That drug store on the corner pays top dollar to attract passing walk-in traffic. Nationwide, that adds up to billions of dollars’ worth of retail leases that until now have stayed off pharmacy companies’ financial reports.
Public companies in 2019 will start reporting on their balance sheets trillions of dollars’ worth of leased assets, including long-term leases for retail stores, airplanes, and warehouses. Companies also will report lease related debt on the balance sheet under rules issued by the Financial Accounting Standards Board in 2016.
“Our expectation is, for retail in general, you will see some sizable amounts come onto the balance sheet,” said Ron Graziano, director of HOLT accounting and tax at Credit Suisse.
CVS Health Corp. and Walgreens Boots Alliance Inc. together operate nearly 20,000 retail locations in the U.S. and have warned investors that new lease accounting rules will result in a significant shift to their balance sheets.
The companies’ real estate footprint isn’t changing, neither will profits or cash flow. But the accounting change could affect gross margins along with an income statement metric closely watched by investors: earnings before interest, taxes, depreciation, and amortization, known as EBITDA, said Tom Roland managing director with MorganFranklin Consulting.
Billions in Leased Assets
CVS expects to bring up to $21 billion in leased assets onto its balance sheet when the company adopts the lease accounting rules in 2019, according to its most recent quarterly report.
In comparison, the health care company’s total assets are $131 billion.
The balance sheet exposure for CVS is expected to be the largest in the health care industry and among large cap companies, according to a Credit Suisse LLC analysis, which estimated the company, which now includes Aetna, has an even greater long-term lease portfolio of $27 billion.
Walgreens, which recently acquired Rite Aid drug store locations, is expected to have about $31 billion in operating leases that will come onto its balance sheet. In comparison, total assets were $68 billion, according to its annual report released in October.
International Business Machines Corp. and DowDuPont Inc. are expected to hold $17 billion or less in long-term leased assets in comparison—leading the information technology and materials industries, according to the Credit Suisse review.
Rents are much higher than they were 10 years ago—a factor likely contributing to the high value of the drug stores’ leased assets, said Stephen Bethel, national director of Frazier Capital Valuation Inc.
Leased retail space in high-traffic, high visibility locations is at the core of the pharmacies’ business, said Stephen Bethel, national director of Frazier Capital Valuation Inc. They pay top dollar for prime real estate in a booming market, he told Bloomberg Tax.
“They have to be there,” Bethel said. “All retailers really need to have walk-in traffic.”
The pending material changes to the balance sheet shouldn’t come as a surprise however. Investor and credit analysts have long estimated leased assets based on information that companies voluntarily disclosed, Credit Suisse’s Graziano said.
Those estimates have been used to evaluate company financial health as well as credit worthiness, he said.
But the new reported leased assets and liabilities, due to ASC 842, will provide more consistent numbers, Graziano said.
Companies have preferred to lease instead of own to take advantage of both tax and financial reporting preferences—a balance sheet with less debt plus tax benefits for separating business operations from property ownership, MorganFranklin’s Roland told Bloomberg Tax.
For long-term leases, companies historically only had to show one year’s worth of expenses and they would disclose any future period commitments—even if that commitment stretched over 25 years. But those commitments didn’t weigh down the balance sheet in the form of debt, Roland said.
“Companies have generally gone to greater lengths than the general population would realize to take advantage of that presentation preference,” he said.
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