The auto rental business is approximately a $30 Billion industry (60% US, 30% Europe and 10% other). Linked to travel, the industry has good growth prospects and has grown at approximately 5% CAGR since 1990. Approximately 50% of rentals are on airport sites that you and I would rent when going on vacation or business, and the majority of the remaining cars are used as insurance replacements when a renter is in an accident. The eight major companies in the industry are: Hertz, Avis, Budget, National, Dollar, Thrifty, and Enterprise. Of on airport business, Hertz is largest with Avis, National and Budget rounding out the top 4 respectively. The industry suffered a slowdown in topline in the 2000-2003 period (like many travel related businesses) due to the effects of 9-11 in the US, SARS in Asia, and a general economic slowdown. However, the industry has recovered since that point and is on track for continued growth in the 5% range. Avis Budget Group Inc. (CAR), the subject of this analysis, is the holding company for both the Avis, and Budget car rental brands.

There have been some stumbling blocks in the stocks due to various economic events as noted above. With the resurgence of corporate and leisure travel however, car rental companies have seen their revenues return to pre 9/11 levels. With revenue headwinds behind them, the companies most recently have faced a different problem: that of controlling costs. In 2005, major auto manufacturers passed along a 15% price increase on guaranteed repurchase/depreciation program cars. These are cars that are agreed to be repurchased by the manufacturer at a certain date or cars with guarantees limiting depreciation.  Obviously this was a detriment to margins and thus earnings for the companies. Although these programs sound good, the rental companies must pay more for these program cars. In addition to having to pay more for program cars to begin with, a 15% increase in their price can (and did) effect margins significantly. Cars that are not protected by these programs and are not returned to the manufacturer are sold through auctions or the rental company’s own sales network. Non-program cars have become a larger proportion of rental companies’ balance sheets as car manufacturers put less emphasis on selling to the rental market and the price gap between program and non program cars continues to widen.

There are advantages to having more non-program cars:

·         Program cars cost about $3000 more per car compared to the exact same vehicle that is non program.

·         Residual values have been holding up better in the non-program market compared to the program market.

CAR has an opportunity here as it had only 1% of its cars in non-program at the end of 2005.

That was a quick rundown of the industry, here is more about CAR:

CAR consists of Avis and Budget. Together they have a fleet of over 400k vehicles.  Avis is the world’s second largest car rental brand and focuses more on the business market, it offers various customer retention/bonus programs and has a good overall level of service for its customers (the rental industry is really differentiated on service and price, many of the vehicles are the same from company to company). Budget is a top renter to the leisure travel customer and to small business owners with its truck division. The two companies really operate on an individual basis with different price points, customer targets, and business plans, and share only certain behind the scenes operations. Below is a simply historical model for reference.

For 2007, management has guided the following:

·         Revenue growth of 7-8% y/y

·         EBITDA growth of 1-6%

·         Pre-Tax Income growth of 13-25%

These assumptions are with the belief that pricing in the leisure segment will remain ‘competitive’ meaning flat to down at best. Large upside is possible should pricing improve.

The company has the possibility for positive change in a few key areas which can drive growth and improve profitability:

·         Lessening costs/Increasing prices

·         Switching from program cars to more non-program vehicles

·         Expanding its off-airport presence to grow revenues

·         Improving the usage of its fleet

In addition to the above factors, the company has been punished recently with the uneasiness in the credit markets. We believe this is unwarranted and thus presents an opportunity to own the company at a steep valuation discount. The company is cheap in valuation to begin with, and when one considers all the potential for margin improvement and growth, it looks even more so.

