Takeaways From Last Week’s Digest: IFRS 16

We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback! Click here to receive both posts weekly via email.


Our weekly readers know that we have a few contributors who share notes with us on conference calls that they read.  One of those contributors is Erick Mokaya, a talented young analyst based in Europe.  Last week Erick shared a quote that he picked up in a Tesco earnings call about IFRS 16.  Here was the quote:

“IFRS 16 has got a lot of complexity, not only in terms of the going forward implication but the actual point of implication. And it will change very significantly the way that all of us look at the balance sheet and the P&L, as a result, no change to cash clearly, because it’s a no economic change…We’re spending a lot of time thinking through it.” —Tesco CEO Dave Lewis (Retail)

This week I asked Erick to write a brief explanation of IFRS 16 for our readers.  The new accounting standard affects lease treatments and is likely to have a significant effect on financial statements in a variety of industries.  Below is Erick’s work.

I would also like to mention that Erick is currently looking for an entry level role at a buyside investment firm (likely in Europe but he is flexible on location).  I have been extremely impressed with Erick’s work and give him a whole-hearted recommendation.  If you are looking for a bright, dedicated, diligent young analyst please respond to this email and we will connect you with Erick.


IFRS 16: A New Life for Leases

Off-to-on Balance Sheet

Deep in the throes of the Great Recession, former International Accounting Standards Board (IASB) Chairman Sir David Philip Tweedie, in an oft-cited quote from a speech at The Empire Club of Canada, remarked that: “one of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.” His remark was motivated by the fact that most airline companies use operating leases that appear as off-balance sheet items. Notably, the IASB estimated that although 2014 total leases around the world were worth around US$3.3 trillion, only less than 15% of these appeared on balance sheets as they were classified as finance leases. The rest, classified as operating, only appeared in the notes and were considered off-balance sheet.

Earlier this year, Tweedie´s wish came true as the IASB issued IFRS 16 on leases that is meant to blur the lines between finance and operating leases bringing more of the latter onto the balance sheet. A month later, the US Financial Accounting Standards Board (FASB) issued an Accounting Standards Update(AUS) meant to deal with the same. It has been a long and tedious road to changing the accounting for leases. As regards convergence, the new approaches by the IASB and FASB changes are similar in most respects except that the FASB allows the distinct treatment of former off-balance sheet items by the lessee. The IASB does not expect this to result in significant material differences in the resulting financial statements.

Key Implications

IFRS 16 will replace the current IAS 17 on leases. The main change is that classification of leases as finance or operating lease will be eliminated for lessees. All leases are to be treated similar to finance leases in IAS 17. The new standard becomes effective from 1 January 2019. (Earlier implementation is allowed as long as IFRS 15 Revenue from Contracts with Customers is also implemented). Companies can choose between a full retrospective approach or a modified retrospective approach in implementing the standard. Lessors will remain generally unaffected and will continue to classify leases as finance or operating. Leases for a short period of time (12 months or less) and those of assets of low-value are exempt. The key implications on the 3 key financial statements are below:

  • Expanding Balance Sheets: Companies will recognize the present value of lease payments as lease assets or PPE. Lease payments when made over time are recognized as financial liabilities. The result is an increase in assets and liabilities with companies with significant off-balance sheet assets to be affected. Further, there may be a slight, mostly insignificant, decline in equity.
  • Realigned Income statements: Lease expenses relating to operating leases in IAS 17 which have treated an operating expense will now be charged as depreciation on leased assets and interest expense on lease liabilities (finance cost). As a result, EBITDA and EBIT will increase but with little to no effect on profit before tax. While depreciation can be stable, interest expenses tend to be front-loaded and taper off as the lease period nears the end. Total expenses will therefore decrease over the period of the lease.
  • Unchanged CashFlow Totals: Cash outflows from operating leases that were previously taken to be operating expenses will be treated as financing activities. The new IFRS is expected to have an increase in cash from operating activities with an offsetting decrease in cash from financing activities leaving total Cashflows will not change.

