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Avis Budget Group, Inc. (CAR)

Q3 2006 Earnings Call

November 9, 2006 9:00 am ET

Executives

David Crowther - Senior VP of IR

Ron Nelson - Chairman and CEO

Bob Salerno - President and COO

David Wyshner - EVP and CFO

Analysts

Jeff Kessler - Lehman Brothers

Chris Gutek - Morgan Stanley

Zafir Nazim - J.P. Morgan

Michael Millman - Soleil Securities

Emily Shanks - Lehman Brothers

Presentation

Operator

Good morning and welcome to the Avis Budget Third Quarter Conference Call. Today's conference is being recorded. At this time for opening remarks and introductions I would like to turn the conference over to Mr. David Crowther, Senior Vice President of Investor Relations. Please go ahead sir.

David Crowther

Thank you Ravi. Good morning everyone and thank you all for joining the first Avis Budget Group earnings call. On the call with me today are our Chairman and Chief Executive Officer, Ron Nelson; our President and Chief Operating Officer, Bob Salerno; and our Executive Vice President and Chief Financial officer, David Wyshner. Before we discuss our results for the quarter, I would like to remind everyone of four things. First a rebroadcast, reproduction and retransmission of this conference call and webcast without the express written consent of Avis Budget Group is strictly prohibited. Second if you did not receive a copy of our press release it is available on our website at www.avisbudgetgroup.com or on the FirstCall systems.

Third, the company will be making statements about its future results and other forward-looking statements during this call. Statements about future results made during the call constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations and the current economic environment. Forward-looking statements and projections are inherently subject to significant economic, competitive and other uncertainties and contingencies, which are beyond the control of management. The company cautions that these statements are not guarantees of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements.

Important assumptions and other important factors that could cause actual results to differ materially from those in the forward-looking statements and projections are specified in the company's quarterly report dated June 30, 2006 on Form 10-Q, included under headings such as "Risk Factors" and in our earnings release issued last night and filed on Form 8-K.

Finally, during the call the company will be using certain non-GAAP financial measures as defined under SEC rules. Where required, we have provided a reconciliation of those measures to the most directly comparable GAAP measures in the tables in the press release and on our website.

Before I turn the call over to our CEO, let me briefly review the headlines of yesterday's press release.

Our revenue from vehicle rental operations increased to a record $1.55 billion for the third quarter. EBITDA from our three operating segments was $141 million excluding separation-related costs, and we updated our full year 2006 financial projections that we announced in July and reiterated in August.

Now I'd like to turn the call over to Avis Budget Group's Chairman and CEO, Ron Nelson.

Ron Nelson

Thanks David and good morning to everyone. May be a good place to begin is to quickly state the obvious. The separation of Cendant into four companies has been completed with Avis Budget Group, Realogy and Wyndham not trading as separate public companies and the sale of Travelport having closed in August. As a legacy Cendant entity, we formally adopted our new name Avis Budget Group and effectively we did a stock split which leaves us with just over 100 million shares outstanding. As expected, there was some heavy trading and stock price volatility in the first few weeks of August, however volumes and volatility appear to have now settled into a trading range. As a result of being a legacy entity however our GAAP financial results this quarter reflect various one-time expenses associated with the split-up and it makes it somewhat difficult to discern how our core car and truck rental operations performed. We will try to provide some clarity on that front.

I should also note that we expect -- we do expect to file our Form 10-Q next Tuesday, largely because of the complexity of the tax calculations associated with the reclassification of former businesses as discontinued operations and the one-time items associated with the separation plan have caused our quarter-close process to take longer than is usual for us. Amid this corporate activity, we believe that Avis Budget maintained its position as the leading car rental company at the US airports and the largest general-use car rental company in North America. Our [sale on truck] revenues remained under 32%. In the local rental or off-airport segment, we opened 57 stores in the third quarter brining our year-to-date total to 131 and we remain on track to achieve our target of 200 main locations this year.

In the quarter our local-market revenue grew 13% year-over-year including 9% on a same-store basis. In capital investment, fleets expansion continues to be quite manageable, even small relative to the growth opportunity we are capturing. For the quarter, our insurance replacement revenue growth was greater than 60% year-over-year, albeit off a small base. More importantly, (inaudible) significantly expand our insurance replacement account relationships, and fully expect to double our insurance replacement revenue year-over-year. We were in the year with about 750 million in local market revenue, up some 20% overall.

Before I turn the call over to Bob and David, let me spend a few minutes sharing some observations about the current climate that we find ourselves in. Currently, this is an interesting time to say the least. In the span of three or four months, our industry will grow on from being one which has been substantially private to one which will become substantially public. The amount of public equity capital invested in this industry will grow at least 3 or 4-fold and the industry dynamics and competitive results will become more transparent than ever before.

The idea of this is that it is a critical time when industry economics have been significantly challenged, the time when all three of the principal suppliers to our industry are losing vast amounts of money, cutting production and in certain cases grabbling with [deteriorating] credit. And at least for us, the time when we are completing one of the larger restructurings in corporate history; in short this transitional time is a curious one for an industry to attract as much capital as fast as it seems to be. So, (inaudible) is one of my suppliers, it makes identifying and successfully pursuing the way forward a lot more critical. For us, I'd say the way forward is having far more opportunity than it has problems. There is no question 2007 will be a transitional year. But the elements that are affecting us now actually are laying the foundation for a more vibrant future.

First, the simple notion that the majority of the industry is going to public is not new. As many of you know the history of this industry over the last 30 years has been defined by industry players flipping between public and private. But in the category of timing is everything, the industry has moved now into the public phase of its ownership cycle is particularly beneficial. As we believe, it will result in greater discipline in many areas, and in particular pricing, something the industry has lacked over the last few years and something the industry needs in the near term to overcome fleet and other cost pressures.

Second, we'll be in limits. I think it’s a good thing that our suppliers are cutting back production. 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 guarantee labor agreements than it has been by intrinsic demand in the car rail sector. 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.

