The Hertz bankruptcy was no surprise

One of the biggest bankruptcies during the pandemic has been rental car giant Hertz.

It seemed to come out of nowhere, a company that had a long operating history and founded in 1918, was now filing for Chapter 11 bankruptcy. How could this happen?

I can tell you this if you know what to look for, the writing was on the wall years before they made the announcement. Poor capital allocation choices and a huge debt load bought Hertz down.

Coronavirus only exposed the problem.

Tourism industries have been the worst affected by the Coronavirus; during June, Sydney Airport has come out and said airline traffic has declined by 97%. Hertz is part of this tourism industry with most of their rental car stations located in these airports that have no travellers. Or, they rely on travellers going to their rental car outlets situated not far from airports.

Nearly every airport worldwide would be experiencing a similar decline in travel numbers, directly affecting the rental car business. These cratering tourism numbers mean a vast collapse in Hertz’s revenue (to almost none). The decline in revenue works its way down to a sharp decline in operating cash flow. The cash that keeps the business alive.

So, if a decline in cash flow was the problem, then why hasn’t every other rental car or tourism industry business gone bankrupt then?

Because Hertz had a significant debt problem, and once the cash flow stopped, they could no longer service their debt, and the creditors came knocking.

Debt safety

These companies with huge debt loads will usually keep taking on more debt over time. They need the money to survive, becoming similar to an addict who needs a hit, only this time it’s a hit of cash. The company keeps increasing debt levels to pay back creditors and portions of previously issued long-term debt that have come due. Consistently kicking the can down the road delaying the inevitable.

One of the key steps to analysing a stock is checking the companies debt levels and interest repayments. Companies that are highly leveraged with debt will usually need to spend a large portion of their earnings on interest repayments. Leaving little for us shareholders and the company itself. We can also check the debt relative to earnings and free cash flow and see how long it will take to pay back. There’s plenty of debt analysis metrics to look at, but we’ll look at 3 of them in this blog post.

Hertz debt analysis

Below are some earnings numbers and cash-flow numbers combined with their long-term debt, which you can see is off the charts!

All numbers are in millions, so yes, they’re were carrying billions in debt, while either making negative earnings or very little earnings relative to that debt load.

 

What’s the percentage of operating income to pay the interest expense?

If you don’t know, operating income is the income left over after all operating expenses are subtracted from the company’s revenue. Once these expenses are deducted, they need to subtract financial costs such as interest expense and taxes. Once the interest expense is paid, we look at what percentage of operating income did that interest expense consume.

Starting with 2010, they had $746 million in operating income. Great stuff, if only Hertz’s interest expense wasn’t $761 million! That large interest expense means Hertz paid out 102% of their operating income as a financial cost. Leaving a big fat $0 leftover for shareholders (they actually recorded a $49 million loss).

If you keep working your way across the table, you’ll notice that pretty much from 2014 through to 2019 they were paying out all operating income as interest expense. That’s is insane to me, it would be like you paying out all your income from your job on credit card repayments or other loans you might have. There’s almost a sense that it got so bad in the end no one cared anymore, slowly getting worse and worse each year. Management went to work, collecting their million-dollar paychecks while they ran this business into the ground.

The red bars are interest repayments, and the green bars are operating income. Notice from 2014 to 2019, it looks like they were barely holding their head above water.

How many years for net income & free cash flow to pay off long-term debt?

To find out how many years it would take for a company to pay off their whole long-term debt load, we divide the long-term debt by either Free cash Flow or Net Income. This metric gives us a sense of the size of the debt relative to free cash and net income. Typically the high end is anything over 3 years. So, if we had an answer of 3, it’s saying it would take 3 years to pay off long-term debt. 

The results for this analysis are out of this world again! If the high end we look for is 3 years, then we can stick a knife into this. With all the years they had positive earnings not one of the years was it below 45 years to pay off their long term-debt.

Their free cash flow was better, but not by much. 2010 wasn’t bad, but it progressively deteriorated until 2017 when they went cash flow negative, form there it looks like it accelerated faster and they couldn’t get back to cash flow positive. The end result? Bankruptcy.

How could they be paying so much in debt repayments?

Interest rates determine the cheapness of money, and we’ve had a historically low period of interest rates. Money is cheap, and these companies keep borrowing (remember the addict?). Look at their Long-term debt, each year it’s slowly increased as they’ve kept borrowing more.

With all their earnings and any excess cash leftover being used to service this astronomical debt burden, they had no cash left at the end of each year. So what do they do to keep the business running? They keep adding more debt, or fuel to the fire if you will.

As they keep adding to this debt load, they keep increasing the company’s interest repayments, which keeps decreasing the potential for any earnings or cash being leftover. No cash leftover? Just add more debt. It’s a vicious cycle that keeps going around and around until finally, there’s no more money left to borrow, and they can’t pay back any of their debt obligations. Hopefully, you get the picture, that it’s at this moment the party stops.

Hertz debt conclusion

Seems crazy that anyone managing a corporation valued at billions would do something like this. These people in positions of power only make smart decisions (so we’re led to believe). That’s why they make millions. But even the most intelligent people can have errors in judgement. In terms of managing a corporation, they have thousands of employees salaries at stake. Maybe they were trying to turn the ship around knowing their level of responsibility they had to their employees.

Hertz had a cash flow problem for years, bought on by that gigantic debt load. The numbers tell the story, this company never stood a chance during the pandemic.

Our job as investors is to find companies our money will be safe with. Sometimes it’s better to work backwards and see what signals are present when a company files for bankruptcy, then avoid stocks that display the same signals.

Have you ever been invested in a company that’s filed for bankruptcy? Let me know in the comments below!

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