Description

Hertz has been written up many times over the years on VIC. Why is it interesting again? Despite 2018 being the best of environments for HTZ, the company was unable to produce significant earnings or FCF. Nevertheless management has opted to shoot the moon and grow the fleet. Should either used car pricing, Rental pricing, or vehicle utilization start going the other way, HTZ may find itself cash constrained in 2020. While the equity is heavily shorted and expensive to borrow, HTZ debt is GC and seems overpriced.

Hertz Debt

Sell the HTZ 2nd Lien Notes or Senior Unsecured due 2022. Either HTZ manages to execute on its cost savings plan and a new 2nd lien issuance of 2020s/2021s drives up leverage and adds pressure to an already weak coverage or HTZ operating performance deteriorates and HTZ becomes unable to refinance 2020/2021 maturities. Longer term, it is difficult to come up with a path where HTZ will be able to generate meaningful free cash flow to delever its large debt stack.

Thesis Points

• 2018 was the best year HTZ could have expected with vehicle utilization high, used vehicle pricing strong and favorable rental pricing. Yet the company was not able to generate meaningful positive FCF. This is because HTZ is the least efficient operator in the industry while it also has the most overlevered balance sheet as measured by Debt/Total Capital (94%), net corporate debt / net corporate EBITDA (7.9x)

• Operating income hasn’t covered interest expense since 2015 and total debt continues to grow. The below chart by Daniel Ruiz does a good job of illustrating this point

• 2019 FCF will be negative; benefits in 2018 FCF are unlikely to repeat. Hertz Adj. FCF in 2018 was $99mn, benefiting from better residual values and higher advance rates on European vehicle facility (more debt on same assets, which on its own is a bit concerning as well). Hertz’s recent strong results probably reflect better industry conditions rather than the success of its business turnaround initiatives.

• Q4 was probably the strongest quarter they will have in a while: Price, volume, and fleet costs all went heavily in their favor, yet they still were not able to produce positive FCF indicating an overlevered balance sheet that will probably require restructuring at some point.

• Instead of paying down debt, management is trying to grow their way out of the problem. In 1Q19 management drew down cash from $1,127MM to $554MM leaving little room for error. The competition has been pressuring revenue since 2013 and is only getting stronger. As more ride-hailing and alternative mobility options gain access to more airports, there will be greater competition for on-airport volumes, which are higher priced than off-airport rentals.

• Hurricanes and auto manufacturer rebates have put upward pressure on used vehicle pricing. This is unlikely to continue in 2019 and 2020

• Icahn is trying to reduce his 28% stake in the company. His most recent sale in March led to the stock price collapsing from $20 to $16. This indicates that he is not looking to support the company through an equity infusion.

Drivers

• Spread between pricing (revenue per day) and residuals (depreciation pet unit)

• Used car depreciation as measured by the Black Book is still holding in but stands at record lows

Source: Barclays

• HTZ monthly vehicle depreciation expense is close to all time lows

• Pricing/Revenue per day. Down, pressured by Enterprise, Avis, Sixt Uber, Lyft

Source: airportrentalcars.com, Company data, Goldman Sachs Global Investment Research

• Vehicle Utilization is already off the highs

Vulnerability to residual values and Recessions

As a debt or equity holder in HTZ I would ask myself what the path back to meaningful free cashflow is and how HTZ will delever. 2018 has provided meaningful reprieve in particular through lower used vehicle depreciation, but are there any signs of underlying cost savings that could lead to meaningful free cashflow generation?

Recent improvements in margins are entirely due to lower vehicle depreciation whereas operating expenses as a % of revenues are actually rising. An increase in used vehicle depreciation or a weakening in pricing should make it clear that HTZ is trying to shoot the moon by “deleveraging” through growth. This only increases their exposure to an adverse economic environment.

