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In Part I, we took a look at a potential emerging moat in the consumer truck rental industry, Amerco (UHAL).  Today, we take a look at another potential emerging moat in the consumer car rental , Hertz (HTZ).[1]

The consumer car rental industry includes three companies with sustainable competitive advantages and dominant market share positions:  HTZ, CAR and privately held Enterprise.  HTZ recently completed its acquisition of a fourth major company, Dollar Thrifty.  Here we see a comparison of the major players excluding Enterprise:

Amerco Hertz Avis Budget Dollar Thrifty Moody’s
UHAL HTZ CAR DTG MCO
Market Cap as of 7/12/13 3.35 10.82 3.48 N/A 13.64
Net Debt                  1,198            14,344                  2,299                  891           (166)
Revs                  2,559              9,021                  7,357               1,549          2,730
OI                      499              1,096                      940                  339          1,090
Op Margin 20% 12% 13% 22% 40%
NI                      264                  243                      290                  160              700
Net Margin 10% 3% 4% 10% 26%
ROA 5% 1% 2% 0% 20%
ROE 22% 44% 6% 0% 647%
ROIC 9% 6% 9% 0% 61%
Klarman Factors
Barriers to Entry High High High High Very High
Capex/Revenue 17% 30% 27% 27569% 2%
Reliable Customers Med Med Med Med Very High
FCF/Revenue 9% 1% NMF 9054% 28%
5 Year CAGR 147% -54% NMF -43% 17%
10 Year CAGR -203% -12% NMF 5% 10%

We can see that the car rental companies do not do well in the critical Klarman factors.  This is particularly evident when comparing them to Moody’s, our model of the wide moat company.

However, the CBS Students argue that the economics of the car rental industry have shifted dramatically.  The CBS Students HTZ investment thesis is primarily based on a simple premise:  HTZ’s acquisition of Dollar Thrifty reduces the number of players in the industry from 4 to 3.  This consolidation leads to an increased likelihood of coordination among the remaining players and an end to the endless battles for market share through price cutting.  Further, rising returns on capital is unlikely to attract competitors because the barriers to entry in the industry are very high.  For these same reasons, the FTC blocked the deal on anti-competitiveness grounds.  Essentially, the CBS Students turned the FTC’s arguments on its head – what is bad for consumers (ie., rising prices) is good for investors.

To support their argument, the CBS Students point to rising RPD in recent quarters and blatant price signaling by both HTZ and CAR.  In the first quarter of this year, Avis raised prices six times. CEO Ron Nelson attributed the increases in part to Hertz’s acquisition of Dollar Thrifty. Since the transaction, “the basis of competition in our industry has become better balanced between service and price than it has been in recent years,” Nelson said on the May 2 call.

In sum, the CBS Students are resting their investment decision on rational pricing discipline taking hold in the car rental industry.  However, pricing dynamics among competitors is notoriously difficult to predict, particularly in a commodity industry.  For a variety of reasons, we are not quite as confident as the CBS Students.

In Valuation: Measuring and Managing the Value of Companies, the authors explain this uncertainty:

In commodity industries with many competitors, the laws of supply and demand will push down price and ROIC.  This applies not just to obvious commodities such as chemicals and paper, but also to more recently commoditized products and services, such as airline seats.  It would take only a net increase of 5 to 10 percent in airline ticket prices to turn the industry’s aggregate loss to an aggregate profit.  But each competitor is tempted to get an edge in filling seats by keeping prices low, even when fuel prices and other costs rise for all competitors.

Occasionally, we find an industry that manages to overcome the forces of competition and set its prices at a level that earns the companies in the industry reasonable returns on capital (though rarely more than 15 percent) without breaking competition law.  For example, for many years, almost all real estate agents in the United States charge a 6 percent commission on the price of each home they sold.  In other cases, the government sanctions disciplined pricing in an industry through regulatory structures.  For example, until the 1970s, airline fares in the United States were high because competitors were restricted from entering one another’s markets.  Prices collapsed when the market was deregulated in 1978. . .

Even cartels (which are illegal in most of the world) find it difficult to maintain price levels, because each cartel member has a huge incentive to lower prices and attract more sales.  This so-called free-rider issue makes it difficult to maintain price levels over long periods, even for the Organization of Petroleum Exporting Countries (OPEC), the world’s largest and most prominent cartel.”

If you are looking for historical analogies to gain insight into the rental car industry, the most favorable is the railroad industry.  Following deregulation in 1980, the railroad industry went through a period of rapid consolidation – goings from 26 major railroads in 1980 to only 7 by 2001 to just 4 major players today.  As the number of railroads dropped, rates and profitability increased.  Railroad rates surged 76% from 2001 to 2012.

