Description

Hertz shares the #2 or #3 position in the global rental car market with Avis depending on which region you’re looking at.  The rental car space has been trafficked on VIC in the past with HTZ being written up as a long three times and CAR as a short once so I won’t spend too much time on the basics.  We think the current fundamental challenges the industry is facing are transitory and the popular secular short thesis of share theft from Uber/Lyft are overstated.   The rental car industry is effectively a commodity-like spread business and since their rental fleets are short duration in nature (roughly 18 months for a full refresh) the industry is able to respond to cost pressures by cutting fleet to boost price IF all players are willing to behave rationally.  Over the past 12-18 months HTZ has been attempting irrationally to recapture market share lost during their integration of Dollar Thrifty, this has left them and the industry chronically over fleeted.  HTZ’s new CEO effectively stated on their Q1 call that she plans to underfleet going forward, and CAR said they de-fleeted to “take their medicine” we think this marks the beginning of the industry maintaining a tighter fleet and taking price.  Not because it will be all gravy to their bottom line but because they need it to maintain margins in the current environment of soft used car pricing.  Our fair value for HTZ is $32, a triple from here at 10x their normalized earnings profile of $3.25.

The long thesis from here rests on these points:

• Most of HTZ’s current issues are self-imposed, their average EBITDA margin from 2006-2016 was 10.5% and they typically out-earned CAR by 200-300bps, in 2017 their EBITDA margin looks like it will be around 3.5% and they will under-earn CAR by about 550bps

• The Q1 report was an utter disaster but a big chunk of the pain was nonrecurring as the company took steps to right size their fleet into a soft used residuals environment, it also smelled like the new CEO wanted to kitchen sink numbers and expectations

• The industry seemed to be telegraphing on their conference calls that they were doing everything possible to tighten up fleet, dispositions of fleet were up (+20% y/y for HTZ) and new purchases were down (10%+ according to CAR)

• Aside from fleet tightness heading into the summer used residual values have improved into Q2 and airport pricing surveys from MKM and Goldman also show sequential improvement

• Bear point #1 of severe residual value pressure in the range of 7-8% as reported by NADA was/is incorrect as both companies reported declines in the 3.5-5% range for Q1, more inline with the Manheim Rental Index, this chatter is what got the stocks selling off in Mid-March.  They will also be sitting down with the OEMs to negotiate rates for the upcoming season, in the past there has been a correlation between residuals and fleet pricing  

• Bear point #2 of secular challenges from Uber/Lyft is also overdone, only around 5% of rentals in the US are single day trips, ridesharing is more of a taxi substitute.  

• The short interest has more than doubled in the past 2 months or so and is now 46% of the float

• Icahn owns 35% and purchased more than half of the position off the Q3 print last November, I have zero insight into his plans

Net net, it’s a mediocre commodity business but with the stock trading at roughly 3x normalized earnings, leading fleet supply metrics heading the right way, and bears piling on after the move from $50 to $10 we think its materially undervalued.  

Normalized earnings/margins

Two things have been at play since the 2013 peak:

• Increased fleet costs for the industry from the 2012 lows, ie—lower residual values and a shift from program to risk cars.  See the chart from Avis below, and note that even when fleet costs were peaking out from 2007-2009 HTZ was able to earn higher margins despite a terrible demand environment in the great recession

• HTZ also made a very costly operations error after their acquisition of Dollar Thrifty and moved their headquarters from New Jersey to Florida.  Only 20% of their staff relocated and while the company won’t quantify the hit they’ve said its “material”

Using the 10% normalized margin without assuming revenue growth gets you to approx. $900m in EBITDA or $3.25 in EPS.  If they can make it back to 14% EPS would be $6.00.  Also note that when the spin took effect last summer consensus earnings for 2017 were in the $4.00-$4.50 range so this isn’t exactly heroic.

Why would we think margins start to normalize?

