Events: Hertz Re-Initiation August 2015

Hertz Global Holdings

Events: Re-Initiation

August 4, 2015


SUMMARY INFO

  • NYSE: HTZ
  • Recent PPS: $16.55 (8/3/15 close)
  • Shares Out: 454 million
  • Market Cap: $7,514
  • Corporate Net Debt: $5,807
  • Enterprise: $13,321

INVESTMENT SUMMARY

  • Uber a limited threat over the next 3 to 5 years
  • Large-scale operational turnaround underway, driven by the operations-first, value-oriented John Tague
  • Hertz Equipment Rental (HERC) spin-off in 1H16, preceded by a $1B repo, acts as near-term catalyst
  • YE 2016 SOTP conservatively $42.26; excludes upwards of $5.42 per share of NOLs, and the use of $3.33 per share of incremental debt for an additional repo program. FVPS and 1.5-Year IRR $36.63 and ~87%.
  • Icahn $30 take-out?

DISCUSSION 

This is a re-initiation because I was originally involved in the stock between mid-June 2014 and early November 2014, and wrote it up in early October 2014. My original analysis was overly aggressive on pricing and Fleet D&A assumptions – as evidenced by 2014 U.S. RAC sales growth of less than 3% versus industry growth of ~7%, and Fleet D&A PUPM (Per Unit Per Month) of $294 versus $218 in 2013 – which the stock price ruthlessly demonstrated with a peak to trough decline of ~51% over the last 52 weeks. Fortunately, I saved myself a significant amount of absolute and relative performance by dumping the stock in early November 2014 after the price failed to outperform the market on the way out of the October 2014 market bottom. In the meantime I monitored the situation from the periphery, but failed to gain conviction even at significantly depressed levels, as it was next to impossible to verify earnings power without updated filings and limited Company communication. I noted on Twitter that I thought somewhere in the low- to mid-teens would be an interesting entry point, but never acted on it.

On July 16th and 17th, alongside restated SEC filings HTZ filed an excruciatingly detailed Restatement 8K and held a highly informative call with investors outlining future strategy and earnings power building blocks. The stock initially shot up to over $19, then sold off to below $16 before settling out to between $16 and $17 where it resides at present. I am somewhat of a hypocrite because typically it is a bad sign when a stock sells off on presumably good news, and I generally heed those signs. However, I tend to weight those signs more heavily if I am uneasy about the fundamental backdrop.

The fundamental and investment backdrop is superb here, so I am willing to overlook negative technical signs at present. After years of mismanagement, accounting issues, and tepid 2015 guidance, investors have a right to be wary…but at a higher price. A MUCH higher price…

THESIS

Uber. The Uber threat gets a lot of press; and while certainly a wildcard in the long run, I believe the risk is overblown over the next 3 to 5 years, as Uber needs to find out where it ultimately wants to land on the cost curve. Certainly the technology is cutting-edge, but if the all-in cost matches or exceeds a traditional taxi service, I do not know how wide of a moat Uber will be able to carve technologically if traditional taxi services ramp up their technological game. And lastly (admittedly something I need to dig into more), what % of traditional car rental customers would forgo a rental car for a glorified cab? (More than likely an asinine question.)

Operational Turnaround. President & CEO John Tague – formerly of United Airlines (2003-2010) – is the crux of the operational turnaround aspect of the investment thesis. Hired in November 2014 by a search team headed by Carl Icahn, he is an operations guy thru and thru – maniacally focused on customer service, cost controls and value-oriented growth. Tague is not unlike Peter Hancock at AIG, Tom Rutledge at CHTR, and Hunter Harrison at CP; all three of whom brought an operations-first, value-oriented approach to turning around a historically under-/mismanaged asset. The projected outcome for HTZ is simple and three-fold: higher RPD via innovative product development & customer loyalty; higher utilization via value-oriented capacity growth; and a lower cost structure via better management.

Catalysts. HTZ has guided to a $1B repo program, followed by a spin of HERC, within the next 12 months. The repo will collapse shares by 11% to 14% pre-spin; while the spin will afford HERC management the ability to either be consolidated by URI, or to be a consolidator itself. Regardless of the consolidation outlook, with HERC capacity utilization still below pre-recession levels, depending upon where we stand in the economic cycle in mid-2016 HERC could be in fantastic position to grow its earnings power over the near- to medium-term. Lastly, HTZ will have upwards of $725MM to buy-in shares immediately post-spin, collapsing shares by a further ~6%.

