Our last column dug into some of the reporting practices used by Hertz Global, specifically its somewhat misleading depreciation of its rental fleet.We noted that Hertz reported the fleet in the 2006 10-K as a long-term asset, showing full cost less accumulated depreciation. It also showed depreciation as an add-back to net income in the operating section of the cash-flow statement. To provide a scale, out of $18.7 billion total assets, the fleet's book value at the end of 2006 was about $7.4 billion, or 40 percent. On the cash-flow statement, the reported operating flow for 2006 was about $2.6 billion, after adding back $1.8 billion of depreciation.
This does not make sense to us, because depreciation is a cash expense for Hertz, since it acquires only the short-term use of the vehicles through repurchase agreements that specify the initial purchase price and the amount that the factory will pay to take them back. Because the average life of any vehicle is only 10 months, we think that better accounting would report the fleet as a current asset like prepaid rent, and not add back depreciation to net income in the cash-flow statement. In effect, Hertz managed to look better with on-balance-sheet financing by making current assets look as if they're noncurrent.
SO, WHY ARE WE WRITING MORE?
We're back because we're persuaded that these misleading results were not an unfortunate result of technical adherence to GAAP. Rather, we think the presentation was exactly what management was after: a rosier-than-reality picture designed to support a higher stock price with a little GAAP helium.
CONSORTIUM OR CABAL?
In December 2005, Ford Motor Co. sold its 100 percent holding of Hertz to a consortium of three major private equity "sponsors" - Clayton, Dubilier & Rice, The Carlyle Group and Merrill Lynch Global Private Equity. Their goal from the start was to quickly buff up Hertz, spritz a little new car aroma around, and send it back to the markets. They did just that by November 2006, but the three of them are still holding 72 percent of the shares.
Those who buy Hertz shares should keep their eyes wide open. You can be absolutely certain that this triumvirate will not be looking after anyone's interests other than its own, period.
And forget about anyone exercising any influence through the usual governance channels. As proof that this consortium is a cabal, the 10-K reports on page 41 that: "These funds and Hertz Holdings are parties to a stockholders agreement, pursuant to which the funds have agreed to vote in favor of nominees to our board of directors nominated by the other funds." We've seen high school social clubs with less egregious rules about who gets to be a member.
Other evidence that Hertz's bad reporting isn't accidental can be found in events that occurred between the acquisition and the public offering.
Page 55 of the 10-K revealed that in June and November 2006, the trio paid two "special" dividends to themselves totaling $1.26 billion. Given their initial cash outlay of $2.3 billion in December 2005, that was an awesome return. What should absolutely not be missed, too, is the fact that the offering in November 2006 brought in $1.28 billion. It's clear this management has a nontraditional view of stewardship. In fact, it resembles a Ponzi, because they bought the company, sold part of it, and put the cash into their own pockets.
We really think they're into this deal just long enough to pump and dump.
The cash-flow statement also reveals another pair of outcomes. Specifically, it shows that the company borrowed and paid back $1.3 billion of long-term debt. There doesn't appear to have been much of a business reason for the deal, because the interest rate didn't change. However, page 157 of the 10-K discloses that "affiliates" of Merrill Lynch Global Private Equity purchased the new debt.
It looks like the trio gave Merrill Lynch a nice break to let it replace the previous creditors with insiders. All this surely produced a huge outlay of fees to the investment banker who handled both sides of the deal. Hmmm. We wonder who that was?
LITTER BOX ACCOUNTING
The next transaction is bothersome because management got caught in a mistake and used "litter box accounting" to cover it up. Specifically, page 53 discloses that Mark Frissora was named chief executive on July 19, 2006. Page 97 describes a deal on August 15 in which he purchased 1,056,338 shares of stock at $5.68 each, $2 less than the apparent market value of the untraded stock. So, for an outlay of $6 million (we don't know whether that was in cash or put on the cuff), he had stock with a nominal value of $8.1 million.
But a funny thing happened in September, just a few weeks later. Page 97 says: "We determined that the fair value of our common stock as of Aug. 15, 2006, was $16.37 per share, rather than the $7.68 that had originally been determined at that time." Oops! Turned out that Frissora now held stock worth $17.3 million, $11 million more than he had paid for it.
The obvious best move to fix this mistake was to rescind the original sale and execute it again at $14.27 per share, so he still had his $2.1 million. Not to mention 800,000 options with a strike price of $7.68, and another 800,000 with slightly higher strikes that were still less than the "new" market value.
Here's why we call it litter box accounting: The note explains that they added $13 million to compensation expense and sweetened this deal to shelter this poor guy from paying taxes on his pittance. It boggles our minds to think about his compensation for that month's work, but isn't it completely clear whose interests the board is protecting?
THE REST OF THE STORY?
What we're about to say is speculation, so don't bank on it. But we think what really happened in September was that someone happened to look at the calendar and suddenly realized that the public offering was supposed to take place in only a couple of months at a much higher offering price around or above $15. We think that they were worried that sweet insider deals left behind too much evidence contrary to that valuation. All this happened after the cabal filed an initial S-1 with the Securities and Exchange Commission in July 2006, which was reported in Business Week in an article entitled, "Buy it, strip it, then flip it."
Turns out they were wrong, and perhaps we're wrong, too, because the stock was trading just above $21 when we wrote this column (down a bit from its high). We have no idea what the stock's real intrinsic value might be, but we are convinced that it would ultimately be much higher without all the risk associated with the governance issues and really bad accounting.
Our opinion must not be construed as advice to buy, hold, sell, or sell short. The reason we have devoted more attention to this subject is to remind everyone that despite the scandals of a few years ago and the resulting legal and policy responses, the managerial and accounting professions still need to raise their standards for truth and transparency in financial reporting. If the Hertz cabal is typical, this lesson was obviously lost on them, because it appears that they are up to no good, and it's no accident.
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