Audit Integrity, an independent research firm, raised a few hackles recently by publishing a list of major companies that, in its opinion, are most likely to go bankrupt.
We would disagree with particular details of the report, which included the following passage:
"The results from Audit Integrity`s bankruptcy research indicate that the media and transportation industries are especially vulnerable. Of the over 2,500 U.S. corporations receiving bankruptcy risk scores from Audit Integrity, TV and Publishing companies were found to be over four times as risky as other companies, while automobile and airline industries were just slightly less risky."
Specifically, we believe that automotive and airline companies are more rather than less risky than average, and publishing companies less than "four times as risky" (we own Gannett (NYSE:GCI)). But that's not the point.
One of these companies, Hertz Global Holdings Inc. (NYSE:HTZ), took particular issue with Audit Integrity's report, to the point of suing the company over it.
As of its latest (mid-year 2009) financial report, Hertz had $1.8 billion of net worth supporting $9.8 billion of debt. Because of goodwill and other intangible assets, tangible net worth was negative.
This is not the profile of the average company with stock. It's more like the profile of equity that's a de facto option (like other auto companies such as the recently bankrupt General Motors). The security will do extremely well in a favorable economic environment, and extremely poorly in a bad one. The actual performance of the issue has reflected this, ranging from $1.55 (much like an out of the money option) to 11.99 (well in the money).
To its credit, the company listed among its risk factors, the following:
"We have substantial debt and may incur substantial additional debt, which could adversely affect our financial condition, our ability to obtain financing in the future and our ability to react to changes in our business…
We may not be able to generate sufficient cash to service all of our debt or refinance our obligations and may be forced to take other actions to satisfy our obligations under such indebtedness, which may not be successful…
A significant portion of our outstanding indebtedness is secured by substantially all of our consolidated assets. As a result of these security interests, such assets would only be available to satisfy claims of our general creditors or to holders of our equity securities if we were to become insolvent to the extent the value of such assets exceeded the amount of our indebtedness and other obligations.…
So why the angst?
One thing that the Audit Integrity report did not say was that Hertz would go bankrupt. Instead, it rated Hertz as one of 20 (out of 2500) companies most likely to go bankrupt (the top 0.8%). That's on the curve. If there are zero bankruptcies, Hertz will be spared.
At Value Line, where I used to work, 5% of all companies had to receive the lowest rankings for Timeliness and Safety. If only 20 blue chip companies were rated, one of them would have to be lowest in each category. There was no policy of "social promotion," where all passed.
In its rebuttal letter to Audit Integrity, Hertz wrote:
"Several analysts follow Hertz and its competitors closely, and all of them have significantly increased their estimates of the per-share price of Hertz’s common stock from where their price targets were 6 months ago. In addition, had your staff taken the time to review what the analyst community is saying about the rental car industry in general and Hertz in particular, you would have learned the favorable macro economic factors working in favor of the industry into the foreseeable future."
Just about everyone is agreed (including this writer) that Hertz will do well if the economy does in fact, turn around. (And the recent stock price action said as much.) But an independent analyst is not required to use the same external assumptions as company management. In fact, it is often the job of the analyst to use a contrary assumption (e.g. the economy will not turn around), thereby coming to the opposite conclusion.
One of the greatest bugaboos of just about any parent is to hear their kid say: "But Mom, Dad, all the other kids are doing it." A good parent's response would be: "Just because all the other kids are doing it doesn't mean that you should."
In his autobiography, Lee Iacocca of Chrysler (DCX) praised his former boss, Robert McNamara for knowing a bunch of " hypothetical facts." That is, McNamara knew not only the facts pertaining to the actual situation, but those that would pertain to a bunch of hypothetical ones as well. It's called an "if, then" statement.
Here's an exercise in hypothetical facts: "If (as we believe), the U.S. economy goes back into a double dip recession/depression, then Hertz will probably go under."
Disclosure: Long GCI. No positions in HTZ or GM.