How Will Fleet Cuts Affect the Auto Rental Industry?

Could the trumpets be any louder?

The domestic automakers have declared very publicly that decreasing incentives, low-margin sales to rental fleets and vehicle repurchase programs will help return them to profitability.

For the auto rental industry, this means no more government cheese. What are the car rental "Big Five"—Hertz, Avis Budget, Dollar Thrifty, Vanguard and Enterprise—doing about it? And how will their actions affect the independent car rental operator?

Reduction in Fleet Sales Underway
Ford, General Motors and DaimlerChrysler have all started reducing fleet sales. In 2007, this will contribute to the lowest level of auto sales in a decade, economists warn.

Ford, which posted a $5.2 billion third-quarter loss in 2006, reported a drop in fleet sales in November, on the heels of the demise of the Taurus. Even on its last wheels in 2005, the mighty fleet car sold 122,000 units into rental. By contrast, the Taurus replacements, the Five Hundred and the Fusion, sell less than 30 percent of Taurus' numbers into fleets.

DaimlerChrysler, with inventory that took an average of 80 days to turn on dealers' lots in 2006, said in November it has also reduced fleet sales.

It's no secret now that much of DaimlerChrysler's sales gains in the past two years—in the face of GM and Ford's sales slide—came with low-margin fleet sales. However, "they haven't sweetened any of their car-buy deals to help with this excess inventory," says one medium-sized RAC.

DaimlerChrysler is about to go through the same cost-cutting, plant-closing pain that GM and Ford are going through now.

GM said final tallies for 2006 will disclose 80,000 to 90,000 fewer vehicles sold into fleet. The decline will continue into 2007. GM reported "a fairly substantial" improvement in prices on its rental-car sales in November. [PAGEBREAK] Lower Incentives, Higher Depreciation Expense
The Big 5 are feeling the pinch—to varying degrees—with increased depreciation expense and lower incentives, as their third-quarter 2006 earnings reports and conference calls reveal.

Hertz reported a 17-percent increase in monthly per-car depreciation costs for 2006 model-year program cars. The company expects a 20-percent increase for 2007.

Dollar Thrifty President and CEO Gary Paxton said the company expects per-vehicle depreciation costs to be about 25 percent higher in 2006 than 2005. For 2007, manufacturers have again raised program vehicle depreciation rates and reduced purchase incentives.

Avis Budget Group echoed these increases. The company absorbed a 20-percent increase in per-vehicle depreciation costs for the 2006 model year and expects another 20-percent hike in 2007.

Medium-sized RACs are not immune. One estimates a $1,900 increase in cap costs on 2007 models over similar 2006 iron.

How Are They Coping?
RACs are responding by making changes on many fronts: they are modifying their mix of vehicles, increasing hold periods, reducing their overall fleet buy, increasing their risk buy and developing ancillary revenue streams.

Hertz shrank its percentage of Ford vehicles from 50 percent in 2005 to 42 percent in 2006. Hertz expects fewer program-car offerings from Ford, though the company says it hasn't struck any deals with other manufacturers to make up the difference.

Vanguard's fleet runs about 80 percent General Motors and 16 percent DaimlerChrysler. While it will continue a comparable level of DCX purchases, Vanguard said last August in its IPO filing it has "committed to purchase substantially fewer GM vehicles for the 2007 and 2008 model years."

Avis Budget reported it is reducing the GM portion of its fleet by 100,000 units from its 2005 level. The company intends on reducing its overall fleet purchases by 19 percent in 2007.

There has been speculation that the difference will be made up with Asian makes.

Enterprise reports that its percentage of Asian purchases was up in 2006 and is expected to continue in 2007. Yet overall, mid-year 2006 rental fleet registrations did not show a marked increase in foreign nameplates over 2005, nor have other major RACs revealed plans for a major foreign brand buy.

Hyundai and Toyota seem to be echoing Detroit. The Korean manufacturer's sales fell in November, due in part to its "company strategy to reduce fleet sales."

"Our allocations over the past two years have gone down with Toyota," Charlie Mullen, vice president of Ace Rent A Car, told ARN. [PAGEBREAK] More Risk, Longer Life
Without an alternate supplier, the Big Guys will be purchasing a larger portion of risk vehicles and aging their fleets.

Dollar Thrifty intends to move its percentage of risk vehicles from 35 percent in 2006 to 40 percent in 2007. The company's average hold period in 2006 was eight months; the company expects to add a month to that in 2007.

Avis Budget's risk fleet will go from 6 percent in 2006 to approximately 22 percent, while extending its fleet life from nine to approximately 10 months on average.

Hertz plans to purchase a "larger proportion" of at-risk cars. Enterprise, the risk-car kings, seem less affected by the changes. "Actually our fleet levels are higher than last year," Pam Nicholson, executive vice president and COO, told ARN. "At this point we aren't increasing months in service, though that is an option down the line."