Third and finally, increased fleet costs are driving us to require more risk fleet, which couldn’t provide a cost advantage, but just as important it also means we are getting more control over the fleet decisions in terms of mix, whole periods and numbers of cars. I don’t think any of these observations are of course without limits, so it's important to wrap them in some context.

The most important part of that context is the view that our industry still has a fair amount of pricing elasticity. We are almost always the most convenient and cheapest way to get to a destination for travelers having a ride to an airport. The other part of the context is that we also believe that the used car market is highly depended on market factors such as fuel prices, styling the economy, and consumer confidence. As a result, while we plan to be more aggressive in acquiring risk vehicles, we will likely be somewhat more measured than our competitors. This will result in us having somewhat greater forecasted fleet costs than others who are taking on more risks vehicles if their forecast to residual values actually proves to be correct.

I do think that assuming a decent economy and a more reasonably fleet cost increases for model year 2008, we will get to the necessary equilibrium between pricing and fleet costs over the course of 2007, which will put us on the road to restoring margins to normal levels. I also believe that some of the initiatives we are undertaking, some of which we will talk about today and some we won't, will allow us to drive our top line and grow margins beyond traditional levels, but make no mistake financial results in 2007 are highly dependent on our ability to get pricing in both the commercial and leisure arena. While we continuously manage our costs as carefully as any one, we cannot cut our way into growth. The full year impact of higher fleet and financing costs simply cannot be overcome with cost reductions.

So why am I optimistic? I think when you look at the core driver of our business enplanements, growth has been soft this year for a variety of reasons. Longer term, it [pre-stages] growth for our company [overload] that with effect that we are the largest on airport rental car company and it suggests that we will leverage that growth to a greater extent than all of our competitors.

Second, our margins are at a cyclical low. I do believe that fleet costs and pricing also will come into equilibrium and that will drive at least a return to normalcy.

Third, I think coming out of the private phase of our life cycle, our businesses are under invested. The only results of some of our new marketing initiatives, Cool Cars, Where2 and [i-turns] are very encouraging. Moreover, other brand extension opportunities that take advantage of the strength of our brands and their position in the market place will ultimately drive incremental revenues throughout this (inaudible).

On the corporate side, we have had 98% renewal rate among our corporate customers, as I have been getting around to talk to a lot of our customers, the dialog is rarely about rates but rather about our longstanding and well deserved reputation for service excellence and then finally it's about new markets.

For years, we have left the local market including insurance replacement on the table and allowed the competitors to dominate this space. I do not believe you can define yourself to be a leader in the vehicle rental market and leave half the market on the table. I am mindful that others are pursuing this opportunity as well but it is a $10 billion market and I suspect there is room for all of us. After all given our leading on-airport presence we are used to competing head-to-head and side by side with car rental companies of all sizes. My optimism principally relates to a longer-term look at our business -- the way forward if you will. We do recognize that we have a business to run one year at a time and having talked to several investors over the last few weeks I would like to ask Bob Salerno, our President and COO, to address the three issues that are uppermost on their minds -- fleet costs, pricing and margins. Bob.

Bob Salerno

Thanks Ron. Beginning with the issue of fleet cost, three points. First fleet costs continue to escalate model year 2007, two we are confident this is an industry-wide issue, and three we are taking significant steps to mitigate the effects of rising fleet costs. For our model year 2006 fleet, our principal vehicle suppliers proposed year-over-year cost increases for program cars of over 20% as measured on a per vehicle basis. Through various measures we reduced the impact of that increase so that our overall cost per unit is averaging in the 10% area. For model year 2007, our vehicle suppliers again proposed increases of approximately 20% on program cars, and we have taken the following actions. First we are increasing the risk car portion of our model year 2007 fleet buys from 6% this year to approximately 22% next year. That's on an available car months basis, which is how we manage the fleet. This will result in a somewhat lower risk component in the calendar year because of averaging. Second we are modifying the mix of our fleet to reduce the number of specialty cars. Our purchases of SUV's and other premium vehicles are down 29% and 15% respectively and almost 50% of our risk buy has 4-cylinder engine. We've tried to be smart about our risk buy and managed the residual exposure by what we buy rather than what we have to sell. Thirdly, we are holding cars longer. We hope to extend the average life across our fleet to approximately 10 months or more than an average -- more than a month longer than 2006. This is the very real impact of reducing the need to purchase as many vehicles and we expect through all of these actions plus the modest increase in utilization our 2007 fleet buy will be about 19% below 2006. Remember this is our purchases that we plan to shrink not our average fleet size.

Taken together we estimate that these steps will permit us to bring our calendar year 2007 fleet cost on a per vehicle basis down to around 10%. We do have the opportunity to increase the risk portion of our fleet as time goes by and our model year 2006 experience with risk vehicles has been very good. But as Ron noted we are probably not going to be as aggressive as other players in the market unless and until we have good clarity on the distribution of used cars.

Let me spend a minute on reaching pricing trends. For the quarter, domestic time and mileage revenue per day was up 5% year-over-year reflecting a sizeable gain in leisure pricing, but only a modest improvement in commercial rate. We continue to believe that generally speaking pricing is too low for the service we provide and for the cost of the assets required to provide that service and are taking every opportunity to maximize pricing.

On the commercial side while we have been able to achieve modest price increases in commercial contracts renewed so far, they are below what we would have liked to achieve as this sector has remained very competitive. We are frankly surprised that in the face of the higher industry-wide fleet costs and the changing ownerships structure of the industry, commercial prices have not increased at a faster pace. Based on historical patterns in the industry, we remain confident that conditions will normalize overtime and that price increases will occur. However, the timing of those increases has been delayed compared to our 2006 business plan. Rest assured, the entire management team is keenly aware of the importance of maximizing pricing opportunities. We are taking all the appropriate actions to raise rates while balancing this with the competitive nature of the industry.