Railroads

Prior to this consolidation, the railroad industry looked a lot like an even worse version of the tire industry or the car rental industry – capital-intensive, low-margin and low-return.  Following consolidation, competition rationalized.  The companies then spent the new profits on more fuel efficient engines, improve rail lines, and maximize the efficiencies. Since 1980, freight rail’s marketshare has risen from roughly 30 percent to 43 percent.

Buffett, famously, recognized this transition earlier than most.  The tremendous amount of railroad consolidation and the monopolistic/duopolistic nature of most BNI freight routes virtually ensures annual profitability In 2005, Berkshire purchased a 22 percent position in BNSF (originally called Burlington Northern Santa Fe Railways) and four years later acquired the remaining shares at nearly $100 a share.   Here are the BNSF financials at the time of the purchase:

BNSF
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Revenues            9,207            9,208            8,979            9,413          10,946          12,987       14,985       15,802       18,018       14,016
Operating Income            2,113            1,750            1,656            1,665            1,686            2,927          3,521          3,486          3,912          3,262
Net Income                980                731                760                777                791            1,534          1,889          1,829          2,115          1,721
Diluted earnings per share              2.36              1.87              2.00              2.09              2.10              3.98            5.07            5.06            6.06            5.01
Average diluted shares            415.2            390.7            380.8            372.3            376.6            381.8          369.8          358.9          347.8          342.5
Total assets          24,375          24,721          25,767          26,947          28,925          30,436       31,797       33,583       36,403       38,675
Long-term debt            6,846            6,651            6,814            6,684            6,516            7,154          7,385          8,146          9,555       10,335
Stockholders’ equity            7,480            7,849            7,932            8,495            9,311            9,638       10,528       11,144       11,131       12,798
Net Debt to Total Capitalization 47.70% 45.80% 46.10% 44.00% 39.90% 42.30% 40.00% 41.20% 44.50% 41.5%
Total capex excluding equipment            1,399            1,459            1,358            1,726            1,527            1,750          2,104          2,248          2,167          1,991
Depreciation and amortization                895                909                931                910            1,012            1,111          1,176          1,293          1,397          1,537

Importantly, the amount of profitability is improving relative to the capital deployed. This has allowed debt/operating income to move to new lows as less debt is needed to provide acceptable returns to equity investors. Free cash flow, after being abysmal for many years, is improving, though it is still too low a percentage of annual net income for a slow growth business.

The counter-example is the airline industry.  The airline industry has experienced consolidation and now the top 4 carriers have 90% of the traffic.  Yet, rational price discipline has never taken hold.  Here is Buffett commenting at the 2013 Berkshire Hathaway meeting on whether consolidation in the airline industry will lead to rational price discipline:

In some industries, two competitors can do stupid things.  Freddie Mac and Fannie Mae drove prices for insuring loans down to improper levels. In the airline industry there is very low incremental cost per seat, but very high fixed costs.  The temptation to sell the last seat is very high, and it is hard to distinguish between which is the last seat and the other seats.  The industry is labor intensive, capital intensive, and largely commoditized.  It has been a death trap for investors. If it ever gets down to one airline and no regulation, then it will be a good business. Is it a good business yet? I do not know, but I am skeptical.

Interestingly, Munger then added:  “The last time we were presented with an opportunity like this was in railroads where you had consolidation and the industry improved. We missed it and came back to it late. . . .But, you could not create another railroad.  You could create another airline.”

As investors, we are caught in a bind, do we wait and see if pricing discipline holds in the car rental industry and risk paying a much higher price?  Or, do we buy now when the price is relatively cheap?  Buffett and Munger waited and paid a high price for BNSF.  At the same time, airlines have been a disaster.  Further, like the airlines, car rental companies have low variable costs.  The temptation to rent the last car will be very high.

This dliemma has been bothering Buffett and Munger for some time.  Here is Munger again on the subject in 1995:

Here’s a model that we’ve had trouble with. Maybe you’ll be able to figure it out better.  Many markets get down to two or three big competitors – or five or six. And in some of those markets, nobody makes any money to speak of. But in others, everybody does very well.  Over the years, we’ve tried to figure out why the competition in some markets gets sort of rational from the investor’s point of view so that the shareholders do well, and in other markets,there’s destructive competition that destroys shareholder wealth.  It’s easy to understand why air travel is so unprofitable….

If it’s a pure commodity like airline seats, you can understand why no one makes any money. As we sit here, just think of what airlines have given to the world – safe travel. Greater experience, time with your loved ones, you name it. Yet, the net amount of money that’s been made by the shareholders of airlines since Kitty Hawk, is now a negative figure – a substantial negative figure. Competition was so intense that, once it was unleashed by deregulation, it ravaged shareholder wealth in the airline business. But why is the cereal business so profitable?

