I got a comment in the BEBE analysis post related to their $186M in operating lease obligation and what my view was as the company announced that they are closing down all their remaining stores. As I started to write an answer in the commentary section I came to realize that this might be a good time to put my view about operating leases into print. Also, as the BEBE situation is currently playing out in real-time it makes it a good live case study for how to view operating leases when it comes to investing in net-nets and companies selling below liquidation value. At least I hope it makes the post about operating leases a bit more interesting.

Off-balance-sheet financing & operating leases

Before diving into the more interesting stuff, lets first remind ourself what we are talking about. First off, what is off-balance sheet financing? Well, in broad terms it refer to assets or liabilities that we can’t find on a company’s balance sheet but nonetheless are forms of assets or liabilities of the company. The reason why I say “forms of” is because there exist some nuances, but for the most part they fit the assets and liabilities definitions. Lets remind ourself of the definitions for asset and liabiliy:

Asset: Resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow the entity.

Liability: Present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefit.

The most common reason for not capitalizing an asset or a liability on to the balance sheet is that it misses on the first part of the above definitions. Resources controlled as it concerns assets and present obligation as it concern liabilities. In other words, the company is not the recognized legal owner of an asset or does not have direct legal responsibility of the liability.

Operating leases is probably the most common type of off-balance sheet financing and it’s also the oldest form of off-balance-sheet financing. In 2014 listed companies using IFRS or US GAAP disclosed almost US$3 trillion of off-balance sheet lease commitments. Yes, that’s trillion with a T. An operating lease is a contract between two companies where one company is allowed to use the asset (lessee), but where the rights of ownership of the asset stays with the other company (lessor). So an operating lease represents an off-balance sheet financing of an asset, where the leased asset (future benefits) and associated liabilities of future rent payments (outflow of cash) are not capitalized on the balance sheet of the company using the asset. In other words, provided both parties are behaving rationally, the economic substance of this arrangement is that the lessor has made a loan to the lessee that is equal to the capital value of the leased asset. The lease payments will be equivalent to the loan repayments on that loan plus the interest that would have been charged.

So whats the problem?

A distorted view

Since operating leases are found off the balance sheet they distort the view that you would get of a company’s financial position and performance if you were looking through a screener. The same would apply if you were only looking at the financial statements presented in an annual report or 10-K. Primarily, a company with a big operating lease obligation will look a lot slimmer than it actually is. As you can imagine, a number of important key ratios, such as equity ratio and return on total assets, would therefore be quite different if the company decides to put it on or off the balance sheet. However, with a quick search for “operating leases” in the annual report or 10-K you would find the following note:

With this note you could be guide in your division for what is to be regarded as current assets and liabilities (< 1 year) and non-current assets and liabilities (>1 year). Therefor it could be argued that it is not rocket science in order to get a more fair view, just add-on the numbers back on the balance sheet. However, both IASB and FASB would argue against me and as I will later demonstrate with the case of BEBE this is not even the whole truth…

New lease standards from IASB (IFRS) & FASB (US GAAP)

About a year ago both IASB and FASB announced that they had issued new lease standards. It was stated that the new standard from IASB will come into play as of 1 January 2019 and the standard from FASB as of 15 december 2018. There are minor differences between the two standards but the main change and effect of the new standard is the same. That is, all leases, except short-term leases (< 1 year), must be capitalised, i.e. put on the balance sheet. As a result, the expense for operating leases will be moved from operating costs and divided into one part depreciation and one part interest, similar to a regular assets and liabilities.

One should also note following regarding the effect on cash flow stated by the IASB:

Changes in accounting requirements do not change amount of cash transferred between the parties to a lease. Consequently, IFRS 16 will not have any effect on the total amount of cash flows reported. However, IFRS 16 is expected to have an effect on the presentation of cash flows related to former off balance sheet leases. IFRS 16 is expected to reduce operating cash outflows, with a corresponding increase in financing cash out flows, compared to the amounts reported applying IAS 17. This is because, applying IAS 17, companies presented cash out flows on former off balance sheet leases as operating activities. In contrast, applying IFRS 16, principal repayments on all lease liabilities are included within financing activities. Interest payments can also be included within financing activities applying IFRS.

