On May 13, 2014 Hertz (HTZ) notified the SEC that it wouldn’t be able to file its quarterly report (known as Form 10-Q) on time. In the filing (Form 12b-25, or NT 10-Q) Hertz disclosed that “additional work” was needed in order to “complete the closing procedures associated with the first quarter primarily related to evaluating the company’s conclusions regarding the capitalization and timing of depreciation for certain non-fleet expenditures in prior periods”. The company asserted that the 10-Q would be filed no later than May 19th.
May 19th came and went, but the company did not file its 10-Q. Instead, on June 6th Hertz issued an Item 4.02: non-reliance guidance for its previously issued financial statements. The stock immediately tumbled down 9% to $27.73, on 4x average volume.
Were there any signs of accounting trouble at Hertz leading up to this restatement? Looking over the recent history of Hertz SEC filings, one might notice some early indications of potential trouble. In their November 7, 2011 10-Q, the company noted: “we identified certain errors in our previously issued consolidated financial statements” … “These errors relate to additional telecommunication charges and depreciation of revenue earning equipment, as well as certain corrections to deferred taxes on income for years 2005 through 2010 and the related impact on the 2008 goodwill impairment.”
Then, in March 2014, Hertz issued another statement where, among other things, it warned: “During the fourth quarter of 2013, we identified certain out of period errors totaling $46.3 million.”
We also notice that Hertz made a sequence of changes in accounting estimates related to its depreciation rates for its US rental car segment. According to its most recent annual report, Hertz saw increases to income of $44.2M in 2013, $139.4M in 2012, and $26.7 in 2011 resulting from the changes in depreciation rates in its US segment. In lay terms, Hertz recognized less depreciation expense on its US rental cars, because the company estimated that it could now make more money selling them than it originally estimated it could. Normally, positive changes in estimates are one-time non-cash adjustments — some call them paper profits — that increase the bottom line in a given period. While such one-time gains can help meet short-term EPS target, they do not normally have any long-term impact on growth prospects. (Changes in accounting estimates are one of the many red flags highlighted by Schilit and Perler in their classic book on the matter, Financial Shenanigans.)
In Hertz’s case, it is important to note that the depreciation adjustment does underline an important trend in the industry that, as Fitch notes, would have a meaningful impact on the company’s valuation. In some cases, a disclosure such as this actually represents high-quality reporting, since it provides more transparency and better information. Few of Hertz’s competitors have made similar disclosures, despite the fact that longer useful lives is an industry-wide trend.
But perhaps the strongest warning came in the May 13th NT 10-Q itself: “the Company identified certain errors relating to prior periods which may require it to restate its previously issued financial statements for 2011”. The company further stated that it was evaluating some changes in their internal controls, hinting that their already disclosed (and priced-in) accounting troubles may be just the tip of an iceberg.
In all, of the numerous accounting and other risk red flags that we track, Hertz had six prior to the restatement announcement, four of which we would classify as “Critical”.
While an investor might have had reasons to disregard many of the flags, the May 13 NT 10-Q should have been a trigger to start taking measures to mitigate the risks related to potential accounting irregularities. Out of 2,219 late filings filed in 2014, only 87 cited resolution of accounting issues as a reason, making it a very good early red flag. Recent research has found that accounting-related delays to quarterly filings had the most severe negative market reactions. However, the filing had been largely overlooked by the market. Only the restatement announcement of June 6th caused a significant drop in the stock price.
The lesson? Generally, by the time a restatement hits the market it’s already too late. But what should investors do now, when the effect of the restatement and any related legal actions have largely been priced in? The stock ratings, as usual, range from “Buy” to “Sell”, and any two analysts have at least four opinions.
Lately, following Hertz’s announcement of a potential rentals mobile app, the stock has shown some positive momentum. From a purely technical perspective, there may be a trading window based on a potential closing of the gap from the June 6th sell-off.With HTZ this would mean buying close to $28 and selling close to $30 where significant resistance is expected to build up. Yet, if Hertz is unable to meet its consensus $0.08 EPS target, the stock can easily retest the support at $26.5 from June 10th.
The longer term prospects are even less clear. It is not uncommon for stocks to recover lost ground after the restatement process is complete and uncertainty is left behind. Given the circumstances, a company might take the “opportunity” to push all the bad stuff accumulated over the years (and some extras) into restated financial statements – what’s known as a “big bath”. By the time the restated financial statements are finally filed, the stock is frequently oversold, sometimes with significant short interest accumulated. No wonder any good news can create a momentum opportunity.
On a macro-level, the recent agreement with Uber was definitely a welcome development. However, according to Fitch, the positive trend of rising residual values may not continue for much longer. Without additional $44.2M income, noted above, Hertz financials may not look as attractive.
It remains to be seen what the pending restatement will reveal and whether Hertz will be able to meet its $0.08 consensus EPS target, but in general given the associated uncertainty and unclear growth perspective, as a long term investor, we are going to stay on the sidelines. We have mentioned that two analysts have at least four opinions, haven’t we?
Disclaimer: Audit Analytics is not a financial or investment adviser, nor are we offering or attempting to offer any trading or investment advice.