Published: July 13, 2010

"We Try Harder."

That's the motto from Avis Budget (NYSE: CAR), and indeed they do try harder. Avis just reiterated plans to outbid rival Hertz (NYSE: HTZ) to win the rights to buy Dollar Thrifty (NYSE: DTG). Yet even though the deal would make great sense for Avis if it prevails, shed no tears for Hertz, which stands to greatly benefit from losing this bidding war.

Investors initially applauded the sound of a Hertz and Dollar marriage, pushing Hertz's shares up +14% to $14.69 when the deal was announced on April 26. Since then, shares have drifted steadily lower, and now trade for around $10. In fact, they are more than -20% below levels seen before the deal was announced. Blame it on broader market weakness as well as concerns that the European economies will slump later this year.

But investors may be missing the point. This is just another step in a long phase of industry consolidation that benefits both Hertz and Avis equally, regardless of which party buys Dollar Thrifty.

If you flew into any major airport five years ago, you would have found the same six rental car counters: Hertz, Avis, Dollar, Thrifty, Enterprise and Budget. Those firms were once all separately owned, but in recent years, the industry's also-rans joined forces to battle with industry leader Hertz.

As a result, three publicly traded companies now exist: Hertz, Avis Budget and Dollar Thrifty. (Enterprise remains privately controlled by the St. Louis-based family of Andrew Taylor). The trouble with so many rental car choices is that the major players have no pricing power. If one counter is a few dollars cheaper, it will steal away business.

Yet as the industry consolidated, it made less sense for Avis to operate both an Avis and a Budget counter. Or for Dollar to man both a Dollar and a Thrifty Rent a Car counter. Once the outcome of the Dollar Thrifty buyout battle is concluded, you can look for additional Dollar Thrifty counters to close.

And fewer rental car counters means fewer consumer choices. The major players have already done a solid job of cutting their fleet sizes in order to limit supply and boost rates. A deal to acquire Dollar Thrifty -- by either Hertz or Avis -- would simply strengthen that trend. And in this industry, pricing is the name of the game.

For example, when the supply of rental cars was in line with demand in 2007, Hertz generated 46% gross margins. But weakening demand for rental cars in the last few years led to price wars which pushed gross margins back to 41%. Goldman Sachs anticipates that gross margins will climb back to 45% by 2012, in part to more rational industry pricing as fewer rental cars are available.

Even in the absence of an acquisition of Dollar, Hertz is clearly seeing the benefits of a stable economy. Sales are expected to rise about +7% this year, due to slightly higher rental volumes and slightly higher rental car pricing. Profits should rebound more than +50% from last year. Another modest +5% sales gain next year should still boost earnings per share by more than +60% to around $0.75. Goldman Sachs believes that EPS could exceed $1 by 2012, with modest sales growth assumptions. If Hertz indeed prevails in this buyout battle, the accretive deal would boost those forecasts even higher.

The extreme earnings leverage is due to the fact that Hertz carries more than $12 billion in debt, and its equity base is valued at just $4 billion. Debt service costs stay fixed, so earnings growth is magnified on moderately higher EBITDA.

To be sure, whoever wins the tussle can likely boast of compelling returns on their investment. Avis figures it saved $100 million in annual operating expenses when it bought Budget. And Hertz stated in late April that a buyout of Dollar Thrifty would yield $180 million in annual savings.

A Stretched Balance Sheet

But the deal is a financial stretch for Avis. Hertz offered $1.2 billion, though Dollar Thrifty is currently valued at $1.3 billion in anticipation of a bidding war. Dollar Thrifty has said that Avis' offer will need to be "substantially higher" than the offer from Hertz. But Avis has just $770 million in unused borrowing capacity and $470 million in cash). That adds up to $1.34 billion, meaning Avis will need to borrow yet more, and then watch expenses like a hawk if it offers closer to $1.4 billion, as some suspect.
Hertz, meanwhile, has ample liquidity, thanks to recent financing moves.

Action to Take --> It's not clear which bidder will prevail. The deal makes great sense for Hertz, less so for Avis. If the economy strengthens from here, both firms stand to benefit from a deal being done with either party as industry pricing firms. Yet if the economy cools, then Avis might run into financial distress. Stick with Hertz, which offers lower risk and a still-high reward..

-- David Sterman
Staff Writer
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