Bidding for Hertz: Leveraged Buyout

Bidding for Hertz: Leveraged Buyout

Hertz was established in 1918 by Walter L. Jacobs as a modest car rental operation. Since
its inception, the company has been bought out by Yellow Cab (1923), GM (1926), Omnibus
(1953), RCA (1967), and Ford (1987). Since 2001, Hertz has become an independent wholly
owned subsidiary of Ford Motor Company. The company has grown quite steadily since
those early days and has achieved positive pre tax profits each year during 1967. Most
recently, revenues have grown at any annual growth rate of 7.6%, with positive growth rates
in 18/20 years. Hertz business was currently organized into two distinct segments; Hertz
Rent A Car (RAC) and Hertz Equipment Rental Company (HERC). RAC constitutes 81% of
company revenues, while HERC produces 19% for the company, with operations in 145
countries worldwide. Hertzs current CEO was Craig Koch. The management team at Hertz
were not very involved and were not incentivized through compensation to excel.

The US car rental market constitutes of the global car rental industry market. The top
three competitors in the industry (Enterprise Rent-A-Car, Hertz, and Avis Rent a Car),
provide 68% of the revenue within the industry. RAC led the airport car rental market ahead
of its competitors and produce 79% of RACs revenues from this segment. However, there
are risks associated with such high airport car rental revenues, as this led the business
being directly influenced by domestic and international air travel. Air travel is a luxury
expense for most, so when economic downturns occur, as well as low gas prices or terrorist
attacks, the RAC airport revenue is directly influenced.

The North American Equipment rental market was worth $25 Billion, while those
internationally in Spain and France were $4 and $2 Billion respectively. However, because
only certain types of equipment were offered by Hertz, the market in North America was
significantly smaller. Growth rates for the Equipment Rental Industry suggest an average of
9.7%. The market was highly fragmented with only a few national competitors: in order of
highest market share RSC Equipment Rentals, United Rentals, and Hertz. Risks associated
with the Equipment Rental Market, were that customers were widely scattered throughout
the company, bringing local competitors into the mix. Furthermore, the equipment rental
business was highly competitive and rental prices are highly susceptible to downturns in the
economy.

Ford Motor Company was following the tumultuous reign of Jacques Nasser in which $14
Billion of the companys reserves were spent on acquisitions to turn the company into a
leading consumer company. Bill Ford Jr. assumed the role of new CEO in 2001, and by mid
2002 the company was losing $190/vehicle and lost $5.5 Billion in the previous year. In
short, Ford was hurting and Hertz was a viable asset to sell and attract capital. To date,
Hertz had purchased primarily Ford cars, but due to declining vehicle values and an increase
in vehicle costs, the sentiment was to move away from owning large vehicle fleets.

Deal
In June 2005 however, Hertz has been put to sale by Ford in order to raise cash and
improve its profitability. Any deal accepted would have to provide adequate returns to
sponsors limited partners, the deal would have to have higher value than Ford could achieve
with an IPO, and the bid would have to beat the other rival bidding groups. The deal
proposed would occur in the United States in the form of an LBO. In 2005, the markets were
getting stronger yoy and most firms had recovered from the tech bubble bust. Furthermore,
the LBO would follow a dual-track process, meaning that if no potential acquirer purchases
the company, Ford would issue an IPO in its place. The bidding process for Hertz is clearly
impacted by the dual-track process, as the IPO alternative serves as a tool for Ford to
increase its negotiation power and ultimately to push the LBO offer upwards to a higher
price. The two bidders for Hertz are Carlyle, Clayton, Dubilier & Rice (CD&R) and Merrill
Lynch Global Private Equity (The Bidding Group), and another consortium formed by Texas
Pacific Group, Blackstone, Thomas H. Lee Partners LP, and Bain Capital LLC. Both bidding
groups consider Hertz to be an attractive LBO target and foresee operational savings and
synergies coming from a potential acquisition. However, each groups offer not only has to
be more appealing to Ford than the other consortiums, but also the offer has to generate
more potential cash flow than the IPO could raise.

