At the end of 2005 CCM, led by CD&R managed to buy the Hertz Corporation for $5.6 billion. To decide whether this was a reasonable price for the business a reasonable method is to calculate the IRR of the investment. In this particular case we used a horizon of 5 years – just as CD&R did. A crucial point in calculating the IRR of this investment is to accurately estimate the cash flows and the expected value of the company at the end of 2010. We calculated the cash flows for every year between 20061 and 2010 using available data and our expectations and assumptions about the future. When calculating the cash flow, we divided the entire company into three dimensions: the Rent-A-Car (RAC) division, the Hertz Equipment Rental Corporation (HERC) and the – quite small – outcome of activities that do not belong to any of the previous two dimensions or that are done on a corporate level (Corp.). The RAC division has three segments: U.S. (Onand Off-Airport), Europe and Other International; while HERC is divided into two sections: North America (N.A.) and Europe. For revenue, we expected an annual increase of 5.2% and 3.2% for RAC and HERC, respectively2. For the operating expenses and SG&A of the On-Airport section an expected $75 million annual savings are taken into account, but we do not think the company will be able to reach this amount of annual savings already in 2006, so we considered it to be $25 million in 2006 and then it to increase by $25 million per year, reaching $75 million within three years.3 For the Off-Airport division the expected annual savings are expected to be $58 million, also reached within three years. We also expect some savings in operational expenses and SG&A for Europe ($33 million per year)4 and for the Other International section ($8.95 million per year5). In the case of HERC, the OpEx and SG&A are expected to grow by 1.6% annually, and for Corp. a decrease of 1.56% is expected in this row.6 From these data we can calculate the expected Gross EBITDA that will be an important starting point later when we evaluate the company using the discounted cash flow method. When dealing with the fleet, we assume that its book value is constant, i.e. the depreciation is the same as the value of newly purchased items. The calculation of fleet interest is based on the proposed capital structure of the company (see Table 2). For the debts with floating rate we used the futures LIBOR interest rates (in Table 2 these future rates are presented). In the case of Europe and the Other International section we allocated the Fleet Interest in proportion of the Gross EBITDA. Adjusted EBITDA is calculated by subtracting the Fleet Depreciation and the Fleet Interest from the Gross EBITDA. Corporate EBITDA has the same value as Adjusted EBITDA in the case of RAC, while in the case of HERC and Corp. it 1
Because 2006 will be the first year when CCM is managing the Hertz Corporation. For Corp. we calculated the weighted arithmetic mean of the expected annual increase in the two other divisions (5.2% and 3.2%) using the total revenues as weights. 3 So in 2006 the company will save $25 million compared to 2005, in 2007 it will save $50 million compared to 2005, and in 2008 the annual saving will be $75 million (again compared to the level of 2005). From 2009 the level of operational expenditures is expected to remain constant on the 2008 level. 4 Because this is quite a conservative estimation and this volume is really small compared to the entire OpEx in Europe, we expect to reach this amount of savings within one year. Moreover, most of the $33 million savings come from consolidating some back-office and reservation systems, and these can be done within one year. 5 This amount is based on the assumption that the proportional annual savings for Other International will be 2
the same that is expected for Europe, so 6
.
For the calculation in the case of Corp. we used again the weighted average of the other divisions.
equals the Gross EBITDA. Nonfleet depreciation for the U.S. RAC division is expected to have a $57 million annual savings reached within three years, and in the case of Europe and the Other International section the proportional annual savings are expected to be the same as for the U.S. The annual savings for the HERC division is expected to be $31.8 million (thus $159 million can be saved during the five-year period), while for the Corp. division the expected annual saving rate is the weighted average of the other divisions’ (17.82%). The Nonfleet depreciation is assumed to be always the previous year’s Nonfleet CapEx. The Year -End Fleet Value, as we discussed above, is assumed to remain constant throughout the five-year period. RAC
HERC Europe
Total HERC
Corp.
Total Hertz
1 261
157
1 418
74
7 805
3 820
731
99
829
77
4 726
157
2 493
531
58
589
-2.4
3 080
224
86
1 374
171
43
214
0
1 588
313
96
29
438
–
–
485
0
923
–
437
202
42
681
–
–
-110
-2.4
569
–
–
437
202
42
681
–
–
589
-2.4
1 268
Nonfleet CapEx
124
8.8
133
53
8,8
195
51
3,2
54
3.3
253
Nonfleet depriciation
142
10
152
61
10
223
81
5,0
86
4.0
313
Year-End Fleet Value
4 335
1 720
6 055
1 656
465
8 176
1 694
162
1 856
0
10 032
OnAirport
OffAirport
Total U.S.
