Lease-adjusted comparison of two UK retailers
An analyst is comparing two UK retailers. Retailer A owns its stores and reports revenue £600m, EBITDA £120m, depreciation £55m and interest £10m; net debt is £200m and equity £300m. Retailer B leases most stores. Under IFRS 16 it reports revenue £600m, EBITDA £110m, depreciation of owned assets £25m, right-of-use depreciation £30m, lease interest £8m and other interest £4m; net debt including lease liabilities is £200m, of which £150m is leases, and equity is £250m. Both pay 25% tax. B's CEO says the IFRS 16 figures show the asset-light model is more efficient and that analysts should add back lease costs when comparing EBITDA. The analyst is unsure whether B is genuinely more profitable or whether the lease accounting flatters reported EBITDA and leverage. B is considering a sale-and-leaseback of its remaining owned stores to fund a special dividend.
1. Adjust B's results to a lease-neutral basis and compare EBITDA margin, EBIT margin, net debt/EBITDA and return on invested capital with A. Show your calculations and state assumptions.
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B's implied rent is approximately lease depreciation £30m plus lease interest £8m = £38m. On a pre-IFRS 16 basis, B's EBITDA would be £110m − £38m = £72m and EBIT would be £72m − £25m owned depreciation = £47m. Reported IFRS 16 EBIT is £110m − £55m = £55m. A's EBITDA margin is 120/600 = 20.0% and EBIT margin is 65/600 = 10.8%. B's reported EBITDA margin is 110/600 = 18.3% and EBIT margin is 55/600 = 9.2%; lease-adjusted EBITDA margin is 72/600 = 12.0% and EBIT margin is 47/600 = 7.8%. Net debt/EBITDA: A is 200/120 = 1.67x. B reported including leases is 200/110 = 1.82x; B including leases but using lease-adjusted EBITDA is 200/72 = 2.78x; B excluding leases is 50/72 = 0.69x. ROIC: A NOPAT is 65 × 0.75 = £48.75m on invested capital of £500m, or 9.75%. B reported NOPAT is 55 × 0.75 = £41.25m on £450m, or 9.17%; lease-adjusted NOPAT is 47 × 0.75 = £35.25m, giving 7.83% including leases or 11.75% excluding leases. The assumption is that lease depreciation plus lease interest is a reasonable proxy for rent; variable rent and lease maturity would refine the comparison.
2. Assess whether B's sale-and-leaseback and special dividend would improve or merely flatter its financial position. Consider accounting, credit metrics and economic substance.
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A sale-and-leaseback would derecognise the owned stores, recognise a right-of-use asset and a lease liability, and may produce a gain on sale limited to the rights transferred. Because rent is replaced by depreciation and interest, reported EBITDA would rise, which could make B look more profitable and less leveraged if the covenant or rating metric excludes lease liabilities. Economically, however, B would exchange ownership for a fixed rental obligation, reduce its asset flexibility and increase its committed cash outflows. The special dividend would reduce equity and increase leverage without improving operations. Rating agencies and sophisticated lenders typically include lease liabilities in net debt or adjust EBITDA for rent, so the apparent improvement may not be real. The analyst should recalculate net debt/EBITDA including leases and using lease-adjusted EBITDA, and should treat the sale-and-leaseback as a financing decision rather than value creation. If the proceeds are distributed rather than reinvested, the company is simply borrowing against its property.
3. Recommend which retailer the analyst should prefer and what additional disclosures are needed. Address the CEO's claim that lease costs should be added back.
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On the adjusted numbers, A is more profitable and has lower fixed-obligation risk: 20.0% EBITDA margin versus B's 12.0% lease-adjusted margin, and 1.67x net debt/EBITDA versus B's 2.78x including leases. B may still be attractive if it has higher growth, lower capital intensity or valuable flexibility to exit stores, but the analyst needs evidence beyond reported EBITDA. The CEO's claim is only partly right: adding back rent is appropriate for an EBITDAR or before-rent comparison, but it is not appropriate to add back rent while ignoring the lease liability. A consistent comparison must either include leases in both earnings and debt or exclude them from both. Additional disclosures needed are lease maturities, discount rates, variable rent, renewal and break options, store closure costs, maintenance capex, covenant definitions and the proportion of leases that are variable. The analyst should prefer A unless B's lease-adjusted ROIC and growth clearly compensate for its higher fixed obligations.