Thursday, April 23, 2009

Fixed Costs Not So Fixed

We have always advocated that investors seek out future operating lease payments that a company has agreed to. Under ordinary circumstances, these payments are fixed obligations, like debt payments, and should be treated as such. (For a discussion of why this is the case, see here.) Under the exceptional economic malaise with which we are currently afflicted, however, lessors appear willing to allow lessees to re-negotiate these contracts, even for financially healthy lessees!

Consider Build-A-Bear (BBW), the make-your-own-stuffed-animal retailer. In February, the company announced it had been able to improve store lease terms. In its recently released 10-K, we got to see the magnitude of that reduction. Here's a graph depicting the dollar reduction in future lease obligations from what they were last year:

By my calculations, this changes BBW's debt to total capital from 64% to 57%, and reduces its lease payments for 2009 by an amount greater than BBW's entire net income for 2008! 

If these had been debt payments instead of lease payments, would BBW have been able to reduce the amounts so drastically? Unlikely, as this is not a company in dire straights: assuming even a catastrophic shortfall in revenues in the near future, it currently has enough cash on hand to cover lease payments for the next year. 

It appears that owners of assets (e.g. land/building/mall owners) are willing to share the pain of this recession with even healthy tenants, perhaps to build goodwill or for competitive reasons. Investors should be on the lookout for companies that have been able to reduce their cost structures, even when it appears that those costs are fixed!

Disclosure: None


Unknown said...

Hey Saj, I understand that operating leases are discounted by the cost of debt to determine the present value. Why is the cost of debt and not the overall cost of capital, given that the company will use its future capital structure (equity and debt) to pay for these future obligations?

Saj Karsan said...

Hi skoper,

It's discounted with the cost of debt because the lease amount IS debt. It's akin to buying an asset and financing it completely with debt: those debt payments would obviously be discounted at the cost of debt. Make sense?