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Avis Budget Group: Watch The Debt Load Before You Reach For The FCF Yield

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About: Avis Budget Group, Inc. (CAR)
by: Cardon Capital
Summary

CAR operates in a oligopoly-type industry.

Being one of only 3 major industry participants, the company generates a healthy amount of free cash.

The car rental industry at large has seen selling pressure as Wall Street is concerned about innovation disrupting the business model.

While we believe these concerns are misguided, CAR's debt load & reliance on short-term credit markets makes the stock risky.

Overview

Avis Budget Group (NASDAQ:CAR) is one of the three largest car rental companies in the world. The business has three segments. Its two car rental brands are "Avis" which is the company's premium segment that serves commercial flying customers (business class), and separately the "Budget" brand which is the company's segment for value seeking consumers. The main difference between the two brands is Avis costs more and gives customers the optionality to select upgrades (vehicle selection, chauffeur, etc. - the company calls these 'Ancillary products'). The company's smallest segment is Zipcar. Zipcars are vehicles anyone with the app can rent and are used for shorter term / day trips.

(Source: 2016 Investor Day)

Avis' main competitors are Enterprise and Hertz. They all comprise roughly the same percentage of airport market share at around 30-35% a piece, with Avis being on the lower end. The industry is quite capital intensive in nature as each company rents or buys outright its entire fleet of vehicles that they in turn rent out to consumers. Usually it's a mixture of the two as cars bought outright are considered 'Risk' vehicles from the company's standpoint and the cars leased from automotive OEMs are 'Program' cars. These dynamics are a material part of the business as it allows the company to manipulate the number of cars in the fleet to match the expected demand. This gives the business a good amount of variability from an operating standpoint. The capital required and the benefits associated with scale in this type of business are the two main sources of moats that are responsible for the consolidated aspects of the industry. Further, given the limited real estate available at airports, a few dominant players seem inevitable. These industry dynamics plus meaningful leverage in the business lead to solid returns on equity and copious amounts of free cash flow.

The nature of the industry is also inherently cyclical for rather apparent reasons. First, we have the obvious reasons for the business being exposed to cyclicality as travel tends to fall in the discretionary spending camp -- most travel tends to scale down dramatically in downturns (Bureau of Labor Statistics). Additionally, you have CAR being exposed to the aftermarket prices of used cars as they have to regularly sell Risk cars which comprise ~ 50% of the fleet.

Industry Trends

The industry at large finds itself in the crosshairs of several larger societal trends. The most obvious being the appification/digitization of the way in which consumers participate in transportation (Uber, Lyft). The second being the less obvious and more futuristic idea of an autonomous vehicle society. If the future does indeed turn out to be one where we use our phones to order a self-driving car to pick us up from the airport, then standard thinking would assume that has grave implications for the business model of CAR.

Avis is very much aware of these trends, as we would expect. It's also quite clear management wants investors to view the company as one which will be a beneficiary of such trends, not the victim. They opened the 2018 shareholder letter with the following (2018 annual report):

There's an App for Everything. By the year 2022, it is expected that roughly 258 billion apps will be downloaded… Increasingly, these apps are more than games, social media nd business productivity. They're becoming a gateway to personal mobility, from car sharing to ride sharing, eBikes to eScooters, microtransit to public transit. Which means if you're in the business of mobility, you better have a mobile app strategy. We do.

At the 2016 investor day:

So in the end we think we and Uber are working together to change the way people use cars much more than we compete with each other.

These societal trends can arguably pose a threat to automotive OEMs and their suppliers. However, there's good reason to think ride-hailing services and the possible future of no (or substantially less) car ownership might be a non-factor for the car rental business - rather than posing as an existential threat. This point is heavily contested, but the evidence arguably supports the notion that people utilizing ride-hailing services and those that are using car rental services are fundamentally different customers. Uber and Lyft have exploded onto the scene in the past 5 years, yet the car rental business model seems largely untouched. For Avis specifically, revenues have been at least been keeping up with inflation. As per the 2016 Investor Day, management claims that their average customer rents the vehicle for 4 days and puts close to 450 miles on the car. Even for customers who rent a car for one day put over 150 miles on the vehicle.

