A Buying Opportunity in the Car Rental Industry

Market overreactions create great buying opportunities, and the latest victim is a hedge fund favorite.

Jun 18, 2014 at 1:13PM

Hertz Global Holdings (NYSE:HTZ) is the leading car rental company in the U.S. But shares are down 12% over the last week. Accounting problems have pressured the stock and may potentially delay the spinoff of its equipment business.

The accounting issues
Hertz recently announced that there is at least one material weakness within the company's internal controls for financial reporting. Financial statements all the way back to 2011 might need an adjustment. The costs relating to these accounting issues are expected to pull fiscal first-quarter earnings below consensus estimates. 

But there's also speculation that Hertz could be looking to replace its CEO. That could be a consolation prize for investors, and shares were up slightly on the news. Despite its issues, Hertz is still one of the most loved stocks by hedge funds--at the end of the first quarter, there were 33 hedge funds with Hertz as one of their top 10 stocks.

The industry has gotten a lot smaller
The industry has consolidated a lot over the years, which should help with pricing and margins going forward. For instance, Hertz bought up Dollar Thrifty Automotive for $2.3 billion last year. The three major car-rental players make up a large part of the market share, including Enterprise Holdings, Hertz, and Avis Budget Group (NASDAQ:CAR).

After losing the bidding war over Dollar Thrifty, Avis went out and bought up car-sharing company Zipcar. The business failed to live up to the hype, and Avis was able to buy up Zipcar at a 30% discount to its IPO price. But Avis' move did not put it at the forefront of the hourly rental market.

Getting out of the equipment business
Hertz is looking to exit the equipment-rental business. Hertz's equipment business makes up less than 15% of total revenue. Big name hedge funds got active in the company in an effort to push for a spinoff. It plans to complete the spinoff of its equipment-rental business some time next year. The move will give the company net proceeds of $2.5 billion.

It plans to spend upward of $1 billion of that on share buybacks. The big advantage for the spinoff is that the company can focus solely on growing its car rental business. Hertz CEO, Mark Frissora, said that there's the potential for multiple expansion after the spinoff.

Meanwhile, the Hertz spinoff will be left to compete with the likes of United Rentals (NYSE:URI), the world's largest rental company. United Rentals has exposure to the construction industry, which is starting to pick up. It owns 13% of the rental market for construction equipment.

United Rentals is also working on expanding its rental services. Its acquisitions of National Pump and the HVAC unit of Blue-Steam give it a presence in the pump-rental sector and the air/heat equipment market.

How shares stack up
Hertz already trades at one of the cheapest valuations in the industry. It trades at a P/E ratio of 11.6 based on next year's earnings estimates. Avis trades at a forward P/E of 12.9, while United Rentals is at 15.9.

But shares of Hertz are down 8% year to date; meanwhile, United Rental and Avis are both up more than 35% over the same period. Hertz has an operating margin of 14%, while Avis' is only 11.1%. In addition, Hertz's return on equity is 28.6% versus Avis' 9%.

Bottom line
The car rental business should accelerate on the back of a rebounding economy. The other big benefit to the industry will be margin expansion, where the remaining companies have pricing power. For investors looking for a niche play on the auto industry, Hertz is worth a closer look.

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Editor's note: A previous version of this article stated that Hertz, rather than United Rentals, had acquired National Pump and the HVAC unit of Blue-Steam. The Fool regrets the error.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool owns shares of Hertz Global Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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