Description

Dollar Thrifty Automotive (DTG) is one of the largest rental car operators in the United States, with more than 1,600 corporate and franchised locations worldwide. The company offers a very compelling valuation -- exclusive of its significant excess cash and NOLs, we believe DTG trades at approximately 4x adjusted 05 EBITDA and 8x 06 EPS, offering investors upside of 40-60%. The business is significantly under-levered and offers a meaningful recapitalization opportunity. We believe that DTG could lever up to 3x EBITDA, pay out a $20 dividend and still generate FCF/share of nearly $1.50. Furthermore, the valuation on the recent Hertz sale to a private equity consortium (led by Clayton Dubilier and The Carlyle Group) implies that DTG should trade in the high-40’s, a 50% premium to its current price.

When two large and highly successful private equity shops make a huge capital commitment to industry, it is generally worth assessing why. While this is largely a commodity business, recent structural changes in the industry suggest a dramatically improving environment: a) Fleet sale “stuffing” by the OEMs has fallen off dramatically, reducing vehicle supply and leading to better prices. Improved pricing has been publicly noted recently by several companies; b) Industry consolidation has reduced the playing field to five national competitors with eight brands; and c) New ownership – Cerberus (which bought Alamo and National out of bankruptcy) and Clayton/Carlyle. The importance of the industry leader’s being transformed from a dumping ground for Ford vehicles to a for-profit enterprise has the potential to dramatically change the tone of the market.

There are also several on-going changes in the car rental industry that should allow low-cost rental providers like DTG to capture additional market share in the airport segment. First, the Internet should benefit low cost providers due to more transparent pricing. Second, most major U.S. airports are moving to a consolidated rental car facility configuration with a shared bus service and one main hub. Historically, companies like Hertz had a competitive advantage with their larger buses that arrived at the terminal with higher frequency, but this new setup improves the positioning of the value provider. In the top 25 airport markets, 7 have already consolidated their rental car facilities, 4 are under construction and 6 are in planning stages. DTG offers the opportunity to own a very well-run, low cost competitor in a rapidly leveling playing field and improved industry structure.

Disclosure: I own this stock and may buy or sell at any time, without notice. We have no obligation to inform you of any changes in our views of Dollar Thrifty Automotive.

Company Overview:
Dollar Thrifty is the 4th largest rental car company in the U.S. with 13% market share. The company focuses on the leisure travel segment of the rental industry. The industry is under-followed and generally misunderstood, as there are only two publicly traded competitors (one of which, Cendant, is a diversified real estate and travel conglomerate). DTG generated $1.4 billion of revenue in 2004, with the vast majority of revenue coming from retail rentals (~80%), and the remainder from tour rental and vehicle leasing. We estimate that the revenue breakdown by traffic source is as follows: Branded web sites (thrifty.com, dollar.com) – 35%; Call center – 29%; Online travel aggregators – 24%; and Travel agents (mostly tour operator business) – 12%.

The management team has a real passion for the business and seems obsessed with cost management. The company operates out of a very modest headquarters in Tulsa, has minimal union operations, and its call centers are situated near college campuses allowing the company to leverage a less expensive labor force. One interesting note that speaks to both the strong cost controls of the company and the higher than perceived level of variable costs relative to fixed costs in the business is that despite the miserable industry state that existed after 9/11, the company was actually able to turn a profit in both 2001 and 2002.

We believe that the leisure car rental business is a superior business model to one focused on the business traveler for several reasons: a) rental companies like DTG can maintain higher utilization rates, as the typical leisure customer will rent for longer time periods and often rents on weekends; b) leisure market providers do not need to have locations in all markets, whereas business customers generally demand complete geographic coverage; and c) the leisure market is less cyclical than the business market – people always have birthdays, weddings and funerals that they need to attend, and American culture places a very high value on the family vacation.

