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A fresh approach to value investing in
undiscovered, quality businesses.
“It’s EBITDA Jim, but not as we know it”

Chris Steptoe  looks at a new accounting standard that will change a number of reporting and valuation metrics.

 

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One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet”

Sir David Tweedie ‐ International Accounting Standards Board chairman – April 2008

 

There is a new frontier in accounting standards called AASB 16. This comes into effect for reporting periods beginning on or after 1 January 2019 (i.e. 31 December 2019 or 30 June 2020 year ends) and has the potential to change the way we look at key metrics such as EV/EBITDA, Debt/EBITDA, ROCE, Interest Coverage and even the price to earnings (PE) ratio.

 

What is AASB 16?

 

AASB 16 is the Australian implementation of the IFRS 16 accounting standard for leases. Effectively it means that Operating Leases (e.g. rental expense for a fashion retailer) will be treated as a capital item rather than an expense. This means that on the profit and loss statement (P&L), instead of having a single expense line (ie rent), the expense will be split between Depreciation and Finance costs. On the balance sheet, operating leases that were previously off-balance under AASB 16 will be on the balance sheet as a liability. An associated Right of Usage (ROU) Asset is the balancing asset entry.

 

The new Depreciation expense will reflect the depreciation of the ROU Asset on a straight-line basis over the lease contract period. The balance of the existing rental expense becomes a finance cost. The new expense calculated may not equate to the previous rental expense in a given year. In fact, in early years, the interest and depreciation may be higher than in later years, in which case NPAT will be different under the two scenarios.

 

This standard will impact the accounts for most listed companies, and for some, in a material fashion.

 

Metric Implications

 

Under the new standard, the operating lease expense (rent) previously reported above the EBITDA line will now be moved below the EBITDA line. Therefore, we are likely to see a potentially large increase in reported EBITDA. The EV/EBITDA multiple we have become accustomed to for an industry will suddenly seem a lot cheaper. But of course, that will just be a mirage.

 

Let’s work through an example for the P&L. Rent is no longer an expense item, while EBITDA has doubled, however the NPAT is the same (assuming that the depreciation and finance cost equates to the previous rental expense).

 

 

Before

Adjustment

After

Change

Revenue

100.0

 

100.0

0%

Rent

-20.0

20.0

0.0

-100%

Other Expenses

-60.0

 

-60.0

0%

EBITDA

20.0

 

40.0

+100%

Depreciation and Amortisation

-2.0

-16.0

-18.0

+large

EBIT

18.0

 

22.0

+22%

Interest

-2.0

-4.0

-6.0

+200%

NPBT

16.0

 

16.0

0%

tax

-4.8

 

-4.8

0%

NPAT

11.2

 

11.2

0%

 

However, even the NPAT and therefore PE ratio has the potential to be impacted. As mentioned above, the interest and depreciation may in fact be higher than the rental expense in earlier years. This has an impact on short-term reported NPAT. Macquarie Equities has suggested that Myer's EBITDA would rise significantly in 2019 as cash rental expenses were added back, but depreciation and interest on leases would more than offset these EBITDA gains, at least in the first few years, sending Myer's net profit into the red.

 

Is the DMX Portfolio impacted?

 

Some portfolio companies will be more affected than others. We expect Blackwall Limited (ASX:BWF) to show the biggest percentage movement in EBITDA. BWF’s subsidiary WOTSO is one of the largest co-working businesses nationally, and enters leases in relation to its WOTSO workspaces. Based on our discussions with Management, they intend to explain the position and the effect on the accounting profit and the balance sheet, but have noted that it won’t have any real cash flow effect to them. BWF will implement this new standard next financial year.

 

Sign of a quality company will be transparency

 

How companies report the new standard may give investors a chance to gauge the quality of the management team. We would expect transparent reporting with ‘before’ and ‘after’ AASB 16 numbers. If there are any Long Term Incentives (LTIs) based on EBITDA, we would expect them to be modified to take into the new standard. Failure to adjust would be a red flag that management are not aligned with shareholders.

 

For example, we understand 5G Networks Limited (ASX:5GN), which has performance rights (LTIs) based on achieving certain levels of EBITDA, will be reporting using AASB 16 in the current reporting period. This company has high leasing costs for data centres. The EBITDA hurdles for the LTIs (set before AASB 16) will now become a lot easier for management to achieve if not adjusted.

 

Key takeaways for us

 

With ASX companies required to adopt AASB 16 from 1 July 2019 (and some companies adopting it already) it is important to understand the changes now.

 

To a large extent, cashflows will not change as a result of the standard. This reinforces the importance of free cashflow as the key metric to follow.

 

As an Equities Analyst, I feel my job is going to get substantially more complex, but I can also see that opportunities arise as the market is slower to digest the changes to the EBITDA and NPAT lines that may occur. For instance, if the NPAT line is weak due to AASB 16 and the share price reacts negatively, but the free cashflows are strong, buying opportunities may arise.