As a result, financial ratios will be affected especially the leverage ratio and, asset turnover. Companies may incur additional costs in implementing the new standard also but the IASB expects the new standard to require no more data as is needed for IAS 17 although the data collection may need to be more frequent. Businesses will also have to reconsider leases as a financing option also. Debt covenants may need to be adjusted while costs of borrowing may be affected. Notably, there are some disclosures that need to be made even before IFRS 16 becomes effective.

Changes ahead

What are the benefits of the new lease standard? The key benefits lie in financial statements that faithfully represent the underlying economic transactions more faithfully with an additional advantage to improved comparability across companies. IASB Chairman Hans Hoogervorst puts it well in the press release[i] for IFRS 16 that it is meant to help end “the guesswork involved when calculating a company’s often-substantial lease obligations.” This guesswork is where analysts themselves rather than the companies try to estimate the amount of operating leases and liabilities to add to the balance sheet to make the financial statements give a better picture of the health of the company. Further, it will “provide much-needed transparency on companies’ lease assets and liabilities” and “improve comparability between companies that lease and those that borrow to buy.”

Companies that would be most affected are those in industries prone to off-balance sheet financing in industries like airlines, Travel, Transport and leisure, and retailers with the IASB estimating that half of all listed companies will be affected. Some of the companies that may be affected like Tesco are beginning to assess the impact. In the last financial year, Tesco had £17.3 billion worth of non-current liabilities on the balance sheet with an additional £13 billion of non-cancellable operating lease commitments disclosed in the notes.


In sum, IFRS 16 presents a significant shift in accounting for leases and investors and analysts alike would do well to pay attention to its effects on financial statements and business practices. Further, we would tend to agree with the closing comment from the panel at the joint ICAEW & IFRS Foundation Conference discussing the new standard that “IFRS 16 is a force for good.”
[i] Press release at http://www.ifrs.org/alerts/pressrelease/pages/iasb-shines-light-on-leases-by-bringing-them-onto-the-balance-sheet.aspx

Takeaways From Last Week’s Digest 10.3.16

We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback!  Click here to receive both posts weekly via email.

1) September economic data could be pretty strong

Readers may have noticed that the macro commentary section of our weekly piece has swung increasingly positive since the middle of the summer.  In our July 22 digest we highlighted a quote from Halliburton’s CEO, Dave Lesar, that “animal spirits are back in North America.”  While Lesar was primarily referring to the energy sector, there have been plenty of quotes in other industries that support the idea that these “animal spirits” are filtering more broadly across the economy.

Last week we highlighted some quotes from consumer facing companies that also continue to say that the consumer is showing strength.  Industrial companies have also noted that inventories have been destocked.  Both of these are preconditions to inventory restocking, which would eventually filter into the economic data as above trend growth if it does materialize.

Animal spirits have been missing from the US economy since the financial crisis, but now that we are 8 years removed from Lehman’s collapse, the emotional memory of that panic is fading further away from view.  While that does not mean that a burst of speculative fervor or heavy consumption is necessarily overdue, the conditions are right for an upside surprise in the economy.  The economy has struggled for the last 24 months and this has led growth expectations to decline significantly.  A return to more normal consumption habits would be surprisingly strong.

A strong economic surprise doesn’t necessarily have to fuel a large rise in stock prices though.  The level of pessimism about the economy and markets is high, yet valuations are still beyond extreme levels.  In past historical periods the levels of pessimism that we currently see would likely have been matched by low teens or perhaps even single digit earnings multiples. Because earnings multiples are significantly higher today, a positive surprise in the economy could actually lead to a decline in securities prices if it is met with rising interest rates.

There is also the possibility though that a better than expected economy could lead to a 1928 or 1999-like situation for markets in which the economic cycle crests with an extreme level of speculation in securities markets.  We continue to believe and hope (as citizens) that policymakers will not allow this to happen.  However, by continuing to prop up markets, it may already be too late to avoid this.