Industry Rationalization:
The airport car rental market saw a significant downturn post-9/11, and Budget and ANC Rental (Alamo and National brands) both declared bankruptcy. In recent years, the car rental industry has consolidated down to five companies with eight national brands. The primary players in the airport market are Hertz and Cendant (Avis and Budget), followed by three smaller players, Dollar Thrifty, Vanguard (National and Alamo) and Enterprise. Hertz, Avis and National generally focus on the business customer, and Dollar Thrifty, Budget and Alamo focus on the leisure segment, with Enterprise historically focused on the off-airport insurance market but seeking to gain market share in the airport market. Consolidation in the industry has helped shape a sector where competition is more rational, as airports typically have 4-7 concessionaires, and brands with common ownership (i.e. Alamo and National or Dollar and Thrifty) typically co-locate together to capture synergies on fleet management and shared back office expenses.

Historically, auto manufacturers have pushed vehicles down on the rental providers and did tremendous damage to the pricing dynamics of the car rental industry. The automakers typically offered strong incentives, often through high guaranteed repurchase prices on the sold vehicles, to encourage the car rental companies to take more supply than was prudent. Hertz, which was owned by Ford, would historically take significant supply from its parent to support the parent company, and Alamo had a reputation for irrationally accepting excess supply as well. Now that Alamo and National are owned by Cerberus, a large private equity shop known for its strict cost discipline, and with Hertz soon to be in the hands of a large private equity consortium as well, we believe that the car rental industry will be more profit-oriented and significantly more prudent in managing its fleet. In both public statements from the automakers and in discussions with rental industry participants, it appears that the car manufacturers are stuffing fewer cars to rental fleets. While this should lead to higher car costs for the rental companies, we believe it is a long-term positive structural change for the rental industry and should allow for greater pricing power for rental car providers.

Recent conversations with industry experts indicate that car rental pricing has increased meaningfully in the past several months. While a significant portion of these price increases is due to recently negotiated increases in vehicle pricing from the automakers (new vehicles typically enter the fleet in September), we believe that the rental companies will more than offset these amounts, leading to improved profitability. Cendant and Hertz raised pricing 5% this summer, and Cendant announced a further $5/day price increase in September that was followed immediately by Alamo/National. Furthermore, Cendant management has made recent public statements about the improved state of the industry and further price increases that they anticipate making. DTG has articulated that their car costs are going up by 20-25% this season, implying that they will need to raise pricing by 6-8% to keep up with these costs. Management believes that half of this amount can actually be achieved through further cost improvements (despite the fact that they are already one of the leanest operators in the space). As the value provider, DTG is a price follower in the industry, but the positive pricing indications from Avis and Hertz are certainly a good sign.

Rational industry pricing has yet to play itself out perfectly, however. This past spring, Expedia demanded most favored nation pricing from Dollar Thrifty in return for keeping the company on the preferred vendor section of their site. As Hertz and Enterprise were the only other brands on the preferred list and Cendant had refused to give in to the MFN demand in 2004 negotiations, DTG made the decision to play hardball and was removed from the front page by Expedia. Surprisingly, Cendant agreed to Expedia’s preferred provider terms shortly thereafter for its Budget brand. The loss of traffic to DTG was significant, as roughly 7% of revenues and 11% of non-tour traffic came through the Expedia channel historically. However, we believe that it was a good long-term business decision for DTG as Expedia takes 17% of gross revenue and giving away MFN pricing clearly limits the future growth and flexibility of DTG’s highest margin traffic (branded web sites). Although we are disappointed that the industry behaved irrationally in this case, more recent moves from Cendant indicate meaningful improvement.

Investment Merits:
• Inefficient balance sheet – DTG’s balance sheet has significant excess cash and is under-levered. Management believes that the company will have more than $225 million (>$8/share) of excess cash on hand at year-end. Additionally, the company keeps significant restricted cash balances on hand to finance fleet purchases. We believe that the company over-equitizes its fleet purchases and may have an additional $2-3/share of excess restricted cash, but for valuation purposes below we have excluded that amount. All of Dollar Thrifty’s debt is secured for the purchase of vehicles. The company’s significant and growing free cash flow generation should allow it the opportunity to raise unsecured debt in the capital markets and pay out a large one-time dividend and/or repurchase a large portion of its current equity value. The management team took a positive first step with its announcement of a $100 million share repurchase program in December 2004. To date, however, it has repurchased only 1.5 million shares for $44 million, an amount that we consider to be insufficient. Larger share repurchases through cash on hand or a broader recapitalization event would create significant value for shareholders. If DTG raised 3x EBITDA of unsecured debt and used both the incremental leverage as well as $150 million of their cash on hand, they could pay out a $20 dividend to shareholders and still generate approximately $1.50 of FCF/share on a $12 stock.

