Description

Apologies for the hastily written note, but this is a fairly time-sensitive recommendation that has already run away from me since beginning this write up earlier in the month.

Despite my negative bias on the U.S. rent-a-car industry, I view the nearest dated Hertz bonds (HTZ 5 ⅞ 10/15/20 and HTZ 7 ⅜ 01/15/21) as attractive adds below par, with a high probability of being taken out in the next few quarters. There is a lot of yield sensitivity to price and timing, but both issues continue to change hands at yields to worst in excess of the high yield benchmarks. Owing to convexity and a higher coupon, I'm recommending the 7.375% notes due 2021.

My thesis is based primarily on the company’s liquidity position and secured capacity, which is sufficient to address these two maturities in the near term. Additionally, Q2 should be a step further in the right direction after a horrendous 2Q17. Leverage notwithstanding, the 2020s and 2021s are the best positioned within the HTZ capital structure. I suspect that management is evaluating a secured deal to address these notes, which makes me cautious on the second lien notes due 2022. Offer prices for both issues have chopped around below par, but my trader tells me they are still buyable at 99.00 with patience.

Ultimately, I think both of these notes will get refinanced in the next few quarters, ideally in conjunction with a strong Q2 announcement, but more likely at the October or January call step-downs. Although gross leverage is uncomfortably high at ~14x non-vehicle, Hertz has a sizable liquidity position and ~$1.5bn of secured capacity that could be utilized to term out its near maturities.

A couple of scenarios as to how returns could play out based on the timing of a refinancing:

In this market, that’s a range of returns I’m happy with given the limited downside risk.

Q2 comps

YoY comps will be incredibly easy for Q2. It’s well documented that 1Q17 was a challenging quarter across the board with poor pricing (-1% YoY), utilization (-3pts YoY), and depreciation (+15% YoY per-unit) all exacerbated by elevated strategic spend. 2Q17 turned out to be a kitchen sink quarter as the company took a huge depreciation hit (+27% YoY per-unit) rebalancing its fleet, redoubled its restructuring efforts, and fully drew on its revolver heading into quarter end. In the back half of the 2017, results stabilized a bit owing to rebounding residual values and more stable pricing on a rebalanced fleet. Based on last year’s cadence, there is some possibility that the company looks to term out both maturities sooner rather than later.

Residuals

Coincident indicators suggest continued strengthening in the used car markets. This runs very contrary to my longer-term views, but I’m willing to concede in the near term.

A few recent clippings on this:

I’ve found a moderate correlation between Manheim’s rental index and Hertz’s quarterly per-unit depreciation, which is intuitive:

It’s not perfect for a number of reasons, including timing of disposals, alternative sales channels (e.g. directly placing its used fleet online instead of through auctions), and renting older fleet into ride sharing platforms like Uber. However, rental car operators remain heavily levered to used car prices and it is comforting on the long side that used car prices continue to rebound in the near term.

Rental rates

Data points have been more mixed on pricing. Goldman publishes a weekly study that tracks fleet tightness and pricing at select airport locations. After posting solid gains through the first quarter, Hertz pricing has been mixed across brands, with modest sequential slippage during the current quarter. Specifically, on a YoY QTD basis, Goldman’s survey is tracking to the Hertz brand +0.9%, Dollar +5.3%, and Thrifty +5.2%.

Liquidity

·         Cash: Hertz had $1.05bn of unrestricted cash on its balance sheet at 3/31

·         Revolver capacity: Hertz had no drawings under its $1.55bn revolver, with $520mm of availability at 3/31

·         2nd lien capacity: Between $550mm of junior lien capacity, $400mm of additional capacity that can be freed by moving LCs to the company's standalone LC facility, ~$400mm available through secured ratio capacity, and a $200mm general basket, Hertz has ample cushion to refinance its near maturities with secured debt

·         FCF: The company has guided to FY2018 free cash flow improving y/y (vs -$750mm) but still in the negative range

Summary projections

As I mentioned above, I am biased negatively on auto residuals and Hertz’s longer-term fundamentals. For 2018, I’m projecting $311mm in company-defined EBITDA, ~11% below the Bloomberg consensus of $349mm. However I expect that leverage will tick down by ~2.5 turns after Q2, after which I expect secured ratio capacity to decline modestly.

Relative value

From a YTW perspective, both notes offer above-average yields with limited duration and significant upside to a potential early refinancing.

Catalyst

Earnings improve in the short term and the company utilized ample balance sheet liquidity or secured capacity to refinance the 20s and 21s and secured notes due 22 potentially get layered.