Carl Icahn (Trades, Portfolio) is associated with billion-dollar activist campaigns and many turnaround stories that were the result of the guru’s prudent management. However, even the most astute investors are bound to make some errors in judgment, which could eventually cost them billions of dollars.
Icahn’s investment in Hertz Global Holdings, Inc. (HTZ, Financial) falls into this category. The guru first invested in the company in 2014 and upped the ante by buying more shares in the first quarter of 2020, taking his total investment in Hertz to $2.3 billion, or 39% of the total outstanding shares of the company.
On May 22, Hertz filed for bankruptcy protection as the company failed to entice its creditors to extend the due date for overdue debt repayments. Soon after this was announced, Icahn confirmed in an SEC filing that he sold his entire stake in Hertz at a price of 72 cents per share, fetching $39.8 million. With this sale, he booked a loss of close to $2 billion from his investment. In a statement filed with the SEC, Icahn wrote:
“I have been an investor and supporter of Hertz since 2014. Unfortunately because of Covid-19 which has caused an extremely rapid and substantial decrease in travel, Hertz has encountered major financial difficulties. Yesterday I sold my equity position at a significant loss, but this does not mean that I don’t continue to have faith in the future of Hertz. I believe that based on a plan of reorganization that includes new capital, Hertz will again become a great company. I intend to closely follow the company’s reorganization and I look forward to assessing different opportunities to support Hertz in the future.”
A deep dive into the fundamentals of Hertz reveals that recovery is highly unlikely, and I think value investors should steer clear from the company’s shares. At the same time, the spectacular fall of Hertz teaches many important investing lessons.
The broken business model
Some analysts have been quick to put the blame for Hertz’s failure on the global lockdown and the current recession. However, the macro-economic environment was already proving to be a difficult-to-overcome challenge for the company even before the economic downturn. For instance, Uber Technologies, Inc. (UBER, Financial) and Lyft, Inc. (LYFT, Financial) were eating into the market share of Hertz in the last few years, and car rental companies were forced to reduce their rates dramatically to remain competitive.
It is natural for companies operating in an unfavorable industry to experience financial difficulties, and this is exactly what happened with Hertz. The company had to invest millions of dollars to improve its online presence and billions more to lease its fleet of vehicles. In comparison, the likes of Uber continued to reap the rewards of working with independent drivers who were required to own a vehicle to be part of the ridesharing ecosystem. As a result of this novel business model, this new breed of companies never incurred vehicle financing costs.
Rising operating costs and challenging industry conditions led Hertz to assume a high degree of debt in the last decade, and prudent investors might have seen this coming to haunt the company in the case of any black swan events that could suddenly disrupt cash flows.
Source: GuruFocus
More than the current recession, Hertz was the victim of dynamically changing industry conditions. This is not the first time Icahn has lost money as a result of similar macroeconomic developments. The guru’s investment in Blockbuster LLC is a classic example. When Icahn invested in this company in 2004, everything seemed fine as Americans were in love with video rental service providers. Netflix Inc. (NFLX) was one of the closest rivals of Blockbuster as both these companies had very similar business models. However, consumer behavior changed quickly, and the popularity of streaming content over the internet gained exponentially in the years that followed the guru’s investment. Netflix was quick to identify this trend, and the company decided to radically change its business operations to embrace industry-wide developments. Blockbuster failed to adapt, and this led to a spectacular collapse of a company that was once touted to be an industry leader.
Source: Bloomberg/Business Insider
In 2010, Icahn told Forbes that investing in Blockbuster was his biggest blunder to that date, and the guru then invested in Hertz, which would eventually take over the top spot as the guru’s most costly mistake.
Investing lessons
The collapse of Hertz teaches a very valuable lesson regarding the importance of due diligence before making investment decisions. A thorough and frequent review of the industry dynamics and the company’s financial performance would have been sufficient to realize the need to sell any shares or avoid Hertz altogether. According to many behavioral finance studies, investors tend to pay a premium to buy shares of companies they are familiar with. Many Hertz investors fall into this category, as the century-old history of the company combined with its sheer size made it look too big to fail.
Second, the failure of Hertz serves as a warning sign for investors who solely depend on the guidance of legendary investors and forget the importance of diversification. For the likes of Icahn and Warren Buffett (Trades, Portfolio), an investment in a company often represents a very tiny percentage of their portfolio value. This is because most of these investors tend to bet on dozens of companies spread across different business sectors. In addition, there investments often include securities other than common stocks, such as exclusive high-yield debt issuances or other unique arrangements. Therefore, the impact of the failure of a single investment is likely to be negligible in the long run. However, some retail investors ignore this fact and put every egg in one basket, which increases the risk of failure.
Third, the downfall of Hertz highlights how critical it is to invest in a company with a strong balance sheet and liquidity position. Avis Budget Group, Inc. (CAR) is the closest rival to Hertz, and the company is not in a distressed financial condition even after a significant decline in revenue in the last couple of months. This was possible because of the considerably low level of debt in comparison to Hertz. A thorough analysis of the balance sheet health of a company will help investors get an idea of the margin of safety associated with a specific investment at any point in time. This, in return, will go a long way in generating attractive returns.
Takeaway
I think investors should not keep hopes for a recovery from Hertz. If the company is forced to liquidate its vehicle fleet, senior secured bondholders and other creditors will be paid before common shareholders. Even if the company survives and restructures, the unfavorable macro-economic conditions make the future business model problematic. The failure of Hertz teaches us several important lessons that could help value investors make better decisions in the future.
Disclosure: I own shares of Uber.
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