Europe
Other Int'l
Total RAC
NA
Revenue
3 436
904
4 340
1 540
433
6 313
OpEx
1 771
533
2 304
SG&A
202
19
222
1 018
276
1 463
351
1 814
522
797
267
1 064
–
–
Adjusted EBITDA
–
Corporate EBITDA
Gross EBITDA Fleet Depreciation Fleet Interest
Value
interest
U.S. Fleet ABS
5256.7
5.95%
International Fleet ABS
1972.4
6.35%
Fleet Equity ABL
1662
396
7.85%
Term Loan B
1850
8.35%
Senior Unsecured Notes
2250
9.50%
800
10.75%
Senior Sub Notes Equity
2295
Afterwards we are able to calculate the cash-flow-to-equity (though some further assumptions are needed). Our starting point is the Adjusted EBITDA, as this takes the Fleet Depreciation and the Nonfleet Interest into account. If we subtract the Nonfleet depreciation and assume that all interest obligations are allocated to the fleet, then we get the value of Earnings before taxes. If we make one more assumption, namely that the company pays taxes on a consolidated basis and the taxation system is the one that was in effect in 2005 in the
U.S., then the tax the company has to pay is simply the 35% of the Earnings before taxes. 7 Subtracting the taxes, we get the Earnings after taxes, and if we add the depreciation (both fleet and nonfleet) and subtract the CapEx (again both fleet and nonfleet), we get the cashflow-to-equity. Calculations for 2006 and 2010 are presented in Table 3 and Table 4, respectively. Adjusted EBITDA
569
– Nonfleet depreciation
313
= Earnings before taxes
256
– Tax
= Earnings after taxes + Depreciation – Nonfleet CapEx – Fleet CapEx
89 166 1901 253 1588
=Cash flow to equity
226
Adjusted EBITDA
1605
- Nonfleet depreciation
196
= Earnings before taxes
1408
- Tax
493
= Earnings after taxes
915
+ Depreciation - Nonfleet CapEx - Fleet CapEx =Cash flow to equity
1784 196 1588 915
After having determined the cash flow for 2006-2010, we estimate the value of the equity at the end of 2010. We can use several methods, one of which is using the Corporate EBITDA as a multiple, and considering the fact the illustrative range of Corporate EBITDA multiples for the company was between 6.0 to 8.0 times. If we use 7.0, we get $16 113 million as the expected value of the equity at the end of 2010. We can also estimate the value of the equity using the framework of CAPM: if we estimate the future cash flows and the expected return from the equity, we can determine the fair value of the equity. We expect that the cashflow to equity will grow at a rate of 8.5% after 2010. In order to determine the expected return from the equity, we calculate the proportion of debt and equity in the capital structure of the company (75,99% and 24,01%, respectively). We know the equity-betas and the leverage of two other companies in the industries we are in, so we can calculate the asset-betas of the two industries, and therefore the asset-beta of our company. 8 After we calculated the company’s asset-beta, we can calculate the equity-beta, that turns out to be 1.6677 according to our calcu7
As the Earnings before taxes are well above the top of the $18 333 333 level, we can use the average tax rate instead of calculating the taxes for every income range separately. 8 When calculating the beta of the two rival companies, we assumed the beta of their debt is 0.2. This assumption of ours is based on the fact that the credit ratings of these two companies were BB in 2005.
lations.9 Using the CAPM, we can calculate the expected return of the company’s ty:
() .
10
Using this expected
return and the growth rate we discussed earlier, we get that the expected value of the equity at the end of 2010 is $19 823 million.11 After we have calculated the expected value of equity, we can calculate the IRR (Internal Rate of Return) of CCM’s investment as
√ .
