US retail investors seem to have embraced Avis Budget as the latest meme stock. Reports also suggest that CAR shares have been heavily shorted, potentially triggering a short squeeze. I’ve been taking a closer look at this situation. Should I be buying Avis Budget shares?

Earnings smash forecasts

After a terrible 2020, the big car rental companies have done surprisingly well in 2021. A recovery in customer demand has been paired with a shortage of new cars, due to the global chip shortage. This has allowed car hire companies to push up their prices without losing business.

Avis Budget generated $3bn of revenue during the third quarter of 2021. That’s 9% higher ahead of the same period in 2019 — before the pandemic. Net profit for the quarter was $674m, compared to just $189m during Q3 2019.

It’s easy to see why profits have soared. During the three months to 30 September, the average revenue from each hire car was $75.50 per day. That’s 27% higher than in Q3 2019, when the company’s cars only generated $59.61 of revenue each day.

EV hype + short squeeze

Avis Budget’s surging profits are impressive. But to be honest, I don’t think they’re the real reason why the shares have doubled.

In my view, one reason for yesterday’s gains is investor demand for exposure to electric vehicles. A couple of weeks ago, rival Hertz said it planned to buy 100,000 Tesla Model 3 cars. Hertz shares have risen by around 40% since then, despite Tesla boss Elon Musk reporting that the sale contract hasn’t yet been signed.

When Avis boss Joe Ferraro said his company would be “much more active in electric scenarios” on Tuesday, traders started buying CAR stock too.

I think the other big factor behind Avis Budget’s sharp rise is that the stock has been heavily shorted. This means that hedge funds have borrowed Avis shares and sold them, hoping to buy them back at a lower price.

Press reports suggest that over 20% of Avis Budget stock was on loan (shorted) ahead of the group’s Q3 results on Tuesday.

When a stock that’s heavily shorted rises sharply, it can trigger a short squeeze. This happens when shorters try to cap their losses by buying back the stock they’ve shorted. The extra buying then pushes the share price even higher. I think this may be what happened to Avis Budget on Tuesday.

Should I buy now or steer clear?

A short squeeze can cause share prices to surge, but the gains don’t always last. Avis Budget hit a high of $545 on Tuesday, before falling back to close at $358.

Yesterday’s gain has left Avis stock trading on around 23 times 2021 forecast earnings. But analysts don’t expect this year’s profits to be sustainable. Ahead of yesterday’s results, broker forecasts showed earnings falling by around 25% in both 2022 and 2023.

In my view, Avis Budget shares look fully priced at the moment. In the short term, the shares could rise further. But, on a longer view, I expect the stock to fall. I certainly won’t be buying at current levels.

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