What Hertz had under the hood was not pretty

From the customer’s perspective, car rental is a straightforward business. The only uncertainty is whether the hire company will charge you for the scratch they discover when you hand back the vehicle.

Hertz Global Holdings Inc’s bankruptcy protection filing on Friday last week was a reminder that today even the simplest business models are underpinned by a lot more financial complexity than meets the eye.

The proximate cause of Hertz’s demise was of course the sudden collapse in bookings caused by COVID-19 travel restrictions. The company’s monthly revenue last month fell 73 percent year-on-year, a shortfall that even the most resilient companies would struggle to withstand for long.

However, Hertz’s complicated financial plumbing contributed to it becoming one of the most high-profile companies to seek protection from creditors during the pandemic.

In the decade preceding its collapse, Hertz took on too much debt, participated in overpriced mergers and acquisitions, and was accused of playing accounting games to pad its earnings.

So when disaster struck and a request for a government bailout was rejected — rightly in my view considering the top shareholder, Carl Icahn, is worth about US$18 billion — Hertz was already standing far too close to the precipice. Regrettably, COVID-19 will probably expose more of this type of corporate frailty, both in the US and around the world.

Hertz’s debt binge began when it was acquired by private equity firms from Ford Motor Co in 2005; the new owners quickly took out a US$1 billion dividend. Piling on debt juiced the potential returns for the owners and helped pay the inflated US$2.3 billion price tag for the Dollar and Thrifty brands in 2012, which Hertz struggled to integrate.

Hertz was only able to amass an eye-watering total of US$19 billion in borrowings thanks to a massive program of asset-backed lending, which became its primary source of capital.

LEASE AND RENT OUT

Special-purpose financial entities purchase vehicles on Hertz’s behalf and investors in the asset-backed securities make a return via the lease payments that Hertz is obliged to stump up. Put another way, Hertz leases vehicles long-term from the financing subsidiary — typically for about 18 months in the US — and then rents them out to customers for shorter periods.

In theory, this is a stable and low-cost way for a risky borrower, such as Hertz, to fund the large capital outlays needed to keep its fleet looking fresh.

Hertz’s corporate credit has been rated junk for the past decade, but many of the asset-backed securities it issued were triple-A rated, at least until recently.

However, economic shutdowns stemming from efforts to curb the novel coronavirus suddenly threw a lot of sand in Hertz’s gears: The resale value of its vehicles fleet fell sharply, requiring the company to inject more cash into the financing structure.

With only about US$1 billion of cash on its books, Hertz was ill-placed to fund that collateral call, and the pandemic meant it was not able to sell vehicles to generate cash, because potential buyers were confined to their homes and auctions and dealerships were closed.

Asset-backed securities holders appear to have decided that allowing Hertz to fall into bankruptcy would prove no impediment to them getting most of their money back, at least for those holding the better-rated tranches of debt.

However, the same cannot be said for Hertz’s unsecured lenders, or its shareholders. Building a 39 percent stake since 2014 probably cost Icahn about US$1.6 billion, based on a Bloomberg average share-cost estimate, but he now risks being wiped out.

Hertz’s predicament was made more severe, because in the US it could not hand back most of its surplus vehicles to the manufacturer, as is common practice in Europe. Instead, it faced the task of selling them itself and bore the risk of any unexpected depreciation. The firm is one of the 10 largest sellers of used vehicles in the US.

The preponderance of these so-called “risk vehicles” in its 500,000-strong US vehicle fleet has increased since 2014, because it was more profitable than paying a premium to the manufacturer to guarantee a fixed repurchase price. There is no reward without risk, though, as Hertz’s bankruptcy filing made abundantly clear.

Having lost money in three of the past four years, Hertz did seem to have turned a corner lately: It raised capital to pay down debt last year and was ranked No. 1 for customer satisfaction in J.D. Power’s North American car rental rankings.

Not that customers have much choice. Consolidation has given just three groups — Hertz, Enterprise Holdings Inc and Avis Budget Group Inc — control of almost the entire US market for airport car rentals.

New competition from ride-hailing companies and a litany of management missteps meant Hertz never achieved the pricing power that Icahn and other recent investors probably assumed would come from all that merger activity.

Because the industry’s fortunes are so closely tied to air and business travel, car rental demand is likely to remain weak for a while.

Still, Hertz remains open for business and thanks to the more lenient Chapter 11 process it should get another chance to make a success of that oligopoly, albeit as a smaller company with different shareholders and a new capital structure.