IFRS Lease Accounting HSBC 2.19.2019 PDF

19 February 2019
ESG & Equities

Lease accounting Global
IFRS 16: the biggest changes in over 30 years
 The introduction of IFRS 16 from January 2019 will bring radical

changes to lease accounting
 The biggest impact will be on net debt which could rise
dramatically at some companies
 We look at what the changes mean for six sectors: food retail,
non-food retail, transport, logistics, pubs, and business services
Dylan Whitfield*
The new International Financial Reporting Standard IFRS 16, which took effect Head of Forensic Accounting
on 1 January 2019, will have a big impact on all companies with significant HSBC Bank plc
dylan.b.whitfield@hsbc.com
leases that report under IFRS. Operating and finance leases, two distinct +44 20 3359 5903
accounting models, are being replaced by a single on-balance sheet lease model. Joseph Thomas*
From now on, companies will recognise an asset and the liability (along with a Analyst
HSBC Bank plc
depreciation and a finance charge) for all leases. joe.thomas@hsbcib.com
+44 20 7992 3618
Why the change? The 30 year old IAS 17 was criticised because the financing provided David McCarthy*
by operating leases was off balance sheet, leading to companies reporting lower financial Global Head of Consumer Retail Research
HSBC Bank plc
liabilities compared to companies that purchased similar assets with debt. david1.mccarthy@hsbcib.com
+44 20 7992 1326
Sectors with high levels of leased large assets, such as stores, warehouses,
Andrew Porteous*, CFA
aircraft, and trains will feel the biggest impact. Sectors affected include airlines, European Retail Analyst
retailers, travel and leisure, transport, telco’s, energy, media, distributors, IT, and HSBC Bank plc
andrew.porteous@hsbc.com
healthcare. We consider the lease landscape and model the impact on the food and +44 20 7992 4647
non-food retail sectors and the transport, logistics, pubs and business services Paul Rossington*
sectors. Airline lease financing is often considered a “known unknown”, consequently Analyst
HSBC Bank plc
we do not include an analysis of the airline sector in this report. paul.rossington@hsbcib.com
+44 20 7991 6734
Our model predicts the newly recognised lease liabilities will often be large. For Edward Stanford*
example, using our model, we estimate that for Tesco and Morrisons, net debt will Analyst, Transportation
HSBC Bank plc
quadruple and double, respectively, and calculated EPS will decrease. Their edward.stanford@hsbc.com
operating lease commitments may also be bigger than previously disclosed. Income +44 20 7992 4207
statements could also become more volatile. Rajesh Kumar*

Pan-European Business Services Equity Analyst
HSBC Bank plc
Companies can be selective in their choices and accounting, which can have a
rajesh4kumar@hsbcib.com
big impact. We consider certain of the key choices with a forensic accounting lens, +44 20 7991 1629
identifying what investors should look out for. We also demonstrate via a simple Chirag Vadhia*
Analyst
example portfolio that permissible choices can have a material impact (e.g. the net HSBC Bank plc
debt impact in our example increases by 47% depending on the choices made). chirag.vadhia@hsbc.com
+44 20 3268 5721
Shocks can happen, but opportunities arise. Understanding the impact will Matthew Lloyd*
prepare investors for what to expect and help identify possible investment Head of UK MidCap Equity Research
HSBC Bank plc
opportunities, e.g. looking at which companies are significantly exposed, or where the matthew.lloyd@hsbcib.com
market has over-reacted to an announcement of the impact on a company. +44 20 7991 6799
* Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is

not registered/ qualified pursuant to FINRA regulations
Disclosures & Disclaimer Issuer of report: HSBC Bank plc

This report must be read with the disclosures and the analyst certifications in
View HSBC Global Research at:
the Disclosure appendix, and with the Disclaimer, which forms part of it.
https://www.research.hsbc.com
ESG & Equities ● Global
19 February 2019
Contents
Executive summary 3
The new lease accounting standard 9
Areas of judgement and choice 15
Assessing the impact 22
Impact on sectors 28
Impact on the Food Retail sector 31
Impact on the non-Food Retail sector 35
Impact on the Transport sector 40
Impact on the Logistics sector 42
Impact on the Pubs sector 46
Impact on Business Services 49
Appendix 1: The key technical

aspects of IFRS 16 55
Disclosure appendix 71
Disclaimer 76
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19 February 2019
Executive summary
 The big changes to lease accounting are here – expect net debt to
rise significantly and income statement volatility to increase
 The accounting appears simple, but the reality is complex and
potentially subjective
 There may be some shocks – understanding the subtlety is key and
may lead to opportunity
The biggest changes to lease accounting in over 30 years
The long-awaited changes to lease accounting, in the form of IFRS1 16 – Leases, took effect for
financial periods commencing on or after 1 January 2019. The change will affect companies
across the world that report under IFRS.
Lease accounting is, perhaps, not the most stimulating topic; consequently there may be a
temptation to over-simplify the changes and consider them along the lines of “just the current
operating lease commitments coming on balance sheet”. We think this may lead to the potential
for shocks and opportunities being missed.
In our view, there will likely be a material impact on financial numbers and commonly used metrics
(in particular net debt) where companies have a significant lease portfolio. Understanding the
changes, and the likely impact on expectations and metrics, will prepare investors and potentially
enable opportunities to be identified. For example, investors need to be able to identify which
companies may be significantly exposed, or perhaps where the market has over-reacted to a
company announcement in relation to the impact.
IFRS 16 in a nutshell
At a high level, what has changed?

 the dual approach of leases either categorised as finance or operating lease is replaced
with a single lease model for lessees. Operating leases will see the biggest changes;
 operating leases are brought on balance sheet as an asset and liability;
 the operating lease charge is replaced in the income statement with depreciation and
finance charge (which won’t be equal to annual cash flow);
 the total cash flow will be neutral but there will be changes to classifications within the cash
flow statement;
 the basis of the liability in IFRS 16 is potentially materially different from the previous
standard (and may be significantly greater than previously reported); and
______________________________________
1 International Financial Reporting Standard
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19 February 2019
 IFRS applies to all contracts (even if not labelled as a lease) that give an entity the right to
control the use of and receive the benefit from an identified asset.
The expected high level directional changes are set out in the table below.
IFRS 16 - Lessee accounting high level changes

Effects on the income statement Effects on the balance sheet Effects on the cash flow statement
EBITDA  Lease assets  Cash from operating activities 
Operating profit - depends Financial liabilities  Cash from financing activities 
Finance costs  Equity - depends Total cash flow 
Profit before tax - depends
Effects on ratios
Interest cover – depends Net debt Gearing 

EPS - depends Current ratio  ROCE - depends
Net debt / EBITDA  PE ratio - depends
Source: IASB, HSBC
There will be limited changes for lessors.
Our view
As set out above, the reported earnings, reported net debt and commonly used metrics
Expect significant impacts.
Comparisons may become and ratios in a given year will change. We think the changes could be significant as liabilities
challenging. IFRS 16 may go on balance sheet and volatility is introduced into the income statement. For example, we
lead to an initial shock estimate that for Tesco and Morrisons, the net debt will quadruple and double, respectively.
There may be additional surprises in relation to the size of the liabilities recognised under
IFRS 16 compared to the previous IAS 17 disclosure (for example the IFRS 16 liabilities go
beyond the first break clause of lease). One should remember that the underlying economics
and cash flows of the existing leases within a company’s portfolio will not change.
IFRS 16 introduces choice, subjectivity and estimation, which has the potential to materially
change the impact (for example, the recognised net debt in our simple simulation increases by
47% depending upon the choices made).
The standard may lead to changes in the ways companies make decisions, e.g. whether to lease or
buy a particular capital asset, or what lease lengths companies are prepared to sign up to.
Is IFRS 16 an improvement?
Balance sheet transparency
will increase at the detriment
The IASB has stated that the new standard provides “a more faithful representation of a
of the income statement company’s assets and liabilities and greater transparency about the company’s financial
leverage and capital employed”2.
Although the change should, in time, improve transparency of the accounting on the balance
sheet, this appears to us to be at the potential detriment of the income statement. In particular,
the profile of expense charges over the life of, what would have been previously classified as,
an operating lease, which may significantly deviate from the actual cash flows. IFRS 16 also
introduces management choice, judgement, and estimates that were not previously required.
______________________________________
2 Source: IFRS 16 Leases - Effects Analysis by the IFRS Foundation, January 2016
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19 February 2019
Transparency and usability will be affected by the choices made. As there are areas where
Accounting choices,
companies can make certain choices (at transition and on an ongoing basis) this could lead to a
judgements and estimates
may decrease the benefit scenario where two companies with identical lease portfolios could have different lease
accounting impacts within their financial statements.
Challenge for investors
We think that the changes will present a particular challenge for investors using certain ratios
Comparisons may
and multiples in evaluating the performance and potential of individual stocks and where
be challenging
making comparisons within a sector. This challenge is likely to be exacerbated by the variety in
individual lease portfolios and the available accounting choices and judgements required.
Overall we think that IFRS 16 may lead to initial shocks in market perception, but, despite
the changes, it is important to consider that the underlying economic reality of the business will
not have changed.
The potential for initial concerns to become more serious exists, particularly if market
There may be a re-basing of
multiple expectations have to be re-based. Consequently investors may have to re-visit their
multiple expectations
models and their expectations of price multiples.
What companies are likely to be affected?
Any company with a material lease portfolio is likely to be affected by IFRS 16, however the
IASB’s top 10 sectors affected
IASB’s top ten affected sectors (excluding banks and insurance companies) are3: airlines,
retailers, travel and leisure, transport, telecommunications, energy, media, distributors, IT, and
healthcare. It is unsurprising that airlines are at the top of the list.
A word on airlines
The off balance sheet financing of leases within the airline sector is considered a “known
unknown” for investors, who can comparatively easily make adjustments for aircraft fleet leases.
Annual lease costs and committed lease obligations are reported. Consequently analysts and
investors have tended to make automatic adjustments for aircraft leased portfolio. Therefore we
think the relative level of surprise for airlines will be smaller than other sectors. We do not
discuss the airline sector in this report.
Our view on selected sectors

We have developed a model that estimates the impact of IFRS 16 based upon the limited disclosure
We’ve looked at the impact
within companies’ operating lease commitment note. We have run that model across selected stocks
on six sectors
within the food and non-food retail transport, logistics, pubs and business services sectors.
With Tesco having reported on the 15 February, we are able to gauge how accurate our model
Some results much as
expected, some surprises is. In Tesco’s announcement (which applied to 1H18/19, the last reported period), it reported:
 An EPS impact of (0.91)p or a 14% reduction as a result of IFRS 16
 A lease liability of GBP10.6bn leading to total indebtedness of GBP15.3bn
Compared to our modelled impacts, the differences are relatively minor from a P&L perspective.
We expected an impact of c1.7p and the implied FY impact for Tesco would be around 1.8p.
From a net debt perspective, the reported liability was even higher than we had forecast, in part
due to a slightly lower discount rate (5.8% vs 6%) but mainly due to the timing of breaks and
expectations of continuations beyond these breaks, something that is very hard to model
without complete information of the portfolio.
______________________________________
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19 February 2019
The results were often as expected; for example we saw significant increases in net debt for
most of the companies we modelled (including four companies that moved from net cash to net
debt). However, in some cases, the impact was surprising:
 the impact on net debt varied significantly company to company (e.g. in Retail, our model
predicted Tesco’s net debt would quadruple, versus Morrisons’, which doubles; and in
Pubs, Marston’s net debt increased by 18% whilst Mitchells & Butlers’ increased by 22%);
 the impact within retail appeared particularly prone to understatement within Europe (as
European lease contracts typically have earlier break clauses);
 within transport, indications that track access may not be within the scope of IFRS 16 but
rolling stock will;
 rail operators may be considering adopting a fully retrospective transition approach; and
 within the logistics the income statement impact was lower than first expected and
companies appeared to be attempting to minimise the impact on the free cash flow
reporting by separately disclosing lease payments.
Conclusion and what to look out for
IFRS 16 may ultimately mean investors receive a more accurate view of lease liabilities in the longer
Balance sheet transparency
at the expense of the term, albeit at the potential detriment of the income statement, which will further diverge from the
income statement cash flow statement. It remains to be seen how the investors will respond to the changes.
We are concerned that there will be variations between companies using different accounting
Concerns around
possible variations choices which will reduce the potential benefits. We are also concerned that some companies
will make adjustments to segregate lease charges from metrics such as net debt, EBT and EPS
to attempt to effectively ignore the impact and remove leasing completely from their metrics.
Accounting choice, judgements and estimates

Choice, judgements and estimates in accounting often present challenges to investors and in
Understand the choices
our view the IFRS 16 allows for potential material divergence between companies. Key areas
investors should consider are:
 the transition approach used (and the exemptions taken);
 which contracts are considered leases (and therefore subject to lease accounting);
 how the periods of the leases are determined;
 the discount rate used;
 exemptions used (e.g. low-value leases and short-term leases); and
 variable lease payments.
Debt covenants and financing

No indications yet that IFRS
16 is a reason for refinancing Covenants may be stretched or breached following the adoption of IFRS 16. We think most
corporate debt facilities will have “frozen GAAP” clauses (or similar) in their debt agreements.
Anecdotal evidence also suggests that any breaches of debt covenants as a result of IFRS 16
will not, in isolation, be used by lenders as rationale to amend or terminate facilities.
IFRS 16 does not affect cash flow. If a company provides IFRS 16 as rationale for any re-financing
or new capital issue, we consider that investors should look carefully at whether the underlying
reason is the strength of the balance sheet rather than a change in accounting.
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19 February 2019
Opportunities for structuring of future leases to achieve a desired accounting treatment

Potential opportunities may arise for companies to structure contracts or make judgements to
Be alert for structuring to
achieve accounting rather achieve a particular accounting treatment (e.g. using more short-term leases that could remain
than value off balance sheet). Investors should be alert to those potential opportunities and question
management where there may be indications that decisions are made for accounting reasons
rather protecting shareholder value.
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19 February 2019
Stocks mentioned in this report
MCap Current
Company name and ticker Analyst USD Currency Rating Price Target price
Food Retail
Tesco (TSCO LN) David McCarthy 27,654 GBp Buy 219 265
Sainsbury’s (SBRY LN) David McCarthy 8,002 GBp Reduce 282 230
Morrisons (MRW LN David McCarthy 7,207 GBp Buy 236 265
Non-Food Retail
Asos (ASC LN) Paul Rossington 3,118 GBp Buy 2,886 4,500
AB Foods (ABF LN) Paul Rossington 23,497 GBp Buy 2,304 3,250
Boohoo (BOO LN) Paul Rossington 2,824 GBp Buy 189 240
Brown N (BWNG LN) Paul Rossington 341 GBp Buy 93 150
B&M (BME LN) Andrew Porteous 4,211 GBp Buy 327 500
Dixons Carphone (DC/ LN) Andrew Porteous 1,984 GBp Buy 133 160
Dunelm (DNLM LN) Andrew Porteous 1,922 GBp Reduce 739 650
Halfords (HFD LN) Paul Rossington 620 GBp Hold 242 250
Inchcape (INCH LN) Paul Rossington 3,230 GBp Buy 604 690
Kingfisher (KGF LN) Paul Rossington 6,342 GBp Hold 233 240
M&S (MKS LN) Paul Rossington 6,108 GBp Hold 292 285
Next (NXT LN) Paul Rossington 8,789 GBp Buy 4,959 5,900
Pets at Home (PETS LN) Andrew Porteous 833 GBp Buy 129 160
Ted Baker (TED LN) Paul Rossington 1,111 GBp Buy 1,935 2,215
Transport
Stagecoach (SGC LN) Joseph Thomas 1,158 GBp Hold 157 165
Firstgroup (FGP LN) Joseph Thomas 1,454 GBp Hold 93 80
Pubs
Marston’s (MARS LN) Joseph Thomas 778 GBp Hold 95 100
Mitchells and Butlers (MAB LN) Joseph Thomas 1,573 GBp Buy 285 310
Logistics
A.P.Moller Maersk (MAERSKB DC) Edward Stanford 13,150 DKK Buy 8,640 10,100
Deutsche Post DHL (DPW GR) Edward Stanford 36,680 EUR Hold 26.3 24.5
DSV (DSV DC) Edward Stanford 14,727 EUR Buy 517.8 625.0
Kuehne + Nagel (KNIN SW) Edward Stanford 16,230 CHF Hold 136.3 130.0
Panalpina (PWTN SW) Edward Stanford 3,718 CHF Hold 157.7 180.0
Business Services
Brenntag (BNR GR) Rajesh Kumar 7,412 EUR Buy 42.4 52.0
Hays (HAS LN) Rajesh Kumar 2,951 GBp Buy 157 190
Page (PAGE LN) Matthew Lloyd 1,963 GBp Buy 464 685
Randstad (RAND NA) Matthew Lloyd 9,481 EUR Buy 45.8 67.0
G4S (GFS LN) Matthew Lloyd 4,125 GBp Hold 206 220
Prosegur (PSG SM) Rajesh Kumar 3,250 EUR Buy 4.67 6.60
Prosegur Cash (CASH SM) Rajesh Kumar 3,471 EUR Buy 2.05 2.30
Securitas (SECUB SS) Rajesh Kumar 5,445 SEK Reduce 145 115
SPIE (SPI FP) Matthew Lloyd 2,312 EUR Hold 13.2 14.0
Bunzl (BNZL LN) Rajesh Kumar 10,683 GBp Buy 2,465 2,800
DCC (DCC LN) Rajesh Kumar 8,549 GBp Buy 6,755 8,350
Electrocomponents (ECM LN) Matthew Lloyd 3,301 GBp Hold 577 550
Ferguson (FERG LN) Rajesh Kumar 16,092 USD Buy 5,385 6,520
IMCD (IMCD NA) Rajesh Kumar 3,933 EUR Buy 66.3 63.0
Aggreko (AGK LN) Rajesh Kumar 2,395 GBp Buy 726 1,050
Ashtead (AHT LN) Rajesh Kumar 12,260 GBp Buy 2,007 2,500
Rentokil (RTO LN) Matthew Lloyd 8,347 GBp Buy 352 440
Elis (ELIS FP) Rajesh Kumar 3,421 EUR Hold 13.8 15.0
Source: Bloomberg, HSBC estimates. Current prices as of close of 13 February 2019.
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The new lease accounting

standard
 New accounting standard for leases brings material changes to

financial statements
 There will be increased potential choice, judgement & estimates in
the accounting compared to the old standard
 Potential for significant variations between companies causing
challenges if making comparisons, which may lead to an initial shock
A new standard for lease accounting – operating leases are

(almost) no more
From 1 January 2019, IFRS 16 – Leases, replaces the accounting treatment for leases that has
IFRS 16 brings radical
changes to the accounting existed for over 30 years and is, arguably, one of the most substantial changes to the accounting
and likely material changes landscape since the introduction of IFRS 1 in 2003. The changes are likely to impact a significant
to financial information proportion of quoted companies, as most utilise some form of lease arrangements within their
business. As an indication of scale, an impact study by the IASB undertaken in 2016 estimates that
the present value of future payments for leased assets of listed companies is over USD2trillion.4
Why the change?

