If you are thinking of investing in the shares of airline, rail or retail companies, and many others, you need to understand of the biggest risks that you will face as a shareholder - hidden debts.
By understanding what hidden debts are and how to analyse companies that have them, you will make better investment decisions and take on less risk.
Retail company with big future rent commitments
Where a company has big future rent commitments, there are 2 useful things you can do:
1. Calculate a company's fixed charge cover.
2. Calculate the capitalised value of operating leases.
1. Fixed charge cover
Fixed charge cover = (EBIT + operating lease expense) / (net interest + operating lease)
A result within the range of 1.5 to 2 is not unusual.
Fixed charge cover of 1.3 times is the lowest level investors should tolerate, as the risk of financial distress becomes significant below that level.
Fixed charge cover has been a great way to spot retailers in trouble in the past, such as HMV, Game Group and Woolworth. These companies did not have huge amounts of debt on their balance sheets, but the rental commitments crippled them when profits start falling.
In 2005, Woolworth's fixed charge cover was only 1.3 times which was right at the limit of what is normally comfortable. Once profits started to fall in the following year, the company was in the danger zone. By 2007, the company's finances were close to breaking point. It filed for bankruptchy in January 2009. Prudent investors would not have invested even in 2005.
For the year to December 2015, Domino's had normalised EBIT of Sterling 73.6m, rental expenses of Sterling 21.3m and normalised net interest expenses of Sterling 0.02m. Its fixed charge cover was therefore:
(73.6 + 21.3) / (0.02 + 21.3) = 4.5 times
This is a healthy figure.
Domino's fixed charge cover has been consistently healthy despite the rapid growth in new stores. As the profitability of new stores increases, the fixed charge cover should improve.
Domino is a franchising business. It sublets the building it is renting out to its franchisees: the franchisee commits to pay the rent. This gives it an extra level of protection and explains why its fixed charge cover is not a matter for concern.
2. Capitalising the value of operating leases
There are two ways to estimate the value of hidden debt by taking an approach that is referred to as capitalising operating leases. In other words, you are working out what the total amount of the future liability might be in today's money.
a) The first way is to discount the future lease commitments to their present value using an interest rate similar to the interest rate paid on existing borrowings.
b) A quicker way, used by the credit rating agencies. Multiply the current annual rental expenses by a multiple between 6 and 8. (Use this which is simpler and much more straightforward).
Using the simpler method of multiplying by a number between 6 and 8 with the company's annual rental expense. Look for this in the annual accounts labelled "operating lease payments" or something similar.
For example, for 2015, the lease or rent expenses for Domino's was Sterling 21,313m.
Sterling m 2015 2014
Rent expense 21,313 20,874
Capitalised at 8x 170.5 167.0
Capitalised at 7x 149;2 146.1
Capitalised at 6x 127.9 125.2
Domino's hidden debts has evolved over the years. They have been growing as the company has opened more Pizza shops.
How are these calculations useful to an investor?
The impact on ROCE
Many retailers rent rather than own their high street stores, which means they have a lot of hidden debts.
Without taking these debts into account these companies can look like very good businesses with very high ROCEs. Once the debts are factored in, this changes.
There is nothing wrong with investing in companies with hidden debts, but it makes sense to ensure that they pass the tests of quality and safety, meaning:
- a minimum adjusted ROCE of 15%.
- a minimum fixed charge cover of at least 2.
Example
All in Sterling
Company Next WH Smith
Capital employed 1501.9 188.0
Lease adjusted Capital employed 3004.1 1987.0
Estimated hidden debt 1502.2 1799.0
ROCE (%) 60.2% 33.2%
Lease adjusted ROCE 33.2% 12.9%
Using Lease adjusted ROCE gives you a truer picture of a company's financial performance. In most cases, ROCE will decline when hidden debts are included.
Once the hidden debts are factored in, ROCE changes. In the above example, Netx still looks good, but WH Smith sees a big fall in ROCE.
Be wary of sale and leasebacks
In recent times, one of the easiest ways for companies to raise cash has been to sell some of their properties to property companies or investment funds and then rent them back. This is known as a sale and leaseback transactions.
For supermarket companies, such as Tesco, this was a big warning sign that all was not well.
Without the cash proceeds from selling supermarket stores to property companies, Tesco would have been struggling to find the free cash flow to pay dividends or invest in its business. The cash inflow from property sales made it look as if Tesco's debt was nothing to worry about, but the off-balance sheet debt ((Tesco's future rent obligations) increased at a rapid rate from 2005 to 2013.
After selling a number of its stores, Tesco tied itself into long-term rent agreements for stores that aren't as profitable as they used to be. This was one of the main reasons why Tesco had to stop paying a dividend in 2015. Trying to get out of these rented stores could prove to be very expensive for Tesco in the future. This is a good example of why investors ignore hidden debt at their peril.