Lessening Costs/Increasing Prices-

Management has guided for 5-7% in vehicle cost increases for 2008 model year vehicles. This compares very favorably to the 25% cost increase experienced for 2007 model year. The company expects an additional decrease of ‘a couple of points’ next year. In addition it has implemented a cost saving strategy which will result in an estimated savings of $100-$150 Million. This would be achieved through counter bypass programs, using more non-program cars, controlling insurance and damage costs, and other areas. These should take place in the back half of 2007 and into 2008. This plan is part of the company’s goals to get to normalized EBITDA margins of 10-11%, and as stated above assumes continued competitive pricing. However with continued industry consolidation, it is arguable that pricing can improve in the future as participants become more rational.  We believe that the estimates from the program are base case and have upside.

Expanding off airport presence to grow revenues-

The off airport side of the industry provides over $10 Billion in revenue to participants. At the moment, the current leader is Enterprise with market share of 70% compared to CAR’s ~7%. At the moment about 81% of CAR’s business comes from on-airport. The 19% that is off-airport has traditionally been leisure travelers. Currently, management is making a concerted effort to break into the insurance replacement business. The company opened 196 new off airport locations in 2006, and plans on another 200 in 2007. These opening coincide with the company rolling out an IT system that directly interfaces with insurance companies, allowing a more seamless transaction when acquiring the business. The company estimates 30% annual growth in revenues from this segment going forward.

Switching from program cars to more non-program vehicles-

Company expects that 50% of their 2008 model year purchases will be non program cars. By purchasing non-program cars, the company is able to save approximately $3k per vehicle. Currently, the company is able to sell non-program cars in the second hand market for a net gain compared to the $3k upfront outlay they would have to make to guarantee a repurchase. This makes the carrying cost for the non-program cars less than the program cars. The terms from the big American car makers continue to be unfavorable, and as a result the company has also been switching more of its vehicles to Hyundai and Toyota.

Improving the usage of fleet-

Car rental companies want to be as efficient as possible with their rental fleet. You do not want vehicles sitting on lots depreciating while not being productive, yet you do not want to spread yourself so thin that you are unable to provide more vehicles in high demand areas and thus capture pricing upside. CAR’s utilization rate has hovered around the 74-75% range, but there is room for improvement. It was 74.6% last quarter and we expect to see a large increase this quarter as the company goes into its strong travel months. For every 100 basis point in utilization, $19 million in EBITDA is gained. Management has included .50% of increase in its guidance for the year, but we believe this is conservative and 1.50% or more exists here, meaning a possible EBITDA upside of $20 Million just from utilization alone.

Recent pullback/financial standing-

With the rumblings in the credit market, CAR has pulled back. Investors worry that since it finances vehicle acquisitions through the ABS market, the company will be in trouble when it needs liquidity or financing. This however, is not the case. The company has recently converted most of its debt to fixed rate instead of floating, protecting it from rate moves. Other than ABS rollovers the company has no debt coming to maturity until 2012, and has $1 Billion in undrawn capacity on its credit line. It was able to place $650 Million in ABS financing during Q2 at “the tightest spreads they had ever encountered”, and has an additional $1.7 Billion available under its vehicle financing programs available for future fleet purchases. The company has plenty of financing available.

Other interesting points:

The company produces a large amount of free cash flow. Traditionally CAR has used this to pay down debt but on the last earnings call management stated that if the stock price were to remain where it was they would consider buying shares back. The company produced $2.76 per share in 2005, $1.85 in 2006 as costs from program cars brought down margins. As margins regain traction, it is easy to see free cash flow next year of close to $3 per share that’s over a 13% yield on the current stock price.

Car rental companies have consistently been targets of private equity. As tired as this argument is given current financing constraints, the fact remains that with its cash producing ability, the company is attractive.

Conclusion

The (probably conservative) consensus estimate for CAR’s 2008 EBITDA is $541 million. With this estimate, the stock is trading at 7.2x EV/EBITDA which is cheap considering the amount of FCF it throws off. At 8.5x EBITDA, the stock is worth $29. The stock has multiple opportunities to exceed management’s guidance in regards to margins and growth and at over a 13% FCF yield, it is a good buy.

Catalyst