Two ideas this week – Michael Cooper and James Price from the Melbourne office explain why Hertz is a good option despite driverless cars and disruptive services and Ben Taylor shows why when the going gets tough, the tough invest in government bonds and other low risk options
James Price & Michael Cooper
Add Hertz USD senior secured
Hertz is the second largest company by market share in North America’s oligopolistic car rental market. The company has strong pricing power as a result of its brand strength and market positioning. We believe the company’s value proposition continues to improve as the company executes on initiatives to improve its fleet management capabilities and operational performance. Continued execution is likely to position the company well in a changing automotive environment.
‘Fleet’-ing Issues & Hertz Inflection
The car rental market is primarily driven by fleet supply/demand dynamics and has recently seen pricing weakness as a result of Hertz’s historical fleet mismanagement. Hertz’s oversupply of cars, in conjunction with supplying the wrong type of vehicle (too many smaller vehicles), has had a significant impact on the company’s operational performance as a result of weak rental car pricing.
Hertz’s fleet mismanagement meant the supply has not accurately met consumer demand – leading to lower utilisation and subsequent operating margin contraction. In addition, selling this under-utilised capacity in a severely depressed second hand car market has led to significant abnormal losses in the form of asset write downs – negatively impacting the company’s recent bottom-line performance.
A new CEO appointed in January committed to rebalance the fleet and announced it had been achieved during its 2Q earnings call.
The company is committed to better managing its fleet - in both number and vehicle composition. This is likely to position them well going into the US’ peak rental season. Purchasing high demand vehicles will ensure that come time for resale, the cars will demand the highest possible price. Matching vehicle supply to demand should lead to EBITDA margin expansion and higher vehicle resale will contribute to the bottom line.
The market’s expectation of Hertz being at inflection and future improvement in profitability can be seen in the equity price movement in Figure 1.
Source: Bloomberg
Figure 1
Although the free cash flow generation (important for equity value) is likely to improve, the company has committed to spending what is necessary to see it continue to be competitive in a changing car rental market.
In the short term, this is likely to partially offset the reduction in the contribution of abnormal losses to the improvement of bottom line performance. EBITDA margin expansion, which is more relevant to bond investors, is likely to increase directly as a result of the improvement in fleet positioning and subsequent improvement in car rental pricing. This outcome leads directly to improvement in the company’s credit profile in the measurement of the company’s leverage and interest coverage.
Car Rental – Disintermediation, Disruption and Long-term Opportunity
Mobility and transportation services are a $5.4 trillion opportunity (JP Morgan, 2017), which is likely to result in interest in the space from non traditional automotive companies looking to capitalise on an increasingly integrated and ecosystemic consumer driven global economy. Ride sharing has seen strong growth (+36% compound annual growth rate 2010-2016 [JP Morgan 2017]) – disrupting rental car providers through the reduction in cost per mile and convenience.
The recent emergence of ride sharing is estimated to have taken a small percentage of total rental car transactions. It is important to note that the market share taken by ride sharing has been, and is expected, to continue to be short-term one to two day car rentals. These rentals are the lowest margin product offering as it costs the same amount for Hertz to ‘turn around’ a rental of one to two days as it does for rentals of weeks.
Attributes of different transportation models
| Cost per mile | Convenience | Miles per transaction | Average rental period |
| Taxi | Highest | Highest | Lowest | Lowest |
| Ride hailing | Highest
| Highest
| Lowest
| Lowest
|
| Car sharing | Highest
| High
| Lowest
| Low |
| Car rentals | Low | Low | High | High |
| Personal ownership | Lowest | Highest
| Highest | N/A |
Source: J.P. Morgan estimates
The growth of car sharing is expected to grow strongly through 2025. Although this is likely to cannibalise rental car revenue, companies like Hertz and Avis are likely natural owners and operators of car sharing solutions with their established fleet and management capabilities.
Global Car Sharing Revenues and Members (2010-2025E)
Source: J.P. Morgan estimates
Analysts estimate fully autonomous vehicles are likely to arrive in the not so distant future. A fully autonomous vehicle environment could be seen to level the playing field for rental car companies as ride sharing, car sharing and car rental become one in the same. The convenience of being driven will exist for both ride sharing and car rentals and the time to rent will be equal. While ride sharing companies would see a reduction in a primary variable cost (labour in paying drivers) the increase in fixed costs in the purchase, management and infrastructure of a fleet of cars makes competition exceedingly difficult. In this environment Hertz’s established fleet as well as its significantly improved fleet management capabilities is likely to put the company in a strong competitive position.