Valuation. HTZ RAC – free of HERC and Donlen – will earn approximately $2.40 in 2017. Valued at 15X, HTZ RAC is worth approximately $35.93 at YE 2016. Incremental debt and HERC add another $6.33, for an all-in YE 2016 FVPS of $42.26. From the recent close, the 1.5-year IRR is ~87%.

Icahn. At $30, an HTZ take-out would cost Icahn approximately $13.6B – well within his capacity given his historical take-out proposals (i.e. Dell, Clorox). This potential is discussed very little (if at all, to be honest), so I could be far off base here; but given the operational outlook under Tague’s leadership, portfolio rationalization potential, debt capacity, tax assets, and strong core FCF generation, I struggle to see why Icahn would not want to take a crack at it.

ANALYSIS

Market. HTZ estimates the 2014 global car rental market was approximately $51B, comprised of $26B U.S., $13B Europe, and $12B APAC. With $6,439 of 2014 U.S. RAC rental revenue, HTZ U.S. market share is ~25%. The U.S. market grew 7% in 2014.

Industry. In the U.S., HTZ – Hertz, Dollar, Thrifty, Firefly – competes with Avis Budget Group – Avis, Budget, Zipcar, Payless – and Enterprise – Enterprise, National, Alamo.

History. Founded in 1918, HTZ was owned by Ford Motor Company from 1987 to 2005. After being taken private in 2005, HTZ IPO’ed in 2006, and the PE sponsors sold down their remaining stake between 2006 and 2013. HTZ acquired Dollar Thrifty in 2012.

Avis and Budget were founded in 1946 and 1958. Avis Budget Group (NASDAQ: CAR) purchased Zipcar and Payless in 2013.

Enterprise, National and Alamo (owned by privately-held Enterprise Holdings, with over $17B of revenue) were founded in 1957, 1947, and 1974.

Accounting. Due to a lack of appropriate operational controls, and misaligned incentives emanating from the former C-suite that resulted in aggressive reporting practices, HTZ misstated its 2011-2013 financial statements. Under accounting investigation since 2014, HTZ was unable to file with the SEC for over a year. In the long-awaited restatement filings on July 16th, HTZ revealed that it had overstated 2011, 2012 and 2013 EBT by 23%, 20% and 11%. After a long investigation, complete management turnover, and significantly enhanced monitoring and controls, I am fine with the accounting in the restated financials and moving forward.

2014. The real disaster of 2014 was operational performance – not the accounting investigation. As a result of the following key factors 2014 Actual Adj. Corporate EBITDA was $1.331B versus original guidance of $2.24B (courtesy of Credit Suisse):

  • Higher U.S. RAC DOE: $400MM
  • Lower Revenue Contribution: $165MM
  • Other/International: $59MM
  • Higher Fleet Depreciation: $200MM
  • HERC-related: $85MM

HTZ’s over-arching operational problem was an aging fleet, which resulted in a lack of a competitive offering, poor capacity utilization, and thus elevated costs. Exacerbating utilization problems in 2014, HTZ moved rapidly in 4Q14 to turnover its aged fleet.

Management believes all but higher fleet depreciation is recoverable.

Efficiency Ratio. On the July 17th restatement conference call, management honed in on what I refer to as the ‘Efficiency Ratio’, or DOE + SG&A divided by Revenue. Based on management commentary regarding the 2014 Adj. Corporate EBITDA gap (outlined above), the ‘core’ 2014 Efficiency Ratio for HTZ RAC (U.S. RAC + International RAC, ex. HERC, Donlen and Corporate) is approximately 60.4%, versus ~66% headline. The CFO guided to sub-60% long-term, which I believe is (easily?) attainable with modest RPD and utilization improvements.

[I believe there is some confusion regarding the recovery of 2014 excess cost vis-a-vis the announced $300MM cost-cutting program. ‘Street’ commentary indicates the cost-cutting program is meant to recover 2014 excess cost; but after following up with HTZ post-call, it appears the cost-cutting program is incremental to the recovery of 2014 excess cost.]

I derive the ‘core’ Efficiency Ratio by adding back the $400MM of excess U.S. RAC DOE and $100MM of remaining DTG synergies. $300MM of cost cuts are excluded from the calculation in order to cover non-Intex Corporate costs, which were less than $200MM in 2014.

