Hertz - Let The Covenant Breach Games Begin

| About: Hertz Global (HTZ)

Summary

HTZ has an odds on chance of tripping its leverage covenant after cutting guidance.

A covenant breach would most likely be cured, but its securities reflect the risk.

Concentrated equity ownership creates additional scenarios investors can play.

Hertz Global Holdings, Inc. (NYSE:HTZ) management wants the company's debt ratings moved up to investment grade, but recent results and guidance are making that goal much more difficult to achieve. On November 8th, post release of Q3'16 results, HTZ reduced its FY'16 EBITDA guidance by an average $300 million to a revised range of $575 million to $650. Although HTZ's free cash flow typically increases in Q4 as the fleet size is reduced, management's free cash flow guidance for the full year was cut in half to a range of $500 million to $600 million. The forecast range for adjusted EPS fell from $2.75-$3.50 to $0.51-$0.88.

The reasons given for the guidance reduction were 4-fold. First, after reviewing the fleet in September, management increased US rental car depreciation expense based on a higher $300 depreciation expense per unit per month estimate. Second, management forecast a further decline in fleet utilization in Q4'16. Third, US rental car transaction day levels dropped in Q3'16 and were expected to continue tailing off in Q4. Fourth, based on market conditions, international vehicle residuals were decreased.

The higher depreciation expense and lower fleet utilization resulted in a $100 million increase in car ownership costs. The lower transaction day levels from US vehicles out of service and weaker European markets resulted in a $70 million incremental cut to the corporate EBITDA guidance. The company's $425 million cost savings plan was turned into a more likely $350 million cost savings realization plan, shaving another $75 million off guidance. The decrease in international vehicle residuals accounted for another $50 million reduction. And the remaining $55 million balance of the $300 million EBITDA guidance cut was ascribed to other one-time items (e.g., higher-than-expected gross damage, maintenance, transportation costs).

HTZ management had good reason for cutting guidance based on those factors, but their lowered EBITDA estimate had consequences not just for the equity. For HTZ bondholders, it removed any chance HTZ's net leverage ratio would drop toward management's stated goal of 3.5x and heightened the prospect that HTZ would breach a bank debt leverage ratio covenant in Q4'16.

Here's how that happened. It's not a matter of liquidity. HTZ has lots of cash available. In fact, as of Q3'16 end, HTZ had $1.7 billion liquidity ($1.1 billion available under its L+250 1st Lien Senior Secured Revolving Credit Facility due '21 plus $600 million unrestricted cash after putting aside cash needed for an October bond redemption). However, while the Q3'16 corporate net debt to adjusted EBITDA ratio of 4.5x fell well within the 5.25x maximum, compliance was only possible because the adjusted EBITDA calculation defined in the revolving credit agreement allows HTZ to add back to EBITDA the pro forma impact of certain cost savings initiatives. The cost savings addbacks are allowable up to 25% of reported EBITDA and, with that permission, HTZ added back about $100 million of pro forma cost savings for the quarter.

What worked in Q3'16 may not work for Q4'16 as the maximum net leverage ratio under the revolving credit agreement covenant steps down from 5.25x to 4.75x during Q4'16 and through Q1'17. (It steps back up again to 5.25x for the peak Q2 and Q3 quarters of FY'17).

See Summary Financial Information table below. Assuming FY'16 EBITDA comes in at the high end of management's $575-650 million revised guidance level, HTZ would be allowed up to $3.09 billion net corporate debt or $3.56 billion with $100 million of add backs. At Q3'16 end, however, the company had $3.85 billion net corporate debt on its books. Although management asserted on the Q3'16 conference call that HTZ remains within compliance of the 4.75x maximum leverage ratio, that's not how the markets read it. On the other hand, current consensus estimates for Q4'16 below would place full FY'16 adjusted EBITDA at just north of $700 million, per the table. That would give the company a better chance at staying in compliance:

HTZ Sum Fin

News Impact. The guidance cut and its implication of a possible leverage covenant breach was not the only recent news. In December, John Tague resigned and was replaced as CEO by Kathy Marinello, a private equity and tech executive previously affiliated with Ares Capital Management. The replacement came with the approval of Carl Icahn, whose 35.3% ownership position in HTZ common stock makes him by far the company's largest equity investor. Other HTZ investors, however, were spooked by the timing of a CEO change just prior to the final check off from management on FY'16 financials and they reacted by selling HTZ bonds and common stock with great vigor.