Updating lease accounting has been on The International Accounting Standards Board’s
“IASB”) agenda since 2006. The criticisms of the previous IAS 5 17 model were focused upon
there being two distinct accounting categories for leases, operating and finance leases which
had two very different accounting models. Of particular concern was the position that
commitments under operating leases were off balance sheet. Sir David Tweedie, former
chairman of the IASB, famously joked:

One of my great ambitions before I die is to fly in an
aircraft that is on an airline’s balance sheet.”
Sir David Tweedie, former Chairman of the IASB

IFRS 16 brings operating leases onto the balance sheet and removes the two distinct
categories of leases into a unified accounting approach, which will fulfil at least one of Sir
David’s “great ambitions”.
______________________________________
5 International Accounting Standard
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19 February 2019
Our consideration of the changes

Since IFRS 16 was issued in January 2016, various organisations, including all the large
We consider the areas of
choice, judgement and accounting firms and industry bodies, have written substantive papers that focus upon the
estimates and what this technical changes arising from the new standard. Although helpful, these have focused on the
might mean for investors impact to the corporates preparing to implement the changes and produce the disclosure rather
than the impact on and challenges faced by the users of financial information.
Rather than seek to replicate a technical accounting discussion, we have sought to focus on the
impact for investors. We have considered:
 the areas of choice, estimation and judgements that management will have to make
both during the implementation (i.e. transition) of IFRS 16 and on an ongoing basis;
 how the changes might affect the results and financial position of a lessee;
 utilising a forensic accounting approach, how the available choices, judgements and
areas could potentially have a material impact on the reporting of companies and the
meaningful comparisons that could be made by investors;
 six selected sectors, for each:
 discussed what the broader impact of IFRS 16 might be;
 modelled the impact upon the previously disclosed operating lease commitments; and
 what we might expect when the companies begin making their first disclosures about
the impact of the new standard during the course of 2019.
In order to provide sufficient context for these areas we have set out an overview of the relevant
technical aspects of IFRS 16 below.
Our view
The IASB has stated that, in its view, the new standard provides “a more faithful representation of a
IFRS 16 introduces volatility,
and increased judgement company’s assets and liabilities and greater transparency about the company’s financial leverage
within the income statement and capital employed”6. In our view, although the change should bring more transparency to the
which further diverges from accounting and financial position of the companies in time, the transition is likely to cause a challenge
the cash flows for both investors and companies with large and/or complex lease portfolios.
However, as mentioned above, whilst the reporting of the financial position (i.e. the balance
sheet) will be improved, this appears to us to be at the potential detriment of the income
statement. In particular the profile of expense charges, over the life of what would have been
previously classified as an operating lease, may significantly deviate from the real cash flows,
and introduce management choice, judgement, and estimates that were not previously required.
This is likely to be compounded on an ongoing basis as there are still areas where companies
can make certain choices which could lead to a scenario where two companies, with identical
lease portfolios, could have different lease accounting impacts within their financial statements.
It remains to be seen whether companies make similar choices within sectors.
In addition, it may take significant time to achieve consistent and comparable financial information
as there are potentially material choices in relation to the approach adopted within the transition
arrangements. We discuss these areas of choice and other potential areas of divergence in the
next section.
______________________________________
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19 February 2019
Finally, in our view, the standard may lead to changes in the ways companies make decisions,
e.g. whether to lease or buy a particular capital asset, or perhaps what lease lengths companies
are prepared to sign up to.
What are the changes?
At a high level the changes are simple; operating leases that are currently off balance sheet will
Operating leases will be
brought onto the balance be brought onto the balance sheet as a leased asset and a financial liability, the costs of which
sheet. The income statement are then recognised over the life of the lease separately, within the income statement, as
charge is replaced with depreciation and finance charges. The income statement charges will not simply equate to the
depreciation and “old” operating lease charge each year.
finance charges
However, there are further, more granular, changes within the detailed technical aspects of
IFRS 16, which introduce further complexity and choice for companies.
In our view, the choices available to company managements, and the judgements and
estimates they must make, could potentially lead to significant variations in impact.
We discuss the changes below, under the headings of:

 Scope and exemptions;
 Identification of a lease;
 Recognition of leases within the financial statements;
A simple change at a high
level, but complexity, choice  Leases previously classified as finance leases;
and judgements may make
the accounting more  Transition arrangements;
challenging to interpret
 Accounting by lessors; and
 High level comparison to US GAAP.
In addition, we have set out more detail of the relevant technical aspects IFRS 16 in Appendix 1.
Scope and exemptions

IFRS 16 applies to almost any leased asset7, tangible or intangible8, whether leased via a
Choice to use exemptions for
short-term and specific lease contract or embedded within a wider contract (which may not necessarily be
“low value” leases described as a lease). Companies have the choice to not apply the requirements for:
 “short-term” leases, i.e. less than 1 year; or
 leases where the underlying asset is of “low value” (suggested, but not mandated, by the
IASB as USD5,000) subject to certain conditions.
Identification of a lease
IFRS 16 mandates that lease accounting rules apply to any contract that gives an entity the
right to control the use of and receive substantially all the economic benefit from an identified
asset (which IFRS 16 defines) for a period of time in exchange for consideration.
All contracts which contain this criteria (even if the contract is not labelled as a lease) will have to
be unbundled into the lease and non-lease components and be accounted for separately.
______________________________________
7 For exemptions see Appendix 1
8 Although companies have a choice whether to adopt lease accounting for certain intangibles
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Recognition of leases within the financial statements

At a high level, for a lessee, IFRS 16 requires that:
Operating and finance leases
“dual approach” replaced by  all leased assets will be recognised on the balance sheet as the present value of the lease
a single on balance sheet
payments, along with a corresponding, but not constantly equal, lease liability within
lease model
financial liabilities;
 a separate depreciation and interest expense in relation to the lease asset and liability will
be charged to the income statement. The income statement charges will not simply equate
to the old operating lease charge each year, in fact the total lease cost will be front-loaded
within the lease term; and
 the cash outflows are separated into the principal and interest components within the cash
flow statement, although there will be no net overall cash impact.
The impact of recognition under IFRS 16 will greatly depend upon the individual lease
Expect significant variations
and comparisons by portfolio of a company and the choices (including the transition approach) that are made by
investors to become management. The widely anticipated movements are summarised in the table below. It should
challenging which may lead be noted that the table summarises the overall changes; it is likely that IFRS 16 will introduce a
to an initial shock degree of volatility into the income statement that was not previously present.

EBITDA Lease assets Cash from
  operating activities 
Operating profit Financial Cash from

(depends) Liabilities  financing activities 
Finance costs Equity Total cash flow

 (depends) 
Profit before tax

(depends)
Effects on ratios
Interest cover Net debt Gearing
(depends)  
EPS Current ratio ROCE

(depends)  (depends)
Net debt / EBITDA PE ratio

 (depends)
Source: IASB, HSBC
Depending upon the individual lease portfolio of the company, the change to earnings and net
Earnings, and net debt, will
change, but overall cash flow debt of a company, compared to the previous model, may be significant. In addition IFRS 16 will
remains the same change the profile of the financial position and performance of company reported in the financial
statements which consequently may affect financial measures and commonly used investor
ratios and debt covenant limits. We have discussed this further in the next section.
We think that this will lead to challenges for investors, particularly where there are significant
changes to ratios and multiples used in evaluating individual, and the relative merits of, stocks.
Additionally, in relation to lease arrangements previously classified as operating, the increased
volatility within the income statement, increased influence of judgements and divergence from the
cash flows will likely increase the complexity and decrease the clarity of the financial information.
These challenges may, in some cases, lead to initial shocks in market perception.
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19 February 2019
Transition arrangements
There are choices and
elections during the
Companies can elect to apply IFRS 16 fully retrospectively; if this election is made, companies
transition – this could lead to must do so for all leases in which it is a lessee. IFRS 16 also permits companies to adopt the
significant variations and standard using a “cumulative catch-up” (also known as “modified retrospective method”). In both
prove challenging to analyse cases, IFRS 16 also permits some further elections of whether to use a number of “practical
expedients” set out in the standard. We have set out further detail of these choices in the next
section and in Appendix 1.
The choices provide companies with a significant amount of latitude on how to treat existing
leases, which, in our view could lead to significant variations if comparing company to company,
and provide investors with particular challenges in understanding the disclosure and results of a
particular company.
Leases previously classified as finance leases

The most significant changes will be in relation to leases previously classified as operating
leases, and that is where we have focused most of our analysis within this note. However,
leases previously classified as finance leases are also subject to IFRS 16 and may be impacted
by the changes in measuring the lease liability. However, in our view, in most cases this will be
to a much smaller degree. Going forward there will be no distinction.
Accounting by lessors
For lessors, however, very little has changed. IFRS 16 requirements for lessors are similar to
Limited changes for lessors
the requirements of the preceding International Accounting Standard (“IAS”) 17; this will lead to
asymmetry in the accounting by lessors and lessees. This is unlikely to be a concern for most
companies, although it would potentially affect any companies that on-lease any leased assets.
As there are limited changes to the accounting by lessors we will not consider the accounting by
lessors within this report.
US GAAP
The US standard setting board, the “FASB”9, and the IASB began the process of reforming
Potentially significant
differences between IFRS lease accounting jointly, however the project did not result in a fully convergent approach. The
and US GAAP FASB’s new leasing standard10 differs from IFRS 16 in a number of areas including:
 keeping the distinction between operating and finance leases, although operating leases
are brought on balance sheet;
 the lease expense is recognised on a straight-line basis in a single line item in the income
statement; and
 US GAAP does not include any exemptions for low value assets.
Consequently, depending upon the circumstances, there could be substantial differences in impact
for two entities with identical lease portfolios reporting under the different regimes. For the purposes
of clarity within this report we will only consider the impact of the implementation of IFRS 16.
Challenge for investors
The reported earnings, reported net debt and commonly used metrics and ratios in a
Earnings, net debt and
common metrics may change given year will change, in some cases significantly. However, the underlying economic
significantly despite net cash reality and related cash flows of the existing leases within a company’s portfolio will not.
out over the life of a lease
The longer-term company earnings impact of the standard (even if the changes to the numbers
being unchanged
are significant) should, in most cases, be neutral at the point a lease contract concludes.
______________________________________
9 Financial Accounting Standards Board
10 effective for periods commencing after 15 December 2018
13
19 February 2019
We think that this will present a particular challenge for investors using certain ratios
and multiples in evaluating the performance and potential of individual stocks and where
making comparisons within a sector.
We are also concerned that there will be variations between companies using adjustments to
segregate lease charges from metrics such as net debt, EBT and EPS, adding to the challenge
when comparing the performance within a peer group.
The potential for initial concerns to become more serious exists, particularly if market multiple
A re-basing of multiple
expectations may be required expectations have to be re-based. Consequently, investors may have re-visit their models
and their expectations of price multiples.
These challenges may, in some cases, lead to initial shocks in market perception. It remains to
be seen whether this will lead to a longer term re-basing of particular stocks by the market.
In addition, noting that IFRS 16 affects neither cash flow nor the underlying economic reality of
the contracts, if a company provides IFRS 16 as rationale for any re-financing or new capital
issue, we consider that investors should look carefully at whether the underlying reason is the
strength of the balance sheet rather than a change in accounting.
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19 February 2019
Areas of judgement and

choice
 IFRS 16 is not simple; lease portfolios are frequently material and

involve non-straightforward transactions
 Choices, judgements and estimates made when applying IFRS 16
increase the complexity of analysing the financial information
 We explore the key choices and set out questions investors may
wish to consider or perhaps pose to management
Starting simple, but the complexity of the standard, choices,

judgements and estimates rapidly increases difficulty
Comparison to the old standard (IAS 17)

Previously, the judgements required in relation to operating leases were often limited and were
principally related to disclosure rather than having an effect on earnings. It is likely that this will
not be the case under IFRS 16 as it requires judgement and estimates and choice for all leases
but in particular for leases that were previously classified as operating leases.
Consequence of choice
Accounting judgements, estimates and choices in the preparation of financial statements, and
Leases are often material and
complex; understanding the the challenges these often present to investors, are not a new issue. However, as lease
judgements made is important portfolios are often material to companies and involve non-straightforward transactions,
when drawing conclusions understanding the accounting is particularly important.
In addition, where there is choice and accounting estimate and judgement, there is also a
potential opportunity for the choices made, even if well intentioned, to present the transactions
in a potentially more favourable way than in manner that may more accurately reflect the reality
of the circumstances.
Investors should, therefore, be alert to the key choices and judgements made and evaluate whether
these reflect the substance of the particular circumstances and whether the impact of the accounting
could lead to significant variations in the resulting net debt and earnings numbers.
What choices are there?

It is impractical to set out every connotation and variation of the possible choices and
judgements and estimates that could be available to a company11. However, we have set out
seven issues that we think are particularly important choices, areas of judgement and/or
estimation that we think investors should be aware of and may seek to obtain clarity on.
______________________________________
11 Many of the choices will also depend upon the nature of the contacts and the assets being leased and others will apply
to a limited number of leases
15
19 February 2019
We have also set out key questions that investors may wish to pose to management. Equally,
corporates may wish to consider those questions and how pre-empt them or provide suitable
detail and disclosure to investors and analysts in response to them.
1. Is a contract a lease?
IFRS 16 applies to almost any leased asset, whether leased via a specific lease contract, or
Identifying that a contract
contains a lease is not embedded within a wider contract. In order for IFRS 16 to apply:
always clear cut and it will  there must be an identified specific asset;
determine whether IFRS 16
applies (i.e. whether the  the customer must have the right to obtain substantially all of the economic benefit of the
contract is on or off asset; and
balance sheet)
 the customer must have the right to direct the use of the asset.
In many cases, little judgement will be required as it will be obvious, for example the lease of an
entire building or piece of land. However in some circumstances it will be less clear-cut.
Illustrative example
If a customer enters into a contract to purchase 100% of the output of a factory for five years;
the assets are specific, and the customer has the right to exclusive use of the asset.
However, if no clear indications exist (for example, controlling the production schedule or
specifying a particular criteria for the design of the plant) the criteria of whether there is an
implicit right to direct the use could be subjective.
This could mean that this asset and liability remains off balance sheet and the income
statement would just reflect the annual charge, as the decision of whether to apply IFRS 16 is a
judgement, and therefore open to variation.
Opportunities to structure contracts to avoid having to use lease accounting

As there is further potential for judgement within the criteria for identifying a lease, this could
Opportunities will exist to
structure future contracts to provide opportunities for companies to structure future contracts and arrangements in such a
avoid meeting the criteria way as to not meet the criteria of containing a lease.
thereby keeping the
For example, a company that requires data bandwidth, rather than contracting with the fibre
contracts off balance sheet
cable owner for the right to 100% of a particular cable, could structure the contract to be a
particular bandwidth instead (equal to 100% of an individual cable) but allow sufficient implied
discretion to the supplier so as to not meet the criteria for lease accounting.
Therefore, again the contract would not require the recognition of the asset and liability on
the balance sheet and the income statement would just reflect the annual charge.
Investors may wish to understand

Particularly for new (rather than legacy lease) contracts, investors may wish to understand
whether the company has any material contracts that:
1. would previously have been considered a lease but do not meet the IFRS 16 criteria;
2. were considered as potentially being lease contracts but did not meet one of the criteria; and/or
3. are service contracts that include the supplier using a material capital asset?
In addition, investors should seek to identify where there are material reductions in the lease
portfolio of a company and understand why those leased assets have not been replaced, e.g.
by the purchase of a replacement or with a new lease.
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19 February 2019
2. What is the period of the lease and therefore what lease payments
should be included (or excluded) in the asset and liability?
Determining the appropriate term of a lease is vital as the initial recognition and measurement
Any subjectivity in the lease
term could potentially have a of the asset and liability is based upon the present value of the lease payments over the “lease
material impact on both the term”. The profile of the depreciation and finance charges within the income statement would
balance sheet and the also vary depending upon the lease term. Therefore any subjectivity in the lease term could
income statement potentially have a material impact (e.g. for a 10 year lease with a 10 year option to extend, the
initial liability would double, depending upon a judgement).
The lease term is defined as the non-cancellable period of a lease together with any options to
Options to extend (including
renewals) must be taken into extend or terminate (by the lessee) if the lessee is reasonably certain exercising either of those
account if “reasonably options. This could potentially also include renewals of leases. This is different from the current
certain”. This could basis of minimum operating lease payments disclosed by companies within the operating lease
significantly increase the note. The changes also potentially affect finance leases.
impact and lead to surprises
IFRS 16 requires that “an entity shall consider all relevant facts and circumstances that create
an economic incentive for the lessee to exercise the option to extend the lease or not to
exercise the option to terminate”.
In the case of a completely fixed-term lease the term would, therefore, be free of any judgement.
However, where there are options to terminate or extend, there is the potential for some subjectivity
to be introduced in relation to certainty of exercising of the options in relation to lease term.
A company with a single operating lease of ten years with a break clause after five and an
annual lease payment of GBP10,000, could, depending upon the circumstances and
judgements, recognise an initial liability of the present value of either GBP50,000 or
GBP100,000 in the first set of financial statements (ignoring the required discounting for the
sake of simplicity).
In addition, it is of note that, under IAS 17, in the first set of financial statements following
entering into a lease, the company might disclose GBP40,000 of minimum future lease
payments12 compared to the present value of the entire GBP100,000 that would be recognised
as the lease liabilities under IFRS 16.
Depending upon the lease portfolio of a particular company, this could potentially lead to a
surprise for investors working on the assumption that the current IAS 17 operating lease
note will directly translate to the IFRS 16 position.
Opportunities to structure contracts to minimise the impact of lease accounting

In addition to the judgement, the IFRS 16 definition of lease term could change the structure of
Contracts could be
structured to shorten the future contracts; it is possible that companies will to seek to specify shorter non-cancellable
lease term to achieve a periods in order to minimise the lease liabilities recognised. However, we expect that this would
desired accounting likely increase the cost of the lease in most circumstances, which may ‘naturally’ discourage
treatment. This may lead to companies from pursuing this approach.
overall increased costs
______________________________________
12 i.e. 10,000 per year, one year paid, four further to go as minimum lease payments under IAS 17
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19 February 2019

1. whether there are any material leases within the portfolio that have lease terms that are
Investors should be alert for
incomplete / shortened potentially subject to judgement;
lease terms
2. what assumptions are being used in determining the likelihood of cancellation and/or
extensions of lease terms; and
3. whether the average lease term is static or decreasing/increasing?
In addition, in relation to the transition, investors may also seek to understand any material
divergences from previous operating lease commitment notes in relation to the average (or inferred)
lease lengths.
3. How is the discount rate determined?
Leased assets are frequently material items (e.g. land and buildings) and lease terms can run
Discount rates are subjective
for substantial periods (e.g. >20 years). Therefore a relatively small difference in discount rate
and variations can have a
material impact can result in a material difference to the amounts recognised.
Determining discounts is rarely an exact science and often open to significant amount of
judgement. IFRS 16 attempts to limit flexibility, to a degree, on what discount rate to apply by
specifying two rates that should be used, being either:
 the rate implicit in the lease or, if that is not readily determined;
 the lessee’s incremental borrowing rate.
However, both options are potentially open to judgements and estimation by a lessee’s
management. Companies will also not always have the information from their lessors in order to
determine the implicit rate (particularly if there is no open market for the asset being leased) and
may have to make assumptions in order to do so.
In the case of a 15 year lease of an asset with lease payments of GBP2 million per annum, if a
discount rate of 4% is applied the entity would recognise an initial liability of GBP19.6 million,
however if 7% was used the initial liability would be reduced to GBP15.8 million.
Opportunities to be selective in order to influence the impact of lease accounting

Depending on the desired outcome13 a company could seek to make favourable assumptions in
relation to the discount rate. For example, management could change the assumed residual
value of the asset (which would affect the implicit rate) or, where the cost of borrowing is more
preferable, make the judgement that the implicit rate is not readily determined.
1. whether implicit rates are being used, and, if so, how these are calculated;
Question whether the
discount rates make sense, 2. what assumptions are being used in determining the rate (in either case);
and whether they are
consistent with other 3. if using asset valuations to compute the implicit rates, what the basis for these valuations is
assumptions. Approach any and how it was arrived upon;
changes made to discount
rates with a degree of caution 4. whether this is consistent with other balances within the financial statements where
discounts are used. If not investors may wish to question why; and
5. if, going forward, there are any significant changes to the discount rate (which should be
estimable from the required disclosures), what is the rationale for such changes?
______________________________________
13 i.e. whether a company wishes to increase or decrease the present value
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19 February 2019
4. What transition approach is being taken and what choices are

being made?
IFRS 16 allows for a number of choices that will further complicate the impact and the
The transition approach
choice could have an disclosure, adding to the challenge of interpreting the numbers. As these will apply until the end
enormous impact depending of the life of leases at transition the impact of any choices could last for many years, although
on the portfolio and the the effect will likely reduce over time. We have set out in Appendix 1 the details of the key
effects of the choices could accounting and the choices within the transition. In our view the most significant choice in
be long-lasting relation to transition will be the method of adoption. Companies have the choice to either:
 retrospectively apply the standard – i.e. restating the accounts as if IFRS 16 had always
applied; or
 to use an option which is often referred to as the “cumulative catch-up approach” (also
referred to as the “modified retrospective method”).
The choices are summarised in the following diagram.
Transition options
Fully retrospective or cumulative catch-up (a.k.a. modified retrospective)?
OR
Cumulative catch up
Fully retrospective LIABILITY
Apply IFRS 16 for each Do not restate
lease from inception of comparatives
each lease historically. Recognise the liability
Re-evaluate all leases as the present value of
Restate comparatives. future lease payments
at the date of transition
ASSET option (a)

ASSET option (b)
Do not restate
Do not restate
comparatives OR comparatives
Recognise the asset as
if IFRS 16 had always
equal to the liability
applied
Practical expedients available to both approaches, including maintaining the decision of

whether a contract contains a lease and leases with less than one year to run can be
excluded
Source: HSBC
Accounting for the transition can be complex and arduous. We have set out a simple example of the
impact of different transition approaches for the same circumstances in the next section. For our
portfolio both the retrospective and cumulative catch-up approach have an adverse effect on the
income statement, however the cumulative catch-up is four times worse in the year of adoption.
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19 February 2019
1. what transition method has been applied;

