Investors in Hertz (HTZ) had a great end to the year following the adoption of a poison pill by the company's board. The board claims that activist investors might have initiated a large stake in the business, prompting the board to take measures to limit their holdings in Hertz.
The momentum as fueled by these news events makes shares not appealing enough for me, even if the company were to spin off its cash flow intensive business, as argued by some activist investors.
Hertz Adopting A Poison Pill
On the 30th of December, Hertz announced that the board has adopted a one-year shareholder rights plan. The company noted unusual and substantial activity in its shares, prompting the board to take this decision.
The plan is intended to ensure that the board remains in the best position to perform its duties to all of its shareholders for a fair and equal treatment. The move is aimed to prevents a person or group gaining control through open market accumulation.
The board believes the Rights Plan allows Hertz to preserve the ability to implement strategic initiatives to drive value, including the Dollar Thrifty integration, the expansion of the off-airport footprint and the introduction of new brands, among others.
For now the board set the threshold for the pill at merely 10% which in essence means that no one can acquire a greater than 10% stake in the business. On the back of the news, shares of Hertz ironically rose by 10% on Tuesday, trading at highs of $28.50 per share.
Third Point Is On Board?
Management admitted that the company has been in dialogue with shareholders, welcoming the input of investors to drive the value of its shares.
Some of these investors who have met the board and management could be Dan Loeb, the owner of Third Point Capital, or Keith Meister's Corvex Capital. In a response to the rumored buying of Loeb, Hertz adopted the poison pill.
Note that Loeb does not have to own 10% outright to trigger a breach of such a pill. Even collaborating with other shareholders, or holding a great potential stake through stock options would constitute a breach of the pill.
Activism Focuses On Equipment Business?
Reports indicate that some investors might be looking for Hertz to divest the equipment rental business. The unit is relatively capital intensive, as outlined below. Selling or spinning of the business can free up a lot of cash and improve cash flows going forwards.
The fragmented nature of the equipment business requires Hertz to hold relatively a lot of inventory to supply its customers.
US car rental revenues totaled $1.78 billion for the third quarter, reporting adjusted pre-tax income of $392 million. Revenue earning equipment of $8.99 billion implies that Hertz requires to make a net $1.25 investment to generate $1 in revenues based upon $7.12 billion in annualized revenues.
International revenues for the quarter came in at $769 million while reporting pre-tax adjusted earnings of $129 million. Net equipment investments of $2.71 billion implies even greater efficiency of the business compared to the domestic activities. On average, Hertz only has to invest $0.88 in investments to generate a $1 in revenues.
Equipment revenues were $402 million for the same time period while adjusted earnings for the quarter came in at $57 million. Yet the business requires Hertz to invest roughly $2.41 billion in investments to run the activities. Given the annualized revenue run rate of $1.61 billion, the equipment business requires Hertz to invest $1.50 to generate $1 in revenues. This "locks" up a lot of capital in the business, something which is not welcomed by activist shareholders.
Operating Performance In 2013.
In November Hertz reported its third quarter results. Reported revenues for the first three months of 2013 came in at $8.22 billion, up 22.6% on the year before. Reported earnings for the time period came in at $354.1 million, with adjusted earnings reported at $636 million.
Factoring in the huge recent gains, with shares trading around $28.50, the market values Hertz at $12.8 billion. Full year revenues are seen around $11 billion, while GAAP earnings could come in around $250 million. This values equity in the business at 1.2 times annual revenues and roughly 50 times GAAP earnings.
Note that it takes quite some investment to generate these revenues. To service its clients, Hertz owns about 493,000 cars for the US activities and another 188,000 abroad. This fleet requires massive investments, resulting in a very sizable net debt position of $16.1 billion for the firm to operate with.
Hertz's Recent Performance
Investors in Hertz have seen strong momentum in recent years, partially fueled by the late rally in 2013. After shares traded as low as $2 in 2009 shares have recovered to current highs around $90 per share, after shares had risen nearly 75% in 2013 alone.
Over the past five years, Hertz increased its annual revenues by an expected 55% to $11 billion. The company improved its GAAP earnings in each of these subsequent years, after reporting modest losses in 2009 and 2010.
Implications For Investors
Investors in Hertz are a bit inpatient with the improvements of the business, yet expected synergies of the $2.3 billion Dollar Thrifty acquisition and benefits from other initiatives are yet to pay off. Synergies from Dollar Thrifty are seen at $300 million in terms of revenue synergies, with another $300 million benefits seen from reduced costs.
For now, Hertz sees adjusted pre-tax earnings of $1.2 billion in 2013 as margins increase towards 10%. Continued growth is driven by the oligopoly following the deal with Dollar Thrifty resulting in pricing power. Further location openings and the growth of airline traffic should provide further topline growth. Pricing power increased even more following the bankruptcy filing of Advantage Rent A Car. Note that growth in airplane traffic is important, with some $5.5 billion in revenues, or roughly half the total revenues being derived from locations at airports.
Despite these initiatives, some investors are not happy with Hertz's performance trailing behind Avis. To accelerate growth and return on invested capital, some investors could now demand the spin-off or sale of the equipment business.
Back in October, I last took a look at the implications for shareholders in Hertz following a downwards revised guidance for the year and the unexpected resignation of the CFO. Trading around $22 at the time, I was very cautious given the strong momentum this year and the high leverage of the firm, leaving the company vulnerable to a correction in the economy.
I noted that the deal to acquire Dollar Thrifty was very important and appealing. The modest impact on leverage and the sizable synergy estimates are the main drivers behind the appeal of that transaction, with benefits expected to accrue going forwards.
The strong recent performance, as fueled by activist shareholder interest highlights the interest in the company's shares. A possible deal for its equipment business, could fetch a nice price, free up cash flow and be used to please investors. Yet the size of the operations at roughly 15 % of total revenues is modest, and possible action is already priced in with shares returning some 20% in December alone.
Despite the nice prospects going forward including a further recovery of the US and European rental market, the possible equipment business divestiture and the acquisition-related synergies I remain cautious. To justify the current valuation at nearly $13 billion, many more improvements have to hit the bottom line.