New regulation provides artificial boost to technology company profits and cashflow


Software companies are set to report higher EBITDA profits and cashflow due to new accounting standards. Chris Errington describes below the real impact of IFRS 16 on investors.

While many companies are reporting a decline in profits due to COVID-19, investors are likely to see an offsetting positive EBITDA and operating cashflow impact with the onset of IFRS 16.

And it is likely that deals will look far cheaper than previously, with market M&A valuation metrics and EBITDA multiples depressed and disrupted by the adoption of IFRS16.

The extent to which this was made clear in recent AIM company announcements has been mixed but most companies have stayed quiet about the positive impact.

IFRS 16 is a new accounting standard that governs how operating leases are accounted for, and is effective from 1 Jan 2019. For technology companies, IFRS 16 will mainly impact how they account for the lease of offices (operating leases).

Before IFRS 16 After IFRS 16
Balance sheet Create assets and liabilities only for prepaid or accrued rent Create new assets and liabilities to estimate the entire fair value of each lease (the right to use the assets and the obligation to pay the rent).
P&L Charge rental costs to administration expenses. As the lease is consumed, charge depreciation to reduce the lease asset and make interest charges for the time value of money.
Cash flow Rental payments show as an outflow within Operating cash flows. Rental payments show as an outflow within Investing cash flows.

There is no requirement to restate comparatives, and few companies do, meaning that in the year of adoption the financials will be presented on an entirely different basis to the prior period.

Impact for investors and our approach

  • Lease assets are an accounting feature. There is probably no tangible value in the asset created, and we ascribe none to it
  • Lease liabilities look like debt, but not debt as we know it and we ignore them for net debt purposes
  • Since depreciation and interest is excluded from the EBITDA profit measures, EBITDA will increase and to maintain symmetry with market reporting we retain this higher EBITDA measure but remain mindful of it in valuations
  • Lease payments no longer show as operating cash outflows, OCF and FCF will increase but we adjust to reverse this and continue to show lease payments in OCF and FCF

Example

Eckoh plc adopted IFRS16 for year ended 31 Mar 20 and as permitted did not restate comparatives.

  Eckoh plc year ended 31 Mar 20 Reported Before IFRS16
FY20 FY19 FY20 FY19
Lease assets 0.3 0.0 0.0 0.0
Lease liabilities (0.3) 1 0.0 0.0 0.0
AEBITDA 6.4 2 4.3 5.9 4.3
Net cash generated in operating activities 7.1 7.2 6.6 7.2
Net cash utilized in investing activities (1.4) (1.0) (1.4) (1.0)
Net cash utilized in financing activities (3.7) 3 (2.8) (3.2) (2.8)
Increase in cash and cash equivalents 2.0 3.4 2.0 3.4

 

  1. Office leases now recorded as assets with liability to pay rent
  2. Office lease costs no longer charged to AEBITDA
  3. Office lease payments now shown as capital repayments

 

Kestrel Insight

While some companies chose to explain the positive EBITDA impact of adoption, far fewer were keen to point out the equally positive impact on operating cash flows. Investors that follow cashflow closely will have spotted the operating cash flows associated with office leases slipping down the cash flow into the financing section under IFRS 16 – a welcome but cosmetic boost to cash performance.

Investors should remember that EV/EBITDA multiples and FCF/EV yields will be affected by IFRS 16 since the numerators of EBITDA and FCF are both increased as a result. For our example above, Eckoh plc, the differences for FY20 are as follows:

  • EV/EBITDA multiple is 18x under IFRS16 versus 19x before
  • FCF/EV yield was 5% under IFRS16 versus 4.5% before

It is likely that market M&A valuation metrics will be disrupted by the adoption of IFRS16, with EBITDA multiples depressed making deals look cheaper than they had been. Imagine an underperforming company making £2m EBITDA pre-IFRS16 but with extensive, and expensive, global offices and a rent bill of £2m pa – overnight their EBITDA doubles to £4m and their lower EV/EBITDA multiple makes them look much cheaper but net cash flows haven’t changed.

At Kestrel, while the financial information required to adjust is provided by the company, we have chosen to unwind the IFRS 16 impact on operating cash flows so as to retain comparable results in the key cash metrics we follow. Many analysts have seamlessly jumped to using reported IFRS 16 numbers.


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