U.S. RAC. I project top-line growth of 5.3% per annum from 2014 thru 2017, assuming: 1% annual capacity growth, 2% RPD growth, and utilization of 77.77%, 80%, and 82% in 2015, 2016 and 2017. Per Unit Per Month (PUPM) Fleet Cost and Corporate D&A remain constant with 2014 levels of $323.25 and $36.40 (Fleet Cost is Fleet D&A + Fleet Intex); Opex Per Day (OPD) remains constant with the adjusted 2014 level of $24.59; and Corporate Intex estimated using 3X leverage on LTM Corporate EBITDA and a 6% interest rate.

International RAC. I project top-line growth of .92% per annum from 2014 thru 2017, assuming: .5% capacity growth, 0% RPD growth, and utilization of 77.5%, 78% and 78%. PUPM Fleet Cost & Corporate D&A remain constant with 2014 levels of $288.10 and $20.47; OPD remains constant with 2014 at $35.47; and Corporate Intex estimated using 3X leverage LTM Corporate EBITDA and a 6% interest rate.

Repo. I assume HERC is spun with leverage of 4 times 2014 EBITDA ($672MM v. $600MM 2015 guide), or $2,688 at year-end 2015; and using the above RAC projections, I estimate HTZ RAC will end 2015 with debt capacity of $3,624, for consolidated year-end 2015 debt capacity of $6,312. With $5,807 of Net Debt at 1Q15, incremental debt capacity is approximately $505MM.

Credit Suisse believes HTZ will sell its Donlen unit for approximately $520MM, and that its Car Inc. (699-HK) is worth ~$800MM. I discount the Car Inc. stake to $700MM, bringing non-core asset valuation to $1.22B.

All-in repo capacity is approximately $1.725B.

Assuming a $1B pre-spin program at a $20 PPS, and a $725MM post-spin program at $28.57, HTZ will retire ~75MM shares by year-end 2016.

Valuation. Looking out to year-end 2016, HTZ RAC is valued at 15X 2017E EPS of $2.40, or $35.93; HERC at 17X adjusted 2014E EPS of $.17 (using 404MM pre-spin share count), or $3; and YE15 to YE17 debt build of $3.33, for an all-in SOTP target price of $42.26. From the recent close, the 1.5-year IRR is approximately 87%.

OTHER

HTZ 17M Analysis August 2015

Sources: Company Filings. Company Presentations. Wells Fargo. Deutsche Bank. Credit Suisse. Factset. Analyst Estimates.

Disclaimer: Do your own work

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15 thoughts on “Events: Hertz Re-Initiation August 2015

  1. This is a very undervalued situation, even assuming that they only manage to offload $2bn-2.2bn of debt onto HERC.

    If HERC trades at a $3.6-4bn EV (a meaningful discount to URI), you’re paying very little for core Hertz’s $1.6bn in EBITDA. Secondly, you have a free call option on the monetization of Donlen, which could be sold to LeasePlan for at least $1.5bn (including debt).

    The smartest thing that Tague has done in the last 15 months is to reduce North American fleet growth to -2% to -3% this year. That, and buying back $600mn worth of stock in the last 2 quarters. At these prices, he should be buying back more than the $400mn left in the repo – he also has the $240mn in cash from the mid-March sale of the CAR (HK) shares.

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    • Agreed. Needs a thorough review here in the very near future.

      Concern #1: Used car pricing
      Concern #2: Uber threat
      Concern #3: Is this the time in the credit cycle to be buying?

      Key Upside Risk: Icahn takes it out

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      • #1 – a very real threat and likely to get worse in ’17. Throttling back fleet growth and culling older cars makes a lot of sense in that light.

        #2 – Also very real. The 6% decline in airport pricing in 4Q was not all Avis.

        #3 – if you put it like that, probably not, but HTZ has a lot of levers to pull.

        #4 – Doubtful he has, or can raise the cash for an asset as cyclical as this. He usually threatens, rarely carries it through. Actually, I can’t remember the last time he did a deal.

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      • A really good deep dive investor I talk to on Twitter told me he has no clue why Icahn even bothered with HTZ; and that the HF cohort in the stock clearly had not ‘done their diligence’ on the ground.

