Tuesday, August 7, 2012

Operating Leases Not Created Equal

As value investors, we're conditioned to immediately capitalize operating leases as debt. While that's the simplest way of handling them in order to derive a credible valuation, it leaves a lot to be desired. For one thing, the maturity of the leases can be a huge determinant of how large a "debt load" the leases actually represent. For example, compare the lease obligations of these two electronics retailers:

hhgregg's lease payments are due several years out, while more than half of RadioShack's will expire in just the next year and a half! Not only does this play a significant role in determining how risky these liabilities are, so too can it have a large impact on each company's strategy.

RadioShack, for example, has the option of shutting down a bunch of stores on short notice. (That's not what it's doing right now, but it does have this option should its turnaround not work as planned or should certain stores underperform relative to others.) GameStop is a company with a similar lease profile that has been taking advantage of this option in the face of lower sales as the video game console cycle gets long in the tooth.

hhgregg also faces sales pressure, as overcapacity in the flat-screen tv industry has lowered prices while demand for 3D and smart TVs has been nowhere near as strong as expected. But because of its lease structure, the company doesn't have the flexibility of closing the under-performers or lowering its occupancy costs. Instead, the company's strategy has to include adding new products to fill the void of its declining lines. This requirement can be seen in the company's recent announcement that it will be testing furniture and fitness equipment merchandise in a chunk of its stores later this month.

Debt maturities that are further out make a company safer; payments aren't due anytime soon. I would argue that the opposite is true for operating leases; the sooner they are due, the more flexibility the company has with respect to strategy and the less risky the liabilities. Capitalizing leases to arrive at one final "debt" number does not allow for this distinction.


Anonymous said...


I think the terminology you're using in this article is confusing. When debt matures it requires the company to make a (usually) large principle repayment. So the debt being "due" implies that a large outflow of cash is about to happen. When a lease expires, which is what I think you mean by the lease being "due", it means the opposite: the cash outflow obligation has *ended*. So that's why debt maturity being distant in time is good, and it's also why lease expiration being sooner rather than later is good.


Anonymous said...

Agree with aagold on this. RSH's structure is the preferred one. Think about the annual cashflows related to the least payments. If both companies renewed all of the their leases, they would each have relatively level annual cashflows related to their leases. The only difference is that RSH has the option to exit more of its leases in any given year than HGG does.

Saj Karsan said...

Looks to me like we're all on the same page here. Let me know which part of the article is making you think otherwise and perhaps I should correct.