Finance is a beautiful thing. The number of ways you can create value for different parties is what made me fall in love with the subject. But not everything engineered in the name of finance is good. There’s a dark side to the field. Often times, this dark side makes its way known through the catastrophes left in its wake, the illegal acts that end up occurring or the lack of oversight for an aspect of finance that is perfectly legal that creates the pain in question.
But then there’s the rare gem. The act performed in the name of finance that is perfectly legal, completely transparent, but still utterly dangerous at best and destructive at worst. A perfect example of this rare phenomenon is what a court just ruled Hertz Global Holdings, Inc. (HTZ) could do with its latest move to raise capital. The company’s strategy will likely result in the creation of hundreds of millions of dollars for the now-bankrupt car leasing business, but it will come at the expense of the thousands (or more) investors who are willing to take a roll of the dice on the firm’s prospects.
A look at what happened
Since late last week, when news broke that Hertz was considering receiving permission to raise up to $1 billion by selling shares on the market, I have watched the picture closely. Never have I heard of a business that had just entered into Chapter 11 bankruptcy protection seek a raise of capital for stock that might go on to be worth absolutely nothing over the next few months. The very thought of it sounded preposterous. Without enough information to fully understand the situation, I waited. My confusion, though, worsened as the US Bankruptcy Court in the District of Delaware announced approval of the company’s plan but, according to a CNBC article, the court stated that ‘in no event will [this] result in the issuance’ of the firm’s common shares.
Frankly, this made zero sense. What’s the point in approving a measure to sell stock if the stipulation is that the common shares cannot be issued? I dug into Hertz’s actual bankruptcy filing and found the answer. For starters, the CNBC article was confusing because it just referenced the court saying no shares would be issued without providing added context. The court did not say that the shares cannot be sold. It actually stated that no more than 246.775 million shares can be issued. That number may seem oddly-specific, but when you dig in, the entire legal argument made by Hertz and approved by the court makes sense.
You see, as of the end of its latest quarter, Hertz had 400 million shares authorized, but only 142.29 million shares outstanding. Other shares are elsewhere, such as in treasury stock. In short, the 246.775 million shares approved are already shares the company had authorized to release as it saw fit. The court looked at different cases to see what rights Hertz should have, but at the end of the day it sided with the following mindset: the company’s debtors do not have any property interest in shares that are authorized but not yet issued by the firm. Similarly, the company does not own these shares because they are not considered an asset. Because of this conflicting nature, the debtors who are taking over the business have the right to sell the shares without complying with Section 363 rules. In short, this creates a legal mysteryland where there’s a lot of grey area to work with.
Normally, this wouldn’t be an issue because in most bankruptcy cases common stock is trading at or near $0. For some reason, because of speculators on the market allegedly, Hertz’s stock just will not die. At one point following news they had entered into bankruptcy protection, shares of the business soared to more than $5 per share. Even now, as I write this, the company’s stock is trading at $1.88.
On June 15th, in response to the ruling, the management team at Hertz announced plans to sell up to $500 million worth of its shares to whomever will buy them at the prevailing market price (or upon any other appropriate arrangements that can be arrived at). The reason for the drop in price from the $1 billion sought to the $500 million mark simply has to do with the number of shares the company’s allowed to sell and the fact that its share price has dropped since. In fact, at $1.88 per share, the maximum gross proceeds that Hertz can generate (assuming this price holds as an average) will be $463.94 million. Jefferies, LLC, the company that Hertz got to agree to the sales, is entitled to take up to 3% of any proceeds generated by the sales. At today’s pricing, that could be a windfall of up to $13.91 million.
In its filing related to this planned sale, the company said that it will use its ATM (at-the-market) approach to sell stock. Management has not been very transparent regarding its plans for the cash. In its filing on the matter, the company said that it will use proceeds for ‘general corporate purposes’, but in a prior note on the matter, the company said it would look into using the cash to cover DIP (debtor-in-possession) financing. As I pointed out with the now-defunct J.C. Penney Company (OTCPK:JCPNQ), DIP financing can be incredibly expensive even though it is given special protection by the courts when it comes to seniority. Using some or all of its cash proceeds to lighten this burden would be a wise idea for whomever inherits the business in the future.
One thing is for sure, though. Hertz will need cash and likely soon. In a filing issued on June 15th, the company provided a 13-week cash requirements forecast. Through the week of August 21st, the company will need to spend around $1.28 billion in cash to meet all of its obligations. This includes $193.6 million in cash disbursements for payroll and benefits, $159.3 million for location rent and concession. $328.2 million will be needed for direct operating, SG&A, and other expenses. A further $86 million will be needed specifically for things tied to its Chapter 11 process, including cash for critical vendors.
It’s uncertain what the future holds, but we can discuss what is likely to happen. Management, in its own filings on the matter, said that there is a significant risk that the common stock will be worthless. There is some chance this won’t come to pass, but that will only be the case if a friendly outcome can be negotiated regarding restructuring. For common holders to get really anything, everyone above them must be made whole. That can only be possible, management believes, if the market for their offerings recovers significantly and in a timely manner.
Right now, the picture for Hertz is not looking pretty. In all likelihood, the company will not survive in its present form and any restructuring will probably involve the wiping out (or close to full wiping out) of the company’s common shareholders. Perhaps shareholders will walk away with a small piece of the pie, but that is improbable without a robust marker recovery. In the meantime, management is out trying to snatch some cash from speculators who appear all-too-eager to hand it over in exchange for what is certainly a black swan event they are banking on. If June 15th’s trading history is any indication of what is going on, Hertz is finding a lot of those investors. On that day alone, 174 million shares, about 22.2% more stock than what the company had outstanding as of the end of its latest quarter, traded hands. That implies a lot of people who don’t mind the significant risks being taken at the moment.
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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.