Corporate management have significant discretion in how they disclose operating lease obligations on the balance sheet. Specifically, management can choose the discount rate used to calculate the value of these operating lease obligations.
I’ve identified two companies that use unusually high discount rates to reduce and, perhaps, understate their reported operating lease burden. JC Penney (JCP) and Diversicare Healthcare Services (DVCR) are in the Danger Zone.
A new accounting rule added nearly $3 trillion to corporate balance sheets in Q1. Operating lease obligations, formerly buried in the footnotes, must now be reported as a liability– and corresponding right of use asset– on the balance sheet.
How Discount Rates Impact the Balance Sheet
Capital leases effectively act as debt to own the underlying asset leased. A simple analogy is taking out a loan to purchase a car or home; payments are made periodically and, at the end of the term, the asset is owned outright with the loan repaid.
Since operating leases are a form of debt, the lease payments running through income statements represent, in effect, a combination of depreciation and the implied interest payment for the debt. I use the term “implied” to describe the interest payment because there is no official interest payment. There is no official interest rate for the unofficial debt either.
A company can lease assets in one of two ways: capital leases or operating leases.
Just as a car is a crucial long-term asset to a household, companies often rely on leases to finance key assets for their business. Retailers often lease the real estate for their stores, and airlines almost exclusively obtain their planes through leases. These leases often cover long time periods (sometimes as long as 99 years), so in effect they function, economically, as a form of debt.
Operating leases do not transfer ownership of the underlying asset, and payments are made for usage of the asset. A simple analogy here is leasing a car from a dealer; the lessee makes payments for the right to use the car, but does not gain equity in the car itself and will not own the car at the end of the lease.
Under the new FASB rule, companies are required to estimate an implied interest rate. This interest rate is used to discount future lease obligations to their present value, i.e. the operating lease liability they report on the balance sheet. This methodology creates two significant issues:
A company that is already at a high risk of bankruptcy will have a high implied interest rate. This high interest rate means the company will heavily discount future lease obligations, reducing its reported lease liability on the balance sheet. As a result, a high-risk company will appear to have lower liabilities than an equivalent company with less credit risk.
Under the new FASB rule, companies have significant discretion in how they determine the discount rate. As long as it can plausibly justify the value to regulators, a company can use an artificially high discount rate to reduce its reported lease liability.
In order to prevent these issues from distorting my cash flow and valuation models, I use a standardized implied discount rate, 5.1%, across all companies. The 5.1% discount rate equals the mean-reverting weighted average cost of debt for the ~ 2,800 companies my firm covers. By using the same discount rate across all companies, I ensure that the operating lease assets and liabilities are more comparable between companies.
Why Discount Rates Matter
Just as a car is a crucial long-term asset to a household, companies often rely on leases to finance key assets for their business. Retailers often lease the real estate for their stores, and airlines almost exclusively obtain their planes through leases. Since operating leases are a form of debt, the lease payments running through income statements represent, in effect, a combination of depreciation and the implied interest payment for the debt. This high interest rate means the company will heavily discount future lease obligations, reducing its reported lease liability on the balance sheet. By using the same discount rate across all companies, I ensure that the operating lease assets and liabilities are more comparable between companies.
Lease Commitments Increase Bankruptcy Risk: Most of the short-term bankruptcy concerns have focused on the $123 million in principal and interest payments that JCP owes on its debt in 2019, but Figure 2 shows that leases represent an even more significant concern. JCP has minimum payments of $190 million for non-cancelable operating leases in 2019, and while those payments decline going forward, they will remain a substantial burden for many years to come.
For JCP and ~ 2,800 other companies I cover that have operating lease liabilities, analyzing the operating lease disclosure in the footnotes is critical to a gaining a true understanding of their profitability and valuation. Accordingly, I will continue to analyze footnotes and adjust all reported operating lease assets and liabilities rather than just using the value on the balance sheet.
Below, I dig deeper into the lease footnotes and obligations for JCP and DVCR to better understand their impact on the risk and valuation for these companies.
JC Penney (JCP).
As Figure 1 shows, the difference between the reported lease liability and the lease liability I show for JCP is $457 million, or 120% of the market cap of the company. Investors who do not adjust JCP’s reported debt will have a distorted view of the company’s liabilities.
The company’s revenue has declined in 7 out of the past 10 years, and its return on invested capital (ROIC) fell to 0% in the trailing twelve months (TTM) period. The company barely breaks even on an operating profit basis, and its core business continues to decline.