Depending upon the
particular lease portfolio of a 2. why that method was selected; and
company, the potential
divergence of impact could 3. whether the company has modelled the alternative approaches, and if so what was the
be significant difference to the method chosen?
5. Is the “low value” exemption being applied?
IFRS 16 allows, if management choses, for “low value” assets not to be accounted for under the
Low value exemption is open
to judgement and selective standard. We note that “low value” is not specifically defined, although the IASB has given
application. Low value guidance that it had in mind a value (when new) of USD5,000. This is not mandatory, and
interrelated assets should be allows management to decide.
viewed as one larger asset
This may appear to be for assets of a trifling amount, however in aggregate “low value” assets
could potentially be material. In addition to the judgement of what constitutes “low value”
additional judgement may be required where individual low value assets are interrelated.
A computer server rack may have multiple components that, whilst individually are below the
threshold, are in effect one asset. In this case the low value exemption would not apply.
However, this might require judgement and, similarly to other choices, management could seek
to structure these assets to ensure that they do not qualify for lease accounting (and would
likely be accounted for as an annual expense).
1. what assets the company is leasing but accounting for utilising the exemption;
2. what value management consider “low value” and whether this is applied consistently
across the company’s contracts; and
3. whether the assets considered “low value” are connected.
6. Is the short term exemption being used?
Leases that run for less than one year do not have to follow the accounting prescribed by IFRS
Exercise caution where the
short term exemption is 16. Whilst this is not subject to judgement, it is a choice that management can make, and in
being potentially overused by some instances (where a company utilised a significant number of short leases) may have a
a company; it may point to material impact. The amounts paid under short term leases will be a required disclosure.
lack of value for money in
exchange for simpler
accounting
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19 February 2019
Illustrative example showing potential opportunities to structure contracts to minimise

the impact of lease accounting
A company wishes to lease an asset for five years. If the lessor is amenable, the company could
lease the asset using six ten-month leases. This could, in theory, lead to what is in effect, the
lease financing not being capitalised and therefore could potentially be used to achieve a
particular net debt position or income statement profile. However, that approach potentially
exposes the lessee to commercial risk, if, for instance, the lessor were to decide to withdraw the
asset after, say, 20 months, and the lessee would most likely pay more for the lease than it
would have for a straightforward five-year lease.
In addition, IFRS 16 attempts to preclude this by including likely renewals, although in theory in
some circumstances a company could make a plausible argument that insufficient certainty of
renewal exists to trigger the requirement.
1. where this election is being taken and in particular whether the company may have
structured new leases to take advantage of this option, particularly where that is potentially
detrimental to the overall cash flow; and
2. if a company’s disclosure of short term lease expense shows significant increases,

management’s rationale for using shorter term (likely more expensive, albeit potentially
more flexible) leases.
7. Are there any variable lease payments in relation to the leases?
Leases that include variable lease payments add particular complication to determining the lease
Variable lease payments are
particularly complex, and will liability and asset at the commencement of a lease. The IASB, in their paper IFRS 16 – Basis for
require particular individual Conclusion, sets out further guidance in relation to variable lease payments. This guidance runs to
attention a significant number of pages, which perhaps illustrates the level of potential complexity (and often
judgements) where there are variable lease payments within a lease. The accounting treatment is
highly dependent upon the particular variable payment and may impact the profile of the
recognition of lease payments in the income statement over the life of the lease. For simplicity’s
sake, variable lease payments are outside the scope of this note. However, where investors
believe there may be material variable lease payments (e.g. rent reviews, leases tied to indexes or
the performance of significant assets), obtaining an understanding of those variable terms may be
beneficial when evaluating the performance of the business.
Conclusion - examine the choices, then understand the impact
As illustrated above, the potential for variations between two companies which have similar
lease portfolios could be significant and material. Therefore, obtaining a sufficiently detailed
understanding of the landscape of leased assets within a company is vital when arriving at a
view of the materiality of the leases, when analysing the performance, position and potential of
a company, and when comparing to a peer. In addition, at transition and as the changes embed,
investors should be alert to any operational or financial changes in relation to leases and the
impact to net debt (whether or not explicitly linked to IFRS 16 by management), as,
fundamentally, the cash flows of operating leases are unchanged by IFRS 16. The impact of
IFRS 16 is explored further in the next section.
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19 February 2019
Assessing the impact
 The impact will vary significantly depending on the portfolio and

choices, judgements and estimates of companies
 We set out a simple guide and scenario to understand the high level
impact on financial statements and metrics
 We set out four further scenarios illustrating the material differences
on a simple lease portfolio, depending upon the choices made
The impact – it’s simple isn’t it? Unfortunately it often depends…
As set out above, at a high level, the impact of IFRS 16 might be considered to be straightforward:
The impact is unlikely to
be simple  the dual approach of leases either categorised as finance or operating lease is replaced
with a single lease model for lessees. Operating leases will see the biggest changes;
 all leases are brought on balance sheet as an asset and liability;
 operating lease charge is replaced in the income statement with depreciation and finance
charge (which won’t be equal to the fixed operating lease charge); and
 the effect on total cash flow will be neutral but there will be changes to classifications within
the cash flow statement.
We have set out the widely anticipated movements, which are summarised in the table below. It
should be noted that while the table summarises the overall changes, it is likely that IFRS 16 will
introduce a degree of volatility into the income statement that was not previously present as a
fixed annual charge is being replaced by a depreciation charge and a varying interest charge.
However, as we have discussed in the previous sections above, the actual impact will depend
upon the characteristics of each particular lease portfolio and the choices, judgements and
estimates made by management. In order to understand the potential impact and variations, we
have set out four example scenarios later in this section to demonstrate the potential impact and
the possible differences where management choice is exercised.
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19 February 2019

EBITDA Lease assets Cash from
  operating activities 
Operating profit Financial Cash from

(depends) Liabilities  financing activities 
Finance costs Equity Total cash flow

 (depends) 
Profit before tax

(depends)
Effects on ratios
Interest cover Net debt Gearing
(depends)  
EPS Current ratio ROCE

(depends)  (depends)
Net debt / EBITDA PE ratio

 (depends)
Source: IASB, HSBC
Whilst the reported earnings, reported net debt and common ratios will change, in some
Be prepared for potentially
significant changes cases significantly, the underlying economic reality and related cash flows of the existing
leases within a company’s portfolio will not, although the position of the cash flows within the
cash flow statement will move out of operating cash flow.
Although the ongoing, longer-term economic impact of the standard (even if the changes to the
numbers are significant) will be neutral, the changes in a given year will not be. We think that
this will present a particular challenge when considering the ratios and multiples used in
evaluating the performance and potential of individual stocks and where making
comparisons within a sector.
The potential for initial concerns to become more serious exists, particularly if multiple market
There may be a re-basing of
multiple expectations expectations have to be re-based. Consequently investors may have re-visit their models and
their expectations of price multiples.
However, in our view, investors will need to look beyond the initial optics of the accounting and
focus on the fundamental reality of the lease portfolio of the business, and what, if any, effect
IFRS 16 might have on the business going forward (e.g. ongoing asset and capex strategy).
Debt covenant breaches and re-financing
As IFRS 16 may significantly increase net debt, covenants may be stretched or breached. In our
Debt covenants – we don’t
expect facilities to be
experience companies have “frozen GAAP” clauses (or similar) in their debt agreements. Anecdotal
withdrawn evidence also suggests that any breaches of debt covenants as a result of IFRS 16 (if applicable)
will not, in isolation, be used by lenders as rationale to amend or terminate facilities.
Investors should pay particular attention to the proposed transition approach, the impact of
IFRS 16 – as a rationale for
re-financing or new disclosures provided in 2019, and the ongoing disclosure in relation to IFRS 16. In addition,
capital issues noting that IFRS 16 affects neither cash flow nor the underlying economic reality of the
contracts, if a company provides IFRS 16 as rationale for any re-financing or new capital issue,
we consider that investors should look carefully at whether the underlying reason is the strength
of the balance sheet rather than a change in accounting.
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19 February 2019
A simple single lease to explain the concept
Before considering the impact of IFRS 16 on potentially complex portfolios and transition options, we
For a lease commencing after
transition, the PV of the lease have found that it is helpful to have a clear view in one’s mind of a simple example first.
payments comes on balance Scenario 1: A company has a five-year lease commencing on 1 January 2019 at
sheet as a liability and an
GBP10,000 per annum (paid on 1 January each year) and an implicit interest rate of 5%.
asset. The income statement
charge is front-loaded to the The asset will be depreciated on a straight-line basis.
earlier years of the lease The effect on the income statement and balance sheet of the company is set out in the table
below. In addition, the effect on the income statement is shown on the chart.
Single lease example- IFRS 16 impact on the company’s financial statements by year (GBP)
Year ended 31 Dec 2019 2020 2021 2022 2023
Operating lease charged (not incurred) 10,000 10,000 10,000 10,000 10,000
IFRS 16 net income statement charge 10,865 10,454 10,022 9,568 9,092
Net difference to income statement (865) (454) (22) 432 908
Leased asset balance (net of depreciation) 36,368 27,276 18,184 9,092 -
Lease liability balance 37,232 28,594 19,524 10,000 -
Source: HSBC
Single lease example- IFRS 16 impact by year on the income statement

-8000
Operating lease charge IFRS 16 charge
Income statement charge (GBP)
-8500
-9000
-9500
-10000
-10500
-11000
2019 2020 2021 2022 2023
Year ended 31 December
Source: HSBC
As can be seen from chart and the table, under IFRS 16, the overall income statement charge is
front-loaded into the earlier years of a lease, and is actually less than the old operating lease
charge in later years, but overall, as one would expect, over the life of the lease the charge to
the income statement remains the sum of the lease payments.
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19 February 2019
Multiple leases, many choices and a few judgements
As one might expect, the impact gets more complicated with a varying lease portfolio and with
We have taken the same lease
portfolio and show the effect the choices and judgements that can be made. In order to illustrate this, we have set out two
of taking no exemptions and simple scenarios for an example portfolio below.
maximising exemptions
Portfolio 1
 a building on a 15 year lease with a break clause after ten years, lease charge of
GBP100,000 per annum;
 17 laptop computers on a five year lease, lease charge of GBP1,000 per annum (i.e. total of
GBP17,000 per year). Each has a separate lease agreement and the assets are not linked;
 a piece of plant on a ten year lease, lease charge or GBP45,000 per annum; and
 a lease of a brand (i.e. an intangible asset) for ten years, lease charge of
GBP20,000 per annum.
Each lease has a commencement date of 1 January 2019, pays the lease charges on 1 January
each year, and all the leases have an implicit interest rate of 5%.
Scenario 2
A Company with a year end of 31 December, has the lease Portfolio 1 above. It has chosen to:
 apply IFRS 16 to intangibles; and
 not take advantage of the low-value asset exemption and account for the computers under
IFRS 16.
In addition, the company has made a judgement that it is unlikely that it will exercise the break
clause in the leased building.
The impact for the first five years following the commencement of the leases on 1 January 2019
(which coincides with the adoption of IFRS 16) is set out in the table below.
Scenario 2: Portfolio 1 - IFRS 16 impact on the company’s financial statements for the
first five years14 (GBP)
Year ended 31 Dec 2019 2020 2021 2022 2023
Net difference to income statement (34,422) (29,103) (23,517) (17,652) (11,494)
Leased asset balance (net of depreciation) 1,553,339 1,412,524 1,271,710 1,130,895 990,080
Lease liability balance 1,587,761 1,476,049 1,358,752 1,235,589 1,106,269
Source: HSBC
As set out in the table, the company’s earnings will be lower for the first five years following
commencement of the leases. We have modelled the entire life of the lease portfolio and note
that the impact on the income statement does not become positive until 2026 (year eight).
However, this ignores that the lease of the low value assets (the laptop computers) ends in year
five, and those leases may have to be replaced, which would lead to an increased charge for
those assets in year 6, as earlier year leases have larger charges to the income statement.
The company’s net debt will increase by GBP1.587million, in the first year (as the lease liability
is taken into net debt but the asset is not).
______________________________________
14 the impact will continue beyond the years shown
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19 February 2019
The choices and judgements in Scenario 2 represent the largest potential impact for that lease
portfolio. We have modelled the smallest potential impact for the same portfolio as Scenario 3.
Scenario 3
A company with a year end of 31 December, has the lease portfolio above (Portfolio 1). It has
chosen to:
 not apply IFRS 16 to intangibles (i.e. these would not be classed as leases); and
 take advantage of the low-value asset exemption and account for the laptop computers as
an annual fixed charge (as permitted under IFRS 16).
In addition, the company has made a judgement that it is likely to exercise the break clause in
the leased building.
The impact for the first five years following the commencement of the leases on 1 January 2019
(which coincides with the adoption of IFRS 16) is set out in the table below. Note that the
charges for the low value and intangible assets is not included in the figures below.
first five years15 (GBP) – full exemptions taken
Year ended 31 Dec 2019 2020 2021 2022 2023
Leased asset balance (net of depreciation) 1,058,071 940,507 822,944 705,380 587,817
Lease liability balance 1,082,166 984,024 880,975 772,774 659,163
Source: HSBC
As set out in the table, the company’s earnings will be lower for the first five years following
commencement of the leases. We have modelled the entire life of the lease portfolio and note that
the impact on Company B’s income statement does not become positive until 2024 (year six).
The company’s net debt will increase by GBP1.082million in the first year (as the lease liability
is taken into net debt but the asset is not).
Comparison of Scenario 2 and 3

As can be observed above, there is a significant difference between the potential impacts on the
earnings profile depending upon the choices made. However, the more significant divergence is
found on the balance sheet: the impact on the company net debt is 47% in Scenario 2. Thus
even in this simplistic portfolio, understanding the choices and estimates made by management
is critical when drawing conclusions from the IFRS 16 disclosure.
Transition
As discussed in the previous section there are specific choices available at transition when
Using a similar portfolio, but
with different phasing, we adopting IFRS 16 for existing leases. The most significant choice will be whether to
demonstrate the impact of retrospectively apply IFRS 16 or use the cumulative catch-up16 approach. We have set out two
the transition choices scenarios that illustrate the potential differences in those approaches.
______________________________________
16 a.k.a. the modified retrospective approach
26
19 February 2019
Portfolio 2
 a building on a 15 year lease, lease charge of GBP100,000 per annum. This lease
commenced five years pre-transition;
 17 laptop computers on a five year lease, lease charge of GBP1,000 per annum (i.e. total of
GBP17,000 per year). Each has a separate lease agreement and the assets are not linked.
These leases commenced two years pre-transition;
 a piece of plant on a ten year lease, lease charge or GBP45,000 per annum. This lease
commenced seven years pre-transition; and
 a lease of a brand (i.e. an intangible asset) for ten years, lease charge of GBP20,000 per
annum. This lease commenced three years pre-transition.
Each lease has a commencement date of 1 January, pays the lease charges on 1 January each
year, and all the leases have an implicit interest rate of 5%.
In both scenarios the company will chose to apply IFRS 16 to low-value leases and intangibles.
Scenario 4
A company with a year end of 31 December has the lease portfolio 2 above. It has chosen to
adopt the fully retrospective approach. The impact for the first five years following the adoption
of IFRS 16 (i.e. from 1 January) is set out in the table below.
first five years17 (GBP) – fully retrospective approach
Year ended 31 Dec 2019 2020 2021 2022 2023
Net difference to income statement (5,194) 1,587 8,708 3,025 7,620
Leased asset balance (net of depreciation) 855,095 714,280 573,466 484,593 395,719
Lease liability balance 973,958 831,556 682,034 590,136 493,643
Source: HSBC
Scenario 5
The same company as in Scenario 4, but rather than adopting a fully retrospective approach,
choses the cumulative catch-up approach. The impact for the first five years following the
adoption of IFRS 16 (i.e. from 1 January) is set out in the table below.
first five years18 (GBP) – cumulative catch-up approach
Year ended 31 Dec 2019 2020 2021 2022 2023
Leased asset balance (net of depreciation) 952,048 794,516 636,984 538,547 440,109
Lease liability balance 973,958 831,556 682,034 590,136 493,643
Source: HSBC
As illustrated above, there is a significant difference between the potential income statement impacts.
At the balance sheet level, in these scenarios (as there are no assumption changes in terms of lease
length) there is no difference in the liability profile, however there is a difference in the asset profile.
Noting the significant potential differences is, in our view, essential to have a clear view of the
choices made at transition where a company has a material lease portfolio.
______________________________________
27
19 February 2019
Impact on sectors
 The IASB has indicated its view on the top 10 affected sectors – there
are no surprises, but Airlines might be a “known unknown”
 We have developed a model to estimate the potential IFRS 16 impact
based on the current operating lease note and some assumptions
 We have selected six sectors and modelled the impact for
companies within the sector – there were surprises
Which sectors are affected?
The IASB undertook an impact study in 2016 which identified its view of the ten sectors
No surprises which sectors
are likely to be affected (excluding banks and insurance companies) which will likely experience the largest impact of
IFRS 16. These were19:
 Airlines;
 Retailers;
 Travel and leisure;
 Transport;
 Telecommunications;
 Energy;
 Media;
 Distributors;
 IT; and
 Healthcare.
For investors, there are unlikely to be surprises on this list, in particular that the airline sector is
at the top. Within the many technical papers written on IFRS 16 the airline sector is frequently
used as the example sector.
However, the off balance sheet financing of leases within the airline sector is considered a
“known unknown” for investors, who can comparatively easily make adjustments for aircraft fleet
leases. Annual lease costs and committed lease obligations are reported. Consequently
analysts and investors have tended to make automatic adjustments for aircraft leased portfolio.
Profitability based metrics used by investors for airlines have also looked to normalise for
different fleet ownership structures, notably EV-EBITDAR or PE.
______________________________________
28
19 February 2019
HSBC has used the NPV of committed aircraft lease obligations. Other analysts use ratios of 7-
8x annual lease charges. The adoption of IFRS 16 will see some modest variations between the
value of lease assets and pre-existing assumptions. Airlines with significant leased real estate
assets will have new lease assets in excess of previously assessed aircraft.
Many consider the lease accounting for airlines to be “known-unknowns”. We have, therefore,
selected six sectors (excluding airlines) that we recognise will be significantly affected by IFRS
16, but perhaps have had less consideration of the impact than airlines.
For each of the selected sectors we have considered the broad impact of IFRS 16 and what we
might expect when the companies begin making their first disclosures about the impact of the
new standard during the course of 2019 and 2020.
These sectors are:

 food retail;
 non-food retail;
 transport;
 logistics;
 pubs; and
 business services.
Modelling the potential impact
We have developed a model that estimates the impact of IFRS 16 based upon the disclosure within
Our model estimates the
IFRS 16 impact based on the companies’ operating lease commitment note, and have used that across selected stocks within
previous operating lease each of the six sectors. The results were often as expected, however, in some cases the impact was
commitment note and some surprisingly greater than we had expected. These are discussed in the following sections.
further assumptions
Limitations of the model and the assumptions made
To accurately determine the impact of IFRS 16, one would need information at a granular level
for each lease and know what transition choices management are planning to make.
The information on which we can base a calculation is limited and, where we utilise the old IAS
17 operating lease note, we are aware that this may be on a substantially different basis than
IFRS 16 (the operating lease disclosure traditionally only includes payments up to the next
break clause, whilst IFRS 16 requires the entire lease term to be taken into account).
In the absence of complete information, the model and its output estimations (i.e. the impact
estimated) should considered as illustrative only. The key assumptions include:
 that companies chose the cumulative catch-up approach;
 one discount rate is used for the entire portfolio;
 companies will not take any exemptions for short term leases, leases expiring within one
year of transition and low value leases; and
 leases are not renewed as they expire.
We emphasise that the outputs from this model (set out in subsequent sections) are illustrative
rather than forecasts, and we expect greater clarity and certainty to develop as companies
disclose their impact assessment during the course of the next twelve months.
29
19 February 2019
Model performance
As we discuss in the next section, we used our model to illustrate the potential impact on Tesco,
and set out the results in our report results Tesco Buy: IFRS 16 Leases: What to watch out for.
on 13 February.
Tesco reported their calculated impact on the 15 February, and we are able to gauge how
accurate our model is. In Tesco’s announcement (which applied to 1H18/19, the last reported
period), it reported:
without complete information on the portfolio.
Mindful of the limitations of the model and the available information, the Tesco example appears
to suggest that the model is providing sensible outputs. However, we reiterate that all our
calculations are illustrative only.
30
19 February 2019
Impact on the Food Retail

sector
 The role of physical assets and leases are changing. IFRS 16 may
hasten those changes
 Unsurprisingly, we expect net debt to increase significantly, but the
structure of the property portfolio matters
 Multiples may inflate overnight
David McCarthy*
Leases are becoming more flexible
Global Head of Consumer Retail
Research
HSBC Bank plc The UK retail sector has come under pressure due to changes in shopper habits and weak macro.
david1.mccarthy@hsbcib.com The role of real estate is thus changing as more and more shoppers move online or prefer
+44 20 7992 1326
omnichannel. 2018 saw several companies applying for Company Voluntary Arrangements (CVA)
Andrew Porteous*, CFA
Analyst and many others going down the administration route. The combination of these factors in food retail
HSBC Bank plc have seen the balance of power tilt towards the lessees. We have seen Tesco reduce its overall
andrew.porteous@hsbc.com
+44 20 7992 4647 lease liability by GBP1.6bn over the past 3 years by shuttering unproductive space and walking away
from upward only, inflation-linked leases. This reflects a general trend across the sector with
* Employed by a non-US affiliate of HSBC renegotiations resulting in lower rents and more flexible terms.
Securities (USA) Inc, and is not registered/
qualified pursuant to FINRA regulations
We expect the role of The result is a rise in more flexible contracts.

