Description

Hertz (HTZ)

On Dec 31, 2013, Hertz rose 9% after it announced it had adopted a one year poison pill in response to unusual shareholder activity.  It was then revealed that Third Point, Corvex, and Carl Icahn had taken stakes in Hertz.  Given the market chatter I thought it would be appropriate to review the HTZ upside from here.  In addition to upside in the core business from a positive industry backdrop driven by a positive US growth outlook (which is not priced by the sellside), I believe the two catalysts in the near term which have both increased in probability and moved forward in timing are (1) the spin-off of its equipment rental business HERC and (2) increased share repurchases.

Valuation

Using a conservative rental car pricing assumption of 1% increases per year, I believe the company can easily do $2.70+ of earnings in 2015 (vs. consensus $2.58) while keeping its 1.6x leverage target and holding onto HERC.  Applying the Avis multiple of 14.5x NTM P/E, that implies a $40 stock.  I can get to $3+ 2015 EPS easily by increasing the leverage.  The increased leverage potentially adds $5/share and HERC spin adds $4/share, so potential upside on this stock within 12 months is $45-49/share, or 75% upside from current levels.

Car Rental Volume Growth

Volumes are levered to US GDP growth.  The company generally does 2-4x GDP growth in volume growth with 85% R^2.  If US GDP growth is 2.5-3% in 2014 (driven by fading fiscal drag) we could see the company to do 5-12% volume growth.  The average sellside volume growth estimate is around 4%.  Every 1% pickup in RAC volumes is worth 0.04/share in earnings, so this could be a significant source of upside.

Car Rental Industry Consolidation Leads to Pricing

Before I discuss the upside from HERC and capital return, let me recap the industry story.  The car rental industry has recently undergone significant consolidation.  I think others have written quite a bit on this, so I will just summarize.  With the acquisition of Dollar Thrifty by Hertz in November 2012, three companies control 90% of the US rental car market.  This allows the industry to raise pricing, which flows straight to profitability given the fixed cost of holding a car.

After the downturn, the industry benefited from record low fleet depreciation costs as used car values benefited from limited supply.  Margins benefited from lower costs, although pricing gains were limited as the competitive nature of the industry meant that much of fleet costs savings were passed on to the consumer.  Although the data is spotty, Q1 2013 clearly represented an inflection point as pricing rose 5% for HTZ US and 8% for Avis North America.

The pricing trackers I follow, industry contacts, and the commentary from both companies indicate the pricing story is only getting better in Q1 2014.  Historically Avis has been the company to initiate price increases, but starting in January 2014 we are seeing Hertz proactively institute pricing for the first time and greater follow-through from Enterprise.  There are three temporary reasons why Hertz has been slow to the pricing game, both of which are fading.

First, the FTC did not give final approval to the DTG deal until summer 2014.  So, CEO Mark Frissora was under intense pressure from his lawyers not to talk about pricing or behave in a way that would suggest price fixing. This deal has now been approved and legal experts say there is almost no chance the FTC could reverse the merger.  As a side note, legal experts tell me that the industry raising pricing is not price fixing if it is done in “conscious parallelism” (i.e. companies imitating each other is perfectly legal as long as they are not colluding).  Second, Hertz has been overfleeted as a result of the acquisition and thus has been more concerned about getting volume than price.  The Dollar Thrifty fleet is expected to fully integrate by Q1 2014, so the pressure to pursue volumes over price should subside as pricing takes the front seat again.  If Hertz can manage to achieve 2% price increases in the US despite having extra cars, then it can certainly achieve more when its fleet is right-sized.  Third, the company faced a tough comp from Q4 2012 as rental cars were in high demand due to Hurricane Sandy.  This base effect should fade over in Q1 2014.

A 1% move in net pricing is worth 0.10 of EPS for Hertz.  Applying a 14.5x NTM P/E multiple, that is $1.45/share, or 5% from current levels. The latest pricing surveys indicate very good traction from HTZ - previously it appeared as though HTZ was slow to raise prices because of their excess fleet (needing to manage utilization)

Fleet Costs

A quick word on fleet costs, as this is the issue that burned investors with the latest quarterly earnings.  Today rental car companies buy and sell most of their cars (called risk cars), so they bear the loss if used car values fall more than expected.  There is no doubt that as a rental car company, Hertz is sensitive to used car residual values.  A 1% move in residuals is a 4% move in depreciation expense.  However, there are a great deal of offsets to declines in used car pricing, the first being pricing.  As long as car values to not fall too rapidly, companies can pass on to pricing.  In addition, Hertz is being extremely proactive on building its retail channels.  We know these channels work because Enterprise has done it, and their depreciation costs are much lower than both Hertz and Avis’s.