2) The financial services industry is fatally impaired by low interest rates

Nearly all revenue generated by the financial services industry is in some way tied back to the prevailing level of interest rates.  We estimate that the industry is broadly structured for a normalized 5% interest rate environment.  In other words, the infrastructure that it takes to run the US financial services industry requires a 5% interest rate environment in order to meet the expectations of the labor and capital that has supplied itself to the industry.  Below a 5% interest rate, the amount of revenue that is generated by the industry is insufficient to pay the (inflated) salaries that were expected by those who are working in the industry and also insufficient to generate meaningful returns on the capital that has been invested in it.  As a result, the longer that interest rates remain below 5% the more that the financial services industry will continue to shrink.

Last week we highlighted a quote from Factset that shows the symptoms of low interest rates on the industry.  Factset is seeing an increasing number of hedge funds and small buy side firms go out of business.

” We had a record growth in new client acquisitions…but it was mixed with an increased cancellation rate that was what I would call market related. So, it was clients going out of business, hedge funds going out of business, some of the smaller buy side where they have been shedding employees…We definitely saw an increase in the quarter of the market-related cancellations in that buy side sector.” —FactsetDirector Global Sales Scott Miller (Financial Data)

While many may point to the shift to passive investment as the underlying cause of shrinking active management, we would argue that the move towards passive is in large part created by the low interest rate environment as well.  This is because fees become a greater percentage of expected returns when expected returns are low.  In a 10% return environment a client can easily bear a 1% fee.  However in a 4% return environment that fee becomes a greater and clearer burden.  In other words, if client portfolios had been rising in value by 9% per year for the last 15 years (instead of a level well below that) the passive movement would likely not have gained the traction that it has.

3) The Chinese government wants the cruise industry to succeed

We tend to take note any time that an international government has provided specific incentives to a single industry.  When any government puts public resources behind the development of anything, it’s usually a good bet that the government will get what it wants.  This has been particularly true in China, where infrastructure construction was highly incentivized for more than a decade.  During the early 2000s commodity prices boomed as China built roads and skyscrapers.

Now as the Chinese government attempts to shift the economy towards a more “consumption led” economy, investors should expect that consumption focused companies could benefit as much as construction focused companies benefited in the past.  To that end, a statement from Carnival Cruise Lines caught our attention last week:

“cruise is in the 5 year plan for China. So that means the government has committed to developing the Cruise industry. The reason for that is pretty self-evident. We’ll employ, overall with port development and infrastructure, and supply chain, and training as well as ship building that will employ millions, and millions, and millions of Chinese. So the government is very interested and they see cruise as an economic engine going forward. So you’ve got the support of the central government and the various provincial municipal governments, so that’s very important.” —Carnival Cruise Lines CEO Arnold Donald (Cruises)

We are personally skeptical that the Chinese government can shift the Chinese economy without generating serious instability, but some industries are bound to benefit.  The Cruise industry could conceivably be one of them.

Takeaways From Last Week’s Digest 9.26.16

We’re continuing our new experiment this week running a weekly post each Monday to expand upon the quotes that we gather in our weekly digest. The weekly digest is intended to be an unbiased view of what we are hearing from management teams, and our Monday piece will try to interpret those views and hopefully help steer readers towards insights that can have a real impact on investment decisions. This is a pilot project, so please give your feedback!  Click here to receive both posts weekly via email.

This week we’ll focus on takeaways from last week’s Fed meeting. By now there has been plenty written about the Fed, and we know that many readers suffer from Fed fatigue, but the Fed matters. Its actions are fundamental to the pricing of securities markets and changes in its policies have dictated economic cycles for nearly 100 years. Here were a few insights from last week’s press conference:

1) The Fed is waiting for the whites of inflation’s eyes

Yellen’s new explanation for delaying the increase is that “the economy has a little more room to run than might have been previously thought.” While this is an ambiguous statement, we (and the market) have taken this to mean that the Federal Reserve does not expect to meaningfully raise interest rates until inflation returns above its 2% target rate.

