Description

Avis Budget Group (CAR) is a short because:

·        Shares are trading near all-time highs for unsustainable, non-fundamental reasons

·        Business is over-earning due to the auto OEM production issues impact on used car prices and rental vehicle supply

·        Applying a justified multiple to normalized earnings yields a fair value 40%-50% below the current price. Stock is not cheap even if earnings never return to normal levels

·        Higher retail fuel prices, higher interest rates and emerging competition should be headwinds

Business and Industry Overview

Avis Budget Group (CAR) is the second largest car rental company globally operating under the Avis, Budget, Payless and Zipcar brands. Avis has a rental fleet of approximately 590,000 vehicles at 10,400 locations including 4,000 operated by licensees. The Americas account for 81% of sales and 95% of EBITDA with the balance form other geographies. 45% of the fleet are SUVs, 41% are sedans and the remainder are trucks and luxury vehicles.

Figure 1: CAR Revenue Breakdown

The US car rental industry is fairly concentrated with the top 3 players claiming 94% share. Despite this market structure, competition is intense and the economics have historically been uninspiring. For the 3 years prior to COVID, CAR traded at an average P/E of about 10x and ROA averaged under 3%. Avis’s best public peer, Hertz, was the only large travel-related company to file bankruptcy as a result of COVID.

Figure 2: US Rental Car Market Share

CAR is Over-Earning

In 2021 CAR’s adjusted EBITDA was 3x the pre-COVID average as the result of much stronger pricing and lower depreciation relative to historical levels.

Figure 3: CAR is Over-Earning

Car’s historically strong pricing is the result of historically low industry supply. After COVID, rental companies reduced fleet size in response to falling demand. When demand started to return last year, firms were unable to rebuild fleets due to the well-publicized production challenges faced by auto OEMs. As a result, both the total supply of rental cars and the number of new vehicles added to fleets hit a 10-year low in 2021 leading to a surge in pricing.

Figure 4: CAR is Over-Earning

In addition, higher used car prices have caused CAR’s depreciation cost per vehicle to be lower than normalized levels. This impact has been magnified by the company’s lower percentage of program vehicles relative to historical levels. Program vehicles are either leased by CAR or subject to agreements requiring OEMs repurchase at a specified price / time. A lower percentage of program vehicles increases the benefit from lower depreciation costs. If depreciation per car returned to 2018 levels, CAR’s 2021 EBITDA would be almost $600mm lower.

Figure 5: Annual Depreciation and Lease Expense Per Vehicle

Stock Price Driven by Non-Fundamental Factors

SRS Investment Management is shown as the largest shareholder with 18.4mm shares or a 34% stake. SRS holds 2 board seats and CAR’s CFO came from SRS. SRS has been steadily reducing their exposure using swaps and now has an economic exposure to only 8mm shares. Using swaps rather than selling shares outright increases short interest as swap counterparties need to hedge without increasing the overall float.

Between August and November of last year short interest increased from about 12% to 20% due to funds hedging post-reorg HTZ shares, and SRS’s continued use of swaps to hedge their exposure.

After reporting 3Q results on November 2nd, CAR closed up 109% to $357/share after spiking as high as $545 intraday. 30.5mm shares traded that day representing 30x the average volume or 2/3rds of the total float.  While earnings were good, what really caused the spike was share repurchase discussions on the call which triggered fears of a short squeeze.

Similarly, between March 7th and March 17th shares rallied 83%. Initially this was due to a broad market recovery, however on March 16th Avis announced an increase in their buyback authorization sending the price up 22% on heavy volume.

Figure 6: CAR Short Interest

Fair Value Implies 40%-50% Downside

Obviously its hard to know when OEM supply chains will normalize and how long increased auto production will take to impact car rental rates and used vehicle prices. We’ve assumed Avis earnings excess profits in 2022 and 2023 before earnings normalize. We’ve also assumed that normalized gross margin per day remains above per-COVID levels leading to a normalized EBITDA that’s roughly 35% higher than the pre-COVID average.

Figure 7: CAR Model

Using a 14x normalized cash flow multiple implies a fair value for CAR of $152 /share. At this price CAR would trade at 11.5x EBITDA which is well above the average pre-COVID multiple and the balance sheet would be levered 3.4x. We don’t give any value for the next two years of above normal earnings since much of this cash flow will likely be needed to rebuild the fleet size.

Interestingly, even if we’re wrong and earnings never normalize CAR shares still trade at 9.4 this year’s cash flow which is only modestly below the average pre-COVID level. As such, further upside to the stock appears limited even if we’re wrong.

Figure 8: Valuation

Other Issues

·        Higher fuel prices should be at least modestly negative for demand.

·        Alternatives to rental cars such as ride sharing or car sharing services like Turo should continue to gain popularity.

·        Avis also has about $4B unhedged floating rate debt.

Biggest Risk

This year, it seems entirely possible that estimates are too low. The travel recovery is continuing while automotive supply chains remain challenged. As such, 2022 earnings could ultimately exceed last year’s records.

Longer-term, the biggest risk here is that competitive dynamics have permanently shifted such that normalized earnings power is sustainably higher than pre-COVID levels. While there has been no change to market structure or any other tangible factor that should change of competition it is possible that COVID somehow has permanently altered the way firms behave. However, rental cars are a commodity product sold to price sensitive customers with supply constraints (under normal conditions at least) or barriers to entry making a permanent change unlikely.

Catalyst

Normalized trading dynamics

Resolution of OEM production issues causing increased rental supply and lower used car prices