Assignment N.2 – Bidding for Hertz Students: Luca Marmori, Rok Ferjan and Mads Solberg Thomas Questions 1: How does the dual-track process used by Ford to initiate “consideration of strategic alternatives” affect the bidding process for Hertz? The dual-track process is based on the assumption that Ford will be able to propose an IPO of Hertz if other sales opportunities fail. In this case, the IPO price would function as “benchmark” of how much Ford could get if there is no buyers. An IPO price would reduce the risk from Ford`s point of view so that they have an additional option (flexibility) to extract much needed cash. Hence, an upfront bid from the “Bidding group” and other buyout consortiums would be compared with a prospective IPO. Any bid should then be above or equal to what Ford can get from an IPO. Question 2: In what way does Hertz conform or not conform to the definition of “an ideal LBO target”? An ideal LBO target firm has to satisfy different criteria’s: • First of all, a target firm should have Predictable revenues and cash generating capacity. Historically, Hertz had proven a reputation for outstanding financial stability with pre-tax profits since 1967. Revenues had grown at a compound annual growth rate of 7.6%. As a consequence of this, Hertz has emerged as a truly global firm with diversified risk into 145 countries around the globe, of the total revenue 30% was from outside the U.S. The biggest concern of predictable revenues was the correlation with the general economic conditions and the travel industry. However, these indicators were rebounding after 9/11 and there were expected to grow significantly. The same was expected with the equipment rental market (third based on 2005 revenues). As to cash generating capacity, Hertz had an impressive 1,237 billion in cash in 2004; this was expected to fall slightly to 1,102 in 2005 at pre- LBO levels. • Secondly, target LBO should have a competent management that understand the demand imposed by the financial structure of LBO. LBO usually focuses on the cash generation and on the retirement of debt. As stated in the case, Hertz's management team has lot of valuable industry experience. A key point is that Ford never expected Hertz management to increase their performances, a new incentive plan linked to the performance targets (cash flow, capital usage metrics) would make sure that targets are met so the LBO could produce sufficient returns. In any case, and if needed, George Tamke could step in if needed in order to implement the required improvements. • Thirdly, the nature of the company's assets. It should be easy to reduce the Net Working Capital so to increase profitability and it should also be easy to be resale the company in the market. Hertz has clearly underperformed on key targets compared with competitors. Reducing NWC should be possible and within range of other firms. Moreover, in Hertz' case, the business is basically divided into two segments: HERC and RAC. It is clearly easier to resell two different legal entities instead that just one; especially if the assets and the business are completely different and independent of each other. • An important point is that the target company should be a large company that want to sell a unit for a lack of fit but cannot find a corporate buyer. This is exactly the Ford's situation with Hertz division. It seems to be an obvious point, but this is a main factor in the LBO transaction. • Finally, LBO's purpose is to resell the company at the end. Because of this, target company should permit different exit strategies, for example: Through IPO; sale to strategic buyers; another LBO; a dividend recapitalization. Do you believe Hertz is an appropriate buyout target? In conclusion we can say that, thanks to the new ABS debt, the value for the Bidding Group has increased significantly, and this should be a big motivation. All in all, Hertz seems to be a favourable buyout target. In addition, in respect to all the criteria explained above, the effective level of Hertz's attractiveness depends on the management's ability to reduce inefficiency and make the company more profitable. Question 3 Strategically, what value- creating opportunities can the sponsor exploit in this transaction? Basically, the sponsor can exploit value-creating opportunities from two sources: 1. operating synergies 2. financial synergies 1.) As mentioned before, Hertz presented large opportunities for operational improvement from the two main divisions: RAC and HERC. On the rental car business, value could increase working on the number of transactions, the length of each rental (which is largely dependent on customer and end-product mix), revenue per rental day and the fleet utilization. As said before, margin of improvement in term of value could be reached from price driver. Essentially Bidding Group identified the following operational savings: 1) Current adjusted EBITDA margins were below the 2000 levels and below those of Avis. EBITDA, the Bidding Group believed that an amount form 400$ million and 600$ million could be saved in 2009. 2) From 2002 to 2005E non fleet related operating expenses had increased by 38% and had outpaced revenue growth by 6%. 3) Hertz's off airport strategy resulted in significant losses. Bidding Group can rationalize this strategy. 4) RAC's CAPEX in the United States were higher than Avis one. 5) RAC's CAPEX in Europe were three times higher than those in U.S. 6) HERC's return on assets demonstrated an inefficient use of capital. 