Even though Janet Yellen explicitly said that “I’m not in favor of the whites of their eyes sort of approach,” it looks more and more like this is exactly what the Fed is looking for. The Fed appears to have delayed raising rates based on a single day 2% decline in the stock market in mid-September. When the board is that jittery, it suggests that the Fed will not raise rates meaningfully until it believes that it has a good reason to.

2) Watch for changing perceptions of the neutral rate

The Fed now appears to be focusing in on a concept of the “neutral rate” for interest rates. Yellen described this as “the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel.”

It looks like the Fed believes that the current neutral rate is very low. Since the beginning of this year, Yellen seems to be buying into the idea that we are in a “new normal” economy. She explicitly used this terminology in her press conference: “we’re struggling with difficult set of issues about what is the new normal in this economy,” and also voiced concern about longer term economic growth: “we have further written down our estimate of the longer run normal growth rate. And with that reflects is in assessment that productivity growth is likely to remain low for an extended time.”

The neutral rate is not something that is set in stone though. It is something that is highly theoretical, subjective and something that cannot be calculated. For this reason the neutral rate is subject to the same revisions that any other Fed indicator is, if not more.

3) The Fed is under increasing political pressure

Although the Federal Reserve likes to champion its independence, in reality the Fed does not operate in a political vacuum and historically has yielded to the demands of the President and Congress, because it knows that is only independent as long as the government allows it to be.

Ahead of this year’s presidential election, the Fed is under increased political scrutiny. This could go away after the election, or it could potentially get worse if an adversarial President is elected.  Either way, Yellen was asked multiple times about political motives and gave an impassioned response to one question:

“I have no concern that the Fed is politically motivated, and I will assure that you will not find any signs of political motivation when the transcripts are released in five years. We– I–It is important that we maintain the confidence of the public, and I do believe that we deserve it.”

Even if the Fed is not explicitly acting with political motivations, it cannot escape politics though. Its actions create economic winners and losers and as a result it will always be tied to the goals of elected officials. There is no such thing as an interest rate that is best for all citizens. While a low interest rate may promote near term economic growth and inflation, economic growth and inflation at all costs are not necessarily good for all Americans. Property owners benefit at the expense of lenders and wage earners in an environment in which GDP growth is allowed to exceed wage growth and interest rates. The best that policymakers can do is engineer a fair interest rate that properly balances the interests of varied stakeholders in the economy. When one set of stakeholders benefits more than another there will tend to be a political response, which is what we may be seeing in this election.

4) Beware of Commercial Real Estate

Yellen did pay lip-service to the idea that low interest rates could lead to asset bubbles in her press conference, but felt that in general asset valuations are not out of line with historical norms.

“interest rates both here and in advanced countries around the globe appeared to be very low. And that is an environment that, if we do have to live with that for a long time, we have to be aware that it does give rise to a reach for yield as individuals and investors seek to, perhaps, take on risk or lengthen maturities to seek higher yields…Overall, I would say that the threats to financial stability I would characterize, at this point, as moderate…In general, I would not say that asset valuations are out of line with historical norms”

While we’re not sure how Yellen justifies the assertion that “asset valuations are not out of line with historical norms” it was interesting that she did specifically mention Commercial Real Estate as one area of concern.

“there are areas my colleague President Rosengren is focused on commercial real estate where price to rent ratios are very higher, or cap rates are very low. And that’s something that has caught our attention…We’ve recently issued new supervisory guidance pertaining to commercial real estate. I would say in the area of commercial real estate while valuations are high, we are seeing some tightening of lending standards and less debt growth associated with that rise in commercial real estate prices.”

Especially at this point in the business cycle, we would strongly caution investors in Commercial Real Estate to take this information into account. If the Federal Reserve chooses to target Commercial Real Estate as a sector that is overheated, it is inevitable that the sector will ultimately be slowed by the pressure of the Central Bank. It is completely within the Fed’s power to slow the Commercial Real Estate market.