The net-net formula and operating leases

If you are still reading at this point give yourself a pat on the back. Now let’s get into the more interesting stuff for how the above relates to investing in companies that are selling below liquidation value.

If you had asked for my opinion about operating leases, as it relates to net-nets, just a few months ago I would have given you a completely different answer than what I will give you today. Back then I would have said something like “all backtesting that I have ever come across doesn’t take operating leases into account and the returns are still awesome”. While this is true I would now argue that I don’t think this is a healthy approach to investing. Also it’s not what Benjamin Graham thought of when he initially stated the approach for how to invest in companies selling below liquidation value:

A good part of our own operations on Wall Street had been concentrated on the purchase of bargain issues easily identified as such by the fact that they were selling at less than their share in the net current assets (working capital) alone, not counting the plant account and other assets, and after deducting all liabilities ahead of the stock. It is clear that these issues were selling at a price well below the value of the enterprise as a private business. No proprietor or majority holder would think of selling what he owned at so ridiculously low a figure. – Benjamin Graham (The intelligent Investor)

Specifically note the bold text related to liabilities and ask yourself: would Graham include off-balance sheet financing in a net-net calculation if he lived today? I’m sure he would. So while the quantitive approach to net-net investing from a balance sheet approach has proven to be a solid strategy for generating alpha it also deviates from the wise words once written by Graham in the Intelligent Investor. On this note one should remember what Graham stressed above all everything else: margin of safety. So what I have come to realize is that you shouldn’t let a backtests sway you away from the true meaning behind the concept of margin of safety as it relates to the liquidation value approach of investing. In other words, just because something doesn’t show up on a screen it doesn’t mean it does not exist and should not be accounted for as a future inflow or outflow of cash, i.e. asset/liability. This epiphany has become even more relevant as of the new lease standards that will soon come into play for both US GAAP and IFRS. So now you might think that the correct way to calculate the liquidation value for BEBE is just to add the $186M of operating leases into the net-net calculation. Well, unfortunately it’s not that easy if you aim for a fair estimate of a liquidation value. With the help of the current situation in BEBE I will try to demonstrate this. But before I do that I would like to set the stage by presenting two important quotes from two of my favorite investors, Marty Whitman & Seth Klarman. We do net nets based more on common sense. As, for example, you have an asset, a Class A office building, financed with recourse finance, fully tenanted by credit-worthy tenants, that, for accounting purposes, is classified as a fixed asset, but, given such a building, you pick up the telephone and sell it, and really it’s more current than K-Mart’s inventories, for example, which is classified as a current asset. – Marty Whitman As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws. – Seth Klarman

Lessons about leases and liquidation value

With the situation in BEBE I will try to demonstrate three lessons that I have acquired via my previous quantitative approach to investing in net-nets. All three could be summarised under the lesson that the quantitative net-net calculation is a strict theoretical valuation method not based on common sense. In recent time I have therefore decided to leave my previous quantitive approach behind me and apply a more semi-rule based approach for investing in companies selling below liquidation value. I will write an additional blog post about this new approach and the implications for other factors than just the valuation aspect some time in the future.

Lesson 1: Operating leases ≠ 100 % future outflow of cash

Remember the $186M in operating leases obligation that BEBE had stated in its note from the latest 10-K? In other words, the same $186M that the new lease standards wants us to put directly on the company’s balance sheet:

Well, it turns out that it’s not a $186M obligation. The actual liability (future outflow of cash) as it relates to the company’s operating leases (leased stores) is more in the ballpark of $60-65M.

The Company has hired a real estate consultant to negotiate with its landlords to terminate existing leases and the Company will have to make payments in order to close all of its retail stores. While the Company does not know the exact amount of such termination payments it believes the payments will be in the range of approximately $60 to $65 million. – Q3 2017

In the table attached above it is important to highlight the word noncancellable leases. Reason being is that this gives us the answer for the difference between the total minimum leases payments that is “noncancellable” (the obligation that the new standards will require the company’s in the future to put on the balance sheet) and the actual liability (actual outflow of cash) as a result of the termination of the company’s leased store contracts. I want you to read with full attention now: It is named noncancellable but it be cancelable. But only when:

A lease which is cancelable (i) only upon the occurrence of some remote contingency, (ii) only with the permission of the lessor, (iii) only if the lessee enters into a new lease with the same less, or *iv) only upon payment by the lessee of a penalty in an amount such that continuation of the lease appears, at inception, reasonably assured.

