Disclaimer: This is not investment advice, just one person’s opinion. Always complete thorough analysis on your own before investing and understand the risks associated with an investment as you could lose it all. I will use a lot of jargon and financial ratios, so please check out the vocabulary section at the bottom of the article for definitions.
Before Invstr took Hertz down, I saw many trading it, and as it was going into bankruptcy this continued. Having followed the restructuring and distressed debt fields for quite some time, I understand the risks of buying stock before and in bankruptcy. Because of this, the case of Hertz really puzzled me. With this article I hope to caution those trading bankrupt companies’ stock and explain the risks of owning stock in the bankruptcy process. I strongly advise to not buy stock without understanding the risks, it is even more critical in this case because the risks are so magnified.
I will summarize their most recent financial statement, which used financial data from March 31st and has commentary from management up to May 4th. Hertz “began experiencing a high level of rental cancellations and a significant decline in forward bookings.” As a result they cut costs, did not increase their fleet, furloughed as well as laid off employees, tried to renegotiate leases and drew their revolvers to have $1 billion in cash. A significant expense for Hertz is their operating leases, which “to preserve liquidity, on April 27, 2020, Hertz did not make certain payments in accordance with the Operating Lease.” This means that Hertz can no longer finance new vehicles under this agreement. This also means that if Hertz sells any vehicles they leased, the full amount must go to pay back the lease.
On May 4, 2020 Hertz and the debt holders agreed that Hertz could enter forbearance until May 22nd. On May 22nd, Hertz filled for bankruptcy, and has begun the process. Alexander Gladstone and Nora Naughton of the Wall Street Journal wrote, “Hertz didn’t reach a deal with creditors before entering chapter 11, heightening the risk of a full liquidation of the fleet, although the company and investors have several weeks to work out an agreement avoiding that outcome, people familiar with the matter said.” Since hitting a low of 56 cents, Hertz shares rallied hitting a high of $5.53. As a result, Hertz has been allowed by a bankruptcy judge to sell $1 billion of stock. The danger is that those who own this stock, are potentially paying for a worthless asset. By taking a closer look at the bankruptcy process, and Hertz specifically, I will examine the specific risks of trading bankrupt companies’ stock.
Bankruptcy 101
There are two types of bankruptcies for companies. Chapter 7, where the company liquidates, and Chapter 11, where the company restructures its debt but still exists after the fact. In Chapter 11 a company asks for an automatic stay, which essentially provides the company a temporary break from paying its creditors. This also means creditors temporarily cannot demand collateral from the company. The goal of a Chapter 11 filling is for a company to exit with a more manageable debt load and to be in better shape than it entered. In bankruptcy there is a wide range of power given to the judge, they can approve anything from canceling existing shares, issuing new shares (diluting the value of of existing shares), or selling assets (giving all proceeds to debt holders).
This is because of the absolute priority law in bankruptcy law, which requires senior creditors to be paid in full before any junior creditors are paid. In a capital structure, there are different classes of debt holders, some are senior, some are junior, some have claims on assets as collateral called liens (See vocabulary section for definitions). After all the debt, comes preferred equity, then the most junior of all is equity, the stocks you and I trade. Equity is the last to be paid in bankruptcy, and thus requires the highest return because it is the riskiest.
To exit bankruptcy a company must submit a plan of reorganization. To approve the plan the classes of impaired creditors must vote to approve the plan, and it must be approved by the court (For more detail see the vocabulary section).Even if the plan does not get the required votes, it can still be approved in a cram-down if at least one impaired class approved, as long as the court deems the plan “fair and equitable” as well as non-discriminatory.
One important point is that a historically courts have deemed plans that cancel shares as “fair and equitable” and non-discriminatory, thus they have approved them. Also a company can exit bankruptcy without the approval of equity. Finally, if a company is insolvent (liabilities greater than assets) the court may determine that stock holders don’t get anything. Because of these potential outcomes, the equity class will often accept any amount proposed, if any amount is even proposed. Thus the rallies of Hertz, Chesapeake, JC Penny and others are surprising. So, I would caution those trading bankrupt companies’ stock because it is likely that they could lose 100% of their investment. The risk of loss is so much greater than the chance of return, so I would not hold these stocks for any period of time.
