On 08/09/2012 19:40:07,
This article is very good - I like the use of examples.
The issue of how to treat leases in accounting terms is difficult because there is a wide disparity of value in a lease - from (A) negative where you are committed to a long-term in which there are few / no obvious alternative lessees to (B) positive where the site is prime and the long-term lease agreement is actually below market value and could be readily sublet on for a premium. Maybe the accounting system needs to therefore take into account the rental payment vs market rent - but this of course makes it open to subjectivity and accounting abuse and one would still have to take into account the probability that it actually would be re-let on a vacant possession basis in the current market.
You can imagine a scenario where a CEO has had their incentive package changed to reflect your suggested approach of measuring ROCE and determines not to take up a lease which is in a prime site in spite of the fact that the returns would be significant from the small amount of investment needed to get the shop up and running but the long-term lease obligation (which is a mirage because its sublettable) undermines the ROCE calculation - in this scenario, the shareholders lose out.
Over the last 4-5 years, the number of As seems to far out-number the number of Bs so on a balance of probability basis, it is almost definitely better to shackle the CEO rather than not. I wonder if this has always been the case? If we look back to the balance of As vs Bs through the cycle, maybe it provides a more rosy picture.
We wrestle with this issue and have still not reached a satisfactory solution except to look hard at the risk, try to identify businesses with a reasonable coverage of their lease liability (EBITAR > 2 times annual lease + interest costs) and focused on how strong the moat is to give us predictability of that EBITAR number...most cases affected by this are retailers and the competition from the Internet has put this issue into a much brighter spotlight. Halfords is quite an interesting case study - they have been successful in the last few years at reducing their lease costs by renegotiating lease renewals at lower rates - the balance of power between landlord and lessee has shifted a bit.