Hertz LBO Case

1.) Is Hertz a good LBO target relative to the characteristics for an ideal buyout target? Hertz was not a good LBO target relative to the characteristics for an ideal buyout target. What LBO companies look for are perpetually underperforming and, in many cases, subpar management. Hertz is a market leader in the rental car industry, as well as having a national and international presence in an industry that is highly fragmented. The characteristics that do fit LBO targets is its reliable stream of cash flows, large amount of tangible assets in special purpose vehicles and no synergy with Ford. There are also opportunities to cut operating expenses and an acquirer won’t need to make any sizable upfront capital outlays. Even with asset or operating subunit divestitures, there would be plenty of potential buyers who would be interested in the trimmed down version of the rental car company. The biggest challenge for a LBO firm is that Hertz is already highly leveraged, with additional debt greatly increasing the financial risk. 2.) List and briefly explain the value creating opportunities for the buyers. Considering the challenges for the acquirer of Hertz, there was enough opportunities for growth to justify the acquisition. First, under Ford, Hertz’ management was emphasizing lower margin segments of the rental business. This means there is an opportunity to increase profitability by focusing on the higher margin rental customers. Second, Hertz’ operating costs in Europe were so much greater than what they should have been compared to other well-run operations in the U.S. So, this would present an opportunity to for an owner to create value by driving those cost differences down. Additional opportunities to create value could be derived from using economies of scale to profitably compete based on the fragmented nature of the industry, as well as increasing overall fleet utilization. 3.) Critically evaluate the key assumptions in case exhibits 8,9,10. The income statement shows RAC sales growing by a declining series of growth rates with a high of 8% in 2006. Then the growth rate begins to decrease, hitting a long-term revenue growth rate of 4.5%. The short term revenue growth rates appear to be reasonable, but the long-term revenue growth rate of 4.5% is unreasonable because the long-term growth rate should be basedon either a

very low starting point of revenue or for a large company, like Hertz, long-term global growth. Hertz’ business is sensitive to changes in the general economy. A more interesting figure is the projected 10% initial growth rate for the HERC business unit. This business is highly fragmented and the level of growth required would seem to require additional company acquisitions. The projections of profit margin appear to be modest, increasing from 2.06% in 2006 to 4.35% in 2010. The problem with those projections is that equates to a compounded growth rate of approximately 34%. There appears to be a disconnect between fleet asset growth and changes in depreciation. Also, deferred taxes looks like a manipulation to increase short-term cash flows. 4.) If the buyers make an equity investment of $2.3 billion, what is their expected rate of return, related to the 20% return target. Is this another way of asking if $2.3 billion is too much to pay or too little...please comment by considering the market rate of return relative to the target rate of return. If the company is acquired per the initial financing plan, then making an equity investment of $2.3 billion would appear to be paying too little for the equity contribution because, based on the projected balance sheet, the book value of equity would only have appreciated at a compounded growth rate of 10.95%. Also, the changing capital structure of the company in its projections does show the debt-toequity ratio declining over time, but the amount of long-term debt increases from the original $12.5 billion financing the deal to $14.769 billion by the end of 2010. 5.) What is the value of Hertz? Optional: Use the 'residual equity' approach - see article attached. Discounted cash flows produce an equity value of $12.267 billion for the company. If the company is sold in 4 years, the value of the company at that point would be $14.36 million. This would produce an IRR of 58.1%. Using the market multiples approach (EV/EBITDA and EV/Revenue) for both business units of Hertz, the company would value between $4.76 and $7.50 billion. 6.) Can Ford get more money with an IPO instead of a sale to a private equity group? Ford may not be able to get more with an IPO than by directly selling to a private equity group. However, the process of an IPO would be longer and there is no way of predicting how well the market may receive the IPO. Additionally, the market would value the IPO based on the way Hertz is

currently run rather than based on how well a single new owner could run the business, resulting in a lower price.

FCF VALUATION Perpetual growth rate

3.0%

K-wacc (discount rate)

6.81%

Value of liabilities

0.0

Number of shares outstanding

1.00 Base Year

Forecast

Forecast

Forecast

Forecast

Forecast

PERIOD

0

1

2

3

4

5

6

YEAR

2005

2006 165.3

2007 252.4

2008 311.3

2009 403.6

2010 434.0

2011

Net Income + Increase In Deferred Taxes

53.2

4953%

4432%

3842%

3467%

+ HERC Fleet Depreciation

249.5

269.5

285.7

298.5

307.5

+ Total Non-Fleet Depreciation

196.2

202.0

206.0

209.0

212.0

=Cash flow from operations (CFFO)

664.3

773.5

847.3

949.6

988.1

- HERC Fleet Capital expenditures

410.7

447.7

430.0

413.3

387.4 254.2

- Total Non-Fleet Capital expenditures

287.0

219.8

202.6

223.2

-115.8

46.3

43.0

38.3

37.0

- Net Fleet Equity Requirement

134.2

79.5

72.9

64.4

60.8

+ Operating Company Interest After Tax

309.9

312.6

313.6

308.5

297.7

=Free cash flows to equity (FCFE)

258.3

292.8

412.4

518.9

546.3

1,628.8

1,481.4

1,289.5

964.8

511.5

10,638.6

11,362.6

12,135.9

12,961.8

13,844.0

12,267.4

12,844.1

13,425.4

13,926.6

14,355.5

458.4%

141.6%

82.3%

58.1%

- Increase in NWC

PV of FCFs Terminal value estimates: Perpetual growth PV of terminal value Value of firm (enterprise value)

14,786.2

Value of liabilities Value of equity

0.0 12,267.4

Shares outstanding Value per share

1.0 12,267.4

Annualized Return

Value COST OF DEBT: Coupon Rate Marginal Tax Rate Cost of Debt weight of debt COST OF EQUITY: Risk-Free Rate Risk Premium Beta Cost of Equity weight of equity k-wacc

Source

Equation

5.19% Ex2 interest/Ex1 debt 36% given 3.32% 77.11% Ex1

k-d = I x (1- t) d ÷ d+e

4.12% Ex11-5 yr T-Bond 5.50% judgment

R-m - R-f

2.62 judgment or based on peers 18.5%

k-e = R-f + [ß x (R-m - R-f)]

22.9% 1-b8

e ÷ d+e

6.81%

562.7