Business Review continued
Operating environment
Market size and growth
The latest European independent market data (Euromonitor IMIS Travel Database 2006) estimated the car rental revenue generated in the 10 main countries that the Group operated in on a corporate basis to be €8.51 billion during 2006. The largest countries by revenue were Germany (24%), the United Kingdom (18%), France (17%), Spain (16%) and Italy (11%). During this period, Euromonitor estimated that 41 million rentals were made and that a combined fleet of approximately 1.2 million vehicles was employed by the car rental industry.
Historically, the growth of the car rental market has been closely tied to general economic activity levels and, in the case of rentals from airports, to airline passenger volume growth. Economic growth prospects for the Group's key markets presently appear to a degree less positive than they were last year. As at January 2008, the Economist Intelligence Unit was forecasting Euro-area GDP growth at an annual rate of between 1.9% and 2.1% from 2008 to 2011 (previous forecasts of between 2.1% and 2.2% from 2007 to 2010), and between 1.7% and 2.5% in the United Kingdom from 2008 to 2011 (previous forecasts of between 2.0% and 2.5% from 2007 to 2010). Euromonitor estimated that the total industry revenue in the 10 main corporate countries grew at a compound rate of 1.2% per annum from 2002 to 2006 and forecasted growth of 5.2% per annum from 2007 to 2011.
Growth expectations for the airline sector tend to be higher than GDP growth, driven in part by structural trends, in particular by the continued growth of low cost airlines.
The International Air Transport Association forecasts growth in passenger arrivals for flights within Europe of 4.8% per annum for 2007 to 2011.
| Air passenger growth estimates 2007-2011 (average annual rate) | ||
| Intra-European | 4.8% | |
| Europe-Asia | 6.6% | |
| Europe-North America | 4.3% | |
| Source: IATA, as at October 2007 | ||
Market composition
Euromonitor generally categorises the car rental market either by the type of customer (corporate, leisure, insurance/replacement) or by the location of rental (airport, non-airport). In 2006, Euromonitor estimated just under 52% of the market to be leisure, with approximately 42% being corporate and 6% being replacement business. During 2006, 38% of the industry's revenue came from airport rentals, with 62% attributable to non-airport locations.
Customer groups
Broadly reflecting the above, customers are classified by the Group as: corporate, individual and insurance/leasing.
Individual:
These customers are individual travellers booking directly or indirectly through travel companies, tour operators, partnership arrangements and brokers.
To support business from individual customers Avis has an extensive portfolio of over 70 international partnerships with the world's airlines, railway networks and other leading travel companies.
The individual customer category is more seasonal than the corporate customer category, with demand peaking over the key holiday periods. Individual customers are principally attracted to Avis by its widespread network, quality of service, reliability, brand, website and competitive prices.
Corporate:
Corporate customers book via negotiated arrangements with their employers and through vehicle replacement companies.
The corporate customer category displays a relatively even pattern of demand throughout the year. The key requirements of corporate customers are competitive prices, speed and quality of service, reliability, availability of management information and geographical coverage.
Insurance/Leasing:
These customers come through insurance and leasing companies, vehicle dealerships and repair shops with which Avis has a direct contractual relationship. This category also displays a relatively even pattern of demand throughout the year and customers' requirements are similar to those in the corporate segment.
Stations/locations
Rental locations throughout the network are selected for their convenience to customers, with particular importance attached to representation at airports,rail locations and other major travel points. Whilst Euromonitor estimates that across the market as a whole, 38% of revenue comes from airport rentals,Avis benefits from a broadly even distribution of revenue from airport and non-airport locations, due to its significant international network.
Competition
Euromonitor research shows that the Group had the second highest aggregate market revenue share in its 10 largest corporate countries in 2006 at 18.3%.
The merger between Europcar and Vanguard (primarily National and Alamo brands) in November 2006 has given Europcar a leading position in this European market place with a reported share of 23.7%. Hertz is the third largest with a reported market share of 15.2% in 2006.
In specific markets the Group faces competition from other car rental operators. For example, Sixt is a major competitor in Germany and Enterprise in the United Kingdom. There are a large number of smaller-scale operators with strength in particular markets (frequently the Mediterranean), examples being Maggiore in Italy and ADA in France.
It is noteworthy that the Group operates two of the three established global brands, Avis, Budget and Hertz. The merger between Europcar and Vanguard referred to above creates a fourth global operator.
Risk factors
The Group may be affected by a number of risks, not all of which are within its control. Outlined below are some of the risk factors that may affect the Group's business. Other factors besides those listed below may also adversely affect the Group. The process the Group has in place for managing these risks is described in the Corporate Governance report.
There are inherent risks and uncertainties behind the forward-looking statements contained in this section which could have a material impact on the future results.
International
Given its extensive geographic coverage, the Group's business is subject to various risks inherent in international operations. These risks include, among other things, regulatory requirements, differing legal and tax practice and interpretation, difficulties in managing foreign operations, different local accounting practices and potential political instability.