This is why Uber and Lyft haven't affected business results and it's why they likely don't pose a threat to the business model: They serve different customers. Avis customers on average travel hundreds of miles each time they rent a car, whereas Uber and Lyft customers' average travel distance is less than 10 miles. There are many reasons for this, but one is that Uber's customers use the service to maneuver in the city they're already in - not to travel between cities. The Uber business model and the Avis business model look to be competitors from a superficial level. Ultimately, each cater to a vastly different customer base.

With respect to autonomous driving, again, we deem it unlikely that it will impact the business. Even if autonomous driving were made possible by next year, there's no law explicitly forbidding these types of businesses (car rentals) from buying autonomous vehicles and having customers rent them out. In fact, this would likely bring in an additional customer base for the business, De Shon at the investor day:

Yes. I think autonomous cars bring a lot of benefits to us. If I can just start first with the fact that through autonomous cars, you are going to attract a market that you can't attract today, so people that don't drive.

None of this is to say that there are no problems with the business. But the idea that these momentous society-altering innovations will happen on a very specific time scale and occur just how we predict them is a notion that has thoroughly permeated the investment community and seems to have been accepted without a second thought. We would argue the lessons of history are that thoroughly researched, peer-reviewed studies of what innovation will occur and when are often rendered futile. That's to say, there's a lot of randomness inherent with a complex society like ours and the future is largely unknowable.

For the investment community to price many healthy, cash-generating businesses (whether it be OEMs, suppliers, or rentals) the manner in which they have, requires investors to have a very precise time-frame about not only how the future will play out, but when. This framework for equity valuation is one that isn't likely to bode well for investment returns.

Business Trends

Turning to company-level analysis, Avis operates one of the three largest rental companies in the US. Other lesser known and/or tuck-in acquisitions consist of Budget Truck Rental, Payless Car Rental, Apex Car Rentals, & Maggiore Group. Avis directly operates in 30 countries, with licensees operating in another 150. This corresponds to 70% of top-line coming from the Americas segment, and the remaining 30% from Rest of World. The company has over 11,000 rental locations worldwide. The Avis brand name accounts for 5,500 locations, Budget for the remaining 4,000. Of the 11,000 locations, 4,600 are operated by licensees. Like most licensee businesses, these stores provide a very high-margin source of revenue for the company. This segment brings in roughly $135 million annually. As a $9 billion company, a $130+ million segment might seem immaterial. But Avis is a low-margin type business and much of the $135 million flows directly to the bottom line. 65% of revenue comes from airport customers, the remaining 35% from non-airport. In terms of revenue from each brand, ~ 60% of revenue comes from Avis, while 35% is attributable to Budget, and the remaining 5% is 'Other' being Zipcar, and the tuck-in acquisitions listed above.

Source: (Q2'19 Investor Deck)

The company maintains 650,000 vehicles in the fleet. As noted previously, fleet costs (and how they're managed) are very important to the cost structure of the business. Historically, around ¼ of total costs stem directly from the fleet. Management touted in the 2016 presentation that the company has a very high variable cost structure. The main components of this are SG&A (100% fixed) Operational Costs (management claims are 75% variable) and Fleet Costs (management claims are 100% variable). While management's attempted candidness by revealing their cost structure is laudable, we must conclude that while this description of fleet costs being 100% variable may be technically true, it's certainly misleading.

Fleet Costs aren't 100% variable, they can't be. The company owns a good portion of the fleet. This means that no matter what happens with the business, these vehicles are depreciating. That's a fixed expense. That's a major fixed expense which can't be handwaved away. While I do see where Management was coming from when saying this (they can rapidly scale down the fleet in a downturn), it is probably not the best way to view the cost structure from an analysts' point of view. It's reasonable to assume that no matter what happens in the broader economy Avis will always have a minimum number of vehicles on the balance sheet. Those costs are fixed.