Finally let me spend a moment discussing our car rental EBITDA margins -- where they are, have been in and also where they could go. The historical margins I am going to refer to will be on a pro forma basis, incorporating our current capital structure and excluding transaction-related items.

In 2006 our EBITDA margin for car rental is about 7%, which is down from over 8% in 2005, nearly 11% in '04 and 8% in '03. We see no reason why margins cannot return to the '03-'04 levels. We are aggressively managing cost, pricing, yield, revenue generation, commercial and affinity relationships and our infrastructure to get there. Each of these earlier years had one thing in common -- pricing and fleet costs were moving in tandem. Unfortunately, there are a variety of trends in addition to fleet cost that are uniquely impacting our margins to varying degrees. Over the past 12 to 18-months, having a large commercial account base, a low risk-fleet percentage and higher reliance on GM have all been negatives versus the overall industry. The combination of these factors has caused our margins to come under greater pressure than the industry as we unfortunately have been on the short side of all these. And as a risk of repeating ourselves, we are taking steps to address all these. We are nearly tripling our risk fleet and reducing the GM component of our fleet by about 10 points. This will result in the GM portion of our fleet by declining from 2006 levels by some 50,000 vehicles and by 100,000 units from our '05 level.

Finally, we are aggressively seeking price increases in both the leisure and commercial segments. The one attribute that we don’t want to change is our commercial account base. We like having a balanced portfolio of commercial and leisure business and over time feel that the Commercial segment can and will support premium pricing for the services we provide. In addition, we believe the demand from this segment offers better visibility and less variability throughout a cycle than does the leisure segment. So, while our leisure activity has become relatively more attractive over the last year, we like our balance between commercial and leisure business over the long haul.

Going forward what is going to increase margins and why do we feel this can happen? Clearly, we have to achieve equilibrium between pricing and fleet costs. The industry has displayed rational behavior on leisure pricing and we expect the same to occur on the commercial side. While this has taken longer than we expected, we believe it will happen. As the fleet costs increases are an industry-wide issue and with all of us heading towards being public companies, we will all have to answer to our investors on a quarterly basis.

David will review, which is the earnings impact of pricing sensitivity, but I would just point out that on an incremental basis a 1% increase in price is almost the point of EBITDA margin. While price is certainly a key focus, we have to look at other areas in which to either drive revenue growth or reduce cost and one of the most obvious is improving higher margin with ancillary revenue streams.

Our new Garmin Where2 GPS unit is a great example. It is a product that customers' desire, are willing to pay for, and the incremental margins are substantial. Better serving consumer demand for our optional insurance products is another and frankly affecting counter up-sales as a huge opportunity as well.

On the expense front, we are also looking for opportunities to continue to increase productivity and reduce cost. From 2002 to 2005, our operating and SG&A costs per rental day excluding fleet and interest costs essentially remained flat. In 2006, we saw increases, which outstripped revenue and productivity. (inaudible) was one of the items driving the increase, but most of the unfavorability relates to maintenance and damage. In late 2005, we returned to accepting debit card and concurrently stepped up our leisure volume. This drove much higher levels of maintenance and damage than we were historically seeing. We implemented actions to control this in the back half of the year. Additionally, the further integration of Budget Truck that we are implementing right now is another example of reducing costs in the back office area that do not impact our customer experience.

So while 2007 will be a challenging year as we look to find equilibrium between fleet costs and pricing, we believe that over the course of the cycle that the EBITDA margins in the car business should certainly average in the high single digits and can easily reach the low double digits during better times.

With that, I will turn the call over to David Wyshner.

David Wyshner

Thanks, Bob. This morning, I would like to discuss our recent results, the steps we are taking to turnaround our truck rental business and our outlook. As Ron mentioned, there are a number of non-recurring items related to our recently completed separation that makes year-over-year P&L comparisons difficult. As a result, I will focus on the results of our vehicle rental business and it's free operating segment in which the separation related items are more easily understood. We have also provided year-over-year comparisons on a pro forma basis in Table 4 of our earnings release.

In the first nine months of 2006, we've grown Avis Budget Car Rental revenue by 8% to $4.3 billion, generated pro forma EBITDA of $315 million and generated pro forma pre-tax income of $136 million. In the third quarter, we grew revenue 2%, while EBITDA excluding separation expenses was $141 million and pre-tax income excluding separation costs was $85 million. Our revenue growth was driven by 5% increase in car time and mileage revenue per day and a 1% decline in car rental days versus the prior year. Pro forma EBITDA declined 24% due to the double-digit fleet cost increases, Ron and Bob discussed, and due to weaker results in truck rental.

Earnings to our domestic car rental operations, revenue increased 2% reflecting a 5% increase in T&M revenue per day offset by a 3% decline in rental days. The decline in rental days mirrors a 4% decline in domestic enplanements according to the preliminary airline data. Year-over-year drop in enplanements was particularly sharp in August. It was typically our busiest and most profitable month, and unfortunately, was impacted by a significant terrorism scare, disruptive changes and airport security rules. Interestingly if you break out, our 3% decline in third quarter rental days to its components you will see a 7% decline in leisure volumes but a 2% increase in commercial activity. As a result domestic EBITDA excluding separation costs declined 20% in the quarter to $73 million. Our average fleet size decreased 3% in line with our volume decline, but we still experienced a 9% increase in fleet costs due to the model year 2006 cost increases and the introduction of model year 2007 cars.

Our operating expenses excluding fleet-related costs remain flat with last year as a percentage of revenue. Our largely variable cost structure and our cost saving initiatives allowed us to offset increased maintenance and damage costs. Nonetheless the margins and returns we're generating domestically are below what we have reported in the past and what we believe we can achieve in the future.

Moving to international car operations, revenue increased 16% driven by a 12% increase in rental days and a 3% increase in rates. The increase in rental days was driven primarily by our acquisition of the budget Toronto and Melbourne licensees during the last year. On an organic basis rental days increased 1% for the quarter. Reported EBITDA increased 7% in the third quarter and EBITDA excluding separation costs grew 6% organically and 10% overall.