12
This result seems
reasonable given that the risk-free rate for the 5-year term is about 4.5% and the expected rate of return of the market portfolio is around 10%. If we modify our assumptions on operational efficiency and the expected savings to be more optimistic (savings on U.S. RAC off-airport OpEx. and SG&A: $100 million instead of $58 million and in Europe and the Other International section $100 million instead of $33 million; savings on U.S. RAC nonfleet capital expenditures $90 million instead of 57 million increases the IRR to 32.26% and the value of equity at the end of 2010 to $22 661 million. If we are rather pessimistic and reduce these savings so that they are half of their original amount, and also take only the half of the savings on both U.S. RAC on-airport OpEx. and SG&Aand HERC Nonfleet CapEx., the IRR decreases to 25.71% and the estimated value of the equity at the end of 2010 will be $17 584 million. On the other hand, if we reduce the expected growth rate of the revenue by 10% (i.e. from 5.2% and 3.2% to 4.7% and 2.9%) but leave the efficiency improvements untouched, the IRR reduces to 26.11% and the expected value of the equity will be $17 865 million. If we are more conservative and calculate with a growth rate half of the original one (2.6% and 1.6%), the value of the equity would reduce to $10 084 million and the IRR would be 12.48%: just above the expected return of the market portfolio (though the risk of the market portfolio and the investment consisting of buying the Hertz and reorganizing its processes are far away from one another). The fact that the real catalyst of the value creating process is the expected growth of revenue is also emphasized by the scenario when the company manages to achieve all of its operational efficiency improvements but does not realize any growth in the revenue: in this case the value of the equity at the end of 2010 is only $1 449 million and the IRR is negative: -23.7% (this is reasonable since CCM paid $5.6 billion for Hertz). We can also use the model to see what happens if the financing structure changes. Interestingly, if the company could not issue Asset-Backed Securities (ABS) on the market and it could only use Asset-Backed Loans (ABL) on a 1.9%-point higher rate (7.85% instead of 5.85%), this would not mean a large difference in the IRR and the expected value of the equity: the former would decrease to 26.88% and the latter to $18 418 million. If the company could access only senior unsecured notes with a rate of 9.5%, the internal rate of return would decrease by more than 5.5%point (to 23.26%) and the expected value of the equity would 9
We assumed that the beta of Hertz’s debt is 0.2.
10
The risk-free rate is assumed to be 4.82% and the expected return from the market portfolio is 10.03% according to our assumptions. These assumptions are based on the following lecture: th http://fisher.osu.edu/~diether_1/b722/test_capm_2up.pdf (downloaded: 24 September 2011). 11 12
Here we assume that the cash flows are not taken out by equityholders during the 5-year period (for example, because these cash-flows are needed for the further (post-2010) cash-flows).
decrease by nearly $4 billion (more than 71% of the amount of money CCM paid to Ford for Hertz!). If we would like to analyze how things changed because of the downgrade of Ford and GM and the increase of the Federal Funds rate, we have to examine what the capital structure would look like in the new environment. According to the new enhancement level, the company could use less Asset-Backed Securities because they need more equity to borrow a given amount of money. They already issued ABS in 2004 in a value of $600 million, and according to the calculations, they can borrow $4 334 more (the new general enhancement level as a weighted average of the separate new enhancement levels will be 25.14% (it used to be 15.70%), using the proportions of the vehicles of different OEMs in the fleet). The strategy of CCM is to use this amount of ABS to finance the U.S. fleet while using bank loans to finance the international fleet. This means that in the capital structure of Hertz there will be $600 + $4 334 = $4 934 million as ABS, $1 662 million as equity and $322.7 million as bank loan. The company cannot get any more ABL because they ‘used up’ all of their collateral, so they have to use other kinds of debt. If we (reasonably) assume that they can only access unsecured notes, they will have an amount of $2 646 million outstanding in senior unsecured notes. We also assume that they have $1 850 million in Term Loan B and $800 million in senior sub notes (just as they did before). Since 2004 the U.S. Federal Funds rate increased by about 3%points. If we assume that this increase also appears as an increase in loan- and debt-rates, the new interest rates that the company now faces are the following: 8.95% on ABS Securities, 12.5% on Senior Unsecured Notes, 11.35% on Term Loan B and 13.75% on Senior Sub Notes. If Hertz has to pay according to these interest rates and uses the abovementioned capital structure, the expected value of the equity at the end of 2010 will be $13 406 million. Considering that it was $19 824 million in the base scenario, this means an approximately $6.5 billion decrease, just as much deterioration as much money CCM paid to Ford for Hertz! The IRR also decreases: from the original 28.77% it goes down to 19.08%, i.e. it decreased by more than one-third of its original value. We can conclude that the most important scenarios regarding the risk assessment of the deal are the failure to reach the expected growth of revenue (both in the RAC and in the HERC divisions), the further increase of the Federal Funds rate (because a significant proportion of the company’s debt has floating rate and if the Federal Funds rate increase the floating rate tends to increase, too) and failure to close the deal (what would mean that CCM has to pay an enormous amount of money as a breakup fee).
