicles at airport and non-airport locations. The goal is to earn a spread over its financing costs, which it terms profit.
This business is hugely affected by macro economic conditions and now by ride sharing services like Uber. So, as an investor, you are investing hoping interest rates, economic conditions, tourism and travel hold up.
Management does have control over the FLEET. This is a consolidated industry with only two major players left in the U.S. market. So it is unlikely management will go nuts trying to get market share by undercutting competition on price.
The operational side of the business is measured in terms of a few metrics: Revenues, Direct vehicle expenses, Depreciation, Transaction days, Revenue per transaction day, average vehicles, size of fleet, program vehicles vs. non-program vehicles.
To get a sense of the business all these things matter. So you can't control macro (economy, interest rates, technology) but the core business performance can be measured. Let's look at Q3 results, which resulted in a huge sell off. The main culprit here was an increase to depreciation expense, due to falling used car prices. As an investor, you can not do anything about this. But it hits Hertz since most of the vehicles in the fleet are non-program cars (92% according to the latest report, down sharply from 28% a year ago) and this comes straight out of profits. The important thing to remember is that used car prices will fluctuate and ultimately come back up if they fall too much. But that's not a good game to play - too macro and unpredictable.
The operating metrics for the quarter aren't bad per say. The fleet size has not shrunk but it isn't growing rapidly either, transaction days are up so demand is still there, RPD is down but only so slightly. Vehicle utilization rates are hovering near 80%, which is decent.
Given how much the stock has fallen, one thing is clear. The net profitability of this business is hugely variable and almost all the variables are correlated. In other words, the 80% drop in stock price shouldn't surprise you, nor would a 5X rise from here in a few short months.
Cutting fleet size to reduce expenses will hit revenues assuming it also results in lower transaction days. It might result in lower net income, but if the reduction in fleet size is accompanied by rising rental rates, it might actually INCREASE net income. So the business would become MORE valuable on lower revenues.
This business is hugely affected by macro economic conditions and now by ride sharing services like Uber. So, as an investor, you are investing hoping interest rates, economic conditions, tourism and travel hold up.
Management does have control over the FLEET. This is a consolidated industry with only two major players left in the U.S. market. So it is unlikely management will go nuts trying to get market share by undercutting competition on price.
The operational side of the business is measured in terms of a few metrics: Revenues, Direct vehicle expenses, Depreciation, Transaction days, Revenue per transaction day, average vehicles, size of fleet, program vehicles vs. non-program vehicles.
To get a sense of the business all these things matter. So you can't control macro (economy, interest rates, technology) but the core business performance can be measured. Let's look at Q3 results, which resulted in a huge sell off. The main culprit here was an increase to depreciation expense, due to falling used car prices. As an investor, you can not do anything about this. But it hits Hertz since most of the vehicles in the fleet are non-program cars (92% according to the latest report, down sharply from 28% a year ago) and this comes straight out of profits. The important thing to remember is that used car prices will fluctuate and ultimately come back up if they fall too much. But that's not a good game to play - too macro and unpredictable.
The operating metrics for the quarter aren't bad per say. The fleet size has not shrunk but it isn't growing rapidly either, transaction days are up so demand is still there, RPD is down but only so slightly. Vehicle utilization rates are hovering near 80%, which is decent.
Given how much the stock has fallen, one thing is clear. The net profitability of this business is hugely variable and almost all the variables are correlated. In other words, the 80% drop in stock price shouldn't surprise you, nor would a 5X rise from here in a few short months.
Cutting fleet size to reduce expenses will hit revenues assuming it also results in lower transaction days. It might result in lower net income, but if the reduction in fleet size is accompanied by rising rental rates, it might actually INCREASE net income. So the business would become MORE valuable on lower revenues.
Looking carefully at the quarterly results.
1) International segment is doing fine. Total revenues of $683MM. Adjusted Corporate EBITDA of $151MM. Very decent 22% Adjusted Corporate EBITDA Margin. Revenue per available car day was flat. Average vehicles remains constant. Net depreciation per unit is low at $188. Good stuff.