        To be fair, that was when the stock was closer to $20. But those first two concerns bother me in conjunction with the leverage. Yet likely completely different proposition at this price…

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  2. You could argue that Icahn entered HTZ at the wrong price (too high a price) and so it’ll take him longer to be made whole, but I don’t see it as a mistake. Icahn doesn’t make too many mistakes or too many big mistakes.

    And as for not doing due diligence on the ground, I don’t get it. The short story a couple of years ago was that HTZ was under-depreciating the fleet and carrying values were too high. In that case, they should have been hemorrhaging money on car sales and that never happened. The Uber threat was well understood even 2 years ago, so that’s not it. The most you can say for “on the ground due diligence” is that HTZ had too many off-airport locations in dodgy suburban strip malls that were never profitable, and were never going to be profitable. HTZ now knows that and is shutting down over 200 locations. I would like them to shut down more – competing against Enterprise in the off-airport segment is a miserable business. It’s a waste of time and money and brain cells, in my opinion.

    The leverage is par for the course. I’ve never seen a debt-free car rental business model in any case, and it is mostly ABS debt to finance the fleet and HERC assets. Yes, if credit and ABS markets seize up again, HTZ will have a devil of a time financing new purchases, but I don’t see a repeat of ’08 as imminent. And once you factor in the $2bn debt that can be shucked off onto HERC and the value of Donlen (including debt), the residual debt at HTZ doesn’t look bad at all.

    This valuation compensates you for a lot of moving parts. What I like best about the story is Tague’s decision to shrink the fleet. You won’t find too many CEOs with that sort of clear-headed thinking.

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    • To my understanding, on the ground focus was primarily re pricing actions by Enterprise. Key component of the HF hotel thesis was newfound pricing power post-DTG acquisition, so good set up for disappointment.

      Agree 100% on Tague. Phenomenal operator.

      Thanks for the discussion. Time to dig in here…

      Like

  3. If URI believes that energy capex has reached rock-bottom, then I expect them to submit a bid for HERC. Assets the size of HERC don’t come around often in the equipment rental industry. My thinking on this is that if HTZ manages to offload at least $2.4bn in debt (or more) onto HERC in a sale or spin-off, that’s a home-run for HTZ. The market is going to value HTZ’s equity very differently when it sees a net debt figure of $3.3bn or lower.

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    • HTZ just reaffirmed 2016 EBITDA guidance of $1.65 billion; but they have EPS at around $1.

      Using their 4Q15 presentation numbers I get to the following:

      EBITDA: 1,650
      D&A: 350 (my estimate)
      Intex: 345
      Tax: 40%
      Shares: 423 million (taken from 2015 balance sheet)
      EPS: $1.35

      At $8.70, 6.4 times.

      Would love to know what is in their $1 EPS guidance.

      Like

      • I think they’re sandbagging guidance. I’m using a 37% tax rate and 385mn shares – they have $400mn left on the repo, and they said they would complete it before the HERC spin in ’16, so I’m assuming they’ll buy back another 37-38mn shares. At these prices, I would be fine if they took another $200mn in debt and bought back more stock.

        Proforma interest expense should be ~$625mn in ’16.

        Like

      • How do you get to $625 intex in 2016?

        I am really struggling with how they get to $1 EPS from $1.65B Corp EBITDA. Even for a sandbag I don’t get it.

        Outside of the stock ‘acting’ like death, this is a big buying opportunity.

        So total debt of $6.057 is 3.67 times $1.65B EBITDA.

        With $486 unrestricted cash + $450 2016 FCF, they have total year repo capacity of $936.

        Say they use 75% at $9. Shares out fall to 345 million.

        EBITDA: $1650
        D&A: $225 (non-feet capex)
        Intex: $345 (high end guide)
        Tax rate: 40%
        Shares: 345
        EPS: $1.88 (call it ‘owners earnings’…as much as I despise that phrase)

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      • Tactical plan: start averaging in when the broad market gets oversold. It’s trading weak enough that at this point I don’t think it holds up well on say a 5% pullback.

        The market is focused on that $1 EPS guide, and whatever monthly used car pricing data that comes out.

        In other words, my inclination is to be patient, despite the extreme undervaluation out of deference to this funky market.

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      • This shows a consolidated P&L. If they’re on track to spin out HERC by June/July, you have to nip and tuck the consolidated EBITDA for HERC’s EBITDA.

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