2.) In addition to operational savings, Bidding Group identified several sources of financial value. In fact, debt could be backed by Hertz's fleet of rental cars as an asset-backed securitized debt. This can lower the Hertz's cost of capital and help it increasing liquidity, reducing the high dependence on more expensive non-securitized financing. Not only was the ABS debt less expensive, but it also provided a more flexible financing arrangement that could increase the debt and decrease the fleet size. Question 4 How realistic are key assumptions that underline the Bidder groups projections in Exhibit 8,9,10?Which assumptions are the most likely to have the largest impact on returns? In order to test some assumptions we compared their forcasted growth trough projected period. We focused on two main assumptions. One of them is projected revenue growth, which follows a positive trend from 2005 to 2010 averaging 6,1% in RAC and 6% in HERC. Revenue growth should stabilize in 2010 4,5%RAC and HERC 3%. We could say that this growth rates make sense as RAC is highly correlated with airport traffic growth, which is expected to grow at steady rate of 3,7% till 2010. Previous high growth rates in equipment rental industry (9,7%) were due to economic boom so we can not expect growth that high soon. Steady revenue growth of 3% for HERC seams realistic as construction sector is recovering together with economy. We tested EBITDA margin, comparing it with comparable companies in the same sector. For RAC we selected Adjusted EBITDA margin, which is expected to grow from 2005 for 8%-10% per year but stabilizing at around 10,5% in 2010. Adjusted EBITDA margin is not the highest in the industry, but it looks like it is in industry frame so we consider it to be realistic. As comparable companies have higher EBITDA margin this offer a chance for improvement. HERC gross EBITDA margin averges at 43% with small ups and downs trough analized period. Compared with other companies in the industry HERC projected margin is almost twice higher. According to our oppinion this EBITDA margin forcast is very unlikely to happen as 2004 EBITDA margin is 36% and this is already high according to industry average. Ability to increase EBITA margin will have a big impact on returns as well as reduction of CAPEX and NWC which will increase the level of FCF in the future. Question 5 Based on the base case estimates in cases exhibits 8,9,10 and your estimate(s) of the terminal value if the sponsors put up $2,3bn in equity , what return can they expect to earn? As is suggested in the Assignment papir, we used market based multiples to evaluate the terminal value of the company. Following Exhibit 7 we calculated value of separate segments, RAC Operating company, RAC fleet and HERC Segment value. Joining these values togther we get HERZ Total enterprise value which is $20.764.540.000. Next step was to deduct end debt in 2010 from the total value in order to get end equity avalible for sponsors. According to the question, sponsors invested $2,3bn. We calculated their projected return using IRR formula as we presumed that NPV of investment should be 0. Investors return is 21, 12%. Question 6 If Carlyle desires a 20% target return on its equtiy investment, does your analysis suggest that $2,3bn is too much to pay, or can it afford to pay more- in either case, by how much? To answer this question we used the same formula as calculating IRR for question 5. Using What-If analysis in Excel, we found out how much could investment change in order for investors to get target return of 20%. To achive this goal, investors could invest additional $107,09 million so in total $2.407,09bn. Question 7 What is the market required rate of return on this investment, and why might this difffer from the sponsors target rate of return We calculated market required rate of return using CAPM model and compare results with sponsors target return of 20%. Because of changing D/E ratio we made a scale of required market returns from 2006-2010. Required market returns are high in first years due to highly indebted company which increases equity holders risk. As the debt level is decreasing troughout the years the market requried return decreases. That trend can be clearly seen as we compare investors vs. Market required rate of return. Market returns are 27% higher than sponsors in first year but they come to almost insignificant difference in 2010 whan the debt level stabilize. We also calculated required market return presuming that returns would be paid out at the end of 2010, which equals to 22.94% or 14,71%higher than requred return from sponsors. Sponsors might be willing to accept lower return according to level of risk than the market, because they wish to win the bidding competition for HERTZ, but there is always a probability that competitor will come with a better offer than Bidder accounting for differnet synergies offering a better price. Question 8 What is the value of Hertz using the equity residual method of valuation (cash flow to equity)? It is difficult to evaluate cash flows to equity holders since all of the cash-flows are used to amortise the Term Loan Facility (RAC) and interest. Valuating Cash-flows corresponding to equity holders from exhibit 10 would then be fruitless. Hence we make the assumption that the investment (from the sponsors/equity holder’s view) will materialise returns in 2010. This is the year when all synergies are fully implemented and debt (2010, 79%) is back to pre LBO levels (2005, 77%), i.e. the perfect timing to reap the benefits of the investment. In addition, since , we could use the implied EV given by the valuation schematic for Hertz and subtract (same as in question 5) net debt thereby extracting the value of equity. EV (2010) 20.764 Less : Net debt (2010) 14.570 = Value of equity (2010) 6.194 To find the PV of equity we shall use the cost of equity to discount it. Here we have different measures. We could use the implied cost of equity from 2010 (20.16%) or simply the cost of equity corresponding to the change in market returns. We will do both: 2005 2006 2007 2008 2009 2010 Relevered equity Beta 3.86 3.87326327 3.691033064 3.450430986 3.153786745 2.891781592 Relevered cost of equity 25.49% 25.56% 24.56% 23.24% 21.61% 20.16% Cash Flow To investors 0 0 0 0 0 $ 6,194.00 PV using 20.16% $ 2,472.21 PV using market returns $ 2,199.15 PV using required return $ 2,489.23 As seen above, using 2010 market returns on the investment yields a PV of $2.472. This is close to the required rate of return at 20% and both values are in excess of the initial investment of $2300. However, using the actual market returns/cost of equity which better incorporates the risk which is associated with high levels of debt, gives us a PV of $2.199. A high level of debt is more prone to bankruptcy, which is why the cost of equity increases. This price is lower than the initial investment and might give us a hint that the sponsors should demand a higher return. If that is the case, the sponsor should offer less upfront cash, in return they might risk losing the bid to the other consortium or the bid might be lower than the implied IPO price.