Thursday, November 5, 2009

Off-Balance-Sheet Debt at BT Group

The heavy burden of hidden debt
BT Group, plc, is one of the world’s largest telecommunications companies. Since the telecom crash in 2001, it’s been struggling with operating, management, and reporting problems. You can add financial problems to the list as well.

Its leverage – or “gearing”, as the English put it – is high. Reported debt to capital (adjusted for actuarial losses in its pension plans) is 66%. That’s based on the numbers reported on the company’s balance sheet.

Look beyond the balance sheet, and leverage gets much worse. BT has retirement benefit obligations that exceed pension plan – or “scheme,” as the English say --- assets by £2,870. If you consider that to be debt, leverage increases to 71%. Treat operating leases as a form of debt financing, and BT’s leverage climbs to 75% (capitalizing annual rental expense at 8x).

Off-balance-sheet debt equivalents
What explains the difference between BTs reported leverage and its adjusted leverage? Why treat pension and lease obligations as the equivalents of debt? How do you tell if an off-balance-sheet liability belongs in your leverage analysis?

We use these criteria. To be the equivalent of debt, an obligation has to:

• Be a financial obligation, not money owed to a supplier
• Have an imputed or actual interest rate
• Have a fixed payment schedule
• Allow the holder to demand payment in full on default
• Be a substitute form of capital

By these standards, unfunded pension obligations are debt because they are financial, are discounted at an interest rate, and often have a payment schedule that is enforced not just by pensioners but by government regulators as well. Operating leases are debt because they are another way of financing assets. If BT securitized its trade receivables, that would be another form of off-balance-sheet financing equivalent to debt.

U.S. and international reporting rules are precise about what debt is, but those rules don’t always capture the economic reality of how companies finance themselves. Sometimes reported leverage understates real leverage. That’s the case for BT.


Arthur James said...

I certainly go for capitalising rental/operating lease expenses at 6-8x as a useful rule of thumb. An alternative method (provided you have sufficiently detailed info) is to discount back the expenses at the cost of debt and add this sum to the debt to get teh lease adjusted leverage.

Tim Delaney said...

Your alternative is really the better way. It's the present value of the the lease rental payments, and, by definition, that's the value of debt. The problem is that it's hard to do that with the typical public disclosure about future lease payments. You end up making assumptions to fill in the information gaps. It's probably no more accurate and definitely more time-consuming than using a simple multiple to capitalize the expense. So the best argument for the multiple method is analytical efficiency.

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