Hertz's 2006 Results: Finding the Forest in the Trees

| About: Hertz Global (HTZ)

Before we automated our demand forecasting with JDA we were not choosing how many cars we rented. . . We took reservations until our stock was gone. Today we look at no-shows, historical demand trends and other factors that help us sell the right car to the right person at the right time for the right price.

- Stewart Brown, staff vice president of revenue management for Dollar Thrifty Automotive Group. Found in a "case study" (advertisement) for JDA Rental Car Revenue Management System

On Monday night (rather late) Hertz Global Holdings (NYSE:HTZ) reported fourth quarter and full year 2006 financial results. As most of you are aware Hertz (after being sold by Ford earlier in the year to a group of private equity investors) became a publicly traded company on November 15, 2006. Since that time, the stock is up ~40%. Hertz replaced Adesa (who is going private) in the autoretailstocks index February 1, 2006.

The analysts came out pretty enthusiastically about the financial results and management's strategy to cut costs. You do not need me to regurgitate these figures and metrics for you. But I should point out whenever a company transitions from private life to public life, and even worse transitions from being part of a larger organization to its own entity, you often end up with a lot of "noise" in the financial data.

Management teams try their best to provide "pro forma/adjusted" financial results to help investors navigate through this noise. The adjustments are management's best attempt to provide kind of a recurring (continuing operations) earnings (return) picture. However, you should keep in mind that there are a lot of moving parts. And a global corporation like Hertz is hardly without said moving parts.

Based on the company's efforts to remove this "noise," adjusted net income for 2006 increased to $299.7 million, or $0.92 per share (based on a "pro forma" diluted number of shares outstanding of 324.8 million), compared to $202.5 million, or $0.62 per share in 2005. In 2007, management expects to earn between $372 million to $395 million, or $1.15 to $1.22 per share (a 24% to 32% increase). And this is what got the analysts so excited.

I have to admit, while it was not the longest conference call (and GM decided to top it with an even longer call), it was one of the longer opening remarks I have heard over the years. There was certainly a lot of good data and insights provided during the conference call, and perhaps some levels of detail that could best be provided in filings or addendum/slides on the company's website.

But this brings me to a broader issue (and we can use Hertz's results) as a great example. Whenever you have a lot of "noise" in the financial data, and just a ton of information/insights being thrown at you over a pretty short period of time, what is an investor supposed to do? I think we (investors/industry observers and analysts) all tend to get lost in the noise. And then (because of all of the noise) focus on the bottom line results (even if there are all of those moving parts) and everyone gets all excited (or disappointed).

And yet I am not sure this really helps us figure out/assess what the returns will be over the long run. Were Hertz's improvements in year over year results just due to a lot of "low hanging fruit?" If so, management thinks there is more of this "fruit," specifically bringing up on the call that they thought they could improve the operating cost structure by two full percentage points (200 basis points as a percent of sales).

If we (investors/industry observers, etc.) are really trying to analyze the data, however, I don't know if we are adding a lot of value to the process if we are simply taking the data and then repeating what management said. Especially given all of the noise. Especially given how volatile the car rental industry's profits have been over the last decade or so. Don't forget about 5 years ago many competitors in the industry filed for bankruptcy protection, and Ford bought back its 18.5% stake of Hertz from public equity investors.

I don't think any of the analysts that are so excited about Hertz today were around writing investment research on the car rental industry back when things were really tough for the industry (2001/2002). And I am not going to pretend that my experience is any better. Was I "around" back then? Technically, yes, but I was more focused as a junior covering the automakers and suppliers, and just ramping up coverage of the franchised auto retailers (a due diligence process I began in 1999). Even Hertz's current CEO Mark Frissora was also focused on the production side of the auto market, having been the CEO of automotive supplier Tenneco from November 1999 to July 2006.

I am not trying to come across as critical of the analysts following Hertz or even Mr. Frissora. I am simply trying to point out that this is still fairly new to all of us. Remember, Hertz has been a part of Ford since 1994 (except for when Ford let an 18.5% stake of the company float in the public equity markets for a few years). When you are part of a larger organization, your goals and objectives (particularly when your parent wants to sell you cars) are sometimes different than when you are functioning for shareholders.

And so sure, now that you are focused on serving shareholders versus a parent (whose goal is to sell vehicles to you), your results can be improved. Does it take a year? Two years? Five years to get to where they should have been all along. Right now it appears there are several years of improvements.

But the bottom line is that there is a lot of noise that makes it difficult for investors to simply look at the financial results and listen to management's goals/objectives and determine what the long term returns of the company will be. There are simply too many unknowns.

Therefore we should just throw our arms up in the air and forget even trying to analyze Hertz, right? Of course not, don't be silly. I just want you to understand there are limitations. And then walk you through the approach that should be taken in order to focus your attention on the critical issues. In essence, how I try to sort through all of the noise.

And it begins with two simple questions. I should add that whether you have a lot of noise or a little noise. Whether you are first considering an investment, or have owned a stock/company for 10 years, I think you always want to get back to these two simple questions: 1) What is the need? and 2) Who/how are organizations best trying to fulfill that need?