Finally turning to truck rental while the silver lining may be that truck rental represents less than 15% of our company, the cloud is that this business is under performing. Revenue declined due to a 16% decline in rental days and a 4% decline in time and mileage revenue per day. The rental day decline was driven by a planned 6% reduction in fleet and an unplanned decline in local commercial volumes. The decline in T&M per day reflected a decrease in one-way rental rates which we believe is consistent with market trends.

Turning to earnings, EBITDA declined by $8 million due to the impact of higher fleet costs as we cycle out of very low-cost legacy fleet and the effects on revenue of having a smaller fleet. These two issues were anticipated and were part of the projections we made in March and July. The remaining $10 million decrease excluding separation costs represents the under-performance of this business, which we are taking some significant steps to address. We are adjusting our fleet mix, restructuring and streamlining our centralized truck rental operations, creating a separate local rental sales force, and evaluating ways to reduce our reliance on third-party dealers. As a result we will be closing the Denver truck headquarters, merging truck administrative operations into the existing back-office of our car rental operations. Most of these functions will be merged into our existing sites in New Jersey, Virginia and Texas to take advantage of the infrastructure and scale efficiencies of our car rental business. This will result in the reduction of approximately 50 positions equal to about 20% of current staffing levels in Denver.

We have named a new head of truck rental operations, Joe Ferraro, who has 27 years of experience with Avis. We are purchasing more 24-foot trucks with lift gates to capture more mid-week commercial business. We have established a new sales force focused exclusively on the commercial truck, insurance replacement, and local market opportunities.

And lastly, we are undertaking a comprehensive review of our dealer network. We will identify and either fix or eliminate unprofitable locations. More importantly, we need to identify and rectify situations where our dealing network is not taking advantage of the market opportunity that is available. Strategically along those lines, we believe that we will make more -- it will make sense for us to operate more locations ourselves and have more combined truck and car rental operations in local markets.

The restructuring of the Denver headquarters is expected to be largely completed by the end of the first quarter of 2007, and we expect to incur a restructuring charge of $10 to $12 million in the fourth quarter of this year. These moves are expected to provide some savings in 2007 and cost savings of $5 million a year beginning in 2008. While some of the restructuring actions can be completed quickly others will take time to implement, especially the dealer network review and the expected strategic refocusing of this business. We believe we have the right team to turn around this operation, and we continue to view budget truck as a core business with a meaningful number two position in its industry and a significant growth potential.

So within our Avis Budget car rental subsidiary in Q3, we had total EBITDA including separation cost of $141 million. Depreciation and amortization are $23 million, and net corporate interest expense was $33 million. This gives us $85 million for adjusted pretax income. On an ongoing basis, we expect our GAAP tax rate should be in the 38 to 40% range, and our cash tax rate will be substantially lower as we are not federal cash tax payer, but do pay some fee in international cash taxes. Our diluted share count is approximately 101 million.

We continue to invest in our brands and our infrastructure. Our Avis Budget Car Rental capital spending totaled $18 million in the third quarter, primarily for rental site renovation, the information technology asset and we remain on track to invest $70 million to $80 million for the year. This investment includes an insurance replacement IT system that will seamlessly integrate rental information among insurance, carriers, customers and us. We are also developing a new claims billing and management system that should reduce our damage expense through more rapid billing and increased collection.

Turning to our outlook; when we reviewed the pro forma projections we provided in late July, we feel we are defiantly trending toward the lower end of the ranges for the full year. This translates into revenue of approximately $5.6 billion, pro forma EBITDA of around $400 million, pro forma EBITDA less corporate interest expense of approximately $260 million and pro forma pre-tax income $165 million. We try avoid any confusion about how the math works, this translate into fourth quarter revenue $1.3 billion, EBITDA of $85 million, EBITDA less corporate interest expense of $50 million, and pre-tax income of $25 million, all excluding separation and restructuring costs.

It's not currently our intent to issue specific quarterly earnings projection. Since we've felt it important to update investors on our full year projections, we have three quarters in the books; they are by definition pinning down Q4. Most of the trends we saw in our business in the third quarter are expected to continue in the fourth quarter. We did however had some long length of rental business in the fourth quarter 2005 related to Hurricane Katrina. That won't be there this year. The experience in areas where we self-insure for potential losses continues to be quite favorable.

I'd like to highlight our projection of 2006 EBITDA less corporate interest expense of approximately $260 million. We think EBITDA less corporate interest expense, which is equivalent to pre-tax income plus non-vehicle depreciation and amortization, is an important metric for few reasons. First, among vehicle rental companies with different capital structures, this measure can be used to compare the companies' equity multiples; and second, because we are not a Federal cash tax payer, we believe that this metric over time should correlate to free cash flow before capital spending.

Turning to 2007, we have completed most of our model year 2007 fleet negotiations and we are nearing the end of our annual budgeting process, and we look at the actions outlined by Bob regarding fleet costs mitigation and pricing. Restructuring of our truck rental operations and expectation that domestic enplanements will grow by a few points next year. We expect to grow our revenues, EBITDA, and free tax income in 2007 compared to our 2006 pro forma results. The extent of our growth is highly dependent on price increases. We believe price increases in the 4% range are necessary to overcome the impact of higher fleet costs as well as inflation in our normal operating expenses. This is comprised of about 2.5 point to address fleet cost increases and close to two points to offset other cost inflation.

We are cautiously optimistic about our ability to achieve these increases for the reasons Ron discussed. To assist you in your model building, I should note that each 1% change in total car pricing equates to about $40 million of EBITDA and each 1% in total car volume is worth about $14 million of EBITDA. As you can see, a little pricing can go a long way.

Nonetheless, our margins and our return on capital are not where they have been or where we would like them to be, neither 2006 or 2007. Finding equilibrium between pricing and fleet costs has taken longer than we expected, but the history of this industry indicates that we should find a balance that is north of our current margins and returns and we are excited about the positioning of our (inaudible).

