This year has seen many companies conduct sale and leaseback transactions to raise money to cope with the impact of the Covid-19 pandemic. But what are they and are they good or bad for shareholders? Like many things in the world of finance, it depends.
What are sale and leasebacks?
It is when an owner of an asset such as a building or piece of equipment sells it to raise cash and at the same time agrees to rent it back from the buyer.
Sale and leasebacks have been commonplace in sectors such as retail and airlines for years, but have soared this year as companies have scrambled to raise cash to pay their bills as lockdowns have caused income streams and cash resources to dry up. Without sale and leasebacks some businesses, such as easyJet (EZJ), may not have survived until now.
The advantages
A big benefit of a sale and leaseback is that it allows the company to raise cash by realising the value of some of its assets. This can often be a much better and cheaper way than asking banks or shareholders for more money.
While it may no longer own the asset by agreeing to rent it back (the leaseback part of the transaction) it can keep on using it in its business while passing on the maintenance of it to someone else.
The disadvantages
It may well have been the case that a company owned an asset outright without any debt attached to it (a bit like a home with its mortgage paid off). When it sells it and rents it back it will be signing up to pay cash rents perhaps for a very long time.
These extra expenses can reduce a company’s profits, but they also crucially increase its fixed costs and operational gearing. If the company’s rent bill gets too big relative to its revenues and profits then a sale and leaseback can leave a company vulnerable to a downturn in trading. Retailers such as Woolworths and Debenhams are classic examples of businesses where the value was stripped from their property assets, leaving them with rental expenses that it could not cope with when a recession hit.
The other key disadvantage is that once the asset has been sold, the company can no longer benefit from any appreciation in its value.
Are they good or bad for shareholders?
There is no right answer to this as it depends on the nature of the transaction. You need to look at each one individually.
Not so long ago, sale and leaseback transactions could give less diligent investors a false impression of company health. The cash received from the sale went on the balance sheet, but the obligations to pay rents in the future did not.
That has all changed with a new accounting standard (IFRS 16) where the value of the rented assets (the right of use to the renter) and the value of future rent liabilities have to go on the balance sheet. This gives investors a much more realistic view of the assets a company is using and the liabilities that it has (if you want to read more about this then check out my articles on the subject from October 2019).
When you are looking at a sale and leaseback you need to consider the following issues:
- Is the asset being sold for a profit or a loss? The company will usually tell you this, but you can work it out by comparing the net cash proceeds of the sale (cash received less the cost of selling) with the net book value of the asset on the balance sheet. A big profit may be a sign that the management has been a shrewd seller and has realised some value for shareholders. Selling at a loss may be a sign of a distressed sale and a company desperate for cash. It may also be a warning sign of dodgy accounting and of assets that are being underdepreciated and profits overstated.
- The terms of the rental agreement. Check out how much rent the company is paying and for how long. Are there any break clauses in the rental agreement? Can the company extend the agreement? Are the rents fixed or do they increase every year or periodically? You might not get all the answers, but you need to be aware of a struggling company signing up to very long rent agreements or one where the agreement could be too short, and disrupt a business in the future if it loses the right to use an asset. You also need to get a feel for whether the company has the revenue base and profitability to cope with any extra rent expenses it takes on.
- The impact on the balance sheet. The right of use asset and liability can often be similar numbers. Pay attention to the size of them relative to the balance sheet of the whole and its potential impact on its financial strength.
- What is the cash being used for? Using it to stop bankruptcy is not a great sign. Realising substantial asset value is something to be happy about, as is raising cheap money to invest in attractive projects.
We will now look at a number of real world examples of sale and leasebacks to highlight some of the key analysis points you need to be aware of and help you to work out whether a sale and leaseback is a good thing to do for a business.
Tesco: raising money to make bad investments
Between 2005 and 2014, Tesco (TSCO) raised over £11bn from selling its supermarkets and renting them back. It used the cash to invest in its supermarket empire across the world, opening new stores. Most of this money was wasted as Tesco’s profits collapsed. Tesco’s return on capital over the period went from 15 per cent to less than 8 per cent.
The sale and leasebacks were a sign of the company’s weak free cash flow generation at the time and the cash raised was invested in poor assets. The company had to spend many years clearing up the mess and has only got back on track recently.
Ted Baker: Selling London office for a good profit and flexible rent
Fashion retailer Ted Baker (TED) is going through a difficult time and has raised cash to help with its recovery plan. It has sold its London head office for a healthy profit and realised a substantial amount of cash. It has not tied itself into a long rental agreement and has given itself the flexibility to find new offices that suit its needs going forward. This looks like a reasonable outcome for the business.
