Description

Dollar Thrifty Group (DTG) - $75/share, $2.2B mkt cap, trading $15m/day - Short

 Note: 2012 numbers in the table above are on normalized EBITDA of ~$145m, think '12 should remain a bit elevated on high used car prices, but should end up closer to $200m EBITDA down from $287m EBITDA in FY11.

DTG is trading at $75/share.  I think a reasonable standalone value is closer to $40-50/share.  I think there is a good chance that Hertz still buys DTG, but they are now the only bidder and have withdrawn their $72/share offer because the valuation was too high, I don’t expect they pay more than $50-60 for DTG.

This is a very non-consensus idea but I think it has merit.  I see a good chance that HTZ buys DTG near market price, but I think a better chance there is a lot of downside.  I don't see much justification for HTZ to pay any higher than market price.  This runs counter to some very smart event-driven / merger arb investors I respect (York owns ~19% of DTG), but I like that dynamic.  This stock has been in event-driven / merger arb hands for almost two years, reputable sell-side has withdrawn its coverage, and I don’t think anyone has been taking the hard look at DTG’s accounting and doing the hard work on field research needed to really understand the fundamentals of the company. 

Event driven investors are blithely comfortable that some “structural changes” have altered DTG forever, and EBITDA that never used to top $150m will now always be above $250m.  Citi’s event desk put together a widely circulated piece of research using the minimum $250m EBITDA assumption to justify DTG’s stock price on a standalone basis.  I think the reality is not only has DTG benefitted a ton from used car prices that aren’t long term sustainable, but they have also been unsustainably aggressive in their depreciation assumptions to boost profitability during a bidding war they expected to end in a takeout.  As a leasing company, DTG has a pretty unique position where they can basically choose their profitability over the short term, which they used to drive up profitability  during the HTZ/CAR takeover battle, however that might catch up with them shortly.  DTG is now sitting on a fleet with very little depreciation embedded in it, and could see EBITDA snap back to ~$125-175m levels even if used car prices stay high (which I expect they will in the medium term).  I think DTG could potentially keep their EBITDA elevated if they get increasingly aggressive on depreciation assumptions, but they should run out of room by 1Q/2Q at the latest.  I think there is potential that their EBITDA guidance on the 4Q call is significantly below consensus of $260m, which itself has fallen from ~$280 over the past 3 months. 

So I think DTG is an attractive fundamental short.  But I also think people are seriously misreading the bidding dynamics from last year’s Avis/Hertz battle to take.  Hertz’ latest bid was $72.  However Hertz withdrew that bid because the valuation was too high, which they’ve said publicly (bid was part stock and valuation was $66 when Hertz withdrew and walked away).  Hertz initial bid was $41.  Hertz and Avis went back and forth a bit, Avis’ highest bid was only $53, and it was never a real bid since Avis had close to insurmountable anti-trust issues.  Avis is now occupied and highly levered following its recent all cash purchase of Avis Europe and is out of the running for this asset. 

DTG’s stock is richly valued due to the Hertz/Avis bidding war over the past two years.  DTG is currently trading above the most recent $72 HTZ offer that HTZ retracted because valuation was too high.  CAR is no longer an active bidder on DTG and though there is speculation CAR comes back next year, I think it is unlikely.  CAR’s bids were never real in the first place, only meant to disrupt HTZ’s acquisition (Avis refused to make any ATR assurances the way Hertz did, Avis would have had to basically divest the Budget brand to close the deal which made little sense for them).  But even if you believe CAR was a real bidder – their highest bid was only $53!  With no competition for the deal, and having withdrawn the $72 bid explicitly because the valuation was too high, I don’t think Hertz needs to pay more than $50-60 to get DTG done.  I also think Hertz is well aware of DTG’s aggressive accounting which may soon crack.  HTZ mgmt will acknowledge that DTG has some funny accounting when you start asking them questions around the periphery on it. 

 I’m going to split this into 2 pieces – the fundamental short, then the bidding dynamics. 

DTG is a compelling short from a fundamental perspective, but acquisition scenarios complicate things

• DTG has received a massive tailwind from used car prices.  DTG has also been very aggressive in their depreciation assumptions in order to boost profit during the HTZ/CAR takeover battle.  EBITDA reported in 2010 & 2011 reflect profit pulled forward from 2012 as well as significant profit carried in from 2009.  Unless DTG gets bailed out by another Japan-earthquake type event, I think profit falls substantially in 2012.
• DTG’s EBITDA improvement has been massive and is entirely function of lower car depreciation  – the entire movement from ~$100m EBITDA to $285m EBITDA is due to lower car depreciation, per table below.  

