On Thursday afternoon, car-sharing pioneer Zipcar (ZIP) reported very strong Q3 earnings. The company reported net income of $43 million, or 10 cents per share, on revenue of $78.2 million. This exceeded the company's prior guidance and analyst estimates for both revenue and profit. Part of the upside surprise was due to the sale of $1.7 million in zero emission vehicle (ZEV) credits, which was previously expected to occur in Q4, but the results were better than expected even excluding the ZEV credits.
The big story for Zipcar this quarter was margin expansion. Zipcar did report 15% year over year revenue growth, but revenue growth was also 15% in Q2, which was considered a disappointing quarter. The big difference in Q3 was that adjusted EBITDA improved by $1.9 million over the prior year, versus a $1.1 million increase in Q2. In other words, the company is making significant progress on margin expansion even with the same level of revenue growth. This was particularly notable because Zipcar's average daily revenue per vehicle was flat year-over-year due to lower utilization offset by higher rates. Lower utilization was most likely a lingering effect of lower-than-expected membership growth this past spring. However in future years, utilization is likely to return to historical highs, further expanding margins.
Zipcar's management team is still very confident that the company can return to higher revenue growth (20% or better) due to various initiatives to attract new members; e.g. offering a lower-tier free membership plan, branching out into the cargo van market with Zipvan, etc. However, from an investor standpoint, a return to 20%+ revenue growth is not necessary to justify a higher valuation for Zipcar. Even after a strong 16% post-earnings gain on Friday (Zipcar traded up almost 30% intraday), Zipcar's market cap is still less than $300 million. This represents an extremely modest Price/Sales ratio of 1.0. While this is higher than the daily rental chains like Hertz (HTZ) and Avis (CAR), it is much lower than most companies with medium-high growth rates. Moreover, Zipcar has a relatively low net debt level of $50 million (less than 20% of trailing revenues), whereas Hertz is burdened by $12 billion in net debt (nearly 150% of trailing revenues) and Avis has $2.5 billion in net debt (35% of trailing revenues). This further justifies a P/S premium for Zipcar.
As 2012 will be Zipcar's first year of profitability, I think it is still more appropriate to value Zipcar by the P/S ratio rather than a traditional P/E or cash flow valuation model. I am currently expecting Zipcar to post an annual profit of 8 cents per share, which equates to a roughly 1% margin. However, the company's long term financial model assumes a 19% EBITDA margin, which should be able to support a 15% pre-tax margin (note that Zipcar only excludes non-vehicle depreciation when calculating EBITDA). Moreover, Zipcar's financial statements demonstrate that the company has made very consistent progress in growing margins toward this goal over the past several years. Zipcar is likely to approach its target profitability level by 2015, at which point the company could be posting EPS of approximately $1.
A big advantage of Zipcar as an investment opportunity is that its business model is not dependent on a strong economy. Many people use Zipcars for discretionary (leisure) activities, but customers also use the service for errands and other everyday activities. For many city-dwellers, using Zipcar is a very cheap alternative to owning a car. In a weak economy, while some individuals may cut down on discretionary Zipcar use, many people will be drawn to the service as an alternative to owning a car. By contrast, traditional car rental agencies like Hertz, Avis, Enterprise and Dollar Thrifty (DTG) are heavily dependent on airport rentals. In a weak economy, businesses typically cut down on travel, and leisure car rentals may also take a hit. Not surprisingly, the major car rental firms all struggled mightily during the 2008-2009 recession.
Many Zipcar followers are very skeptical of the company's prospects. Rich Duprey at the Motley Fool blamed Friday's jump on short-covering (likely true) and advised Zipcar investors to sell the bounce. He primarily argues that Zipcar is overpriced compared to traditional daily rental agencies and that competitors are better-financed and will be able to out-compete Zipcar. However, I do not find either of these arguments (or other variants of them that I have heard) to be persuasive.
On pricing, I suspect that Mr. Duprey was comparing a daily rental from Zipcar vs. a daily rental from a traditional car rental agency. Zipcar does not aim to compete in daily rentals, although it does offer the service as a convenience for customers. Zipcar's rental model is primarily intended for short (2-5 hour) rentals. For this length of time, Zipcar is almost always cheaper than a daily car rental, especially because Zipcar includes gas and insurance with every reservation (for up to 180 miles). I also think that Mr. Duprey insults the intelligence of Zipcar members by suggesting that it's not price-competitive with the daily rental model. Clearly, more than 750,000 people are willing to pay anywhere from $25 to $60 a year just for the privilege of being able to pay Zipcar's rates for hourly car rentals. A large customer base thinks Zipcar is a valuable service compared to the alternatives.
In terms of competitive threats, it is worth noting that Hertz has been offering hourly car rentals in New York and Boston (two of Zipcar's four largest markets) since 2007. Hertz has been attempting to compete with Zipcar for more than five years, yet Zipcar is still growing at 15% annually even in those mature markets, while improving profitability. Enterprise is also attempting to build a major presence in car sharing, but it too has struggled mightily since first getting into the car-sharing market five years ago. Avis has been partnering with I.D. Systems (IDSY) to install car-sharing technology in its vehicle fleet. However its hourly/car-sharing efforts have been focused on businesses through the Avis on Location program, which places cars on corporate campuses. Avis has not mapped out any strategy to compete in the consumer car sharing market. Lastly, Daimler's (DDAIF.PK) Car2go service targets the market for one-way trips within a city. Unlike Zipcar, Car2go offers by the minute rental and one way trips. However, for customers who want a car for a round-trip, car2go is much more expensive than Zipcar at $13.99/hour. Moreover, the car2go fleet consists of smart cars, which are not useful for major shopping trips (a popular Zipcar use case)
Thus, while there are potential competitors out there, many of them have deliberately steered away from direct competition with Zipcar (e.g. Avis on Location and car2go). Moreover, as noted earlier, most of the daily rental companies are burdened by extremely heavy debt loads, so they can't afford to rack up heavy losses in an attempt to compete directly with Zipcar. Lastly, Zipcar has faced competition for several years in most of its major markets, which has not prevented the company from continuing to grow revenue at a double digit pace in those markets while also improving margins. There is no evidence to date that competitors will be able to out-compete Zipcar.
In part, I think that the bad will towards Zipcar in the investment community stems from the company's poor stock performance. Zipcar quickly rocketed to $28 following its IPO last spring, and like many other recent "hot" IPOs, went into a tailspin thereafter and lost 75% of its value. Zipcar was an overpriced IPO at $18, and an even more overpriced stock at $28, but the pendulum has now swung too far in the other direction. I would place Zipcar's fair value at $12-$15 based on its good long-term growth prospects (management estimates the total addressable market at $10 billion) and rapidly improving profitability. This valuation seems reasonable based upon my projection of $1 EPS in 2015 with 15-20% annual EPS growth beyond that. I therefore think Zipcar is a great buy at the current price of $7.