Hidden debts. How to analyse companies with hidden debts.

 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.

Leases, Retirement Obligations and Receivables Accounting

Leases, pension obligations and securitized receivables are like debt obligations.

Accounting rules can allow them to be off-balance-sheet items.

Such items can bias ROIC upward, which makes competitive benchmarking unreliable.

However, valuation may be unaffected.



Operating Leases Accounting

Adjust for operating leases:

• recognize the lease as both an obligation and asset on the balance sheet (which requires an increase in operating income by adding an implicit interest expense to the income statement and lowering operating expenses by the same amount),
• adjust WACC for the new leverage ratios, and 
• value the company based on the new free cash flow and WACC  

Assuming straight-line depreciation, an estimate of a leased asset's value for the balance sheet is:

Asset Value at time t-1 = Rental Expense at time t / [ kd + (1/Life of the Asset)]

kd = cost of debt




Receivables Accounting

(a) When company sells a portion of its receivables

Another source of distortion occurs when a company sells a portion of its receivables.

This reduces accounts receivable on the balance sheet and increases cash flow from operations on the cash flow statement.

Despite the favourable changes in accounting measures, the selling of receivables is very similar to increasing debt because

• the company pays fees for the arrangement,
• it reduces its borrowing capacity, and 
• the firm pays higher interest rates on unsecured debt.

(b) Securitized receivables

In the wake of the financial crisis of 2007, accounting policy has tightened.

Securitized receivables are now classified as secured borrowing.

In these situations, no adjustment is required

In the infrequent cases where securitized receivables are not capitalized on the balance sheet,

• add back the securitized receivables to the balance sheet and 
• make a corresponding increase to short-term debt.

These alterations will determine the necessary changes to return on capital, free cash flow, and leverage.

Interest expense should increase by the fees paid for securitizing receivables.



Pension Accounting

Companies must report excess pension assets and unfunded pension obligations on the balance sheet at their current values, but pension accounting can still greatly distort operating profitability.

Three steps should be taken to incorporate excess pension assets and unfunded pension liabilities into enterprise value and the income statement to eliminate accounting distortions.  

These three steps are:

1. identify excess pension assets and unfunded liabilities on the balance sheet,
2. add excess pension assets to and deduct unfunded pension liabilities from enterprise value, and
3. remove the accounting pension expense from cost of sales and replace it with the service cost and amortization of prior service costs reported in the notes.

Much of the necessary information for this process appears in the company's notes.

How Healthy Is the Balance Sheet with All Those Leases?

Common Investing Pitfall: How Healthy Is the Balance Sheet with All Those Leases?

Many retailers use operating leases to "rent" space for their stores. Because these leases aren't capitalized and are kept off the balance sheet, they understate a firm's total financial obligations and can artificially inflate financial health. The leases aren't inherently bad or sneaky; in fact, their existence is core to most retailer's expansion plans. Lease obligations can be found in the footnotes of a firm's 10-K under the heading "commitment and contingencies."

Be sure to give a retailer a thorough checkup before declaring it to be in tip-top financial shape.

For example, Tommy Hilfiger appeared to have pretty good financial health going into 2002. The firm had $387 million in cash and $638 million in total debt. However, the specialty apparel firm also had $273 million of future financial obligations in the form of operting leases. If we add off-balance sheet leases to the debt on the balance sheet, the toal comes to $911 million, and the coverage ratios don't look as robust. Tommy Hilfiger entered 2002 with declining sales and stagnating profits and cash flow. When Hilfiger announced that it neede to close many of its retail stores in October 2002 and pay to break the leases, the stock price was hammered.