Autonomous Driving Revolution

Posted On May 16, 2017 2:04 pm

The big news Monday was ride sharing firm Lyft teaming up with the self-driving driving technology firm Waymo, in what was described as a “broad and fluid partnership.”

That may be an understatement given Lyft, which happens to be Uber’s most potent competitor, already has a deal with General Motors (GM) and Waymo is a subsidiary of Alphabet (GOOGL).

Indeed, the stakes of the future of the car industry, nay, all transportation, are creating a Game of Thrones like atmosphere in which alliances can shift quickly as the enemy of my enemy is align to become friends. The ultimate goal is to achieve scale across a vertically integrated platform.

The disruption occurring in the auto/transportation industry stems from a confluence of factors, ranging from geographic shift towards urban centers, the shift away from buying or leasing towards “on demand”, coupled with autonomous driving technology has everyone in the industry scrambling to position themselves for an uncertain future.

Everybody Hertz

To get a handle on the forces disrupting the industry it might be instructive to drill down into Hertz (HTZ). Hertz, as one of the largest buyers of new cars, resellers of used cars and facilitator of long term leases and short term rentals occupies a huge middle swath of the auto industry.

The shares tumbled another 15% following its May 9 earnings report. This decline came on top of an already 70% decline over the past year and off a whopping 92% since its 2014 high. So what’s the problem?

Most of Hertz’ issues stem from it’s a very capital intensive business, in which everything, from purchase of the vehicles, physical counters, dedicated parking to maintenance (none of which “ride sharing” model such as Uber or Lyft incur) needs to be offset with auxiliary services such as insurance and fuel surcharging for profitability.

The active management of legacy fleet costs is a really big thing. The large inventory of used cars needing to be sold into a soft market is a huge weight on a debt laden business like Hertz. As companies like Tesla (TSLA) mature and load up on the debt it needs to be considered to improve economies of scale, the need to regularly shed excess inventory makes Hertz cyclically sensitive – extremely vulnerable to secondary market price swings, exposing them to their other big cost: asset depreciation.

There appear to be bigger forces at play, throwing the entire car rental value chain up for grabs. Cutting costs, terming out debt and gaining share from weaker competitors may pay off in the longer term, but we do not believe it will be sufficient in the short-term to fully offset some very powerful forces outside of the company’s control.

What shared autonomous mobility enthusiasts neglect is precisely this. The car rental market’s biggest challenge is not administrative or organizational, it’s financial.

The sector’s massive car inventories must be funded by someone at a cost-effective rate if the business is to remain viable. What’s more, this has been the case since the earliest days of the business, a long time, given the likes of Hertz started operations in 1920.

Try as they might, rental companies can only make money if the proceeds of after-use vehicles sales, rentals and auxiliaries surpass the collective cost of financing, depreciation, marketing, admin, maintenance and location. Financing is a critical component in the profitability equation as are conditions in the after-sale market.

The structure of rental fleets is idiosyncratic and variable. Cars come in a multitude of different makes and models, mostly because users demand this. Renters want a wide a selection of vehicles as possible. Catering to this frivolity however costs rental companies in terms of efficiency and economies of scale.

A fleet of highly commoditized multi-purpose vehicles – catering to all passenger scenarios from children, dogs, large families, groups, baggage holders to the disabled – will always offer a better utilization rate. Nevertheless, within the medium time range rental companies operate in, low utilization rates are just about tolerable.

What they lose in economies in scale they gain in more favorable secondary market conditions.

The shorter the rental period gets, however, the greater the need for vehicle commoditization. It’s why once you get into the taxi market, pro services often run commoditized vehicles.

This is one of the problems for the future of shared mobility. If the venture is to be a cost effective alternative to private car ownership servicing short-term needs as well as longer-term ones, fleets will have to be commoditized. Given the rental business’s general dependency on resale rates, this poses a big challenge for shared autonomous mobility.

In the best case scenario, the costs associated with not being able to sell vehicles at reasonable rates will have to be passed onto customers. In the worst case scenario, shared mobility succeeds in its aim of obliterating private ownership, leading to a collapse in the secondary private market altogether.

As things stand, the high turnover of the rental market is a double-edged sword for auto manufacturers. On one hand, they get to benefit from a constant and predictable source of demand for new cars. On the other hand, the high turnover also insures a constant feed of highly depreciated cars into the secondary market.

This adds another vicious circle into the equation. The quicker private cars depreciate, the greater the incentive it is for users to lease or rent cars rather than to buy them outright (due to fears of excessive capital losses in a short period of time). From an auto manufacturer’s point of view however, the more users lease or rent cars, the greater the slump in primary auto prices: they suffer both from having to sell to more rental professionals in discounted bulk and from diminished opportunities to charge premiums on bespoke features like sunroofs.

For as long as cars in the secondary market remain affordable on fully self-financed terms, the system can choke along. When it flags, however, the consequences don’t just mean diminishing car sales. They mean out-of-the money automakers and rental agents who have punted heavily on the spread between new and used car prices being predictably stable.

But this stability may be being compromised. It’s no coincidence automakers are suddenly clamoring to make deals across platforms of manufacturing to distribution, claiming the scale of vertical integration will lead to profitability.

Unfortunately, while the spin makes out this is a step forward, all indicators suggest it’s probably an act of desperation. The primary sales market is tapped out, the lease market is running into equal limitations due to collapse of the used market and third parties prepared to front the capital for new purchases are fast diminishing.

No wonder shared mobility seems tempting, but the cost of capital in the face of an uncertain future makes the future of autonomous driving up for grabs.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.