On Lease Obligations and Cash Flows

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Includes: DIA, IGTE, QQQ, SPY
by: Kenneth Hackel, CFA

This week, a prominent financial journalist was reporting on the cash flows of a well-known company, accentuating its strength and growth.

The reporter detailed the analysis of this public company by a firm which “specializes” in cash flow-based security analysis. However, as I looked into their analysis (which I have a hunch is a computer generated number, as they are a small firm, yet issue cash flow reports on every S&P segment) I discovered they neglected the effect of lease obligations, which for this company, was substantial. The company does produce healthy and consistent cash flows, and its credit strength allows them to sign large capital leases which, under Generally Accepted Accounting Standards (GAAP), appear on the balance sheet, as opposed to operating leases, which do not, but should. Thus, capital leases result in more conservative reporting as they are included in normal debt and leverage ratios. This is not always the case with operating leases, similar to other post-retirement benefits, like health care, which are not normally included on the balance sheet and are not pre-funded.

The problem lies in that operating lease payments are deducted as part of cash flow from operating activities (like rent), while the firm under the journalist’s analysis, due their financial strength, has signed the preponderance of their leases as capitalized lease obligations. In a well-known example on the subject, UPS (NYSE:UPS) leans toward capital leases, and FedEx (NYSE:FDX), operating leases, for delivery aircraft. After comparability adjustments (see below), the subject of the story’s free cash flows were not as impressive as in first blush, and hence the need for their standardization.

Even though capital leases are typically entered into by stronger firms relative to operating leases (when a choice is present), because principal payment reductions are considered a financing activity, while the interest portion of the lease is included under operating activities, they (the capital lease) often result in higher free cash flows for the stronger credit solely due to the accounting rules. This is in spite of what could be identical monthly lease payments for the same asset. Computer programs cannot distinguish this so the adjustments must be made manually. There could be other factors at work here related to taxes and Special Purpose Entities, but I’ll ignore those for purposes of this example.

Such classification issues are not uncommon and often distort comparability in addition to fair value, if the analysis is based off of free cash flows. This is because free cash flow is most commonly defined as cash flow from operations and asset sales minus capital spending and preferred dividends. Because cash flow from operations are enhanced under finance leases, so too are free cash flows.

It is quite possible, therefore, weaker credits are being unjustifiably punished, due to their handling of, and ability to sign, capital leases.

iGATE Corporation (NASDAQ:IGTE), a firm which filed its June 30, 2010, 10-Q today, shows the principal payment on the capital leases as a separate line entry. Large firms will combine their principal payment reductions (bonds, bank debt, leases) in the Statement of Cash Flows (financing activity) under a heading such as “repayments of borrowings.”

Although capital lease obligations are small for IGTE, for other firms, like UPS and many others (including that subject company), it is significant. The investor must carefully understand the debt footnote and related entry on leases to grasp the real free cash flows, without which, an accurate assessment of fair value cannot be determined. This is because the growth rate in, and stability of, free cash flows, will be incorrectly computed without understanding the accounting for leases. (Click to enlarge)

Source: iGATE Corporation 10-Q (Edgar Database)

Disclosure: No positions