Among the phrases that investors hate to hear, "accounting restatements" ranks near the top.
Yet, there can be a silver lining. It can push shares well below intrinsic value to the point that upside results simply from new management cleaning up the mess. That's the setup in place for Hertz Global Holdings (NYSE: HTZ).
Hertz's accounting woes began many quarters ago, and as recently as June, appeared to be attributable to manageable missteps, which analysts at RGL Forensics explained here.
Hertz didn't have just one set of math errors to justify; it had a litany of them. At the time, the various accounting issues seemed to fall under the umbrella of improper recognition of various expenses, depreciation and receivables rather than any sort of malfeasance.
Nevertheless, many investors stuck around over the summer, expecting an eventual tidy resolution. Yet when they learned in September that Hertz had been badly managing its core business, letting its fleet of vehicles grow too old, and CEO Mark Frissora resigned, many threw in the towel. Since then, shares have been in freefall.
Activists Bring Pressure to Reform
The next chapter in the Hertz saga is quite predictable: A company with a strong brand and a weak share price tends to attract the interest of activist investors. The appeal is that such companies are not broken beyond repair, but just need a course correction.
In late November, we learned Carl Icahn raised his stake in beleaguered Hertz from 8.5% to 11%. Whenever investors get news like this, shares of the company in question invariably rise, due to his (mostly) successful track record. Indeed, HTZ moved above $25 a few weeks ago, but has since fallen back, potentially due to year-end tax-loss selling.
Hertz is now in the portfolio of Jana Partners as well. Jana was recently in the news for successfully pushing PetSmart (NASDAQ: PETM) to sell itself to private equity firms for $8.7 billion. Jana began investing in PetSmart back in the spring when shares dipped into the mid-$50s. The buyout at $83 a share represents a solid and rapid return for these activist investors.
In their pursuit of changes at Hertz, Jana and Icahn are joined by private investment group Fir Tree Partners.
These investors are already beginning to have an impact. Icahn's pressure, for example, led management to add two new independent directors to the board, and the newly expanded board then hired John Tague as CEO.
The new CEO has an unusual pedigree. He is not a veteran of the car rental industry, but instead has been involved in transportation and logistics companies that have been in need of an overhaul. One of Tague's first moves was to buy $2 million of Hertz stock with his own funds, which he vowed to retain for as long as he helms the company. His average purchase price was $24.11 a share, which means that, thus far, he is several hundred thousand dollars in the red.
Tague's tasks are pretty straightforward and set the stage for near-term and midterm catalysts. First, he must focus on cleaning up the company's legacy accounting issues. When that process is complete, he is also expected to announce a fairly stiff accounting charge to write down the value of an aging rental fleet.
This is the kind of clear-the-decks move that investors will eventually embrace, as it positions Hertz to aggressively invest in a rapid upgrade of its vehicles. Once investors are able to quantify the impact of the recent accounting issues and fleet age, they likely won't be concerned about any sort of worst-case scenario in terms of write-downs.
It's important to note that Icahn increased his stake after he was able to get an insider's view of the company's books. Presumably, he didn't see any reason to dump his existing stake.
The midterm catalyst for this stock is the eventual spin-off of the company's equipment rental division. It was originally slated for early 2015, but management's attention is now focused elsewhere. Jana Partners, in light of its success in locating buyers for PetSmart, may be seeking a sale of the division, which would expedite the process of unloading this asset.
This year's results will certainly be dampened by the accounting issues and fleet upgrade charges. But analysts at MKM Partners believe that annual EBITDA of $2 billion should be realized by 2016. That anticipated cash flow strength led them to peg fair value for shares at $31, which is where they traded before the accounting mess and CEO departure derailed the stock.
Think of HTZ as a two-step gainer. First, when the accounting mess is cleaned up, by mid-2015 at the earliest, shares have potential for quick 20%-plus upside, to around $26. Then, over the subsequent few quarters, as the equipment rental division is spun off or sold, HTZ could rebound toward the $30 mark. That represents more than 40% potential upside for patient investors.
Recommended Trade Setup:
-- Buy HTZ at the market price
-- Set stop-loss at $19
-- Set initial price target at $26 for a potential 22% gain
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This article was originally published on ProfitableTrading.com: Follow Icahn's Lead to 40% Potential Upside in This Beleaguered Stock