SII - AUTO: THE FINAL NAIL IN HERTZ'S COFFIN - A FLAWED FLEET DEPRECIATION MIX
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 under-performing 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.