These Stocks Are More Dangerous Than You Think

With the huge growth in securitization over the past decade, banks were able to move large numbers of loans off their balance sheets -- with grave consequences. Outside of financial institutions, the largest source of off-balance-sheet financing is operating leases.

Last week, the Financial Accounting Standards Board (FASB) released a proposal that would bring those commitments right back onto the balance sheet. If implemented, it could whip the rug out from under companies that have been abusing the use of operating leases.

Why companies love operating leases
Under current accounting rules, no asset or liability is recorded on the balance sheet in an operating lease -- despite the fact that the lessee commits to making a set of future payments, much like a form of debt. Capital leases, on the other hand, are recorded on the balance sheet.

Here's the interesting part: Companies have some discretion over whether to account for a lease as an operating or a capital lease. That opens the door to accounting manipulation because operating leases:

  • Feature no lease liability on the balance sheet, understating the company's true leverage, and
  • Feature no lease asset on the balance sheet, raising return on assets.

In these industries, look out for the leases!
The industries that are most heavily dependent on operating leases include retail, airlines, trucking, and railroads.

A high-profile example in the retail sector is Starbucks (Nasdaq: SBUX  ) , which announced in 2005 that certain aspects of its operating lease accounting did not meet accepted standards. As a result, it restated its financial results for 2002 through 2004. In this instance, the negative impact on earnings was very small (on the order of 0.5% annually) and there was no discernible effect on the stock price.

Other companies that have had problems with their treatment of leases include Wendy's International (now Wendy's/Arby's Group (NYSE: WEN  ) ), Sears Holdings (Nasdaq: SHLD  ) , and American Tower (NYSE: AMT  ) .

Would an accounting change hit stock prices?
If companies were forced to put operating leases back on the balance sheet, would it impact stock prices?

In most cases, I expect the answer would be "no," as accounting statements will reflect the economics of the transaction more accurately. However, odds are good we'll witness negative surprises at companies that are currently misstating their leases once the new accounting treatment imposes greater transparency.

Five companies to keep an eye on
The table below contains five companies with significant operating lease commitments and above-average risk of some type of accounting misstatement (as estimated by a model similar to the one I discussed here, but which includes operating leases as a risk factor). Not a reassuring combination.

Company

Total Operating Lease Commitments as a Multiple of Shareholder's Equity

Likelihood of an Accounting Misstatement Relative to a Randomly Selected Company

Liz Claiborne (NYSE: LIZ  )

5.90 times

80% more likely

SIRIUS XM Radio (Nasdaq: SIRI  )

3.02 times

52% more likely

Pier 1 Imports

2.61 times

Nearly 3 times more likely! (+285%)

CVS Caremark (NYSE: CVS  )

0.75 times

56% more likely

Sherwin-Williams

0.68 times

61% more likely

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

If you own one of the companies in the table, there's no cause for panic. However, it may be worth reviewing the financials in some detail to ensure you're comfortable with the effective level of leverage -- and to look for any signs of aggressive accounting that would corroborate the model's above-average risk score.

Spotting ticking time bombs for protection ... and profit
Operating leases are just one of many items that are vulnerable to aggressive accounting. In his free report "5 Red Flags -- How to Find the BIG Short," John Del Vecchio, CFA, discusses five red flags that are part of a proprietary model he has spent five years developing to zero in on ticking time bombs. Del Vecchio and his model are battle-tested: As the manager of the Ranger Short Only portfolio from 2007 to 2010, John outperformed the S&P 500 by 40 percentage points. If you want to put a proven methodology to work for your portfolio, enter your email in the box below.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. American Tower is a Motley Fool Rule Breakers recommendation. Starbucks is a Motley Fool Stock Advisor selection. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

 


Read/Post Comments (10) | Recommend This Article (49)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 02, 2010, at 7:27 PM, ecloud wrote:

    Where do your numbers come from? I ask not out of doubt but because this would be a good kind of analysis to conduct regularly on any stock on my watch list. Where do they publish the operating lease commitments?

  • Report this Comment On September 02, 2010, at 11:41 PM, TMFAleph1 wrote:

    @ecloud,

    Thanks for your interest.

    I obtained my data from Capital IQ. However, operating lease commitments are included in a company's 10-K reports.

    Alex D

  • Report this Comment On September 03, 2010, at 9:51 AM, nofoolingforme wrote:

    There is no advice or information from Motley Fool that can be trusted. I joined several of their newsletters and paid alot of money for their advice. I lost money on every stock that they recommended and made money on the ones that I bought which they panned. If they advise buying something don't do it. If they tell you not to invest in something, ignore what they say and make up your own mind. I believe that they profit personally from a stock declining in price and that is why they tell people to sell or not buy it. Taking the advice of Motley Fool is dangerous.

  • Report this Comment On September 03, 2010, at 9:57 AM, dfrizzle03 wrote:

    nofoolingforme

    maybe you should have done your own research in the first place instead of paying someone for their ideas. in an education setting, this is known as plagiarism. in an investing setting, it's known as ignorance.

  • Report this Comment On September 03, 2010, at 10:41 AM, TMFAleph1 wrote:

    @nofoolingforme,

    "I believe that they profit personally from a stock declining in price and that is why they tell people to sell or not buy it."

    That is false and slanderous. What is your evidence to support that claim?

    If your experience with the Motley Fool has been that unhappy, why do you continue to read the articles here? If you believe that "there is no advice or information from Motley Fool that can be trusted", what stock newsletter service do you consider to be more reputable?

    Alex D

  • Report this Comment On September 03, 2010, at 10:46 AM, TMFAleph1 wrote:

    @nofoolingforme,

    I should add that I am not an employee of the Motley Fool, nor does the Motley Fool dictate which stocks to include in my articles.

    Alex D

  • Report this Comment On September 03, 2010, at 2:18 PM, sage1001 wrote:

    @TMFMarathonMan

    Yea Barron's

  • Report this Comment On September 08, 2010, at 5:57 PM, henryking54 wrote:

    Shorting is unFoolish for many reasons. It's amazing to me how the Fool has betrayed all of its long-standing principles just so that it can make a buck off of innocent investors who don't know better.

    http://www.fool.com/FoolPort/1997/FoolPort970729.htm

  • Report this Comment On September 10, 2010, at 12:52 PM, tradecraft46 wrote:

    Actually there is a pretty good way to analize these companies: capitalize the projected lease payments based on an interest rate consistent with estimated or actual bond rating, and use it for your capital ratios.

    Appy that interest rate to the value of the capitalized operating leases, then increase interest expense by that amount, decreasing operating expense.

    To get a good proxy of true leveragel use the adjusted debt to market cap. That ratio will show true debt capacity.

    With the new information you can see how leveraged the company is, and better see if the market has adjusted for the risks involved.

  • Report this Comment On September 10, 2010, at 3:33 PM, NDimensionalDino wrote:

    Is it safe to point out that this proposal is exactly what de-regulationists have argued against in the past?

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