Defying all rationality

At the end of May, Hertz filed for bankruptcy. Naturally, the stock price plunged more than 90% from its January high. However, shortly after, prices started rising again, increasing more than five-fold from its recent lows. Later still, the company announced to be raising 1 billion USD by issuing shares. This article will dive deeper into this strange phenomenon, which seems to defy all rationality.

Let us start at the beginning. Hertz is a car rental company active on multiple continents. As you might imagine, the company hasn’t had much business during the coronavirus pandemic, due to the reduced amount of tourism and business travel. This led to the company going bankrupt after a century of doing business. When the news broke, shares in Hertz started declining in value as investors started offloading shares. Carl Icahn, for example, sold his entire 40% stake in the company at a loss.

Strangely enough, shares started rising again later and left many people wondering about what was going on. Though nobody knows for sure, the most likely cause is that retail investors are collectively jumping into the stock. Why? Well, probably for no other reason than the low price it has registered recently. This caused a massive jump in the stock price, which increased more than five-fold from recent lows. 

Cleverly, Hertz decided to benefit from the momentum it has by announcing a share issuance of a total of 1 billion USD. From the company’s point of view, the idea makes sense. Raising money via loans is not an option because, with risk like this, lenders will demand absurdly high interest rates if they are willing to lend money at all (which is very unlikely). In ‘normal’ circumstances, a company would also refrain from issuing more shares, because nobody would buy the shares of an almost bankrupt business anyways. However, with the current irrational momentum, chances are retail investors will buy the shares. This would give the company 1 billion USD extra to try and save the business. 

From the investor’s point of view, however, buying into the newly issued stock makes less sense. Sure, there are businesses that have recovered from an Article 11 bankruptcy, but that doesn’t mean Hertz will. Risks involved with this stock offering are incredibly large, as recognized by Hertz itself, which included the following sentence in its prospectus for raising the first 500 million USD: “We are in the process of Chapter 11 reorganization cases under the Bankruptcy Code, which may cause our common stock to decrease in value, or may render our common stock worthless.” Should the company indeed have to cease operations, shareholders will be last in line when the company is liquidated. So, if the company fails, the proud owners of recently purchased shares will likely end up empty-handed.

Current shareowners are also not entirely content with the offering. One of the shareholders tried to object in court by stating that issuing more shares would result in dilution, which would result in even more losses for current shareholders. (Dilution happens when the number of shares outstanding increases, resulting in a lower price per share.) However, the court overruled the objection and gave Hertz the green light for the offering. 

In contrast, bondholders are probably more content with the offering because it makes continuing operations more likely, which will increase the chances of fully recouping loans to the company. In the case the company still fails, the offering will lead to an increase in assets and a higher liquidation value, which should, in turn, provide bondholders with more of their investment recouped.

The move can be seen from two perspectives. Critics say Hertz is taking advantage of an irrational market. Others (the court among them) say the same but in kinder words, by stating that Hertz is just trying to get the most out of current circumstances. If the share issuance results in Hertz being able to continue operations, many jobs will be saved, bondholders will be happy, and the retail investors who bought the shares will probably have an excellent return. If Hertz won’t make it after all, bondholders will recoup more of their money, and retail investors will have learned a valuable lesson about risk-seeking-behavior. A win-win, if you ask me.

Robert Foppen