In discussions with management, it is clear that they understand that DTG could manage a substantially higher debt burden without damaging its business. However, the company a) has a very cautious board and b) would prefer to see demonstrated improvement in pricing industry-wide before taking on leverage particularly given the dramatic travel downturn suffered post-9/11 that is in such recent memory.

• Hertz transaction should structurally benefit rental industry – Ford recently sold its Hertz business to a private equity consortium for $15 billion in a very competitive auction process. The private equity group, led by Clayton Dubilier, demonstrated its comfort level with both the Hertz asset and industry structure by seeking to raise significant non-asset-based leverage in financing this transaction (note that this capital raise has not been completed). The additional leverage signals that Hertz will have to be very disciplined on pricing which should lead to a more rational industry structure. Since Hertz and Avis have traditionally been the price leaders in the industry, this is a positive for all rental players. We believe that the Hertz transaction/financing structure will allow DTG more flexibility in examining the most appropriate capital structure for the company.

• Hertz valuation implies significant upside potential for DTG – Hertz’s equity value of $5.6 billion implies a purchase price of 8x 05 EBITDA and 18x 05 FCF. Furthermore, approximately 20% of Hertz’s business is in the equipment rental sector which typically garners a 5-6x EBITDA multiple (URI, NLEQ, Odyssey purchase of NEFF), implying that the purchase price for the car rental business was higher than the previously mentioned multiples. The Hertz multiple may serve as a catalyst for Cendant to spin-off its car rental business and/or a potential IPO of the Vanguard Group. The analysis below demonstrates that the Hertz purchase price implies 40-50% upside potential for Dollar Thrifty. Given the large valuation disparity and the number of interested private equity parties that took a long look at the Hertz asset, we believe that it is incumbent upon the company to examine shareholder-value creating opportunities including an outright sale of the business.

Hertz Relative Valuation DTG Hertz
Stock Price $32.00
Shares 26.5
Equity Value $846.5 $5,600
Less: 05 Avg Est Cash balance 198.3
Less: PV of NOL 102.7
Adjusted Equity Value $545.5

Adjusted EBITDA
Operating Income $192.0 $895.9
Plus: Non-vehicle D&A 34.0 200.0
Less: Interest Expense (99.1) (384.4)
2005 Adjusted EBITDA $126.8 $711.5

Free Cash Flow
Operating Income $192.0 $895.9
Plus: Non-Vehicle D&A 34.0 200.0
Less: Non-vehicle capex (34.0) (250.0)
Less: Taxes (34.4) (153.4)
Less: Interest Expense (99.1) (384.4)
2005 Free Cash Flow $58.5 $308.0

2005 Adjusted EBITDA Multiple 4.3x 7.9x
2005 FCF Yield 10.7% 5.5%

DTG Implied Price based on:
HTZ Adj EBITDA Multiple $50.13
HTZ FCF Yield $52.60

Apply 10% Discount
HTZ Adj EBITDA Multiple $45.11
HTZ FCF Yield $47.34

• Conversations with leisure travel competition and a close examination of recent pricing trends indicate that publicly stated price hikes are being implemented, and industry is becoming more rationale from a pricing perspective. Car rental rates rose by 2-5% a year between 1995 and 2000 but are still roughly at 2001 levels, indicating that there is much room for improvement. Once again, increased pricing should yield dramatic improvements to the bottom line.

• Franchise acquisition strategy showing positive results – in December 2002, the company articulated a franchise acquisition strategy that was focused on the top 75 markets in the U.S. The company is well ahead of its schedule, as it has successfully acquired more than 45 U.S. and Canadian markets to date (70% complete). In general, DTG acquires a Dollar or Thrifty franchise in large markets in which the other brand is managed corporately. By having both brands in the same airport markets, the company should see improvements in fleet utilization rates and save on shared G&A expenses.

