EXECUTIVE SUMMARY In April 2005, Ford announced its intention to investigate possible strategic alternatives for Hertz. At the same time, Ford’s stock price went down significantly. This negative reaction from the market shows Ford’s lack of confidence in its future operation, since Hertz is one of the strongest subsidiaries and revenue sources for Ford. Even though Ford would lose significant value of itself in this transaction, the slump in Ford’s main business especially in North American segment and a possible downgrade of its bond rating forced them to conduct drastic financing strategy to recover itself. The company had two alternatives to rid of Hertz: selling to a private bidding group via LBO transaction and listing on public stock exchange market. Their priority was to acquire the immediate cash through this transaction of Hertz. Our analysis of the LBO offer proposed by Bidding Group yields an expected return of 21.2%, and expected return by the public market to equal 24%.
FORD’S MOTIVATION In 2005, Ford is valuing possibilities of selling its 100% subsidiary of Hertz in the most financially favorable manner. During Jacques Nasser’s presidency, Ford lost its financial stamina. Nasser successfully finalized many deals including Volvo, Land Rover and Hertz, yet this aggressive business expansion and buyout gave Ford a very vulnerable position. As the Ford’s need for cash increase, it began considering the strategic alternatives of selling Hertz privately to private investors and going to a public offering. This dual truck process can increase the bargaining power for Ford in the bidding for Hertz.
FORD’S DUAL-TRACK PROCESS (1) During Jacques Nasser’s presidency, Ford’s cash reserve was quite low and they were looking to unload Hertz in the most financially feasible way. By putting Hertz on the market to privately held bidding groups like Carlyle’s and not just releasing an IPO, Ford created a more flexible and competitive future for Hertz, and increased the bidding price. First, private bidders realize that if Ford is unsatisfied with the offers for Hertz, they will be very likely to list it as a publicly traded security, which will offer them an immediate inflow of cash. Knowing this, each bidder must be aware of what the differences in valuation and incentives for the involved parties will be if Hertz remains private or goes public.
Second, this may also have the affect of Hertz receiving premium bids if those bidding see additional value and synergy in the acquisition. Further, the bidders run the risk of having to pay a significant premium if they still wish to acquire Hertz after an IPO. Based on the logistics of game theory, the bidders who see additional value in Hertz will not risk offering a low price. Instead, to beat out competitors, they will offer their highest price feasible to ensure competitors cannot free-ride on each other’s efforts in valuation. Therein, the dual track process creates a more competitive environment in the bidding for Hertz, which should only help Ford obtain a higher sale price of Hertz.
HERTZ BUSINESS ENVIRONMENT
Rental Car Market Revenues of the US rental car market in 2004 were about $17.4 billion. It is a 5.5% improvement from the previous year. In the US the top three players, Enterprise, Hertz, and Avis, capture more than 60% of market share in the rental car market. This oligopoly market structure can be a barrier for new market entry and gives stable cash flow to the companies. The revenue determiners for the rental car business are: number of transaction, length of each rental, price per rental day, and fleet utilization. Since Hertz is the leading player in the airport segment, volume of air travel is a crucial revenue factor. Additionally, travel volume is expected to increase by 6.9% from 2005. The 9/11-related downturn in enplanement seemed to rebound back, although, off-airport rentals are expected to grow faster pace than airport rentals.
Analysts project that the total US car rental market would continue to grow at approximately 7.4% in 2005. Equipment Rental Market The equipment rental market depends on GDP measures, such as, industrial productivity, and commercial & residential construction. Historically, the market has shown growth of 9.7% and a recent trend of companies renting equipment rather than owning it is expected to continue. The structure of this market is highly competitive, and only few national major players have big roles, RSC, Atlas Copoc Group, and Hertz. Due to the nature of business, concentrated source of revenues, like airport rental for RAC, is impossible and Scale in operation is hard to obtain since customers are widely spread. Unfortunately, price deduction in the business is foreseeable due to the highly competitive market structure.
HERTZ AS AN IDEAL LBO TARGET (2)
There are several characteristics of an “ideal LBO target”; these include: a large asset base, low future capital requirements, potential for process improvements and costs reductions, strong and competitive market position, undervalued, low debt levels, predictable and stable cash flows, and a relatively low enterprise value. An LBO target becomes even more attractive when it can be divided into clear subdivisions, which is conducive to a smoother exit strategy. Analyzing Hertz, it is clear that they mostly conform to this definition of an “ideal LBO target.” Hertz has already established a large asset base of rental vehicles for both car and equipment rental purposes. With this large asset base, future capital requirements are low and fleet replacement is required only when aging cars are pulled out of use and replaced with newer vehicles.
Hertz as a brand is well established and is the dominant player in the airport rental market, further exhibiting its strong market position and attractiveness for LBO purposes. Additionally, Hertz has its two distinct business segments, Hertz Rent a Car (RAC) and Hertz Equipment Rental Company (HERC), which conform to the ideal LBO target in that these subdivisions are both successful and can be used separately in event of a future sale. Additionally, the large resultant interest payments from acquiring so much debt are sustainable given the strong and reliable pro forma cash flows from Hertz. However, Hertz does not conform because of the relatively high CAPEX (future capital) requirements; in fact, CAPEX exceeds equity value in the initial years.
