Hertz Case Is Example of What Ails Big Three

The car guys finally got their White House appointment this week to plea for government help. And at some level, you've got to sympathize with their predicament. Foreign imports continue to pour into the United States from countries that manipulate their currencies or protect their domestic markets. And the Big Three are forced to carry billions of dollars in health care and legacy retiree costs that their foreign rivals never will.

But then comes another reminder that these companies are their own worst enemies, careening from one strategic blunder to another for nearly three decades. This week's concerns Ford and its decision about a year ago to sell its Hertz subsidiary to a trio of private equity firms.

Ford picked up the car rental company in 1987 as a defensive move to make sure it didn't fall into the hands of Chrysler or General Motors (which, itself, had owned Hertz once upon a time). Even then, the car companies had become addicted to selling lots of cars to the rental companies as a way of holding market share and keeping their factories running. And although they didn't make much money on them, these sales of relatively fuel-efficient sedans helped the companies meet average federal fuel-economy standards for their entire fleets, offsetting the gas-guzzling trucks and sport-utility vehicles that would come to account for the bulk of Big Three profits.

What we now know, of course, is that this gaming of the fuel-economy standards proved to be too clever by half, putting the Big Three behind the 8 ball when gas prices rose and consumers suddenly demanded more fuel-efficient cars. And all those extra Focuses and Tauruses that were dumped into Hertz lots were, in turn, dumped onto the used-car market, where they helped to lower resale values and depressed new-car sales even further.

Hertz also proved useful to Ford in masking its underlying financial weakness. In 1997, with shares of car rental companies selling at much higher multiples than shares of domestic automakers, Hertz sold 18.5 percent of itself to the public for $450 million, which it used to try to boost Ford's stock price by buying back Ford shares. But in the fall of 2000, at what turned out to be the peak of the economic cycle, Ford, for reasons it never fully explained, decided it was urgent to buy back the same shares. By the time the solicitation was completed, in early 2001, the price was $710 million, a 46 percent premium over the pre-offer market price.

Then, last spring, with its auto business beginning to crater, and bond-rating agencies beginning to worry about financial viability, Ford again set in motion a process of selling Hertz to raise as much as $6 billion in cash. Unfortunately, no strategic buyer stepped forward, and public investors weren't wildly enthusiastic about another initial public offering. So, after a private auction that attracted only two teams of private equity firms, Ford sold the country's leading car rental company for $5.6 billion to Clayton, Dubilier & Rice, the Carlyle Group and Merrill Lynch's private equity arm.

At the time, the price, at 5.1 times earnings before interest, depreciation, taxes and amortization, seemed a bit low. But how low will not be clear until late this afternoon, when the new owners will sell about a quarter of the company in an initial public offering. If they get the price they expect, Hertz will turn out to be one of the sweetest public equity deals in history. According to calculations by my colleague Allan Sloan at Newsweek, it would effectively give the new owners a paper profit of about $3 billion on the $900 million in cash they still have invested in the business. And all that in less than a year.

How did they do it? Sloan has already explained in these pages about the $1.4 billion in special dividends, the $90 million in fees and the refinancing of the company that added nearly $4 billion in debt to Hertz's balance sheet. And it certainly didn't hurt that, in the intervening period, air traffic skyrocketed, helping all rental companies, while the Dow Jones industrial average hit new records.

I will leave it to moral philosophers to debate whether Hertz's new owners "deserved" a $3 billion profit without making any substantial improvements in the operations of what was already a profitable, well-run company. But it's fair to ask why Ford's top executives and directors didn't see the same possibilities as the private equity firms and left what turned out to be $3 billion on the table.

Certainly much of the blame falls to the three investment banks that advised Ford on the deal: J.P. Morgan, Citigroup and Goldman Sachs. They were the ones that told Ford it would get more money from private equity investors than doing its own IPO. And they were the ones that told Ford's then-board of directors -- including former Goldman Sachs president John Thornton and Citigroup vice chairman Robert Rubin -- that the private equity offer was fair and reasonable.

But while Ford may have come out on the short end of the stick on this, as with most of its other Hertz transactions, the investment bankers have once again profited handsomely.

After advising Ford on the sale, for example, Goldman earned another round of fees helping the new owners refinance the company with asset-backed bonds that used the cars as collateral. And now Goldman is set to earn more as one of the three lead underwriters for this week's IPO.

And then there is Merrill Lynch, which not only is one of the three private equity partners but also earned fees arranging for the refinancing and is another lead underwriter in the IPO.

The important lesson here, however, isn't about the cravenness of Wall Street investment bankers, or the shrewdness of private equity firms. Rather, it is a lesson about what happens to companies when they lose their focus and rely on game-playing and financial manipulation. While the Big Three were dickering around buying and selling car rental companies, or getting into and out of the defense business and consumer finance, companies like Toyota and Hyundai and Honda were eating away at their market share by delivering great cars and value to customers. And it is that, more than any other factor, that has brought the Big Three to their current crisis and the car guys to Washington.