Financial Projections and Valuation:
Before laying out DTG’s valuation, it is useful to examine the unit economics of the business. An average car rents for approximately $40/day. DTG’s historical utilization rate has been in the 82-85% range, and cars are held in the fleet for 7-9 months (although several competitors have recently been extending this period). DTG cars have earned a pre-tax operating margin of 7%, and the company believes they can reach 8% over the longer-term. Since depreciation and lease expenses are approximately 25% of rental revenue per car, return on capital invested (After-tax profit / Depreciation) for DTG is 17%+.

Historical and projected operating results for the company are set out below. We believe that the improved industry structure, share gains on the part of the value providers, and continued successes from the franchise acquisition strategy should generate positive revenue and margin growth over the next couple of years.

2000 2001 2002 2003 2004 2005E 2006E
US Car Rental Revenue (bn) $19.4 $18.2 $16.4 $16.5 $17.4
% Growth (6%) (10%) 1% 5%

DTG Revenue (mm) $1,114 $1,050 $1,133 $1,228 $1,424 $1,550 $1,652
% Growth (6%) 8% 8% 16% 9% 7%

DTG Adj. EBITDA (mm) (a) $158.3 $49.6 $100.7 $82.5 $113.4 $126.8 $142.8
% Margin 14% 5% 9% 7% 8% 8% 9%

(a) Calculated as operating income plus non-vehicle D&A less interest expense

We have analyzed DTG’s valuation using both adjusted EBITDA (calculated as Operating Income + Non-Vehicle D&A – Interest Expense) and projected fully-taxed earnings. Since all of DTG’s debt is secured against the vehicles, we believe that deducting interest expense is the correct way to calculate the true EBITDA of the business. For each metric, we deduct both current excess cash and our calculated present value of the NOL ($835mm of NOL’s at the end of 2004) from the current equity value of the business. It is important to note that we are using a conservative cash figure as the working capital needs of the business are greatest as the company enters its busy summer season. DTG management articulated on their 2Q earnings call that they believe they will have $225 million of excess cash at year-end, and in 2004 the cash balance grew from $141 million at the end of the second quarter to $205 million by year-end. A summary of the DTG valuation follows:

$mm Per Share
Equity Market Capitalization $838 $32.00

Cash Balance (2Q05) $185 $7.06
Less: PF Franchisee Acquisitions 35 1.34
$150 $5.72

Less: PV of NOL 103 $3.92
Remaining Value $586 $22.36

2005E EPS $2.21
2006E EPS $2.75

Implied Price / 2005E EPS 10.1x
Implied Price / 2006E EPS 8.1x

2005E Adjusted EBITDA $126.8
2006E Adjusted EBITDA $142.8

Implied EV / 2005E EBITDA 4.6x
Implied EV / 2006E EBITDA 4.1x

We believe that DTG should be valued in the 13-15x EPS range (net of cash and NOL), implying upside of 40-50% for the investment.

Investment Risks:
• Heavily dependent on airline traffic – while airline traffic trends this summer were robust, recent airline bankruptcy filings and the troubled state of the industry may bring about reduced capacity and increased air traffic pricing, which should lead to reduced demand in the leisure car rental market.
• Fuel pricing – higher fuel prices will at the margin cause leisure travelers to a) rent smaller cars, b) travel shorter distances, or c) not travel altogether.
• Managing residual value risk on non-program cars – although 80% of DTG’s fleet are program cars (the automaker guarantees the residual value), the remaining 20% of vehicles are purchased at-risk, so the company is dependent on the used car market. Used car pricing was up 2-3% this summer, and September was a particularly strong month.
• Enterprise has been entering the airport market with aggressive pricing – while gate constraints at airports have limited Enterprise’s entrance to a degree, the company is becoming a formidable competitor in the airport market and has been pricing aggressively to create brand awareness and to capture market share. However, we believe that the new Hertz owners will focus much of their efforts on growing the off-airport business, and may force Enterprise to retrench its competitive positioning in the airport market to defend its near monopoly position in the insurance car rental business.

Catalyst

-Large share repurchase and/or recapitalization event would create significant shareholder value
-Hertz financial leverage forces pricing discipline by the industry pricing leader
-Cendant car rental spin/off and/or Vanguard IPO will draw increased investor interest in the sector and a better awareness for the value of these assets
-Separation of car rental businesses from automakers will drive “profit-seeking” behavior
-Potential sale of business given Hertz valuation