Colefax: more indebted than I thought

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'Orrible operating leases

Thanks to a reader I spent Friday afternoon pondering my least favourite investment subject: operating leases. As usual, they're complicated, but also important because they subtly shift my perception of Colefax's financial strength.

memyselfandi007 asked if I could explain why Colefax has such high operating leases and fixed assets, in comparison to the largest German wallpaper manufacturer AS Creation when it doesn't actually manufacture wallpaper and so, presumably, doesn't have factories to finance, just warehouses and offices.

I can't, and admit to having been a little complacent about Colefax's operating leases, lulled perhaps, by how much I like the company. It would be prudent to include them on the balance sheet as debt, although accounting convention doesn't do that. The company is committed to £25m in non-cancellable lease payments, and however you look at it, that's a debt.

It's a big debt, considering Colefax's net asset value is also £25m and any calculation that calculates debt as a proportion of equity or equity as a proportion of total assets, i.e. the company's financial gearing, will be affected by it.

Colefax's equity as a proportion of total assets is 66%, well above the arbitrary 50% figure below which a company might be too indebted. Add the value of operating lease commitments to total assets, though and that ratio falls to 40% (because we must add them to total liabilities as well, the value of equity, or net assets (total assets minus total liabilities) does not change).

Just as the 66% figure understates Colefax's indebtedness, the 40% figure overstates it. If Colefax had borrowed the money to finance its operating leases, the amount recorded on the balance sheet would have been less than its total future commitments because it would not include interest payments. To find the value of Colefax's commitments in today's money we need to discount them.

These kinds of calculations are scary because I don't know how to pick a discount rate. Finance Professor Aswath Damodaran suggests using the firm's current pre-tax cost of debt but Colefax doesn't have any debt so I've just plumped for a conservative 5%.  To discount more steeply, at, say, 10% used by fellow value investor Nate Tobik, would be to reduce the value of the 'debt', perhaps, flatter Colefax's financial position.

Also, the accounts don't reveal exactly what year lease payments are due, only whether they are due within one year, between two and five years, or after five years. So, in working out the present value I've made assumptions about the timing of lease payments (for a more sophisticated treatment of operating leases see Damodaran's spreadsheet [xls]).

My estimate is a better guess than 40%, or 66%. Colefax owes around £20m, about 43% of its total assets are funded by equity. That's a bit less than the benchmark, but I'm comfortable because:

  1. I think it's more likely to be an underestimate than an overestimate, and
  2. Colefax has so many other qualities.

Even so, I've redrafted my two minute monologue, the document that summarises the investment case, to correct the impression there is a big margin of safety in Colefax's finances.

This investigation has also revealed another misconception. Colefax's operating leases appear to have risen sharply over the years, although turnover has only increased slowly and the value of property the company owns has stayed much the same. I questioned this when adding Colefax to the Thrifty 30, but decided not to follow it up.

The answer lies in note 24 to the 2009 accounts. The disclosures in prior years were for annual commitments, not total commitments (this wasn't obvious in the respective accounts).

That answers my question, operating lease commitments haven't exploded, but not memyselfandi007's, why they're so big.


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