Will Autonomous Driving Dreams Lead to a Crash

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The upcoming self-driving revolution will disrupt the entire auto industry and all the players, jockeying for a position in what is still an unknown landscape.

This means massive investments, uneasy alliances and probably plenty of wreckage along the way.

Last week ride sharing firm Lyft made headlines by 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 achieve scale across a vertically integrates platform.

The disruption occurring the auto/transportation industry, which 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 to physical counters and dedicated parking to maintenance, non of which “ride sharing” model such as Uber or Lyft incur, needs to be offset with auxiliary services such as insurance, fuel surcharging for profitability.

The active management of legacy fleet costs is a really big thing.  The large inventory of used cars that need 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 debt it needs to be considered to improve economies of scale, the need to regularly shed excess inventory makes them cyclical sensitive, extremely vulnerable to secondary market price swings and exposes them to their other big cost: asset depreciation.

There appear to be bigger forces at play that are 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 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 that profitability equation as are conditions in the after-sale market.

This in turn impacts new car sales as used car values determine in large the velocity of new car sales. Most new car transactions involve a trade.

The level of equity in the trade oftentimes determines whether a new vehicle transaction will be successful or not. Declining used car values lead to faster trade cycles while declining used car values lead to slower trade cycles.

And there is about to be a flood of used cars coming to market as the surge of leases over the past 5 years start to expire.

Dismal new car sales volume during our last recession created a shortage of used cars. This created a large supply and demand imbalance that made used car values soar from 2009 till 2014 as seen on this chart.  But that trend will now reverse as abundant cheap used cars drag down residual values forcing lease rates higher.

Uniform Fleet

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 that 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 creates another vicious circle into the equation. The quicker private cars depreciate, the greater the incentive 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 sun-roofs.

For as long as cars in the secondary market remain affordable to 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 that auto makers 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.

Kind Regards,

Steve Smith

Steve Smith is an expert options trader with 25 years experience in the markets. Steve was a seat-holder of the Chicago Board of Trade (CBOT) and the Chicago Board Option Exchange (CBOE) from 1989 – 1997. Steve is currently the editor of The Option Specialist and runs the 20K Portfolio Program which provides all types of options trades for all types of traders.

 

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