physical assets to change.
 In the last two years, the percentage of Retail leases with break clauses for leases of 6-15
Large store economics are
under pressure but retailers years length have been the highest since 2005 (MSCI). Although this segment saw a slight
may be able to seek lower dip in 2018 vs. 2017 in terms of numbers having break clauses, the overall trend has been
and more flexible leases an increasing one.
going forward
 Lease lengths for the retail sector declined by 15 months in 1H18 on a rent-weighted basis
(MSCI). On an unweighted basis, the lease lengths for the sector increased slightly, though,
suggesting that the larger tenants are going for shorter leases.
Going forward, as was discussed at our Retail in 2030 conference (see ‘UK Retail in 2030’, The
Future is bricks and clicks ), we expect the role of physical assets to continue to evolve. Overcapacity
is more an issue for non-food, where online has been more disruptive, but there are disruptive trends
in food retail too. The growth of discounters in some markets (e.g. the UK) and growth of proximity
formats globally is putting large store economics under pressure and the need to rebase cost
structures is likely to see retailers seek lower and more flexible lease terms in the future.
This trend could be compounded by the introduction of IFRS 16, which brings lease liabilities
front and centre of investor attention (if in a rather unhelpful manner). Retailers are likely to seek
greater flexibility from landlords, which would enable greater discretion over how lease liabilities
impact liabilities.
31
19 February 2019
Impact of IFRS 16 on the numbers
We have used our IFRS 16 transition model to estimate the impact of IFRS 16 on a selection of
Unsurprisingly the biggest
impact is on net debt, retailers based upon the disclosures within the operating lease note from the most recent
however we also expect annual report.
EPS to decline
The biggest impact of applying IFRS 16 to food retailers is the increase to net debt from
the additional liability recognised from the discounted lease commitments. As result, for retail we
expect leverage to increase significantly. Within the sector, those companies with frequent
breaks, the increase in net debt could be much greater than implied by the disclosed minimum
lease commitments as companies will be required to make a judgement over whether they are
likely to continue to operate a given store beyond a break in the lease.
We expect net earnings or EPS see a decline as capitalisation leads to additional finance costs
which are more front-end loaded and depreciation which is not fully offset by the exclusion of
rental expenses. Hence we also expect a jump in the visible PE.
However, we must not forget that there are no underlying changes to the business or cash flows
We expect companies to try
to exclude the impact by re- due to IFRS 16 kicking-in. There is a risk, given the sizeable impacts on the income statement,
defining adjusted earnings. In that companies begin to disclose new definitions of “adjusted earnings” which more closely align
our view this will not be in the income statement with the cash flow, although this would certainly not be in the spirit of the
the spirit of the new rules rule. Another, more likely, solution is that investors place greater scrutiny on cash flow valuation
metrics as the income statement becomes increasingly theoretical.
The industry standard established by credit ratings agencies is an over simplistic

We think the calculations
could be under-cooked indication of how IFRS 16 will impact companies. There are important differences to
consider between the approach used by the ratings agencies and IFRS 16:
 A likely lower discount rate – historically, c7% has been a sensible assumption but with
IFRS 16 a rental yield or cost of debt must be derived for each lease and this is likely to be
a little lower, and so inflate overall liabilities.
 Continuing leases beyond breaks – if a company is reasonably certain that they will
continue to operate an asset beyond the next lease break then the liability continues,
meaning IFRS 16 liabilities are likely to end up greater than the minimum lease
commitments shown in the accounts.
 Contingent liabilities – these exist where there are options around lease breaks such as a
requirement to buy back a property if a lease were to be exited at a break. Tesco, for
example, has contingent lease liabilities of cGBP2.6bn beyond its breaks or GBP2.8bn if it
were to buy back properties at (current) market value at the time of a break.
Taking Tesco as an example (see also our previous specific report on Tesco Buy: IFRS 16
Leases: What to watch out for), they have historically disclosed lease liabilities of GBP6.9bn
using the standard methodology used by the credit ratings agencies with a discount rate of 7%.
However, we consider a scenario assuming:
 A discount rate of 6% rather than 7%; and
 Contingent liabilities of GBP2.6bn
Using our model, we could see liabilities rise to GBP8.6bn and this does not include any
additional liability for continuing leases beyond the next break (where there are no contingent
liabilities). In the table below we show what we believe the impacts could be for Tesco at
different levels of the income statement and for overall leverage.
32
19 February 2019
Tesco estimated IFRS 16 impact (GBPm)

Tesco FY18a Post-IFRS 16 % diff
Sales 57491 57491
EBITDA 2939 4018 36.7%
Margin 5.11% 6.99%
EBIT 1644 2001 21.7%
Margin 2.86% 3.48%
EPS (GBp) 12.50 10.83 -13.4%
Net debt -2747 -11338
Net debt/EBITDA 0.93 2.82
Source: Company information for FY18, HSBC estimates
With Tesco having reported on the 15 February, we are able to gauge how accurate our model
is. In Tesco’s announcement (which applied to 1H18/19, the last reported period), it reported:
without complete information on the portfolio.
Implementation of IFRS 16 will impact almost the entire income statement of food
Multiples may inflate overnight.
retailers as they generally have significant operating lease commitments. The corresponding
Impact will be industry-wide,
but there will be differentiation valuation multiples (PE) would seem to inflate overnight as the result would be a reduction in
in the severity of the impact accounting earnings. EV/EBITDA multiples would also be confused by the impacts and
generally, the simple P&L-based valuation multiples used by most investors would become
unhelpful and incomparable with history. Leverage levels would also increase but would be hard
to forecast for those companies with greater flexibility in leases (i.e. European companies)
where management will have some discretion over whether leases continue or end at breaks.
Looking forward, the UK names are the most relevant given their financial period ends and the
structure of leases in the UK being more inflexible i.e. with future breaks. With Tesco having
reported, we show in the next section how the impact on Morrisons impact could differ from that of
Tesco given a much greater freehold portfolio. Sainsbury’s, on the other hand, is in theory even more
susceptible than Tesco and has to date been far less forthcoming in terms of disclosing its exposure.
Differences between companies
Between companies there are two main areas where differences will arise:
The structure of the property
portfolio matters  Companies where more assets are leased (e.g. Tesco/Sainsbury’s) vs those where most
assets are owned (e.g. Morrisons)
 Companies with long, inflexible lease contracts (e.g. UK) vs those where leases are short
with frequent breaks (e.g. Europe).
To demonstrate we compare our estimated impact for both Tesco and Morrisons, with the latter
having a much higher freehold component. The table below shows that, as a result of IFRS 16:
 Tesco would see a c37% uplift in EBITDA, while Morrisons would see just a 13% uplift. In both
cases, EBITDA margins post-IFRS 16 would roughly equal EBITDAR margins pre-IFRS 16.
 Tesco would see a 22% uplift in EBIT vs Morrisons at 12% as Tesco would have a much
bigger asset to depreciate as leases are brought onto the balance sheet.
33
19 February 2019
 Tesco would see a 14% reduction in EPS compared to Morrisons at just 5% as Tesco
would have to “finance” the larger lease liability.
Modelled impacts of IFRS 16 on Tesco and Morrisons (GBPm)

Tesco FY18a Post-IFRS 16 % diff Morrisons FY18a Post-IFRS 16 % diff
Sales 57491 57491 Sales 17262 17262
EBITDA 2948 4027 36.6% EBITDA 879 990 12.6%
Margin 5.13% 7.00% Margin 5.09% 5.74%
EBIT 1644 2001 21.7% EBIT 458 511 11.6%
Margin 2.86% 3.48% Margin 2.65% 2.96%
EPS 12.08 10.41 -13.8% EPS 13.00 12.34 -5.1%
Net debt -2747 -11338 Net debt -973 -2199
Net debt/EBITDA 0.93 2.82 Net debt/EBITDA 1.11 2.22
Source: HSBC estimates
How might the companies respond?
IFRS 16 will result in greater debt on the balance sheet. The natural response is likely to be
Companies may respond
operationally to minimise the towards reducing the impact as far as possible. So we explore the areas where management
accounting impact discretion is possible under IFRS 16 or where we can expect a change in strategy.
 Discount rate remains an area of management discretion. To reduce the liability, higher
discount rates may be more favourable.
 The retailers may try to secure shorter leases. This has a dual benefit of reducing the lease
liability as well as giving them more flexibility to renegotiate more frequently. Given the
pressure and structural changes in the food retail industry, this flexibly is valuable.
 The UK companies may try to include more frequent breaks in their lease contracts, as is
prevalent in Europe.
 Leases of properties other than real estate (like vehicles) may be reformatted to make it
look different (perhaps more like a service contract than a lease contract). However, these
leases account for a small portion of the food retailers’ operating leases.
We would watch out for these…
As a result of available scope of management discretion and the tilt towards shorter and more
The full impact is not yet
known – look out for changes flexible leases, we would be cautious and closely watch how the financial metrics evolve.
to portfolios and  UK vs. Europe – As we have said earlier, historically European lease contracts have had
financing structure
more breaks built in. This may make the optics better for the European retailers vs. the UK
retailers, as seen through the IFRS 16 lens.
 While IFRS 16 would introduce greater comparability across sector balance sheets, it also
introduces a significant degree of management discretion and also adds significant
complexity to the P&L statements, making them less relevant for valuation purposes.
 Debt covenants – it remains to be seen how the covenants will be defined and whether the
accounting changes would trigger them for any company.
 As rental expenses will be excluded in EBITDA, it will not be as good a proxy for operating
cash flow as it has traditionally been.
With a generally negative impact on EPS it remains to be seen how the market will cope with
PE multiples that could increase 10% or more overnight with no changes to fundamentals. We
would advocate greater focus on FCF metrics, as we have been discussing for some time. This
is likely to happen, however there may be a period of adjustment during which time we could
see greater volatility.
34
19 February 2019
Impact on the non-Food

Retail sector
 The transition to online means there is too much retail selling space.
Our ‘UK Retail in 2030’ conference suggests 30-50% overcapacity
 IFRS 16 offers a useful insight into the off balance sheet
commitments assumed by non-food retailers
 Mature retailers with large leasehold portfolios are at greatest risk.
Online retailers / retailers with material freehold are better placed
Paul Rossington*
Too much space
Analyst
HSBC Bank plc
paul.rossington@hsbcib.com One of the key takeaways from our ‘Retailing in 2030’ conference (31 January) is that there is
+44 7991 6734 still too much physical retail space in the UK (see our note ‘UK Retail in 2030’, 29 January 2019
* Employed by a non-US affiliate of HSBC for more detail). Our C-suite guests and panellists put the oversupply of physical retail capacity
at c30-50%. With non-food worst affected by the structural shift to online, high fixed costs and
high operating leverage, the resulting decline in the profitability of bricks and mortar channels to
market has had pronounced impact on sector profitability, and a paradigm shift in demand for
retail property. This is creating a pressing need for all non-food retailers to:
 Exit loss making stores to preserve short-term profitability: However this often incurs
There is a need for action to
re-shape store portfolios onerous exit costs or, in a negative case scenario, business failure resulting in
administration and/or CVA and destruction of equity values.
 Reduce exposure to profitable but peripheral trading locations: These are stores that
might be profitable today but where medium-term financial returns are at risk even allowing
for a successful renegotiation of the lease agreement.
 Negotiate better terms on the stores you want to keep: Retailers with anchor tenant
status are achieving average rent reductions of over 20% (e.g. Next 28%) and better terms,
e.g. shorter contracts (c5-10 years), breaks clauses and removal of upwards-only reviews.
The lease environment for UK retailers is actually improving

The key questions are: by how much does this situation need to improve to stem the decline in
It is not all bad news
business failures seen to date, and why are some retailers better positioned than others.
Traditional retailers can be split into two broad categories:
1. Immature retailers growing off a low base can take advantage of low rents attainable in
many trading locations; discounters and select small/midcap names are best positioned.
2. Mature retailers with large/nationwide store portfolios and onerous rental commitments
above market rates that put them at a financial/strategic disadvantage to the peer group.
35
19 February 2019
In the case of mature retailers, strategic focus turns to the development of the omni-channel
platforms to leverage fixed costs, take advantage of all channels to market, and offset the
decline in store-based sales. In this regard the adoption of IFRS 16 offers a new insight to how
severe or otherwise the off balance sheet lease commitments retailers are tied into actually are.
The impact of the implementation of IFRS 16
The majority of our UK non-food retail coverage list comprises mature retailer with large
The impact will vary and will
depend upon the factors one established store portfolios. The impact of the implementation of IFRS 16 will impact the P&L
might expect and balance sheets of all non-food retailers to varying degrees. The key factors in the sector
that significantly affect the impact of IFRS 16 are:
 The relative size of the lease portfolio. A company owning a majority of the assets it uses
(so lower operating leases) will have a much lower impact than a company leasing the
majority of assets. In our list M&S, Kingfisher and ABFoods via Primark have significant
freehold ownership.
 The length of leases. Larger retail formats (e.g. department store and big shed user)
typically carry structurally longer lease terms than smaller formats. Of the UK stocks we
analyse in this report we estimate an average lease length of 8 years.
 Break clauses and underestimating the total liability. The difference between the old
operating lease disclosure basis and IFRS 16 means that the underlying lease liability will
be higher than that outlined by the company under their ‘minimum’ commitments. This is
particularly relevant for European companies where break clauses are more prevalent
(discussed later) and some UK companies.
 The discount rate used. The higher the discount rate, the lower the liability. However the
discount rate needs to be assessed on a lease-by-lease basis and will depend on several
factors, including when that lease was signed.
While other factors including the proportion of fixed vs flexible (i.e. turnover related rents) can
also impact of the adoption of IFRS 16, this is only relevant in a small minority of cases.
Considering the impact for UK stocks

If we take a look at the table of UK stocks that we cover below we get a feel for the IFRS 16
impact on underlying EPS and by default the resulting impact on PE valuations. We also get a
feel for the impact on balance sheet leverage and the implied net debt/EBITDA ratios that would
result and need, in our view, to considered relative to the wider sector rather than in isolation.
We also think it is worth remembering that leases can also be considered assets as well as
liabilities. In the case of companies with well managed property portfolios and superior financial
returns vs the wider sector (e.g. higher EBIT margins), the impact of IFRS 16 can be minimal
(e.g. Next). This is even the case of companies that have large / nationwide and c100%
leasehold estates that we might normally consider to be more severely impacted by the
introduction of IFRS 16.
36
19 February 2019
Impact of IFRS 16 on EPS (see chart below)

Impact on earnings is as
expected, however some Given the dynamics we have outlined previously the theoretical impact on earnings is pretty
surprises for individual much as anticipated. There are, however, a couple of exceptions to the rule.
companies
The key observations are:
 Pure play online retailers and/or well developed omni-channel platforms are best
positioned. Asos, Boohoo and N Brown, by the nature of their online focus and nil exposure to
bricks and mortar retail assets, are barely impacted by IFRS 16. Next is also well positioned
which comes as a little surprise given it generates c45% of revenues online, c5% revenues from
credit, has well managed property exposure and strong EBIT margins vs the sector.
 Retailers with large/nationwide store estates and material freehold property exposure
are well positioned. This includes companies like Kingfisher (GBP3.6bn freehold), M&S
and ABFoods / Primark which we understand owns a third of the freeholds of the stores
from which it trades. We estimate that the simple average lease length of these retailers is
12.3 years ranging from 8 years at Kingfisher to 15 years at M&S and ABFoods / Primark.
ABFoods / Primark also benefits from low operating cost model. Auto distributor Inchcape
also has heavily freehold-backed property exposure.
 Retailers with large/nationwide and c100% leasehold store estates are more impacted
positioned. This is where the total operating commitment is highest relative to underlying
profitability. This includes companies like Pets At Home and Halfords. We estimate that the
average the lease length of these retailers is between 6-8 years and we estimate both
retailers will see EPS reduce by 18-19%. Dixons Carphone also may see a relatively large
impact on earnings of c15% but this is more down to its low margins than a particularly
large lease adjustment as we know this is one of the most progressed companies in the
sector from a property perspective.
What we should highlight, of course, is that these changes do not impact the underlying cash
generative qualities of the companies in our coverage list. We do however need to acknowledge
that the potential impact on reported earnings on some of the names on our list could negatively
impact investor sentiment towards these names in the short-term.
Exceptions to the rule…

 B&M: Despite a large and growing nationwide portfolio of leasehold stores, B&M share a
similar IFRS 16 impact to retailers with a high freehold component. This is because B&M’s
low-cost operating model helps to reduce the total operating lease commitment. We
estimate that B&M’s average lease length is broadly in line with the sector at c8 years.
 Ted Baker: With only 23 stores in the UK, the vast majority of Ted Baker’s retail presence
is achieved via department store concessions. On rolling 12 month contracts concessions
effectively have a 1 year break clause. Given that the minimum lease obligations assume
that these leases do not continue beyond break, this artificially benefits EPS. Were we to
assume that these concessions continue beyond break, the theoretical impact on EPS
would be -6% and more in keeping with the wider sector.
Impact of IFRS 16 on net debt/EBITDA based on most recent annual report (see charts below)
The impact of the IFRS 16 on the net debt / EBITDA ratio, our preferred measure of balance
Net debt will rise, in some
cases severely sheet leverage, is to materially increase the implied level of leverage of our UK coverage
universe. The charts below outline our UK coverage list net debt / EBITDA ratios, both pre- and
post the theoretical impact of IFRS 16. We would note that in this data we assume a discount
rate of 7%. While historically a good guide to discounting lease commitments, this is likely to be
a little high for IFRS 16 purposes and 6% might be more likely (Tesco reported 5.8%), which
would lead to larger net debt commitments.
37
19 February 2019
Pre-IFRS 16
4.0x
3.0x
2.0x
1.0x
0.0x
-1.0x
-2.0x
-3.0x
M&S
Asos
Halfords
Pets At Home
Brown N
boohoo
Ted Baker
B&M
Inchcape
Dixons C.
Next
Dunelm
Kingfisher
AB Foods
Source: HSBC analysis
Post-IFRS 16
4.0x
3.0x
2.0x
1.0x
0.0x
-1.0x
-2.0x
-3.0x
Pets At Home
Asos
Brown N
M&S
Halfords
boohoo
Ted Baker
Dixons C.
Next
B&M
Inchcape
Dunelm
AB Foods
Kingfisher
Source: HSBC analysis
Our key observations are:

 The implied level of leverage is set to increase across the sector as a whole. Of those
stocks that carried a net debt balance pre-IFRS 16, the impact has been to increase the
average level of leverage by a factor of 1.3 to 2.3x net debt / EBITDA.
 The severity of the impact is broadly in-line with impact on EPS. Retailers with large /
nationwide leasehold portfolios are most severely affected. Retailers with large nationwide
store portfolios including a material freehold component are well positioned. Retailers with no
exposure to bricks and mortar retail assets are best positioned.
 Some stocks that have previously had net cash positions will now report a net debt
position. Post-IFRS 16 we expect Kingfisher, ABFoods, Asos and Inchcape to report net
debt positions from what were previously net cash positions. All however are well below
what we would consider to be distressed levels.
We understand that S&P use a lease-adjusted net debt/EBITDA ratio of 3.0x as a benchmark
over which retailers are considered to be financially stretched. In the case of our analysis there
are no stocks that materially break this limit. Levels of leverage consistent with a net
debt/EBITDA >3.0% would normally be associated with private equity backed retailers vs listed
retailers where investors’ appetite for risk is lower.
38
19 February 2019
IFRS 16 impact on European stocks likely to be higher than our analysis suggests
European retailers benefit from a much higher incidence of break clauses in their respective
Earlier break clauses in
continental Europe may lead store estates. Indeed as Inditex have previously highlighted, within the context of their global
to the impact being higher and predominantly leasehold portfolio, it could close up 50% of the >7000 stores it operates in a
than we expect 2-3 year time window.
As we have already highlighted, retailers are currently only required to disclose minimum
operating lease commitments up to the first break clause. Under IFRS 16, judgement is now
required when assessing whether leases will continue beyond the next break clause.
What this means is that the underlying operating lease commitment is likely to be materially
higher than that outlined by the company under their ‘minimum’ commitments. What this also
means, by default, is that the existence of a high penetration of break clauses and our analysis
of the minimum operating lease commitments could materially underestimate the underlying
operating lease commitment / liability.
39
19 February 2019
Impact on the Transport

sector
 Rail and bus companies rely heavily on leases, but rail operators are
likely to see higher impact
 Rail rolling stock will be in scope, however early indications are that
track access will not
 Surprisingly, early indications suggests that rail operators are
considering a fully retrospective transition approach
Paul Rossington* Within the transport sector, we focus specifically on the bus and rail companies. In this subsector, we
Analyst
HSBC Bank plc do not think that leases have historically been taken into wide consideration compared to, say,
paul.rossington@hsbcib.com airlines, where sell-side analysts have tended to make automatic adjustments.
+44 20 7991 6734
* Employed by a non-US affiliate of HSBC

