Thus far, we have looked at two great companies and one not so great company. Now, we will look at something even more exciting for the value investor: 2 mediocre companies that seem to have emerging moats. If we can grab shares at this stage, while the moat is obscured or not yet fully formed, we have the possibility of owning a true compounding machine for the long term.
The two companies we refer to are Amerco (UHAL) and Hertz (HTZ). We owe a debt of gratitude to Kerrisdale Capital for publishing a terrific report on UHAL and 3 students a Columbia Business School for an equally terrific presentation on HTZ. We urge you to read both documents in their entirety here and here.
What do these companies have in common? On the most basic level, both are involved in the rental of cars and trucks to consumers. Amerco’s main line of business is renting moving equipment under the U-Haul brand name. Hertz’s primary activity is the renting of cars under the Hertz, Dollar and Thrifty brands. Indeed, the two companies were direct competitors until Hertz abandoned renting moving equipment.
On a more interesting level, however, both companies operate in industries undergoing fundamental change – change that could make these companies much more profitable. Historically, the vehicle rental industry was characterized by high levels of competition causing reduced rental volumes and downward pricing pressure. In other words, it looked a lot like what we saw in the tire industry. Some of the market participants chose to compete on the basis of price and engage in costly battles for market share. The truck rental sub-segment was particularly hurt by price competition as it is even more difficult to reduce fleet size in response to reduced demand. That is, it is easier to unload used cars than used trucks. The emergence of the Internet merely exacerbated this problem by increasing pricing transparency among the rental companies and allowing cost-conscious consumers to more easily obtain and compare rates. This transparency increased the prevalence and intensity of price competition.
Yet, we now seem to be observing the long-term rationalization of the industry – a topic we shall explore in some depth. We propose to undertake this study in two parts. The first part, regarding UHAL and the consumer truck rental industry, is below. The second part, regarding HTZ, and the consumer car rental industry, will be posted in a few days.
Introduction to UHAL
Consumer truck rentals accounted for 88.3 percent of UHAL’s revenue in 2012. UHAL clearly dominates the consumer truck rental industry with almost 4x the revenue of its largest competitor, Avis Budget Group (CAR). Penske is the third national brand and there are a number of smaller local and regional players.
Truck rental companies generate revenue through the leasing of trucks and sale of ancillary products and services to “do-it-yourself “ household movers. UHAL describes its market as “individuals and families moving their belongings from one home to another, college students moving their belongings, vacationers and sports enthusiasts needing extra space or having special towing needs, people trying to save on home furniture and home appliance delivery costs, and ‘do-it-yourself’ home remodeling and gardening enthusiasts who need to transport materials.”.
The most profitable rentals are one-way moves where the truck is rented in one city and dropped off in another. To facilitate this, consumer truck rental companies maintain large networks of locations that allow trucks to be picked up in one city and dropped off in another. These locations are both company owned and operated by independent franchisees. For UHAL, approximately 8% of the locations are company owned. Agents are paid a percentage of the sales they generate.
Since truck rental companies largely use outside agents to rent the trucks and store the vehicles and rent the trucks, they have no need to maintain an expensive footprint. Their customers also pay upfront so they limit accounts receivable. However, there is a great deal of capital tied up in the truck fleet itself. As a result, truck rental companies will never generate returns on capital that we saw with MCO, but they might be attractive nonetheless.
Does UHAL Have A Moat?
Kerrisdale’s excellent report touches on the existence of a moat for UHAL but we propose to undertake a deeper dive.
Quantitative Evidence of a Moat
A quick look at the numbers suggests that UHAL does not in fact have a moat. UHAL’s performance over the past decade has been spotty at best.
Free cash flow has been very erratic during this period. Three of the 10 years have actually been loss producing. As we have seen in previous case studies, steady earnings performance are the hallmark of a wide moat company while no moat company are highly cyclical.
Net capital expenditures (defined as purchases of plant, property and equipment less sales of plant property and equipment) ate up most of the CFOA.
During this period, net capex as a percentage of sales ran anywhere from 1% to 26% with an average of 13%. Over the last 10 years, management put almost $3 billion of earnings back into the business. Compare this to Moody’s which never spent more than 8% and averaged 3%.
Returns on equity and invested capital show much the same pattern. Returns dipped dramatically in 2004 before recovering and peaking in 2006 only to dip again during the financial crisis. They are now in another up cycle. Overall returns have been mediocre.
As we saw with Goodyear, capital intensive businesses in highly competitive industries can destroy wealth for shareholders. In this vein, Kerrisdale wrote, “Generally, commoditized industries with high capital costs and low variable costs tend to earn poor shareholder returns over time (i.e, airlines, grocery stores, unregulated power plants, commoditized manufacturing, etc.).” Yet, there is some indication that UHAL is building barriers to entry. The improvements in key metrics over the last 5 fiscal years have been eye-popping:
- FCF has gone from $6 million in 2009 to $226 million in 2013.
