What happened

Shares of Hertz Global Holdings (NYSE:HTZ) and rival Avis Budget Group (NASDAQ:CAR), well-known vehicle rental companies, and Carvana (NYSE:CVNA), a used-car retailer, all dropped double digits Friday morning as COVID-19 is causing ripple effects throughout the automotive industry. Here are the key details.

So what

The clock is ticking for Hertz and its investors as it previously disclosed it had missed lease payments related to the vehicles it rents out, and that business was down roughly 80% since the coronavirus drastically slowed the economy. Another negative development for Hertz investors was Fitch Ratings placing a "Ratings Watch Negative" on $6 billion worth of Hertz asset-backed securities debt. The rating agency noted the impact on the travel sector and "the ongoing dislocation, closures of, and limited activity in the wholesale market across vehicle auctions nationwide is creating unique challenges." Hertz has until May 4 to make payments or work with lenders to waive a potential default, and the ripple effect could impact more of the automotive industry than investors realize. 

rows of cars at a dealership

Image source: Getty Images.

For instance, if Hertz is forced to liquidate some or all of its fleet to repay the bonds, it could send already struggling used-car residual values even lower. For companies such as Hertz and Avis, falling residual values across their fleet assets is obviously a negative development, but it's also a bad development for manufacturers such as Ford and General Motors. When those automakers use their financial arms -- Ford Credit and General Motors Financial -- to lease a vehicle to a consumer, they must estimate a returned value of the vehicle upon lease end. Generally, the estimate is close enough to the actual value at lease end and the financial arms earn a profit. However, when values of used vehicles drop far more quickly than anticipated -- such as during the COVID-19 pandemic, during which Automotive News estimates used-car residual values have dropped 10% to 12% -- the financial arms can take huge losses. In fact, J. P. Morgan analyst Ryan Brinkman estimates it could hit Ford Credit and General Motors Financial to the tune of $2.6 billion and $3 billion, respectively.

Carvana, as well as other used-car retailers, are also likely to feel financial pain from lower prices as used and off-lease vehicle supply stacks up without wholesale auctions or consumer demand. This development will weigh on used-car dealers such as Carvana, as the company will have less valuable inventory, and it will almost certainly cripple the company's 2019 impressive growth in sales and gross profit per unit (GPU) in the first and second quarter of 2020. The good news for investors is that Carvana has roughly 15 months of cash after recent financing actions, according to Wells Fargo analyst Zachary Fadem.

Now what

Investors should expect volatility for Hertz as the industry keeps an eye on the company's ability to avoid bankruptcy. Keep in mind, the largest Hertz shareholder is billionaire investor Carl Icahn, and the rental company is also hoping to get government support during this unusual COVID-19 development. It's certainly plausible Hertz can avoid bankruptcy and attempt to rebound from the negative impacts of COVID-19, but it's simply another massive hurdle for a company that was already trying to evolve and compete with companies such as Uber and Lyft, among others. Investors in the auto industry would be wise to keep an eye on many developments as COVID-19's impact will continue to send ripple effects through the entire industry, from manufacturers, to rental companies, to used-car retailers, and many others.