Retail's big property gamble

Thanks to a pretty dreadful Christmas performance – the weeks either side of the big day faring worst – Debenhams was forced to start the year with a 35 per cent profit downgrade. The resultant sell-off in the shares means the group is down more than45 per cent in a year, and trades on a rating and dividend yield that suggests the company is in trouble. Indeed, the pain for Debenhams is unlikely to ease in the short term, particularly as companies start to quantify the financial impact from next year’s introduction of International Financial Reporting Standard 16 (IFRS 16).

IFRS 16, the brainchild of the International Accounting Standards Board (IASB), provides guidance on how companies should “recognise, measure, present and disclose” leases in their accounts. The definition of a lease is broad, and refers to a contract that “conveys the right to control the use of an identified asset for a period of time in exchange for consideration”, although exclusions are made for leases where the term “is 12 months or less or the underlying asset has a low value”. Chief financial officers need to get their ducks in a row soon: IFRS 16 comes into effect for all annual reporting periods beginning on or after1 January 2019.

Although there are business-specific exclusions – for instance, leases used in oil and gas exploration – this new accounting standard will affect several industries, from airlines and hotels to restaurants, and (most importantly, for our purposes) retailers. The reasoning behind the new standard is simple: by taking leases onto the balance sheet, investors will be able to better understand a company’s assets and liabilities.

At present, establishing retailers’ lease arrangements for their physical store estates is not easy. Companies are not even obliged to list the total number of their leases in their financial results, and typically we need to turn to the annual report for the real detail. One noteworthy exception to this is Debenhams, whose full-year results last October acknowledged an investment in a new property management system to “prepare for the adoption of the new standard”. The group said it was currently assessing the impact of IFRS 16 on its “existing lease portfolio of approximately 250 property leases and other contracts”, while work performed to date included “consideration of the transition approach and collection of relevant data from different areas of the business”. And although Debenhams said the effect of IFRS 16 was “not yet practicable to quantify”, the group did flag the regulation’s likely “material impact on the balance sheet” as both assets and liabilities will increase. The impact doesn’t end there. Debenhams also expects “a material impact on key components within the income statement” because “operating lease rental charges will be replaced by depreciation and finance costs”.

Debenhams may not have quantified its likely IFRS 16-linked provisions, but at least it put a number on how many of its lease arrangements are under scrutiny. Compare this with Marks and Spencer. The retail behemoth has established a working group to assess the impact of the new standard and said, on adoption, lease agreements will result in “a right of use asset and a lease liability for future lease payables”. Depreciation of the right of use of an asset will be recognised in the income statement on a straight-line basis, with interest recognised on the lease liability resulting in a front-loading of the total charge in the income statement.

While M&S says it is not yet at a stage to provide “a reliable estimate” of the financial impact, we have been told to expect an update in the annual report and financial statements for the March 2018 year-end. Although this hints at how Marks and Spencer might treat IFRS 16 in its accounts, it provides no detail on how many leases the group currently carries – which would go a long way to quantify the significance of the impact.

There’s more useful information to be found in the 2017 annual report. Here M&S provides a breakdown of its current operating leases, which it says covers the stores, offices, warehouses and equipment currently held under non-cancellable operating lease agreements. The total figure for future minimum rentals payable under non-cancellable operating leases comes to £4.37bn – that’s against a current market capitalisation of £4.83bn. 

Of those leases, more than £1bn fall under arrangements dated for 25 years or longer. In our view, this is where the danger lies. Companies in long-term leases will find it harder to remove themselves from these arrangements, as M&S has learned to its cost. In the same annual report, the company said it planned to reduce the average length of its leases, to provide “greater flexibility” and to ensure “a better mix between growth and ‘business as usual’ investments”. This was probably spurred on by the group’s decision to exit completely from stores in 10 international markets, incurring “significant closure costs” in the process, largely due to lease break clauses and redundancies.

Marks and Spencer provides an ongoing case study of the decision facing many traditional retailers in the UK this year. Lumbering, extensive property estates are proving to be an albatross around the neck, but exiting long-term leases brings with it additional expense. The question is, is that short-term cost worth taking to get out of years and years of rising rent payments? The answer will ultimately depend on how profitable any store is to the wider group.

Traditional retailers need not look far for a potential solution. Like Debenhams and M&S, Card Factory (CARD) started this year on the back foot, after reporting a far weaker Christmas trading performance than investors expected of its usual seasonal reliability. But if there’s one area in which Card Factory has done well, it has been to strike a balance in its property portfolio. True, most of its locations are what the wider industry might call second rate, but leases on these properties are typically short in length. In its 2017 annual report, the group also confirmed that most of its current agreements were struck during the last recession, and are therefore up for renewal. With more and more retailers opting to invest in online channels, thereby placing downward pressure on high-street rents, the group reckons it can claw back some significant future savings.

While Card Factory admits IFRS 16 will also have a material impact on its financial statements, a quick overview of its lease payments makes for an interesting comparison against the likes of Marks and Spencer. Total future minimum rentals payable under non-cancellable operating leases reached £169.6m at the end of FY2017, compared with £172.1m in FY2016, and against the group’s current market capitalisation of £683m. Crucially, all but £0.5m of these payments fall under leases dated within just 10 years, and the bulk – £40m – within just one year.

Shoe Zone (SHOE), a not dissimilar business, has also spent years streamlining its estate – in fact, multiple store closures account for its less-than-inspiring track record when it comes to the top line. As of September 2017, its future minimum payments under non-cancellable operating leases totalled £59.4m, against a current market capitalisation of £88m. Around £35m of these leases are for no longer than five years, while only £5.4m falls under terms between five and 10 years, and Shoe Zone has no lease arrangements dated beyond 10 years. Profit decline has also stabilised and the group remains debt-free.

Market newcomer Joules (JOUL) operates a similar model. As of 28 May 2017, future minimum lease payments under non-cancellable operating leases totalled £65.1m – that’s against a current market capitalisation of £277m – with the bulk, £34.7m, falling between one and five years. Encouragingly, in terms of the flexibility of its lease estate, only £20m-worth of its leases date beyond the next five years. It also chose to purchase the freehold for its new head office – a decision analysts at Liberum believe “makes total sense” in light of the introduction of IFRS 16. In Liberum’s view, the transaction “fully brings the financial benefits of ownership on the balance sheet” and comes with the bonus of being “earnings accretive in outer years”.

The question is, will companies with extensive, ageing store estates start to do business differently? If the answer is yes, this could have a knock-on effect on the commercial property sector as landlords try to accommodate more lenient and flexible rent arrangements. However, any flexibility on the part of landlords is likely to depend on the commercial viability of the locations in question. For instance, central London retail property landlords typically have greater tenant options and demand than their provincial counterparts. Whether this pattern holds over the long term will depend in part on retailers and assumptions about demographics, brand awareness and shopper preferences to visit physical store locations.

Indeed, there are some signs of untapped potential. According to data from the British Retail Consortium and the Google Online Retail Monitor, the highest volume of internet searches conducted for retail products in the fourth quarter of 2017 came from the north and Yorkshire, pushing Greater London into second place. Whether – and how – retailers and their landlords are able to capture those latent energies is a challenge, and perhaps the opportunity, of investing in both sectors.