The Bond
In addition to the outlook of the company and the sector, the HERTZ-7.625%-01Jun22-USD, is the highest ranking bond in the capital structure with a recovery rating (Standard and Poor’s) of ~90% and a current indicative yield to worst of around 5.89%. In contrast, Hertz direct competitor Avis Car Rental – with better historical operating performance - has a longer dated 2023 senior unsecured (S&P Estimated Recover 25%) bond which trades at a yield to worst of 3.18%. The performance of the bond since FIIG initiation has been exceptional – at that time the HTZ 2022 was available at a yield to maturity of ~8%.
Source: Bloomberg
Spread-Bench: This represents the spread which the bond’s yield pays above the relevant benchmark.
HTZ = Hertz
CAR = AVIS Budget Group
In the short term, the sector’s performance should continue to improve as supply dynamics lead to improving pricing leading into the most important quarter of the year. Hertz’s execution on fleet turnaround and commitment to spend to improve its value proposition and future competitive advantage gives confidence in the company’s ability to perform in a changing global automotive environment.
Note: Yields accurate as at 12 September 2017 but subject to change
Ben Taylor
Government bonds have a place in your portfolio, as do low risk corporate bonds
“Neither a man, nor a crowd, nor a nation can be trusted to act humanely or to think sanely under the influence of a great fear.” Bertrand Russell – British philosopher
Investors across the globe are coming to grips with the escalation in developments on the Korean peninsula and the very real implications for managing their portfolios. Testing of H-bombs and firing ballistic missiles over Japan raises the stakes to unprecedented levels not seen in recent times.
“Risk off” as investors seek a safe haven is to be expected, although to date, equity markets are being remarkably resilient. However, if the rhetoric were to move to another level and fear levels ratchet up, past experience shows that the lowest risk Commonwealth government bonds outperform. Prices climb as investors flock to safety and the bonds act to protect overall returns when other riskier asset prices are falling dramatically. In ‘finance speak’ government bonds have been negatively correlated to shares in times of stress.
For example, take a look at Figure 2 below of US government bond prices shown on the white line vs the S&P 500 yellow line during the GFC. The bonds spiked in price while the S&P 500 was being smashed. Therefore, it is very handy to have government bonds in your portfolio given they are assets that climb in value as well as provide liquidity when everything else is crashing.
US Govt bond vs. S&P 500 Index Jan-07 till Apr-15 WHITE = BOND, YELLOW = S&P 500 Index
Source: Bloomberg
Figure 2
It is true that no one can predict the future and with the current cast of characters in play, having some high quality bonds as part of a well balanced portfolio can offer benefits that are just not recognised in the lower yield.
BEST PROTECTION = LOWER YIELD + BENEFITS (liquidity & potential negative correlation)
Consider adding some higher quality bonds to your life … just in case things don’t go to plan.
Government and semi government bonds
| Issuer | Sector | Rating | Maturity date | Yield to maturity | Running yield | Minimum face value investment (AUD) |
New South Wales Treasury Corporation
| Semi-Government
| AAA | 1-May-23 | 2.192% | 4.997% | 50,000 |
| New South Wales Treasury Corporation |
Semi-Government
| AAA | 1-May-30 | 3.007%
| 4.571%
| 50,000 |
| Treasury Corporation Victoria | Semi-Government
| AAA |
17-Dec-24 | 2.491%
| 4.589%
| 50,000
|
| Treasury Corporation Victoria | Semi-Government
| AAA | 17-Nov-26 | 2.697%
| 4.485%
| 50,000
|
| Queensland Treasury Corporation | Semi-Government
| AA+ | 14-Mar-33 | 3.373%
| 4.727%
| 50,000
|
Western Australia Treasury Corporation
| Semi-Government
| AA+ | 16-Oct-23 | 2.533%
| 5.023%
| 50,000
|
| Australian Government | Government | Aaa | 21-Apr-27
| 2.441%
| 3.970%
| 50,000
|
Australian Government
| Government
| Aaa | 21-Apr-33
| 2.784%
| 3.701%
| 50,000
|
Corporate Bonds rated A- or better
| Issuer | Rating | Call date | Maturity date | Capital structure | Yield to maturity | Minimum face value investment (AUD) |
Apple Inc
| AA+ | 22-Nov-26
| 28-Aug-22
| Senior debt | 2.68% | 10,000 |
GPT Wholesale Office Fund No 1
| A- |
| 22-Feb-27 | Senior debt
| 3.88% | 10,000
|
Hyundai Capital Services
| A- |
| 30-Mar-22 | Senior debt
| 3.27% | 10,000
|
Telstra Corporation Ltd
| N/A | | 30-Mar-22
| Senior debt
| 2.67% | 50,000
|
A link to company updates and research is available here.