• Consensus puts DTG EBITDA next year at $260m, and merger arbs who own the stock see “normalized” EBITDA of ~$250-275m with no risk of EBITDA falling below $250m. 
• Arbs have a few bullet points on “structural changes” which make this new normal of $250m possible (DTG no longer tied to Chrysler purchases, leaders in moving to risk vehicles, structurally higher used car pricing).  There is some validity to these points qualitatively, but in terms of dollars it does not add up to the quantums of incremental EBITDA the arbs would need to rely on $250m as a “new normal” EBITDA. 
• But arbs really aren’t doing their work on profitability. 
• Citi guy who put together risk arb deck justifying price off $250m said he didn’t get any questions on the fundamentals of his assumptions.  I’ve heard from some merger arb holders that they believe EBITDA is definitely stable above $250m – one guy thought my numbers were wrong when I asked how you could square new ~$250m profit level with DTG’s own guidance of just $175m-$200m given in Feb ’11 (before Japanese earthquake made used car prices spike. 
• And most of all, no one is paying attention to the nitty gritty of the "discretionary" part of DTG’s depreciation accounting

• Background on DTG’s EBITDA guidance to give perspective to the accounting
• 2010 EBITDA development
• Feb 2010 (before the first HTZ bid) – DTG guides 2010 EBITDA of $120-140m and $325/mo vehicle depreciation
• April 2010 (2 days after deal announcement) – DTG guides 2010 EBITDA of $170-190m and $275/mo depreciation (to be fair to DTG the used car market was getting better).  Maintains that depreciation should go back to $325/mo in 2011, which would bring EBITDA back to $120-140m
• DTG then steadily raises guidance and ends up delivering $260m EBITDA and $243/mo depreciation in 2010
• 2011 EBITDA development
• Feb 2011 – DTG guides $175-200m EBITDA and $300-310/mo depreciation
• May 2011 (after earthquake hits Japanand used car prices jump) DTG guides $260-285m EBITDA and $230-240/mo depreciation
• I currently expect $287m EBITDA and ~$220/mo depreciation.  DTG hasn’t introduced next year guidance but they have estimated the non-recurring impact of the earthquake on EBITDA as $40-45m of EBITDA, that alone should make $250m EBITDA hard to hit next year. 

• 2 components to car depreciation  - and how DTG can essentially “choose” their EBITDA level.
• Ongoing monthly charge (“period depreciation” or “chosen depreciation”) - straightlined depreciation from current carrying value to management’s estimate of what the car will be worth when they estimate they will sell it.  This portion is highly subjective.  
• Actual gains/losses vs. depreciated book value when cars are sold  - this is the true up to real prices when cars are sold.    
• DTG’s profitability is uniquely exposed to residual values and depreciation assumptions because
• DTG’s fleet is ~100% risk cars (CAR is ~50% risk, HTZ is ~65-75%)
• DTG’s hold period on risk cars is longer than competitors, so larger depreciation imbalances can be built up.  HTZ holds 16-18 mo.  DTG says they hold risk cars 18-20 mo but it looks mathematically improbable.  They are probably holding at least 2 years+ 
• DTG has been much more volatile than its competitors in the depreciation assumptions they employ, in particularly they over-depreciated in 2008/9 and underdepreciated in 2010/11

