With Hertz Buying Dollar Thrifty, Could Rental-Car Stocks Become More Appealing?
There are at least three things that make the rental-car business great for customers but utterly detestable for investors. First, there’s too much leverage. Second, there’s too much depreciation. Third, there are way too many players.
If you’re renting a car at an airport, Expedia has 19 vendors to choose from. Travelocity has 14. Orbitz lists 13. And if you live in a big city and you’re just eager to rent wheels for a few hours, there are smart car-sharing clubs ready to serve you. They include national networks like ZipCar (ZIP), based in Cambridge, Mass., and smaller outfits like iGo Car Sharing, which serves Chicago.
But could things be changing? Hertz Global (HTZ) will purchase a smaller, mid-market rival, Dollar Thrifty Automotive Group (DTG). Hertz agreed to pay $87.50 a share in cash, an 8% markup from Dollar Thrifty’s closing price on Friday, as seen in a Hertz stock chart.
The deal would leave only two large-cap car-rental companies trading in the public markets: Hertz, based in Park Ridge, N.J., and Avis Budget Group (CAR), based in Parsippany, N.J. Essentially, we’re talking about the Cola-Cola (KO) and Pepsi (PEP) of rental-car outfits.
Speaking of soda pop, it’s intriguing to contemplate a rental-car industry going the way of the fizzy-drink business. That business, dominated by two big, financially stable players that each control vast portfolios of varied drink brands, has been a good place for investors to make a nifty profit since 1990…
… and since 2002.
Meanwhile, the two largest rental-car stocks have been a source of heartburn for investors.
Neither Hertz nor Avis pays a dividend. And they’re both over-leveraged.
Both outfits have also posted sizeable losses in recent years. Ugly.
But along with the prospect of less competition, there’s good news. The analysts who follow Hertz and Avis are projecting very strong earnings growth in the next year or two. The consensus is that Hertz will earn more than $1.50 in 2013 and that Avis will earn $2.60 or so. So their stocks are trading PE ratio of 8.5 and 6, respectively.
Is this earnings growth going to be driven by huge jumps in revenue? No. It’s going to be driven by the two companies producing enough cash flow to cover their outsized interest payments and depreciation charges and produce some profit. You know, if you strip away the debt service, depreciation, amortization and taxes these firms shell out, you see they normally have fairly strong cash flow:
Alas, the companies have such high depreciation and debt-service charges, their earnings have a tendency to vanish during the slumps and race upwards during better times.
There’s no getting around the depreciation charges. If you’ve ever purchased a new car, you know how much value it loses the minute you drive it off the lot. And we Americans expect our rental cars to look new.
But what about those big debt-service charges? They’re another matter. If only these companies could reduce their indebtedness, they’d produce more predictable, growing profit.
So let’s play some what-if. Say this Hertz-Dollar merger and the projections of strong earnings growth could bring fresh interest from investors. Why, it’s quite possible that Hertz and Avis could use the newfound interest to raise equity—they could issue preferred stock and common shares that pay a modest dividend—and use the proceeds to pay down their debt. The hotel industry succeeded at just such a revolution in the mid-1990s, breaking its addiction to debt and putting its balance sheets on more solid ground.
If you doubt you’ll ever see a modestly levered rental car company, you should take a closer look at Dollar Thrifty, which YCharts shined a light on earlier this year. Its liabilities are pretty modest, stacked up against its total assets.
And for a lesson in what low leverage can do for a company, compare Dollar Thrifty’s stock performance to that of its acquirer over the past five years.
Let’s hope Hertz emerges from the Dollar Thrifty merger having absorbed some of the smaller firm’s good habits in regards to debt. Let’s hope Avis is also inspired to cut its leverage as well. With fewer competitors and less debt, these two big outfits could be fattening their bottom lines the way Coke and Pepsi are fattening our bottoms for years to come.