Securities (USA) Inc, and is not registered/ Lease environment within the sector
The bus and rail sector is one that relies heavily on operating leases. Unlike with, say, airlines or
There may be surprises for
investors in the rail and pubs, it is not one where sell-side analysts have typically made adjustments when modelling debts or
bus sectors enterprise values and, as such, the impact could come as a surprise for investors, and not a pleasant
one. Within the sector, it is rail that accounts for the bulk of operating lease commitments, though
there do tend to be smaller commitments for buses – especially in London – and in property.
Bus leases tend to be used primarily in London (where contracts are c.5 years in duration and
therefore have some risk attached to them), rather than in the provinces where operators
essentially run their routes into perpetuity if they so choose.
Within rail, company disclosure tends to split rail operating lease commitments into two
Early indications that track
assets will not be in IFRS components: rolling stock and track access charges. Both are part of the fixed cost of running
16’s scope. Rolling stock railways. It’s early stages in companies’ planning, but indications are that it will only be rolling
leases will stock that comes on to company balance sheets. Rail franchises typically last for around 7 years
(plus the option for extensions), so the duration of these liabilities is not long, though the
absolute charge each year is.
It results in very high levels of operating lease debt moving on to balance sheets.
40
19 February 2019
Illustrative modelled impact for selected stocks
We’ve selected Firstgroup and Stagecoach because these should provide a good comparison
Early indications suggest that
operators are considering between a company with high rail exposure and one that will soon have very little.
adopting a fully – retrospective Operators have so far said very little about the impact of IFRS 16. However, we expect them to
transition approach. Our model
implement it on a fully retrospective basis. It’s the reason we have not calculated earnings in
assumes the alternative
approach therefore may be this note. News flow should start to emerge from the middle of this year.
misleading
Impact of IFRS 16: Stagecoach and Firstgroup compared

SGC FY20e Post IFRS 16 % diff FGP FY20e Post IFRS 16 % diff
Sales 1417.3 1417.3 Sales 7047.7 7047.7
EBITDA 211.3 238.3 12.8% EBITDA 741.6 1081.3 45.8%
margin 15% 17% margin 10.5% 15.3%
Net debt 268.2 323.2 20.5% Net debt 932.9 2173.0 132.9%
Adj net debt 289.4 344.4 19.0% Adj net debt 1325.2 2565.3 93.6%
Adj net debt/EBITDA 1.4 1.4 Adj net debt/EBITDA 1.8 2.4
Source: HSBC Analysis
Our observations
From our modelling, the increase in net debt is clearly very large as a result of IFRS 16 where
companies have high rail exposure. Net debt/EBITDA multiples rise significantly. We don’t think
that this has a major impact in the short term, with covenants being set on a “frozen GAAP”
basis, and ratings agencies taking a more independent view.
Points for investors to consider
We think it is debateable whether rail operating leases should really count as debt at all. In the UK, if
IFRS 16 accounting may lead
to a strange outcome. franchises fail, then operators have the ability to default with rolling stock transferred to the next
Ultimately it could influence operator. In these circumstances, the liabilities are limited to a level of losses that is pre-agreed with
the way rail operators bid the DfT plus performance bonds. This contingent liability (not the capitalised value of leases) is what
for contracts S&P considers to be the liability associated with rail when setting credit ratings. As such, they are
fixed costs, but not really debt as such. To this extent, they sit in the same category as track access
charges. We do not expect them to have an influence on the operators’ credit ratings.
With more debt coming on balance sheet, however, it could influence the way that operators bid
for rail franchises. Margins on rail franchises are already very thin. With capital commitments
now also looking much larger, we wonder whether it will force greater bidding discipline.
41
19 February 2019
Impact on the Logistics

sector
 IFRS 16 adopted early by Deutsche Post and Panalpina, and DSV

already announced impact for FY2019
 Limited impact at PBT level, but FCF measurements have had to
be changed
 Freight forwarders have unusually short-lived lease portfolio in
keeping with asset-light model and 3-to-5-year contracts
For some IFRS 16 has already arrived

Edward Stanford*
Analyst, Transportation
HSBC Bank plc Two companies in the logistics sector were early adopters of IFRS 16; with both Deutsche Post and
edward.stanford@hsbc.com
+44 20 7992 4207 Panalpina electing to use it from the start of 2018. This year, DSV reported its 2018 results (on 7th
February) and has provided detailed guidance on the effects of IFRS 16 on 2019 numbers and
* Employed by a non-US affiliate of HSBC management’s financial targets for 2020. We note that the mid-point of EBIT guidance for FY 2019
at DKK6,100m was broadly in line with prevailing consensus forecasts, excluding IFRS 16 we
presume, at DKK6,000m, suggesting a disguised cut to expectations given that the impact of the
accounting change was expected to be DKK325m positive at the mid-point.
Pure-play freight forwarding businesses like DSV, Kuehne + Nagel and Panalpina operate an
asset-light business model. For example, most buildings, and more importantly warehouses, are
leased. In the case of contract logistics businesses, where typical contracts are three to five
years long, these assets are on back-to-back leases co-terminus with the ending of the relevant
contracts. Lease length, therefore, tends to be fairly short in contrast, for example, to the UK
retail and pub sectors.
We have already seen a substantial increase in the balance sheet debt of the early adopters
Big increase in debt, little
impact at EPS level and would expect to see a similar profile for the remainder. In the table below we show how
reported net debt has changed, in the case of Kuehne + Nagel and Panalpina net cash
positions have turned, or we expect to turn, into modest net debt.
42
19 February 2019
Impact of IFRS 16 on reported net debt estimated and reported
5000
-5000
-10000
-15000
-20000
-25000
Maersk (est)(USDm) DP DHL (EURm) DSV (DKKm) K+N (est) (CHFm) Panalpina (CHFm)
Before IFRS 16 After IFRS 16
Source: Company, HSBC estimates
Similarly as operating lease charges are split into the depreciation and interest components
under IFRS 16, the sector has seen a significant increase in reported EBITDA. This is set out in
the charts below. Overall the impact on PBT for these companies has been minimal.
Impact of IFRS 16 on reported EBITDA (estimated and reported)
10000
9000
8000
7000
6000
5000
4000
3000
2000
1000
0
Maersk (est) (USDm) DP DHL (EURm) DSV (DKKm) K+N (est) (CHFm) Panalpina (CHFm)
Before IFRS 16 After IFRS 16
Source: Company, HSBC estimates
Will IFRS 16 change corporate behaviour?

It could be argued that the implementation of IAS 19 a few years ago hastened the decline of
defined benefit pension schemes. Under IFRS 16 there is now limited accounting distinction
between an operating lease and lease purchased with finance– could that herald a change in
the way companies acquire assets? We think this is possible at the margin, but in the logistics
sector at least it would represent a significant strategic departure from an asset-light business
model, which seems unlikely in our view. Moreover, operating leases provide much-needed
flexibility so that, for example, a logistics company is not left with an empty warehouse it owns in
the event that a contract with a customer comes to an end. Likewise, shipping companies make
use of charters to allow them more easily to flex capacity according to demand.
On the other hand, we note that Deutsche Post recently placed an order for 14 Boeing 777 freighters
DPW buys 14 Boeing 777
freighters for its DHL Express subsidiary. The primary motivation was financial, the group could borrow more
cheaply than leasing companies, and operational, there was more flexibility with owned aircraft.
However, IFRS may have had a very slight impact on decision making in our view as there would
have been no distinction in the balance sheet in how the assets were treated.
43
19 February 2019
Impact on valuation multiples

However, for the three companies that have adopted IFRS 16 or provided detailed guidance on
EV/EBITDA multiples fall
the impact, the effect at the PBT level has been very modest as might be expected. The
changes have however led to a significant change in EV/EBITDA multiples, which has
complicated sector comparisons. We highlighted the impact on the two early adopters in our
report “Fishing for Value”, 7 June 2018, and have updated this for recent information on DSV.
We have based this illustrative multiple analysis on the current year forecast prevailing at the
time when IFRS 16 information was made available, therefore the pricing for Panalpina and
Deutsche Post is for the middle of last year, while DSV is more current.
Illustrative impact of IFRS 16 on EV/EBITDA multiples (Yr1 e)

Panalpina* Deutsche Post* DSV+
EV/EBITDA Pre-IFRS 16 17.7 12.0 16.3
EV/EBITDA Post-IFRS 16 9.2 7.5 12.3
NPV lease obligations/Current operating lease expenditure 2.8 4.8 3.5
*Priced as at 4th June 2018
+Priced as at 12th Feb 2019
The table above also shows the lease multiple defined as the NPV of lease obligations divided
by the current operating lease expense. Typically the lease debt is relatively low when
compared to the annual lease charge, attesting to the fact that operating leases tend to be fairly
short duration. According to Deloitte20 the following rule of thumb applies: “When the lease
multiple is lower than the current EV / EBITDA trading multiple, the EV/EBITDA trading multiple
decreases following the introduction of IFRS 16. Conversely, when the lease multiple is higher
than the current valuation multiple, the EV/EBITDA multiple will increase.”
Impact on free cash flow calculations

Left unadjusted, free cash flow metrics would be flattered by the boost to EBITDA created by
New “net cash for leases”
line to normalise FCF IFRS 16. Both Deutsche Post and now DSV, have elected to neutralise the impact of the new
accounting standard by introducing a new line reflecting payment of lease liabilities, a figure that
is broadly equal and opposite to the positive impact of IFRS 16 on profits. It appears that
Panalpina has not chosen to do this.
While companies will have to adjust other financial targets, if published, free cash flow generation
targets for those companies that have published the impact of IFRS 16 have not been changed.
How to deal with WACC

The addition of lease debt should in theory alter our calculation of WACC, as the extra debt would
We have not adjusted
our WACC serve to lower cost of capital all else being equal. Intuitively this appears wrong as underlying cash
flows have not been affected, a compensating offset in observed levered beta should offset this over
time, but until the standard is more established we have elected to leave our WACC calculations
unchanged, as far as the capital structure is concerned. It will be interesting to see how the market
reacts in 2019 when the standard is implemented more widely.
We have selected Kuehne + Nagel and Maersk as they are the remaining logistics companies in
our coverage that have yet to report the impact of IFRS 16. We have had to adapt the standard
model used in this report for other sectors to fit Kuehne + Nagel. This is because the lease
profile is abnormally short. Our analysis is calibrated using the before and after data for DSV
which has a similar lease payment profile. It is not clear whether logistics companies are making
______________________________________
20 IFRS 16 “The impact on business valuation” 2016
44
19 February 2019
use of the requirement to declare minimum operating lease commitments up to the first break
clause in any lease agreement but with many contract logistics contracts lasting for three to five
years we think this is unlikely. Companies are in any case required to recognise lease payments
when there is a reasonable certainty that leases will be extended and we expect the early
adopters to have taken this into consideration. The risk of understatement of liabilities is
therefore low in our opinion. Maersk on the other hand has a more conventional lease portfolio;
it also disclosed in the 2017 report and accounts that preliminary indications were that IFRS
would add some USD6-8bn to net debt which is in line with our model.
Estimated impact of IFRS 16 (2018e)

Maersk (USDm) 2018e 2018e post IFRS 16 % difference KNIN (CHFm) 2018e 2018e post IFRS 16 % difference
Sales 39,889 39,889 0% Sales 20,807 20,807 0%
EBITDA 3,748 5,698 52% EBITDA 1,202 1,643 37%
% margin 9.4% 14.3% % margin 5.8% 7.9%
EBIT 767 828 8% EBIT 983 1,009 3%
% margin 1.9% 2.1% % margin 4.7% 4.8%
PBT 326 -84 -126% PBT 998 992 -1%
Net Debt -11,621 -18,961 63% Net Debt 586 -288 -149%
Net Debt/EBITDA 3.1 3.3 Net Debt/EBITDA -0.5 0.2
Experience to date suggests that the adoption of IFRS 16 has not impacted underlying EPS too
much and some companies at least have been at pains to eliminate the IFRS 16 impact on
underlying free cash flow metrics. Set against wider macro-economic uncertainty, the adoption
of IFRS 16 does not appear to have changed investors’ perception of individual stocks.
45
19 February 2019
Impact on the Pubs sector
 Different freehold/leasehold splits will likely cause variations in

impact across the sector, which is no surprise, but valuation
multiples may have to be reappraised
 IFRS 16 impact may increasing concerns about debt levels, but give
greater clarity when comparing leasehold and freehold models
 Sector likely to be exposed to the asymmetrical accounting
Paul Rossington*
Within the context of the wider leisure sector, we focus on the pubs when analysing IFRS 16.
Analyst
HSBC Bank plc This is because, despite being viewed as directly comparable businesses, they have different
paul.rossington@hsbcib.com
freehold/leasehold splits which will lead to variations in impact.
+44 20 7991 6734
* Employed by a non-US affiliate of HSBC

Securities (USA) Inc, and is not registered/ Lease environment within the sector
For pub groups the main lease exposure is to property. They operate a mixture of freeholds
alongside short term and longer term leases. Lease lengths can be extremely long: Marston’s,
for example, cites lease durations of up to 30 years (vs. plant and machinery at 6 years). But
operators are by no means uniform in their approach.
Given the variance in freehold/leasehold mix, operating leases are one of the things that we have
IFRS 16 impact may not come
as surprise. However taken into consideration historically when calculating underlying gearing levels and enterprise values.
valuation multiples may have As such, the changes being implemented by IFRS 16 shouldn’t come as a huge shock to those that
to be reappraised have considered them in the past. However, as we show below, there will be a limited earnings
impact which may mean that appropriate valuation multiples have to be reappraised.
Two other things to note:

 Within the sector, the pub groups also operate as lessors, letting some proportion of their
properties to tenants. IFRS 16 does not allow the operators an offsetting benefit. It is
asymmetrical, penalising lessees but not benefitting lessors.
 The lease profiles of Marston’s and Greene King are much steadier than those of MAB. We
think that this may mean that MAB are only recognising leases until their break clauses. As
such, calculating lease liabilities from the notes to the accounts could underestimate the
actual impact. It would fit with commentary that we have received from MAB.
Operators have so far given practically no guidance on the impact of IFRS 16 in their
businesses. We remain unclear whether it will be implemented on a full retrospective basis or
cumulative catch-up approach. Here, we assume that cumulative catch-up is used, and
calculate the impact on earnings as well as net debt and gearing.
46
19 February 2019
We have selected Marston’s, which is the sector’s most freehold-basis pub estate (93%) and
We believe we can have more
confidence in the impact Mitchells & Butlers, which is lower, with 81% freehold and long leasehold and is an example of
estimates for Marston’s than a group where our methodology may underestimate the risk .
MAB as MAB’s break clauses
We are confident in our calculations around Marston’s, which has a relatively steady lease
may cause an under-valuing
of the liabilities exposure, which is what we would expect from long-term assets.
However, we are less sure about our calculations for MAB. On our calculations, payments drop
quickly after year 5, from cGBP50m p.a. to cGBP20m. This might reflect the group choosing to
only recognise leases until a 5 year break clause. That would understate the true debt impact,
along with the calculated gearing multiple and also the earnings downgrade, based on our
calculation methodology.
Impact of IFRS 16: Marston’s and Mitchells & Butlers compared (GBPm except per-share
data in GBp)
Marston’s FY20e Post-IFRS 16 % diff Mitchells & butlers FY20e Post-IFRS 16 % diff
Sales 1227.2 1227.2 Sales 2,293 2,293
EBITDA 240.6 259.8 8.0% EBITDA 437 486 11.2%
Margin 19.6% 21.2% Margin 19.1% 21.2%
EBIT 195.8 204.6 4.5% EBIT 312 323 3.5%
Margin 16.0% 16.7% Margin 13.6% 14.1%
EPS 14.6 14.1 -3.6% EPS 35.7 34.2 -4.1%
Net debt 1364.4 1600.0 Net debt 1,560 1,898
Our observations
Our main observation is alluded to above. Investors must beware the lease profile that operators are
recognising in their accounts, which could be understating the scale of liabilities at present.

IFRS 16 is only going to increase existing investor concerns around high debt levels. However, it will
IFRS 16 may increase
concerns about debt, but
aid comparison between freehold and leasehold models, which we think has been muddied in the
may give clarity when past. Arguably, there’s greatest risk (balance sheet and valuation) around one of our preferred picks
comparing leasehold and in the sector, MAB. However, we like MAB mainly because of the positive earnings momentum.
freehold models.
While the standard approach of putting an 8x multiple on lease payments may underestimate
the scale of the lease debt that has to be taken on to balance sheets, we do not expect it to be a
major consideration in practice. We think that ratings agencies and lenders are likely to take an
independent view on the scale of risk when setting covenants.
Marston’s – Changes to estimates and target price

Our forecasts and valuation for Marston’s change in this note. We lay out the changes below.
We make no changes to our FY19 EBIT forecast. We make small cuts to our finance charges in
each year as shown in the table below. We make the following changes to our FY20e/FY21e
cash flows to reflect the group’s debt reduction programme: 1) Assume GBP15,-20m pa of
lower disposal proceeds despite the plans as our old forecasts were too aggressive, 2) Trim
maintenance capex by GBP12.5m each year 3) Reducing new build capex assumptions by
GBP25m and 4) Pension charge saving of GBP3m in FY20e and GBP7.5m in FY21e.
47
19 February 2019
MARS: Changes to estimates (GBPm, unless otherwise stated)

_________ 2019e ________ __________ 2020e_________ _________ 2021e _________
Old New Diff Old New Diff Old New Diff
Revenue post acquisitions 1,176 1,176 0.0% 1,227 1,227 0.0% 1,254 1,254 0.0%
EBITDA 239 232 -3.0% 248 241 -3.0% 250 243 -3.0%
Destination & Premium profit 95.4 95.4 0.0% 100.8 100.8 0.0% 102.4 102.4 0.0%
Taverns and leased profit 86.6 86.6 0.0% 88.3 88.3 0.0% 88.4 88.4 0.0%
Beer profit 32.0 32.0 0.0% 32.6 32.6 0.0% 33.3 33.3 0.0%
Central costs -25.5 -25.5 0.0% -26.0 -26.0 0.0% -26.0 -26.0 0.0%
Operating profit 188.5 188.5 0.0% 195.8 195.8 0.0% 198.1 198.1 0.0%
PBT 109.0 107.0 -1.8% 111.8 110.8 -0.9% 115.1 114.1 -0.9%
Net profit 92.1 90.4 -1.8% 94.5 93.6 -0.9% 97.3 96.5 -0.9%
EPS 14.4 14.1 -1.8% 14.8 14.6 -0.9% 15.2 15.1 -0.9%
Net debt 1,392 1,399 0.5% 1,370 1,364 -0.4% 1,348 1,331 -1.2%
Valuation and risks
We continue to apply a lease-adjusted EV/EBIT multiple of 11.5x on our FY19e earnings, the
average multiple of 2011-12, the period of consumer weakness. After making all the relevant
deductions (pensions, provisions, out of the money swap, leases), we arrive at a new SOTP
valuation of 102p per share vs 103p earlier. Our valuation declines marginally to reflect forecast
cuts. This gives us our new rounded target price of 100p, down from 105p, which implies upside
of 4.2%. We maintain our Hold rating as we do not see any imminent catalyst for a re-rating.
MARS: SOTP valuation summary (GBPm, unless stated otherwise)

