Avis Budget Group - A Thought Experiment

Summary

• CAR reported lower Q4 earnings and issued weak guidance.
• Based on large hedge fund ownership of the equity, cash flow might be used to buy back common.
• But, then again, it might not.

Avis Budget Group, Inc. (NASDAQ:CAR) caught multiple equity analyst downgrades last week after release of its Q4'16 financial results, but unlike Hertz Global Holdings, Inc. (HTZ), Avis has been generating stable cash flow and is not headed toward a likely debt covenant breach this quarter. What the two car rental companies share in common are equity holders with activist agendas - in CAR's case, a group of hedge funds owning 23.2% of the common and angling for share repurchases and, in HTZ's case, a more concentrated group of hedge funds holding 53.1% of the common and depending on 35% shareholder Carl Icahn to make a decision for it. Icahn's intentions remain unknown.

On February 15th, CAR reported Q4'16 revenue, EBITDA and adjusted net earnings of $1.88 billion, $121.0 million, and $0.15 per share, respectively, missing consensus estimates of $1.97 billion, $132.8 million, and $0.17 per share, respectively, by 4.4%, 8.9%, and 11.8%, respectively. Commercial demand is 45% of CAR's revenue while leisure is the other 55%. Soft commercial demand amid a glut of competing cars sent Q4'16 pricing lower by 70 basis points year over year. Both rental days and average revenue per rental day dropped by 1%.

Despite more positive macro expectations for travel, lodging and airline bookings, CAR management issued subdued FY'17 guidance indicating just small upticks from FY'16 results. The FY'17 revenue range of $8.80-8.95 billion is just on top of the $8.75 billion recorded for FY'16. The midpoint of management's adjusted EBITDA range of $840-920 million for FY'17 is $880 million versus the $875 million produced in FY'16. The midpoint of the free cash flow range of $450-500 million for FY'17 is just above the $472 million the Company booked in FY'16. The $3.40 midpoint of adjusted EPS of $3.05-3.75, however, would be a solid 16% improvement from the $2.93 adjusted EPS in FY'16. Alas, 10 cents of that improvement is ascribed to expectations of more favorable foreign exchange rates.

CAR's guidance was weak but still indicates an improved 10.0% adjusted EBITDA margin (vs. 9.7% in FY'16). In addition, management forecast a 300 to 500 basis point improvement in adjusted EBITDA margin within the next five years via expansion of the Company's demand-fleet-pricing yield management system, better manpower planning and shuttling initiatives, improved vehicle acquisition/disposition to counter residual value declines, and enhanced mobility services (Avis Now, Connected Car). Most important was the simple fact that CAR guided higher for FY'17 after HTZ, its most direct public comparable, had previously guided lower.

To remind you, the primary reason for HTZ's lowered forecast was that its management increased US rental car depreciation expense to $300 per unit per month based on a review of its fleet. Should investors expect CAR's management to similarly move depreciation expense higher…?

CAR and HTZ have different types of cars in their fleets. HTZ's fleet is primarily comprised of automobiles from Nissan (OTCPK:NSANY) (22%), Toyota (TM) (17%), and Fiat Chrysler (FCAU) (17%). CAR's fleet is mostly Ford (F) (21%), GM (GM) (17%) and Chrysler (7%). But there are analogous residual valuation issues despite the differing fleet compositions. HTZ made the decision to lower residual values based on type of vehicle, i.e., certain harder-to-rent compacts and mid-size vehicles. That would seem to increase the chances the Company will be obliged by its auditors to do the same on its own lower-end compacts, sub-compacts and mid-size cars, even if CAR owns fewer of these models than HTZ does.

About 51% of CAR's fleet isn't covered by a manufacturer repurchase agreement versus 80% at HTZ. Those agreements are formula driven with repurchase prices and timing based on the covered vehicles' depreciation rates. CAR's harder-to-rent "risk vehicles" are a growing proportion of its fleet and they are particularly suspect as candidates for a possible residual value cut. Some of that has already occurred, which may indicate additional expense recognition down the road (no pun intended). CAR booked higher vehicle depreciation and lease charges in FY'16. Those charges increased to 19.2% of revenue from 18.7% in FY'15, primarily due to lower pricing although that was partly offset by a 1% decrease in per-unit fleet costs (including a 2% favorable impact from currency exchange rate changes).

Financial Summary. See table below. CAR generates more consistent cash flow and remains in a much better financial position than HTZ. LTM revenue has been growing modestly, and LTM adjusted EBITDA is stable. Net leverage of 3.6x has also been stable and well within the 3.0-4.0x range management pursues. In FY'16, CAR was able to use $390 million of that cash flow to repurchase 12.3 million shares of its common stock without raising the Company's leverage metrics.

Management expects to spend at least another $300 million this year to buy back shares based on its projected $450-500 million free cash flow forecast. That forecast assumes a projected $430-520 million adjusted pre-tax income, adds $205 million of non-vehicle D&A, subtracts $210 million of capex, subtracts $55-75 million of cash taxes, adds $20 million from vehicle programs, and adds $50-60 million of working capital. The free cash flow forecast excludes certain acquisition and other items and includes restructuring expenses viz the working capital range.