I am more confident in Hertz’s 2014 fleet costs because I think the slate was cleaned when they reset fleet cost expectations to $250-260/unit/month in November.  I am using $255/unit/month for US depreciation in 2015 and $265/unit/month in 2016.  Rental risk residual values have actually done fairly well seasonally adjusted in the past few months.  Used vehicle market indicators (Manheim, Adesa, NADA numbers) have all been fairly positive on rental risk residual values since November.  Even though the headline Manheim generally gets more attention, rental risk values have performed better, with realized rental risk price was up 4.4% YoY in December.

The risk to fleet costs is either when you get a sudden drop in residual values (happened this past April with Avis) or when they overfleet and have to dispose vehicles early, leading to losses on sales (happened in Q4 with HTZ).  I have done some work bridging HTZ fleet costs to CAR's fleet costs and bridging 2013 to 2014 fleet costs and you can get comfort around the numbers as they are.  

Other Growth Initiatives

Hertz is pursuing a lot of “soft” growth initiatives that are difficult to quantify the in the immediate term but should result in revenue and margin upside.  I will highlight two.

First, the company is expanding into the off-airport / insurance replacement market, a market that has historically been dominated by Enterprise.  These are typically lower price rentals as they are paid for by insurance companies on a temporary basis while customers are repairing/replacing their vehicle.  However, the cost associated with servicing off airport is much lower (8% lower labor costs, 34% lower operating expenses, and 48% SG&A) and rentals are longer length so utilization rates are 220 bps higher.  Industry contacts say that Hertz is making decent progress in this area as insurance companies welcome the increased competition, and that Enterprise is not concerned about losing market share.

Second, Hertz has invested heavily into fleet technology.  You can rent a car without talking to a human at some locations by simply going to an automated video kiosk.  Anyone who has ever stood in long lines at an airport rental car office or tried to rent a car before or after hours will appreciate this benefit.  The company is gradually rolling out “Hertz 24/7” which is Zipcar on steroids.  With Hertz 24/7, the company will have cars scattered throughout parking lots throughout the country at local shopping centers and city lots where you can book on demand and simply hop in the car.  Note that Zipcar rentals are usually single day and renters have to return Zipcars to the same location, so Hertz 24/7 is a tremendous improvement.  The technology will also enable you to add on ancillary purchases such as GPS on-the-fly.  Anyone who has ever rented a car and declined the GPS only to find their iPhone has lost service and cannot function anymore as a GPS will jump at this the first time they get lost.

HERC Spin Adds $4/share

I look at what the HERC spin does to HTZ though a couple angles.  First I look at the free cash flow profile of the rental car (RAC) segment, as HERC is a significant drain on cash.  HERC annual net capex is about $350-$400mm, more than twice that required for the RAC segment, even though the RAC segment generates more than 75% of the company’s cash.  I estimate that HERC delivers about $250mm of FCF in 2015E.  Backing this out from the wholeco’s 2015E FCF projection of $1.1bn, the RAC segment delivers $840mm of FCF.  If I assume HERC would be valued at 6.6x EBITDA as a public entity, the RAC market cap would be $7.2bn.  $840mm of FCF over a $7.2bn market cap yields 11% FCF yield in 2015.  This compares to the wholeco’s current FCF yield of 9.0%.

For what it’s worth, Avis yields 12%+ FCF yield on my 2015 projections, so this yield makes sense.  Avis stock returned 95% in 2013 while Hertz stock only returned ~75%.

The increased FCF yield should give Hertz some multiple expansion.  Hertz currently trades in line with Avis on P/E and EV/EBITDA, though historically has traded at a premium as it has higher margins and is more positioned to grow through its technological investments.  Half a turn of EBITDA multiple expansion is worth $2.50 a share, or 9% from the current share price.

Unquestionably, Hertz is a better stock without equipment rental.  Management knows this.  Frissora said in November 2013: “If you do the math on it, obviously if you're just a pure rent-a-car company versus a cyclical HERC business, you generate more cash flow on a per-dollar-invested basis in the rent-a-car side than you will on the HERC side. HERC, as it grows, uses cash.  We invested $700 million in cash, and the return on that cash doesn't happen as quickly as it does in the rent-a-car model. So, yes, the capital structure, if we separated those two companies, would look really different and our capital strategy will be different as well.”

Second, I look from an accretion / dilution standpoint.

There are two possible scenarios for a HERC divestiture: a sale or tax-free spin.

Let’s start with a sale (note at the end of this piece I discuss why HERC is attractive for URI).  URI purchased RSC in 2011 for 6.6x EBITDA, which would be a roughly 1x premium to URI’s current trading multiple.  This puts the valuation of HERC at $4.9bn.  Next we subtract taxes.

Some say the tax issue is prohibitively expensive on a sale as HERC has a low tax basis as it is a homegrown asset.  The first question is what the tax basis is.  I estimate the tax basis to be approximately $2.9bn.  Frissora remarked in Q3 2013 that he was facing a $2bn taxable gain.  Assuming a 6.6x EBITDA valuation for HERC (the URI-RSC multiple), the HERC segment is worth $4.9bn, so backing out the $2bn gain yields $2.9bn.   The second question is how much they need to pay in capital gains taxes on a sale.  It very likely that the effective tax rate is close to 0% due to the $3.8bn of NOLs on Hertz’s balance sheet.  I have heard from both the former CFO and legal experts that the company is able to utilize these NOLs to offset capital gains taxes.  The exact amount of the NOL tax shield depends on details that are not available to us, but I do not believe the tax basis is the primary obstacle to a HERC divestiture.

