Avis Budget May See Its Earnings Stall as Debt Load Climbs

Adopting the philosophy “if you can’t beat ‘em, join ‘em”, Avis Budget Group (CAR.N) announced plans to acquire Zipcar (ZIP.O) at the beginning of the 2013, but the purchase will just take its debt burden up another notch at a time when its earnings from recently-acquired European operations are flagging. Little wonder that the company seems to about to report an earnings “miss” for the fourth quarter.

Avis Budget Group Inc. (CAR.N) is trying to change the rules of the road with its announcement that plans to acquire Zipcar (ZIP.O) for $500 million, a 50% premium to the company’s share price at the time the transaction was announced. While Zipcar’s stock price has been floundering, the concept of “car sharing” has gained ground in many urban areas, and Avis Budget’s CEO, confessed that he has come around to the model as he as seen the way that technology can transform even such an established business as renting a car. Rather than supplement its own existing longer-term rental business by setting up a competing business catering to urban residents simply trying to get hold of a car to run errands for two or three hours, Avis Budget opted to acquire Zipcar and its existing brand at what it clearly saw as a budget price.

But will the acquisition jump-start Avis Budget’s stalled earnings growth? In the third quarter, the company reported profits of $1.46 a share, falling short of analysts’ forecasts by 5 cents a share. Analysts cited weakness in the truck rental business as a source of concern that is likely to be a drag on earnings for the third quarter. And those analysts have spent the last 90 days or so cutting their estimates for Avis Budget’s fourth quarter results. The consensus today is that Avis Budget will report a loss of 7 cents a share, a larger loss than the 5 cents a share that had been anticipated at the beginning of the quarter. (The company’s business does tend to be cyclical, with fourth-quarter earnings tending to be the weakest.) But the StarMine SmartEstimate, which emphasizes the most recent forecasts and those by the analysts who have the greatest track record for accuracy, stands lower still: it anticipates a loss of 8 cents a share, giving the company a large negative Predicted Surprise of -10.2% and increasing the likelihood that the company either will report another earnings “miss” or that the consensus estimate will fall further still in the days between now and February 11, when Avis Budget expects to report its results.

There are some fundamental reasons for this growing bearishness on the part of analysts, notably the weakness in Avis Budget’s European operations. Before Avis Budget completed the acquisition of Avis Europe in the final months of 2011, the latter had been an independently owned licensee of Avis Budget Group, operating the Avis brand in Europe, the Middle East, Africa and Asia. At first glance, the timing of the $1.04 billion acquisition seems poor, given that the European slowdown has dented earnings in that region; understandably, it hasn’t been able to command high rental rates. Avis has benefited from higher residual costs – the remaining value of the cars once they are used and that they can be reasonably expected to sell for in the second-hand market. What remains unknown is whether those residuals will continue to offset those higher costs (associated with building a new fleet of cars and depreciation expenses) into 2013. In the short term, Avis Budget may benefit from a rise in residual values in the wake of Hurricane Sandy, as natural disasters tend to curtail the supply of used cars and cause demand to climb. But while the company can take advantage of these rising prices today, at some point residuals will slide back to their historic averages. At that point, Avis Budget will need to find ways to generate more sales and profits to compensate for the decline in residuals.

Avis Budget also labors under a large debt burden, with more than $10.8 billion dollars in total debt, the vast majority of which is long-term debt. As a result, the company faces a big burden in the shape of interest expenses. In the trailing four-quarter period Avis Budget paid out more than half of its $913 million in operating income, or a total of $598 million, to repay interest on this debt. That means that those interest payment are competing with income that Avis Budget otherwise could devote to expanding its business (including Zipcar) and increasing profits. This explains why the company fares so poorly – recording a score of only 2 out of a possible 100 – on the StarMine SmartRatios Credit Risk (SRCR) model, which translates to an implied credit rating of only CCC. The company scores particularly poorly on the leverage, interest coverage and liquidity components of this quantitative model.
In the third quarter, Avis Budget’s business was hit by the loss of a big truck rental contract as well as by higher tax rates. On the margin, together with the weakness in Europe, this casts a bit of a cloud of the company’s ability to beat analysts’ expectations in the current quarter as well. Moreover, Avis Budget’s plans to finance the Zipcar acquisition with debt means it also will see its interest payments grow.

Two analysts who track Avis Budget and who have received a five-star rating from StarMine for their accuracy in predicting earnings today believe that the company’s losses may be still larger. (One analyst has an estimate for a loss of 9 cents; the other forecasts a loss of 13 cents, or more than double the loss foreseen in the consensus estimate.) For much of 2012, Avis has demonstrated robust earnings growth, even though it hasn’t always been as significant as analysts had forecast. The prospect of a larger-than-expected loss in the fourth quarter is part of this pattern, and investors may want to keep an eye open both on the level of interest payments and on its new European business, to gauge the extent to which these may become more of a drag on future earnings.

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