With that Ron, Bob and I would be pleased to take your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Let’s take our first question from Jeff Kessler with Lehman Brothers.

Jeff Kessler - Lehman Brothers

Thank you. First, with regards to the Truck Rental business, it’s a question that has probably been asked you before, but when you folks originally bought Budget, when Avis and Cendant essentially bought Budget, I guess I asked the question then, I will ask you again and I got the same answer back then is that why are you keeping the truck business? And the answer was, well its number two brand in the industry and that we have a lot of expectation from where that business is going, and I guess I have to ask you the same question because hopefully we'll get more than just the answer of why you are hanging out to a business that's been returning a lot less than the rest of your business is doing?

Ron Nelson

There's a few reasons, Jeff. I mean first of all over the last two or three years the truck rental business hasn't been returning a lot less than our other businesses, it's been doing well and it actually has been improving even when you take out the impact of the purchase price accounting on the legacy fleet. Secondly, I think that this is $500 million of revenue. It is in the vehicle rental business. It's under-performing and I think that we can improve this business and get the margins up north of where car rental are. Certainly when Cendant owned this, we did look to sell it over -- at various points and times and the truth of the matter was we couldn't get enough money to justify selling it. So I think on an economic basis it made sense and frankly given its poor performance this year would make even less sense to sell it.

I think the other thing too that you've got to keep in mind is that brand control is important, and it doesn't make you comfortable and warm and fuzzy if somebody else is out there with 30,000 trucks with your brand on them. So I think for all those reasons we are committed to this business, we are committed to improving it and we think we can.

Jeff Kessler - Lehman Brothers

Okay. On the commercial pricing area where you folks are a little bit discontented with what you are getting, I kind of know what our business has given you and your major competitor in terms of pricing and I kind of know where the largest companies are pricing but there are three companies in this business, essentially the major commercial players and if you are talking about there being significant price competition after you get over a certain point in terms of price increases, is that implying that one of the players is underpricing the industry to keep you from being able to get more than 4 or 5% commercial pricing?

David Wyshner

I don't think that's the motivation. You know, look -- yes the answer to your question is partially yes. I think one of the three players has been very aggressive on the pricing side, and I can only speculate on their motives. It may well be to the turnaround share declines that they have had over the last couple of years in preparation for an IPO. And I don't think that -- although we have been able to get some price increases I don't think that has abated to the extent that we would like it, but we do feel reasonably confident that -- look at the end of the day I think these are all rational smart people and they know if their fleet costs are going up and they are going to need to get pricing on a big chunk of their business in order to come to some equilibrium and build the margins and return on capital. So I think we are hopeful that it will turn around but for the first 10 months of the years it's been pretty competitive.

Jeff Kessler - Lehman Brothers

One of the longer-term projects of combining Budget and Avis has been to combine the physical plants, the actual lots and the people and the service areas at the airports. I realize that it rolls over, over a period of time because of lease restrictions and things like that from the airports. I am just wondering if you -- if I can get some idea of where you are in combining those -- combining the physical lots to basically gain cost and gain synergies from what you have gotten from your lets just say the front -- the front kiosk at the airport?

Bob Salerno

Hi Jeff how are you doing?

Jeff Kessler - Lehman Brothers

Hi Bob.

Bob Salerno

It's substantially done. There are as you said opportunities overtime that continue to come up as the airports change configuration -- logistical configuration and as those arise we are taking -- trying to take advantage of those. We are very still focused on keeping the customer-basing portions of our brand separate. We think that's healthier for our two brands. We like having the two brands but don't wish to combine them from a customer basing standpoint but as the logistical components of the airport change we are attempting to take advantage of combining things behind the curtain, so to speak to pick up further synergies.

Jeff Kessler - Lehman Brothers

Alright. Your major competitor on the on-airport side has obviously made a concerted effort to get into the off-airport business, the auto replacement business and they have -- they are exhibiting a specific strategy to do that which might be a little bit different than where enterprise has gone in terms of trying to hold down its share of the business. Could you talk a little bit about the strategy that you are using because Avis talked years and years and years ago about getting into off-airport and now I suspect that you are talking more about using the Budget brand to get into off airport?

Ron Nelson

Well I am not -- I won't claim to be an expert in what Hertz's strategy is in the off-airport market but I can tell you that our strategy has two or three tenets to it. One is where we had to build our geographic distribution of sites and as you know we'll add 200 this year, we will add 200 next year. I think we will cover somewhere between 80 and 85% of the population area is in the major urban areas with that distribution. By the way, I don’t think we will ever get to the 5,000 or so that Enterprise has, but I don’t think we need it for the insurance replacement business. So that --.

Jeff Kessler - Lehman Brothers

Where you are in number of sites?

Bob Salerno

We will be about 1,400 at the end of this year with 200. Two, I think the insurance replacement business and I think Enterprise's advantage over all of us is that they had an IT systems that integrated with the insurance companies and the rental car agencies to make billing and notification seamless. We actually have spent the last two years building that system. It went live two weeks ago. We are in the process of -- we've done demos for our existing customers. We are in the process of doing demos for our prospective customers and it is very well received. But until that system got developed, we were not going to get an enormous amount from insurance replacement business. This is not just an insurance replacement -- insurance company itself. At the end of the day, not only do you have to sell the insurance company, but you got to have feet on the street selling the local body shops and car rental -- car repair stores, and if you recall in our release, we've put a local sales force on the street. It's specifically going after insurance replacement at the local level with the body shops as well as going after commercial truck rental body shops. So we are getting twofer if you will.

And third, I think is our force, we are doing reasonably well in this. We are going to double our revenue this year, we'll probably double our insurance replacement revenue next year and as I said it's a big market. I think there is plenty of room for all of us.

