Retailers with high rent expenses will soon be looking more leveraged than ever.
The Financial Accounting Standards Board, which sets out accounting standards for public and private companies, recently updated its position on operating leases, deciding the expense of rent should be detailed as debt on a company’s balance sheet. Today, operating leases are not listed by a company unless some kind of deferment or landlord agreement is in place.
While this change isn’t going into effect until 2019 and won’t affect a company’s earnings or cash flow, those with leases that make up a large portion of business, like retailers, will be unable to escape looking more leveraged, according to Wells Fargo.
“Simply put, the companies who pay the most rent expense (as a percent of sales) would generally see the most significant change to their balance sheet,” Wells Fargo senior analyst Ike Boruchow said in a note.
The bank calculated that retailers that will see the highest adjusted net debt with the new standards include Fossil Group Inc., PVH Corp., Hanesbrands Inc. and Sally Beauty Holdings Inc., but noted that these companies “already have a significant amount of balance sheet debt.”
Doing the math to figure out which retailers will see their leverage increase by the most, Wells Fargo said Gap Inc. and Urban Outfitters Inc. are at the top, along with DSW Inc. and Finish Line Inc.
Boruchow said all four of these companies would go from a net cash position to being leveraged between 1.5 and 2.5 times against its equity, should the rule change take place today.
“Obviously, the wholesale-heavy businesses in our group (where store rent is a much smaller component of cost structure) would experience the smallest impact,” Boruchow added.
But the change doesn’t only mean more debt for retailers.
Boruchow explained that the new accounting could be a plus for margin optics, because it could move some costs “below the line” of gross profits, as a portion of the lease costs will be counted as interest expense.
From this angle, retailers that pay the highest rent as a portion of sales will see their margin optics “improve most meaningfully.”
Boruchow also noted that “most stocks will look cheaper” when doing valuation calculations because retailers will be able to exclude rent from their earnings before interest, taxes, depreciation and amortization numbers.
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