Can Zipcar Become Profitable?

By Shawn Robinson - December 27, 2011 | Tickers: CSTR, HTZ, ZIP | 0 Comments

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Zipcar (NASDAQ: ZIP) operates a car sharing business in 16 major cities and over 250 college campuses that is growing rapidly. The service is popular among college students and those living in dense metropolitan areas as it offers a convenient way of accessing a vehicle without the hassle of ownership. Even with 65% annual growth in members over the last five years, consistent profitability has been elusive for the 11 year old company as acquisitions and investments for growth have been the priority for management.

Can Zipcar be profitable in the long run?

It’s a question that investors have been asking since the initial public offering this past May. For businesses that operate in existing industries with known profit margins, it’s easier to forecast profitability because you can assume industry average profit margins. It’s more difficult to evaluate businesses that operate in new industries as comparison models don’t exist. Investors believing that Zipcar’s model is similar to established rental car companies like Enterprise Rent-A-Car or Hertz (NYSE: HTZ) are off to a good start. But with their many physical locations, the traditional car companies spend more in overhead compared to the parking spots and iphone apps used by Zipcar to provide similar services.

How do investors figure out margin potential for Zipcar?

Conveniently enough, in a presentation on December 1st at the JPMorgan Smid Cap Conference (smid = small/medium cap), Zipcar CFO Ed Goldfinger noted that they believe the business can have long term adjusted EBITDA margins of 19%. For those who aren’t familiar with the concept of EBITDA, this tutorial from the Motley Fool should be helpful.

Here is how Zipcar’s management envisions the EBITDA margin growing to 19% over time.

Examining the table above, the three main drivers management envisions toward high profitability are;

• Increasing fee based revenue as a percent of total revenue
• Lowering fleet operation costs
• Lowering selling general and administration costs (SG&A).

Are management’s assumptions realistic?

Increasing fee based revenues

Fee based revenues models typically have higher operating margins than variable revenues as they provide more visibility into future cash flows creating higher returns on investments. The growth in fee based revenues as a percent of total revenues should occur as the company gains momentum in programs with universities and governmental agencies that likely want the predictability of fixed fees.

Fleet operation costs

Fleet operation costs will likely be the most difficult for management to control as it relies on volatile items like fuel, maintenance & automobile financing. Management has done a nice job lowering the cost of this line item since 2008:

The main driver of the lower fleet operation cost was the implementation of an Asset Backed Securitzation (ABS) program in May 2010. You can notice the drop in fleet operational costs when you look at the quarterly results from Q309 to the most recent quarter.

Investors can expect modest decreases in financing costs as the ABS program becomes fully implemented and brought to scale. However, the non financial fleet operations costs will become more difficult to lower. Over the next few years, fuel costs are expected to rise or at least be maintained at current levels. Management could implement some type of fuel service fee to partially offset the charges, which carries its own operational risk.

SG&A

Selling, General and Administrative costs should decrease as economies of scale in the business ramp up. Management has already had some success in the past maintaining these costs as a percentage of revenue but needs to monitor these costs closely going forward.

Investors can turn to Coinstar (NASDAQ: CSTR) as a proxy. The operator of the ubiquitous RedBox DVD kiosks, which has a similar business model to Zipcar, reports SG&A as a percent of revenue at about 11%. This should give comfort that the Zipcar management can bring the SG&A costs down to around 14%.

Potential valuation

It’s important to note that there are a lot of variables involved in hitting the margin expansion targets demonstrated by management. A conservative assumption is to assume they can do half of the EBITDA margin target. Let’s also assume that the ITDA part of EBITDA further cuts the margin percentage in half leaving net profit margins at roughly 5%. I am not sure when management feels they can reach this target profit but let’s make our final assumption of estimated annual revenue at $300 million. Given a 5% profit margin, Zipcar is trading at future potential price to earnings ratio of 42. Not the best valuation but given the number of conservative assumptions in my estimate, the valuation could end up being a lot more appealing.

Profitability continues to remain a concern but if management can reign in expenses and grow the business Zipcar will be a great long term investment.

Do you think Zipcar will be able to be consistently profitable? Share your comments below!

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