If significant enough, a penalty for cancellation may result in a conclusion that continuation of the lease appears, at lease commencement, to be reasonably certain. If so, it should be considered noncancelable for any periods in which the penalty exists.

The lesson here is that the actual liability (outflow of cash) as it concerns operating leases is likely to be lower than what is stated in the note and what in the future will be stated in the liability section of the balance sheet. Remember that the company does not have direct legal responsibility (liability) of the leased asset. This will not change even when the new standard comes into play.

While the information about $60-65M was quite recently announced (2017-05-16) I will demonstrate how one could obtain this information already in March 2017. If we take a look at this 8-K the following could be noted:

On March 28, 2017, bebe stores, inc. (the “Company”) committed to close 21 bebe store locations. As a result, the Company will incur an impairment charge related to the closed stores of approximately $2.0 million and will make a termination payment to the landlord of approximately $7.4 million. The Company is continuing to explore options with respect to its remaining stores.

If we use these figures above and apply it to the 151 stores that BEBE had not closed at that point in time we get the following total termination payment:

$7,4M / 21 stores = $352,000 x 151 stores = $53M –> $53M + $7,4M = $60,4M.

This fits perfectly into the ballpark of the $60-65M stated above.

Lesson 2: Operating leases ≠ asset

The next lesson is a direct outcome of the situation in BEBE. While the new lease standards requires operating leases to be capitalised both on the liability side and the asset side of the balance sheet this is in my opinion not a fair view. Remember why operating leases did not fit the real asset definition? Yes that’s right, the company is not the recognized legal owner (asset). From this we can draw the following conclusion, the liquidation value of operating leased asset is zero. Or really its negative considering the termination payments that the company will incur in a situation similar to BEBE’s. So when calculating a liquidation value you should in my opinion attach no value to the “asset” leased. Reason being that the company will not be able to sell the asset and therefore there is now future inflow of cash. This is especially important to take into consideration when screening for companies in the future since operating leased assets then will be part of the company’s total current asset position.

Lesson 3: The importance of readily ascertainable net asset value (raNAV)

The third lesson relates to the a concept of liquidation value that Marty Whitman has coined. It is explained in the book The Aggressive Conservative Investor but also in the quote I presented earlier in this post. I will try to demonstrate the importance of using raNAV instead of NCAV by presenting the valuations of BEBE from both perspectives as of Q3 2017. BEBE is also a perfect example for the fun side of the equation when it comes to off-balance sheet items. That is, off-balance sheet assets.

If we take a look at the Q3 2017 report from BEBE that has just been published the following net-net calculation would be made from a strict quantitative approach:

‘000 $ Cash 26 755 Recieviables 7 862 Inventory 28 413 Assets held for sale 25 796 Prepaid and other 8 491 Current assets 97 317 Total liabilities -46 482 NCAV 50 835 NCAV per share 6,3

In relation to the share price of $4,82 that would give us a P/NCAV = 0,76x which is pretty good. However, if we dig into the Q3 report and other announcements made there are some interesting facts that should be taken into consideration when trying to get a fair view of BEBE’s liquidation value. So let’s try to get the whole picture sorted out regarding the situation in BEBE. In connection I will also state what conclusions I draw from the facts as these will be built into the valuation for the raNAV calculation that I present below.

1. BEBE has announced that its closing all stores. The cash outflow because of this economic event is by the company stated to be $60-65M. As I have displayed by my earlier calculation of lease termination payments I believe that the final amount will be at the lower end of the stated spectrum ~$60M. This amount has been used in my raNAV calculation below.

