Has Zipcar been Unzipped?
Erik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Let's face it, America is a lousy place to start a car-sharing company.
Most of the country's cities were built out of farm towns after the automobile was invented and thus are designed specifically to cater to door-to-door transportation. They sprawl in low density over multiple counties rendering public transit hopelessly expensive and ineffective. Car ownership is not an option; it is essential to the vast majority of residents.
So I'm impressed with what Zipcar (NASDAQ: ZIP) has achieved so far; but the Market is most certainly not, having steadily battered the stock price from its IPO of $28 to its current low of just under $8, with every sign of sliding lower.
The Source of Pessimism
The Market is unhappy with two things: Membership growth is declining faster than anticipated; and competitors are arriving on the scene.
At the current low share price, however, Zipcar's membership growth is unimportant. Yes, you read that right, and I'll shortly explain why.
The arrival of competition is both good and bad. It's good in that others believe there is money to be made, which validates Zipcar's claim; but it's bad in that it can erode everyone's profits and hand all the value to customers and suppliers.
Hertz (NYSE: HTZ) placed 500 cars in New York City to compete head to head with Zipcar, but soon backed off on their expansion plans. Not to be left out, Enterprise Holdings and U‑Haul have also opened for car-sharing business in major cities, but do you hear anything substantial? I haven't. They are discovering what Avis (NASDAQ: CAR), the only major yet to enter the fray, suspected: Starting a car-sharing business will drain alot of cash that can be put to more immediately profitable uses in their primary business.
Zipcar CEO Scott Griffith summed up the competition's dilemma when he remarked that while the barrier to entry is low, the barrier to profitability is very high. His implication is that Zipcar has done 10 years of homework that will be very costly for a new entrant to replicate, especially with first-mover Zipcar constantly on their back.
To examine which view is correct - the Market's belief that Zipcar has a failed business model, or the CEO's belief that Zipcar is a buying opportunity for the long haul - let’s look at how the money flows through this company to ascertain just how profitable they could become. Over time the share price will follow that profitability.
Forget Growth; It's the Cost Structure that Matters!
As a currently unprofitable company that is throwing all of its resources into expansion, I initially struggled to determine how profitable they could be once they achieved major market penetration and throttled back on the expansion. Then I discovered the golden motherlode.
In Zipcar's most recent conference call, Griffith spoke explicitly of their "target cost structure." This is how much they intend to spend on each expense category listed in the Income Statement of their financial reports. The table below compares their costs today, as a fraction of revenue ("margins") with Griffith's goals.
As you can see, they have a ways to go to achieve their goal, but we can use it as a best-case outcome. If the CEO had confidence they could do better, you can bet he would be hawking that to Wall Street analysts today. The beauty of the target costs is that they allow us to assess a fair stock price for the company were they to halt all growth and morph into those target costs. This tells us what the company is worth, at its current size, without having to guess at – or pay for – how fast or how profitably they can grow in the future.
There is a wonderfully simple equation for calculating fair value for exactly this scenario, that of a static company churning out cash in perpetuity, called the Earnings Power Value (EPV). In a nutshell, EPV estimates how much free cash flow a company accrues each year if it reinvests only as much cash as is required to operate without either growing or declining. The key inputs are the cost margins (I used the CEO's target), the tax rate (I used 35%), the "maintenance" capital expense (I used 80% of the 2011 capex), and the weighted average cost of capital from both equity and debt (I used 9%).
Zipcar’s no-growth fair-valued share price is (drumroll please...) $10.77!
Keep in mind that last Friday’s (Aug. 7) closing price was $7.84! It says that Zipcar is on sale today, if it can achieve the CEO’s target cost structure (always keep your caveats in mind when valuing your companies).
But Zipcar is not a static company, and its profits are stacked well into the future; so we next want to evaluate a few growth scenarios.
Will Zipcar's Growth Reward Shareholders?
Though its growth has slowed faster than anticipated, Zipcar still continues to grow at a healthy clip. The next step in our valuation is to sum all the cash flowing into the company as it grows, and as it moves toward its target cost structure.
To get at its fair value across a range of future outcomes, I crafted a discounted cash flow (DCF) model with three different scenarios equating to good, average, and bad outcomes. The only two things I changed between each scenario is how successfully the company achieves the CEO's cost target over the next ten years, moving steadily from today's margins to the target margins; and how quickly the revenue growth rate decelerates from the 25% year-over-year of 2011 down to a mere 2% per year by 2021. For the discount rate I used 11%, which is higher than the static case above to account for the extra risk in growth projections.
The results hammer home my thesis: Zipcar's value is not in its growth rate, but rather in how successfully they achieve their target cost structure. The table below illustrates this with the fair value share price for each of the three scenarios (the price which would net you 11% annual returns), and the resulting annualized returns over the next 10 years if you bought at last Friday's $7.84 share price.
It's a Bargain, but Remember Your Caveats!
If you believe that Zipcar can achieve more than half of the CEO's target cost structure, then Zipcar is a buying opportunity no matter how you slice it; and even at only half the target it provides respectable returns on your investment. That "Big If" depends on good execution as they expand internationally, leveraging their first-mover advantage to leave competitors in their wake or to outright buy them, and partnering with complementary business models (such as peer-to-peer car sharing). So far they are doing all these things, so even today's slowing growth rate is plenty good at this share price for those who know what to monitor at Zipcar through the years: its cost margins.
As the saying goes, "Any company becomes a bargain at a low enough share price." Zipcar is looking mighty ripe for bargain hunters.
FoolishErik owns shares of Zipcar (ZIP).. 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. If you have questions about this post or the Fool’s blog network, click here for information.