The concentration of accounting and administrative activities in a shared service centre in Budapest and, in respect of reservations, in a shared service centre in Barcelona exposes the Group in the event that these centres suffered serious disruption. Recognising this, the Group has made appropriate plans to facilitate the continuation of business, as best practicable, at alternative locations.
Demand
The Group faces various risks associated with the demand for its services, which in itself is highly seasonal. Disruption could occur during the peak summer season at the time when the Group increases staff levels and purchases more vehicles to accommodate the anticipated usual increase in demand. There may be disruptions in air travel patterns or a general decrease in air travel as a result of a significant event such as a terrorist incident or as a consequence of increased security measures being taken by the authorities in anticipation of such a threat. An economic downturn would also pose challenges for the Group that would require careful management of the business to manage capacity and costs and to maintain profitability.
Pricing and competitive pressures
The Group and its licensees are subject to competition from a wide range of other operators both directly and via intermediaries and brokers. Large European competitors compete with the Group in most customer categories, and mergers and acquisitions involving those competitors may result in increased competitive pressure. Local operators may have lower operating costs, enabling them to charge relatively low prices. In addition, the car rental industry faces pressure from increased pricing transparency as a result of the growth of internet travel portals, other forms of e-commerce and rental brokers. This transparency has increased the prevalence and intensity of price competition.
Fleet
Loss or material change in the terms on which the Group obtains its fleet vehicles from major vehicle suppliers could harm the performance of the business. In the event that the Group could not procure all its required vehicles from current sources, vehicles could be obtained from other sources such as dealers. However, there could be risks to business volumes and to financial and operating results as the Group sought alternative supplier arrangements.
The effective cost of vehicles is dependent on the new purchase price, the level of discount, the amount of any marketing contributions and the residual value of the vehicles, either on the pre-agreed price for repurchase vehicles or the open market for non-repurchase vehicles. There is a risk that the effective cost of vehicles increases and that because of competitive pressures, the Group will be unable to pass on such an increased cost of vehicles to its rental customers.
Historically sales incentive and discount programmes offered by manufacturers to car rental companies have tended to keep the average cost of cars low for the car rental industry. In periods when the environment for new car sales improves, manufacturers could decide to reduce their allocation of sales to fleet purchasers such as the Group, or to remove the incentives and discounts thereby increasing the average cost of vehicles.
Vehicles not covered by repurchase programmes are sold on the open market. Residual values of these vehicles are exposed to an adverse movement in second-hand vehicle prices, which can be a result of a number of factors, including general economic conditions, tightening of availability of credit to potential buyers, model changes and changes in environmental legislative policy which cause short term uncertainty and prompt change in customer preference. Equally, a severe or persistent decline in the results of operations or financial condition of one of the major manufacturers supplying vehicles for the Group's fleet could impact residual values. Any such movement in used vehicle prices or poor demand in the used vehicle market may hinder the Group's ability to sell these vehicles and could adversely affect the Group's results.
If a decline in the results of operations or financial condition of a vehicle manufacturer (or other repurchase programme counterparty, such as a dealer) were so severe as to cause it to default on an obligation to repurchase vehicles covered by repurchase guarantees, the Group would have to find an alternative method for disposal of those vehicles, which could increase the Group's expenses and decrease the proceeds from such disposals. Any such default might also leave the Group with an unpaid claim against the manufacturer or dealer with respect to repurchase vehicles that have been sold and returned but not yet paid for.
A severe or protracted disruption of fuel supplies or significant increases in fuel prices could have an adverse effect on results, either by directly interfering with operating activities or by disrupting air travel on which a significant portion of the Group's business relies.
If governments generally across Europe introduce too rapidly changes to taxation or environmental regulations designed to encourage the use of vehicles with lower CO2 emissions this may result in lower current vehicle residual values and in the short term have an adverse impact on the Group's performance until existing fleet is replaced.
In addition, further legislative changes encouraging the use of vehicles with lower vehicle emissions could result in additional costs in the medium term, if the Avis fleet cannot be adapted to wholly mitigate these changes.
Relationship with Avis Budget Group
Avis Budget Group, Inc. (ABG) licenses the Avis and Budget brands to the Group for operation in specified territories through master licensing agreements which expire in 2036.
The Group does not have any cross shareholdings with ABG, yet through the close contractual and business relationship the two companies work together to provide a seamless service to customers of both the Avis and the Budget networks. The Group relies on ABG to operate its own business in a manner that both upholds the value of the global brands and allows the Group to provide a similar service in the locations in which it operates. The Group has joint marketing initiatives with ABG and shares market and customer information where appropriate. It also provides joint services and cross-refers customers through a formalised agreement. Although management believes that the relationship with ABG is good, there can be no assurance that it will remain so. Any adverse changes to the terms of the agreements or any deterioration in ABG or its business or in the relationship with ABG is likely to have an adverse effect on the Group's financial condition and results of its operations.
The Group uses the Wizard rental and reservation system under licence from ABG pursuant to a long-term computer services agreement, which is subject to a five-year notice period. Wizard has been operational since 1972, and has been continuously enhanced and expanded since that time. It is a fully integrated reservation, rental and management information system that is used by Avis Europe and ABG worldwide. The Group is obliged to contribute to the cost of upgrading and enhancing Wizard, therefore unanticipated costs could adversely affect the Group's results. Should Wizard need to be replaced, process and execution issues could present a substantial risk to the Group's operations.
