China's car rental industry is in its infancy, yet already showing potential to become the world's biggest--much as its automakers dominate global sales. Car rentals feed into the narrative of a rising middle class in China, with consumers increasingly looking to travel for work and leisure. As such, S&P Global Ratings projects 10%-15% annual growth for car rental companies for each of the next two years.

But such growth doesn't come without pain. Investors' concerns for the segment center on its tight liquidity, aggressive expansion, and market competition. We believe the risk for the next three to five years is that some players may have overextended themselves given narrowing liquidity and leverage buffers. The industry's struggles are reflected in our recent downgrades of the two companies we rate: CAR Inc. (B+/Stable/--) and eHi Car Services Ltd. (B+/Stable/--).

China car renters want to expand to achieve better efficiencies of scale--essential for this industry--and to be in position of strength when the sector consolidates. The main players are desperate to grow, which has led to stretched balance sheets, testing the credit appetites of lenders (see charts 1a and 1b).

Chart 1a

Chart 1b

China's Car Rental Market Radically Undershoots Potential

The Chinese market is critically underpenetrated, in our view. China's population is four times that of the U.S. but its car rental market is one-tenth the size of America's in dollar terms (see chart 2).

China's market is also fragmented. Even the biggest issuers are small. The three top car hire firms in the U.S. essentially control the rental sector, while in China the top three's combined market share is still below 30%.

Chart 2

Car Inc. has more than 120,000 cars for short-term rental and eHi has more than 80,000, making them the top two players. Shouqi Car Rental Co. Ltd. is a distant number three with around 10,000 vehicles, and downsizing. Hertz Corp., the second largest rental car company in the U.S. with around 20% market share, has a fleet of more than 500,000 vehicles in the U.S., by comparison.

Growth Push In Tight Credit Market Leads To Liquidity Risk

The small and fragmented market limits the bargaining power of China's car renters with automakers. U.S. car rental companies are the largest purchasers of cars in the domestic market. They collectively buy around 2 million cars every year, accounting for 10%-15% of new car sales. This means they can secure excellent terms for their fleet purchases.

China's funding environment is less favorable, with limited fleet-based financing channels and a cautious bank lending culture toward privately owned enterprises (as are the leading car renters).

The average tenor of both Car Inc.'s and eHi's onshore borrowings is less than three years, a tad shorter than the economic life of vehicles. Car Inc. aims to secure two-to-three year financing from financial institutions. However, about one-quarter of the funding is still one year. eHi's onshore borrowings are predominantly short-term loans from Chinese banks or two-to-three year financial lease obligations from leasing firms or carmakers. Only recently have Chinese banks begun providing three-year loans to eHi--largely matching the economic life of vehicles--but only in small amounts.

Chinese car renters are able to access the offshore market to raise unsecured notes or syndicated facilities to fund their capital expenditure (capex), but such funding is typically in the form of bullet deals that translate into maturity walls (see chart 3).

Chart 3

Car Inc. has debt of about Chinese renminbi (RMB) 6.4 billion (US$910 million) coming due in the 12 months ending September 2020, including RMB3.3 billion in bullet maturities, compared with its cash on hand of about RMB4.5 billion as of September 2019.

eHi underwent bumpy refinancing in December 2018, finally securing a syndicated loan to replace maturing U.S. dollar notes. However, the loan carries tight covenants that may see eHi quickly consume its liquidity buffers as it expands.

By comparison, U.S. and European peers can access deep capital markets, using diverse capital channels such as asset-backed borrowings and fleet financings. The pools of assets backing their funding are large and varied which makes them good candidates for asset-backed deals.

An Underdeveloped Used-Car Market Adds To Risks

Chinese car renters lack funding flexibility, and they also lack a deep used-car market into which they might recycle their fleets. Despite consistent growth in the past decade, sales of used cars in China still account for just about half that of new cars. In the U.S., by comparison, more than two used cars are sold for every new one. Used-car prices in China have been volatile, particularly for brands and models in which there is little supply.

This undermines Chinese car renters' ability to sell inventory in a downturn or when liquidity is squeezed. U.S. car rental companies were able to sell autos to rapidly shrink their fleet during the last two economic downturns--a flexibility largely unavailable to the Chinese renters (see chart 4).

Chart 4

In addition, an underdeveloped used-car market exposes Chinese car renters to greater profit volatility, as swings in used-car prices can directly hit profit margins through higher depreciation costs (falling residual value).

eHi is an early mover to actively manage its residual value risk with its wide adoption of program-car agreements. Under the agreement, car dealers agree to buy back vehicles from eHi after one or two years at preset rates. eHi's program cars make up about 60%-70% of its fleet size, leaving 30%-40% fleet at-risk vehicles (vehicles that are subject to pricing risk when sold back into the used-car market).

On the other hand, Car Inc. relies mainly on the used-car market to sell its older fleet vehicles. This approach tends to be more profitable when the automotive market is healthy, but exposes the company to downside risk when the market turns. And as a result of the weakening automotive market, Car Inc.'s depreciation costs over asset value increased by two to three percentage points in the third quarter of 2019. This was a key factor in the about 30% decline in EBIT during the quarter, even as revenue grew 12%.

