Last week, shares of rental-car pioneer Hertz Global Holdings (NYSE:HTZ) advanced nearly 11%, after privately held automotive information site Edmunds proclaimed a multiyear peak in used-car pricing. Edmunds' quarterly assessment, issued on June 12, reported that the average used-vehicle transaction price in the first quarter of 2018 rose 2.2% against the prior-year quarter, to $19,657. This is a record sticker amount, which also represents a cumulative five-year advance of 17.6% against the first quarter of 2013.
Edmunds attributed the increase to "the ever-growing supply of near-new vehicles coming off-lease and a greater demand for vehicles of all sizes and ages, thanks to shifting market factors." Hertz gained 8% on June 12 alone following Edmund's press release, and fellow car-rental giant Avis Budget Group Inc. (NASDAQ:CAR) rose 5% in the same trading session.
Could a 2% year-over-year rise in used-car prices really mean so much to a rental-car conglomerate's stock price? No way. At least that's what flitted through my head when I saw the report. So I reviewed some of Hertz's recent filings, including its 2017 annual report, to see if investor enthusiasm was warranted; my findings are below.
A tilt toward "non-program" cars
Last year, Hertz Global's total worldwide rental fleet averaged roughly 663,000 vehicles. The company's approximate holding period for a rental car before sale was 17 months for U.S. vehicles, and just 14 months for international vehicles.
Following an industry convention, Hertz divides its primary money-generating asset into two classes: program and non-program vehicles. Program vehicles, as their name implies, are obtained via purchase programs with automobile manufacturers. Adding such vehicles to a fleet reduces a rental-car company's overall residual risk. That's the risk associated with a vehicle once its useful life as an economic asset is complete.
In program agreements, manufacturers commit to repurchase vehicles based on prespecified parameters such as total mileage, depreciation, and overall condition. The rental company gains a guaranteed minimum repurchase price from the manufacturer for each program vehicle, and this provides a hedge against possible pricing declines in the used-car market.
There are two drawbacks to program vehicle purchasing. First, vehicles under program agreements cost more, to compensate the manufacturer for its own risk. Second, in a period of rising used-car prices, the rental-car company loses out on opportunity, since its resale range for program cars is already predetermined and capped.
As for non-program vehicles, they're disposed of in a variety of ways, including auctions, sales to dealers and wholesalers, and sales through third-party brokers. According to Hertz's management, "[We] also dispose of vehicles at our own Hertz retail sales outlets, primarily in the U.S. which consists of a network of 80 company-operated vehicle sales locations ... Vehicles disposed of through our retail outlets allow us the opportunity for value-added service revenue, such as warranty and financing and title fees."
Direct sales to consumers, with opportunities for additional revenue, are a desirable path to realizing vehicle residuals. What's the current balance between program and non-program vehicles in Hertz's fleet?
The image above shows that only a fifth of U.S. cars were purchased via program buying last year. Hertz's U.S. rental vehicles outnumber international rental cars by nearly 3 to 1. So while used cars climb in value, Hertz has more flexibility to maximize its residual sales as it keeps higher numbers of cars out of the program purchasing category.
The impact of a couple of percentage points
Now that we've reviewed how Hertz manages its vehicle residual risk, let's return to my initial question: Does a 2.2% increase in used-car pricing really warrant a double-digit gain in stock price?
The answer, surprisingly, is yes. First, any indication of a sustained financial tailwind is positive for Hertz Global shares. While the stock has nearly doubled over the last twelve months to trade at close to $18 per share, it's still down 80% over the last five years, when it traded closer to the $100 level.
As my colleague Demetrios Kalogeropoulos recently noted, Hertz has suffered from the advent and rise of car-sharing services in recent years, but expects to achieve higher operating profit in 2019. Thus, value investors appear quick to react to any positive shifts in the company's outlook that support the turnaround story.
From a quantitative perspective, a few percentage points of improvement in used-car pricing do impact Hertz's fundamentals positively. Below, I've isolated two line items from the organization's 2017 statement of cash flow: "revenue-earning vehicle expenditures" (cash paid for new fleet vehicles) and "proceeds from disposals of revenue-earning vehicles" (cash received for sales of used fleet vehicles). I've reduced the first line by the second to isolate the net the company has paid over the last three years for new vehicles, after accounting for cash received from vehicle sales:
|Revenue-earning vehicles expenditures||($10.596 billion)||($10.872 billion)||($11.266 billion)|
|Proceeds from disposals of revenue-earning vehicles||$7.653 billion||$8.679 billion||$8.676 billion|
|Net revenue-earning vehicles expenditures||($2.943 billion)||($2.193 billion)||($2.590 billion)|
|Percentage of fleet purchases supplied by dispositions||72%||80%||77%|
While the percentage has declined a bit over the last three years, in 2017, 72% of Hertz's total vehicle expenditure was supplied by cash from used-vehicle sales. For comparison, Avis achieved an 83% ratio of used-car receipts to new-car purchase expenditures.
Now, consider a 2.2% increase in the amount Hertz receives for cars it retires from its fleet. Last year, this would have equaled $168.3 million on $7.6 billion in used-car sales. That benefit packs the same punch as a 7% improvement in 2017's $2.4 billion in operating cash flow -- no tidal wave of cash, but a palpable boost all the same. So, if the economy continues to grow moderately and used-car prices tighten further, Hertz may reap additional rewards from its flexible approach to vehicle dispositions.