Tower Private Advisors
- Relief rally in stocks
- Merger mania
- Ugly economics (more…)
Way back in 2002, when Sarbanes Oxley was passed, many hoped that it might mark an inflection point in that nasty bear market. I specifically remember thinking/hearing that the CEO and CFO having to sign off on financial statements might do just that. According to the internet (it must be true; it was on the internet), here is the timeline of the bill (colors correspond to the vertical lines in the chart below).
Liberally borrowed from the Wikipedia link above.
Thinking the passage of FinReg might do the same thing, I asked the fine folks at Strategas Research Partners–Dan Clifton, specifically, the firm’s Washington guy–to help us out.
In addition to his comments below on the subject, the firm also provided us with this nice overlay based on when the two bills were approved in Committee. (The green annotations are mine). So far, the similarity in the two lines is evident, but as Dan points out below, that was a different time, with the War in Iraq still in the future, etc.
Similarities: As you may recall the House and Senate were governed by different parties in 2002. The House, led by Oxley, has a mild plan. The Senate, led by Sarbanes, had a more aggressive plan. President Bush supported the House plan and with the 60 vote threshold required in a 51/49 Senate, investors assumed the more moderate plan would win out. The Senate passed the more aggressive version leading to a stand off between the House and Senate. Worldcom then declared bankruptcy, which occurred in the DC media market, and President Bush asked for a bill and told Oxley to allow the Senate to take the lead. This led to a more aggressive plan (one with higher costs to businesses). The S&P declined into the proceedings. It took more than 3 months later for the S&P to bottom out as investors digested the impact of the bill and investors became more bullish on the potential recovery. It is also important to note this ran into the run up of the War in Iraq which tended to overwhelm the other issues. Financial regulation occurred similar but over a longer period of time. The Worldcom event was the SEC action against Goldman Sachs, which led to more aggressive reforms. We also believe investors are at a similar point in the business cycle, looking for the upturn becoming self sustaining.
Differences: Financial regulation is more than 2,300 pages and we are still finding provisions we did not know existed. Sarbox was 60 pages and the main provision impacting cost was a couple of sentences. The financial regulation bill also outsources the details to regulators and spreads out the timeline in some cases as long as a decade. There will be continuing uncertainty but over time the banks can adjust to the costs.
The Economist featured a story in this week’s magazine–or as the Brits call it, newspaper–on a proposed accounting change. It was proposed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) on August 17, and it focuses on how leases are characterized.
Here’s the short-term version of lease characterization–and I’m playing loosey-goosey with this, too (if you’re an accounting type, feel free to clarify or correct by adding a comment below.) Basically, by having or not having certain characteristics–a bargain purchase option comes to mind–a lease can be characterized as operating or capitalized. That’s a critical difference, as an operating lease doesn’t show up on the balance sheet, per se, nor does the asset that’s being leased. A capitalized lease, in contrast, is considered long term debt, with an associated asset on the balance sheet, and that can have huge implications in corporate finance and investing.
The Economist cites a Pricewaterhouse Coopers study that, “found that it would add about 58% to the average company’s interest bearing debt.” Rent is paid on an operating lease while principal and interest are paid on capitalized leases. Those two items are found in different places on the financial statements: rent is part of operating income; principal and interest payments are not. “On the other hand, since rents will no longer be a running expense, operating earnings could see a bump upwards.” Also, that, “since the downturn, many companies are close to their maximum debt limits, and the new rules could push them over the edge.”
Thanks to Dave Whisler, CPA, for pointing out that, “one more consideration is that in many situations companies that in the past had been in compliance with their debt covenants will now be violating them. This means that banks and their borrowers will be in a different world than they are this year. You still have the same benchmark (debt covenant) but you are calculating ratios such as debt to equity using different components than what was used when the loan was originated.”
Here’s an example of one company that would be very affected. Walgreens (WAG), along with most other retailers, owns none (again, loosey-goosey) of its store buildings, but occupies them with operating leases; thus, there is no debt related to buildings on the company’s balance sheet.
A close look at its SEC 10-Q filing shows that its long-term debt is $2.35 billion (see below; click to enlarge). That gives it a very modest 13.5% long-term debt to capital ratio. Its operating leases, however, total $36.4 billion. A portion of that ($2.2 billion) is due in the next year and is considered a current liability, so long-term debt should be $34.2 billion (36.4 – 2.2) higher.
Complete table below.
Suddenly, a company conservatively positioned–i.e. with low leverage–is outrageously leveraged at 2.08x–or on an equivalent basis, 208%!
Unfortunately, the operating lease information is buried in the notes to the financial statements, which means that one can’t screen for high or low operating leases. It requires going through each company’s 10Q and searching for the data.
As our newest-minted earner* of the Chartered Financial Analyst† designation, Zach Higgins, pointed out, this shouldn’t be news to the analysts. They should have looked through to the notes and seen the financial impact. Zach’s right if the analysts do their jobs, but the same should be able to have been said about options expensing, and yet that produced plenty of softness in the big option issuers.
* Technically, Zach needs another year of experience before he can be a holder of the coveted designation.
† Just in case any one from the CFA Institute is trolling the internet looking for degredations of the integrity of the charter, Zach will not be a CFA. Instead, he will be a holder of the CFA® designation.
One would think that at least the cashflow impact would be nill since the cash effect of the reclassification is zero: the companies are still going to make the same payment. In fact, the statement of cash flows will be different. The statement is divided into three parts:
The cashflow associated with the operating lease is shown as an outflow in the operating section. A capitalized lease’s cashflow is shown as a cash outflow in the financing section. The operating section is considered the core of the business, since it represents what the company is set up to do (i.e. operate, sell books or machines or whatever). The financing and investing sections represent the way the company funds its operations.
So here’s the bottom line. Reclassifying from operating to capitalized will do the following:
We’re coming up on that treacherous time of year . . . September and October. It didn’t matter in 2009, because most were all beared-up for the Fall. This year also seems like the year of disbelief.
We’re in the worst of the four years of a Presidential administration–who’d have noticed?–according to history stretching back to 1900. Next year will be the third year, which has historically been the best. (It’s also the year when some say we meet the Four Horsemen of the Apocalypse, but we can worry about them when we see ‘em.)
As to seasonality, it has tended to be pretty mild in year 3, although it does suggest a lower low in September. Based on the lousy year so far, though, that’s only a 6% move lower.
For now, our thinking is that we stick with the consensus of our various services, which is to be modestly over-weighted to equities, but it would be hard to fault one who raised cash in anticipation of a lousy September/October. After all, it’s easier to make up for lost opportunities than it is to make up for lost losses.