To us it sounds like HTZ’s new CEO, Kathy Marinello, understands that her company has historically been the irrational player and for the industry to realize pricing fleet levels need to tighten.  It also sounds like CAR is on the same page.  Tight fleet means better utilization/pricing.  Here are a few quotes from the Q1 calls:

HTZ

<A - Kathryn V. Marinello>: “So, as we are very aggressively, as Tom and I have both mentioned, getting out of fleet, again, 21% more in the first quarter, the same level of intensity we'll have in getting out of fleet the second quarter, we believe that we'll be in a great position to manage profitable demand and to manage back up to a normal utilization rate. But we are focused on regardless of the expense at this point getting the fleet right”

<A - Kathryn V. Marinello>: “And we will not be holding cars for long periods of time as a way to meet demand. I found, over the years, that there's a lot of people out there that love to sell cars and would love to sell cars to us, particularly in this market, as there is some pressure on car sales. So, we believe that fleeting up is a lot easier to do, and a lot more profitable to do, as versus trying to rapidly get out of cars that you don't have the demand for. And that's going to be our approach going forward.”

CAR

David B. Wyshner: “In the context of weak residual values in Q1, each week, we had to make a decision about whether to keep our fleet in line with demand or to hold cars in hopes that residual values would improve. Sometimes the first loss is the best loss and we took our medicine selling cars to keep our fleet levels where we felt they needed to be. In particular, we went into the quarter planning to sell 51,000 cars and in the quarter, we sold 51,000 cars. We actually set a new record in the quarter for the number of used cars we sold.”

<A - Larry D. De Shon>: “although there are markets that are starting to tighten up, it's not at the levels that you would want it to be kind of this time of the year. So our expectation is that it's going to take a few more months before the fleet levels really get aligned to the demand; so we're really thinking more summer as we go into summer. But you couple that with the fact that all the data points that we have tells us that the industry overall registered fewer cars in the first quarter compared to last year. The data we have for January and February really puts the industry down almost 10 points of cars being registered in those two months, and then reports we've read since then about March is even a larger decline year over year. So I think the combination of the two things where we see cars being pushed into the auctions, they're having record number of rental vehicles going through the auctions in the first quarter going into the second quarter, combined with the fact that registrations are down should bode well for a good level – the right level of fleet to demand as we go through the summer.”

A note on residual values

Starting in late March any auto name with exposure to used car prices (HTZ/CAR/ALLY/KMX/etc) started to sell off on Q1 NADA index data which had used values at approx. -7% y/y.  The Manheim index had pricing up about 1%.  Obviously a massive spread.  A lot has been written about the differences between the two indices so I won’t go into it.  I think the key takeaways are as follows:

• The Q1 data is in and it seems like the answer is that the rental guys fall somewhere in between the two indexes.  HTZ took their residuals forecast from -3% to -3.5% for 2017 and CAR took theirs from -2.5% to -3.5%.  The point is that the idea that a 700-800bps hit to residuals was in the cards for 2017 was wrong.

• Used pricing has recovered into April

• Both companies have said there is a strong correlation between residual values and prices they are able to negotiate with the OEMs for the next model year fleet

• Not that it’s a huge deal but the spread between new and used cars is the largest its been since 2009

Conclusion

• This is a name that was a hedge fund darling in 2013-2014, their view that industry consolidation would allow them to take price and juice their P&L was unfortunately wrong.  Fast forward a few years and its one of the most shorted stocks in America.  We think the reality of the business quality lies somewhere in between and the industry will finally get price, but only because they have to in order the recover costs.  

• The leading indicators are pointing in the right direction.  Everyone seems to be de-fleeting.  Used pricing has improved sequentially.  MKM and Goldman airport pricing surveys show sequential improvement into Q2.

• Normalized earnings are in the $3.25 range, the stock should get 10x this but given the short interest it may overshoot.  Our target is $32.

Catalyst

-monthly residual data

-pricing surveys

-long term goals from new CEO