{"id":54377,"date":"2019-05-17T14:43:07","date_gmt":"2019-05-17T13:43:07","guid":{"rendered":"https:\/\/valuesque.com\/?p=54377"},"modified":"2019-05-17T18:58:14","modified_gmt":"2019-05-17T17:58:14","slug":"deutsche-post-more-debt-same-equity-value-the-ifrs-16-financial-analysis-problem-part-1","status":"publish","type":"post","link":"https:\/\/valuesque.com\/en\/blog\/2019\/05\/17\/deutsche-post-more-debt-same-equity-value-the-ifrs-16-financial-analysis-problem-part-1\/","title":{"rendered":"Deutsche Post: More Debt \u2013 Same Equity Value: The IFRS-16-Financial Analysis Problem (Part 1)"},"content":{"rendered":"\n

Sometimes stories are better told short. But not so when it is about IFRS 16, the new standard on lease accounting which basically brings all lease commitments of the lessee onto the balance sheet starting in the financial year 2019 (for more details on IFRS 16, see https:\/\/www.iasplus.com\/de\/standards\/ifrs\/ifrs-16<\/strong>)<\/a>. In fact, the short story goes like: \u201cNothing has changed for equity values (from a technical perspective), it is only accounting!\u201d So far, so good. For some investors and analysts, however, it is still quite confusing to understand how this no-change-in-equity-value has an impact on other valuation components such as WACC, enterprise value and the unlevered cost of equity. This is why we better tell this story in a slightly longer way.<\/p>\n\n\n\n

Just to\nmake clear at the beginning: This article is only about technical aspects of\nanalysis and valuation. In reality, IFRS 16 has changed a couple of points with\nregard to equity values \u2013 simply because it brought a new set of information to\ninvestors: the information of present value calculation per se, more flexible\nmaturity time range disclosure and additional information on complex features\nof lease contracts (e.g. cancellation and extension options or residual value\nguarantees). But for reasons of clarity we abstract from these non-technical\ndetails below.<\/p>\n\n\n\n

The\nstarting point of our analysis is the above told short story: Due to this\nIFRS-accounting-only-change the equity value remains unchanged. Not even tax\neffects are recorded. The cash flows to shareholders (Flow-to-Equity) are also\nuntouched. And hence the (levered) cost of equity stays the same, too. No big\nsurprise. In practice this is, however, not super-straightforward. In\nparticular if we use the WACC approach for determining business values. In\norder to highlight the proceeding in a real world case we use Deutsche Post DHL\n(DP) \u2013 an early adopter of IFRS 16 already in 2018 \u2013 as a working example below.<\/p>\n\n\n\n

Important:\nThe following numbers are no analytical numbers but just some simplified guesses\n(though not very far away from our actual guesses). It is not about calculating\na fair value of equity, but rather to show the interrelations between the\ndifferent parameters before and after IFRS 16 here. The main results of this\nexercise are of course also valid for other estimates of cash flows, values and\nparameters. But \u2013 promised \u2013 we will go deeper in some of the aspects of IFRS\n16 in one of the next blog articles. <\/p>\n\n\n\n

For our example it is assumed that DP DHL generates in 2019 a sustainable, steady-state operating cash flow pre lease payments (but including cash inflows of financial assets) of 6,800 mio Euros, lease payments of 2,000 mio Euros (both after adjusted taxes) and capital expenditures of 2,500 mio Euros. The risk free rate is 1%, the the cost of debt of DP is also assumed to be 1% here for reasons of simplicity (a 1.625% fixed coupon 2028 maturity plain vanilla bond of DP has a yield-to-maturity just below 1% at the time of writing). The market risk premium is set at 7.5%. Net debt ex leasing (and ex financial assets but including long-term provisions) is 9,433 mio Euros at the end of 2018 and the IFRS 16 leasing liability is 9,127 mio Euros. The tax rate is set at 30%. The (levered) equity beta is assumed to be 1,0. We assume the steady state company increases by 2% per year. Leases also grow at 2% per year until eternity (for reasons of simplicity here, i.e they are re-contracted at a 2% growing speed).<\/p>\n\n\n\n

In a pre IFRS 16 world, the 2019 Free Cash Flow to the Firm (FCFF) of DP DHL is 6,800 – 2,000 – 2,500 = 2,300 mio Euro. The cost of (levered) equity according to the CAPM is Riskfree rate + levered Beta * Market risk premium = 1% + 1 * 7.5% = 8.5%.<\/em> Using an iterative process we get for the market value weightings: Equity \/ Enterprise Value = 79.8%, and for Net Debt \/ Enterprise Value = 20.2%. <\/p>\n\n\n\n

The WACC is hence 8.5% * 79.8% + 1% * <\/em>20.2% * (1-0,3) = 6.92. This leads to an end of 2018 Enterprise Value of FCFF \/ (wacc-g) = 2.300 \/ (6.92% – 2%) = 46,704 mio Euros. Deducting now the net debt, leads us to an equity value of 46,704 – 9,433 = 37.271 mio Euros (implied value per share \u2248 30 Euros). And just to show that our iteration worked: Dividing the value of equity by the enterprise value is 37,371 \/ 46,704 = 79.8%. Exactly the value that we included into our WACC calculation.<\/p>\n\n\n\n

