The lesson in Hertz: Lost compasses

The Hertz recap while bankrupt thanks to free equity has become the poster child of what has gone nuts in markets, courtesy of central banks. 

In essence, dumb money would seem happy to oblige in a last-minute capital raising while the issuer and courts are flagging giant warning signs that this amounts to throwing money to the wind. Dumb money is owed to a combination of frictionless access of retail money into equity markets and the utter disconnection of markets with underlying assets’ cash flow generation. The only issue is whether central banks will keep the ball rolling so that a dumber investor can be sold the hot potato. 

The interesting question raised by the Hertz experience is when a zombie with a cross in its chest becomes a respectable living entity again by the sheer might of endlessly available risk-prone liquidity.

If the extra money does not go directly into debtors’ pockets, one could see a case where the business is buying enough time to see its rental cars being used again and its FCF strong enough to service debt eventually. This is, after all, a strong brand. While owning the equity of Chapter 11 Hertz amounts to holding a call option squared, it remains a call option which has value as long as money flows. Crazy individual investors might end up as a wise crowd.

The Hertz rebirth, if ever, would indeed confirm that equity can be cheaper than debt and raises serious issues in valuation models as it would be too easy to say that this is a one-off. 

Since 2016 and the European first brush with negative rates, valuations have become a question mark better not left to university researchers and with a closer connection to option valuations than to a DCF. 

In a DCF, negative risk-free rates imply deflation and therefore falling FCF so that corporate spreads need to go up as an insurance which kills the benefits of cheap risk-free money. On paper at least highly geared companies will not fly higher in a NIRP context. Investors agreed to that up to now with junk issuers seeing their equity value going south with lower risk-free rates.

What a DCF does not capture is the optionality created by the provision of enough free liquidity to buy time and restart FCF generation. In this respect, dusting off university courses about the valuation of equity as a sum of options held by various stakeholders might be necessary. 

Congrats extended to Central Banks for keeping analysts awake.