Old New
2019 2019e
EV/EBIT adj (average) 11.5 11.5
Premium/(Discount) 0.0% 0.0%
EV/EBITR adj for pension/provision/SWAP and lease 11.5 11.5
EV adjusted for pension/provision/lease 2414 2405
Pension adjusted 0 0
Provision -25 -25
Assets held for sale 2 2
Capitalised lease -171 -165
SWAP -178 -178
Net debt -1386 -1386
Market value 656 654
Value per share (p) 103 102
Discount (%) 0% 0%
TP (p) rounded 105 100
Downside risks include consumer weakness, higher cost inflation, beer volume declines
affecting tenanted pubs, and tax increases. Upside risks include improved returns from new
builds and upgrades from retail agreements.
48
19 February 2019
Impact on Business Services
 The IFRS 16 changes are likely to optically increase margins and cash
flow measures often used by investors
 This reduces comparability of multiples with history and necessitates a
case-by-case bottom-up analysis of the adjustments
 Whilst the companies with higher level of financial gearing may
receive greater scrutiny, lenders are likely to adjust for such changes
Rajesh Kumar* The business services sector consists of a heterogeneous bunch of companies ranging from
Pan-European Business Services capital-light (e.g. staffers, security/facility management) to capital-intense (e.g. equipment rental
Equity Analyst
HSBC Bank plc companies). In the middle of the spectrum, we have the testers and distributors. Whilst testers
+44 20 7991 1629
and distributors are more capital intense than labour service companies, the investors often
gravitate to these companies as they offer a relatively (to their suppliers) capital-light way to play
Chirag Vadhia*
Pan-European Business Services a theme in an industrial supply chain (e.g. Brenntag in the chemical industry).
Equity Analyst
HSBC Bank plc
+44 3268 5721 Lease environment within the sector
The Business Services sector relies for operating leases predominantly for office/laboratory
Matthew Lloyd*
Head of UK MidCap Equity spaces, vehicles, and equipment. For most services companies (staffers, and security), office
Research
HSBC Bank plc
space forms a lion’s share of the operating leases. There are few key factors to consider:
matthew.lloyd@hsbcib.com
+44 20 7991 6799
 Lenders are likely to adjust for such accounting changes: Most of the companies in the
sector have indicated that their lenders and rating agencies are unlikely to evaluate them on
* Employed by a non-US affiliate of HSBC a changed basis due to IFRS 16 changes. So whilst the highly geared companies in the
qualified pursuant to FINRA regulations sector, such as Elis, Spie, or G4S, may see their net/debt to EBITDA ratios increase, the
impact of financial covenants is likely to be limited, at least in the short run.
 Approach: Most of the sector companies seem to be adopting a cumulative catch-up
approach. Relx seems to be an outlier in that respect as it has already applied a full-
retrospective approach.
The chart below should give helpful context of the extent of the magnitude of leases and the
companies likely to be affected within the sector.
49
19 February 2019
Last reported annual operating lease expense as a percent of EBITDA offers some
insight on the sensitivity IFRS16
Source: Company data
The potential impact of IFRS 16
Some of the companies have offered clear updates to the market on the potential impact of
Any estimates that attempt to
model the impact IFRS 16 IFRS 16, albeit most of the sell-side estimates so far seem to be on the IAS 17 basis. Most of
face several unknowns the sector companies (bar Relx, which has already done so) will move to IFRS 16 in the coming
quarters as they report their current financial year report. Thus, any estimates that attempt to
model the impact of these accounting changes will need to deal with the following uncertainties:
 Mix of assets: Distributors have a mix of owned as well as leased properties in the mix,
whilst the staffers tend to have largely leased assets. Such a mix may impact the relative
level of increase in EBITDA as well as capital employed.
 Minimum lease obligations and break clauses: The companies often tend to disclose the
minimum lease payment obligations. Any analysis that assumes that is the overall liability
may underestimate the impact severely. Similarly, where there is lack of certainty, the break
clauses may exclude the known leases from IFRS 16 capitalisation requirements. For
example, from Brenntag’s disclosures at the capital market days we know that only c65% of
annual lease payments will require a revised accounting treatment.
 Duration of the leases: The duration of contracts will be key unknown. Depending on the
approach applied by the company (“cumulative catch-up approach” or “full retrospective
approach”), the remaining lives of the leases will be a key unknown.
 Discount rates: In certain scenarios the lessors are not willing to provide an implicit
discount rate. This creates subjectivity for the lessees as they may have to look at a
portfolio of similar leases to assess the implicit interest rates in such contracts.
 Break clause: Finally, the commentary so far seems to imply that the companies are
focussed on capitalising the assets over the life of the leases
The aforementioned diversity of the sector dictates that the IFRS 16 exposure is examined on a
sub-sector basis.
50
19 February 2019
Staffing, security and FM
Service companies
Company Ticker Comments from the annual reports
Staffers
Hays Group HAYS.L • IFRS 16 is expected to have a significant impact on the amounts recognised in the Group’s Consolidated Financial Statements.
• This will result in an increase in operating profit and an increase in finance costs. The standard will also impact a number of statutory
measures such as operating profit, and cash generated from operations, and alternative performance measures used by the Group.
• The full impact of IFRS 16 is currently under review, including understanding the practical application of the principles of the standard. It is
therefore not practical to provide a reasonable estimate of the financial effect until this review is complete. IFRS 16 will become effective in
the Group’s financial year 2020.
Page Group PAGE.L • The transition to IFRS 16 is likely to have a significant effect on the Group, the main areas impacted being leases for properties and cars. It is
considered unlikely for there to be many other leases in the Group either exceeding $5k, or a term of more than 12 months.
• IFRS 16 is expected to result in an increase in EBITDA for the Group, as rentals are reclassified as depreciation and interest expense.
Margins may also appear higher as a result.
“It doesn't have a huge impact at an EBIT level. So at an EBITDA level, we've modelled that it probably increases EBITDA by about GBP 25 million. So
that's the lease cost charge coming out above the line and going in as a depreciation charge essentially. If you actually then look at an EBIT level, that
really is only a matter of the distortion between the flat cash flow that you pay on an operating lease as opposed to the interest charge
You pay mainly interest at the beginning of the mortgage and you pay mainly capital back at the end of the mortgage. It means that actually, in
the early years, we'll end up with a benefit of about GBP 1 million in the EBIT line, so nothing hugely material.
It does obviously mean that whilst we run our net cash on the balance sheet, we will show debt on the balance sheet, and that probably needs a little bit
of help through our communications to ensure that people understand the values of lease-related debt as opposed to real financial debt.
[Kelvin Stagg, CFO and Member of Executive Board & Executive Director, 10/10/2018]”
Randstad RAND.AS • Preliminary calculations indicate that as of January 1, 2018, IFRS 16 will lead to the recognition of 'Right of use' assets and other assets of
EUR 560 million (9.4% of operating assets FY'17) and of financial liabilities of EUR 610 million. • The net impact on equity, taking into account
deferred taxes, is expected to amount to EUR 35 to EUR 40 million.
• For operating leases, an amount of EUR 274 million expenses (2016: EUR 240 million) is included in operating profit.
• Lease contracts of which the majority of risks and rewards inherent to ownership do not lie with the Group are classified as operating leases. Expenses
related to operating leases are included in operating expenses and/or cost of services on a straight-line basis over the term of the lease.
Security and FM
G4S GFS.L • The impact on the Consolidated income statement is currently expected to be a small increase in Adjusted PBITA, due to the re-classification
of the interest element of operating lease rentals as finance costs.
• The impact on Profit before tax will be variable over the term of a lease, as interest is charged at the effective rate on the reducing balance of
the liability over the lease term. Over the course of each lease the cumulative impact on pre-tax profit will be neutral.
• The impact on the Consolidated statement of cash flows will be an increase in net cash flow from operating activities, equivalent to the
increase in Adjusted PBITA, matched by an increase in cash outflow from financing activities due to the re-classification of finance lease
interest, with no impact on net cash flow.
Prosegur PSG.MC • While the Group has not yet calculated the impact of adopting IFRS 16], new assets and liabilities for its operating leases of properties and
vehicles [will be recognised]
• IFRS 16 replaces the straight-line expense of the operating lease with a charge for amortisation of ‘right to use’ assets and an expense for
interest in lease liabilities.
Prosegur CASHP.MC • Although the Group has not quantified the impact of the adoption of IFRS 16, it estimates that the impact on its financial statements will be
Cash significant and will consist of the recognition of new assets and liabilities for its operating leases of real estate and fleet
• It will also change the nature of the expenses related to these leases, since IFRS 16 replaces the straight-line expense of the operating lease
with a charge for amortisation of right-of-use assets and an interest expense on lease liabilities.
Securitas SECUb.ST • One effect that is expected on Securitas from IFRS 16 is that total assets and total liabilities will increase.
• Further, the Group’s operating income is expected to improve while financial expenses are expected to increase.
SPIE SPIE.PA • The Group has assessed the impacts of this standard in its financial statements, but is not in a position to provide any quantitative information
on these impacts.
• At this stage, the main impacts expected are an increase of the financial debts and right-of-use assets in the statement of financial position,
and an improvement of the operating income as well as an increase of the financial expenses in the Group income statement.
Source: Company data, HSBC Research
Most of the labour intensive business models rely on operating leases for renting office spaces. By their very nature, the contracts are
multi-year with a break clause. Over the years since the financial crisis in 2009, many of the staffing companies have consolidated their
fragmented branch networks into larger branches. The capitalisation of these leases should increase the net financial liabilities. For
example, Page has indicated that it may move from a net cash to a small net debt position.
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Distributors and Testers

Like staffers, most of the operating lease payments for distributors and testing companies
Complexity of lease
portfolios and limited involve properties, and to a lesser extent, plant and equipment. However, unlike labour-based
information makes precise businesses (e.g. staffers), these companies tend to own some freehold properties (e.g.
modelling challenging warehouses and distribution centres) and equipment. Therefore, the level of increase is not
materially different in magnitude at the EBITDA level (10-20% of EBITDA depending on the
company). We have used our model to estimate the impact for Brenntag, however, we think that
the company’s lease portfolio may be too complex to model based only on the limited
information within the operating lease note. We are aware that the company has set up a
separate IT database just to deal with the impact of leases last year. Therefore our model, whilst
giving an indication of direction of travel, will be different from the actual outcome.
Modelled impact IFRS 16 on 2017 EPS (EURm)

__________________________ Brenntag___________________________
IFRS 16 Impact Post IFRS 16 Change
EBIT 38 658 6%
Interest (12) (99) 13%
EBT 27 558 5%
Net Debt (244) (1,520) 19%
EBITA 38 748 5%
EBITDA 93 929 11%
EPS (EUR/share) 13 281 5%

Source: Company data, HSBC estimates
Within these companies, the differences in the business model may create different levels of impact.
Unsurprisingly, different
capex models are giving For example, Brenntag operates its own logistics network. It, therefore, has a higher operating lease
varied impacts expenses than a number of its peers, particularly those that outsource most of their logistics. More
importantly, Brenntag has assessed that it will have to capitalise c65% of its operating lease
expenses. Others have as yet not issued explicit guidance on IFRS 16, or its disclosures.
Distributors
Companies Ticker (price) Comment
Brenntag BNRGn.DE • Application of the new IFRS 16 will result in an improvement in operating EBITDA and in an increase in depreciation and interest expense.
• Brenntag has introduced a Group-wide software solution in which existing leases are currently being entered and will next be
measured uniformly. Therefore, the effects of the new rules on the presentation of the Group’s net assets, financial position and
results of operations cannot yet be quantified exactly.
Bunzl BNZL • Whilst the actual impact will not be known until IFRS 16 is adopted on 1 January 2019 projections based on leases in place at 31
December 2017 and assuming an adoption date of 1 January 2017 [have been used instead]
• It is currently estimated that adoption of IFRS 16 would increase the carrying value of property, plant and equipment at 31
December 2017 by between £350 million and £400 million (or 12.1% - 13.8% of operating assets for FY'17), with liabilities increasing
by between £450 million and £500 million.
• Net debt to EBITDA (being earnings before interest, tax, depreciation, customer relationships and software amortisation and
acquisition related items) calculated at average exchange rates will increase by approximately 0.2 times but current banking
covenants will be unaffected.
DCC DCC.L • The Group continues to perform a full review of all agreements to assess whether any additional contracts will now become a lease
under IFRS 16's new definition in addition to determining which optional accounting simplifications to apply and assessing the
additional disclosures that will be required.
• At this stage the Group expects to adopt the modified retrospective approach. In order to assist with meeting the requirements of the new
standard, the Group has selected a lease accounting software solution which is in the process of being implemented across the Group.
Electrocomponents ECM.L • The accounting for leases under IFRS 16 will result in higher operating profit, with a lower lease expense partly offset by depreciation of the
right-of-use asset, and higher interest expense due to the unwinding of the discount on the present value of the liability
Ferguson FERG.L • The Group continues to assess the full impact of IFRS 16, however the impact will depend on the transition approach and the
contracts in effect at the time of adoption.
• It is therefore not yet practicable to provide a reliable estimate of the financial impact on the Group’s consolidated financial statements.
IMCD IMCD.AS • So far, the most significant impact identified is that the Group will recognise new assets and liabilities for its operating leases of
offices, certain warehouse facilities, and company cars.
• The Group expects to disclose more detailed quantitative information in the financial statements of 2018. The Group expects that
adoption of IFRS 16 will not impact its ability to comply with the maximum leverage threshold loan covenant.
Source: Companies’ FY0 annual reports
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19 February 2019
Similarly, testing companies, with a greater degree of inspection and certification (e.g. Bureau
Veritas), may end up with a lower level of operating lease cost-capitalisation, as opposed to
companies with a greater amount of lab based testing (e.g. SGS).
Comments from rental companies

Company Ticker Comment
Equipment rental
Aggreko AGGK.L • This initial impact assessment has been calculated by reviewing a sample of leases (circa 35% of total lease commitment value) and
then applying this to the full population of leases.
• The total annual income statement charge is expected to increase by circa £1 million.
• EBITDA is expected to increase by around £30 to £40 million as the expense is now depreciation and interest.
• The total income statement charge over the life of the leases is unchanged – the difference under IFRS 16 is a ‘front-loading’ of the
recognition of the charge.
• Recognition of a right-of-use asset of circa £60 million and a lease liability of circa £60 million (2.7% of operating assets for FY '17) with no
impact on net assets. During 2018 the Group will complete its assessment of this standard and will concentrate on some areas of judgement.
Ashtead AHT.L • IFRS 16 will be effective for the financial year beginning 1 May 2019 and will have a material impact on the Group’s assets and liabilities as
leases are capitalised, as well as an increase in EBITDA offset by a decrease in depreciation and an increase in financial charges.
Rentokil RTO.L • The lease liability will increase net debt. It is anticipated that operating expenses will decrease and financing costs will increase as
the operating lease expense is replaced by depreciation and interest.
• Depreciation will be straight-line over the life of the lease but the financing charge will decrease over the lease term. The overall
impact on net profit is not expected to be material.
Elis ELIS.PA • The Group has chosen not to apply IFRS 16 early. It has not yet quantified the impact of the adoption of IFRS 16 and has not yet
determined its position on the transition method.
Source: Company data, HSBC Research
Equipment rental
The equipment rental companies are lessee in many scenarios. Most rental contracts are for a
duration for less than a year and hence may be excluded in IFRS 16 treatment by their clients.
Longer duration rental contracts may come under scrutiny, if they are with private sector customers
IFRS 16 may stir up the
renting vs. owing debate on (e.g. workwear rental contracts for Elis). That may stir up the renting vs. owing debate in parts of the
longer duration contracts sector. The rental companies may point to the total cost of ownerships, whilst the lessors (the
customers) may re-valuate the increased cost on balance sheet. The accounting treatment of these
contracts may end up being asymmetric between the lessors and the lessee.
That said, existence of break clauses or creation of future break clauses might offer some
protection to the customers. Aggreko’s customers, which are often government sector entities in
frontier market contracts, may escape this issue.
What should investors consider?
As the companies adopt IFRS 16, investors need to watch the following factors for the Business
Services companies:
 EBITDA and cash flows: Clearly, most of the companies are likely to increase their
reported EBITDA and operating cash flows/free cash flow calculations as a result of these
accounting standards. Investors may benefit from remaining vigilant when the multiples or
valuation calculations done on these metrics are indeed adjusting for such changes.
 Phasing between companies: The business services sector companies often have
varying year-ends. As a result, investors may need to exercise caution whilst comparing
valuation multiples of companies that have adopted IFRS 16 with companies that are yet to
adopt IFRS 16.
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 Question the assumptions: The subjectivity around the capitalisation means that the
assumptions used to capitalise the assets may end up creating an optical upgrade at the
EPS level for companies. The differences in the choice of asset lives (lease duration or
perpetual), depreciation approach (straight-line or declining) and treatment of break clauses
may result in different impact for peer companies.
 Treatment of intangibles: There is more flexibility around how software contracts are
treated under IFRS 16. For a chemical distributor, even with digitisation and cloud, it may
not matter as much. However, for a digital company (e.g. an analytics company’s choice
between third-party cloud vs. own infrastructure) these differences may prove meaningful,
both commercially and for comparison of earnings.
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Appendix 1: The key

technical aspects of IFRS 16
 IFRS 16 is detailed and potentially complex, but with a simple overall

objective to recognise off balance sheet lease finance
 The changes are significant; we set out a summary of the key
provisions of IFRS 16 to provide context to our note
 Actual application will vary company to company
Introduction and limitations
We have set out in this appendix what we consider to be the key technical aspects of IFRS 16.
This is intended to be a summary and, therefore, is not exhaustive in relation to all the
requirements of IFRS 16. The specific application of the standard will be distinct to the particular
circumstances of individual leases.
The most significant changes will be in relation to leases previously classified as operating
leases, and that is where we have focused most of our analysis within this note. However,
leases previously classified as finance leases are also subject to IFRS 16 and may be impacted
by the changes, but in our view in most cases this will be to a much smaller degree. Going
forward there will be no distinction.
What’s in and what’s not within the scope of IFRS 16?
Any leased asset, tangible or intangible, whether leased directly or within a wider contract, except for:
The new standard applies to
virtually all leased assets  leases to explore for or use minerals and non-regenerative resources;
 biological assets;
 service concession agreements;
 licenses for IP within the scope; and
 rights held under licensing agreements for certain intangible assets (e.g. copyrights).
Additionally, companies have the choice to elect to not apply the requirements for:
Choice not to apply IFRS 16
for certain leases  “short-term” leases i.e. less than 1 year;
 leases where the underlying asset is of “low value” subject to certain conditions – we note
that “low value” is not specifically defined, although the IASB has given guidance that it had
in mind a value of USD5,000 (when new).
 intangible assets (not excluded as above).
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Identifying a lease
IFRS 16 changes the focus when identifying leases from the previous “risk and reward” to a
Risk and reward approach
replaced with right to control “right to control” approach. IFRS 16 applies, not just to those contracts that are labelled leases,
but also covers any contract that gives an entity the right to control the use of an identified
asset for a period of time in exchange for consideration. Contracts which contain any rights that
meet this criteria will have to be unbundled into the lease and non-lease components and be
accounted for separately.
Does the contract contain a lease?

