There's A Lot Of Iron In The Cloud

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Includes: AMZN, BOX, CRM, IBM, LNKD, MSFT, UAL, URBN, WBA, WFM
by: Lipper Alpha Insight

By Tim Gaumer

Sir David Tweedie, then Chairman of the International Accounting Standards Board (IASB), in a 2008 speech to the Empire Club of Canada said, "One of my great ambitions before I die is to fly in an aircraft that is on an airline's balance sheet." Sir David may finally see his wish fulfilled, thanks to a recent rule change enacted by the Financial Accounting Standards Board (FASB).

Now for some green eyeshade stuff: under GAAP, leases fall into two categories, capital leases and operating leases. Capital leases give the lessee the use of the asset over most or all of its useful life. Its present value shows up on the balance sheet. However, operating leases show up only in the footnotes. That makes companies look less highly leveraged, increase profitability ratios like return on assets, and boosts EPS because there's no associated depreciation expense. But, beginning on Dec. 15, 2018, operating leases longer than 12 months will have to move onto the balance sheet, as capital leases currently do, recorded as both a liability and corresponding right-of-use asset. (FASB issued ASU 2016-02, Leases (Topic 842), February 2016.)

Will the impact be any more than merely cosmetic? Perhaps not much for sophisticated investors and analysts who have followed companies in the airline, hospitality (hotels and restaurant operators) or retail industries. They've likely been factoring these lease obligations into their analyses for years. So, we decided to look in some less obvious places - like the IT sector. To be even more specific, cloud computing. The cloud is just out there somewhere - right? Clouds are ephemeral, light and fluffy. Well, as it turns out, there's a lot of metal in the clouds of Amazon (NASDAQ:AMZN), Salesforce (NYSE:CRM) and other large data center providers.

Amazon.com has a 2015 year-end balance sheet that showed $8.235 billion of long-term debt vs. $65.444 billion in total assets and $13.384 billion in equity. It had an additional $5.948 billion in long-term capital leases and $6.517 billion in operating leases, of which $1.181 billion is due within a year.

Salesforce.com has an annual report showing $1.294 billion in long-term debt and an additional $558 million in capital lease obligations (with a present value of $498 million). However, it has $2.319 billion in operating lease obligations. In the case of Salesforce, much of its lease obligations are for facilities, which the company has been acquiring all over San Francisco.

LinkedIn (NYSE:LNKD) ended 2015 with over $2 billion of operating leases in place. If those obligations were added to the company's long-term debt of $1.1 billion, the total would reach nearly 12 times its 2015 EBITDA of $270 million. S&P, the ratings agency, categorizes total debt/EBITDA greater than 5.0 as "highly leveraged." Those leases shouldn't be a problem for Microsoft though. If the proposed acquisition is completed, LinkedIn's leases will join just $5.2 billion of Microsoft's (NASDAQ:MSFT) own but be covered by its $34 billion of EBITDA.

The fairly recently-listed cloud storage solutions company, Box Inc. (NYSE:BOX), does not yet have positive EBITDA. Even at that, lease providers have been generous. Compared to its smallish $498 million in total assets and just $138 million in shareholders' equity, it has $272 million in operating leases. Add that to its $41 million in debt and $14 million in long-term capital leases, and total debt/equity would soar to 2.3.

Even fairly staid old IBM Corp. (NYSE:IBM), a recent entrant to the cloud computing space, had over $6 billion in operating leases at the end of 2015, nearly half the level of shareholders' equity. Add that to the $33 billion in long-term debt, much of which has piled up due to borrowing used to repurchase shares, and its debt/equity ratio would be 2.8 - a large ratio for a tech company, or for that matter, a company in any industry.

Historically, it's been difficult to find tech companies with high debt/equity ratios. Banks and bond holders were hesitant to lend to tech companies, maybe due to the availability of cheap equity capital or perhaps because of the often more-volatile nature of their earnings. But for whatever reason, it appears no longer unusual to find high leverage in the technology sector. Once companies have to move operating leases onto the balance sheets, it will become more common still.

Of course, companies have been given plenty of advanced notice by FASB and many might replace lease obligations with other sources of financing, such as equity. But diluting existing shareholders may not be a popular action. Meanwhile, a growing awareness of this pending accounting change and its impact on balance sheets may one day surprise a few investors.

*Author Note: We chose to focus on cloud computing and technology companies for this article because we thought readers would find tech companies with a large exposure to operating lease obligations more surprising than airlines and retailers who are generally known to lease assets.

The Usual Suspects

Drug store retailer Walgreens (NASDAQ:WBA) has approximately $38 billion of operating lease obligations not "on the books." This represents more than half of total assets. If the total of these leases were moved onto the balance sheet, 2015 total debt would have been 7.6 times EBITDA.

Whole Foods Market (NASDAQ:WFM), the high-end grocery chain, has nearly $9 billion of operating leases, well above shareholders' equity of $3.8 billion. Add up leases, stick them onto the balance sheet, and suddenly the company goes from appearing to be unlevered, with no long-term debt to one with a debt/equity ratio of 2.4. Since lease obligations exceed total assets, adding them to the asset side of the balance sheet would drive the profitability ratio of return on assets (ROA) from a respectable 15.0% down to a ho-hum 5.9%.

More severely, performing this same exercise on Urban Outfitters (NASDAQ:URBN) would see its ROA plunge from 19.3% to 9.3%.

Turning back to Sir David's example industry, United Continental Holdings (NYSE:UAL), parent of United Airlines has nearly $20B of operating leases lurking in the footnotes to its financial statements. If we were to add that to the $9.7B of long-term debt and $0.7B of capital leases already on the balance sheet, its debt/equity ratio would balloon from 1.2 to 3.4 - a level most would consider very highly leveraged. United Airlines has nearly $20B of operating leases lurking in the footnotes to its financial statements. If we were to add that to the $9.7B of long-term debt and $0.7B of capital leases already on the balance sheet, its debt/equity ratio would balloon from 1.2 to 3.4 - a level most would consider very highly leveraged.