What do using a newspaper for stock quotes, buying DVDs from physical stores, and renting cars at airports have in common? They will all be things we used to do, displaced through cheaper, more efficient technologically enabled means.
Autonomous cars are coming, but it is not the only trend changing how we travel. Ride sharing is also bringing disruption to the transportation industry. Eventually these two trends will combine into a single dominant megatrend. I have already pointed out two stocks to buy for our autonomous future, but this article is about two stocks to avoid in an industry about to be turned on its head: car rental.
At a brief glance, there is a lot to like about car rental stocks Hertz (NYSE:HTZ) and Avis Budget Group (NASDAQ:CAR). The industry is an oligopoly with pricing power. Used-car prices are high, providing a sizable boost when turning over rental fleets. And as stocks, they are -- Avis in particular -- not just dirt cheap, but subterranean cheap. However, these stocks are a classic value trap. The ground is shifting in this industry, and even well-managed players will find themselves in trouble if they are not aggressive in identifying and combating the threat of ride sharing. I found it stunning that in the most recent set of conference calls from Hertz and Avis, Uber was only mentioned once, and it was to -- obviously -- point out that it was different from Avis-owned ZipCar. It is amazing how deep in the sand the people running these companies have their heads collectively buried.
Let's think about the economics of a rental car from the perspective of the customer. There is an advertised price, but after a myriad of local taxes and insurance, the final bill essentially doubles. This vehicle then is driven to its destination, where it sits idle for the majority of its prepaid service. How exactly is this an efficient use of resources? Car-sharing services like Uber and Lyft will change this dynamic. Increased availability of rides will push costs down while giving customers confidence in short wait times and reduced fear of getting temporarily stranded in a location. Currently, Hertz and Avis, combined with the privately held Enterprise, use their oligopoly status to force small price increases on their customers every year. In the face of a cheaper competitor not playing by the old rules, will their ability to levy price increases disappear?
The taxi industry is facing the brunt of Uber's assault, but car rental is still suffering collateral damage. Here are some incredible stats from business expensing firm Certify. Nationwide, in the first quarter of 2014, taxis made up 52% of expensed travel, Uber 9%, and car rental 39%. As of the first quarter of 2015, taxis have plunged to 35%, car rental 36%, and Uber soared to 29%. You might think car rental is holding up relatively well, but a 3% decline in one year is a significant red flag, especially when Uber is not allowed at airports. Uber is also cheaper, with an average ride cost of $31.24 versus a taxi at $35.40. Uber usage varies by city, largely thanks to its staggered rollout, so those nationwide stats are likely downplaying the trend.
What is noticeable are the huge inroads Uber makes once established. In just a year, expensed Uber rides versus taxi rides (as a percentage of total paid car rides for business users) jumped from 20% to 49% in Washington, D.C., 27% to 56% in Dallas, and 8% to 41% in Atlanta. The pressure is only going to ramp up, not only on taxis but also car rental companies, as travelers realize that Uber can provide superior services at a portion of the cost.
Investors also need to be aware that used-car prices are currently near record highs. This is an important component to car rental companies, as they constantly turn over large portions of their fleet. Hertz stated that a 1% change in residuals is worth $83 million in pre-tax profit. The reason used-car prices are so lofty is that the Great Recession stunted new car sales dramatically. The age of vehicles on the road increased to an all-time high of more than 13 years, and the supply of lightly used off-lease cars became constrained in the wake of diminished new-vehicles sales that fell to 9 million.
However, new-car sales have recently exploded, with 16.5 million sold domestically in 2014 and tracking for around 17 million vehicles sold in 2015. These new vehicles will eventually flood the used market. Automakers have more than replaced the capacity lost in the downturn, and an accommodating financing environment has seen transaction prices soar while monthly payments have only inched higher. Used-car prices will start to face pressure soon enough, but when the inevitable cyclical correction comes, expect a pricing adjustment per vehicle that's several factors greater than new-car counterparts. This will lead to negative surprises in rental car earnings when companies' fleets of used vehicles are suddenly worth 10% less than management's guidance.
Eventually, autonomous cars and ride sharing will intersect and we will have autonomous on-demand vehicles. This is the project Google is reportedly working on. Uber struck a deal with Carnegie Mellon University's robotics program to jointly work on its own autonomous technology, and recently posted 19 job openings for that partnership. In the meantime, increasing ubiquity of human-driven ride sharing is enough to dramatically reduce the demand for rental car services.
Bottom line: It doesn't matter how cheap these stocks look given the current industry fundamentals. Those fundamentals will erode, and with them any hope of capturing additional value.
David Williamson owns shares of Google (C shares). The Motley Fool recommends Google (A and C shares). The Motley Fool owns shares of Google (A and C shares) and 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.