In order for a contract to be considered to be (or include) a lease under IFRS 16, the contract
May apply to contracts not
labelled as a lease must give the customer both the right to:
 receive substantially all the economic benefit from use of an identified asset; and
 direct the use of the identified asset.
What is an identified asset and what does “direct the use” mean?
The standard’s guidance ensures a wide range of assets, usage scenarios and contractual terms are
included and therefore fall within scope. For example, restricting, but not eliminating, the argument
that a supplier’s contractual ability to substitute one asset for another would exclude the contract from
scope. There is further subtlety that may lead to certain contracts being excluded despite appearing
to be leases. However we believe that those will not be the norm.
Determining the lease term
The lease term is defined as the non-cancellable period of a lease together with any options to
extend (including renewals) or terminate (by the lessee) if the lessee is reasonably certain of
exercising either of those options. Once again there is the potential for some subjectivity to be
introduced in relation to certainty of exercising of the options. It is also possible that companies
will to seek to specify shorter non-cancellable periods in order to minimise the lease liabilities
recognised. However, we expect that this would likely increase the cost of the lease in most
circumstances which may ‘naturally’ discourage companies from pursuing this approach.
Recognition of leases within the financial statements
Balance Sheet
Lease liability
At the start of a lease, the lessee must recognise, as a financial liability in the balance sheet, the
PV of lease payments are a
liability on the balance sheet present value of the lease payments (split between current and non-current) that are outstanding.
and subject to interest The standard specifies that the discount rate to be used to determine the present value is either:
 the rate implicit in the lease or, if that is not readily determined; or
 the lessee’s incremental borrowing rate.
We note that both options for determining the discount rate are potentially open to judgements
and estimation by a lessee’s management. Companies will also not always have the information
from their lessors in order to determine the rate and may have to make assumptions to do so.
Therefore this is an area of subjectivity that management could potentially use to influence the
presentation of the lease payments. Unless the implicit rate is straightforward to determine, we
expect, particularly in the initial application, that companies will tend towards using their own
borrowing rate as a basis adjusted for the particular facets of the type of lease.
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In addition, where there is any variability in the lease payments (for example any payments that
are dependent on an index or rate, or conditions on return of the asset) these may also
introduce further subjectivity to the magnitude of the liability recognised.
Similar to a loan balance, as time progresses the liability increases to reflect the interest
incurred on the liability and reduced to reflect the payments made.
Lease asset – the right-of-use asset
On commencement of the lease the financial asset is recognised “cost”. Cost is defined as the
Lease asset goes on balance
sheet and is depreciated – amount of the initial lease liability (above) plus:
the asset does not always  any lease payment made at or before the start of the lease (less any lease incentives);
equal the liability at
commencement  an initial direct costs incurred by the lessee; and
 decommissioning costs21.
Assuming the lease proceeds unchanged to its conclusion, the capitalised cost is then subject
to a similar treatment to a bought asset i.e. depreciated over the course of the life (of the lease)
and subject to any impairments in value that may arise.
Income Statement
Operating costs
Under IFRS 16, a depreciation charge from the recognised leased asset is charged in operating
Lease charge “moves” to
depreciation and finance costs (i.e. within EBIT). The annual depreciation charges are, in most cases, likely to be less
charges, however the profile than the straight-line operating lease charge. Therefore EBIT will, in most cases, increase for
does not match the old lease individual leases.
charge and the cash flows
Finance costs
The interest charged on the outstanding financial liability recognised under IFRS 16 will form
part of the finance expenses of companies and will be reported separately22.
Overall charge to the income statement and profile of costs
Over the life of the lease, the total charges to the income statement will not change as a result of
IFRS 16. However, the charges within each individual year will vary from the current approach.
The resulting overall expense recognition profile will, in almost all cases, change and higher
charges23 will be recognised in the income statement in the early periods of a lease and lower
charges towards the end of lease (as the finance charges decline as the financial liability is paid).
We have set out a simple example illustrating the different expense profile between the previous
model and IFRS 16 in the section titled “Assessing the impact”.
The example considers a single lease commencing after the implementation date of IFRS 16, the
reality will be more complex as the existing lease portfolio is brought onto the balance sheet (see
Transition Arrangements, below) and as the maturity of a company’s lease portfolio may vary.
Cash flow Statement

Although the accounting under IFRS 16 for what were classified as operating leases will
Net cash flow remains the
same, however the cash is change, the cash paid will not. Under IFRS 16 however, the cash flows relating to leases will be
split between the repayment classified as financing activities, split between the repayment of the principal and interest in
of principal and interest relation to the financial liability.
______________________________________
21 Note that IFRS 16 does not define them as such, we use this term to simplify
22 within the notes to the financial statements
23 compared to the current approach
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Impact of IFRS 16 on financial metrics
The impact of IFRS 16 will vary significantly from company to company depending upon the
Movement of metrics will
vary significantly based upon lease portfolio and the choices, judgements and estimates made by companies (discussed in
the lease portfolio and the the relevant section of this note). We have set out below our expectations of the direction of
choices, judgements and likely changes in a selection of commonly used financial metrics assuming a simple lease
estimates made by portfolio that is relatively static (i.e. that renews leases as they expire) and after all leases that
companies existed pre-transition have expired.
Summary of changes to key financial metrics

Metric Expectation of effect of IFRS 16 Explanation
EBITDA Increase The operating lease charges will be absent following the
implementation of IFRS 16
EBIT / Operating profit Varies depending on the lease The depreciation charge is likely to be lower than the operating
portfolio lease charge as a portion of the cost becomes finance cost
Profit before tax Varies depending on the lease For each individual lease in the earlier years the EBT will decrease
portfolio compared to a straight line operating lease model but increase in
the later years. Therefore it will depend upon the proportion of the
lease yet to go.
EPS Varies depending on the lease Similar to EBT
portfolio
ROCE Varies depending on the lease Both EBT and net debt will change therefore the effect on ROCE
portfolio will depend on the relative magnitude of those changes
Net Debt Increase The introduction of a financial liability bringing operating lease
commitments on balance sheet will affect net debt.
Operating cash flow Increase As EBIT increases the operating cash flow component will increase
Net cash flow No change Net cash flow will not change, the increase in operating cash flow will be
offset in decrease in cash outflow reflecting the finance charges.
Source: HSBC
Accounting for the transition – choices may lead to some divergence
To simplify the transition for companies, IFRS 16 provides a number of optional reliefs or
The transition approach
choice could have an “practical expedients” mechanisms, although a company can, if it wishes, apply the standard
enormous impact depending fully retrospectively.
on the portfolio and the
We expect most companies, particularly those with a large lease portfolio, will use some (or all)
effects of the choices could
be long-lasting the simplifying options available to them. We have set out below the key reliefs and practical
expedients for non-fully retrospective application.
Although helpful for companies24, the addition of choices will lead to the possibility of a
temporary divergence of accounting treatment between companies. This may reduce
comparability of financial statements of companies with similar lease portfolios. Although
temporary, it could theoretically last until all leases entered into prior to transition come to an
end, however we think any impact will likely reduce over time.
Key choices, reliefs/practical expedients for in-scope leases (i.e. not “short term” or “low
value”25)
We have set out below the key choices that a company has to make in relation to the transition.
We note that, whichever approach a company uses, it is also permitted to opt to continue the
classification of whether a contract contains a lease for any contract that was in place at
transition. In addition leases with less than one year to run can be excluded.
______________________________________
24 by reducing the administrative burden of the application of the standard
25 as defined above
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19 February 2019
Transition options
Fully retrospective or cumulative catch-up (a.k.a. modified retrospective)?
OR
Cumulative catch up
Fully retrospective LIABILITY
Apply IFRS 16 for each Do not restate
lease from inception of comparatives
each lease historically. Recognise the liability
Re-evaluate all leases as the present value of
Restate comparatives. future lease payments
at the date of transition
ASSET option (a)

ASSET option (b)
Do not restate
Do not restate
comparatives OR comparatives
if IFRS 16 had always
equal to the liability
applied
Practical expedients available to both approaches, including maintaining the decision of

whether a contract contains a lease and leases with less than one year to run can be
excluded
Source: HSBC
1. Fully retrospective approach
A company can choose to take a “fully retrospective” approach. This decision must be taken for
all leases taken as a whole, rather than “cherry picking” individual contracts or leases.
If using this approach the company restates its financial statements as if IFRS 16 had
always applied.
2. Cumulative catch-up approach - Recognition and measurement of existing leases

using cumulative catch-up approach
Companies have the option to deal with the transition from the date of transition rather than
looking back. This is known as the cumulative catch-up approach (also referred to as the
“modified retrospective method”). If using the cumulative catch-up approach, companies will:
 not restate comparatives but recognise the cumulative effect of the application of the
standard as an adjustment to opening retained earnings;
 recognise the carrying amount of any leases previously categorised as finance leases; and
 for leases previously classified as operating, recognise a lease liability as the present value
of remaining lease payments discounted using the incremental borrowing rate at the
transition date.
Companies using cumulative catch-up have a choice in relation to the lease asset. Companies
can either measure the lease asset either as:
 the carrying amount of the asset as if IFRS 16 had been applied from since the lease
commencement date, discounted by the incremental borrowing rate at the transition date; OR
 the amount equal to the lease liability adjusted for any prepayments or accrued lease payments.
If the first option is taken then the difference between the value of the lease asset and lease
liability will be taken to retained earnings.
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Impact on financial statements of the transition options

The impact of the choice among the different options on a company’s financial statements will likely
vary significantly based on the individual characteristics of the company’s lease portfolio.
Companies will have an opportunity to choose the option that minimises the future net expenses for
their portfolios. For example, a company with a lease portfolio that is more mature on average may
benefit from valuation of the lease asset as if IFRS 16 had always applied, as the resulting on-going
depreciation charge will be lower (as the recognised asset value will be lower).
Choices in the ongoing application of IFRS 16
We have discussed some of the potential choices in relation to IFRS 16 within the section titled
“Areas of judgements and choice”.
Lessors
For lessors, the main changes introduced by IFRS 16 compared to IAS 17, are related to
disclosures. From an accounting perspective, lessors will still use the categories of finance and
operating leases which means the accounting between lessors and lessees will be asymmetric.
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Valuation and risks
Food retail
Valuation Risks
Current price: We use a DCF model to arrive at our fair value target price of 265p. Downside risks include: Increasing competitive activity
Tesco Our main assumptions include a WACC of 8.7%, based on a risk-free
219p that forces a slower realisation of margin increases
TSCO LN rate of 3.0%, equity risk premium of 4.5% and beta of 1.3, terminal (although this should become less of a risk as Tesco’s
Target price: growth rate of 1%, and a terminal margin assumption of 4.2%. Our TP
265p recovery gathers momentum); structural headwinds
implies c21% upside and we rate the stock Buy as we believe long-term worsening; Tesco’s self-help strategy fails, and its ability
Buy Up/downside: cash generation could rival industry leader Ahold Delhaize and, with
to reduce costs is impaired; and execution risk and
+20.9% little leverage, most could be returned to shareholders.
disruption in integrating Booker.
David McCarthy | david1.mccarthy@hsbcib.com | +44 20 7992 1326
Andrew Porteous | andrew.porteous@hsbc.com | + 44 20 7992 4647
Current price: We use a DCF model to arrive at our fair value target price of Downside risks include: Increased competitive activity
Morrisons 265p. Our main assumptions include a WACC of 7.9% with a risk
236p from either Tesco or the discounters which hinders
Buy free rate of 3.0%, equity risk premium of 4.5%, beta of 1.3 and a margin progress or results in share losses; substantial
Target price: terminal margin assumption of 2.9%. Our TP implies c12% upside, margin reset and investment from ASDA; and failure to
265p and we rate the stock Buy as we see considerable self-help
deliver against wholesale ambitions e.g. McColls.
Buy Up/downside: potential and attraction in cash returns.
+12.2%
David McCarthy | david1.mccarthy@hsbcib.com | +44 20 7992 1326
Priced at close of 13 Feb 2019

Source: HSBC
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19 February 2019
Non-food retail
Valuation Risks
Current price: We have an APV-derived target price of 4,500p. We assume a risk Downside risks include: Significant reduction in online
Asos
2,886p free rate of 3%, market risk premium of 4.5%, beta of 1.2 and a spending; increased competition from new market entrants;
ASC LN terminal growth rate of 3.5%. These assumptions result in a WACC of execution risk associated with new warehouse investment;
Target price:
8.3%. Our target price implies upside of 55.9% and we have a Buy unseasonable weather; and adverse FX
4,500p
rating.
Buy Up/downside:
+55.9%
Paul Rossington | paul.rossington@hsbcib.com | + 44 20 7991 6734
Current price: Our target price is based on a sum-of-the-parts (SOTP) analysis and Downside risks include: 1) Slower-than-expected Primark
AB Foods
2,304p adjusted present value (APV) analysis. Our Primark APV valuation of store rollout and/or LFL sales growth in Europe. 2) Increased
ABF LN cGBP19.3bn is based on 10-year explicit forecasts to FY28e, for margin pressure due to competitor or market issues. 3)
Target price:
3,250p which we assume -1% LFL sales for FY19e and LFL sales growth of Negative FX impacting Primark’s sourcing costs. 4) Excess
1% from FY20e, and 7% new space growth moderating to 4%. This is World/EU sugar supply above management expectations
Buy Up/downside: followed by a 10-year holding period for which we assume 1% LFL
+41.1% sales growth and new space growth of
3%. We assume a RFR of 3.0%, ERP of 4.5% and a beta of 0.9. The
implied WACC is 7.1%. Sugar is valued at zero. Twinings’ Ovaltine is
valued at GBP2.8bn based on 16.3x FY19e earnings. ‘Other Grocery’
is valued at GBP1.7bn, based on 16.3x FY19e earnings. Ingredients
and Agriculture are valued at cGBP2.9bn based on 18. FY19e
earnings. Our target price of 3,250p implies upside of 41%, and we
have a Buy rating.
Current price: We have a TP of 150p based on APV (adjusted present value) Downside risks include: 1. Pronounced slowdown in the
Brown N
93p analysis. We assume a risk-free rate of 3% and equity risk premium of rate of online spending growth; 2. Execution risk associated
BWNG LN 4.5%, a company specific beta of 1.2 and a terminal growth rate of with IT systems implementation; 3. Unseasonable weather;
Target price:
150p 1%. Our TP implies 61% upside and we have a Buy rating. and 4. Negative FX / increase in USD sourcing costs
Buy Up/downside:
+61.0%
Current price: We have a TP of 240p based on APV (adjusted present value) Downside risks include: 1. A significant macro-led
Boohoo
189p analysis. We assume a risk-free rate of 3% and equity risk premium slowdown in online spending; 2. Increased competition from
BOO LN of 4.5%, a beta of 0.9.and a terminal growth rate of 3.5%. Implied new market entrants: 3. Execution risk associated with IT
Target price:
WACC of 7%. Our TP implies 27% upside and we have a Buy rating and new warehouse investments; 4. Reputational damage
240p
and ESG:; 5. FX and sourcing mitigated by 50% UK
Buy Up/downside: production; 6. Fashion risk and Key personnel risk.
+27.3%
Current price: We have a DCF based target price of 500p. We assume a RFR of 3% Downside risks include: 1. - Competitive response by
B&M
327p and ERP of 4.5% and a beta of 1.5., with a WACC of 8.5%. Our sector specialists; 2. Business does not behave as expected
BME LN terminal margin and terminal growth assumptions stand at 9% and during a downturn; 3. Management change; 4.Site
Target price:
500p 1%, respectively. Our TP implies 53% upside from the current price availability; 5. Greater or more persistent cannibalisation
and we have a Buy rating.
Buy Up/downside:
+53.0%
Dixons Current price: We have a TP of 160p based on DCF valuation. We assume WACC Downside risks to our view are: 1.Benefits of new
Carphone 133p of 11.4% which includes a risk free rate of 3%, equity risk premium of strategy fail to materialise, 2. UK consumer downturn, and
DC/ LN Target price: 4.5% and beta of 2.0. Terminal margin of 3.5% and terminal growth of 3. Failure to deliver improvement in cash generation
160p 0%. Our target price of implies upside of 20.5% and we have a Buy
rating as we see attraction in the dividend yield at current levels given
Buy Up/downside: the low leverage the group has. This pays investors to wait for the
20.5% substantial cash flow the new strategy could potentially bring.
62
19 February 2019
Valuation Risks
Current price: We have a fair value target price of 250p based on an APV (adjusted Downside risks: 1. UK macro and a reduction in the growth
Halfords
242p present value) analysis. We assume a RFR of 3.0%, an ERP of 4.5%, outlook for the auto and cycling markets; 2. Poor execution of
HFD LN and a beta of 1.2. We assume a terminal growth rate of 1%. Our TP the Halfords transformation strategy to that of a service-led
Target price:
implies upside of 3.5%, and we have a Hold rating. provider of auto and cycling retail sales; 3. Increase in price
250p
competition in core product lines; 4. Adverse weather and
Hold Up/downside: potential impact on seasonal product lines.
+3.5%
Upside risks: 1. Higher-than-expected demand for Cycling
/ and core Car Maintenance products. 2. M&A related
upgrades to earnings.
Current price: We have a fair value target price of 650p. Our target price is based on Upside risks include: A rebound in category demand;
Dunelm
739p APV (adjusted present value) methodology. We assume an equity risk stronger management turnaround; an easing of political and
DNLM LN premium of 4.5%, a risk-free rate of 3.0%, a stock specific beta of economic pressures; and a more robust UK consumer
Target price:
1.15 and a terminal growth rate of 1.0%. Our target price implies environment leading to a strong rebound in growth.
650p
downside of 12% and we have a Reduce rating as we see risk in a
Reduce Up/downside: premium valuation given the uncertain economic outlook.
-12%
Current price: Our TP of 690p is based on APV (adjusted present value) analysis. Downside risks include: 1) A weaker pace of growth in
Inchcape
604p We assume a risk-free rate of 3%, market risk premium of 4.5% a key EM including South and Central America; 2)
INCH LN beta of 1.3 and terminal growth rate of 1%. Our TP implies 14.2% Contraction in the supply of consumer credit / continued
Target price:
690p upside and we have a Buy rating as we like Inchcape given its weak demand in UK/Europe; 3) Supply constraints or loss
diversified global exposure, including EM, and the high margin of key distribution and/or retail contracts; 4) Negative FX
Buy Up/downside: Distribution contracts that underpin group cash generation. This offers movements; 5) Disruption from changes in industry
+14.2% potential for further M&A and/or returns of value to s/holders. legislation, e.g. emissions
Current price: We have an APV-derived (adjusted present value) TP of 240p. We Downside risks: 1. Execution risk attached to delivering unique
Kingfisher
233p assume a RFR of 3%, ERP of 4.5%, a beta of 1.2 and a terminal and unified offer benefit. 2. Failure to deliver on other targeted
KGF LN growth rate of 1%. The implied WACC is c8%. Our target price implies efficiency and cost savings. 3. Adverse weather and potential
Target price:
upside of 2.9% and we have a Hold rating. The valuation is supported impact on seasonal product lines. 4. Increased pricing
240p
by a strong asset-backed balance sheet underpinned by GBP3.5bn of pressure/competition in key end markets (e.g. France).
Hold Up/downside: freehold property, forecast broadly neutral year-end net debt position, 5. Deterioration in UK/French macro outlook, consumer
+2.9% strong cash generation with DPS yield sufficiently covered by confidence, housing markets.
constantly improving FCF and EPS. Upside risks: 1. Faster than expected traction with French
consumer on delivery of unified and unique/EDLP strategy.
2. Over delivery on targeted efficiency and cost savings. 3.
Reduction in pricing pressure/competition in key end markets
(e.g. UK). 4. Recovery/stabilisation in the UK/French macro
outlook, consumer confidence, housing market.
Current price: We have a target price of 285p. Our TP is based on APV (Adjusted Downside risks include: 1. Macro / cyclical deterioration in
M&S
292p Present Value) analysis. We assume a RFR of 3% and ERP of 4.5%. UK consumer confidence / disposable income; 2 A structural
MKS LN We also assume a terminal growth rate of 1% and a beta of 1.2. The increase in structural headwinds / sector price competition
Target price:
285p implied WACC is 7%. Our TP implies 2.3% downside from the current (Food); 3. Structural shift in consumer spending trends
price and we have a Hold rating. Our Hold rating reflects the near- online (Non-Food); 4. Structural limitations of the traditional
Hold Up/downside: term downside risk to earnings from lower Food LFL sales offset by ‘supply push’ retail model (Non-Food); 5. Execution risks
-2.3% the long-term benefits of the transformation plan outlined by attached to 5-year transformation plan.
management. Upside risks include: 1. A structural reduction in sector
capacity / failure of a major competitor (Non-Food); 2. A
reduction in USD-sourcing costs (Non-Food); 3. Acquisition
of M&S by an acquirer looking for nationwide access to the
UK consumer
63
19 February 2019
Valuation Risks
Current price: Our fair value target of 5,900p is based on an adjusted present value Downside risks: 1. An increase in competition from short
Next
4959p (APV) analysis. Our APV analysis assumes risk free rate of 3%, ERP lead time and/or online retail models. 2. A macro led decline
NXT LN of 4.5%, a company specific beta of 0.7 and a terminal growth rate of in UK apparel demand impacting store based LFL sales. 3.
Target price:
1%. Our TP implies 19.0% upside from the current share price, and Failure to capitalise on the 3rd party branded apparel
5900p
we have a Buy rating as we see its valuation being almost completely opportunity via poor execution. 4. Increase in bad debt risks
Buy Up/downside: underpinned by its online operation leaving substantial optionality in leading to reduced profitability in Financial Services 5.
+19.0% its retail business. Decision to not renew buybacks from FY20e
Current price: Our fair value target of 160p is based on an adjusted present value Downside risks include: 1. A material increase in
Pets at Home
129p (APV) analysis .We assume a terminal growth rate of 1%, risk-free competition requiring further margin investment from Pets at
PETS LN rate of 3.0% , beta of 1.5 and equity risk premium of 4.5%. Our target Home. 2. A need to rebase the fee structure to further
Target price:
160p implies 23.6% upside. We have a Buy rating. support JV vet partners. 3. Further deterioration in vet
economics impeding the ability of vets to pay down
Buy Up/downside:
+23.6%
Current price: We have an Adjusted Present Value (APV) fair value of 2,950p.In Downside risks include: Departure of CEO Ray Kelvin;
Ted Baker
1,935p arriving at our APV fair value we assume a risk-free rate of 3%, ERP uncertain outlook in the UK retail sector; a failure to expand
TED LN of 4.5% and a beta of 1.1. We have a WACC of 7.4%. We apply a the international business in line with expectations; negative
Target price:
discount of 25% to our APV fair value of 2,950p to reflect uncertainty FX/USD input costs
2,215p
over the leadership of the company, thus arriving at a TP of 2,215p.
Buy Up/downside: Our target price implies 14.5% upside and we have a Buy rating. We
+14.5% see the uncertainty over the leadership abating and Ted Baker has
strong global potential including online and EM accessed via a
flexible, low risk multi-channel operating model which supports our
Buy rating.

