Hertz - The Final Nail In The Coffin

Authored by Daniel Ruiz via Blinders Off blog,

As a disciplinarian in the automotive sector, my focal point is concentrated on the study of used vehicle values and how they affect the automotive industry as a whole.

Measure the Cause to Predict the Effect

There are several subcategories that help predict the trajectory of used vehicle values that I use as leading indicators. For example, there is a very strong correlation between the performance of Hertz stock and used vehicle values. In June, while the stock was trading at multi-year lows due to excessive pessimism, I witnessed used vehicle values begin to stabilize. I also noticed the amount of vehicles available from Hertz at auction fall drastically. These events made me believe that a strategy change was at hand. Was Hertz reducing the size of their fleet as they have in the past during difficult times? Would Hertz focus on better utilization rates and other cost saving measures? My suspicions proved to be correct. The benefits of stabilizing used vehicle values plus fleet management changes will likely be felt through the end of Q3.

The reduced volume of rental vehicles at auction has supported higher used vehicle values. Additionally, falling new vehicle retail sales increase the demand for used vehicles. Fewer new vehicle sales result in fewer used vehicle trades forcing dealers to acquire more used inventory at wholesale auctions.

However, I believe the factors currently supporting used vehicle values are transitory, and we should consider what comes next.

Poor Residual Performance Prompts A Change In Fleet Mix

Base trim levels and underperforming passenger vehicle values were identified by Hertz as part of the reason for the excessive per unit monthly depreciation levels experienced in Q1 and Q2 of 2017. The fix? Purchase vehicles with more options, reduce the amount of compact cars and add more SUVs.

This is where it all goes wrong. Higher trim levels are accompanied by higher cost. Assuming that the added cost will be recuperated when the vehicles are retired should not be expected. This is because added options do not depreciate at the same pace as the base value of a vehicle. To use a simple example, a navigation system with an added cost of $2,000 in a new vehicle will only add about $500 of additional wholesale value. The same applies for upgraded stereos, sunroofs, etc. However, the available wholesale and retail supply of a vehicle in a specific trim level is more important than the trim level itself. As the concentration of any vehicle in a specific trim level grows, it will experience pricing pressure. To date, the damage done by Hertz and other rental companies when vehicles are retired en masse has been limited entry level vehicles. When higher value assets experience pricing pressure, they put pricing pressure on all related lower value assets. When these higher trim level vehicles are retired, more pricing pressure will be felt in the used vehicle market because in essence, Hertz has taken one step up on the asset value ladder.

Higher trim levels were not the only change to the fleet. Hertz, like many others experiencing the accelerated depreciation in passenger vehicles, has chosen to seek the safety of the better performing SUV segment. The compact car portion of the fleet was reduced by 5% and replaced with more expensive SUVs. The timing of this decision could not be worse. I have been very vocal about the misconception that the truck and SUV market is healthy. Trucks and SUVs are in a different cycle than passenger cars, but the values have already peaked and will continue to fall for the next 2 to 3 years. SUVs are more expensive than passenger cars, so the losses will be greater.

We’ve Been Here Before

During the 2008 and 2009, Hertz faced a very depressed used vehicle market. In response to the difficult market conditions, they decided to reduce their fleet size and keep the vehicles longer as stated in this New York Times article. During this difficult time, the peak depreciation per unit reached $332 (2009).

In Q1 of 2017, Hertz reported a depreciation rate per unit of $348 and the most recently, a depreciation rate of $353 for Q2.

In response to the rising per unit cost due to weakening used vehicle values, Hertz has decided to reduce the size of its fleet once again.

More importantly, Hertz has committed to only half of the new vehicle purchases thought to be necessary in 2018 as they cautiously measure the demand and the strength of the used vehicle market going forward. If used vehicle values continue to fall (as I fully expect they will), a very similar scenario to 2009 is possible allowing new vehicle sales into rental to fall drastically.

This has very negative implications for manufacturing when you consider that new vehicle sales into rental represented a little more than 1.8 million units in 2016.

The last time this happened for Hertz the story had a happy ending. The peak of monthly depreciation per unit in 2009 also marked the bottom of the stock price declines.

This was largely due to used vehicle values rebounding strongly which provided them with a seller’s market when their aging fleet needed to be retired.

What’s Different This Time?

