Non‐cancellable Operating Leases and Operating Leverage

• Published date: 01 September 2016
• Date: 01 September 2016
• DOI: http://doi.org/10.1111/eufm.12069
• Author: Figen Gunes Dogan

Non-cancellable Operating Leases and

Operating Leverage

Figen Gunes Dogan

Faculty of Business Administration, Bilkent University, 06533 Ankara, Turkey

E-mail: figengunes@bilkent.edu.tr

Abstract

This paper explores the link between a firm’s non-cancellable operating lease

commitments and stock returns. Firms with more operating lease commitments

earn a significant premium over firms with fewer commitments, and this premium is

countercyclical. Non-cancellable operating lease payments represent a major

claim on a firm’s cash flows. Firms with high levels of operating leases have higher

cash flow sensitivity to aggregate shocks and hence higher operating leverage. The

relationship between operating leases and stock returns is stronger in small firms

than in big firms.

Keywords: operating lease, operating leverage, cross section of expected returns

JEL classification: E22, G12

1 Introduction

Operating leases are the most common and important source of off-balance sheet

financing, and operating lease use has increased substantially over the past several

decades.

1

According to Eisfeldt and Rampini (2009); leasing is of comparable

The author is grateful to Selale Tuzel for many comments and discussions. Furthermore, I

would like to thank two anonymous referees and Kursat Aydogan, Cem Demiroglu, John

Doukas (the Editor), Huseyin Gulen, Dong Lu, Armin Schwienbacher, and seminar

participants at the 2014 PFMC Conference, the 2015 MFA conference, and Koc University

for their helpful suggestions. Parts of this paper were written when the author was visiting

the University of Southern California.

1

Cornaggia et al. (2013) document that operating leases increased 745% as a proportion of

total debt from 1980 to 2007. The Financial Accounting Standards Board (FASB) in the US

and the International Accounting Standards Board (IASB) debated whether operating and

capital leases should be combined and presented on the balance sheet (The Wall Street

Journal, March 18 2014). The boards agreed to recognize certain operating leases on the

balance sheet. However, they failed to reach a consensus on how to recognise expenses on the

lessee’s income statement.

European Financial Management, Vol. 22, No. 4, 2016, 576–612

© 2015 John Wiley & Sons, Ltd.

doi: 10.1111/eufm.12069

importance to long-term debt, and for small firms, leasing may be the largest source of

external financing.

2

These authors report that ‘the proportion of capital that firms lease in

merged Census–Compustat data is 16%, which is similar to the long-term debt-to-assets

ratio of 19%’.

Operating lease payments represent a major claim on firms’cash flows. Some of these

leases are short term; they may be reversible and provide flexibility to the firm compared

to ownership. However, some operating leases are non-cancellable during the lease term

except in the event of bankruptcy. During the business cycle, firms cannot easily cancel

or adjust the terms of this type of lease contract with their lessors. This inflexibility in

operating lease costs increases firm risk. Firms with relatively high levels of operating

lease commitment are more vulnerable to the business cycle than those with fewer

commitments. Consequently, shareholders require a higher rate of return for bearing this

risk, and expected stock returns of firms with higher levels of operating leases are greater

compared to those of firms with lower levels of operating leases.

In this paper, I show that a firm’s non-cancellable lease commitments are positively

and monotonically related to expected returns. I construct a measure of the firm’s

operating lease ratio by dividing minimum lease commitments by the firm’s total assets.

This ratio represents the level of non-cancellable operating lease use. The sample

includes US firms in the merged CRSP–Compustat database that report their lease

commitments. On average, firms with high lease ratios have higher expected stock

returns than firms with low lease ratios: a difference of 11.0% per annum for equal-

weighted portfolios and 4.7% per annum for value-weighted portfolios.

Firms with high levels of operating leases are riskier, especially during recessions. The

return spread between high- and low-lease ratio firms is countercyclical and is about four

times as high during recessions as it is during expansions. To investigate the risk

mechanism behind expected returns, I show, first, that operating lease commitments have

very limited comovement with sales. Second, the cash flows of firms with high levels of

operating leases are more sensitive to aggregate shocks than those of firms with lower

levels of operating leases. Third, I show that high-lease ratio firms have more volatile

stock returns and cash flow growth.