64
19 February 2019
Pubs
Valuation Risks
Mitchells & Current price: We continue to apply a lease-adjusted EV/EBITR multiple of 11.5x Downside risks include a weaker-than-expected trading
Butlers (MAB 285p on our FY19e earnings, the average multiple of 2011-12, a period environment and cost pressure as well and lower cost
of consumer weakness. After making all the relevant deductions mitigation, plus failure to execute the investment-based
LN) Target price: (pensions, provisions, out of the money swaps, leases, and catch- turnaround plan and corporate governance concerns.
310p up capex), we arrive at a SOTP valuation of 309p per share
Buy Up/downside: (unchanged). Our rounded target price of 310p implies upside of
+8.8% c8.8%. We maintain a Buy rating on MAB because the underlying
trading trend remains strong and we believe the company is
delivering on its plan.
Joseph Thomas | joe.thomas @hsbcib.com | + 44 20 7992 3618
Current price: We continue to apply a lease-adjusted EV/EBIT multiple of 11.5x Downside risks include consumer weakness, higher cost
Marston’s on our FY19e earnings, the average multiple of 2011-12, the
95p inflation, beer volume declines affecting tenanted pubs, and
(MARS LN) period of consumer weakness. After making all the relevant tax increases. Upside risks include improved returns from
Target price: deductions (pensions, provisions, out of the money swap, leases),
100p (from 105p) we arrive at a new SOTP valuation of 102p per share vs 103p new builds and upgrades from retail agreements
Hold Up/downside: earlier. Our valuation declines marginally to reflect our forecast
+5.3% cuts. This gives us our new rounded target price of 100p, down
from 105p, which implies upside 5.3%. We maintain our Hold
rating as we do not see any imminent catalyst for a re-rating.

Source: HSBC
65
19 February 2019
Transport
Valuation Risks
Current price: We continue to value the company using a sum of the parts Downside risks include: further downgrades in the bus
Stagecoach (SOTP) based on FY19e earnings. We continue to use 7.5x target operations driven by regulation/ competition/weak
157p
(SGC LN) multiple for provincial bus and 6.5x for London bus. We give no patronage/wage pressure, and mileage reductions in
Target price: value to the US division following its disposal in December 2018. London; failure to retain a long-term presence in rail is a
165p However, we add the NPV of total disposal proceeds of further downside risk. Upside risks include rail franchise
Hold Up/downside: cGBP195m (cGBP160m cash consideration), assuming the
wins, earnings upgrades from the non-rail business and a
+5.2% deferred consideration (gross value GBP50m) will be paid in 5
years, to FY18 net debt. We continue to assume a UK rail market disposal of the US operation for better than book value.
share of 5%, which is half of the existing market share, and keep
our rail margin assumption in perpetuity of 2% unchanged. We
deduct FY18a net debt (adjusted for US division sale proceed) and
rail restricted cash as well as the H1 value of provisions on the
group’s balance sheet and the non-rail pension deficit. We then
discount at a WACC of 7.0%, (assuming a risk-free rate of 3%, and
risk premium of 4.5%) the sum of the one-year forward price and
dividend. Our SOTP valuation remains unchanged at 167p. Our
rounded target price of 165p implies c5.2% upside. We maintain
our Hold rating as we don’t see any immediate positive catalyst.
Current price: We continue to apply our target multiples to our FY19e divisional Upside risks include: better-than-expected margin recovery
Firstgroup (FGP earnings streams to derive our SOTP. In UK Bus, we continue to
93p in the US School Bus and UK Bus, a new franchise win, and
LN) apply a 7x EBITDA multiple. We give no value to UK rail as we favorable forex movements. Downside risks include: lower-
Target price: believe the risks to the group’s South Western and Transpennine
80p than-expected profits from UK Bus and North America bus,
franchises broadly offset the near-term potential from Great any weakness in Transit and Greyhound and winning rail
Hold Up/downside: Western. We believe it makes sense to err on the side of caution
franchises on unfavorable terms.
-14.1% with an announcement on the winner of the new West Coast
franchise (for which Firstgroup is competing) unlikely to be
announced before late 2019. We apply a 6.5x EBITDA multiple to
School Bus. We adjust for the impact of provisions (taking the last
five years’ average) on profits in the School Bus business (no
change). We continue to apply an 8.0x EBITDA to the Transit
business and an 8x EBITA multiple to Greyhound. We deduct the
value of provisions from the balance sheet, as well as the last
reported rail ringfenced cash on Firstgroup’s balance sheet. We
derive our SOTP by discounting back (at a WACC of 7.0%, risk-
free rate of 3% risk premium of 5% and geared beta of 1.4) the
one-year forward value per share. Our overall SOTP valuation is
unchanged at 79p. Our rounded target price of 80p (unchanged)
implies c14% downside. However, we maintain our Hold rating as
we believe we have taken a relatively conservative view on rail
valuation, we acknowledge the possibility of some potential mild
improvements in Greyhound.
66
19 February 2019
Logistics
Valuation Risks
AP Moller Current price: We value AP Moller Maersk using sum-of-the-parts approach. Downside Risks:
Maersk DKK8,640 We value the Transport and Logistics business at USD35.9bn,  Weaker than expected volumes and freight rates or
Energy at USD4.6bn and Total S.A shares at USD4.2bn, all stronger than expected fuel price could harm our estimates
MAERSKB DC Target price:
translated at 6.5 DKK/USD to arrive at our target price of  The return of overcapacity in the industry in the coming
DKK10,100 years could undermine freight rates hampering
DKK10,100. With 16.9% upside from the current share price, we
Buy Up/downside: our estimates.
rate the stock Buy recognizing that notwithstanding the risks from
16.9%  The separation of Drilling and Supply Services could take
rising trade tensions between the US and China and the longer than expected and the group might realise less
possibility of slowing economic growth we consider that asset value than expected. The group faces conventional
valuations provide some downside support. execution risks associated with this complex process.
 Any development that slows the velocity of goods across
the globe, be it economic or political, could harm growth.
 Although there has been a significant amount of
rationalisation in the container shipping industry in the
last two years, state support for troubled shipping
industries could prolong the life of otherwise
uncompetitive businesses.
 As was seen in 2017, a cyber-attack could materially impair
the group’s systems and lead to substantial disruption.
Edward Stanford | Edward.stanford@hsbc.com | +44 20 7992 4207
Current price: Valuation method: ten year DCF. We use a WACC of 8.5% Upside risks
Deutsche Post
EUR26.3 incorporating a risk free rate of 3% and a sector beta of 0.8.We  Volumes and yields, across all divisions could be stronger
DPW GR add a 40% company-specific risk premium to the HSBC equity
Target price: than we expect, thereby causing our forecasts to rise
EUR24.5 risk premium of 5% taking into consideration the deteriorating  Cost saving targets in the mail division could be
economic data in Germany. Based on these assumptions, our exceeded thereby causing our forecasts to rise
Hold Up/downside: target price is EUR24.5, implying 6.7% downside. We retain our Downside risks
-6.7% Hold rating ahead of the results on7th March and in view of the  Much of Deutsche Post’s activity is linked to global
fast changing situation regarding postal regulation. Comments trade and GDP growth. Anything that impedes the free
from the German authorities on 11 February suggest a more flow of goods and slows the velocity of imports and
positive outcome but details have yet to emerge fully. exports would be detrimental to Deutsche Post’s
growth prospects, in our view
 Further problems could be uncovered in the PeP
division which could trigger further estimate cuts
 Lower than expected volume growth in any division
could adversely affect our forecasts
Current price: Valuation method: ten year DCF. We use a WACC of 6.9% Downside Risks
DSV
DKK517.8 incorporating HSBC’s estimated equity risk premium for the  DSV’s activity is linked to the growth in global trade and
DSV DC Eurozone of 5.0%, risk free rate of 3% and a sector beta of 0.8.
Target price: GDP. Thus a recession would have an adverse impact
Based on these assumptions, our target price is DKK625, implying on our forecasts as would any structural or political
DKK625
20.7% upside. We rate the stock Buy as our analysis suggests that impediments that impeded the free flow of goods
Buy Up/downside: DSV’s robust corporate governance has supported strong  Slower-than-expected recovery in unit profitability or
+20.7% shareholder returns and this gives us confidence that DSV can slower-than-expected growth in volumes could harm
weather any storm better than many in the sector. our estimates
 An IT failure could have a major impact on the
operations of the business
 DSV, being an acquisitive company, faces conventional
execution risks if it plans to grow further through
acquisitions.
 Our valuation would also be adversely affected if the
bid for Panalpina was unsuccessful
67
19 February 2019
Valuation Risks
Current price: Valuation method: ten year DCF. We use a WACC of 8.0% Upside risks
Kuehne+ Nagel
CHF136.3 incorporating a risk free rate of 3% and a sector beta of 0.8.We  Volume trends in 2019 could be stronger than we
KNIN SW add a 30% company-specific risk premium to the HSBC equity
Target price: expect, which could cause our estimates to rise
risk premium of 5% to reflect our assessment of the rising risks  Further acquisitions could cause our forecasts to rise
CHF130
for the group, especially in air freight.. Based on these  The benefits of the group’s new IT system could show
Hold Up/downside: assumptions, our target price is CHF130, implying 4.6% through faster than we expect
-4.6% downside. We rate the stock Hold. Downside risks
 Weak global economic development and risks to free trade
could undermine projected volume growth assumptions
 Further increases in freight rates could prolong margin
pressures, thereby undermining our unit profitability
assumptions
 Execution risks associated with the roll out of new
technology could undermine the financial performance
of the business
 An IT failure could have a major impact on the
operations of the business
Current price: In light of the non-binding offer tabled for Panalpina shares by DSV we Upside risks
Panalpina continue to use the current offer to value the stock and not DCF.
CHF157.7  Stronger than expected volume growth would cause
PWTN SW Reflecting the revised proposal made by DSV for Panalpina shares,
Target price: our forecasts to rise.
our target price is CHF180. Our target price, implying 14.1% upside, is  A faster than expected turnaround in gross profit per
CHF180 in line with the revised proposal. We retain our Hold rating in view of unit could lead us to raise our forecasts.
Hold Up/downside: the uncertainties about whether DSV’s cash offer will be successful  Greater benefits from the transformation strategy
+14.1% and the risks of the existing bid premium, such as it is, being coming through earlier than expected could lead us to
eliminated if the offer is unsuccessful. raise our forecasts.
 Several parties could enter a bidding war for the group.
Downside Risks
 The current share price is inflated by DSV’s offer,
should it or any competing bid lapse for any reason, the
share price could fall materially.
 Volumes could turn out to be weaker than expected
causing our forecasts to fall.
 The turnaround of the business could take longer than
expected impacting our forecasts for the group.
Priced at 13 February 2019

68
19 February 2019
Business Services
Valuation Risks
Current price: We arrive at our target price of EUR52 by applying a 2019e PE Downside risks: (1) Weakness in oil and gas markets;
Brenntag
EUR42.4 target multiple of 15x, which is the 2012-18 average. The target (2) slowdown in Europe worsens; (3) reversal in market
BNR AG multiple reflects our view that margin woes are due to cost sentiment towards inflation hedges; (4) USD weakness.
Target price:
phasing issues. As this becomes evident through 2019, multiples
EUR52.0
may revert to historic averages. Our target price implies upside of
Buy Up/downside: 23%. We think the current market pessimism creates an
23% opportunity and 2018e earnings should show a cleaner picture on
profitability, leading to earnings estimates and multiples
increases. Therefore, we retain our Buy rating on the stock.
Rajesh Kumar | rajesh4kumar@hsbcib.com | +44 20 7991 1629
Source: HSBC estimates, Priced at 13 February 2019
69
19 February 2019
Notes
70
19 February 2019
Notes
71
19 February 2019
Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), or strategist(s) who is(are) primarily responsible for this report, including any analyst(s)
whose name(s) appear(s) as author of an individual section or sections of the report and any analyst(s) named as the covering
analyst(s) of a subsidiary company in a sum-of-the-parts valuation certifies(y) that the opinion(s) on the subject security(ies) or
issuer(s), any views or forecasts expressed in the section(s) of which such individual(s) is(are) named as author(s), and any other
views or forecasts expressed herein, including any views expressed on the back page of the research report, accurately reflect
their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Dylan Whitfield, David McCarthy, Andrew Porteous, CFA, Paul
Rossington, Joseph Thomas, Edward Stanford, Rajesh Kumar, Chirag Vadhia and Matthew Lloyd
Important disclosures
Equities: Stock ratings and basis for financial analysis
HSBC and its affiliates, including the issuer of this report (“HSBC”) believes an investor's decision to buy or sell a stock should
depend on individual circumstances such as the investor's existing holdings, risk tolerance and other considerations and that
investors utilise various disciplines and investment horizons when making investment decisions. Ratings should not be used or
relied on in isolation as investment advice. Different securities firms use a variety of ratings terms as well as different rating
systems to describe their recommendations and therefore investors should carefully read the definitions of the ratings used in
each research report. Further, investors should carefully read the entire research report and not infer its contents from the rating
because research reports contain more complete information concerning the analysts' views and the basis for the rating.
From 23rd March 2015 HSBC has assigned ratings on the following basis:
The target price is based on the analyst’s assessment of the stock’s actual current value, although we expect it to take six to 12
months for the market price to reflect this. When the target price is more than 20% above the current share price, the stock will
be classified as a Buy; when it is between 5% and 20% above the current share price, the stock may be classified as a Buy or a
Hold; when it is between 5% below and 5% above the current share price, the stock will be classified as a Hold; when it is between
5% and 20% below the current share price, the stock may be classified as a Hold or a Reduce; and when it is more than 20%
below the current share price, the stock will be classified as a Reduce.
Our ratings are re-calibrated against these bands at the time of any 'material change' (initiation or resumption of coverage, change
in target price or estimates).
Upside/Downside is the percentage difference between the target price and the share price.
Prior to this date, HSBC’s rating structure was applied on the following basis:
For each stock we set a required rate of return calculated from the cost of equity for that stock’s domestic or, as appropriate,
regional market established by our strategy team. The target price for a stock represented the value the analyst expected the
stock to reach over our performance horizon. The performance horizon was 12 months. For a stock to be classified as Overweight,
the potential return, which equals the percentage difference between the current share price and the target price, including the
forecast dividend yield when indicated, had to exceed the required return by at least 5 percentage points over the succeeding 12
months (or 10 percentage points for a stock classified as Volatile*). For a stock to be classified as Underweight, the stock was
expected to underperform its required return by at least 5 percentage points over the succeeding 12 months (or 10 percentage
points for a stock classified as Volatile*). Stocks between these bands were classified as Neutral.
*A stock was classified as volatile if its historical volatility had exceeded 40%, if the stock had been listed for less than 12 months
(unless it was in an industry or sector where volatility is low) or if the analyst expected significant volatility. However, stocks which
we did not consider volatile may in fact also have behaved in such a way. Historical volatility was defined as the past month's
average of the daily 365-day moving average volatilities. In order to avoid misleadingly frequent changes in rating, however,
volatility had to move 2.5 percentage points past the 40% benchmark in either direction for a stock's status to change.
72
19 February 2019
Rating distribution for long-term investment opportunities

As of 18 February 2019, the distribution of all independent ratings published by HSBC is as follows:
Buy 55% ( 28% of these provided with Investment Banking Services )
Hold 36% ( 28% of these provided with Investment Banking Services )
Sell 9% ( 20% of these provided with Investment Banking Services )
For the purposes of the distribution above the following mapping structure is used during the transition from the previous to current
rating models: under our previous model, Overweight = Buy, Neutral = Hold and Underweight = Sell; under our current model Buy
= Buy, Hold = Hold and Reduce = Sell. For rating definitions under both models, please see “Stock ratings and basis for financial
analysis” above.
For the distribution of non-independent ratings published by HSBC, please see the disclosure page available at
http://www.hsbcnet.com/gbm/financial-regulation/investment-recommendations-disclosures.
To view a list of all the independent fundamental ratings disseminated by HSBC during the preceding 12-month period, please
use the following links to access the disclosure page:
Clients of Global Research and Global Banking and Markets: www.research.hsbc.com/A/Disclosures
Clients of HSBC Private Banking: www.research.privatebank.hsbc.com/Disclosures
HSBC & Analyst disclosures

Disclosure checklist
Company Ticker Recent price Price date Disclosure

AP MOLLER MAERSK MAERSKb.CO 9044.00 15 Feb 2019 1, 5, 6, 7
ASOS PLC ASOS.L 28.87 15 Feb 2019 6, 7
ASSOCIATED BRITISH FOODS ABF.L 22.66 15 Feb 2019 4, 7
B&M BMEB.L 3.26 15 Feb 2019 5, 7
BOOHOO GROUP PLC BOOH.L 1.79 15 Feb 2019 7
BRENNTAG HOLDING BNRGn.DE 43.43 15 Feb 2019 6, 7
BROWN N GROUP BWNG.L .91 15 Feb 2019 7
DEUTSCHE POST DHL DPWGn.DE 26.75 15 Feb 2019 1, 4, 5, 6, 7
DIXONS CARPHONE DC.L 1.30 15 Feb 2019 5, 7
DSV A/S DSV.CO 535.60 15 Feb 2019 6, 7
DUNELM GROUP DNLM.L 7.66 15 Feb 2019 7
FIRSTGROUP FGP.L .96 15 Feb 2019 5, 7
HALFORDS GROUP HFD.L 2.44 15 Feb 2019 4, 7
INCHCAPE INCH.L 6.06 15 Feb 2019 5, 6, 7
KINGFISHER PLC KGF.L 2.26 15 Feb 2019 4, 5, 6, 7
MARKS & SPENCER GROUP MKS.L 2.86 15 Feb 2019 4, 6, 7
MARSTON'S PLC MARS.L .95 15 Feb 2019 7
MITCHELLS & BUTLERS MAB.L 2.84 15 Feb 2019 6, 7
MORRISONS MRW.L 2.38 15 Feb 2019 4, 5, 6
NEXT NXT.L 47.24 15 Feb 2019 2, 4, 5, 6, 7
PETS AT HOME PETSP.L 1.32 15 Feb 2019 7
STAGECOACH HLDGS SGC.L 1.58 15 Feb 2019 5, 6, 7
TED BAKER TED.L 18.80 15 Feb 2019 7
TESCO TSCO.L 2.24 15 Feb 2019 5, 6, 7
Source: HSBC
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19 February 2019
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19 February 2019

ESG & Equities

IFRS 16: the biggest changes in over 30 years

 The introduction of IFRS 16 from January 2019 will bring radical

statements could also become more volatile. Rajesh Kumar*

* Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is

Disclosures & Disclaimer Issuer of report: HSBC Bank plc

The new lease accounting standard 9

Areas of judgement and choice 15

Assessing the impact 22

Impact on the Food Retail sector 31

Impact on the non-Food Retail sector 35

Impact on the Transport sector 40

Impact on the Logistics sector 42

Impact on the Pubs sector 46

Impact on Business Services 49

Appendix 1: The key technical

The biggest changes to lease accounting in over 30 years

At a high level, what has changed?

IFRS 16 - Lessee accounting high level changes

Operating profit - depends Financial liabilities  Cash from financing activities 

Finance costs  Equity - depends Total cash flow 

Profit before tax - depends

Net debt / EBITDA  PE ratio - depends

Source: IASB, HSBC

There will be limited changes for lessors.

Challenge for investors

What companies are likely to be affected?

Our view on selected sectors

Conclusion and what to look out for

Accounting choice, judgements and estimates

Debt covenants and financing

Opportunities for structuring of future leases to achieve a desired accounting treatment

Stocks mentioned in this report

The new lease accounting

 New accounting standard for leases brings material changes to

A new standard for lease accounting – operating leases are

Why the change?

Our consideration of the changes

What are the changes?

We discuss the changes below, under the headings of:

Scope and exemptions

Recognition of leases within the financial statements

IFRS 16 - Lessee accounting high level changes

Operating profit Financial Cash from

Finance costs Equity Total cash flow

Profit before tax

EPS Current ratio ROCE

Net debt / EBITDA PE ratio

Source: IASB, HSBC

Leases previously classified as finance leases

Challenge for investors

Areas of judgement and

 IFRS 16 is not simple; lease portfolios are frequently material and

Starting simple, but the complexity of the standard, choices,

Comparison to the old standard (IAS 17)

What choices are there?

Opportunities to structure contracts to avoid having to use lease accounting

Investors may wish to understand

Opportunities to structure contracts to minimise the impact of lease accounting

Investors may wish to understand

3. whether the average lease term is static or decreasing/increasing?

3. How is the discount rate determined?