2) The U.S. segment is NOT doing well. Revenues are flat, so that is a good sign in terms of demand. However, depreciation on cars has shot 14% higher compared to this time last year. This has practically decimated Adjusted Corporate EBITDA Margins. $63MM additional depreciation charges over the quarter on total revenues of $1,707MM equate to about 3.7% decrease in margins. Adjusted Corporate EBITDA margins fell 4.7% so that accounts for the bulk of the change. So the first question here is: Is this the new level of depreciation charge going forward? The rest of the $85MM decline in margins is from lower top line revenues, although since costs are 75/25 variable/fixed, the full impact of lower top line revenues was muted by $10MM. (Revenues fell about $32MM on the top line, but the impact on Corporate EBITDA margins was only $25MM.)
On depreciation charges, the company blamed 3 factors. 1) Lower than expected residual values 2) higher mix of non-program vehicles 3) higher vehicle acquisition costs YoY.
On depreciation charges, the company blamed 3 factors. 1) Lower than expected residual values 2) higher mix of non-program vehicles 3) higher vehicle acquisition costs YoY.
3) Other operations from Donlen showed steady performance both from a revenue and Adjusted Corporate EBITDA perspective.
A couple of things also to remember. Non-vehicle capital expenditures is likely to go up next year to $150-200MM vs. $75-85MM in 2016 as Hertz is planning to make investments in subsidiaries. So the FCF guidance next year is likely to be lower.
The other obvious comparison is to Avis. Avis has Adjusted Corporate EBITDA margins in the U.S. of 16.8% in Q3 2016. It is in fact smaller than Hertz in the U.S. since it only has 422K vehicles vs. 505K for Hertz. The international segment is very similar in size and margins. Both Avis and Hertz have 22K vehicles and operate in the 20% Corporate Margin range.
The big question is why Hertz in the U.S. is operating under 12% Adjusted Corporate EBITDA margins vs. 17% for Avis? 5% is a lot of money when you have nearly $9 billion of sales. That is $450MM of cash money. You can bet Carl Icahn is having a word with Hertz management. My feeling is that heads will roll soon...
Well, the previous CEO wasn't able to quite deliver. Avis is massively outperforming Hertz. 2016E Adj. Corporate EBITDA is $600MM for HTZ vs. $875MM for CAR. This is despite the fact that Hertz has a much bigger fleet. In the U.S. alone, it has 505K cars vs. 422K for Avis.
If we go back to the Q1 2016 call, HTZ showed that RAC had produced an Adj. Corporate EBITDA of $883MM in 2015. So if we can get back to those levels (primarily due to the U.S. RAC business) the stock could fly.
New CEO in the house
How much can Ms. Marinello really do here? She can hardly change the dynamics of the used car market. She is either stepping into a company going bankrupt, or the macro environment turns and she makes millions with no exceptional effort on her part. Nice free option of sorts.
The situation at Hertz is looking quite desperate. During the conference call, when discussing potential covenant restrictions on the senior revolving credit facility, Tom Kennedy said that since the EBITDA included potential cost savings over the next year, they could simply model more cost savings to stay within their covenant restrictions!!!! What! That's such a red flag.
Anyhow, business is not going well and I don't want to be in this unless we see signs of improvement. The business could implode if 2017 sees another step down in depreciation rates and the economy and global travel slows. On the upside, if residuals recover or if they can push through the cost of fleet through in pricings, the upside could be material.
Keep an eye on this...
The situation at Hertz is looking quite desperate. During the conference call, when discussing potential covenant restrictions on the senior revolving credit facility, Tom Kennedy said that since the EBITDA included potential cost savings over the next year, they could simply model more cost savings to stay within their covenant restrictions!!!! What! That's such a red flag.
Anyhow, business is not going well and I don't want to be in this unless we see signs of improvement. The business could implode if 2017 sees another step down in depreciation rates and the economy and global travel slows. On the upside, if residuals recover or if they can push through the cost of fleet through in pricings, the upside could be material.
Keep an eye on this...
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