Falling Used Car Prices Create a Decline for Avis Budget Stock (CAR)
Avis Budget group shares (NASDAQ:CAR) have achieved extraordinary performance over the past 24 months. Its “meme” or short-term status aside, the post-COVID landscape was basically very good for Avis’ business. A surge in travel demand has pushed up rental rates and car rental companies are heavily indebted used car owners, who have soared as new car production was weak. Avis will release its third quarter results on October 31stso now is a good time to check the fundamentals to see what the quarter might look like.
Regardless of your opinion of CAR’s assessment, there’s no denying that the company has performed extremely well. In the business second quarter, revenue rose 37% to $3.2 billion, generating a record net profit of $774 million. EPS was $15.71 versus $5.63 last year, and in the first half, it returned more than $25. Thanks to strong cash flow, it spent $1.7 billion on share buybacks, reducing its outstanding shares from 70.6 million to 49.5 million. These are real positives that have fundamentally improved the fair value of CAR compared to the past.
As you can see below, the company has significantly increased its fleet as new car production resumed and prices rose another 2% in the second quarter. In 2019, the income per day was around $47, so rental rates are almost 70% higher today. It is therefore not surprising that the profits are so high. That said, fleet usage has gone down, so Avis might be reaching the limit of what it can achieve price-wise. Still, if he can keep prices in the upper $70s, that would be a big win and better than even the biggest bulls of 2019 would have expected.
In addition to higher rental rates, as used car prices are relatively high, the company depreciates its fleet more slowly. Depreciation fell from $686 per car last year to $259 last quarter, representing a savings of $131 million. On top of that non-monetary saving, because used cars have done so well, he’s selling cars for more than their book value, generating a $497 million gain on the sale this year. It carried out vehicle sales for 2.6 billion dollars (page 6 of 10-Q) in the first half of 2022, so he’s basically selling them at a profit of 24% over their cost of ownership.
As mentioned, used cars have seen a huge increase in value over the past couple of years – they are arguably the best performing asset class in the world. That said, their prices have started to drop. They couldn’t go up forever, otherwise they would end up being more expensive than new cars! Given the combination of rising new car production and fading fiscal stimulus, my general view is that used cars should see further price declines. A very short-term risk to this view is that Hurricane Ian appears to have destroyed many cars – Progressive (PGR) set aside $585 million for damage to cars and boats on Wednesday. This could provide a regional boost to used car prices, but I expect any benefit to be fairly short-term. The Manheim index shows a decline of around 8% in used car prices over the past three months.
In addition to lower used car prices, Wednesday’s CPI report showed that the car rental rates have fallen by 8% since June. Sure, Avis may have outperformed or underperformed this national benchmark, but it’s likely that there was some moderation in rental rates in the third quarter, which will reduce revenue.
While I recognize that the high short interest and passions surrounding the stock can lead to outsized price movements in either direction, I have tried to focus on determining a fair fundamental value. I think it’s best to separate the business into two parts: the pace of operation of its core rental business and any hidden value in its fleet given used car prices higher than their depreciated value.
If we exclude gains on car sales (since we value cars separately), the rental business made $900 million in profit in the first half. If we assume in the future that cars depreciate more normally, this will represent an increase of about $300 million in pre-tax costs. Based on the rental rates Avis was receiving in the first half, it generated $675 million in “normal profits.” Given its cyclical nature, I value the business at 10x or $1.3 billion. Given that he has $7 billion in debt and operating leases, he was worth $6 billion as of June 30.e.
So far this year, Avis has sold cars at a profit of 24%. As a result, its $16.3 billion in net vehicles was actually worth around $20.2 billion. Taking into account $1.3 billion in receivables and other assets minus $16.9 billion in vehicle debts, his vehicles were worth $4.6 billion net.
Combining the two, based on June 30e rental rates and used car prices, Avis was worth $10.6 billion or $214. Now, I tend to think that’s a generous valuation, because his vehicle position includes cars purchased during the quarter from automakers, and he’s unlikely to make a 24% profit on these cars.
Along with the June 30 estimate, the second column shows the company’s valuation if the Manheim and CPI indices, which showed an 8% drop in used cars and rental prices, are accurate. I also assumed that CAR would be able to offset half of its lost revenue through cost reductions to reach $1 billion in profit in this scenario. Due to the high indebtedness of its auto holdings with $16.9 billion in debt and an 8% decline in its used cars, Avis’ car net worth is down more than 33% to 3 billions of dollars. Essentially, every 1% of the used car price is worth $200 million to AVIS, or about $4 per share.
In this scenario, the stock is worth $121. In an environment where we see further deterioration, including a 10% drop in rental rates and a 20% drop in used cars, the value of AVIS would fall to $42. Given that the company has $7 billion in corporate debt and leases and $16.9 billion in vehicle financing, it is highly leveraged and small changes in its business have much larger impacts on value. of its share price. This is one of the reasons the stock can be so volatile, changing the assumptions of the model ever so slightly has dramatic consequences for the stock price.
This is also why I urge caution in trading this stock; it has been and probably can continue to be very volatile. At its current price of $180, the stock is essentially looking for only a slight deterioration from June 30 levels, while other indicators like the CPI and Manheim are pointing to bigger declines. As a result, I see downside risk before earnings and view $100-$120 as Avis’ fundamental fair value in a benign scenario where used cars and rental rates don’t drop much further. There would be a bigger downside in a recession, just considering the large debt load Avis has to carry.
For equity investors, I would recommend selling holdings in the $180 range as I view the Q3 earnings report as a more likely catalyst to push stocks lower than higher if we see the moderation results that I anticipate. Given the volatility of this stock, I would caution against short selling stocks. Instead, I would look to buy put options to limit the downside. The $160 strike on November 4e the put is $7, and I see this as an attractive way to bet on the stock converging to fair value while capping your downside after posting earnings on Oct 31st.