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Hertz: The Higher the Profits, the Larger the Debt

Over the past few weeks I have been watching the developments of the car equipment and rental industry and one company I think is very interesting to analyze is Hertz Global Holdings Inc. (HTZ). While there are many different factors to look at and consider when investing, in the article below I will look at the debt side of the company. I will analyze its total debt, total liabilities, debt ratios and what analyst and other top investors believe about this company. From this analysis we should get an idea of the company's leverage and how much to expect in return for a long term investment.

This company has been through its fair shares of ups and downs in the past, and despite growth never being a problem, shareholders are currently arguing over management's future strategy. While the Dollar Thrifty acquisition helped earn the firm more pricing power, and location openings, as well as airline traffic growth added on to 2013's top line growth, some concerns remain. On the one hand, Hertz is still trailing behind the privately held rival Avis, making shareholders uneasy. Also, the company's equipment rental business is very capital intensive, requiring a lot of inventory, in addition to the large investments necessary in order to maintain the total 670,000 car fleet. So, while profits grow, debt levels do too, as the company must constantly reinvest its earnings.

It is essential to remark that gaining knowledge about Hertz's debt and liabilities is a key component in understanding the risk of investing in this company. In 2008 and 2009 we were able to see some of the repercussions that highly leveraged companies with large amounts of debt succumbed to. By studying the debt part of this firm, investors will elucidate if it's able to keep its capital and use it for growth in the future.

Total Debt to Total Assets Ratio

This is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It is calculated by adding short-term and long-term debt and then dividing this figure by the company's total assets. A debt ratio greater than 1 indicates that a company has more total debt than assets, while a ratio below 1 indicates the opposite. Used along with other measures of financial health, the total debt to total assets ratio can help investors determine a company's level of risk.

In Hertz's case, this ratio has increased very slightly over the past three years, from 0.64 to 0.65. This indicates that since 2010, the company has added more total debt value than total assets, which is not a good sign for bond investors. Given that the ratio of 0.65 is smaller than 1, the financial risk faced by the company is relatively low: Its assets' value comfortably surpasses its total debt levels.

Debt ratio = Total Liabilities / Total Assets

The debt ratio shows the proportion of a company's assets that is financed through debt. If the ratio is less than 0.5, most of the company's assets are financed through equity, but otherwise, they are financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged," meaning they could be in danger if creditors start to demand repayment of debt.

Given that Hertz's 2013 TTM ratio surpasses the 0.50 mark, we can assume that most of the company's assets are financed through debt. As this figure grows, so will the risk of investing in this firm.

Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity

The debt-to-equity ratio is another leverage ratio that compares a company's total liabilities with its total shareholders' equity. This measures how much suppliers, lenders, creditors and obligators have committed to the company, versus what the shareholders have committed. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt and can result in the company reporting volatile earnings. It also indicates that the company may not be able to generate enough cash to satisfy its debt obligations, and therefore is considered a riskier investment.

Compared with 2011, Hertz's debt-to-equity ratio has increased, from 7.24 to 8.29 (in 2013). I prefer companies that have a very low or minimal debt-to-equity ratio, because elsewise it's basically a signal of a conservative balance sheet. The company�s ratio of 8.29 - which surpasses 1x - implies that the company faces high risks, and so do their investors because it entails that shareholders have invested more than suppliers, lenders, creditors and obligators.

Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt

This coverage ratio compares a company's operating cash flow with its total debt, providing an indication of a firm's ability to cover total debt with its yearly cash flow from operations. The larger the ratio, the better a company can weather rough economic conditions.

As Hertz's ratio stands below 1x, the company does not have the ability to cover its total debt with its yearly cash flow from operations, making it a risky and possibly unprofitable long-term investment.

Institutional Investors

I also evaluate recent institutional activity in the stock. In other words, I want to know which hedge funds bought the stock in the recent quarters. In Hertz's case, the odds seem to run against the company, as investment gurus Julian Robertson (Trades, Portfolio) and John Griffin (Trades, Portfolio) sold out their shares this past quarter. This is a clear indication that hedge funds have little faith in the company's future profitability.

Analyst Outlook

However, currently many analysts have a good outlook for Hertz. Analysts at Yahoo! Finance, for example, expect the firm to retrieve EPS of $1.70 for the current fiscal year and an EPS of $2.07 for the next one. The Bloomberg team, on the other hand, is estimating revenue to be at $10.84 billion for the current fiscal year, and grow to $11.60 billion for the upcoming year, which is in line with the 1.7% growth rate.

Bottom line

While Hertz's EBITDA marked a solid 6.50% growth rate for 2013, and revenue has increased by 55% over the past five years, so have the company's debt levels. On almost every level, the firm has accumulated more and more debt, with numbers spiking particularly in 2012, due to the Dollar Thrifty acquisition. And although profits and earnings matter when analyzing an investment, I am somewhat sceptical regarding this company's recent strategic moves.

The Shareholder Rights plan, to be implemented this year, leaves me especially uneasy, as it remains unclear how the plan will affect future profitability. If management's plan of expanding the off-airport footprint and introduction of new brands succeeds, the firm could gain major profits, but these are still too undefined. Therefore, I believe this may not be the best time to invest in Hertz and would recommend shareholders to wait until next quarter's financial results before investing in this car rental firm.

Disclosure: Victor Selva holds no position in any stocks mentioned.

This article first appeared on GuruFocus.