LBO Target
Favorable LBO candidates have several important differentiating factors: steady and
predictable cash flows, mature business and product, a strong industry position, clean
balance sheets with little debt and a strong asset base, divestible assets, a strong and
motivated management team, potential to reduce profits, and lastly LBOs have a viable exit
option. Hertz showcases several of the above mentioned characteristics of an LBO, which
makes the firm an appropriate buyout target. Hertz has proven itself a mature business with
strong cash flows, growing at an annual rate of 7.6% and posting positive pre-tax profits
every year since 1967. Years 2002-2005 show that revenues from both RAC and HERC
have grown, and both EBITDA and Net Income figures have also showed consistent growth.
The separation of RAC and HERC signify the characteristic of divestible assets for the firm.
Additionally, Hertz is well-positioned in both the car rental and the equipment rental markets.
It is a strong leader of the car rental market, operating in more than 7,600 airport and local
locations in 145 countries, and controls a fleet of 300,000 cars in the US and 169,000 cars
internationally. Hertz is ranked third in terms of market share in the equipment rental market,
in which it rents its equipment through more than 360 branches in US, Canada, France, and
Spain. It has clean balance sheets, with a current ratio of 1.7 in 2005, D/E ratio of 3.4, and a
strong asset base from its domestic and international fleet of cars. Hertzs management
team, has considerable experience in the industry, however they are currently not
incentivized to perform as their compensation structure is purely based on market share.
Hertz could generate substantial savings in its operations by optimizing the fleet and
correctly matching to the seasonal demand of the travel industry. Finally, if the LBO doesnt
pan out Hertz could introduce the aforementioned dual-track process, to possibly leverage a
higher price against the bidders.

Value-Creating Opportunities of the Transaction

The value-creating opportunities that could emerge from the transaction are the potential
operating and financial improvements. In terms of operational improvements, these could be
realized through increasing the number of transactions, changing rental length period,
increasing revenue per day, and better fleet utilization. Furthermore, the bidding group would
lobby for a non-airport growth strategy to be rationalized, which would reallocate resources
to their key markets (airports) instead of the local markets. And, the company could look to
implement savings in SG&A in Europe to better match their American counterparts levels.
Financially, HERCs ROA could be increased by better optimizing the use of capital in
comparison to their competitors. Ultimately, a few operation improvements could increase
revenue, EBITA and savings for the company.
Furthermore, the Bidding Group (CD&R) had offered an option for asset-backed financing to
be achieved by Hertzs fleet of rental cars. Traditionally, Ford had instead relied on
expensive unstructured financing. The ABS debt would allow Hertz to secure lower financing
rates (AAA rating) as the debt was based on the assets of the SPV vehicle, rather than the
entire company. Additionally, because of the SPV vehicle (RAC Fleet), Hertz would pay
depreciation and interest of the fleet which would serve as the payments to the debt. The
ABS debt could also be both increased and decreased, and would put all of the illiquid
assets of Hertz to good use.

The assumptions in Exhibits 8, 9, and 10 are fairly realistic, as they give conservative
projections for increased and decreased growth overtime. The growth assumptions about
car rental growth and the equipment rental market, would have a direct impact on the
company's revenues, operating costs, net incomes and free cash flows. Sensitivity analysis
should be performed to provide a more realistic view on what could happen give worst, best,
and base case scenarios to the growth rates for HERC and RAC.

Valuation
To determine the valuation for Hertz, we calculated its worth using the CCF, APV and
Multiples method. Using the CCF method, the present value of Hertz is $12,144M, resulting
in an Equity Value of $2,963M after subtracting the 2005E Debt of $9,180M (Exhibit 1).
Through the APV method, the present value of Hertz comes to $12,102M and an Equity
Value of $2,922M (Exhibit 2). After computing the values using the multiples method, Hertz
resulted in $10,969M using 2005E values and $11,068M using 2005PF values (Exhibit 3).
The FCFE was also calculated resulting in $1213M (Exhibit 6).

Using the schematic valuation of Hertz, if the initial investment by the sponsors is $2,300M,
given that the Equity Value would be $5,996M, the expected return would be 21.12%. If the
desired return is 20%, then the initial investment would be $2,410M, so CD&R could afford
to pay $110M more (Exhibit 4).

The Market-required rate for the investment varies each year; in 2005 it is 21.6% and the
rate declines each year to 17.6% in 2010. It differs from the sponsors target return rate of
20%, because the Debt/Equity ratio also declines each year as well. Therefore, the risk is
less due to the lower D/E ratio, so the required rate will also be less for the years given
(Exhibit 5).

Appendices
Exhibit 1: CCF Valuation Method ($Millions)
Exhibit 2: APV Valuation Method ($ Millions)
Exhibit 3: Multiples

Exhibit 4: Calculation of required return for a $2.3 billion investment and value of
investment if return is 20%

Schematic Valuation (Following direction from Exhibit 7 from the Case)

Return for a $2.3 Billion investment

Investment if the return is 20%

Exhibit 5: Calculation of Market Required Rate of Return

Exhibit 6: Calculation for FCFE