Add Some Zip to Your Portfolio

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

The rental car business continues to be fertile ground for consolidation activity, despite already high levels of concentration.  On December 21, industry giant Avis Budget Group (NASDAQ: CAR) agreed to buy car-sharing startup Zipcar (UNKNOWN: ZIP.DL2) for $511 million or $12.25 per share in cash, a 42% gain from the prevailing price.  This acquisition comes just months after Hertz (NYSE: HTZ) completed its acquisition of the Dollar Thrifty chain for $2.3 billion in cash.  Despite its management’s general dislike of the car-sharing concept, Avis realized that customer demand for the service has reached critical mass, especially in urban areas and on college campuses.

What’s the Value?

Founded in 2000, Zipcar has 760,000 members in 20 U.S. metro markets and on 300 college campuses.  It has also pursued international expansion through the acquisition channel, including purchases of Streetcar in 2010 and Avancar in 2012.  The company’s members pay a daily or hourly rate for use of its vehicles, which includes gas, insurance, and other costs.  The service is invaluable to urban dwellers and college kids whose periodic needs and living restrictions don’t necessitate having a full-time vehicle.

Zipcar has grown very fast over the past few years, with a current fleet of over 10,000 vehicles and locations across the U.S.  In its latest fiscal year, the company reported revenues and adjusted EBITDA of $241.6 million and $10.9 million, increases of 29.9% and 158.5%, respectively, versus the prior year.  While an annual operating profit has remained elusive, Zipcar generated $35.0 million in operating cash flow that it has used to bolster its financial position and reinvest in its fleet.  The company’s improving finances have also allowed it to switch from leasing to purchasing its vehicles, which has reduced costs and led to the highest gross margins in its short history.

In FY2012, Zipcar’s results have continued to improve, with increases in revenues and adjusted EBITDA of 16.5% and 98.1%, respectively, compared to the prior year period.  Operating margins have increased again due to the larger operating footprint, as well as a strong resale market for late model used cars.  In addition, the company has switched its focus from daily rentals to hourly rentals, which has improved operating efficiency although it reduced average revenue per member.  Despite Zipcar’s first-mover advantage, competition in the segment is quickly increasing, as both Hertz and Enterprise are positioning their fleets for short term rental activity.  Obviously, Avis did the math and calculated that buying Zipcar’s network and brand was preferable to building its own network from scratch.

Looking Ahead

How should investors participate in the growth of the rental car industry?  Since size is a necessary requirement for sustained profitability and low financing costs, investors need to think big.  A good starting point would be Avis, one of the three industry giants and the beneficiary of the merger with Zipcar.  As discussed by management on their recent conference call, the business combination should lead to better utilization of their fleet, since peak use for car-sharing occurs on weekends and peak use for traditional renting occurs on weekdays.  The net result should be improved profitability for the merged entity.

Avis’ results have improved in FY2012, with increases in revenues and operating income of 32.6% and 53.8%, respectively, compared to the prior year period.  Despite flat pricing and weakness in its European markets, the company benefited from 5% growth in North American transactions and sales of ancillary services.  In addition, the strong vehicle resale market lowered depreciation charges and led to a 10% decline in per-unit fleet costs.  Avis’ merger with Avis Europe at the end of 2011 should enhance the organization’s efficiency going forward and generate operating leverage with expected future growth of global travel.

Alternatively, investors could take a look at Hertz, which brings added diversification from its equipment rental and fleet management businesses.  In FY2012, the #2 car rental company has reported increases in revenues and operating income of 6.7% and 112.1%, respectively, versus the prior year period.  While Hertz’s car rental revenue growth has been in line with the industry average, its equipment rental revenue increased 12.0% due to a higher level of activity in industrial, construction, and entertainment markets.  The company’s margins have benefited from similar industry trends, including improving domestic travel activity and high vehicle resale prices.  Despite taking on some additional debt in the merger with Dollar Thrifty, cost savings from combining back office operations and overlapping branches should result in a more profitable company.

The Bottom Line

The three industry giants control over 90% of the domestic car rental market, which will increase slightly after the close of this transaction.  While the merger of Avis and Dollar Thrifty was probably bad for consumers, it will likely lead to improved pricing and profitability for the industry.  Avis has taken the lead in the car-sharing segment with this acquisition and stands to benefit from rising consumer demand for short term rentals.  Investors should catch a ride with this industry leader.

rghanley has no position in any stocks mentioned. The Motley Fool recommends Zipcar. The Motley Fool owns shares of Hertz Global Holdings, Inc. and 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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