I assume a 5% effective tax rate on sale proceeds.  After-tax proceeds of $4.77bn are used to pay down debt, which reduces net debt to $0.3bn.  The remainco’s EBITDA is approximately $1.6bn, so pro forma leverage is 0.2x.  From an EPS perspective, I estimate $0.11 of accretion, which is $1.64 a share assuming a 14.5x multiple.  Share buybacks to re-lever the balance sheet are additional upside.

A tax-free spin appears more attractive.  Assuming you lever the HERC asset at 2.0x and spin it off, remainco leverage is 2.2x EBITDA.  Under this scenario the transaction is $0.23 EPS dilutive in 2014 as the interest savings do not offset the net income loss, but the value of the HERC spin stock existing shareholders receive is worth $7.50/share ($4.9bn TEV less 2.0x net debt yields $3.4bn equity value divided by 450m shares).  The net gain to existing shareholders is $4.16/share.

Sidebar: HERC is attractive to URI

It is important to look from URI’s perspective as it is the most likely buyer (either directly or post-spin) in evaluating the HERC asset.  HERC is an attractive asset to URI as the #3 player in the North American equipment rental industry.  URI is the industry leader in a highly fragmented equipment rental industry, with 12% share.  Acquiring HERC would only give it a total 16% share but increase URI’s penetration in key national accounts.

15% of HERC sales are in specialty rental, which are higher margin rentals, the highest of the leading players.  HERC also has nearly half of its sales from national accounts, lucrative accounts that are tough to win and fairly sticky.  URI would benefit from both of these.

URI management talked at length on HERC in November at the Goldman Industrials conference, specifically highlighting some of the benefits of owning HERC:

• “That is diversifying our fleet, because they have a heavier component for earth moving. So that's one area that is about 13% of our portfolio that would increase…”
• “I think those are important considerations,  to position us with those national accounts, position us with the large industrials. We've got a national footprint already. So the footprint is not the main driver, but an important aspect of the footprint is the synergies that we can get out of rationalizing the footprint. You saw that hugely in the RSC deal. Right? And so, that would be another attractive part of acquiring the Hertz asset or any other large equipment rental company.”
• “And most importantly, can we move that leverage down rapidly to a range that we think is comfortable? And I think that's the way we would think about the HERC asset or any other large acquisitions.  Obviously, we don't want to be crazy at the peak leverage that we would go to that threatens our ability to do a lot of other things. So you won't see us going to six or seven times debt-to-EBITDA. But would we go up toward the top end of that range that we've talked about, 2.5 to 3.5 times? Sure. For the right deal, will we go above that range? Yes. Again, if we could see a rapid decline over the next year or two after getting the deal done.”

Synergies in this space are massive as companies get cost savings on the asset financing and eliminate redundant central office functions.  Synergies in this space have averaged 9% of pre-deal target revenue, with synergies in the URI-RSC deal at 15%.

When I run my analysis using an acquisition multiple of 6.6x HERC’s 2014 EBITDA, URI consensus estimates, 5% synergies, and 100% debt financing at 6.5% (URI’s long term cost of debt), the acquisition is 1% accretive to URI in 2014E and 4.2% accretive in 2015E.  Net leverage rises to 3.5x in 2014 and falls to 3.0x in 2015E, consistent with the leverage targets that management highlighted.  So this transaction makes sense for URI.

Abandoning Leverage Target Adds $5/share

A spin off of HERC means Hertz would likely give up its goal of attaining investment grade and pursue capital return instead.  Hertz commitment to a 1.6x net leverage target seems bizarre given Avis’s satisfaction with 3.0x.  A lot of this is tied to HERC.  CEO Mark Frissora said in November “And I think that if you look at investment grade, it saves us – we've said this before – about $60 million a year in interest, a lot of it due to the European issue that we have and getting financing there, but also due to the HERC side on the corporate debt side. So there's advantages to our capital structure by being investment grade”.

When I pay out all excess free cash in share repurchases, I get to 2.2x net leverage in 2015 and $3.07 in EPS.  This would imply $5/share in additional upside from my 1.6x leverage case.  This demonstrates the power of the Hertz free cash flow machine.  The company is on track to do over $1bn of FCF in 2015, over six times its 2012 FCF of $162mm.

Conclusion

Hertz is well set up for 2014.  The stock is both positively cyclically levered to US economic growth and has clear event-driven catalysts that will drive shareholder return.  Frissora said last summer that Hertz stock should be worth $50.  Though that was seemingly outrageous just a few months ago given the stock’s turbulence in 2H 2013, I can now clearly see a path to $50/share within the next 12-18 months.

Catalyst