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Corporate borrowing costs and liabilities set to spike

Glenn Freeman  |  19 Jul 2017Text size  Decrease  Increase  |  

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Higher company borrowing costs and sharp, sudden increases in liabilities may occur among some of your favourite stocks from January 2019, but don't be alarmed.

 

The new leases standard--AASB 16 (IFRS 16)--will require companies to bring most of their operating leases on balance sheet.

Property and equipment leases previously recognised off-balance sheet will be accounted for as a right-of-use asset and lease liability. This will bring more transparency about a company's lease commitments and change key financial metrics such as gearing ratios, asset turnover and EBITDA, according to an explanatory note from KPMG.

The legislative change will also pose challenges beyond financial reporting. Not only will systems, processes and controls need to be modified, but companies will have to assess and manage the impacts to things such as debt covenants, credit ratings, leasing strategy, impairment testing, and tax-effected accounting.

Retail companies are likely to see the greatest effect, along with those in mining, construction and aviation, according to John Likos, Morningstar's senior credit analyst.

"While lease obligations increase the debt side of the balance sheet, there will also be lease assets created simultaneously. Typically, these will amortise quicker than the lease obligations, which could lead to a reduction in shareholder equity," Likos says.

"However, when new leases are signed, the most likely scenario is a sharp, sudden increase in liabilities and interest expense in coming years."

This means company analysis needs to reflect exactly when leases are being signed or renewed, so these changes can be properly explained.

Wesfarmers (ASX: WES) will be among the most impacted companies. With core activities spanning supermarkets, discount department stores, office supplies, and hardware/home improvement, it has a considerable portfolio of properties on its balance sheet, including leases.

Woolworths (ASX: WOW) will also be affected, given its large number of store leases across Australia and globally.

Companies with other types of leases will be affected too, including Qantas (ASX: QAN) through its aircraft leases.

However, Morningstar's equity analyst covering Woolworths and Wesfarmers, Johannes Faul, says "we don’t expect a material impact on our fair value estimates ... our ratings are not expected to be affected by the changes in the treatment of lease obligations".

Likos notes that lower rental expense numbers will "drive higher EBIT and EBITDA numbers, higher interest numbers and higher amortisation numbers".

"The impact will vary considerably from each company, so it’s impossible to apply a blanket conclusion to any sector with regards to magnitude of change," he says.

This change highlights the importance of expert company research, with Morningstar analysts already factoring these lease provisions into their analysis of key accounting metrics.

Not bad news

One potential benefit is that lease expenses might decrease now that they're being brought on balance sheet, and fewer onerous terms must be accepted to make them qualify as "off-balance sheet".

"On the other hand, we might see a shift to shorter-term leases to minimise the amount of debt that hits the balance sheet. Management and boards will now likely spend more time on leasing decisions, determining whether to lease or not to lease is the best course of action," Likos says.

He also suggests company management and boards will give more in-depth consideration on how these changes will affect personnel incentives, such as bonuses.

Discount rate dilemma

Likos sees the discount rate dilemma as a considerable implementation challenge: "I am referring to the fallout from when the rate used to discount future lease obligations is fixed at the time of the lease signing."

The International Financial Reporting Standards Foundation has proposed companies use the marginal cost of borrowing.

"For example, let's assume a retailer locks in a 15-year lease for its operations. In today's environment that retailer might borrow at 5 per cent, so they would use 5 per cent as their discount rate," Likos says.

"However, in three years, a retailer of identical creditworthiness locks in an identical lease arrangement. However, due to the underlying interest rate market having repriced higher during that period, they borrow at 7 per cent, which becomes their discount rate.

"Both retailers are paying the same amount of lease expenses, however, the second retailer has a lower discounted lease obligation on its balance sheet."

In terms of discounted cash-flow valuations, he doesn't anticipate any material changes, "because the changes shouldn't impact cash flows, except maybe tax numbers".

"Other relevant metrics, on the other hand, will be impacted, including return on equity, and debt-to-EBITDA ratios."

Likos also reminds investors that the above changes are "all in the context of leases greater than 12 months, as those less than 12 months aren't included in the calculations".

"In summary, I expect net debt and gearing levels to increase, EBIT and EBITDA to increase and profit before tax to fall. Although, this may not always apply as it will be company-specific."

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Glenn Freeman is a Morningstar senior editor.

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