Hertz cap structure could get rolled as secular pressures collide with maturities, covenants

by Alexander Gladstone, Reshmi Basu, and John Bringardner

Two months after amending its revolving credit agreement, Hertz is again at risk of being driven back to the negotiating table for another round of covenant revisions, according to a lender and two sellside analysts. Moreover, the car rental company’s ability to address a wave of upcoming bond maturities could also be challenged by pressure in the used car market and burgeoning competition in the ground transportation sector, the sources added .

These negative factors weighed heavily on Hertz’ 4Q16 performance. The company booked adjusted corporate EBITDA of USD 12m, a massive 87% fall from the USD 94m generated during the prior-year period. Full-year 2016 corporate adjusted EBITDA clocked in at USD 553m, which was down 35.5% year-over-year and pushed total leverage up to 7x based on USD 3.9bn of non-vehicle debt. Net leverage came to 5.6x, accounting for USD 816m in cash.

Those metrics put Hertz out of compliance with an old 4.75x net leverage covenant in the revolver. In turn, revolver lenders agreed in February to replace the net leverage covenant with a new first lien net leverage test set at 3.25x for the first three quarters of 2017, and then stepping down to 3x as of 4Q.

But in light of Hertz’ downward earnings trend and increasing operational vulnerabilities, the company is driving down a narrow lane of covenant compliance. As of 31 December, net first lien leverage through the company’s USD 697m Libor+ 275bps (0.75% floor) TL due 2023, a USD 1.7bn revolving credit facility less USD 570m of letters of credit and netting out the permitted USD 500m of unrestricted cash, stood at 2.4x.

Another covenant breach could jeopardize liquidity, since the bulk of liquidity is stored in the Barclays-agented revolver, the sources noted. As of 31 December, the company had USD 1.9bn of total liquidity, comprising USD 816m of cash on its balance sheet and USD 1.13bn of availability under the currently-undrawn Libor+ 275bps revolver.

The USD 697m L+ 275bps TLB is currently quoted at par.

Hertz Chart 1

Crash course

A major sensitivity that could further drive Hertz earnings off course this year is fluctuations in residual fleet value, the sources noted. Like other rental companies, such as Avis, Hertz does not directly own most of its vehicles. It instead uses its Hertz Vehicle Financing II LP entity, a bankruptcy-remote non-guarantor special purpose subsidiary to buy new cars. The subsidiary funds these purchases with proceeds from investment grade ABS debt. The Hertz corporate entity then enters into an arrangement whereby it leases the vehicles from the subsidiary, with the lease payments going toward funding the cost of the ABS paper.

Due to customer demand for new vehicles, Hertz is required to sell off older vehicles when they are roughly one to two years old, replacing them with newer ones as part of the cost of doing business. As such, Hertz is exposed to declines in the residual value of the vehicles, as it is required to provide credit enhancement by making payments to the special purpose subsidiary in order to redeem the full value of the ABS debt.

As US auto production has increased dramatically over the past several years, with the sector reaching record sales in 2016, used car prices have sunk precipitously due to over-supply, creating greater depreciation costs. For example, the depreciation of Hertz’ fleet increased by USD 168m to USD 2.6bn in 2016, up 7% from the prior year.

Moreover, Hertz has been suffering from contraction in top-line revenues, largely driven by competitive pressure. (Total revenues for 2016 clocked in at USD 8.8bn, down 2.3% year-over-year). This is likely driven by shifting consumer dynamics in the ground transportation market, as customers increasingly opt to use ride-sharing services such as Uber and Lyft when they go on short trips, rather than renting a car, the sources said.

For example, spending on rental cars represented 33% of the corporate ground transportation spending market in the fourth quarter of 2016, down from 38% in 4Q15, and 48% in 4Q14, with Uber eating up most of the market share. Uber’s market share amounted to 52% in 4Q16, up from 40% in 4Q15, and just 22% in 4Q14, according to a sellside analyst report.

It Hertz

The combination of top-line contraction and rising depreciation costs has severely impacted Hertz’ recent earnings, and there could be more pain on the horizon, the sources noted.

Macro indicators related to the residual sales part of Hertz business are not favorable. The National Automotive Dealers Association (NADA) forecasts a 3% decline in residual values in 2017, and Ally Financial predicts a 5% decline. Assuming a 4% midpoint decline estimate along with management commentary that a 1% residual fleet value shift amounts to a USD 59m impact to corporate adjusted EBITDA implies that 2017 EBITDA could bottom out around USD 320m, according to the sources. Under that scenario, first lien net leverage would reach 4x, while total leverage through the company’s USD 3.2bn stack of unsecured notes would be 12x.

Both metrics could be damaging for Hertz’s ability to tap the capital market at a critical time, the sources noted.

While Hertz generated USD 260m in adjusted free cash flow in 2016, based on USD 553m in corporate adjusted EBITDA, USD 143m of interest expense, and USD 134m of non-vehicle capital asset expenditures, cash flow would become minimal if 2017 EBITDA declines to around USD 320m, the sources continued.

In less than a year, in April 2019, the company’s USD 250m 4.25% unsecured notes come due, followed a year later in April 2019 by the maturity of a USD 450m 6.75% unsecured note.

The 4.25% unsecured notes due 2018 changed hands yesterday at 101 for a 3.122%% yield, and the 6.75% unsecureds due 2019 traded today at 99.75 for a yield of 6.886%, according to MarketAxess. Further down the maturity curve, the USD 800m 5.5% unsecured notes due 2024 traded today at 84.5 for a yield of 8.335%.

Hertz Chart 2

Another restriction on management’s flexibility is the recent loan amendment putting in a debt incurrence limitation of 6x total leverage and 4.25x net total leverage. Hertz carried gross and net leverage of 7x and 5.6x respectively as of 31 December, effectively rendering it incapable of issuing incremental debt, the sources continued.

The company’s stock traded at USD 16.11 today for a market cap of USD 1.34bn, down 2%.

Hertz did not respond to requests for comment.

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