• It’s easiest to walk through these numbers in the models but I put a quick summary table is below showing DTG with CAR as a comparison. 
• In FY08/FY09 DTG significantly over-depreciated its fleet with period depreciation of $375-400/mo. The net effect gave DTG highly depreciated cars at the start of FY10 which led to huge gains when those cars were sold in FY10 and FY11.  So DTG basically carried profit over from FY08/09 into FY10. 
• As the acquisition battle began in FY10, DTG also drastically reduced it’s current period depreciation assumptions (from 375-400/mo to ~300/mo).  That reduction in period depreciation improved EBITDA by about $100m in 2010, EBITDA also benefitted from gains on sale of the old highly depreciated fleet that amounted to $63m in 2010.
• When deciding to juice depreciation assumptions in 2010/11, I think DTG expected to not be a standalone company for very long so they chose to maximize profitability while bidding was underway
• You can see how aggressive they were being in their assumptions by looking at 4Q10 where they sold 8,000 risk cars into a used car market that had reached the highest Mannheim index levels in history (see Appendix IV), yet DTG took a small loss on these car sales.  If used car pricing is at never before seen highs and you are taking a loss on car sales, I think it's reasonable to conclude you’ve been under-depreciating on your discretionary “period depreciation”
• Going into 2011 DTG still had cars with low book basis from 2008/9 depreciation, but they also were carrying cars from pre-'09 with the lower embedded depreciation.  That, combined with the expectation that car prices would normalize, led to DTG guiding 2011 EBITDA down to $175-200m (which I think still assumed DTG would be very aggressive minimizing period depreciation in advance of a sale to HTZ or CAR). 
• In 1Q11 the Japanese earthquake bailed DTG out on used car pricing, and DTG also got much more aggressive by bringing its period depreciation assumptions down to $240/mo. -- at this point they were still driving towards expectation that a sale would take place (and are probably still under that assumption)
• This puts DTG in a difficult position today:
• I estimate DTG has ~$2,000 less depreciation embedded in an 18-mo old car than it did at the start of 2010.  So even assuming strong used car prices like those seen in 2010, DTG might have to start taking losses on sales.
• Based on my estimates if 2012’s used car market looked like 2010’s car market and DTG made the same period assumptions, EBITDA would be $114m lower.  So instead of the $260m achieved in 2010, EBITDA would be $146m .
• This assumes DTG makes the same period depreciation assumptions it did in 2010 (~$295/mo), which seemed aggressive at the time. But this year DTG brought those assumptions all the way down to $240/mo.  Assuming DTG continues this low depreciation assumption, which may not be sustainable, they could offset $67m of EBITDA.  This would lead to 2012 EBITDA of $213m, still well below $270m consensus
• This all goes out the window if used car prices jump to new highs, which would allow DTG to carry on this game longer. 

• The following chart summarizes annual period depreciation assumptions for DTG vs. CAR.  I use CAR assumptions because HTZ assumptions can’t be seen in filings (blended into equip rental business). 
• You can see how drastically DTG “chosen depreciation” assumptions have come down, while CAR’s were relatively stable (to be fair CAR is 50% program cars so it should see less movement in assumptions, but magnitude of DTG's assumption changes vs. Hertz are far greater than a 50% program car mix could explain..)

• This is my analysis and DTG management wouldn’t agree with it.  There are also other ways to think about the numbers, but I think they lead to similar conclusions.  There are a few other items that point to similar results:
• Book value of fleet per car has increased significantly – DTG's holding value is currently $14,245 per car versus $13,587 last year, $11,935 heading into 2010.
• While this is directionally correct with a better used car market, DTG’s fleet mix is significantly older, and I estimate should be carrying ~$650 more depreciation per vehicle
• HTZ told me they normally get 70-75% of a cars' initial purchase price in the used car market, in 2Q on tsunami spike were getting 80-85%, which suggests on a normalized basis Depreciation should be ~50-65% higher than it is now
• DTG kept a $20m range in their FY11 guidance even it was issued with only 60 days of the year left.  Guidance allows a Q4 EBITDA range from $30.3m to $50.3m vs. a prior year comp of $35m and expectations around $50m.  This could indicate management has some uncertainty about their accounting levels. 
• DTG’s risk car fleet has also aged significantly and will need to be replaced near term which should reset deprecation rates higher. 
• CEO told me directly that hold periods on risk cars haven't extended any longer than the typical 18 months.  However, on some simple math I think you can demonstrate that at least 9% of the fleet must be older than 21 months which is very inconsistent with an 18 mo hold life (DTG held 98k at risk cars at end of FY09, have only sold 87k cars in the 7 quarters since then, so at 9/30/11 they were holding at least 11k cars that were bought before 12/31/09)
• A minor additional point on over-earning pre-acquistion --- allowances have come down from 6.4% of AR at the end of FY10 to 2.8% in 3Q11 generating about $1.8m.  Not material versus the numbers we’re discussing above, but another indication management was juicing earnings in prep for a sale.  