Yet, in other fields – like cereals, for example – almost all the big boys make out. If you’re some kind of a medium grade cereal maker, you might make 15% on your capital. And if you’re really good. you might make 40%. But why are cereals so profitable – despite the fact that it looks to me like they’re competing like crazy with promotions, coupons and everything else? I don’t fully understand it. Obviously, there’s a brand identity factor in cereals that doesn’t exist in airlines. That must be the main factor that accounts for it.

Maybe it boils down to individual psychology….

And maybe the cereal makers by and large have learned to be less crazy about fighting for market share – because if you get even one person who’s hell-bent on gaining market share….For example, if I were Kellogg and I decided that I had to have 60% of the market, I think I could take most of the profit out of cereals. I’d ruin Kellogg in the process. But I think I could do it.In some businesses, the participants behave like a demented Kellogg. In other businesses, they don’t. Unfortunately, I do not have a perfect model for predicting how that’s going to happen. For example, if you look around at bottler markets, you’ll find many markets where bottlers of Pepsi and Coke both make a lot of money and many others where they destroy most of the profitability of the two franchises. That must get down to the peculiarities of individual adjustment to market capitalism. I think you’d have to know the people involved to fully understand what was happening.[2]

Like Munger, we do not have a perfect model and cannot predict what will happen in the car rental industry.[3]  The McKinsey book cited above lays out 3 factors to consider in determining whether rational pricing discipline will hold:

  1. Does one competitor act as the leader and others quickly replicate its price moves?
  2. Are there barriers to new entrants?
  3. Is each competitor large enough for a price war to be sure to reduce the profit on its existing volume by more than any extra profit gained from new sales? Are there smaller competitors that have more to gain from extra volume than they would lose from lower prices?[4]

Lets walk through the factors one-by-one.

1.  Both Avis and Hertz are very close in revenue and market cap.  Its not like the US beer industry where Anheuser-Busch InBev, the conglomerate that owns Bud, is the clear leader.  It would be far easier to maintain rational price discipline if HTZ acted as the leader and Avis and Enterprise followed, or vice versa.

2.  There are barriers to entry for new entrants.  HTZ, CAR and Enterprise have moats due to their strong brands, network of locations and large fleets. Entry into the car rental industry would require strong brand equity, superior technological innovation, and significant capital. A threat to the Big 3’s leading share positions would likely come from the low end, discount tier of car rentals. HTZ and CAR have particularly wide moats in the airport rental segment. To get to scale in the airport segment, a new entrant must:

  • Must have airport concessions
  • Establish brand identity
  • Gain access to online travel agencies and other distribution channels
  • Develop a reputation for quality and reliability

These barriers to entry have limited existing fringe firms from expanding beyond their regional footprints and collective low single digit market share.

3.  The main threat to the Big 3 would seem to be deep discount brands like Fox and Sixt, based in Europe.  Sixt has already entered the American market with nine locations, including the Miami, Orlando, Fort Lauderdale, Palm Beach and Hartsfield-Jackson Atlanta airports. They have more to gain from volume gains through price cutting than they would lose in lost profit.  The Big 3 must be prepared to match them price cut by price cut and resist all of their attempts to enter the market.

Having expanded on the concept of rational price discipline that is implicit in the CBS presentation, we can see that the future for this industry is far from certain.  However, as value investors, we need to get used to investing in an atmosphere of uncertainty.  After all, that is when the bargains happen.  They key is having a sufficient margin of safety in the purchase price to cushion against any mistakes.  The recent run-up in the HTZ stock makes it prohibitively expensive.  Nevertheless, watching how the competitive dynamics play out in the industry will be fascinating.


[1] Again, we would like to thank Richard Hunt, Stephen Lieu and Rahul Raymoulik of Columbia Business School (the “CBS Students”) for their hardwork and their generosity in making their presentation public.

[2] “A LESSON ON ELEMENTARY, WORLDLY WISDOM AS IT RELATES TO INVESTMENT MANAGEMENT & BUSINESS.” from a lecture to the students of Professor Guilford Babcock at the University of Southern California Marshall School of Business, as printed in Outstanding Investor Digest’s May 5, 1995 Edition

[3] The FTC claims to have such a model and it tells them that the Dollar Thrifty acquisition will lead to a 4% increase in rental car rates (see page 25 of the CBS presentation).  Color us skeptical.

[4] Munger would have us add a fourth factor, What are the personalities of the individuals involved?  Unfortunately, we don’t have that kind of juice.