Further, Hertz is not necessarily undervalued as valuations have been determined using reliable and similar market comparables. Overall, from the perspective of the Carlyle Group, whose due diligence has revealed Hertz possess most of the qualities of ideal LBO targets, Hertz is a highly appropriate buyout target. Carlyle Group stands to take advantage of significant operational and financial synergies, including the use of ABS financing through an SPV. VALUE-CREATING OPPORTUNITIES IN THE TRANSACTION (3) From a strategic standpoint, the Carlyle Group (CG) has multiple value-creating opportunities in the Hertz transaction. Operationally, the CG believes post-acquisition that it will be able to: improve EBITDA to industry standards, decrease operating expense growth to match or fall below revenue growth, improve Hertz’s poorly performing off-airport growth strategy, improve RAC’s non-fleet CAPEX as a percentage of sales to competitive levels, reduce the European RAC segment’s SG&A as a percentage of sales to a more competitive standard, and improve capital efficiencies for HERC, which lag significantly behind direct competitors.
The above represent $400 – 600 million in EBITDA savings by 2009. Financing of the buyout is also a value-creating component of the transaction. The CG plans to use Asset-backed securitized debt with a SPV to achieve a more favourable debt rating (from BBB- to AAA) for Hertz. The CG also have an advantage in this respect because they have already made an arrangement with Lehman Brothers and Deutsche Bank to provide ABS debt financing. KEY VALUATION ASSUMPTIONS (4) The Carlyle Group makes a number of key assumptions in projecting forward the impacts of their LBO purchase. Key drivers of their projections are the capital expenditures and depreciation rates.
CG projects the capital expenditures to sales (1.3 for RAC & 1.5 for HERC) and depreciation to sales ratio’s (.24 for RAC & .17 for HERC) from historical average ranges. These assumptions greatly affect the ending market value of equity which in turn determines the return Carlyle obtains from this investment as demonstrated by a sensitivity analysis performed on the assumption (Appendix, Figure 9 and 10). To illustrate, if the actual ratio of capital expenditures to sales decrease 10% for RAC, then the market value of equity increases by more than 50%; similarly, if it increases by 10% then the value decreases by more than 50%. This indicates just how important this assumption is to equity value.
Further adding risk to this assumption is that RAC accounts for 80% of gross EBITDA and therefore commands far greater weight in our model. Key valuation assumption are that growth rate of RAC and HERC are estimated to slow down to 4.6% and 3.0% respectively, as given by the case (Case, Page 9), and a blended average calculated using historical EBITDA contribution is used to arrive at the long-term company growth rate of 4.2% used by the WACC. Other WACC assumptions are sourced in the Appendix (Figure 3). A secondary valuation is performed on Hertz to determine its potential IPO valuation using segment multiples from comparable companies on Pre-LBO pro-forma assumptions (also provided by the case).
VALUATION AND DEAL STRUCTURE (5)
In order to value the company, we perform an Equity Cash Flow analysis. All equity cash available is used to pay down long-term debt, or in our case, increase long term debt by borrowing from Term Loan Facility (8%) due to negative ECF (Appendix, Figure 1). Carried forwards, we are able to obtain an ending debt balance for 2010, which is used in conjunction with an enterprise value obtained using the WACC method to derive the ending market value of equity in Dec 2010 of $6.67 Billion (Appendix, Figure 4). We can bring this back 5.5 years to present value through the schedules shown in Appendix Figure 5 and 6 and arrive at an equity value of $2.4 Billion.
It is important to note that ECF commonly has a downward bias because of (1) its use of promised payments versus expected payments and (2) discount rate applied to equity cash flows is too high due to assumed debt beta of 0. This could be corrected by adding back the value to equity of the option to default – however, this was not explored in our analysis. The offer by the bidding group is being financed almost 85% debt. This high amount of leverage affords the Bidding Group a large interest tax shield. We can derive a tax shield of between $4.2 to $5.2 Billion through the schedule shown in Appendix, Figure 11 and 12. It is important at this point to note that this figure is biased upwards because higher financing and bankruptcy risk born by the high amount of leverage are not factored in to the tax shield.
EXPECTED RETURNS (6,7,8)
Assuming a market value of equity of $6.67 Billion by the end of 2010, the annualized return assuming equity purchase price of either $2.4 Billion or $2.3 Billion is 20.2% and 21.2% respectively over the 5.5 years of investment. These calculations can be viewed in detail in Appendix, Figure 6 and 7. If Carlyle desires a 20% return they can afford to pay roughly $2.43 billion in equity. To further compare the offer, we can compare it to what the company could achieve should they pursue an IPO. Using multiples obtained from the case and comparables, we arrive at a total firm value of $11.2 Billion, or a value that is 25% below the Bidding Group’s current offer (Appendix, Figure 8).
If we compare the market value that Carlyle is offering to purchase Hertz (14.5 Billion) and the market value that the public is willing to pay (11.23 billion, Appendix Figure 8), then we can compute the marginal difference in return on equity. It stands to reason that because the market values the firm much less than management, its return on equity must be considerably higher than that of Carlyle (assuming that Ford will match the efficiency and operational improvements of the Bidding Group). We can observe this by using our ECF ending market value of equity and comparing it to the today’s IPO-assumed value of equity of $2.0 Billion (IPO valuation minus Pre-LBO 2005E debt of $9 Billion given in case). We can calculate that the market-required rate of return is therefore just under 24 % for Hertz through an IPO, which is less attractive in comparison to the Bidding Group’s required return on equity of 21.2%.