Unless you’re an accountant or an experienced and well-read investor, chances are you either haven’t heard of capitalising lease obligations or, if you have, it’s something you don’t do because it can be a lot of work.
Until recently I fell into the second group. I knew what lease capitalisation was (don’t worry if you don’t; I shall explain all shortly) but I didn’t do it because a) none of my investments had problems with crippling lease obligations and b) it was a lot of work.
However, the argument (or excuse) that it’s all too much work is about to become null and void, thanks to a new accounting standard known as IFRS 16: Leases.
This new standard is about to shine a great deal of sunlight onto what was previously a dark and largely hidden debt, so now seemed like a good time to review the basics of lease obligations and how much of what is generally a good thing can be too much.
After much pondering, frowning and chin scratching I came to the (long overdue) conclusion that lease obligations are basically the same as debt obligations.
You can learn a bit about lease obligations and how I’m going to factor them into my investment process in this month’s Master Investor magazine (below).
I’ve also included Burberry, The Restaurant Group, Next (all of which I own) and Marks & Spencer (which I don’t own) as examples of how the hidden debt of lease obligations can seriously distort the accounts of retailers and other property-based businesses:
Looking at total future lease obligations
In the article above I said “I’m going to start using a multiplier of six-times minimum lease payments to calculate ROLACE (return on lease-adjusted capital employed) for lease-heavy stocks on my stock screen“.
First of all I should have mentioned where you can get the rental figures. You can get them from SharePad, and possibly other data providers.
You can also find them in the notes to the accounts. For example here are the rent figures for The Restaurant Group:
Contingent rents are rents that are based on a performance metric such as revenues. These are not considered leases by IFRS 16 as the amount owed varies depending on revenues, so they’re not a fixed obligation like debt.
So If I was going to calculate the future lease obligations for The Restaurant Group, I would only use the “minimum lease payments” figure in the rental multiplier calculation. And here is that calculation:
Future lease obligations = £78.2m * 6 = £469.1m
That’s a reasonable estimate, but I now think a better (or at least more conservative) approach is to just use the total lease obligation figure quoted in the notes to the accounts. Here are those figures for The Restaurant Group:
I’ve ignored the first table because it shows finance leases rather than operating leases.
With finance leases, virtually all of the risks and rewards of ownership are transferred to the lessee, such as with a hire purchase agreement. Under current accounting rules these are already recorded on the balance sheet, so we don’t need to capitalise them (i.e. turn them into a capital asset and associated liability on the balance sheet).
The second table relates to operating leases, which are leases for stores, factories and so on. This is what we need to capitalise.
In the Restaurant Group example, it has total lease obligations (net of lease receivables) of £1.1 billion.
That’s a long way north of the £0.5 billion estimate via the six-times multiplier. The reason for the difference is that the six-times multiplier assumes that the average lifetime of a fixed lease is six years.
In The Restaurant Group’s case, it has more than half its leases extending beyond five years, and many of them seem to stretch beyond 10 or even 20 years (it’s hard to tell for sure because the company doesn’t give that much detail; I wonder why).
IFRS 16 will discount those distant future payments (i.e. reduce them by a reasonable interest rate such as the rate on long-term bonds) and so the IFRS 16 figure may end up below £1.1 billion. However, I’m happy to NOT discount the lease obligations figures because a) it’s easier and b) it will make the lease obligations look worse for companies with very long leases, and that’s precisely what I want to do.
Being extra cautious with long leases
I want long leases to look ugly because they lock companies (like The Restaurant Group) into fixed commitments long into an uncertain future.
If that future turns out to be worse than the company expected (perhaps because every Tom, Dick and Harriet opens up a restaurant) then the company is obligated to pay rent for unprofitable sites for the next 10 or 20 years.
Let’s look at this another way. Let’s assume The Restaurant Group decided to borrow £1.1 billion to pay all those rents up front (in reality, landlords would except a lower amount if paid up front, but I’m going to ignore that detail). If it did that, the company’s borrowings would go from their current £360 million to about £1,460 million.
Is that a sensible level of debt? Let’s have a look:
Over the last ten years, The Restaurant Group produced profits of about £50 million per year if we ignore the losses of 2016 (I’m being very generous). It also made average lease payments of £60 million, which it would no longer have to pay if it paid them all up front with a loan. For the sake of simplicity, I’ll assume that the payments on its new £1.1 billion loan equal its old rent payments.
With profits of £50 million and borrowings of £1,460 million, the company would have a debt-to-average-profit ratio of 13.3.
To put that in context, my upper limit for that ratio for cyclical companies (which includes restaurants) is 4.0, so by that measure The Restaurant Group is indebted (to landlords) to an insane degree.
Adding lease obligations to the balance sheet also has a seriously negative impact on the company’s profitability metrics, primarily its return on (lease-adjusted) capital employed. With leases accounted for, The Restaurant Group managed to generate returns on lease-adjusted capital employed (ROLACE) of just 5.6% over the last decade, and that’s excluding the losses of 2016.
As an investor I’m targeting average returns of at least 10% per year. Whether or not I’ll get them I do not know, but what I do know is that it will be harder to achieve if I invest in companies producing returns of less than 6% on their capital.
Now, there are various reasons why this isn’t an entirely fair assessment of The Restaurant Group as it stands today (primarily because of its recent acquisition of Wagamama), but it’s enough to make my point:
Fixed lease obligations are basically the same as debt obligations, so it makes sense to look at a company’s total minimum future lease obligations, either directly or by using a rent multiplier.
And if you want to do these calculations yourself, I’ve added lease obligations to my Company Review Spreadsheet which you can access from the Free Resources page.