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Remind Me P(lease)
Investment Strategy | 6 Comments | Tue 21 Aug 2012
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Company management often use leases to access capital. Despite this source of capital being senior to equity holders, its effect on liquidity, solvency and valuation is often ignored by investors. Using fictional and real examples, with the real arguably more ridiculous, and supported by a critique of some academic research, this article serves as a reminder of the importance of leases to investors analysis.



Comments

1.
On 18/09/2012 04:24:43, Terry wrote:
The McKinsey book "Valuation" includes a simplified method of lease valuation compared to the Damodoran approach you present. Specifically: lease value = rental/(rd+1/asset life), where rd is the pretax cost of debt. The interest component of the annual rental can then be estimated as rd x lease value. Inferred depreciation of the leased asset is then the difference between the annual rental and the inferred interest expense.

2.
On 29/08/2012 16:28:11, James East wrote:
Nice article and much appreciated. However and while reading it, I wondered as a deep value Graham type of investor - who cares about the return on capital. Normally we are only looking at the balance sheet and we know that the leases are essentially debt and we take that into account. Of course, if you are into spreadsheet mode then I guess one is concerned with the metric. We would all love to invest in a high ROE equities, but over the years I have resigned myself to the old school G&D stuff that goes in and out of style over the cycle. The current cycle unfortunately is not showing any love for the value school. However, there are many better than cigar butts out there if one has the patience.

3.
On 30/08/2012 15:58:27, Paul wrote:
James, I guess if you own the stock in true Graham or Schloss style, despite apparently low (or even negative) returns even before taking account of leases. Maybe there is no strong evidence that this is a short term issue for the company, you don'd care because this is an asset play or a hidden value play. Then this isn't such a big factor. Presumably you will already have dealt with the liquidity or solvency issue in your analysis. Good luck with the G&D stocks.. time will out!

4.
On 08/09/2012 19:40:07, Simon Denison-Smith wrote:
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.

5.
On 11/09/2012 15:45:05, Paul wrote:
Simon - your point on the need to focus on the strength of the moat is key for me, although certainly not easy. It is good to see Halfords renewing at lower rates, apparently Home Retail are doing the same. Just regarding the case of A vs B, whether locked into long term above market leases or benefiting from long term below market rent, doesn't the return on capital calculation already capture this? If you are in a prime location, your business will be reaping the rewards of heavy footfall bringing increased sales and higher profits and so returns. (Unless the location is 'prime' for alternative use). This isn't captured in the balance sheet until the profits/losses take their effect over the long term. Spreadsheets are dangerous if used alone. I think this type of analysis helps us understand the economics of a situation a little. (There may be circumstances such as limited company subsidiaries or landlords who are willing to work with you, or the aforementioned moat, which is temporarily breached, which might not show up in a spreadsheet).

6.
On 11/11/2012 20:20:03, Anonymous wrote:
Another potential problem arising is the retroactive restatement issue. Assuming IASB introduces measures for the capitalization of leases in, say, 2014, likely there will only be two years of adjusted historical data required to be reported. If you are analyzing historic ROCE or ROIC-WACC spreads, you'll likely encounter serious comparison issues. When analyzing the drivers of ROE or identifying moats through return on capital sustainability/quality, using a decomposed ROE will also be tricky.

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