To combat rising residual risk, CAR Inc. has gravitated toward program-car arrangements to expand its fleet. The firm acquired 20,000 program cars from Beijing Borgward AG in 2019, about half of the estimated 40,000 vehicles it procured that year. However, this purchasing policy will increase its brand concentration within its fleet--limiting its appeal--and only marginally reduces the proportion of at-risk vehicles within its fleet. We estimate program cars from Borgward will only account for 16% and 27% of its total fleet in 2019 and 2020, respectively, while most of its fleet remains at-risk.

Expansion Is A Must, But Rethinking Strategy

Car rental is a scale business, and eventually this industry will shake out with a handful of massive players. Naturally, every car renter wants to be in that top group, and that creates a conundrum: how do you maintain high growth when liquidity is stretched and funding options limited? (see chart 5)

Chart 5

Car Inc. and eHi are both aiming for 10%-12% net fleet addition in 2020, compared with 15%-30% in previous years. Both companies are searching for less capital-intensive ways to expand their fleets.

Car Inc. is experimenting with lease agreements. Upfront costs under such arrangements are less than 10% of asset value. Fixed monthly payments encompass depreciation and interest costs, but Car Inc. is relieved of any residual value risk. In 2019, about 5,000 vehicles were acquired via this method, and the company expects to acquire another 5,000 this way in 2020 (out of 30,000-35,000). This partly alleviates CAR Inc.'s capital needs for fleet expansion.

eHi has increased its use of "AP model" car acquisition approach--it directly signs program-car agreements with car dealers or carmakers without financial institutions providing credit. The exposure is thus recorded in accounts payable rather than debt, and requires low initial cash outlay. However, the interest expense is moderately higher than the company's overall funding cost. The company will likely conduct 40%-60% of car purchases using direct-program car agreements over the next 12-24 months (see table 2 in appendix).

Operations Are An Important Part Of The Equation

Operating efficiency is just as important as scale expansion and is a key competitive differentiator for Chinese car renters. Demand for short-term car rental is not growing evenly in China and varies across cities, seasons, and use cases. To maximize profits, car renters must forecast demand in each of their markets, anticipate demand for vehicle types, deploy the right number of vehicles, and hit the right price points.

eHi has a good record of maintaining stable utilization despite its fleet expansion, which, combined with the contribution of AP model cars within its fleet, should result in more stable profit margins. Car Inc. has higher rental rates thanks to its stronger brand and coverage in license-plate restricted tier one cities. However, Car Inc.'s pricing and utilization strategies are somewhat fluid, which results in a more volatile financial performance.

China's car renters have limited reliance on airport business, certainly compared with U.S. and European firms, which can capture as much as 70% of their sales from airport rentals (see chart 6).

Chart 6

The limited reliance on airports is good for margins, as airport rentals are highly competitive and low margin. Chinese firms are also less reliant on margin-depleting distribution channels such as travel agents, and tend to make better use of automation (such as staff-free service points) than their global peers.

And, indeed, Car Inc. and eHi achieve EBIT margins that are largely in line with industry norms, despite the cost disadvantages of their smaller scale.

However, the firms are challenged by their high funding costs and large capex requirements (see charts 7a and 7b).

CAR Inc.'s EBIT interest coverage of around 1.6x-1.7x and eHi's 1.1x-1.3x are similar to Avis Budget Group Inc.'s 1.4x and Hertz's 1.1x, yet much lower than that of the industry leader, Enterprise, at about 7x.

Chart 7a

Chart 7b

The X Factor Of The Mobility Moment

Another X factor complicates the expansion ambitions of Chinese car renters: competition from other mobility service providers. Car rental accounts for a small portion of the broader mobility market in China.

Car hailing and car sharing by comparison have generated about 100% annual compound growth in the past few years, capturing most of the expansion in the Chinese mobility market. The car hailers tend to adopt an asset-light model, which means they don't share the rental entities' capital constraints.

In addition, a weak auto market could drive carmakers to accelerate their expansion into the mobility market, fueling competition. We have already seen many large Chinese carmakers launch their own mobility offerings, mostly car hailing but also some car rental.

We see only a slight overlap between the car rental and ride-hailing businesses, given that most rentals involve longer trips and rental periods. The average rental periods for Car Inc. and eHi are both around three to four days.

At the least, we think pricing pressure on rental cars will stay heightened as consumers are offered broader choices of mobility services. Clearly, the Chinese car rental industry will need to manage the risks that come with rapid expansion. We therefore see an outside chance that expansion doesn't rev up profits.

Related Research

• eHi Car Services Ltd. Downgraded To 'B+' From 'BB-' On Slowing Recovery And Limited Liquidity Buffer; Outlook Stable, Dec. 10, 2019
• CAR Inc. Downgraded To 'B+' On Weakening Profitability; Outlook Stable, Dec. 10, 2019

Appendix

Table 1

Table 2