Jeff Kessler - Lehman Brothers

Okay. The final question and that is before the auto manufacturers bought up all the rental car companies back in early 90s and basically got into this old guaranteed buyback program thing, the companies that were involved in auto rental were effectively -- basically nearly 100% at risk at the time. There was a lot of discipline that was forced on these companies because of the need to monitor residual value versus the debt against those cars. Are you stating and did you imply at the beginning that by getting more heavily involved in at risk business, there would be more discipline that would be forced upon the industry overall and essentially maintaining fleet utilization as well as where you are just basically maintaining where your -- monitoring where your fleet would be?

Bob Salerno

Yeah I think that's correct, Jeff. I mean as we said in our release we're probably getting into it a little softer than some others. We do know how to manage a risk fleet as you stated. We used to do it and all the people that used to do it are still here. But I think we want to see how it shapes out this year and how it goes before we get into it much heavier than we are already. I do believe, however, that the amount of risk fleet that is out there will force all car rental companies to think about their utilization and how they dispose the units and be very judicious about that. I do believe that.

Jeff Kessler - Lehman Brothers

Okay. What you're saying is that the people who were doing your at risk business, they are still around at Avis.

Bob Salerno

That's correct, Jeff.

Jeff Kessler - Lehman Brothers

Because that is concern of some people that -- that you guys been on program cars for so long that you may have lost on these at risk experts?

Ron Nelson

That -- we are all still here, Jeff and as a matter of fact, we haven't totally been out of the risk business. While we have been heavily into the buy backs, we've still sold quite a few cars over the docketed at options and quite honestly this year we had pretty good success with it.

Jeff Kessler - Lehman Brothers

Alright, well thank you very much.

Operator

Thank you. Moving on, we will hear from Chris Gutek with Morgan Stanley.

Chris Gutek - Morgan Stanley

Thanks good morning, couple of questions. Let's start to look -- dig a little deeper into the profitability of the domestic car rental business and first in terms of making sure we are talking apples-of-apples, if you take what you reported for EBITDA and add back the separation costs, but then allocate most of what you're calling the corporate interest expense to the US segment, we get an EBITDA margin of 3.5 to 4%, which is roughly half of what the other public companies recently reported and well less than half of what one of the other major competitors is looking at and even now that other major competitor is talking about significant further margin expansion. So, first would you agree with the definition? And secondly, could you help us understands issue by issue where those margin differences lie?

David Wyshner

Sure I think the analysis and the allocation -- this is David. The analysis and the allocation of the debt that you have done does make sense at the -- same time, I think that the top line or that sort of analysis is challenging from one business to another. I think there are some differences between that you can see in our margins domestically and internationally, and we expect that’s an issue among other folks, so to the extent our mix is different from other folks. You will see some changes there. And the other key issues are the ones that Bob was talking about where we are on the short side of commercial versus leisure compared to the more leisure-oriented public company that’s out there. We do have a larger GM portion to our fleet, and that has been a negative place to be and we also have had a smaller risk component this year than a number of other folks and that has been a negative. So we do think that is creating some near-term pressures on our margins compared to other folks. But at the same time I do think some of the comparisons to -- that are out there are very challenging because of combinations of domestic and international businesses as well as adjustments and purchase accounting and other items that folks appear to have impacting our numbers.

Chris Gutek - Morgan Stanley

David, could you elaborate may be a little bit more specifically on the cost structure, and we have heard some suggestion that under Cendant the business had gotten may be a little bit fat in terms of the corporate costs, in particular. It's kind of hard to imagine a lot of excess costs but could you talk about to the extent there might be some low-hanging fruit and then to what extent if there's not low-hanging fruit the management might have an appetite to take a much more aggressive look at the cost structure and consider some more radical actions to improve profitability?

David Wyshner

Chris, we've heard a couple of rumblings along those lines and frankly we think they are completely unfair. I saw all of our other businesses at Cendant and the Avis management team, the team that's responsible for running the operations at Avis Budget now has for a long time been one of the most cost-conscious and cost-aggressive that we have seen, and I think is very effective in managing those costs. We are aggressive in looking at our operating cost by region and by site on a daily basis, that's going to continue. It probably will become even more aggressive but I think it is a part of the culture here that is continuing and, as Ron said, our opportunities are on pricing and expansion. Trying to cut our way into growth is not likely to be the solution for us given the historical ability and focus on doing that. I think there are always some opportunities but it is not a greenfield or untapped area for us; rather it's one that's thoroughly mined, but that's not going to stop us from going through it again.

Ron Nelson

Chris this is Ron. Let me just add three things that you shouldn't overlook in your analysis. I think with respect to two of our smaller competitors, they have a fair amount more franchise income than we do. And as you know that all drops to the bottom-line and adds -- my calculation a point or so to their rental margins. Second, as Bob pointed out, one of the expenses that is out of line with our revenue growth this year is M&D and M&D went up because we returned to taking debit cards and we changed our leisure mix in this past year and that reflected itself in the first half of this year with fairly substantial increases in M&D. We think we have gotten our arms around it now, we have got a much better system where we are doing credit checking on debit card renters and we are going to bring M&D back in line. And then thirdly and this is really not unique to us but it is -- it may impact us more than the rest of the industry is gas. We all make gas revenue because we charge, I don't know, $6 or $7 a gallon to refill it when somebody doesn't come in. When gas went up, the dollar a gallon over the course of this year we didn't really feel like we can move that pricing. So, what you had was where you were making some margin on gas that basically got eliminated in the first half of this year. It will start to come back as gas goes down in the back half and assuming gas did comfortable, we will have some margins going into next year. So, I think those are three things you need to look.

Chris Gutek - Morgan Stanley

Okay. Thanks, and two more quick ones if I could. So, to dig a bit deeper on the price increase, the revenue per rental day was down sequentially Q3 versus Q2 and the year-over-year growth rate decelerated because of easier comps in Q2 versus Q3. But still could you help us better understand what's happening with pricing both on the leisure side as well as the corporate side and what is the underlying price increase for example this quarter versus last quarter and what are you seeing so far into Q4?

