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  • Hertz isn't as cheap as it was when Icahn and Fir Tree built their stakes.
  • Consolidation is unlikely to boost net pricing power in the near to medium term.
  • Financial statement distortions go beyond what's being addressed by the reviews.
  • Significant margin expansion is implied by the current price-to-sales ratio of 1.3x.
  • When HTZ traded above 1.0x sales in the past, subsequent 12-month returns were negative.

Hertz (NYSE:HTZ) gives the appearance of cheapness based on results that overstate profitability and understate capital intensity. Meanwhile, the stock is at least 0.5x more expensive than normal based on P/S, reflecting anticipated margin improvement that seems unlikely to materialize. Even if it does, the improvement likely would not be sufficient to bring actual earnings in line with pro-forma expectations - between 2007-2013, Hertz's cumulative consensus adjusted EPS was $6.33 versus recurring EPS of $1.45 and GAAP EPS of -$1.65.

Pricing power is not a lever. The rental car business is price competitive and will remain so despite consolidation. Price increases reflect changes in costs, particularly residual values. There are two reasons for this:

First: In consolidating industries with relatively fixed capacity, pricing power often improves due to supply constraints. Rental car capacity is extremely flexible. The correlation between supply of potential rental car days and demand for actual rental car days is more than 95% on a quarterly basis. Supply constrained pricing power is very unlikely on a sustained basis.

Second: Cooperation between the remaining three firms - Hertz, Enterprise and Avis (NASDAQ:CAR) - is possible, but it would require both Hertz and Enterprise to change their strategies and seems unlikely from a game theory perspective. Enterprise has funded growth on-airport with its off-airport profit pool. This profit pool was, until the past few years, essentially unchallenged. Hertz has responded to Enterprise's on-airport market share gains by pushing into off-airport. There will be no cooperation as long as both firms are trying to increase market share in the other firm's core profit pool. With Hertz replicating Enterprise's retail re-marketing strategy, it is moving into position to compete on an even footing with Enterprise. Avis appears threatened.

Used car pricing tailwind is dissipating. The past few years financial results have benefited from strong used vehicle values, which lowered both accounting and economic depreciation costs. Depressed new car production between 2008-2011 reduced the supply of used cars, but more normal levels of new car production in 2013-2014 are leading to an increase in used car supply. Furthermore, new car demand growth is increasing at a slower rate as the industry approaches peak demand, while production capacity is returning to pre-crisis levels. As new car demand growth slows and capacity increases, manufacturers will likely cut prices to maintain capacity utilization, which will also pressure used car prices.

HTZ's profitability in 2013 appears overstated as a result of depreciation assumptions that reflected used car prices during the crisis and early recovery, as opposed to long term-history and the likely path in 2014-16. This is separate and distinct from the operational issues preventing them from reporting. It's not possible to prove beyond a doubt, but the evidence heavily suggests that management opted to present income statement results in 2013 that were inflated relative to the economic results (which will become evident only later). Since they haven't filed it's difficult to quantify, but I suspect the withdrawn guidance and lousy results stem, in part, from this.

Understated Capital Intensity. HTZ's last several years cash flow statements understate capital intensity. When HTZ acquires a company, it adds those vehicles to its fleet without a corresponding charge to capital expenditure. When it sells the vehicles, it records the cash flow in proceeds from equipment sales along with vehicles that it purchased directly. The analytical convention on the street is to net proceeds from fleet dispositions against Capex.

HTZ does not provide sufficient information to estimate unit economics. There is no way to tell whether rental rates are consistently high enough to make an economic profit after absorbing 20-25% vehicle depreciation over the period of ownership. Depreciation estimates are easy for management to manipulate and as a result, income statement profitability can vary from operating cash flow for extended periods. Academic research has found higher accounting complexity is correlated with lower earnings quality.

Management needs to examine its priorities. The strategy of pushing into off-airport and building a retail re-marketing capability is probably the best response possible to the competitive pressure exerted by Enterprise. The CEO has done an excellent job of manipulating market expectations, but success with execution and maximizing the value of the company remains on the come. HTZ needs a serious operator to drive execution - rental cars are a near commodity so efficiency is crucial. In my view, Icahn and Fir Tree are right to challenge the legitimacy of the current management team.

It's not as cheap as it appears, because value metrics below the sales line are not accurate. Price to sales is 0.5x higher than its average of 0.8x reflecting consensus expectations for higher margins. Net pricing power and operating improvements are unlikely to deliver sustained improvement under the present competitive dynamics. When HTZ has traded above 1.0x P/S, the forward 12-month returns have been negative on average.

HTZ Chart

HTZ data by YCharts

The firm needs fixing. However, even if fixed, I'm not sure it is fundamentally cheap given how competitive the industry is. I see the risk-reward as $33-34 in an outcome where the spin-off is successful and operational efficiency improves versus $20-22 based on the current fundamentals and a reversion to historical price-to-sales. The kicker is that HTZ is asymmetrically sensitive to economic conditions because demand is cyclical and the balance sheet is leveraged. In a recession, the downside is more like $15-16, in a full blown credit crunch it could be a hat size.

Source: Leave Hertz To The Activists, It's A Short Based On The Risk-Reward