A 2,700% gain, with room for more

By Jon Markman

The law of unintended consequences has run smack into the law of the jungle this year to produce the most unlikely set of superstar stocks in recent memory: rental car agencies.

Dollar Thrifty Auto Group (DTG, news, msgs) and Avis Budget Group (CAR, news, msgs) are each up a touch more than 2,700% since the market's lows in March, while larger rival Hertz (HTZ, news, msgs) is up 335%. And they are still so cheap, with price-to-sales multiples well below thresholds considered to be inexpensive, that they may well have some gas left in the tank.

The reasons for these stocks' successes, which blow away gains produced in more-glamorous corners of the market, such as technology and drugs, give us surprising clues about the character of the recovering global economy, as well as its direction. They also brazenly challenge the conventional wisdom about the kinds of companies that can succeed at a time of great financial stress.

Let's step up to the counter for a moment now to look at why they have done so well, how they fit into the bigger picture and what other supercheap companies might be ready to roll.

Premature obituaries

The vehicle rental business has long been considered an absolute backwater because it is so commoditized. There is virtually no difference in most consumers' minds among the top five companies that constitute almost 95% of the domestic business, as they all try to compete on price while providing the bare minimum of service.

Avis might have once said that it tries harder, but that's a pretty hard sell when both business and leisure customers just want a reasonably clean, smoke-free sedan for $45 a day. Every company has a decent Web site, virtually the same fleet of vehicles, the same set of options, such as GPS and satellite radio, and serve the same airports. There's never a reason to love a rental agency, but so much can go wrong that there are always plenty of reasons to dread and hate them.

Rental agencies are also incredibly capital-intensive businesses, as all of their vehicles must be financed with credit. Yet for years they have had virtually no control over their largest expense, which is their fleets. They have bought the majority of their cars from General Motors, Ford Motor (F, news, msgs) and Chrysler, and costs rose as automakers forced this captive market to pay increasingly more to offset the losses they were incurring from consumers.

Moreover, rental agencies must sell tens of thousands of their cars each year into a used-car market that until recently was just as moribund as the new-car market. And, of course, as the rental business contracted, the companies tried to shrink their fleets, dumping even more used cars into an already saturated field.

So you can see why the industry started sputtering and almost died once the recession began to bite in mid-2007:

• Businesses stopped sending salespeople out on the road.

• Families stopped traveling.

• Credit became almost impossible to get.

• Carmakers kept gouging the rental companies on costs.

• The rental companies couldn't get rid of their old inventories.

As a result, shares of Avis, Dollar and Hertz all fell around 98% from summer 2007 through March 2009, and their obituaries were written, filed and ready to go. As recently as two months ago, in fact, a Morningstar analyst stated that he foresaw a 75% chance of Avis defaulting on its loans and put its fair value at $1 a share.

So why is Avis already at 10 times that fair-value estimate? Well, you can take all those formerly negative factors and run them swiftly in reverse: As the economy has started to improve, companies are sending more salespeople on the road, families that still have jobs are no longer as freaked out about layoffs and have resumed leisure traveling, and pricing pressures have eased as automakers have found they needed to cut prices to get volumes high enough to keep factories running.

Survival of the adaptable

And now there is that unintended consequence I mentioned. One effect of the Cash for Clunkers program launched by Congress last month has been to slash supplies in the used-car market by up to 750,000 vehicles, because every one of the low-mileage clunkers turned in for a $4,500 rebate at a dealership must, by law, be destroyed. So rental agencies finally have pricing power for the sale of their downsizing fleets.

What a difference five months have made. Dollar reported last week that it had recorded a 15% increase in earnings in the second quarter. Excluding some one-time items, the company posted a profit of $6.9 million, versus a loss of $5 million in the second quarter of 2008, even though rental revenue fell 10.6% due to a drop in rental days. Hertz and Avis have reported similar profit gains.

Continued: Survival instincts kick in

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