Bob Salerno

Will Chris, let me start off by saying what's going on in pricing. On the leisure side, we do see as we said good movement and pretty much across the industry and this is kind of a continuation of what's been going on since last year and it's been heartening and we've had good increases on the leisure side. On the commercial side, I don't want anybody to leave thinking there are no commercial pricing increases but certainly are and in a normal year, a year where fleet costs aren't going up to the extent that they are we would be actually quite pleased. The issue is that, it's just not enough in our opinion to overcome the fleet cost increase. So, we continue to push on that and I think that we will be more aggressive on our own in commercial pricing and then we also do believe that as the industry really has to report in and show numbers that -- it will allow further commercial price increase and we will move very aggressively when that happens.

Chris Gutek - Morgan Stanley

Okay. Ron, final question for you, kind of, a big picture question; hypothetically, of course, given the current capital structure will it be feasible or possible for the company to pursue a leverage recap of potentially an LBO? And secondly, to what extent would you have an appetite to move in that direction?

Ron Nelson

Well -- I think in terms on a leverage recap I think that's myself take the gun and point at your head and shoot it quite honestly because so much of our cost structure is dictated by the ability to finance and acquire fully -- and credit rating is important in doing a leverage recap. It's going to hurt your competitiveness in terms of your ability to price and (inaudible). I actually think within -- if you are talking about substantial leverage recap that's a zero sum game. In terms of an LBO, look that's -- that's not within our control. We certainly are running this company for the long term. All the actions we're taking are ones which are going to benefit the company on a long term ongoing basis. But as we have said consistently when somebody makes an offer, the Board has a fiduciary obligation to consider it and -- certainly not are -- not the direction we are moving in.

Chris Gutek - Morgan Stanley

Great thanks.

Operator

Thank you. We will now hear from Zafir Nazim with J.P. Morgan.

Zafir Nazim - J.P. Morgan

Thank you. A few questions, I guess that's an extension of the previous question that was asked. On the commercial side of the business, you mentioned that you got some increases, but not enough, but was your experience in getting commercial price increases during the third quarter similar to what you had in the second quarter or was it better or worse?

Ron Nelson

I would think that in the third quarter it was pretty much along the same lines. I mean, I think our frustration here is an issue that there is a need for further and greater price increases and a lag in the industry and the competitive nature of the industry in allowing that, but it hasn’t gotten any worse. I would not characterize that at all. And you might say there are -- late in the quarter and as we are moving along that you might see glimmers of hope, but it’s a little too early to tell.

Zafir Nazim - J.P. Morgan

Fairly evenly through the year or is there one quarter in which you have a spike?

Ron Nelson

No, I wouldn’t say that there's any big spike. I would say that our increases have been fairly even throughout the year as the renewals will build up.

Zafir Nazim - J.P. Morgan

Okay. In terms of deliveries of the 2007 model cars, when do these start hitting you? And in fourth quarter, what will be the mix between '07 model cars and '06 model cars.

Ron Nelson

Well we actually, we started taking in '07 model year cars in July of this year, and I don’t quite have in front of me the mix of what is going to be in the fourth quarter year. But we can still get that for you.

Zafir Nazim - J.P. Morgan

Okay. In terms of guidance for the rest of the year -- you know you're looking for an EBITDA of 85, which is a small increase of your last year's EBITDA and I am -- I guess I am kind of struggling with getting to that number given that your EBITDA in the first three quarters have been down roughly 25%, you have got higher fleet costs to content with because now you have the '07 price increases in addition to [safe that have still not impact] through, so how can you give us more comfort and say whether you can hit an EBITDA number which is actually slightly higher than what you did in the fourth quarter of last year?

David Wyshner

This is David. I think an important part of the issue is anniversarying the fleet cost increases last year. The price increases that we have seen in the third quarter were fairly significant in the 5% range and the big part of the issue is that we had not yet anniversaried the significant roll end of model year 2006 vehicles. And as a result I think the fourth quarter dynamic on a comparable basis, that changes a bit and that's why we are comfortable with the projections we have for Q4.

Zafir Nazim - J.P. Morgan

Okay. And finally on the truck -- on the truck rental side, any estimate as to when this business is like to stabilize in terms of the top line as wells as margins?

David Wyshner

I think, we've just started our restructuring plan, I think that -- we are thinking about over the course of next year we'll see continued improvement and by the time we turn into '08 we are hoping that we can have a normalize business.

Ron Nelson

I wouldn't under estimate one of the points that David made of outlook looking at our dealer network and moving strategically to open our own locations. One other thing that U-Haul does very well that we don't do particularly well is cell boxes and related ancillary goods. Those are very high margin items. It's very difficult to sell and get the margin from them when you are dealing exclusively with an independent dealer network. And so the move to open up corporate locations where we can control that process and get better volume on those high margin items, I think is very significant in getting the margins back to where they belong. And that is not a quick process. As you know, opening locations and establishing can take anywhere from 12 to 18 months. But this is something that we are starting in earnest and we are going to move as quickly as we can because the bottom line is it can't return fast enough to normal margins.

Zafir Nazim - J.P. Morgan

And how many locations do you think you will have -- corporate locations by the end of next year?

Bob Salerno

I don't want to speculate on it. We just hired a new guy to run it and this has been his marching orders, and we are going see his plan over the course of the next few weeks. We need to give him some time to get his feeling. So we can update you as time goes on that.

Zafir Nazim - J.P. Morgan

Okay thank you.

Operator

Thank you. We now move on to Michael Millman with Soleil Securities.

Michael Millman - Soleil Securities

Thank you. Also a couple of questions. Can you talk about the possibility of off-airport sites and how it differs in the US and international?

Bob Salerno

Michael I think in the US when we look at our off-airport sites, different cost structures in the airport but all in all then -- and different pricings in the airport, so all and all the actual profitability is quite similar to the airport is what we see. Internationally, there's really -- it's a smaller component of our business internationally except in Canada where we have a pretty large off-airport infrastructure, but again there, it is -- it actually is quite similar to the Canadian airports and the Canadian operations.

