New Rules: Net-Nets & Leases

Net-net investing has always been mostly foolproof. It still is. But the implementation of a new reporting standard in the past year has had a big under-the-hood impact on the calculation of what is a net-net. The changes raise some questions and provides opportunities for enterprising investors like us. We examine the implications below.

ASC 842 is a financial reporting standard that provides guidance on accounting for leases (IFRS 16 is the international version). The key update is that leases will now be recognized on the balance sheet as a liability instead of just expensed on the income statement. There is a corresponding “right-of-use” asset entry to offset the new liability. On the income statement, leases will be depreciated with an interest charge.

Effectively, these new reporting standards bring off-balance sheet liabilities onto the balance sheet. It treats leases more like debt. And since total liabilities are increased with no change to current assets, net-current-asset value is lowered.

Off-balance liabilities were always true liabilities, even if they were not reported. These obligations are especially real in a liquidation scenario. Many of us accounted for them in our analysis by factoring in the contractual obligations of the company listed in the 10-K.

Adding incremental liabilities to the balance sheet means that far fewer companies will qualify for net-net status. Take, for instance, Tuesday Morning’s latest 10-Q:

TUES 10-Q Snippet

As of June 30th, Tuesday Morning’s net-current-asset-value was $57 million. By December, the net-current-asset-value dropped to -$286 million and was no longer a net-net. Yikes. The red circles above show the difference. In the December quarter, operating lease liabilities increased to a total of $382 million compared to $0 two quarters ago. Bringing these liabilities onto the balance sheet completely changed the equation. Under this new accounting, it is not surprising they recently filed for bankruptcy.

Tuesday Morning had quite a bit more leverage than their June balance sheet indicated. IFRS 16 helps identify this. It levels the playing field accounting-wise for those who rent vs. buy property & equipment. It also helps shed light on leverage that an unscrupulous manager may have tried to hide off the the balance sheet.

One implication for us is that in making the financials more conservative several former net-nets may no longer qualify by traditional screening. It was already difficult to find net-nets, and now its even harder.

My general view is that the accounting change is a positive. I always do my own work on whether a lease liability is real or not. I generally include them. And the accountants have done the work for me.

But for certain going concerns, I think it’s important to be flexible. Many times, if sales decline, businesses will right-size their footprint by exiting leases over time. The leases were real but the liability was reduced over time. And in a true liquidation, it’s not clear the lessor is going to get everything they are contractually required to get. So in certain situations, that lease liability is overstated.

And because net-nets are harder to find, there may be companies that do not qualify today, but could have qualified under the old accounting methodology. I would happily consider these as potential investments if I felt the businesses would be going concerns and had limited other risks.

On the other hand, one potential downside implication is that by excluding the riskiest of the net-nets, you invalidate the prior studies which showed strong historical performance. For example, in March 2009, the share price of Tuesday Morning dropped to $0.53. About twelve months later the shares had increased more than 10x. If you held your nose and bought a broad basket of these net-nets, you did well. There were some bankruptcies, but also some spectacular winners. By ignoring the hidden liabilities, you effectively took much more risk and could have benefited from it. Would net-nets have performed as well historically under the new accounting methodology?

I don’t have studies to prove it, but my personal experience is yes. Most net-nets did well despite (or because of) the leverage on the balance sheet. And the few that went bankrupt were usually those with hidden off-balance sheet liabilities, or had some other issues associated with it. Net-nets did well across the board.

Overall, I view the changes as a huge positive. It makes net-net financials more conservative. There are fewer of them, but they are higher quality. And if some net-nets are a little harder to discover, I’m okay with that too.