Your depth of understanding will increase over time, but if you do not begin and constantly return to these two questions, you are going to get lost in the "trees" and never see the "forest" (so to speak).

What is the need?
So here is a cursory first pass attempt at addressing these two questions (once again, I expect to provide you more depth/insight in the coming months and years). Also, Hertz has an equipment rental business that represented ~20% of the company's revenues in 2006. We will need to do a similar exercise for that side of the business, but for now, let's just focus on their biggest business (car rental), which is the other 80%.

The car rental market is usually divided into personal/leisure and business. But I can think of four kind of underlying reasons for renting a vehicle:

1) Travel. You have traveled somewhere (most of the time by plane) and need a vehicle to get you around for a short period of time. For those of you that remember my piece on the fleet market back in November, Hertz actually pioneered the industry, and was the first to offer rental cars to people flying in and out of Chicago's Midway airport.

2) Repair. Your vehicle has broken down and is being repaired or is receiving maintenance and you temporarily need a vehicle. Hertz's management said on their conference call that they are once again growing their dealership business after walking away from some unprofitable contracts.

3) Recreation. You need/want a specific type of vehicle (that you don't own). For example, your "two seater" just won't do for the relatives you have coming into town this weekend. Or you need a pick up truck to haul you and your buddies surfboards to the east coast of Florida and your cabriolet just won't cut it. Or you just want to act like a "big shot" and rent a Ferrari for $750 a single day (this actually happens in LA).

4). Alternative ownership. This is becoming a new in auto retail, particularly in metro markets. And further proof that your customers and vendors of today may become your biggest competitors down the road. Zipcars is a new "membership" sharing program where cars are placed throughout the city, and its members just reserve a vehicle, walk up to it and wave the zipcard, and rent it on an hourly or daily basis.

If you live in a metro market, now all of a sudden the idea of owning a vehicle becomes less important. I wrote about how some 40% of the people that signed up for the Zip program either sold their car or stopped their intentions of buying a vehicle. So what does this mean? It means instead of being a mere customer of auto retailers (who buys vehicles) the rental industry itself begins competing with new and used vehicle ownership.

Of course when I mentioned this idea to a Hertz employee a few weeks ago, he immediately wanted to bring this up to the union because this would mean they no longer need people to take the keys and this concerned him (because that was his job). Clearly cultural issues will need to be overcome at Hertz if they decide to do something like this. The company's attrition program (where for every two people that retires, they are only replaced with one person) will probably help in this endeavor.

But on the conference call they said they are just trying to get to the point where they can compete in the 1 -2 day rental market (profitably). Management said if they just get their normal share of the (1 - 2 day rental) market it could mean ~$1.2 billion in organic revenue growth. Now just imagine if they (along with competitors) begin to expand the overall market (versus just gaining share) as they focus on this emerging alternative ownership trend?

Who/how are organizations trying to fulfill the need?
Enterprise is estimated at #1 (at least in size of fleet, locations, and revenues) by fleet-central (AutoRentalNews) in meeting the car rental needs of U.S. consumers. Hertz ranks #2, although fleet-central estimates they generated $3.9 billion in U.S. revenues.

But let's look at Hertz's financials in a little more detail. In the U.S., Hertz had a total of 85,931 transaction days, at an average rate of $43.86. Internationally, Hertz made 37,531 at an average rate of $41.53. If you multiply the number of transactions by the average rate, you come up with $3.8 billion (domestic), $1.56 billion (international), for a total of $5.3 billion. But on Hertz's income statement, you see $6.274 billion in car rental revenues. Where did the other billion go?

The answer lies in table six, where they explain there is about $836.8 million in non rental rate revenue (NeverLost, satellite radio, etc), and $109.5 million in currency adjustments that walks you down to the $5.3 billion. Although, this non-rental rate type stuff (at least in my mind) is all part of the rental. So, if I assume (and assuming is always dangerous) Hertz had a similar split of "non rental" revenues as its rental spit (dividing its $3.8 billion domestic by the $5.3 billion, and $1.56 billion by the $5.3 billion), a 70%/30% split suggests Hertz had about $590 million in "non rental" revenues in the U.S. in 2006 (70% times the $836.8 million).

So my best guess is that Hertz had about $4.36 billion in revenues from its rental operations in the United States in 2006. Given some of these disparities, I don't know how accurate fleet-central's industry revenue estimate is, but going with their $20 billion, you end up with Hertz having about a 20% (21.8% but this is clearly a rough estimate) share of the overall U.S. rental market. Meaning one out of every five car rentals (meeting the above described needs) is done through Hertz.

How profitably is Hertz meeting the need? And why aftermarket participants need to pay attention to reverse auctions?
So clearly the company is meeting a need. But how profitably are they meeting this need. If you can't make money doing it (generate a return), any effort to fulfill a need will prove short lived. Resources in our society simply get deployed to where the best returns are being generated (or another way of saying it: "my money goes where it is well kept.")

