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Tax changes implications for emerging markets

May 2018

The hitchhiker's guide to IFRS accounting standards

We look at why emerging market investors should pay close attention to new IFRS accounting rules.

The new IFRS 16 Leases standard is designed to make financial statements more transparent and comparable by eliminating dual accounting treatment for leases. The changes will impact commonly used metrics for leverage, value and company earnings across all corporate sectors globally, as virtually all companies use these contracts to run their businesses.

As emerging market investors, we spend a lot of our time looking for mispricings (which can happen regularly in our markets).  We think these accounting standard changes merit special attention for bottom-up stock pickers like us especially given that many market participants don’t appear to be watching out for this kind of topic.

The impact on financial metrics can be summarized thus:

  • Asset and liabilities will increase. Companies will look more asset rich, but also more levered. Businesses using more leases will see a larger impact on their financial statements.
  • EBITDA will increase as lease / rentals will be capitalized and reclassified from operating expenses to depreciation.
  • EPS will decline in the early years of the lease as a result of a front loaded lease expense.
  • ROIC should generally decline as new rules mean a higher invested capital for a lessee.
  • Gearing ratios, interest cover or liquidity will be influenced, which could have knock on effects for borrowing costs, credit ratings and loan covenants.
  • To put things into perspective, let’s take a look at a simplified example of the Russian food retail space where most retailers lease property instead of owning it. To assess the approximate impact on financial ratios, we have created aggregate FY2017 data assuming the rules were implemented last year.

    Under the new rules, FY 2017 EBITDA for the industry increases by 64%, but net debt goes up by a whopping 113%! As a result gearing ratios deteriorate by around 30%. In a market where many investors overlook accounting standards and typically tend to ignore IFRS developments, this might cause some surprises.

    The below table is the result of PwC’s extensive study on the potential impact  across various industries.

    Companies are likely to appear more leveraged. On average reported debt would increase by 22%, whilst EBITDA by 13%.
    PWC study on the potential of new IFRS accounting rules across various industries.

    Source: PwC global lease capitalisation study

    Impact on valuations

    IFRS 16 will also have an impact on valuation metrics. In an efficient market, equity values shouldn’t be impacted by new accounting standards if business fundamentals remain unchanged. However, the enterprise value (EV) of companies will increase; meaning that the EV/EBITDA multiple, a commonly used valuation metric, will thus become less comparable with its own history.

    These rules could make substantial changes to our models with no fundamental change to the business.

    Even DCF modelling will become a more complex task as WACC and FCF assumptions will be different. In theory, an increase in a company’s EV should be precisely offset by the increase in net debt, leading to a constant equity value. However, in an inefficient market, practice doesn’t always reflect theory.

    Looking back at the example of Russian food retailers; as of January 1st 2018, the industry traded at an average multiple of 8x EV/EBITDA. Under the new rules, the industry trailing mulitple will contract to 6.1x EV/EBITDA, a hefty discount to its own history with no fundamental changes to the business!

    Being aware of such changes is a crucial part of our day-to-day job. It not only allows us to understand the risks we are taking in the portfolio but also allows us to take advantage of opportunities when the market overreacts.