Insurance
The Group is legally obliged to provide statutory third party motor liability insurance to all customers. This insurance provides financial protection against claims from third parties where the Group's customers are at fault in a road accident. In addition, sales of damage waivers and personal accident insurance are important sources of revenue. The Group also covers various risks arising in the normal course of its business, including damage to its property and general liability. All insurance policies are arranged with insurance companies of strong credit quality. The Group also reinsures a limited amount of the risks through its own captive insurance companies, which in turn buy reinsurance to limit their own exposure to acceptable levels. Significant risks would exist to the stability of the Group's business if access to primary insurance and/or reinsurance was constrained, denied or available only at increased costs that could not be passed on in increased prices.
Funding
Terms of credit between the Group and its principal suppliers of fleet vary widely, depending both on the market in which the vehicles are to be used and on the supplier. Any material worsening of credit terms would result in an increased debt funding requirement.
The Group funds a substantial proportion of its vehicles with borrowings, including on and off balance sheet leasing arrangements, and, as such, depends on access to the debt markets and other forms of financing to fund the Group's fleet. If the Group is unable to access such debt facilities on commercially acceptable terms, or has difficulty meeting the terms of any financial covenants, its current business, results of operations, financial condition and future prospects may be adversely affected.
To mitigate against these risks and to guarantee access to liquidity, the Group ensures that it has a core level of long-term committed funding in place with maturities spread over a number of years. This core funding is supplemented with shorter-term committed and uncommitted facilities particularly to cover seasonal debt requirements. All funding is arranged with a wide range of providers, on both a public and private basis. The Group maintains a regular dialogue with all providers to keep them updated on the trading performance and prospects of the business.
Interest and foreign currency
The Group's interest rate risk arises from the Group's borrowings which, after foreign currency risk hedging, principally arise in euro and sterling. Borrowings issued at variable rates expose the Group to cash flow interest rate risk whereas borrowings issued at fixed rates expose the Group to fair value interest rate risk. A discussion of how the Group manages its interest rate risk is set out in Note 26 to the Consolidated Financial Statements.
The Group's results are exposed to fluctuations in exchange rates where revenues and expenses are denominated in currencies other than euros. In particular, there are net exposures to sterling, Swiss francs and US dollars. The US dollar exposure is largely due to certain guaranteed rate products sold to US customers renting in the Group's corporately owned operations, partly offset by fees paid to Avis Budget Group, Inc. in respect of systems-related services provided. Revenue from licensees is largely received in sterling, US dollars and other non-euro currencies. A discussion of how the Group manages its foreign currency risk is set out in Note 26 to the Consolidated Financial Statements.
Pensions
The Group has two principal defined benefit pension schemes, a UK scheme which is in deficit, and an unfunded scheme in Germany. The Group's balance sheet liability against these schemes is subject to uncertainty concerning the risks and returns around the respective assets and liabilities of the UK scheme and the interest rate applied to the book reserve for the German scheme. In particular, volatility in interest rates has an impact on the amount by which future pension liabilities are discounted and affect the returns forecast to be earned. While the funding level of the UK Plan has improved, largely due to the contributions paid by the Group to reduce the deficit, it is likely that, at the next actuarial valuation as at 31 March 2008, the ongoing funding will need to increase to meet the increased deficit as a consequence of further improvements in longevity and an impact of the new regulated funding environment.
Key performance indicators
The Board monitors a range of financial and non-financial performance indicators, reported on a periodic basis, to measure the Group's performance. Of these, the key measures are set out in the table below.
| Performance indicators | 2007 | 2006 | ||
| Billed days1 (% change)* | 4.7 | 6.1 | ||
| Rental revenue per day2 (% change)* | 0.7 | (1.8) | ||
| Fleet utilisation - average3 (%pts. change)* | 0.4 | 0.9 | ||
| Underlying4 operating margin - continuing operations (%) | 8.0 | 7.15 | ||
| Underlying4 return on capital employed - | 9.1 | 8.55 | ||
| continuing operations (%) |
- * Data is based on the continuing operations of the Avis Corporate segment of the Group, which excludes Avis licensees, Budget and the discontinued operation in Greece. Excluding Greece had no material effect on the change in the indicators presented above.
- 1 Includes any day or period less than a day for which a vehicle rental is invoiced to a customer.
- 2 Rental revenues divided by billed days. (Rental revenue per day is defined as revenue excluding sale of fuel, sub-licensee income and the provision of foreign exchange services to rental customers as well as other incidental operating income divided by billed days. In previous periods revenue per day was defined as revenue divided by billed days.)
- 3 The average period of time during which vehicles are on rent as a percentage of their holding period.
- 4 Underlying excludes exceptional charges and certain net re-measurement gains and economic hedging gains (see Basis of Preparation).
- 5 2006 restated following the prior year adjustment regarding Avis Portugal.