Michael Millman - Soleil Securities

I was asking that because Hertz seems to be suggesting that there is a long period before it's profitable, and that they have built very carefully at their sites and weed out a lot of them, do you see that as well? Does it take a long time to get these up to profit?

Bob Salerno

It takes for us somewhere between 6 and 9 months to get it to the normalized profit we think its going to operate at. The real key we find is that you have to spend time in where you're going to put it and we do a lot of demographic research before we open a store. It's reflected in the amount of closures we have which are really almost nil. So, I mean we -- if you put it in there right the first time and give it a little time and effort, we generally find within 6 or 9 months where we need to be.

Michael Millman - Soleil Securities

Given that it had similar profitability, and it has faster growth, are the earnings there growing faster then on the airport?

David Wyshner

I think that's a fair way of looking at things. It's still a -- you know, it's still a relatively small portion of the business there. So it's hard to draw a lot of conclusions from that.

Michael Millman - Soleil Securities

Because you seem to be focusing -- a lot of focus is on the profitability of that business going forward, so trying to get some idea of where it goes. And also I think you said that the same-store sales growth was 9%. Was that correct?

David Wyshner

Yes.

Michael Millman - Soleil Securities

And it's part of that basically tenuring benefit?

David Wyshner

There would be some in there to the extent that there is some continued growth for a second year site compared to a first year site. But as Bob was mentioning the new locations do come up to speed relatively quickly, but there is some layering or tenuring effect in there as well and that should continue with us having opened about 200 sites this year.

Michael Millman - Soleil Securities

Just to beat a dead horse. We should assume that about 20% of car rental profits comes off-airport?

David Wyshner

I don't think we are going to get into profitability breakdowns between the on-airport and off-airport. Our disclosures are going to be based on the domestic business as a whole.

Michael Millman - Soleil Securities

Moving to the risk cars, can you talk about what risk cars -- how they affect your debt expense?

David Wyshner

Sure the cap cost for risk cars tend to be a little bit less than they are for the program cars, and so there will be a little bit of a reduction associated with the debt expense with the -- in average risk car compared to a typical program car. In the scheme of things I think that effect will be relatively small but it is a positive that were factoring into our 2007 thinking.

Michael Millman - Soleil Securities

Is there a negative that you might have to put up more equity?

David Wyshner

No, there is really not Mike. The issue in terms of how the rating agencies are looking at our program vehicles is that the amount of enhancements we are required to put up on program vehicles is very similar, is not identical now between GM and Ford program cars and risk vehicles. So, one of the reasons that risk vehicles have become relatively more attractive over the last 12 to 18 months that there is no longer a credit enhancement difference between Ford and GM program vehicles and repurchased vehicles and risk vehicles.

Michael Millman - Soleil Securities

And can you give some idea of how -- what had contracted the saving between the two?

David Wyshner

The principal savings relates to depreciation costs, the slightly lower cap costs and then were we can dispose of the cars in the market and I think the opportunity that we've had this year and that we see ourselves having next year as well with the relatively small risk percentages in our fleet are that we can decide which models and which markets and which times of the year were disposing of risk vehicles and that gives us an opportunity to reduce the aggregate costs, the aggregate depreciation costs associated with the risk vehicles.

Michael Millman - Soleil Securities

Can you quantify that?

David Wyshner

I think we're reluctant to do that but suffice it to say we do think that risk vehicles are going to -- they certainly have been less expensive this year and we expect that they will be again next year, but we don’t want to go into details about that.

Michael Millman - Soleil Securities

And your third quarter 5% price increase, could you give some idea of how mix affected that?

David Wyshner

I'll have to follow-up with you on that.

Michael Millman - Soleil Securities

Thanks. And regarding -- you had mentioned I guess to Chris' question about some of those additional costs, can you quantify those impacts? And where do -- and how you --?

Ron Nelson

Well, I don’t think we are going to get into any line item detail on our income statement, Mike. I mean we are trying to give some guidance for things that explain the difference between our third quarter margin and others' third quarter margins, but I think we are not going to get into line item detail.

Michael Millman - Soleil Securities

And talking about following up on what you said, Ron, Hertz seem to be particularly optimistic about '07, are they drinking out of a different fountain than you are?

Ron Nelson

No. look I hope everything that they say on their road show comes true because by and large we have the same mix of business. We are both premium players and if the market is good then we'll both benefit similarly. What it -- it does appear that they have more risk fleet than we do. So if the used car market holds up, then we will enjoy a slight advantage on that, but I think we are just cautious about going forward in '07 and we may I hope everything they say is correct.

Michael Millman - Soleil Securities

Great. Thank you.

Operator

And we will take our final question from Emily Shanks with Lehman Brothers.

Emily Shanks - Lehman Brothers

Thank you. And just a quick question around the vehicle debt, is there a reason or could you give a little bit of color as to why it's down sequentially quarter-over-quarter?

David Wyshner

Sure Emily. It principally relates to seasonality. I think there is no significant change in how we are financing the fleet. The issue is that at the end of June we are pretty close to our -- we are much closer to our seasonal peak to support July and August and summer leisure volumes and over the course of September, we reduce our fleet fairly significantly and that causes the debt to decline typically from June to September.

Emily Shanks - Lehman Brothers

Okay. Great. That's helpful. And then just one quick follow-up as most of my questions have been answered, will you be providing the supplemental data for Avis Budget LLC as you did for the second quarter with more balance sheet etcetera?

David Wyshner

Yes. That’s a great question. We do expect to post the Avis Budget Car Rental LLC financials next week.

Emily Shanks - Lehman Brothers

Next week, okay. Thank you.

Operator

And that’s all the time we have for questions, I'll turn it back over to our speakers for any additional or closing comments.

Ron Nelson

No I think that’s it. I thank you all for joining our first call and we look forward to talking to you at the end of the year. Thank you

Operator

Thank you. That does conclude today's conference call. We thank you for your participation. Have a great day.

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Source: Avis Budget Group Q3 2006 Earnings Call Transcript
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