The best news HTZ holders have recently received came from an Illinois court which ruled against Chicago's attempt to impose car rental taxes on vehicles based in the city's suburbs. Even after that good news item a week ago, net net, over the last 12 months, HTZ's most widely traded bond issue (the HTZ 6¼s due '22) dropped 9% while its common stock dropped 38%. The big decline in HTZ's stock price has taken place in a markedly higher market for US equities (e.g., S&P 500 up 20% during the same one-year time frame).

See graph below. The degree of underperformance by HTZ securities is both absolute and relative. HTZ bonds and stock have not just underperformed broad credit and equity indices. They've also underperformed comparable auto suppliers' debt and equity securities. The graph compares credit default swap prices (top of graph) and common stock prices (bottom of graph) for HTZ and Avis Budget Group, Inc. (NASDAQ:CAR) going back over the last 5 years. From 2012 to mid-2014, HTZ debt and equity outperformed CAR even as both sets of instruments moved directionally together. That is, they were coherent within their capital structures and between their capital structures. After mid-2014 and through mid-2016, HTZ and CAR debt and equity declined, but HTZ's debt and equity underperformed. Finally, from mid-2016 to the present, HTZ's debt and equity not only continued to decline but did so even as CAR debt and equity increased in price. What damaged HTZ's debt and equity within the auto supplier space didn't hurt the debt and equity of its main US comparable. Over the last 12 months, CAR's most widely traded bond - the CAR 5½s due '23 - improved 4.3% while its common stock increased 49%:

HTZ Bonds Stock

HTZ and CAR compete in the same car rental segment at relatively similar operating size. LTM revenue at HTZ and CAR ran $9.5 billion and $8.7 billion, respectively and LTM adjusted EBITDA at HTZ and CAR ran $934 million and $845 million, respectively. CAR lowered its topline and EPS guidance for FY'16 but only toward the low end of previous ranges and did not lower its $850 million to $900 million adjusted EBITDA guidance. While HTZ increased its estimate of depreciation per vehicle and dropped residual values on international vehicles, CAR decreased its depreciation estimate. In part, that's a reflection of HTZ's fleet mix which includes a higher ownership of compact and mid-size cars and 80% of its fleet are risk vehicles (i.e., vehicles that do not benefit from a residual value guarantee from the manufacturer). CAR has recently been raising its risk vehicles exposure to 70% of its fleet.

Car rental company quarterly results are seasonal but I've broken out in the table below the quarterly metrics for HTZ's US, International and Other segments primarily to get a better picture of what metrics management faces. US segment revenue is the dominant factor, accounting for 74% of the company's LTM revenue. In most quarters, US adjusted EBITDA margins are higher than they are for the International segment, although that did not happen in Q3'16 when International rental margins ran 10 percentage points higher than in the US. What matters more than one particular quarter's results, however, are some of the metrics common to each quarter. Note, for example, that revenue per available car day are generally comparable while depreciation per unit per month has been running about $100 higher in the US each quarter than it has been in the International segment:

HTZ Segments

Comparison to CAR. Seasonal and segment variances notwithstanding, what explains the alternate paths taken by HTZ's and CAR's securities are the multi-year declining trends in HTZ's top line and adjusted EBITDA versus improving trends in CAR's top line and more stable adjusted EBITDA. Rather than repeating a separate table for CAR's results, I found it easier to point out these trends over the past 5 years graphically by looking at two items. See below. The top part of the graph shows revenue growth year over year in each quarter and the bottom part of the graph shows LTM adjusted EBITDA through each quarter. Beginning in FY'13, HTZ's revenue decelerated from quarter to quarter and LTM adjusted EBITDA took a more or less straight-line trajectory south. If I took the bottom part of this graph and pasted it on to the stock price chart above, the slope of HTZ's LTM adjusted EBITDA would become the trendline on that overlay:

HTZ and CAR both face a potential existential threat from future deployment of autonomous vehicles within the car rental segment. There's also significant risk to their market shares of the present-day car-rental market should Lyft Inc. (Private:LYFT) or Uber Technologies Inc. (Private:UBER) decide to enter or compete more directly at US airports, locations that HTZ, CAR and Enterprise Rent-a-Car now thoroughly dominate. While HTZ has agreements in place to supply weekly rentals to drivers from Lyft and Uber, it wouldn't be the first time in US business history that customers ate the caterer instead of the food. CAR similarly faces the risk of competition from ride-hailing and car-sharing alternatives to car-renting. However, CAR owns Zipcar, a car-sharing service. Zipcar has more than 1 million paying members and it's growing. HTZ's Donlen subsidiary leases cars and manages fleets, but does not provide a similar service.

