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Off-Balance Sheet Debt – Invested Capital Adjustment

Monday, July 8th, 2013

This report is one of a series on the adjustments we make to convert GAAP data to economic earnings. This report focuses on an adjustment we make to convert the reported balance sheet assets into invested capital.

Reported assets don’t tell the whole story of the capital invested in a business. Accounting rules provide numerous loopholes that companies can exploit to hide balance sheet issues and obscure the true amount of capital invested in a business.

Converting GAAP data into economic earnings should be part of every investor’s diligence process. Performing detailed analysis of footnotes and the MD&A is part of fulfilling fiduciary responsibilities.

We’ve performed unrivalled due diligence on 5,500 10-Ks every year for the past decade.

Operating leases, unlike capital leases or debt-financed purchases, are not recognized on the balance sheet. The only trace of operating leases on the financial statements is as a rental expense that is bundled with other items on the income statement (part of this rental expense is an implied interest expense that we remove).

Any lease not meeting all the specific criteria of a capital lease is classified as operating. The current accounting rules provides lots of leeway for companies to classify a lease as operating instead of capital.

These different accounting methods do not reflect operational differences, so we convert all operating leases to capital leases to ensure comparability despite different accounting. We make this adjustment by adding the discounted present value of all required operating lease payments to our calculation of invested capitalThis adjustment also ensures that each company is held responsible for earning returns on all the capital invested in the business, not just the assets on the balance sheet.

Currently, the Financial Accounting Standards Board is considering a proposal to require all publicly traded companies in the U.S. to report the value of all operating leases longer than one year on their balance sheets. The proposed treatment would be similar, though not identical, to the way we treat operating leases.

Figure 1 shows the five companies with the most off-balance sheet debt added to invested capital in 2012 and the five companies with the most off-balance sheet debt as a percent of total assets.

Figure 1: Companies With the Largest Off-Balance Sheet Debt Added Back to Invested Capital

OBSDSources: New Constructs, LLC and company filings

Note: Figure 1 excludes companies with less than $500 million in total assets.

All ten companies in Figure 1 have physical stores all over the country that they lease, rather than buy. Airlines are also known for having significant off-balance sheet operating leases. Off-balance sheet debt affects a very broad range of companies. In the fiscal year 2012, 2,793 companies had off-balance sheet debt totaling nearly $760 billion. Dating back to 1996 we have found 33,749 instances of companies with off-balance sheet debt totaling over $7.3 trillion.

Having significant off-balance sheet debt does not always mean a company is a bad investment. Walgreen Company (WAG) had over $25 billion in off-balance sheet debt last year and earns our Neutral (3-Star) rating. According to its 2012 Form 10-K, WAG leased around 80% of its 8,385 locations. Its minimum obligations on these leases totals over $35.8 billion. By discounting these obligations to their present value, we arrive at WAG’s $25 billion in off-balance sheet debt.

In certain cases, the presence of off balance sheet debt can significantly alter the investment outlook for a company. Five Star Quality Care (FVE) had the highest ratio of off-balance sheet debt to total assets in 2012. FVE’s $2.3 billion in lease obligations, equivalent to $1.2 billion in debt, were added back to invested capital. Without factoring in this off-balance sheet debt, FVE would have had a top-quintile return on invested capital (ROIC) of 17%. By holding FVE accountable for this capital however, we see that its true ROIC is a much lower 6%, less than its weighted average cost of capital (WACC). Looking  at just GAAP data, FVE appears to be a profitable company. Factoring in the true amount of capital invested in the company reveals that on the contrary, it actually makes negative economic earnings.

Investors who ignore off-balance sheet debt are not holding companies accountable for all of the capital invested in their business. By adding back off-balance sheet debt to invested capital, one can get a true picture of the value that management is creating for shareholders. Diligence pays.

Sam McBride contributed to this report

Disclosure: David Trainer is long WMT. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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  1. varadha says:

    Terrific, yet simple analysis. I’ve always been a fan of ROIC as a measure of capital efficiency and believe that no size/growth outperformance can replace the quest for efficiency.

    Sort of like a big gas guzzling v8 that needs ever increasing gallons of fuel to keep its engine running

  2. David says:

    But Angie’s $90 per user acquisition cost is going to go away. That’s what their approach probably is. How would their outlook be if that $90 cost dropped down to a total cost of $3 per user?

  3. David:

    That would be great, but cost per user acquisition is not something that’s very easy for a company to fix. ANGI can slash their marketing budget to the bone, but then they would stop acquiring new members. They would probably lose members in fact, as their membership renewal rate is at ~75% and declining. If they cut marketing expense by ~95% as you seem to be suggesting, ANGI might be able to eke out 1 year of slight profits, but they would start shedding members and losing money very quickly. ANGI’s only hope is to keep its marketing budget high and hope it can reach the scale and brand awareness to be able to sustain its business while scaling back marketing costs enough to turn a profit. The fact that ANGI’s revenue growth is slowing down even as its marketing costs keep increasing makes it very unlikely it will achieve that goal.

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