In 2006, the company generated about $17.10 in earnings before interest, taxes, depreciation and amortization for every $100 of revenues, about $1.83 better than in the prior year (once again after you have tried to adjust out all of the "noise.")

But Management wants and thinks they can do better. They discussed all sorts of "lean" initiatives (a very popular manufacturing term), including moving cars around better to other locations, putting better controls in place, and even better supply chain planning initiatives (these are all great buzzwords we in the investment community love to hear).

One example given about the company's supply chain initiatives was in the area of reverse auctions. Apparently they are now buying automotive filters through this reverse auction process. I will tell you I did some homework on reverse auctions and I still don't fully understand them. At the most basic level, the way it is supposed to work is that instead of having a bunch of suppliers/manufacturers bid on business (usually with the lowest provider winning), you have a bunch of customers competing/bidding for a manufacturers product (like air filters). Supposedly this is cheaper and more efficient. I'm still trying to figure it out.

Importantly, however, is that these reverse auctions are something automotive aftermarket parts and service retailers and distributors need to start paying attention to. Volume buyers tend to be first in adopting efficiencies. Why because to you or I, saving $2 on an air filter might not be a big deal. But to a car rental company like Hertz that has 438,100 vehicles in the U.S. and another 296,400 units in international markets (as of December 31, 2006), a $2 savings spread across its fleet means a ton. And over time, these efficiencies flow into the consumer market.

Earlier this week I talked about franchised auto retailers incorporating the "all in" costs of the vehicle (including maintenance, fuel, depreciation, etc). into the electronic menu selling process. I did not come up with the idea from the top of my head, it came from looking at what more sophisticated buyers (who are buying in the thousands versus individually) are doing, and looking at the "life cycle" cost of the vehicle is an emerging trend in the fleet market, and it will (I argue) eventually make its way down to the consumer.

So if these reverse auctions are becoming a trend in the fleet market, it is something we (as industry observers and investors) need to take note of. Because it will certainly impact repair shops that sell into the fleet market (Midas has said the fleet market is a major focus for growth), and over time may very well end up in some form or fashion (perhaps via an online parts distributor) in the way consumers actually buy automotive aftermarket products.

It always comes back to productivity
But you can not cost cut your way to prosperity. I still think the idea of PRODUCTIVTY is what is key. What you make and what you spend may be important, but trying to look at it as "one or the other" misses the boat. What you want to get is the MOST out of every dollar you spend. The most number of cars rented per persons you employee. The greatest utilization of the fleet. And the happiest customers.

I am not terribly interested in learning about the $500,000 of annual savings the company plans to get from changing a contract with their glass provider. Instead, I want to hear how management is trying to meet the needs of its customers the most efficiently. I suspect they are working very hard in this endeavor, but this is what I think got "lost in the noise" on the conference call.

So as someone who is admittedly new to the Hertz story, I will simply leave you with three things that I think investors should try to listen for and focus in on with future calls:

1) Fleet utilization. Management actually provided it on the call, and you can easily calculate it from the total fleet figures they provide. It works out to roughly 8 out of every 10 of Hertz's vehicles (in their total fleet) being used every day of the year (technically it was 79.4%).

I opened today's piece with a quote from Stewart Brown of Thrifty Rent A Car. No I am not trying to advertise for JDA's rental car revenue management system. There are probably dozens of these revenue management type products, and I am hardly qualified to say which one is better than the other.

However, this is something that was noticeably absent in management's discussions on the conference call. Aside from a brief mention of moving around the vehicles better, we heard very little about getting the vehicle at the right place, at the right time, at the right price (going back to the beginning about meeting the needs of the customer). The utilization of the fleet. This really needs to be kind of the key focus for management. If they are not aligning the vehicles best with where/when and the price that are needed, all of the cost cutting initiatives in the world won't help Hertz's shareholder's generate outsized returns over the long run.

2) Lost sales. I know so management should be focused on having 100% utilization. I could do that. Just have fewer locations and way over book so I always have more customers waiting around for a vehicle. Of course over time I would have to keep closing locations into a constant "death spiral" as no one would want to rent through me if they always had to wait around, or worse didn't even get a vehicle (even though they booked it).

I understand management might not want to reveal their lost sale percentages for competitive reasons (although even there that is a stretch). But as investors and industry observers, I think we at least need to be sure management is measuring lost sales, and that the number of lost sales are improving. So if we start hearing about improving utilization (i.e. 9 out of the 10 vehicles in Hertz's fleet every day being used), while at the same time fewer lost sales. Wow, now we have a good idea that they are making real and meaningful improvements to the business.

3) Customer satisfaction. At the end of the day, if your customers are happy, you tend to be a better provider than someone who has unhappy customers. I know a lot of games can be played with Customer Satisfaction Index scores. But if management can give some sort of update (directionally) about how the company's satisfaction scores are trending (better or worse than in previous periods), I think that would be another helpful piece of the puzzle.