This write-up will be necessarily brief, as I think that the opportunity may be short-lived.

Cendant is currently in the process of splitting itself into three pieces: i) real estate franchise/brokerage (Realogy), ii) lodging franchise and timeshare (Wyndham), and iii) vehicle rental (Avis Budget).  The split will be accomplished thru simultaneous spin-offs of Realogy and Wyndham, which will leave Avis Budget as the legacy business in the Cendant corporate structure.  Record date for the spins is July 21^st and the distributions will occur on July 31^st.  All three pieces (both spins + the rump) are currently trading on a when-issued basis on the NYSE and all are relatively liquid with average daily trading volumes of roughly 1mm shrs.

 

Virtually all of the attention from the sell-side has been focused on Realogy and Wyndham, as most investors believe that this is where the bulk of the value lies.  Both Realogy and Wyndham management teams have done extensive road shows and issued detailed financial guidance.  The Avis Budget management team, meanwhile, has maintained a low profile and issued very little in the way of guidance.  Their guidance to-date has effectively been that EBITDA is likely to be relatively flat vs. 2005 as growth in the business (top line) is offset by both increased fleet expenses (auto manufacturers are giving less in the way of incentives than they have in the past) and increases in fleet financing costs.  In other words, EBITDA margins are expected to contract in 2006.

 

On July 19^th, Cendant put out a press release stating that “Avis Budget Group reiterated its previously announced expectation that, due to replacing secured debt with newly issued non-vehicle related debt, results subsequent to that transaction will reflect lower vehicle-related interest expense above the EBITDA line and higher non-vehicle related interest expense below the EBITDA line, which will positively impact year-over-year EBITDA comparisons.  However, the benefit of reduced vehicle-related interest expense on Avis Budget’s EBITDA may be offset by anticipated fleet cost increases and lower growth of domestic enplanements and pricing.”

 

Historically, Avis Budget has funded 100% of its borrowing needs for the fleet with asset-linked “program” debt.  The interest expense for this debt is backed out above the EBITDA line.  As the press release states, the company has now moved a slug of this debt ($1.8bn of $7.5bn total) to the corporate level, where its interest expense will be accounted for below the EBITDA line.

 

The press release stated that the guidance was a “reiteration”, but this is a stretch.  Buried in the “Subsequent Events” note of the Mar 31 10-Q was disclosure that Avis Budget had issued $1.875bn of debt and used the proceeds to pay down a like amount of program debt.  Not a single sell-side analyst whose work I’ve reviewed picked up on this and, moreover, in conversations I had with Cendant IR prior to the release of the 10-Q they assured me that the intention was to leave the Avis Budget subsidiary unlevered post spin (by unlevered, I mean that all debt would be program debt, i.e. none below the line).  I am confident that the market is largely unaware of this shift of debt from program debt (above the EBITDA line) to non-program debt (below the EBITDA line).  Take a look at virtually any sell-side analyst report, and all the analysts are applying an EBITDA multiple to the entity’s estimated 2006 EBITDA, explicitly noting that the entity will have no net debt, and then dividing by the share price.

 

So what does all of this mean?  I believe that the current CD-WI stub is trading on the assumption that the entity will be unlevered (below the line) post-spin and, as a result, that it is due for a quick fall.  I do NOT believe that management at CD was previously explicit in detailing that the “flat” EBITDA guidance for 2005 included a very material shift of interest expense from above the line to below the line.  As a result, I view the Jun 19^th press release as an effective material reduction in EBITDA guidance for 2006 from the market’s perspective.

 

Here’s how the numbers work out:

 

Assume flat EBITDA for 2006 = $435mm

1025mm shrs @ $3/shr (current price) = $3075mm equity value + $1875 debt = $4875mm enterprise value

EV/EBITDA = 11.2x

 

Even assuming a strong rebound next year to $520mm in EBITDA, the stub is currently trading at 9.4x – well in excess of the 6-8x EV/EBITDA range that most people feel is appropriate for vehicle rental businesses.

 

Conversely, you can adjust this year’s numbers to push all the interest expense back above the EBITDA line which gives you an apples-to-apples comparison to how Avis Budget has traditionally accounted for its debt and interest expense.  To do this, take the $435mm of EBITDA and subtract $140mm of now below-the-line interest expense ($1.875bn @ 7.5%) to get an adjusted EBITDA of $295mm.  On this basis, having pushed all debt back above the line, the entity trades at $3075mm/$295mm = 10.3x.  For comp purposes, Dollar Thrifty trades today at 6.9x (assuming all debt above the line), and Hertz was taken out last year at 8.8x (with a premium brand name).

 

It is also interesting to note that if you assume the stub is unlevered and all interest expense is captured above the line (what I believe the market thinks currently), then the entity is currently trading at $3075mm/$435mm = 7.1x EBITDA à right in the middle of the customary target range.

 

If I am correct in my assessment, then the stub should be revalued once everybody figures out what is going on.  Using 2007 numbers (to be generous) I would apply a 7x EBITDA multiple to $520mm in EBITDA for an EV of $3.64bn.  Backing out $1.875bn of debt leaves me with equity value of $1.765bn, or $1.72/shr.  This represents roughly 40% downside from current levels.

 

There are two potential catalyst.

 

1)      The sell-side recognizes in short order that the stub will not be unlevered.  Target values are adjusted accordingly and the price drops as the broader market takes notice.

2)      Management of Avis Budget makes the leverage situation clear.  When I brought the issue to their attention, they at first denied that the sell-side “misunderstood” the capital structure, but subsequently stated that they would put out press releases in the coming weeks to clear up this, as well as any other potential, misunderstandings.

 

Side note: the borrow on these when-issued is readily available.

 

Second side note: Morgan Stanley has published a note this morning, acknowledging the implicit reduction in management’s guidance.  The MS analyst is equating EBITDA to pre-tax income, thereby effectively continuing to assume all debt is “above the line”.  This is fine (and presents things on an apples to apples basis), but what he hasn’t done is taken down those “EBITDA” estimates.  Prior estimates were $427mm (i.e. roughly flat with last year’s $435), but management guidance is now that EBITDA before the below the line interest expense (of roughly $140mm), so the analyst should be using a new EBITDA number of $287mm.  Doing so would drop his target value from $3.2bn ($3.12/shr) for the stub to $2.10/shr.