New Zealand car trips
Over the weekend, I decided to do a short trip outside of Auckland (New Zealand) where I currently live. New Zealand is full of natural beauties and I wanted to do the Tongariro crossing (see picture below). I decided to rent a car and since most rental cars were sold out (I planned the trip one day in advance), I tried a car-sharing service. Through this service, you can rent the car of another customer (sort of Airbnb for cars), another product of the sharing economy. Long story short, the service was OK but I did not really think that it could work. In the end, I basically paid the same price but the process was cumbersome. Hence, during my driving time I started thinking that rental car companies might not be dead as some think. Therefore, I committed to looking at rental car companies as potential investments. In the end, they would benefit from a trend toward lower car ownership that is not only starting, but could be fueled by self-driving cars (why would you own a self-driving car?). Personally, I recently sold my car to use a scooter inter-city trips, Uber when needed, and rent a car for weekends.
Avis and Hertz
I started looking at Hertz (NYSE:HTZ) and then I looked at Avis (NASDAQ:CAR). Both companies are very cheap on a P/E multiple basis. Hertz currently trades at 14X expected 2017 EPS and 11X expected 2018 EPS. Avis is even cheaper, it trades 9X and 8X the EPS for the same two years (Source: 4-traders). Avis has been steadily growing revenues and owns ZipCar which, again, might benefit from Millennials' consumer preferences. To grasp a better understanding of Avis, I started looking at a few presentations and, as always, I looked at the latest annual report. Here I got confused.
Avis use of capital
First, please note that Avis does not pay a dividend. The company explains this decision with the following paragraph (page 36 of the annual report):
To be honest, I have rarely seen this in a healthy company that is not on the verge of bankruptcy and where creditors want to keep as much capital inside the company. However, despite being very restricted on the capital returned to shareholders through dividends, the company is very generous with stock buy-backs.
Over the last three years, Avis has invested (or wasted) huge amounts of cash in stock repurchases. In 2016 Avis spent $387M, in 2015 it spent $393M and in 2014 it spent $297M, for the grand total of $1077M. Yes, more than $1B (source: Google Finance). This amount might not sound very large, but if you consider that the current market cap is $2.42B, you would expect a reduction in shares of approximately 30%. If we sum up $2.42B and $1.07B we get approximately $3.5B market cap pre-buybacks. Hence, the amount spent in buybacks represents 31.4% of the previous market.
Again, let's not forget that the company does not pay dividends so, over the years, you would expect an increase in book value and consequently market cap. Further, you would expect a dramatic reduction in shares of approximately 30%. Well, unfortunately this is not the case. Although shares outstanding declined from 111M to 93.3M, this decline is significant, but nowhere close to the amount spent. The decline in shares represents approximately 20% of the shares outstanding. So where did the 11% difference go? It obviously went wasted in two ways: shares bought at the wrong price (for example in 2014 the share price moved from $40 to $60 compared with the current $28) and shares used to compensate the management.
Unhappy with the results, the company writes at page 37: " The Company's Board of Directors has authorized the repurchase of up to approximately $1.5 billion of its common stock under a plan originally approved in 2013 and subsequently expanded, most recently in 2016."
At page 37 of the 2016 annual report, you can find the "securities authorized for issuance under equity compensation plans. As you can see from the screenshot below, the company approved the issuance of more than 3 million shares. Considering that the company has approximately 85 million outstanding shares, this represents more than 3% of the company shares. In the third column, in addition to the 3 million shares just mentioned, the company can still award its management 7.6M shares, for a grand total representing exactly 11% of the outstanding shares (exactly the same amount that we found above).
But even worse, the exercise (weighted average) price is set at $2.91!! This represents a discount of 90% to the current share price of $29. I wonder, what type of incentive is this?
Management will receive a lot of shares, basically for free, so they will profit no matter what the stock price is doing. And in fact, what is the easiest way to boost EPS and the share price? That's right, stock buybacks. And here is where all the cash is going to, since the company does not pay a single dollar in dividends. So the question is, why senior creditors do not allow the company to pay dividends but allow the company to spend so much in share buy-backs?
But let's also take a look at what the management is doing with the shares that they receive. Or, more importantly, let's see whether they are buying shares with their own capital instead of only with shareholders' capital. The graph below (source: GuruFocus) shows the amount of stock transactions conducted by insiders.