HTZ’ mix currently stands at 62% leisure, 38% business. Recessions cause business trips to be cancelled and pricing pressure. Similarly, they reduce leisure travel. The customers that Uber/Lyft were poaching were the best customers for the rental car companies. For decades, business customers were the most profitable source of business for Avis and Hertz. Business customers were also the most price inelastic and profitable. Uber and Lyft have entirely reversed that equation and providing rental vehicles to their drivers is simply not enough to recover that opportunity as they put additional pricing pressure on rentals while being highly price sensitive rental customers themselves.

Residual Values

A weaker used vehicle market translates to lower residual values for vehicles that rental car operators are looking to dispose of after use (typically 12-18 months). Vehicle depreciation costs are cash expenses and typically make up ~25-30% of total operating costs.

Strong used car prices have supported the lowest Depreciation per unit in 5 years. Fleet costs have fallen 15% YoY primarily thanks to this.  The one mitigating factor is that 29% of HTZ cars are depreciation protected through vehicle offtake contracts through which the manufacturer is obligated to buy back vehicles at a fixed prices/depreciation rate at a specified time. HTZ in turn has to pay a premium on cars that it buys through the manufacturer offtake contracts.

Competition

While Enterprise, Avis and HTZ collectively control 95% of the car rental market in the US, competition and pricing pressure is building both from Sixt’s expansion, ride sharing providers and car sharing companies like Turo. HTZ is the least efficient and the most levered out of the group making it the most vulnerable to a downturn and increased competition. Due to its lower debt and higher efficiency, Enterprise runs pricing in rentals, making HTZ a price taker. In addition, rental car operators are largely unable to create their own demand, making them volume-takers depending on customer travel. On-airport rentals make up 66% of rental transactions for HTZ rendering Airport traffic the most important driver of volumes.

The ride-hailing apps are consistently taking market share from car rental.

Cost Structure

The above chart illustrates HTZ problem. Direct operating costs have averaged 55.5% and are difficult to cut further due to wage pressure and unionized employees. Vehicle depreciation is averaging 28% over the last four quarters, a record low since 2015. Vehicle interest expense is a function of rates and there’s little room to move the needle on SG&A.

While the absolute amount of corporate and fleet debt at Hertz has continued to grow, there has been a shift from using more corporate to using more fleet debt by increasing advance rates on ABS. HTZ cannot delever by reducing vehicle debt as this comes at the cost of EBITDA. With fleet debt of $12.4bn, corporate debt of $4.4bn, and corporate EBITDA post vehicle depreciation and vehicle interest expense of $300-400MM in a good year, there is simply not enough free cashflow generation to delever after paying down corporate interest expense of $275MM and annual non-vehicle capex of about $200MM.

Conclusion

The bottom line is that it’s difficult to see how HTZ can produce positive cashflow to delever as long as pricing pressures persist. In fact, management is doing the opposite and trying to grow their way out of the problem. This strategy adds to HTZ’s vulnerability to adverse used car depreciation, pricing and utilization trends.

While HTZ common has 35.5% short interest, the HTZ 7 ‘22 senior secured 2nd lien bonds are trading at about 102.25 with a yield to maturity of 6.6% while HTZ 6 ¼ ’22 are trading at 96.75 or a yield to maturity of 7.35%. For both the use of the make-whole is unikely.

What is interesting about the 2nd liens is that, should HTZ fail to refinance any of its debt the 2nd liens would likely have significant downside as cars are used as collateral for ABS with 91% advance rates, HTZ has few tangible assets outside of its cars and run rate corporate EBITDA ~$400-$500MM. There is $670MM of first lien debt and $1.25bn of 2nd lien debt. On the other hand, should HTZ get enough investor support to refinance its 2020 and 2021 maturities by issuing more 2nd lien debt the collateral package would be diluted and recovery values for the 2022 2nd liens would fall as this would mean an increase of $1.2bn in 2nd lien debt.

Catalyst

Lower Residual Values

Weaker Pricing

Debt Markets Close

Uber/Lyft expand to more Airports

Carl Icahn continuing to sell