The risks associated with holding non-cancellable operating leases are mentioned in

the business press. For example, when UAL Corp., parent of United Airlines, filed for

Chapter 11 in December 2002, it had US$ 25.2 billion of assets, US$ 22.2 billion of

liabilities and US$ 24.5 billion in non-cancellable operating lease commitments. A UAL

spokeswoman acknowledges the company’s high lease costs were a factor in UAL’s

bankruptcy.

3

Similarly, US Airways filed for Chapter 11 in August 2002. Its chief

executive officer, David Siegel, explained,

4

2

Graham et al. (1998) report that operating leases constitute 42% of fixed claims, whereas

capital leases and debt are 6% and 52% of fixed claims, respectively, in the 1981–1992

Compustat data.

3

Jonathan Weil, ‘How Leases Play a Shadowy Role in Accounting’,The Wall Street Journal,

September 22, 2004.

4

‘US Airways to Complete Restructuring Plan in Chapter 11 Reorganization’,PRNewswire,

August 12, 2002.

© 2015 John Wiley & Sons, Ltd.

Non-cancellable Operating Leases 577

‘While US Airways was able to successfully negotiate cost savings from many of its

employee groups, the company determined that it was unlikely to conclude consensual

negotiations with certain vendors, aircraft lessors and financiers in a timeframe necessary to

complete an out-of-court restructuring. Siegel cited as factors the large number of lessors

and financiers and the company’s inability to reject surplus aircraft leases and return excess

aircraft outside of Chapter 11.’

The inflexibility of the firm’s lease obligations creates cyclicality in the firm’s cash

flows, which is related to the concept of operating leverage.

5

For shareholders, lease

expense is a form of leverage that makes equity riskier. Danthine and Donaldson (2002)

propose a general equilibrium model with labour-induced operating leverage.

6

Their

model with fixed labour costs generates operating leverage and provides a better match to

the observed equity premium. Tuzel and Zhang (2013) show that firms have lower

industry-adjusted average returns in areas where wages strongly comove with aggregate

shocks. The idea of labour-induced operating leverage, that is, wages’limited

comovement with revenues affecting firm risk, can be extended to operating leases.

During recessions revenues fall but lease commitments do not fall by as much as

revenues. These precommitted lease payments transfer the risk to shareholders.

Therefore, in the setting of this paper, the operating leverage mechanism is created by the

firm’s non-cancellable leasing contracts.

The firm’sfinancing and leasing decisions are possibly related. Debt and leases have

been studied as both substitutes and complements.

7

Chen et al. (2014) argue that firms

with more inflexible operating costs endogenously choose lower financial leverage

ex ante to reduce the likelihood of default in future bad states. Supporting the substitute

argument, I find that firms that use higher levels of operating leases have lower financial

leverage. To investigate whether a firm’sfinancial leverage has an impact on the

relationship between its operating leases and stock returns, I control for financial

leverage in the Fama–Macbeth (1974) regressions and perform portfolio sorts with

unlevered returns. Both results confirm that the lease premium is independent of financial

leverage effects.

This paper makes the following contributions. A large body of literature on asset

pricing links firm characteristics to stock returns in the cross-section. Fama and French

(2008) provide a survey of this literature. To this literature, my paper adds the firm-level

lease rate as a variable that constitutes part of a firm’s operating leverage risk and

establishes a link to expected stock returns.

Second, this paper contributes to the literature related to operating leverage. While the

role of operating leverage on firm risk is studied in the theoretical works of Rubinstein

(1973) and Lev (1974); there is limited supporting empirical evidence on the relationship

between the firm’s operating leverage and stock returns. The difficulty in measuring

operating leverage is deciding on which costs are fixed, and on the degree and duration of

the inflexibility of costs. Novy-Marx (2011) uses a measure of operating leverage –the

5

See Lev (1974); Mandelker and Rhee (1984); Carlson et al. (2004) and Novy-Marx (2011).

6

See Gourio (2007); Chen et al. (2011); Favilukis and Lin (2013) and Donangelo (2014) for

examples of labour induced operating leverage studies.

7

See Ang and Peterson (1984), Lewis and Schallheim (1992), Graham et al. (1998); Lasfer

and Levis (1998) and Eisfeldt and Rampini (2009).

© 2015 John Wiley & Sons, Ltd.

578 Figen Gunes Dogan