In a post IFRS 16 world, the 2019 Free Cash Flow to the Firm of DP DHL is lower here. This is due to the fact that FCFF is defined before all transactions with debt capital providers. If we now classify lease payment duties as debt (which have been operating before), we have to add back the interest payments related to the lease liability (cost of debt of 1%* new lease liability 2018) and deduct the steady state increase in the lease liability (growth rate of 2% * new lease liability 2018). Take care: We add back the after-tax interest payments which is strictly speaking wrong (because there are no tax effects attached to IFRS 16), but as leasing payments per se are tax deductible we do not make a consistency mistake. However, I admit that we could refine our model further for the real tax effects, but this would make the explanations here much more complicated (but it would still work). The post IFRS 16 FCFF of 2019 is now 2,300 + 63.89 – 182.54 = 2,181.35 mio Euro. The (levered) cost of equity stays unchanged as IFRS 16 does not have an effect on it. Using again an iterative process we get for the new market value weightings (take care: Net debt is now higher than pre IFRS 16): Equity \/ Enterprise Value = 66.75%, and accordingly for Net Debt \/ Enterprise Value = 33.25%. As nothing has changed from an economic point of view it is fair to assume that the cost of debt also stays the same (investors should have taken the liability character of lease payments into account already pre IFRS 16). Accordingly the new WACC is 8.5% * 66.75% + 1% * <\/em>33.25% * (1 – 0,3) = 5.91%. This leads to an end of 2018 Enterprise Value of FCFF \/ (wacc – g) = 2,181.35 \/ (5.91% – 2%) = 55,831 mio Euros. Deducting now the new total net debt of 9,433 + 9,127 = 18,560 leads us to the equity value of 55,831 – 18,560 = 37,271 mio Euros, the same as in the pre IFRS 16 example. And just to check our iteration works: Dividing the value of equity by the new enterprise value is 37,371 \/ 55,831 = 66.75%. <\/p>\n\n\n\n

Again exactly the\nvalue that we included into our WACC calculation.<\/p>\n\n\n\n

Result: Exactly the same Equity Values!<\/p>\n\n\n\n

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The second step of the analysis is to shed some more light on the drivers of the cost of equity, in particular on the nature of risk. Risk in equity valuation is a combination of three components: (A), the sales risk. It describes the uncertainty (measured as fluctuations or volatility or correlation) of the revenues of a company over time and is the result of typical product market forces. (B), the operating leverage as the amplifier no. 1. Operating leverage describes the fact that the existence of fixed costs in a company translates a given sales risk into a higher EBIT risk. And (C), the financial leverage as the amplifier no. 2. This one translates the EBIT-risk into an even higher net income (or Flow to Equity) risk if the company has fixed debt servicing duties to fulfil. The following graph highlights the three drivers of equity risk.<\/p>\n\n\n\n

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The third step of the analysis is now to compare the risk profile of the operating business of Deutsche Post DHL before and after IFRS 16. We do this by eliminating the capital structure risk from the cost of equity by way of the so called \u201cunlevering\u201d technique. This is a standard process in business valuation e.g. when the CAPM risk factor Beta is transported from a group of comparable companies (peer group) to a target company. A typical, simplified unlevering formula for beta looks as follows (Harris\/Pringle, Journal of Financial Research 1985): <\/p>\n\n\n\n

\"\"<\/figure><\/div>\n\n\n\n

Applying this formula to Deutsche Post DHL for both situations leads to an interesting result: The company has different beta unlevered, and hence a different cost of equity unlevered and therefore a different risk profile of the operating business before and after the IFRS 16 implementation. But how is this possible if the company has not changed at all (still it is only accounting!)?<\/p>\n\n\n\n

<\/p>\n\n\n\n

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<\/p>\n\n\n\n

The root to the\nanswer lies in our first two steps of the analysis: If the overall risk profile\nof the company has not changed (and the sales risk has not changed neither) but\nthe financial risk has changed (due to different financial leverage), then it\nMUST be the case that the operating (EBIT) risk has changed as well! The\ncompany has a lower EBIT-risk and hence a lower operating leverage after the\nimplementation of IFRS 16 than before. This is only possible if the company changed\n\u2013 in the sense of DCF valuation \u2013 its set of operating activities.<\/p>\n\n\n\n

That this is in\nfact the case becomes clearer when we look at what happened in the course of the\nIFRS 16 change: an operating fixed cost component (the operating lease payment)\nis taken out of the company and a financial cash outflow (interest payment and\ndebt repayment) is added. It is an exchange of two fixed cost items, a substitution\nof operating leverage with financial leverage. And so the company\u2019s operating\nbusiness profile has in fact changed \u2013 it is obviously a question of\nperspective!<\/p>\n\n\n\n

This is an\ninteresting finding: Not only the scope of operations has changed due to IFRS\n16 (operating lease payments now being part of the financial part of DP) but\nalso the risk of operations. It shows how important consistency in business\nvaluation is. For the shareholder nothing has changed (it is really only\naccounting if we abstracted from any information changes) but we definitely\nhave to take care how we get to this unchanged equity value in practice. If we\napply the well-known WACC-approach then a lot of parameters in our model are\naffected: the WACC itself, the unlevered cost of equity, the net debt and the\nenterprise value.<\/p>\n\n\n\n

For this, the\nrecently implemented accounting standard IFRS 16 delivers a lot of interesting\ninside into our DCF valuation world. In order to not get lost in this valuation\njungle the main lessons learned are summarized below:<\/p>\n\n\n\n