- ROIC has gone from from 5% to 9%.
- Operating margins have gone from 6% to 19% (more on this below)
- Revenue has increased from $1,992 million to $2,559 million – a 28% increase.
- EPS has gone from 0 to $14
These numbers certainly deserve a deeper look.
Qualitative Evidence of a Moat
Despite the mixed financial results over the past 10 years, the qualitative evidence does support the existence of a moat.
Network Effects – Better Network, More Locations, More Trucks
Kerrisdale argues that UHAL has built a moat by having more locations and more trucks than anyone else. Specifically, in the last 10 years, UHAL has spent almost $3 billion net and added almost 3,000 locations and 20,000 trucks. No matter where the customer wants to haul stuff, odds are good that UHAL has a branch at both the sending and the receiving end and a truck at the ready. In this way, the national one way moving network built by UHAL is comparable to a smaller version of a railroad. No competitor comes close to this mass. U-Haul has nearly 8x as many locations as Budget/Ryder in its network and has 4x the number of trucks in its fleet.
Why is this important? Price, truck availability and convenient location are the most important considerations in a consumer’s truck rental decision. If one dealer has the only truck available in the geographical location, this trumps price. This dealer can effectively name his price.
Further, as the web of locations increases, a network effect sets in. The dynamics of the consumer truck rental industry would seem to preclude a traditional network advantage–that is, a network that becomes more useful to all participants as the number of participants increases. Truck rental customers typically use the service very sporadically or even once in a lifetime. They shouldn’t value the option to take the truck to many different locations. Agents, however, might see value in partnering with a truck rental company that can send trucks to as many locations as possible and therefore draw a greater number of customers through its doors. Once UHAL hit critical mass in number of locations, the choice for potential franchisees became a no-brainer. Thus, U-Haul’s locations, as described by Kerrisdale, create a network effect:
- U-Haul has the only national one-way moving network and has the most scale
- U-Haul attracts the most customers because it is either the only one-way rental provider on the route, or the lowest cost and/or most convenient
- Franchisees (which mostly depend on low volume one-way moves) choose to sign up for U-Haul as opposed to competitors because U-Haul generated the most revenue
- U-Haul captures more share, allowing it to buy more trucks
- More franchisees sign up for the U-Haul network
Testing The Hypothesis
We set out to test this hypothesis.
First, we selected 12 one-way trips at random and compared price, truck availability and location for U-haul, Penske and Budget (See Exhibit 1). Prices varied wildly but UHAL overall came in much higher than its competitors. Truck availability was not an issue at any of the companies as we were only once told that no truck was available on the desired date. However, UHAL’s network really made a difference in location as their locations were significantly closer than its competitors.
Next, if a bigger network really does mean that UHAL can attract more customers, then we should expect to see the average operating income per location increasing over time. As it turns out, this is exactly what we see. There is an overall upward trend correlating with the growth in locations, but with major dips in 2033 as the company dealt with bankruptcy and during the financial crisis of from 2007-2010.
A similar pattern holds true for trucks. As the truck fleet expands, the operating income per truck increases as well.
As with any other consumer service, the perception of brand might play a role in UHAL’s profitability. The 112,000 UHAL trucks represent rolling billboards for the brand. With its long record and high brand awareness, UHAL has a widely recognized brand. Given that customers are entrusting a company with their possessions, it’s not unreasonable to believe they might pay a premium to use an operator they trust.
Economies of Scale
Economies of scale is the phenomenon whereby the average cost of a unit declines as more units are produced. Economies of scale require high fixed costs and low variable costs. Here, UHAL has economies of scale because once a truck is purchased the incremental cost of each new rental is very low. This is in sharp contrast to a company like Goodyear which incurs high incremental costs in raw materials and labor for each additional tire it makes. With its lower costs per truck, UHAL should be able to undercut its competitors on price in competitive markets and still make a profit.
As we have discussed, pricing power is the most important indicator of a wide-moat company. In recent conference calls, management has repeatedly asserted that the recent uptick in earnings is not based on price increases but, instead, volume and product mix. Nevertheless, it is clear that UHAL charges much higher prices than its competitors.
Besides Network Effects, the other pillar upon which Kerrisdale rests its bullish thesis is the changing competitive landscape. Specifically, Budget has stated that it is retrenching its truck rental business. In their most recent pronouncement, the CFO stated:
With respect to truck rental, which represents about 6% of our revenue, the – that’s a business that we’re repositioning, we’re reducing the fleet a bit and we think positioning it to have better, more sustainable margins going forward. And I think at this point, it’s worth more to us than it – as part of our business and our operations than it would as a divesture candidate. And I don’t see that changing, particularly when we look at it on both a pre-tax and a post-tax perspective.
The – 20,000 rolling billboards for the Budget brand are helpful out there. And we think the business actually can generate a fairly attractive return on capital. And as I may have mentioned in the past, we acquired Budget Truck Rental for free when we acquired Budget back in 2002. So the return on capital there continues to be pretty, pretty attractive, but we do need to get the earnings and margins up from where they were in the first quarter.
