Metal In the Cloud: Tech Companies Need to Watch Out for New Leasing Standard

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The new lease accounting standard will have an impact beyond the usual suspects of airlines and retailers, with even cloud computing providers taking a hit, thanks to their leases of computer servers.

“What people don’t seem to realize is that there’s actually a lot of metal in the cloud and somebody’s got to pay for it,” said Tim Gaumer, director of fundamental research at Thomson Reuters.
The Financial Accounting Standards Board approved the new lease accounting standard in February (see FASB Releases Lease Accounting Standard). It will take effect for public companies for fiscal years, and interim periods within those fiscal years, beginning after Dec. 15, 2018. For private companies and not-for-profits, it will take effect for fiscal years beginning after Dec. 15, 2019, and for interim periods within fiscal years beginning after Dec. 15, 2020.

The new standard will have the effect of moving operating leases onto the balance sheet for the first time for many types of companies. Operating leases are currently disclosed in the footnotes to financial filings. For businesses that have large numbers of operating leases, the new standard could make them appear more highly leveraged, decreasing profitability ratios such as return on assets and lowering earnings per share due to depreciation expenses.

“This is a form of financing that’s still pretty popular and it doesn’t show up on anybody’s balance sheet,” said Gaumer, who is a Chartered Financial Analyst. “They’re clearly disclosed in the footnotes, but it’s an off balance sheet method of financing, and hence its popularity.”

He pointed to a quote from Sir David Tweedie, the former chairman of the International Accounting Standards Board, who often joked, “One of my great ambitions before I die is to fly on aircraft that is on an airline’s balance sheet.”

“An analyst who follows airlines closely wouldn’t find this surprising at all when the rule is enacted in mid-December of 2018,” said Gaumer. “They mentally and in their spreadsheets have been incorporating this information because it’s not hidden; it’s in the footnotes. They can build that into their own model of how leveraged the company is. I wanted to focus on companies where it will be more of a surprise perhaps to the casual investor, and that’s what led me to tech. Most people don’t find technology companies that have a lot of leverage. Historically they haven’t. But operating leases have been used for a long time by retailers, airlines and hospitality companies.”

He pointed to companies like Amazon.com, whose Amazon Web Services unit sells unused server capacity for cloud computing. “Not all of this is in servers, but if you just look at their balance sheet, they’ve got about $8 billion in long-term debt, but they also have an additional $6 billion in long-term capital leases and $6.5 billion in operating leases,” said Gaumer. “So all of a sudden it looks like they have a lot of debt. Now they can manage it. They’ve got a lot of cash flow. They’ve got $65 billion in total assets. But when that six and a half billion dollars, or whatever it is in 2018, move onto the balance sheet, suddenly it’s going to look like a lot more leverage.”
He sees a similar impact on Salesforce, the online customer relationship management software provider.

“A lot of this is probably going into real estate,” said Gaumer. “Here in San Francisco, they seem to be putting their name on all of the buildings downtown. They’re growing rapidly, but their annual report in 2015 showed just $1.3 billion in long-term debt. They’ve got another half billion in capital lease obligations, so it doesn’t look that leveraged, but there’s another $2.3 billion lurking in the footnotes in operating lease obligations.”

Another tech company example is Box. “Box is one of the pure-play cloud storage solution companies,” said Gaumer. “It’s not profitable. It doesn’t even have a positive EBITDA, so generally you don’t go to the bank in a situation like that. But they’ve been effective in getting a lot of operating leases, $272 million worth. That compares to just $138 million in shareholders equity. They also have $41 million in debt, and some in long-term capital leases. You add that all up and the total debt to equity would be 2.3 times. That’s considered highly leveraged. Most companies, unless they’re in a really stable business, have a hard time leveraging over one times equity.”

However, he does not believe the cloud companies will take a big hit in the stock market once they make the necessary accounting changes.

“I think it’s just going to be a bit more of a surprise to technology investors perhaps than it would have been to somebody who follows airlines,” said Gaumer. “The thing that may hurt a little bit more is when you start to apply ratio analysis for operating efficiency. Look at return on assets. Not only does this add the amount of the lease to the liabilities side of the balance sheet, there’s a corresponding asset that gets recorded. So if you’re looking at a measure of operating efficiency like return on assets, now that denominator is increased, so generally they’ll be comparing something like pre-tax income or operating income to total assets. Well, you increase the asset side because now this has moved onto the balance sheet, and that return on assets declines quite a bit in some cases. Any investor who is running a screen looking for companies that generate good returns, some of these companies may fall off that screen, and not make it through anymore.”

So far, most companies are just in the preparatory stages of getting ready for the accounting change. Many will need to weigh whether it makes sense anymore to continue to lease their assets.

“If this is on the balance sheet, now it’s no more attractive or appealing than ordinary debt,” said Gaumer. “If ordinary debt is less expensive, they might replace it with that and just let this run off. I imagine they’ll choose whatever is the least expensive form of financing, whether that’s equity, debt or leases.”

The old lease versus buy decision may soon take on another dimension for many tech companies.

“It all comes down to the economics,” said Gaumer. “Now they are going to have to record depreciation under either scenario, so that reduces earnings again. What it does do is it takes operating leases out of its historical advantaged spot of being not recorded on a balance sheet.”

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