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Hertz Is a Bargain

August 23, 2012 | About:
Hertz (HTZ) is the one of the largest rental car companies in the U.S. The company also operates an equipment rental business. Hertz reported strong results in second quarter 2012, with 6.8% car rental revenue growth and 11% equipment rental growth.

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(click to enlarge)

* Q2 2012 slideshow here.

Hertz currently trades at $12.40 per share, having reached a low of $1.55 per share during the financial crisis of 2008.

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HTZ data by YCharts.

Let's take a look at the recent financial results.

(In Million $)200920102011
Revenue$7,101$7,562$8,298
Operating Cash Flow$1,693$2,208$2,233
Capital Expenditure$-101$-180$-282
Free Cash Flow$1,592$2,029$1,951


Revenue has been growing consistently since 2009 and free cash flow for the past two years has been roughly $2 billion dollars.

Owner Earnings

Owner Earnings is a better measure for valuation purposes than free cash flow. Warren Buffett defines Owner Earnings as follows:

These represent (1) reported earnings plus (2) depreciation, depletion, amortization, and certain other non-cash charges... less (3) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume... Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since (3) must be a guess - and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes.

I'll calculate owner earnings by taking the net income and adding adding back various non-cash items, such as depreciation, and then a reasonable estimate for capital expenditures. I'll also add interest payments adjusted for taxes since interest is tax deductible.

(In Million $)200920102011
Net income$-112$-32$195
Depreciation & amortization$2,075$2,008$2,037
Amortization of debt discount/premium and issuance costs$171$182$130
Investment/asset impairment charges$0$0$0
Stock based compensation$35$36$31
Other non-cash items$12$45$-27
Interest Payments$680$773$699
Capital Expenditure$-300$-300$-300
Owner Earnings$2,327$2,715$2,490


Owner earnings smooth out capital expenditures and provide a clearer picture of the profitability of the company. Let's use the owner earnings figures to determine Hertz's cash return on invested capital, or CROIC. This is the cash return generated by the company on invested capital, and is simply the owner earnings divided by the total invested capital. This is a better measure than ROIC because ROIC relies on earnings, which is a poor measure of profitability.

2008200920102011
$3,104$2,327$2,715$2,490
$16,451$16,002$17,344$17,673
18.87%14.54%15.65%14.09%


Hertz has maintained a CROIC of around 14% over the past three years, which is quite high. This means than any reinvested capital will return 14%. Generally the company should grow at roughly the value of the CROIC. Let's take a look at the most recent balance sheet.

Cash and Cash Equivalents$594
Investments$0
Debt$11,425
Pension Obligations$0
Minority Interest$0
Net Cash (Debt)$-10,832
Diluted Float440
Cash/Share$-24.57


No matter how you slice it, Hertz has a large amount of debt. However, interest payments are only 28% of owner earnings, which is not high enough to be a real concern. Hertz's strong cash flow should allow the company to maintain these levels of debt.

Valuation

I use a discounted cash flow analysis to estimate the fair value of Hertz. I use a discount rate of 15%, which is my required rate of return. I will assume that Hertz's owner earnings will only grow at the rate of inflation, which I will assume to be 3%. This is a highly pessimistic calculation, but it shows just how undervalued Hertz truly is. Using the above parameters I arrive at a fair value estimate of $23.90 per share. Below is a list of buy targets for various margins of safety.

Margin of SafetyBuy Target
10%$21.52
15%$20.33
20%$19.13
25%$17.94


Conclusion

Hertz is a dramatically undervalued company, with extremely strong cash flow, and is trading at an enormous discount to a pessimistic estimate of the fair value. The amount of debt is a concern, but the cash flow covers the interest payments with plenty of room to spare. Hertz is a company that should be on any value investor's radar.

About the author:

Bargain Bin
I am a physicist who subscribes to the teachings of Benjamin Graham to buy stocks at a significant discount to thier intrinsic value.

Visit Bargain Bin's Website


Rating: 2.7/5 (10 votes)

Comments

pravchaw
Pravchaw premium member - 2 years ago
Have you further analyzed the debt. I notice Z score is quite low. Could the company go bankrupt in a recessionary environment?

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