CAR results a few hours ago support view profitability is coming down

• Avis just announced 4Q11 EBITDA of $64m vs. $93m consensus.  They cited “As expected, fleet costs normalized in the fourth quarter as gains on risk vehicles sold returned to levels experienced prior to the Japanese earthquake”
• Avis sees fleet costs increasing 15-20% next year on normalized residual values.  A 15-20% increase in fleet cost on DTG’s numbers would mean ~$230m of EBITDA, which would be much lower than expectations for ~$260m.  However DTG’s sensitivity should be much higher than CAR’s 15-20%, since a) DTG is 100% at risk cars while CAR is only ~50%, b) DTG could have the carry-over headwind from under-deprecating cars in FY11, c) if you look at DTG/CAR’s historical depreciation assumptions, CAR’s assumptions are only ~25% lower than 2010 levels, whereas DTG’s are ~40% off 2010 levels – however you slice it, DTG depreciation should be up at least 15-20% ($230m EBITDA) and probably 30-40% ($175m EBITDA), before you take into account any additional headwind from DTG under-depreciating in FY11. 

DTG fundamental valuation

• I think DTG’s normalized EBITDA is somewhere between $100-175m.  Rental car investors look at EBITDA and competitors are trading around 5-6.5x.  At 5-6.5x my normalized EBITDA range, DTG would trade between $35 and $55 dollars per share, which would offer 26-54% downside to the current stock price. 
• Used car prices should stay elevated for 1-2 more years and DTG could over-earn, so perhaps the high end of the range is appropriate.  However DTG’s cash flow should weaken to offset some of the used car pricing as they roll off of accelerated depreciation rules.
• Given the arb-heavy investor base that might be fatigued after holding DTG for close to two years, downside could be realized rapidly if something broke investor confidence in DTG’s ability to earn $250m normalized EBITDA or the likelihood of a deal happening. 

Currently there is no deal on the table.  In August, DTG asked Hertz and Avis for final offers by October.  In September, Avis announced it would not be submitting a bid citing current market conditions (price).  In October, Hertz withdrew their existing offer which was worth $66 at the time (DTG was trading at $61), citing current market conditions (price).  Hertz has said they are still working with the FTC and would like to pursue a deal but would need to start negotiations fresh, with the clear message being they have to reduce price. 

Hertz still wants to do a deal.  The stated synergy goal of ~$200m is significant and if that number is real the deal still makes financial sense (though hard to believe this is real as it’s out of HTZ CEO Frissora’s mouth who maintains he’s taken $2B of cost out of the business which is absolutely absurd when looking at the income statement).  Strategically it makes a ton of sense for Hertz to buy DTG and establish a strong leisure brand so they can price aggressively for that segment without diluting the Hertz brand.  So I do think a deal happens, but:

• I don’t think a deal happens above Hertz’s $72 offer price, and think it is much more likely a deal happens well below DTG’s current trading price.
• Hertz is saying they withdrew their offer because the price no longer made sense. 
• I think Hertz truly was on its tippy-toes offering $72/share in May.  That $72 offer was a huge raise on Avis’ prior $53 offer and I think it was intended as a knock out price to get the deal closed. 
• When they made that offer (now worth $70), Hertz’s stock was at $17/share.  HTZ stock is now $14.50.  Hertz already has a weak B+/B1 rating and the deal would add leverage. Hertz just bought Donlen.
• The merger arb guys don’t believe Hertz, they think Hertz will do this deal at a higher price, most of this is justified off of analysis assuming DTG’s EBTIDA is sustainable at $250m
• I think Hertz views DTG’s profitability similarly to how I view it.  Frissora’s comments suggest he thinks price has to come down.  when discussing depreciation with HTZ mgmt you can gently asked them about others in the space and mgmt will immediately jump on it and mentioned how DTG was taking huge gains off of unusually high depreciation booked in 2008/2009.
• I think Hertz plans to work things through with the FTC, wait for DTG’s stock to crack, then come back and buy closer to their $50 September 2010 offer (original offer was $41).  Avis has never offered more than $53, and that wasn’t even really an “offer” since it looks like Avis couldn’t get approval.
• Hertz anti-trust appears very difficult but eventually surmountable
• Supposedly (this is all rumor), the FTC is mandating that in order for DTG to be subsumed into either HTZ or CAR, an entirely new and independently feasible leisure rental car company must be created. 
• This has created enormous problems for Hertz who would need not only to sell their Advantage brand but find a way to convince the FTC it is a viable independent entity.  Evidently this means selling it to one of the existing 3^rd tier rental car companies (Payless, ACE) who has significant expertise in operation (the FTC has allegedly ruled out a financial buyer only).  But these players don’t have any money and must find financial partners.  Interest and indicative values have supposedly been far below what Hertz would accept.
• Consensus view is that a deal will eventually get done to sell Advantage, it is just a high degree of difficulty and will be at a dilutive valuation (though Advantage is very small at only ~$250m revenue).