Game Theory. HTZ has 8 senior unsecured corporate note issues outstanding, but those don't have the leverage covenants contained within the company's 1st lien guaranteed senior secured revolving credit or term loan agreements. The senior unsecured notes do have cross-defaults with the bank debt and cross-acceleration triggers. Should HTZ breach the revolving credit agreement's net leverage ratio covenant, the banks would need to first accelerate payment of their debt before the other unsecured debt concomitantly accelerates.

The lenders would seem to be more likely to grant a waiver than throw the company into reorganization based on a seasonal and temporary tightening of the leverage covenant to 4.75x. The HTZ L+275 Term Loan B due '23 is in about a hundred different hands but still fairly concentrated with 20 lenders owning roughly 31% of the $675 million loans outstanding.

If HTZ's margins were expected to continue to deteriorate, the lenders would have a greater incentive to stanch the bleeding by calling in new management. But the guidance cut for HTZ was based more on reduced residual estimates than on margins. If the lenders had near-term unsecured debt maturing in the months ahead of them, there would be greater urgency in retaining that cash for their own prepayment. But the first upcoming maturity is the revolver due next month. If equity ownership was diffuse, the lenders would have significant bargaining power beyond their security interests. But equity ownership is concentrated with Icahn. Should the lenders refuse to cure a default via waiver in exchange for some remuneration, they might make it that much easier for Icahn to take HTZ private at a significantly lower valuation than he would otherwise pay. Icahn might simply use the threat of reorganization to buy more equity at lower prices or obtain a discounted redemption price on the unsecured senior notes in any acquisition via a pre-packaged bankruptcy reorganization he leads.

See graph below. As HTZ common stock declined, the yields on its loans and bonds increased along with the cost of insuring same in the credit default swap market. As shown, the company's secured term loans are priced to a discount margin of 262 basis points while its senior unsecured notes are priced to about 600 basis point Z-spreads. That's a bit through where the 5-year CDS trades (+624 basis point). The HTZ L+275 1st Lien B1 Term Loans due '23 rated Ba1/BB at 100.25 have a fixed income equivalent yield of 4.45%. The HTZ 5½ Senior Notes '24 rated B2/B at 86.75 yield 7.82%.

As argued above, the likelihood HTZ gets thrown into reorg this quarter looks small, if not negligible. The price declines don't appear to be permanent as HTZ is expected to begin producing better top line and adjusted EBITDA results beginning in Q2'17. While revenue is forecast to be only marginally higher this year (consensus forecast is $8.99 billion), unadjusted EBITDA is still expected to bounce up from the previous year's bottom (consensus forecast is $779.9 million). And FY'18 revenue and EBITDA are also expected to trend higher.

The HTZ senior unsecured notes are highly correlated with the HTZ common stock and priced cheap to same. For example, the price of HTZ 6¼ Senior Notes '22 exhibit an 87% correlation (r-squared) with the end of day price of the HTZ common over the past 6 months and the HTZ 5½ Senior Notes '24 exhibit an 81% correlation with the HTZ common. With HTZ common trading at $21.42 per share, the HTZ 6¼s should be worth three quarters of a point more than their last trade price and the HTZ 5½s another half a point higher. Both senior notes are purchasable at a discount and have US Treasury + 50 basis point make whole calls should HTZ be acquired prior to October '17 (for the '22s) or October '19 (for the '24s). There is a non-negligible possibility that Icahn decides to purchase the other 65% of HTZ that he doesn't already own.

HTZ has two types of near-term event risk and one type of longer-term event risk. The near-term event risks area curable covenant default and a possible acquisition by a shareholder in possession of a 35% ownership interest. The longer-term event risk stems from challenges created by new entrants and alternative car use platforms. My suggestion is to use the near-term opportunity presented by any leverage covenant waiver to get long the HTZ senior unsecured notes at their current wide spreads. Although correlated, I would not use the stock as a hedge given the improving fundamentals which make a near-term acquisition possible. One can see a scenario in which HTZ could revert back to being a private company. The longer-term event risks from an abrupt change in the operational landscape are harder to gauge and hedge away.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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