The Company has hired a real estate consultant to negotiate with its landlords to terminate existing leases and the Company will have to make payments in order to close all of its retail stores. While the Company does not know the exact amount of such termination payments it believes the payments will be in the range of approximately $60 to $65 million. – Q3 2017

2. As a result of the termination of stores the company has also announced that it will terminate the employment of all store personnel and will therefore incur a termination payment of $7-10M. As I have no further insight into this so I will use the ~$10M as my estimate for employee termination payments in the raNAV calculation.

the Company expects that it will then cease to have any retail operations and will instead manage its investment in the Joint Venture. As a result, the Company expects to terminate the employment of all or substantially all of its employees over the coming months as its operations wind-down and to pay severance, accrued vacation and stay-on bonuses in the range of approximately $7 to $10 million to such employees expected to be paid over the next two fiscal quarters. – Q3 2017

3. BEBE has previously provided information about the value of a joint venture with a company called Bluestar. Also, in the Q3 report the company state what the company intends to do going forward. I regard to the remaining 50 % ownership in the joint venture to have a value of ~$35M since Bluestar paid this amount quite recently, June 2016, but also since BEBE still holds licence for two important markets, USA and Canada.

Strategic partnership. During the fourth quarter of fiscal 2016, we entered into a strategic joint venture arrangement with Bluestar Alliance LLC (Bluestar). Under this partnership, bebe contributed all of its trademarks, trademark license arrangements (described in the next paragraph) and related intellectual property, including certain domain names, to a newly formed joint venture (the Joint Venture) and received just over 50% ownership interest in the joint venture. Bluestar contributed $35 million to the newly formed joint venture that was then paid to bebe and received just under 50% ownership interest in the joint venture. – Q3 2017

In connection with this initiative, bebe retained a royalty-free perpetual license to utilize the bebe brand and trademarks within the United States, including its territories and possessions, and Canada which enables us to continue our existing business. – Q3 2017

The Company also intends to transfer the http://www.bebe.com domain name, its social media accounts and its international wholesale agreements to the Joint Venture. The Joint Venture in turn intends to license them to one or more third parties. – Q3 2017

4. BEBE has previously announced that a liquidator had been appointed to sell all of the company’s inventory and FF&E. As a result I have applied a 50 % discount on the company’s inventory value in my calculation for raNAV value. I have not done the same for FF&E (included in PP&E on the balance sheet) since the value as of today (Q3 2017) has already been impaired by a large amount taken this into consideration. Therefore I will use the $9,935 stated on the balance sheet as it relates to other assets that the company is going to sell.

On April 18, 2017, bebe stores, inc. (the “Company”) entered into a Consulting Agreement (the “Agreement”) with Great American Group, LLC, an affiliate of B. Riley & Co., the Company’s financial advisor, and Tiger Capital Group, LLC (collectively, “Consultant”), to, among other things, sell (i) all merchandise and inventory owned by the Company and certain of its subsidiaries located in its existing retail stores (the “Stores”) and (ii) certain furnishings, trade fixtures, equipment and improvements to real property with respect to the Stores. We may incur a loss in connection with this sale of our merchandise and inventory, but we cannot estimate such loss at this time. Consultant will be paid $550,000 in consideration for its services, plus reimbursement for certain expenses, and will receive an additional fee of 15% of the gross proceeds generated from the sale of the furnishings, trade fixtures, equipment and improvements to real property.

5. BEBE has also stated that it intends to sell its owned real estate:

The Company intends to sell its real estate holdings consisting of a distribution center in Benicia CA, a design studio and production facility in Los Angeles CA and two condominium units in Los Angeles CA. The Company has decided that it no longer needs these properties because it is shutting down its operations. The Company will use the proceeds from sale of the buildings to fund the costs of wind down including lease termination costs, severance and other costs. The Company does not expect to incur a loss on the sale of its real estate holdings.

The real estate is currently found under the FSLI “held for sale” for current assets at a value of $25,796. One should note the following regarding the valuation method as it concerns held for sale assets: measured at the lower of carrying amount and fair value less costs to sell.

From previous 10-K’s and the note “Property and Equipment” I have gathered the following information about these real estate properties:

In December 2008, we acquired two condominium units in Los Angeles, California for use as short-term executive accommodations with approximately 3,400 total square footage.

The purchase price for the two condominium units was $1,705.

We also purchased our 144,000 square foot distribution center in Benicia, California in May 2012.

The purchase price for the distribution center was $18,000.

In fiscal 2004, we acquired a 50,000 square foot design studio and production facility in Los Angeles, California that houses our design, merchandising and production activities.

The purchase price for the design studio and production facility was $10,942.