The wild card is whether Avis can still play a role in this transaction to keep the price high for Hertz

• When you ask arbs why they’d still be in this stock the answer is two-fold:
• Hertz needs to do this deal and can afford to pay much more
• Avis will be back so HTZ needs to act quickly (most arbs telling me that Avis will be back in the hunt this Jan!)
• Avis looks like wishful thinking to me.  They have kept the door open to coming back, but they have their hands full and their leverage topped off after buying Avis Europe
• Value - The highest bid Avis ever submitted was $53, and none of their bids were remotely firm.  DTG has much less strategic value for CAR and the synergy potential is lower as well.  CAR would be required to divest much larger pieces of its business at fire sale prices.  In short, CAR can’t afford to pay near the price that HTZ could pay, and can’t pay near DTG’s current trading value. 
• CAR trades at a lower valuation than HTZ so the deal would be even more dilutive
• CAR clearly does not believe in DTG’s runrate profitability.  CAR has the least exposure to used car prices since risk cars are only 50% of their fleet, yet they guided the street that they overearned by $120-140m this year due to the Japanese earthquake.  This would imply Avis believes DTG over-earned $85-100m on used car pricing before even addressing DTG’s depreciation games. 
• Anti-trust – the ATR hurdle for Avis is much higher than it is for Hertz.  Hertz has been working with the FTC for 18 months and still does not have approval.  This deal poses a far greater anti-trust problem for CAR  because HTZ essentially doesn’t compete in budget leisure (Advantage does only $250m revenue) – in a Hertz acquisition scenario there are still 3 budget leisure competitors: HTZ/DTG, Budget and Enterprise, and the FTC is mandating another major player be created for HTZ to do the deal.  If Avis bought DTG, there would really only be two major players with Enterprise, and you would expect the FTC would require huge divestitures out of the combined DTG/Budget business in order to create a legitimate standalone new brand.
• Leverage – CAR just purchased Avis Europe for $1B + $600m assumed debt.  CAR had planned to raise $250m new equity for the deal but its stock price faltered and it ended up paying all cash.  CAR did however generate some excess cash from high used car prices.  CAR’s existing covenants leave the door open to a DTG deal but it must be under 5.25x PF leverage.  Citi’s analysis put them at 3.7x leverage on an $80 deal, based on LTM EBITDA (assuming DTG EBITDA is sustainable at $250m and full synergies).  If you use CAR’s guidance that there is a $120-140m EBITDA headwind next year, I calculate a deal would put them at 4.6x leverage (including synergy credits).  That means as little as a 12% EBITDA miss would bust covenants, which is scary given the current macro environment and European exposure
• Posturing – CAR does want to play spoiler to Hertz however and would love to complicate matters for Hertz.  I think that’s what’s been behind their mixed messaging. 

Countervailing points to note

• DTG CEO has said $72/share is not enough for him (though back when there was still a bidding contest, now both parties voluntarily walked away because $66 was too high a price)
• DTG announced a $400m stock buyback (all the cash on the balance sheet), which they expect to complete over the next year, with $100m already committed to be done by February.  That is clearly a signal of a company that expects a higher price, although it’s also a great use of cash for a fundamental short thesis. 
• Offsetting this signal, there has been heavy insider selling in the month since HTZ’s offer was pulled.  Every named officer other than the CEO has sold material portions of their holdings. 
• The COO, who was the 2^nd largest employee stockholder, resigned the day after Hertz pulled its offer.  In the month since he has sold almost his entire shareholding (departure was his decision, the guy is only 52 and a replacement hasn’t been named yet).  He sold $13m stock and completely walked away from a $7.9m change in control payday if a deal closed.  He does not seem to believe a deal is happening.
• DTG is owned by arbs whose price expectations are high. 

I won’t get too deep into it since it's another conversation altogether - but it could be interesting to add a small bit of long Hertz next to the short DTG - HTZ should trade up on a deal so you get some protection if they pay a little higher than market price, you also get enhanced upside if DTG's stock cracks and HTZ pays a realistic price.  

Deal History

Catalyst