CAR Is a Very Levered Enterprise

(Source: Chart Self-Made, Data from Filings)

When we talk about returns, we have to talk about the company's capital structure. Avis is very levered. There really are two types of debt that the company takes on: corporate debt and vehicle debt. There's debt that the business uses to fund its day to day operations (corporate debt) then there's debt the company uses to finance its fleet of vehicles. And the fleet is virtually entirely financed with debt. During the financial crisis, Avis made headlines as it struggled to renew its credit line.

The reasons are pretty simple: The fleet is virtually entirely financed through debt. No access to the credit markets, the business model has issues. The CEO at the time was cited saying that renewing the credit line was "our most critical accomplishment". Truth is, it was largely just unfortunate timing that their credit line needed renewing in the midst of the crisis. In fact, peers Enterprise and Hertz, despite employing a roughly similar capital structure at the time, didn't face solvency issues - solely because they didn't need to refinance at the exact moment panic struck.

So, while there is obviously balance sheet risk with the company, the coming debt maturity is far more important than how the company was financed back in 2008. Insofar as corporate debt is concerned, the first maturity isn't until 2023, with the majority of the debt coming due throughout the remainder of the decade (note 12 of the '18 10-K).

The financing for the vehicle fleet is a different story, however. Substantial payments are due every year moving forward. The maturity schedule is $1.5 billion this year, $3.5 billion the following, $2.4 billion in 2021, and then it drops off significantly from there. It should be noted that these aren't maturities that will require the company to fund via the cash flows of the business. Rather, Avis manages the fleet so that they can use the fleet to repay the debt by selling the vehicles and then utilize the capital markets to fund purchases of the new fleet.

This makes the business model risky. The company is very reliant on the capital markets. In addition to the debt incurred by the financing of the fleet, Avis also has a considerable amount of corporate debt, over 4.5x EBITDA ($3.5 billion in corporate debt/$750 million in forward EBITDA).

So, this is really why consolidated figures like returns on equity are robust. There's just not very much equity in the business. On a total company basis (including corporate figures and fleet figures) reported equity is only ~2% of the capital structure on a consolidated basis. Why is that? Well, historical loses play a role, as do share buybacks. But it's largely due to corporate debt ($3.5 billion) and the vehicle fleet debt ($15.5 billion). So, if we take reported ROE, we would get close to 50% - sometimes over that figure (fwd. pre-tax income of $180mm/equity of $376mm).

Show Me Don't Tell Me

Despite generating robust returns on equity, the company has clearly underperformed what management was guiding to ~ 2.5 years ago. This underperformance comes largely by (lack of) margin expansion. Back in 2016, Management was insisting they could achieve margin expansion through operational improvements ('16 Investor Day). They told investors they could get EBITDA margins up to 13%-15% within 3-5 years. EBITDA margins were hovering a little over 9.5% back then. Fast forward 2.5 years later and margins are at 8.5% at the end of 2018 (EBITDA $781/Rev $9,124). So, this isn't a catastrophic deterioration in the performance of the business, but now margins have to almost double to reach what the management was guiding to in 2016.

As of this quarter, EBITDA margins have shrunk to 7.6%. So, the question becomes is the reason for margins continuing to compress due to cyclical factors, larger industry players like Enterprise putting pricing pressure on the industry, or industry disruptors impacting the business? It is rather difficult to tell because recent margin compression has been because of the international segment. Americas segment EBITDA margin for Q2 was ~ 9%, while the International segment was a little less than 5.5%. So, the company-wide reduction in EBITDA, at least of late, seems to be because of business being conducted abroad. This could be due to currency fluctuations. But regardless of the reasoning for the underperformance in the International business, the business as a whole has continued to underperform what the company was guiding in years prior.

Despite this, in the 2018 shareholder letter management's tone is strikingly positive. They talk several times about record revenue growth and having 'yet another' record year. However, there is little revenue growth to note. We see a business that has cumulatively grown less than 8% over the past 5 years ('14 revenue ~ $ 8,485, '18 revenue ~ $9,124). That's barely inflation, and still management is talking about having 'record' years. It's a troubling disconnect between the fundamentals of the underlying business and management's rhetoric. If the business performed how management was telling investors it could, then the business would be generating more than $9/share in free cash flow. Full year free cash flow per share as of Q2 for 2019 was - if we take the high end of guidance - projected to be slightly less than $4/share. This is despite the company retiring more than 10% of shares outstanding over the past 2.5 years.

