The Dangers of Purchasing Shares in a Bankrupt Company
Wall Street will never cease to amaze in their attempt to move money away from the pockets of unaware speculators and into their own. The most recent case can be seen in the attempt by Hertz Global Holdings to issue shares to the public after they had already entered bankruptcy. While they have recently announced the suspension of the offering there are still lessons to be learned by those, who for even a brief moment, considered purchasing shares in this bankrupt corporate enterprise.
The first lesson to be understood is that common stockholders of a corporation rarely receive anything in the bankruptcy of a company and bondholders are lucky to receive anything close to par. This is not something that is just left to chance where creditors and shareholders sit by with their fingers crossed hoping for some sort of payout. The numbers are all there in black and white. A look at Hertz's 2019 annual report will show the following figures:
Assets = $24,627 million
Liabilities = $22,739 million
Stockholders Equity = $1,888 million
Now, the mistaken observer may look at these figures and think that there is $1.8 billion to be paid out to common stockholders, which, as we will see, is completely wrong. In calculating stockholders equity one simply subtracts liabilities from assets on a company's balance sheet, but this stockholders equity figure greatly overestimates the liquidation value of the firm. Reason being is that assets carried on the balance sheet are calculated based on GAAP figures and as Warren Buffett frequently preaches, accounting figures are the beginning of financial analysis, not the end.
If we were to take a realistic approach towards valuing the assets of Hertz using the guidelines laid out in Ben Graham's Security Analysis, we see that the total assets of Hertz would optimistically be worth $12,091 million. This means that no only are common stockholders left with nothing, Hertz's creditors would get roughly half of what they are owed. Again, I'm being optimistic.
This raises the question of course of why Hertz would attempt to raise more money by selling common stock that they knew would end up being worthless. The answer is simple. Hertz wanted to take the money from purchasers of their common stock and use it to pay off creditors. This may sound surprising to some but once again a look at their annual report will show that Hertz has a history of trying to deceive shareholders.
The most obvious example is their use of this all too common term "adjusted EBITDA", which is used to make the shareholders of Hertz think the company is profitable, when in reality it is losing money. Let us look closer.
Over the past 3 years Hertz Global has reported the following figures as Adjusted EBITDA:
2019 = $649 million
2018 = $433 million
2017 = $267 million
These numbers seem nice at first glance before you understand what they mean and how distorted they are from economic reality.
The following is a list of charges that are excluded from the earnings figures above.
Non-vehicle depreciation and amortization.
Non-vehicle debt interest.
Vehicle debt-related charges.
Loss on extinguishment of debt.
Restructuring related charges.
Important charges and asset write downs.
Information technology and finance transformation costs.
Essentially, what Hertz is saying with the Adjusted EBITDA figures is this:
"We are a profitable company so long as you ignore some of our most important expenses."
The only thing worse than the people who report these kinds of figures are the people who believe them, such as the "students" who leave business school without questioning what their professors have just taught them.
What any investor should look at to get a true understanding of the earnings (or losses) of a corporation are the pre-tax operating earnings, which for Hertz over the past 3 years have looked like this:
2019 = $13 million
2018 = $(257) million*
2017 = $(575) million*