The Case Study of Hertz
To show the risks of holding Hertz stock specifically, I performed a hypothetical liquidation analysis. Since, Hertz has had profitability issues it is even harder than normal to put a specific value to the firm. As is common place in bankruptcies, I used a potential liquidation value as a ballpark and as a warning to those trading the stock. The liquidation value does hold some merit however. If you take the equity value of Hertz and divide it by the number of shares you get $10.48 per share. But, Hertz has been below this value since February, so the market is indicating Hertz’s assets are worth less than book value.
In this liquidation analysis I made a few assumptions and simplifications so those unaware of the risks of owning Hertz stock can more easily understand. I grouped Hertz’s debt by category and adjusted the names of these categories for readability. See vocabulary section for details on Asset-backed debt (type 1) and Asset-backed debt (type 2), as well as for different terminology and debt classes referenced in this post. I grouped all revolvers together, all other secured debt, and all unsecured debt. I assumed Hertz would raise $1 billion in equity, which was approved by the bankruptcy judge. I also excluded lease assets from Hertz’s assets and I left out all non-debt liabilities for simplicity. I assumed that no secured debt had claims on specific assets, just the dollar amount of assets they are entitled to. Finally, I used the Delta hypothetical liquidation and the Houlihan Lokey restructuring case study as benchmarks.
Using these two resources as well as industry and historical research, I developed a low end liquidation value and a high end liquidation value. Assets that are more liquid have higher recovery rates, however because of Covid-19, some traditionally liquid assets would have lower recovery rates. In the low end example, there is a 52% recovery of all of the assets. The type 2 asset backed debt holders only receive a 68% recovery. This means that other secured debt, unsecured debt and equity get zero recovery. In the high end scenario, there is a 63% recovery on all assets. All debt holders get a full recovery except unsecured creditors which get 18%, and again equity is left with nothing. Looking at how Hertz’s high yield bonds trade can bring some clarity. We can see on Finra’s TRACE software that Hertz’s unsecured bonds have traded between the $30 range and the $50 range in the past 10 days. This means the market is pricing in a 30-50% recovery for those unsecured bond holders, and very little if anything for stock holders.
For equity to get anything in this analysis, there must be a 75% recovery on the assets. This doesn’t sound so horrible at first but, the issue is obvious when you consider the liabilities I left out for simplicity. Hertz has $5.56 billion in non-debt liabilities. If all Hertz’s liabilities are paid for before equity, Hertz’s assets would need to have a 98% recovery value before stock owners see a cent. This makes sense because companies that sold Hertz products and services on credit, thinking they would be paid back, should be. In addition, Hertz’s debt holders will certainly argue for this or for a scenario where debt holders maximize recovery at the expense of stock holders. Historically distressed debt hedge funds have been very successful at getting paid in full, and even taking equity ownership of the company. The result of this will likely mean that equity will have little value, if there is any left.
I hope you enjoyed my analysis of Hertz, and see the risks of trading bankrupt stock. I see and hear about many new investors trading these companies unaware of these risks. When this happens they are likely to lose money and become disgruntled with the stock market. Please share so more people can invest smarter and build wealth!
Check out the vocabulary section if you have any questions and follow my Invstr page @robbieb for updates as well as market analysis.
Vocabulary
Forbearance- Agreed delay of a debt payment to delay bankruptcy or foreclosure.
Creditors- Party that loans money.
Liquidation- Selling assets quickly to get cash.
Senior creditor- Has the right to be paid before a junior creditor. Is senior in the capital structure.
Junior creditor- Is junior to the senior creditors and has the right to be paid after them.
Capital structure- The way a company finances its assets and thus operations. Combination of types of debt, hybrid securities, and equity.
Plan of reorganization- For a class to approve the plan, two thirds of the dollar amount of a claim must approve, and one half of the number of claims must approve the plan. For equity holders, just two thirds of the total amount is needed for approval. If a class in unimpaired, they are assumed to have accepted the plan. If a class gets nothing, they are assumed to have rejected the plan.
Impaired creditors- Creditors who do not get paid in full.
Cram-down – Bypasses objections of impaired creditors in bankruptcy court.
Asset-backed debt (type 1)-HVF II U.S. ABS Program
Asset-backed debt (type 2)- Donlen U.S. ABS Program (HFLF Variable Funding Notes and HFLF Medium Term Notes)
Secured debt- Debt is secured with collateral in case of default.
Unsecured debt- Debt is not secured with collateral.