A business where the general perception is that it faces business-model risk due to innovation, which has also materially been underperforming guidance, and is combined with a management that seems complacent and/or delusional about these facts is a worrisome trifecta.

Capital Allocation

Our primary use of cash flow, however, has been and will probably continue to be share repurchases, particularly when our stock is trading with a free cash flow yield in the teens

- CFO David Wyshner at the 2016 Investor Day

Avis generates a lot of free cash, and management has deployed it relatively well from an investor's standpoint. The company outlines that it tries to maintain a balanced approach to allocating capital, and the figures largely support this claim. Since 2014, the company has generated $3.5 billion in operating cash flow. Cumulative cap-ex has been $1.12 billion. That leaves free cash flow of ~ $2.4 billion, or roughly $480 million annualized.

(Source: Q2'19 earnings report)

Over 65% ($1.5 billion) of free cash has been spent on share repurchases. As the CFO stated at the investor day in the quote above, management has been emphasizing share buybacks largely in part as the stock >50% off its highs, and on a leveraged basis is trading for a double digit FCF yield. Using the middle range for 2019 free cash flow, the yield is a little more than 12%.

Fwd. FCF $250mm

(/) Market Cap

$2 billion
(=) FCF yield 12%

Of course, that's a levered yield - Avis has a lot of debt. Debt/EBITDA is over 4 turns (corp. debt ~$3.5 billion/$750 EBITDA). Since 2014 shares outstanding is down ~ 30%. The company started buying back stock near all-time highs in 2014, but as the shares have steadily declined, they have been continuing the buyback program.

Turning to acquisitions, apart from the Zipcar acquisition in 2013, CAR has primarily executed tuck-in acquisitions. In large part these acquisitions are used to expand into different geographies. While these acquisitions have expanded CAR's reach, they have a negligible impact on financial results.

Valuation

The main risk with CAR isn't secular (innovative threat) - it's operational. There's good reason to think why the companies that are innovating today are innovating for a different type of customer base, as detailed above. I think the major investment problem with this company is figuring out what is driving margin compression and understanding fleet management. As we saw in 2008, given the nature of the business model there could be a good deal of "go to zero" risk if a credit crisis were to emerge.

Turning to margins, it's clear that while both segments have been underperforming, the real issue lies with International. The Americas' segment margins have relatively held flat as of late. In terms of valuation, looking three years out, projecting 2% growth and assuming margins stay at (what could be argued) a depressed margin of ~7.5%, the business would bring in ~ $730 million in EBITDA. Note that this is less than what trailing 12-month EBITDA is, so it's likely that this figure is conservative. The EV/EBITDA multiple for CAR for the past 10 years has ranged between 9-20x. The current multiple is 7x.

Mrk. Cap $2 billion
(+) Debt $3.5 billion
= EV $5.5 billion
(/) fwd. EBITDA $750
(=) EV/EBITDA 7x

(EBITDA is management's forward guidance)

So, if we assume a return to a historically normal 9x multiple, constant EBITDA margins, no change in corporate debt, and shares outstanding remain the same (76 mm), then we get a fair value of ~ $42/share versus a price ~$26/share at time of writing. (EBITDA $750 * 9x less corporate debt ~ $3.2 billion market cap).

Conclusion

Clearly, CAR is a cheap stock. The market is likely attributing too much credit to potential market disruptors. But even though it's cheap, the nature of the business combined with CAR's balance sheet means there's not a margin of safety baked into the price. Margins have been deteriorating and with as much corporate leverage as the company has if margins retreat even to the 6% mark and stay there then the equity value could be reduced by >80% (6% EBITDA margins ~ $550 mm * 7x multiple = $350mm market cap when debt is backed out).

So even though the business is a beneficiary of an oligopoly-type industry and generates a healthy amount of free cash, the business is a highly levered cyclical. That's a dangerous combination. If there's even a slight improvement in the business then investors could see substantial upside, but there is material downside risk.

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.