One question is whether a $300 million minimum share buyback will be enough to satisfy hedge fund investors in possession of nearly a quarter of CAR's equity. If, for example, the Company could have repurchased another $340 million of its common stock and net leverage would be at 4.0x, the top of management's targeted range. Another question is whether management will conclude that spending additional funds on share buybacks actually increases shareholders' longer-term return on investment. It may want to consider other options. More on that later.

Segment Results. CAR has a 28% share of the important airport car rental market - it generates 60% of its revenue at airports. That places it third behind Enterprise (37%) and HTZ (30%), but CAR has a more flexible product offering comprised of three global brands with differentiated strategies - Avis (premium, 75% of revenue), Budget (value, 15% of revenue), and Zipcar (sharing, 10% of revenue and growing rapidly). Payless is CAR's deep value alternative.

CAR has expanded its geographic footprint most recently by negotiating a strategic agreement with Didi Chuxing for ride-hailing users traveling outside China, acquiring AAA France Cars in 2016, buying Maggiore Rent SpA in Italy in 2015, and licensing rental businesses in Brazil, Poland, Portugal, and Scandinavia. Beyond readying for use its demand-fleet-pricing management system, CAR has invested in other digital capabilities, re-working its US and UK websites and used IT to personalize customer mobility options.

See Segment Information table below. Regardless of these many initiatives, CAR's results have been on a low growth track and remain seasonal at the segment level. Operating metrics - revenue per rental day and rental days - move up and down based on the time during the year. One of the most critical metrics is the average daily rate: a 1% increase in that metric would add about $37 million to Americas segment's adjusted EBITDA and $14 million to International segment's adjusted EBITDA. Improving the number of rental days, fleet utilization, or per-unit fleet costs has roughly half that type of expected positive impact. Management hopes to use technology to increase revenue per transaction (e.g., via rules-based fleet utilization and movement). For the past four quarters, however, investors have not seen much better segment results.

Explaining CAR's Equity. CAR's common stock took a hit post release of management's FY'17 forecast. Shares which had traded up at $40.66 before the news closed at $35.76 the following day. But one day's equity change doesn't give anyone looking at CAR a picture of what's been happening to its common stock or, for that matter, the rest of its capital structure. It also helps to have a point of comparison.

CAR and HTZ compete at relatively similar operating sizes. LTM revenue at CAR and HTZ ran $8.7 billion and $9.5 billion, respectively, and LTM adjusted EBITDA at CAR and HTZ ran $838 million and $934 million, respectively. Looking beyond seasonal and segment differences, what explains the alternate paths taken by HTZ's and CAR's securities is the modestly improving trends in CAR's top line and more stable adjusted EBITDA vs. declining trends in HTZ's top line and adjusted EBITDA.

The top part of the graph below shows revenue growth year over year in each quarter, and the bottom part of the graph shows LTM adjusted EBITDA by quarter. Beginning in FY'13, while CAR's revenue generally improved year over year and moved LTM adjusted EBITDA higher, HTZ's revenue decelerated year over year each quarter and LTM adjusted EBITDA headed sharply lower. That remained the case until CAR reported Q4'16 results - we won't see HTZ's December quarter numbers (its fiscal Q1'17) until May 8th.

The revenue and adjusted EBITDA pattern shown above generally made CAR bonds and stock easier to own than HTZ bonds and stock - at least until the Q4'16 earnings and FY'17 guidance was released - but not easier to own than a diversified high-yield fund or mid-cap equity fund.

This becomes a lot clearer when you take a closer look at each car rental company's securities and then compare them to generic high-yield and mid-cap indices. The graph below compares credit default swap prices for Avis and HTZ (top of graph) and their related common stock prices (bottom of graph) going back over the last five years. From 2012 to mid-2014, HTZ's debt and equity outperformed CAR's even as both sets of instruments moved directionally together. That is, they were coherent within their capital structures and between their capital structures. After mid-2014 and through mid-2016, CAR's and HTZ's debt and equity declined, but CAR's debt and equity outperformed HTZ's debt and equity. During the last half of 2016, CAR's debt and equity increased in price while HTZ's debt and equity declined.

At the start of this year, CAR's debt declined while its equity dipped. Its debt and equity were still outperforming the debt and equity of its chief public comparable, but very much under-performing broader indices for high-yield debt and mid-cap equities. The red line in the top part of the graph shows generic high-yield five-year CDS pricing has tightened since FYE'16 to 342 basis points while Avis's five-year CDS has widened to 372 basis points (The Avis five-year CDS references the Avis Budget Car Rental LLC and Avis Budget Finance, Inc. subsidiaries which have issued $2.05 billion senior unsecured notes).