Less Specialty, New Revenues
Avis Budget is reducing the number of specialty cars. Purchases of SUVs and other premium vehicles are down 29 percent and 15 percent respectively. Almost 50 percent of the company's risk buy now has a four-cylinder engine.

"We’ve tried to be smart about our risk buy and manage the residual exposure by what we buy rather than what we have to sell," Avis Budget COO Bob Salerno said.

Avis Budget is building other income sources. Salerno says the company sees opportunity with optional insurance, and pointed to the success of the Garmin Where2 GPS unit. "The incremental margins are substantial," said Salerno.

Consensus: Rates Need to Rise
These changes are dampening the impact of manufacturers' price increases.

Avis Budget said it was able to keep its net cost per unit to a 10-percent increase in 2006. Hertz expects net per-car depreciation costs for 2007 model-year cars to increase by about 6 percent over 2006.

However, rental rates have not kept pace with fleet costs.

A survey of the National Business Travel Association reveals that while most (64 percent) corporate travel managers reported higher average car rental rates in 2006, the greatest percentage (46.8 percent) reported an increase of less than 5 percent. Some 29 percent reported no change.

This differential between rates and fleet costs has squeezed earnings. Avis Budget's EBITDA (earnings before taxes) margin for car rental in 2006 was about 7 percent, down from more than 8 percent in 2005 and nearly 11 percent in 2004. The company says in these years pricing and fleet costs were moving in tandem.

Rental rates are expected to rise: the American Express Global Business Travel Forecast for 2007 predicts a 4- to 6-percent increase in North American corporate car rental rates.

But will that be enough to offset higher costs?

"There is no doubt we will continue to need pricing improvement to offset much higher vehicle costs," said Paxton.

"We continue to believe that, generally speaking, pricing is too low for the service we provide...and [we] are taking every opportunity to maximize pricing," added Salerno.

Meanwhile, Enterprise's tremendous buying power, risk fleet management and stellar credit rating continue to pay dividends. As a result, the company increased prices in 2006 by a miniscule .01 percent, and doesn't expect a large increase in 2007. [PAGEBREAK] Opportunity or Threat?
At least publicly, the Big Guys see less program cars and less available inventory as healthy for the industry.

"I think it's a good thing that our suppliers are cutting back production," Nelson said. "That may seem like a contrarian thought, but industry fleet levels, fleet mix and fleet costs have historically been driven more by the auto companies' need to keep plants producing because of guaranteed labor agreements than it has been by intrinsic demand."

"That need to produce gave rise to higher fleet levels, lower fleet costs and more repurchase programs, all of which stagnated, if not impaired, realistic market pricing in our business."

"What makes your business run is high utilization," says Joe Knight, vice president of Fox Rent A Car. "If you can maintain a high utilization and keep those cars operating, there are a lot of potential catastrophes you can fend off. If you're operating with 70-percent utilization, you're dead."

The Silver Lining
Analysts agree. "The manufacturer's turmoil right now will not necessarily affect the rental industry in a negative way," says industry consultant Neil Abrams.

Up until the mid- to late-80's, guaranteed repurchase programs didn't exist. "Before then these companies were doing fine," Abrams says. "They kept on evolving with the changes in the global travel environment. They learned to make money from rental operations and buying and selling cars."

Abrams says repurchase programs fostered complacency in operational efficiency.

"I warned clients that these programs were almost like dope," Abrams says. "In what industry do you find the supplier is buying back your used inventory? It takes the risk out of the procurement decision.

"Car rental companies have to be more aware of resale markets than they are now. There's also more profit to be made from that," Abrams says.

"If they take more risk vehicles they get to choose the cars they want, and it will help residual values when they go to sell them," says Betsy Snyder, a credit analyst for Standard and Poor's. "Look at Enterprise. They take all the risk and they’re the most profitable car rental company."

GM is seeing results; it has improved residual values by 8 percent over the last year and a half.

Mullen agrees that residuals are up slightly, but it depends on the mileage of the car. "There is such a discount for higher mileage cars now because they're so plentiful," he says. "Cars with 15,000 [miles] are pretty strong. But anything over 30,000 seems to be taking a huge hit on resale."

This situation may exacerbate as fleets age out of necessity.

The Cheese Has Moved
The government cheese may not have gone away entirely, but it will certainly cost more.

In the business bestseller Who Moved My Cheese? author Dr. Spencer Johnson talks about a different kind of cheese, a business's revenue stream. Johnson says a company needs to be jolted out of its comfort zone once in a while in order to survive. It needs to be constantly challenging its business model and vigilant in analyzing and improving upon its products and services. The ever-changing marketplace is not a threat, but an opportunity.

In the auto rental industry, the cheese has moved.