Why Buying a Rental Company Makes a Great Investment

Adam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

What do you do when one of your biggest competitors outbids you to acquire a smaller company and leapfrog over you in terms of market share? Avis (NASDAQ: CAR) experienced this situation last year, when Hertz (NYSE: HTZ) bought out Dollar Thrifty to consolidate the car rental market to three main competitors. True to form, Avis just had to “try harder” and found an opportunity to compete with a $491 million acquisition of Zipcar (UNKNOWN: ZIP.DL2).

0 to 60 in 3 Months

The deal between Avis and Zipcar is expected to close in the spring this year, at which time Avis will become the owner of the most popular car sharing business in the world. Hertz and market leader Enterprise already offer their versions of Zipcar with Hertz on Demand and Enterprise CarShare. Both companies are creating some headwinds for Zipcar with added benefits like one-way rentals and no annual fees. However, Zipcar continues to grow despite these disruptive actions.

By acquiring Zipcar, Avis is taking the catbird seat with a well-established brand in a quickly growing market. Car sharing is especially popular among young drivers, and Zipcar’s focus on putting their service near college campuses has made them the brand of choice for that demographic. Zipcar’s membership rose 18% in the last year from about 650,000 to 767,000, leading to a 15% increase in revenue year-over-year in the most recent quarter.

Avis has the opportunity to leverage its relationships with car manufacturers to improve Zipcar’s service. Most people cite that Avis can use its fleet of vehicles to fill the greater demand of weekend drivers who use Zipcar. That’s simply the tip of the iceberg.

While Zipcar owns 11,000 vehicles, Avis buys tens of thousands of cars every year. As a result, the company gets steep discounts on its bulk purchases. In fact, the big car rental companies are actually able to make a bit of profit when they sell used cars. With lower costs, Avis will be able to grow Zipcar more quickly and more profitably. Alternatively, the company could lower rates and fees to compete with Hertz’s no-fee model.

Strong synergies like these make the acquisition a great opportunity for both companies. Investors agree having sent shares of Avis up 5% the morning of the announcement. Yet, Avis officials said they don’t expect the deal to be accretive until its second year. With the stock now nearly double the price it was a year ago, does Avis make a good investment?

Buy or Rent?

The car rental industry has done very well as of late. Rates are increasing with consolidation along with fleet destruction from Hurricane Sandy. Zipcar is a company that could have caused disruption for the traditional rental car rates. Now, under the thumb of one of the major players in the industry, any disruption from Zipcar will likely benefit Avis’ bottom line.

Avis grew sales at an estimated 24% in 2012, leading to an estimated earnings growth of nearly 50% over 2011. While paying cash for the Zipcar acquisition, will surely depress its earnings growth, I expect revenues to continue growing at a rate in the high single digits based on increased rental rates and a higher number of rentals. Add to that the growth in Zipcar over the next year, and Avis will likely post modest earnings growth. In the long run, analysts expect Avis to continue growing earnings near 25% over the next 5 years (before the Zipcar acquisition). With a forward PE of just over 8, this gives Avis a fantastic PEG ratio of 0.33.

Hertz, however, looks equally tempting for investors. Having consistently beat analysts’ estimates, and posting great growth numbers since the U.S. began recovering from the recession, the company has benefited from the consolidation in the market as well. Earnings growth is expected to come in at over 37% for 2012 compared to 2011, and that growth is expected to continue over the next five years. The company is priced for such astounding growth, but still presents a good value at just over 12 times forward earnings, resulting in a similar PEG to Avis.

Still, if investing in only one company, I’ll take a chance on Avis. With the acquisition of Zipcar, the company has the opportunity to take profits to another level. Zipcar appeared to be marginally profitable in 2012, and with Avis’ pricing power, those margins are bound to improve significantly after the deal finalizes and the synergies are complete.

Of course, that recommendation is based on the deal finalizing in the spring. It’s not out of the realm of possibilities that Hertz disrupt the deal by making a bid of its own. A bid from Hertz could certainly hurt Avis’ stock, but the company and industry look good nonetheless. For investors looking to take less risk, Hertz may be the way to go.

adamlevy has no positions in the stocks mentioned above. The Motley Fool owns shares of Hertz Global Holdings and Zipcar. Motley Fool newsletter services recommend Zipcar. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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