Unlike 2009 when the US government intervened with Cash for Clunkers and the lowest interest rates in history, I don’t foresee a catalyst that will boost or even stabilize used vehicle values for the next 2-3 years. Most important of all, in 2009, when the depreciation for rental vehicles was at its peak, new vehicle sales had been declining for three years: A used vehicle is little more than a new vehicle that is sold then driven just beyond the curb. Weak new vehicle sales for a prolonged period of time created a shortage of late model vehicles with low mileage.

Last year was a record setting year for new vehicle sales. We have not experienced a sufficient decline in new vehicle sales which will be necessary to balance the supply of used vehicles. Similar to the 2008 period, I expect that Hertz will have to keep their current fleet longer than expected due to further used vehicle value declines. However, a fleet can only be allowed to age for so long due to higher wear and tear costs like tire and brake replacement. In conclusion, Hertz has surpassed the previous peak in per unit depreciation and now has to weather a 2 plus year declining used vehicle value storm with a more expensive mix of vehicles.

The greatest challenge for Hertz is not behind, it lies ahead, and it’s one that they may not be able to survive this time.

Chinese Corporate Financials Continue Disturbing Trend Of Deterioration

Authored by Bryce Coward via Knowledge Leaders Capital blog,

Highlighting the deteriorating trend in Chinese corporate financials has been an annual feature our of this blog. This year, instead of looking at just the CSI 300 constituents, we chose to broaden our universe by using the FTSE All A Share Index, an index of about 2000 Chinese A shares. This should give us the most accurate read on the state of corporate China.

For at least the last decade Chinese corporations have levered up, both through debt and working capital, in an attempt to keep the music playing and without regard to stability or profitability. As we will see, 2016 was no different. As an aside, all of the data in this post show aggregated (summed up) metrics for all non-financial companies. For example, sales growth numbers show the sum total of 2016 non-financial constituent sales relative to the sum total of 2015 non-financial constituent sales. Aggregating the data in this way gives us a good top down view without having to control for outlier companies that may be small and irrelevant.

Starting with the balance sheet, one constant characteristic of Chinese corporate behavior has been their willingness to lever up. There are a number of ways to measure leverage, but one of our favorites is net debt as a percent of equity. From 2005-2016 net debt as a percent of equity increased 126%. From 2015-2016 along it increased by 13% to 143%, the highest on record. Meanwhile debt as a percent of capital ticked up again to 63% in 2016 – also the highest reading on record – while cash as a percent of total capital fell to its lowest ever reading of 9%. Luckily, financial leverage (assets relative to equity) remained constant at an egregiously high 6.9x.

Moving on to some ratios of working capital metrics as a percent of sales, we can see that 2016 was just a continuation of an alarming decade-long trend of Chinese companies gutting corporate efficiency to finance sales. From 2005-2016 accounts receivable as a percent of sales has increased 173%, accounts payable as a percent of sales has increased 73% and inventory as a percent of sales has increased 86%. All three metrics increased to an all-time high in 2016.

Building up one’s working capital could be a strategy to manage exploding top line growth, but unfortunately that is not the case for Chinese companies. Sales and net income haven’t grown since 2014 and net income actually contracted in 2016. Cash flow from operations also fell 18% for the largest year-on-year contraction since at least 2006. Plunging cash flow is an indication that the earnings decline of 1% could be painting too rosy a picture.

This brings us to something we like to call Chinese channel stuffing – or the tendency of corporate China to stuff the supply chain with accounts receivable and accounts payable so as to keep sales/sales growth at the desired level. Since 2012 both current liabilities and current assets have outpaced sales growth by between 2%-10% annually. In 2016 both metrics outpaced sales growth by 6%. This is to say, in order for corporate China in aggregate to have generated flat sales in 2016, they needed to grow working capital by 6%. In order for corporate China to have generated flat sales for two consecutive years they needed to grow working capital by a cumulative 16%.

The good thing is that, if you can believe the earnings and cash flow numbers, margins have remained relatively healthy. Net profit margins have remained at the historical average of 8% while cash flow margins stood at a robust 27% in 2017.

But, flat margins and growing balance sheets make for deteriorating profitability stats. In 2016 ROE dropped to an all-time low of 9%, ROA dropped to 5% and ROIC dropped to an all-time low of 4%.

There unfortunately are not a lot of positive things to say about the trends in corporate China. Much of the above is of course driven by SOEs at the behest of the government, but that doesn’t make the trends look any better. No one knows what the tipping point is and how long this can continue, but it goes without saying that we’d like to see these firms align the growth of their balance sheets to the growth of their income statements as soon as possible.