Olympia Analysts Unravel the Auto Rental Conundrum

Continue Shorting the Auto Finance Bubble

PANAMA – 8 Aug, 2017 – Our analysts asked a question back in November: 2016. Why do you not count the income that a rental car company generates from actual car rentals?

Most investors don’t realize that the entire car-rental business is basically a giant leveraged bet on the value of used cars. Since 2010, Avis and Hertz have spent more than $110 billion on new-car purchases. Meanwhile, their used-car sales generated $85 billion. That’s a net cash shortfall of $25 billion!

We can only assume that the ‘used-car sales’ number in the above is exactly that, ‘used-car sales.’

So OK, all good and well, but what about the revenue generated from actually renting the cars? That is the whole point of running a car rental company after all. Buy a car, rent it out and generate as much revenue as possible until you can’t rent it anymore, then sell the car to make some extra revenue.

The ‘extra revenue’ is the entire purpose of a car rental business. So either the rental revenue has been left out in the analysis, or if the losses are used-car sales PLUS rental revenue we have a bleak picture going forward.

Last October, we began to warn people that the market for used cars was about to collapse and as such our clients have reaped large gains. We are still short this market.

Losses in subprime-auto-loan securitizations are poised to break through the record-high levels set following the global financial crisis in 2009. And, as we had been writing about the massive amounts of fraud in auto lending since 2014, we knew this auto credit bust was going to be worse.

We forecast this will undermine the entire structure of auto finance – including the willingness of investors to buy auto loans packaged into securities. These securities, known as auto asset-backed securities (ABSs), are a key funding conduit for subprime auto lenders . . . and car-rental companies.
Most people don’t understand . . . The car-rental business is far more about access to capital and interest rates then it is about car-rental revenue. Why? Because maintaining huge fleets of new cars requires enormous amounts of capital.

In 2015 alone, our two short-sell recommendations – Avis (CAR) and Hertz (HTZ) – spent $25 billion on new cars. Hertz generated $2.7 billion in cash from operations that year. (That’s the car rental revenue) Avis generated $2.5 billion.

So combined, they generated about $5.2 billion in cash in 2015 from renting cars… and then spent $25 billion on new cars.
As you can see, the rental revenues are like a rounding error when compared with the value of the rental fleets. Or, as explained by our Investment Advisory professionals, most of their used-car sales happen in open market auctions. These sales are a critical source of the working capital for rental-car companies. This is why the state of the used-car market can make or break the cash flows for a rental-car business . . . Their success hinges on it.

Right now, used-car prices are at all-time highs. That has been good for business, but that’s going to change as soon as the subprime credit bubble bursts.

These companies make such huge capital investments in their fleets that even relatively small changes to the rate of depreciation in used cars can cause huge problems for their operating results.

In the five years ending 2015, both companies spent $110 billion (yes, billion) on new cars. They only generated $85 billion selling older cars, leaving them with a huge $25 billion funding gap over that period.

The size of these ongoing capital requirements dwarfs every other expense these companies face . . .

Thus, in a very real sense, these companies are highly leveraged bets on used-car prices. Can you imagine sleeping at night if that was your business model?

And, the business is ruthlessly competitive, too. The Internet allows car-rental customers to shop around for the best price automatically using travel websites.

It’s virtually impossible to differentiate the product – at most airports, the major brands even use the same garage facilities.

As a result, these companies can barely generate enough in profits to maintain their access to funding. Hertz and Avis combined produced only $300 million a year in free cash flow during 2010-2015. That’s just barely keeping their heads above water.

Think about it this way: A 1.2% reduction in average used-car prices would eliminate these firms’ free cash flow.

Any further acceleration of used-car depreciation would mean a forced liquidation of their cars… fewer cars mean less revenue… and then further declines in their business. It can quickly lead to a death spiral.

But, that’s not the worst part of the business . . .

The worst part is… the huge rental fleets only exist because of the credit that has been created by the ABS funding market.

And guess what? That lending market shuts down any time used-car prices start tumbling, because the assets backing these loans suddenly aren’t worth what investors thought they would be.

As losses on auto collateral mount, nobody will buy newly issued auto ABSs (asset backed securities). And the funding for the rental-car fleet shuts down or becomes completely unaffordable.

It’s the worst possible situation: Just as these companies need capital the most, it’s no longer available.
That’s what’s happening today…

By the end of 2018, Hertz and Avis face debt maturities that total $25 billion. And don’t forget, they’re also on the hook to buy another $13 billion of new cars from the automakers next year. That’s $38 billion in capital commitments due before the end of next year.

Our bet is that both companies will either try to raise a huge amount of equity to help fund these costs (which would wipe out existing shareholders), or they will simply default on their debts and declare bankruptcy. Either option is very bad for their current investors.

There are a lot of moving parts. It’s confusing. But, realize that the annual profits both firms make from renting cars (about $2.5 billion each in a good year) isn’t enough to afford their huge fleets of cars.

To buy the cars, the firms must leverage their balance sheets by about 80%. As a result, these companies’ earnings are largely determined by used-car prices because their asset base dwarfs their annual earnings.

When used-car prices are firm, these companies can earn cash margins of 3% to 4%. But when used-car prices are weak, their earnings disappear.

As a result of the leverage involved, these firms are far more like “used-car banks” than most investors realize.

We first explained this concept to our clients in 2015 and the risk to rental companies. That’s when first began shorting the subprime-auto-lending market. We helped our institutional clients make around 50% in seven months on a short sell of Santander Consumer USA (SC), the largest subprime auto lender in America.
Olympia Capital Exchange waited patiently for all these troubles to reach the car-rental companies. Our combined short position in Avis and Hertz from last October 2016 has almost reached the same 50% level.
What comes next? It’s not hard to follow the chain of collapsing collateral values. 

First, it wipes out the subprime market. Then, it hits the ABS market, killing the car-rental companies. 

Finally, the reduction in demand for new cars will severely reduce new-car sales, hitting the automakers directly.

We see the decline in consumer auto finance as only being part of a bigger trend – a significant decrease in consumer finance across the board.

Recent weaker-than-expected retail sales reports gives us further information. The U.S. consumer’s access to credit is shrinking. That’s going to lead to much less economic growth; weaker commodity prices and a challenging environment for lenders.  Finally, the Feds recent hike in Rates will only pressure the sector further from the consumer ?nance side AND the carrying costs of auto dealers’ inventories Most investors are going to be blindsided by these changes and the broad impact of a reduction in the availability of consumer credit. Continue to Sell Avis  Continue to Sell Hertz Continue to Sell Santander Consumer USA  And, sell the sector ETFs  Contact your Olympia account representative for detailed advice on this extremely trade.

Contact Olympia Capital Exchange: info@olympiacapitalx.com

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