The total price paid for the owned real estate adds up to $30,647. Naturally this is higher than the held for sale number value because of depreciation (see valuation definition above for held for sale assets). Although there might be some hidden value in the real estate (fair value) I have only assumed that BEBE at least will get the similar amount of money back as they once have paid. Therefor I have used $30,647 in my raNAV calculation.

6. The company has a large amount of net operating losses (NOL’s), $298,600 or $36,9 per share. NOL’s are found off the balance sheet but could be regarded as an asset. Especially by a company that would potentially acquire BEBE. This is because the acquiring company can use the NOL’s to lower their taxes paid. However, the valuation of NOL’s is truly rocket science. It all depends on the potential value of the NOL’s that an acquiring company can use. In other words, since the NOL’s expire over a period of time a more profitable company would assign higher value to the NOL’s than a less profitable company. Therefor I have made four assumptions as it concerns the value of BEBE’s NOL’s. [EDIT: 2017-05-26, see comments regarding NOL’s]

As of July 2, 2016, the Company has federal, state and foreign gross net operating loss carryovers of approximately $169.2 million, $122.1 million and $5.9 million, respectively. If not used, these carry forwards will expire at various dates from fiscal year 2016 to fiscal year 2036. The Company also has foreign tax credit and state tax credit carry forwards of approximately $1.6 million and $0.2 million, respectively, which will be available to offset future taxable income. If not used, the foreign tax credit carry forwards will expire at various dates from 2017 to 2026 and the state tax credit will expire from 2020 to 2022.

NOL’s Discount 298600 0% per share 36,9 149300 50% per share 18,4 89580 30% per share 11,1 29860 10% per share 3,7

7. Before providing you with my calculation of raNAV based on what I have presented above I should also present my view about the company’s future (you might want to compare this with what the company has stated, see point 3 above).

I don’t think that BEBE will continue as a company under the joint venture. I think the company is going to be sold as there is still value in the brand of BEBE (see point 3 above) but also considering the amount of NOL’s that the company has. This is also based on the fact that the company’s has rushed into the termination of all lease contracts and personal and appointed a liquidator of inventory and FF&E and that have decided to sell all their real estate. Moreover, the CEO Manny Mashouf announced in June 2015 that he intended to sell of his then 59 % position in the company. However, as of today he still holds about 57 % of the shares outstanding. I would argue that he has decided to look for a deal where the whole company gets acquired rather than to sell his position gradually on the market. One final note, a very important one, is that Lloyd Miller III seems to be invest on a similar story. Since this story has evolved he has repeatedly and more aggressively increased his stake in BEBE. He now owns 10 % of the company. But enough speculation, here is the raNAV calculation of BEBE as of Q3 2017:

‘000 $ Comments Cash 26 755 Receivables 7 862 Inventory 14 207 See point 4. Assets held for sale 30 647 See point 5. Prepaid and other 8 491 Adjusted current assets 87 962 Total liabilities -46 482 Adjusted NCAV 41 480 Adjusted NCAV per share 5,1 Lease termination payment -60 400 See point 1 Employee termination payment -10 000 See point 2 PP&E 9 935 See point 4. 50 % JV ownership 35 000 See point 3. raNAV 16 015 raNAV per share 2,0

On top of the $2 USD per share of raNAV that I have calculated is the value of NOL’s that one must also take into consideration. I find it hard to believe that an acquirer will pay $1 for every $1 of BEBE’s NOL’s. I also think is it is fair to assume that they will likely pay more than 10 cent for every $1 of NOL’s. My guess is that it is likely going to be in the ballpark of 10-30 cent for every dollar of NOL . But my honest answer is I don’t know. However assuming a 10-30 cent for every dollar of NOL on top of the other $2 per share would give us a raNAV value of $5,7 – 13,1 USD per share. Based on the current price of $4,82 that would give us the following multiples of P/raNAV = 0,85x – 0,37x. [EDIT: 2017-05-26, see comments regarding NOL’s]

As of today I have not increased my position in BEBE but will most likely do so if the stock tumbles back below $4. [EDIT: 2017-05-26, as a result of my misstake regarding NOL’s, see comments]

Disclosure: The author is long NASDAQ:BEBE when this analysis is published. Also note that NASDAQ:BEBE is a nano-cap stock (40 M$ in market capitalization). The trading is illiquid.