Invisible leverage is no longer invisible: Is investor risk perception impacted?

In 2019, accounting rules regarding treatment of operating leases were changed. Under old accounting operating leases were expensed. As per new accounting, operating leases have finally found the place where they long belonged, the balance sheet. Retail, restaurants, airlines, logistics and telecom companies have significant operating lease obligations. With lease liabilities becoming visible as debt (and counter right-of-use asset in the balance sheet), does it change the risk perception of equity investors? While the new accounting treatment has been covered by myriad articles, in this blog, after briefly touching upon (the similarity and difference between) US GAAP and IFRS treatment of operating leases, I focus primarily on addressing equity investor risk perception, which is communicated by expected return. A significant increase in expected return implies that investor perception of risk has amplified since investors want to be compensated for bearing higher risk. In this blog, I examine the degree of increase in cost of equity (or expected return by equity investors) for US retailers and restaurants when the veil over invisible leverage was lifted back in 2019.

What has changed?

Before we dive in, let’s first understand what has changed.

With the new leasing rules, US GAAP allows operating leases to be recognized as either “operating” or “finance”, whereas IFRS allows recognition as “finance” leases only. Both of these lease accounting methods require operating leases to be capitalized i.e. recognize as right-of-use asset (representing the right to use the leased asset) and debt (measured as present value of future lease obligations).

Differences between operating and finance leasing becomes pronounced in their treatment of rent expense in the income and cash flow statement. Under finance lease, rent expense is broken into amortization (of the ROU asset) and interest expense (on the lease liability). Under “operating lease”, rent is recognized on a straight line basis over the lease term. There is immaterial change in the income and cash flow statement for US GAAP companies that have elected to go with “operating lease” accounting. However, companies using “finance lease” accounting (which is all IFRS companies) report higher EBITDA and EBIT (since rent expense is now recognized as a part “A” and “I”) as opposed to companies using “operating lease” accounting. Moreover, the total finance lease expense i.e. total rent is higher (than the operating lease expense) for the initial lease term and then lower for the later part. However, the total rent over the lease term remains the same in both lease accounting methods.

Does investor risk perception following the lease related asset and liability recognition increase?

I have examined 23 US companies – 3 restaurants and 20 retailers with significant operating leases. For each of them, I have sourced their equity, debt, lease and assets values from the time when the veil over invisible leverage was first lifted back in 2019. For most companies this is June 2019 time frame when they reported their 2019 Q1 earnings. Costco, NIKE, Starbucks and Darden Restaurants are exceptions; they reported later that year.

For each of these companies, I have estimated % increase in leverage (assets/book value of equity; in fact % increase in leverage translates to just the % increase in assets), absolute increase in Debt / Market Value of Equity (I should have ideally estimated the market value of debt as well. Book and market value of debt differ, but not substantially and certainly not like equity), % increase in levered beta and eventually the % increase in Cost of Equity following the accounting change. I have sourced sector specific unlevered betas, risk-free rates and equity risk premium from Prof. Aswath Damodaran’s website.

Let exhibit-1 with the intermediate calculations not overwhelm you. I have distilled the key metrics in exhibit-2 below.

After capitalizing operating leases, the companies marked red (refer exhibit-2) – Capri Holdings (fashion), Urban Outfitters, GAP (clothes), Foot Locker, DSW, Caleres (footwear) and Dick’s (sporting goods): – were perceived as more risky by equity investors. The risk manifested in a higher return expectation evident by the amplified Cost of Equity (COE).

Why did their COE (or expected return) increase substantially? Because all these companies had substantial increase in the following

• Financial Leverage following the accounting change
• Debt to Market Equity, which in turn reflects in the % increase in levered beta

Refer exhibit-1 & 3: The % increase in levered beta (levered beta = unlevered beta * (1 + (1-tax%)*Debt/Market Equity), which is a measure of risk in the kind of business and the debt to fund those business, moves almost in tandem with both Debt to Market Equity and COE. It does peak abnormally for Kroger (grocer), Macy’s (departmental store), Michael Kors (Capri Holdings: fashion retailer), BigLots (general), Caleres (footwear) and GAP (clothing). Reason being that the equity for these retailers in June of 2019 (when they posted their Q1 results) was trading below their lease adjusted debt pushing their levered beta higher than others.

Companies marked green (refer exhibit-2) – Costco, NIKE, Target and Starbucks – did not experience any material increase in COE since their lease obligations as a percentage of market equity is very low. Not only, they saw the lowest impact to their overall debt and financial leverage than other firms, but also they have the highest market cap in the list resulting in immaterial leverage impact to their lease adjusted beta. Moreover, Costco and Target own more than 80% of their stores.

Companies in the middle (refer exhibit-2), specifically Chipotle Mexican Grill, Dollar General and Darden Restaurants experienced significant increase in leverage as a result of the accounting change, but had low-med increase in expected return (and perceived risk). This can be explained by observing the relatively low increase in overall debt to market equity and corresponding levered beta. This presents a key insight that operating lease capitalization led significant increase in leverage alone is not sufficient, but significant increase in leverage coupled with low market value of equity drives enhanced risk perception.

It has been almost 2 years since the invisible leverage has become visible. In this writing, I have solely discussed the impact of operating leases capitalization. Of the companies marked red, the ones that delivered high shareholder return (over the last 2 years) have been able to offset the increase in cost of equity to a certain degree, not only because of their higher market value of equity (partly due to COVID-led tailwind for consumer staples and brick-and-mortar accelerated pivot to online commerce), but also because of the fall in US equity risk premium since capital has remained resilient with investors wanting to pay for growth.

Thanks for reading.