The underperformance on the CAR equity side viz the broader equity market is of longer duration. The blue line in the bottom part of the graph shows the S&P Mid-Cap 400 Index has shot higher since Q1'16 while CAR's common has only modestly improved. While the S&P Mid-Cap 400 Index is up 31.8%, CAR's shares have declined 6.1% year to date.

The risks to CAR's existing business can be classified in terms of (A) severity and (B) timing. First, there is the existential threat from future deployment of autonomous vehicles within the car rental segment, a technology CAR has not meaningfully pursued or planned for. Second, there is the nearer-term threat from companies like Lyft, Inc. or Uber Technologies, Inc. deciding to compete more aggressively for a bigger piece of the US airport car-rental business. They might do that if only because those companies face their own technology risks - Google (GOOG) (GOOGL) announced this week an enhanced carpooling application that threatens ride-hailing services. Enterprise Rent-a-Car, Hertz, and Avis could lose their near complete dominance of the airport car renting business should Lyft or Uber or another party take the initiative. CAR is somewhat better positioned than HTZ viz competition from ride-hailing and car-sharing alternatives. Its Zipcar operation is the largest global car sharing service with more than 1 million paying members.

A Thought Experiment. Suppose you are the manager of a decent sized rental service company. If you are finding it harder and harder to raise revenue per transaction or revenue per day because the competition is fierce and your products oversupplied, one thing you might try to do is rent out a really differentiated mix of products. You might do that even if you have already spent a bunch of money on IT designed to cut your costs per transaction or product carrying expenses. Second, if you see very large technology-driven companies fast at work creating autonomous, more efficient, easier-to-use products than what you presently provide, you might try to acquire similar technology or, perhaps, arrange a joint venture with one of those technology companies. That's a better strategy than allowing your existing rental business to evaporate via technological obsolescence. Third, if you notice that other rental companies succeeding by catering to different sets of customers than the ones you serve, you might try competing for those different sets of customers too, either via acquisition or other transactions.

CAR's management is aware of these thoughts and possible solutions, some of which have already been implemented. The third idea - expanding into other types of rental businesses with different customers - might be quite tempting. Consider the graph below which shows the normalized equity performance of both the vehicle and equipment rental companies. Over the last five years, equipment rental companies like Ashtead (OTCPK:ASHTY) and United Rentals (URI) selling into construction markets have seen their common stocks either vastly outperform CAR (in the case of Ashtead), or overtake it (in the case of United Rentals):

It's not a given that CAR will use more than $300 million of its cash flow to buy back additional common shares. That would assuage hedge funds holding a minority, albeit significant, position in its common, but it doesn't take that much imagination to picture a scenario in which the management decides to use cash flow plus borrowed money to instead attempt to address some of the more fundamental business challenges it faces.

An alternative user for cash flow could involve one or more of the acquisition/joint venture strategies outlined in the thought experiment above. In any of these cases, however, leverage looks set to rise. And management has the wherewithal to move beyond the 4.0x maximum leverage target should it choose to do so. Under the terms of its bank agreements, maximum consolidated leverage can be as high as 4.75x until June of this year and only then steps down to 4.50x (until June '19). Should management have a more robust answer to its equity underperformance via a transformative transaction rather than more share buybacks, its bank lending group would be well advised to listen.

Relative Value. CAR has $3.5 billion of long- and short-term corporate debt as of FYE'16 (There is another $8.9 billion of debt under vehicle programs that does not enter into the corporate leverage calculations). CAR's $3.2 billion of long-term corporate debt includes $144 million of secured revolving credit due '19 and $816 million of outstanding LIBOR + 250 First Lien Term Loan B due '21 plus seven senior unsecured corporate note issues which cumulate to $2.6 billion principal amount and are due between December of this year and March '25. The $249 million December maturity is a LIBOR + 275 basis points floating rate note and the notes due '21 and '24 are denominated in euro.

See graph below. The CAR senior note issues maturing from '22 to '25 have been roughly trading in similar volumes. I've used the CAR 5½s due '23 and the euro-denominated 4⅛s due '24 as proxies in the graph. Both issues widened out with the stock's decline post release of weak guidance. Both trade at a slight positive basis viz the interpolated Avis CDS curve: 38 basis points for the CAR 5½s due '23 and 60 basis points for the 4⅛s due '24. Neither issue is particularly well correlated with the CAR common stock.

Within the car rental business, CAR equity represents the best of the lot (no pun intended again). It generates solid cash flows that could be used to buy back shares or could be used to accelerate the Company's transition to a better product, better customer base, or better technology. That presents an opportunity for its shareholders. CAR's bonds on the other hand are trading at spreads with limited upside toward generic high yield levels. However, leverage looks set to increase under any of the scenarios outlined above. The bonds are not nearly wide enough to the high yield index in light of the present or future threats to CAR's core business or, for that matter, the likelihood that its leverage will head higher. Buying the stock to participate in share buybacks or for other, more long-term reasons makes sense. So does selling the bonds before CAR's credit metrics decline.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.