Ted Baker London Office | £m |
Net cash proceeds | 72 |
Net book Value | 56.6 |
Profit | 15.4 |
Right of Use Asset | 9.2 |
Lease Liability | 9.9 |
Annual Rent to Pay | 3.25 |
Minimum Rent period (years) | 2 |
Cumulative Rents to pay | 6.5 |
Source: Ted Baker/Investors Chronicle
The company has a break clause after two years, which would mean £6.5m of cumulative rents to pay, but the lease liability, which shows the present value of future lease payments, suggests that it may rent it for three years.
B&M European Value Retail: Selling new warehouse for a big profit
B&M (BME) spent three years and £103m building a new warehouse facility in Bedford to help it to supply its target of 950 UK stores. It sold the asset earlier this year for a healthy profit and raised a substantial amount of cash to pay a special dividend to shareholders.
B&M Bedford | £m |
Net Cash proceeds | 152.7 |
Net book Value | 103.7 |
Profit per IFRS 16 | 49 |
Adjustment to Right of Use Asset | -32.1 |
Profit booked in Comprehensive Income | 16.9 |
Right of Use Asset | 66.4 |
Lease Liability | 98.5 |
Source: B&M
This disposal shows some interesting aspects of lease accounting. Here B&M is taking a large chunk of the profit (as per IFRS 16) to reduce the initial right of use asset of the warehouse on the balance sheet. The £32.1m will be spread over the length of the lease agreement (20 years in this case) to reduce the lease depreciation. So instead of realising the £32.1m of profit upfront it will benefit from it for the next 20 years. In terms of B&M’s annual profit the impact will be negligible.
I could not find any information as to how much rent B&M will be paying, so I had a go at estimating it. I know that the present value of future lease payments is £98.5m. I also know from the company’s annual report that the average discount rate it uses on property leases is 5.08 per cent. I then just looked at what annual rent bill over 20 years would give a present value of £98.5m. The answer is £7.96m. This is not far from the £7.8m from multiplying the gross sale proceeds of £153.8m by 5.08 per cent.
This is a bit rough and ready but on that basis, B&M is received £152.7m of cash in March and will pay out around £160m in rents over the next 20 years, which looks like a reasonable exchange. However, the working assumption must be that B&M will want to use it for longer than 20 years and so the actual payments are likely to be much higher.
Cineworld: Raising cash to pay a special dividend while significantly increasing its rent bill
Even before Covid-19, Cineworld (CINE) looked as though it had seriously overstretched its finances with the acquisition of Regal in the US in 2018. It then went and sold some cinemas for $542m, which was used to pay a special dividend to shareholders in 2019.
Anyone who had been crunching the numbers at Cineworld will have noticed that its rent bill as a percentage of revenues had been rising for a number of years and was beginning to look dangerously high at the end of 2019 and represented a significant drag on profitability in the event of a downturn.
Woolworths in 2008 hit the rocks with a rent bill of 5.5 per cent of revenues and wafer-thin margins.
JD Wetherspoon: A sale and leaseback in reverse
Instead of selling pubs and renting them back, JD Wetherspoon (JDW) has been doing the exact oppositie in recent years. In order to reduce its rent bill and increase the asset backing of its business it has been using a substantial chunk of its annual free cash flows to buy the freeholds of pubs it had been renting.
JD Wetherspoon: Cash spent on buying freeholds and annual rent bill
£m | Cash spent on freeholds | Rent bill | Revenues | Rent as % of revenues | % of pubs leasehold |
2011 | 5 | 50.9 | 1072 | 4.7% | 57 |
2012 | 8 | 52.2 | 1197 | 4.4% | 56 |
2013 | 8 | 53.3 | 1289 | 4.1% | 56 |
2014 | 24 | 52.5 | 1409 | 3.7% | 53 |
2015 | 22 | 52.7 | 1514 | 3.5% | 51 |
2016 | 36 | 51.3 | 1595 | 3.2% | 49 |
2017 | 89 | 44.8 | 1661 | 2.7% | 43 |
2018 | 16 | 42.7 | 1694 | 2.5% | 41 |
2019 | 77 | 38.2 | 1819 | 2.1% | 39 |
2020 | 97 | 38.3 | 1262 | 3.0% | 36 |
Source: JD Wetherspoon/Investors Chronicle
I think this has been a good strategy, given that the bulk of value of being a pub operator comes from the value of the pub assets. If the pubs are owned by someone else then realising that value from trading them well – which Wetherspoons arguably has – is not possible.
The other key benefit is that owning pubs gives the operator the ability to sell poorer performing pubs and raise cash rather than being stuck in onerous lease contracts. This is the situation that Revolution Bars (RBG) has found itself in, which has led it to seek a Company Voluntary Arrangement (CVA) with its landlords.
Expect more sale and leaseback transactions
The trend is set to continue. Companies such as airlines will arguably still need to raise cash over the next year or so. Stronger businesses may seek to realise some asset value from their business to hungry property investors and pension funds looking for reliable long-term income-producing investments. Supermarkets have been doing a lot of selling recently and I would expect the new owners of Asda to raise substantial cash by selling stores to repay some of the debt they have taken on.
