Description

Avis Budget Group (CAR) is a spin-off in the Joel Greenblatt tradition.  The neglected runt of the litter of Cendant companies, it is underfollowed, underperforming (temporarily), and undervalued.

The following company description is pasted from its web site:

Avis Budget Group operates two of the most recognized brands in the global vehicle rental industry through Avis Rent A Car System, LLC (Avis), Budget Rent A Car System, Inc. (Budget) and Budget Truck Rental, LLC (Budget Truck).  Avis is a leading supplier to the premium commercial and leisure segments of the travel industry, and Budget is a leading supplier to price-conscious car rental segments. We believe we are the largest general-use vehicle rental operator in each of North America, Australia, New Zealand and certain other regions we serve, based on total revenue. Avis Budget Group maintains the leading share of airport car rental revenue, and we operate the second largest consumer truck rental business in the United States.
 

To get this one right I believe you only need to be, as Keynes would say, vaguely right rather than precisely wrong.  My buy case has three basic parts:

 

1)      CAR suffers from a classic spin-off discount.  Leaving aside how the business performs, there should be upward stock price momentum from this fact alone.  Some of this has already occurred, but I believe there is more left. 

2)      CAR is a pretty good business with very good management, which has been underperforming recently, as measured by profit margins.  Its problems are correctable, and in the future margins are likely to improve.

3)      If margins improve by 2008, the stock is very cheap at today’s price.  Even if margins don’t improve, the current stock price is low enough that you do OK from a free cash flow yield perspective, giving you a margin of safety. 

Taking each part in turn:

 

        1.  Avis Budget Group (CAR) is a spin-off “plus”: When Cendant completed its well-publicized and well-marketed breakup last year, CAR was not even what you could call a spin-off; it was a leftover, attracting very little attention.  In addition, it was removed from the S&P 500 Index soon after the breakup, and even traded below $2 a share before a one-for-ten reverse split.   Management is newly liberated from the sprawling, messy, distracting Silverman empire, and will now be compensated based directly on CAR’s success (their long-term incentive grants are struck at a split-adjusted $24.40).  So if nothing else, CAR scores highly on the checklist of non-fundamental reasons a spun-off company tends to trade at a discount.

 

2. This particular spin-off happens to be a well-recognized brand with a long operating history, long-tenured executives, and stable market share.  Also it’s been underperforming recently, with margins at historical lows.  Briefly, recent underperformance is due to the following:

 

a)  CAR’s fleet is highly weighted towards “program” vehicles, i.e. vehicles sold by manufacturers (mostly GM in CAR’s case) and subject to repurchase at contractually agreed prices, as opposed to “risk” vehicles, which are purchased outright and later sold in the used car market.  The cost to purchase program vehicles is rising, which as yet CAR has not been able to pass on to its customers.

 b)  CAR’s revenue is weighted towards the corporate market, in which prices are renegotiated annually, as opposed to the leisure market, in which prices can adjust in more or less real time.  Leisure market price increases have been outpacing those of corporate.

 c)  Budget’s truck rental business is doing poorly; in recent years it allowed its fleet to age too much, creating artificially high margins.  Now it’s paying for that by having to renew much of its fleet, increasing costs and decreasing margins. 

I will also add the likelihood that Avis Budget management was distracted and hindered by being a part of Cendant, especially after the spin-off was announced.  I will also point out that CAR management’s stock-based compensation awards were priced based on CAR’s trading price on the day following the spin-off, so they profited from a low initial price.  For 2006 management projects pretax earnings of about $165mm on revenues of $5,800mm, for a pretax margin of 2.8%.  This compares to pretax margins of 6.6% in 2005, 8.2% in 2004, and 4.7% in 2003 (the five-year average is 5.9%).   For this industry and company, pretax income is a pretty good proxy for free cash flow, for the following reasons:

 

1. By participating in a like-kind-exchange program with its vehicles, the company can defer paying federal income taxes. 

2. Maintenance capex runs at or a little below depreciation

3. There is little to no working capital growth required to grow volumes.  

4. For the next few years, additional fleet growth can be financed almost entirely by debt, not shareholder funds.  

 

3. The business enjoys high operating leverage, so even small improvements in operating performance will translate into big gains in earnings and the stock price.  On the other hand, 70+% of CAR’s costs are variable, so they have the ability to downsize if necessary, meaning operating leverage going downhill is not as bad.  2007 is expected to be an adjustment year for the industry, as it adapts to a new era of public ownership, transitions to a much higher proportion of risk vehicles, and adjusts to significantly higher fleet costs.  So I base my valuation on what an analyst would see as of the beginning of 2008.  

A reasonable good case is that the company gets its margins back up towards historical levels, something management believes it can do.  To accomplish this it must stop the deterioration in the truck rental business, and be able to offset higher fleet costs with higher prices.   

In numbers, my good case looks like this:

            2008 Revenue of $6,500mm 

            Operating margins of 4%, producing op inc of $260mm
 

A reasonable bad case is that margins stay where they are.  In numbers:

 

            Revenue of $6,200mm (growth is a little lower than the good case)
 

            Operating margins stay at 2.8%, producing op inc of $174mm

 

            Historically, car rental companies have traded at free cash flow yields of 6%-10%.  Capitalizing the good case at 8.0% produces a share price of $32.02 ($260mm / 8% = $3,250mm of equity value, divided by 101.5mm shares outstanding = $32.02).  Why a 8.0% discount rate?  I don’t know, but I think low prevailing interest rates, the fact that future growth won’t require shareholder investment, and the all-purpose “private equity put” make it conservative enough.

 

For the bad case, in order to arrive at the current stock price of $23.86 as of 1/23/08, your discount rate works out to about 7.2%.  In other words, if the bad case occurs and the stock stays where it is, then you tread water for a year but end up owning a growing “equity bond” yielding 7.2%, which is OK for a downside case.

I believe the right probability distribution is to say there is some small chance of a complete catastrophe (i.e. a terrorist attack) that hits travel very hard (call this the “very bad” case).  My bad case is well less than 50% likely, and I’d put the likelihood of the good case or better at about 50%, with the rest of the distribution in between my good and bad cases.  I don’t have a huge conviction about these probabilities; they are impressionistic rather than realistic.  Again, I believe I only need to be vaguely right.

It comes down to a bet on management and its ability to raise prices and stabilize the truck rental business.

Catalyst

Catalysts: 2007 is an adjustment year for the rental car industry, but a reversal of margin declines and the return of Wall Street attention should allow the stock to trade closer to intrinsic value by the beginning of 2008.