As you can see most of the transactions are red, meaning that insiders have been selling. And please note that the tall green line represents shares bought by SRS Investment Management (a 10% owners), not by the management. The only significant management purchase was done by the heroic Eduardo Mestre (director) for $475k. All other buy transactions are below $60k.
On the sell-side we have another story. Recently, over the last 6 months, the Executive Chairman went on a selling spree. In September 2016, he sold $1.9M worth of shares. Not happy with the cash, he sold again in November, twice, $1.5M and $2.5M. You would imagine that with this cash he would have enough for Christmas gifts, but you are wrong. The best has yet to come. And, in fact, in December 2016, he goes all-in selling stocks worth $5.85M. Over this period, many insiders sold their stock positions. For example, the General Counsel pocketed $95k, the President and CFO sold shares worth $1.5M (in two occasions) and the HR officer pocketed $150k.
These numbers are significant considering the net income of Avis. As you can see from the below screenshot, taken from page 39 of the annual statement of 2016, over the last five years, the company generated net income of $946M, for an average of $189M per year. Another suspicious number is the amount of "unusual expense" that keeps recurring. For example, in 2016 and 2015 the company faced approximately $500M in unusual expenses, $95M in 2014 and $292M in 2013. These costs seem to be recurring and equaling the net income. But this is a story for another day.
Let's go back to the rough calculation that I have made above, the 11% of stocks that was purchased but did not lower the stock count, would represent $385M (11% of $3.5B). If we compare this figure, we can see that it represents almost 40% of the last five years of profits!
The company computes the cost of equity compensation into its statement of cash flow. So let's take a look. On page F-6 of the 2016 annual report, you can find the line " Stock-based compensation". The screenshot below shows that, over the last 3 years, the company accounted for $80M in stock compensation. This is still significant because it represents 11% of $721M in profits for the last 3 years. And, of course, this is on top of salary.
The company computes its stock-based compensation as follows:
Stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as expense on a straight-line basis over the vesting period. The Company's policy is to record compensation expense for stock options, and restricted stock units that are time- and performance-based, for the portion of the award that is expected to vest. Compensation expense related to market-based restricted stock units is recognized provided that the requisite service is rendered, regardless of when, if ever, the market condition is satisfied. We estimate the fair value of restricted stock units using the market price of the Company's common stock on the date of grant. We estimate the fair value of stock-based and cash unit awards containing a market condition using a Monte Carlo simulation model. Key inputs and assumptions used in the Monte Carlo simulation model include the stock price of the award on the grant date, the expected term, the risk-free interest rate over the expected term, the expected annual dividend yield and the expected stock price volatility. The expected volatility is based on a combination of the historical and implied volatility of the Company's publicly traded, near-the-money stock options, and the valuation period is based on the vesting period of the awards. The risk-free interest rate is derived from the U.S. Treasury yield curve in effect at the time of grant and, since the Company does not currently pay or plan to pay a dividend on its common stock, the expected dividend yield was zero.
In theory, compensating management for good performance might make sense. So let's look at company's performance. Let's see the results from 2012 to 2016 on key indicators (source: 4-traders):
- Sales: from $7.4B to $8.7B
- Net income: from $290M to $163M
- Operating margin: from 10% to 7.4%
- Book value per share: from $7 to $2.5
- Share price (January 2012 to March 2017): from $11 to $28 for a gain of 155% compared to the Nasdaq of 125% (Avis is listed on the Nasdaq).
Overall the company operations performed well in terms of revenues, but this did not translate into net income or book value. In practice the stock went up fuelled by a growing market and strong buy-backs. In fact, market cap moved from $2.1B at the end of 2012 to the current $2.42B, a small increase.
Investors praise stock buy-backs since these can be a powerful tool to increase share price and EPS. However, these can be valuable only if shares are bought at prices that undervalue the company and if these are not simply redirected to the management. Unfortunately, this is not the case of Avis. Over the last few years, the company bought back shares at much higher prices than the current stock price, and redirected a substantial portion of these shares to compensate the management. This despite poor operation performance. In turn, the management sold massive amount of shares back to the market. In sum, the company wasted a large amount of shareholders' capital. For this reason, I would suggest investors to stay away from this stock, despite the seemingly low valuation.
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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.