There is no doubt that Budget has reduced its fleet from a peak of 32,100 in 2005 to 27,000 in 2012 with further reductions to come. It sounds like Budget has decided to focus only on those locations which are the most profitable
In sum, Kerrisdale has done a great service in identifying UHAL’s emerging moat. An investment in UHAL represents a bet that UHAL has reached critical mass and erected huge barriers to entry in the consumer truck rental market. The Kerrisdale argument rests on the premise that the overall trend is upward and UHAL’s moat was imply obscured by three temporary problems: (1) the brutal price wars with Ryder, Hertz, Penske, Budget and others , (2) the family soap opera and the ensuing bankruptcy, and (3) the financial crisis of 2007-2010.
Emerging Moat or Reversion to the Mean Candidate?
As lawyers by training, we are eager to argue the other side of the UHAL story.
First, are the price wars really over or is this merely a temporary respite? Historically, profitability has shifted with the amount of capacity in the industry. In such a situation, you are only as profitable as your dumbest competitor. There is no reason to think that national competitors will not reemerge. On the surface, for a company already in the car rental business, the business looks cheap and easy to start and a natural complement to car rental. Significantly, UHAL management has indicated that Enterprise is looking to get into truck rental. Management has also pointed to ABT, a moving company that reduces fees by allowing the customer to pack the truck. ABT provides competition on the higher end. Also, Budget could look to expand its fleet again at any time. Management commented on the continuing onslaught of competitors on a recent conference call:
“Well, I — just a variety of people are starting to think this is a easy money business. So we’ll pick Enterprise. Enterprise has spent 10 years trying to get into this market. They’re doggedly pursuing it and they’re tightening it and we’re having to respond to them every day. There is — what happens is, of course, as soon as we get a little bit of success, then everyone thinks this must be a good place to put additional capital.”
Contrast the barriers to entry in this industry to what we saw in the Moody’s case study. There is certainly no regulatory requirement to use UHAL. Such a notion is laughable. UHAL will have to vigorously defend its competitive advantages. Management will have to spot threats that are likely to develop and identify those competitive inroads that require strong countermeasures.
Second, Kerrisdale points to operational improvements in supporting higher margins going forward. We are skeptical of operational improvements as they are easily copied by competitors. As management argued on a recent conference call regarding the self-storage business, “And of course, you only get a limited time out of any single advance because then it becomes kind of standard and… But the problem is it’s — I’ll take an example, but this won’t quite speak to what you want. But if you put a feature in storage, let’s say individual door alarms, so we were one of the pioneers in putting individual door alarms and spent gads of money on it and it gave us a little occupancy bump. But what happens is now, every operator who comes in new, puts in individual door alarms, and pretty soon we can get nothing for it. Climatization is another one. We have a phenomenal amount of climatized storage. And originally you could get premiums of up to 40%. Now those have trailed off and you’re getting 10% premiums. So you don’t quite know how — as you roll those in. . .”
The third and perhaps most important issue is management. Kerrisdale’s argument rests heavily on the quality of management and its high level of stock ownership. Management is pouring money in to its truck fleet and ancillary services rather than non-core “diworsification” attempts. Management is allocating capital towards widening the moat rather than going for short term gains. Further they have maintained their niche and not drawn into other fields. Yet, there track record is anything but exemplary. Kerrisdale provides a great description of the family soap opera surrounding this company and we won’t attempt to duplicate it here. Suffice it to say that they have not always respected minority shareholders rights. They continue to suck money out of the company via related party transactions and enrich themselves at the expense of minority shareholders.
Thus, an investment in UHAL is a bet on a dramatic shift in the competitive dynamic and faith in management. At a 7% FCF yield, it is hardly cheap. Further, it is not a wide moat, bulletproof franchise like See’s or Moody’s. Nevertheless, it deserves a place on our watchlist and at the right entry price it could be a very good buy.
 Amerco also participate in two additional businesses: self-storage real estate and insurance. These are ancillary activities to the core truck rental franchise. As the focus of this blog is moats, we will not discuss them here. Again, we urge you to read the Kerrisdale report in its entirety.
 Here, as in a number of places, we are unable to tie Kerrisdale’s capex numbers to UHAL’s reported numbers. Its possible that in some areas, Kerrisdale has made reasonable adjustments. However, here the numbers are pretty clearly scrambled as their 2012 purchase of PP&E amount is actually the 2009 amount, the 2011 amount is actually the 2008 amount, and so forth and so on.
 There is actually an argument that ROIC is much higher than shown here. We believe that UHAL has excess cash and investments on its balance sheet that is not required to run the business. If cash and investments are reduced to say 2% of revenue, ROIC increases dramatically. This makes intuitive sense as the core truck rental business should have negative working capital as customers pay in advance with cash or credit card and accounts receivable are very limited.