Boeing and Lockheed Martin Analysis of Operating Leases
| Boeing v. Lockheed Martin| Analysis of Operating Leases & Pension Plans| | | 10/6/2011| Boeing Co & Lockheed Martin Corp Analysis Our financial reporting analysis consists of Lockheed, the largest defense company in the world and Boeing, the largest commercial aircraft producer. Both companies rely heavily on government funding, contracts, and regulation. Future growth for the two companies relies on sales of Lockheed and Boeing’s aircrafts such as the Fighter Jet F-35 and the Dreamliner 787. Although these companies have many similarities, their core business varies.
Furthermore, to properly compare these two companies, financial analysts have to make adjustments to their quarterly and yearly filings. Although there are any number of adjustments that may be made to the financials of Boeing and Lockheed, we have decided to analyze the effect of operating vs. capital leases, pension obligations on the financial health of the company, and its impact by adjusting the financial statements, particularly the balance sheet. Large capital intensive industries generally have a high need for property, plant, and equipment but do not necessarily have the funds, or the desire to own some or all of it.
As a result they enter into lease agreements so that they can access PP&E, but with operating leases they keep it off the balance sheet. The reason a firm might prefer an operating lease to a capital lease is relatively straightforward. Firms generally want to show as few liabilities as possible on their balance sheet. This makes the firm look less risky to outside investors, and improves several important financial ratios reported out to stakeholders. As financial analysts, it is our job to recognize that this is standard practice, and then to make adjustments so the financial statements are as accurate as possible.
The accounting methods allowing for these leases to remain off the balance sheet are: * Operating leases are accounted for on a per period basis where rent expense is charged, and cash is paid to satisfy the expense. * Capital leases show up as both a lease asset and a leased liability on the balance sheet. * It is important to note that while these are two very different reporting methods the actual expenses also vary annually because capital leases depreciate over time creating a higher expense in earlier years.
In order to accomplish the goal of creating operating leases rather than capital leases a firm must meet several criteria, the most important of which is the 90% rule. “If the present value of the contract lease payments equals or exceeds 90 percent of the fair market value of the asset at least signing” the firm must recognize it as a capital lease, and then report and corresponding asset and liability. The firm has several options in how to get around this 90% rule; the most common being to change the discount rate at the time of lease signing.
The firm can massage their beta which would change their risk profile and increase their Weighted Average Cost of Capital (WACC) and therefore their discount rate. The firm may then be able to justify that as a result of the adjusted discount rate they only reach 89% of the fair market value and are then able to make the lease an operating lease. We plan on analyzing the financial statements of Boeing and Lockheed Martin converting all operating leases to capital leases and measuring the changes in assets, liabilities, and important financial ratios including: Debt/Equity and Debt/Capital.
Additionally we chose to analyze the pension plans of both Boeing and Lockheed Martin. Firms do not have an obligation to report under or over funded pension plans on the face of their balance sheet but rather disclose them in the footnotes. However, in the case of an underfunded pension plans analysts should bring them back onto the balance sheet as a liability. When analyzing the pension plans we must look at three factors, first is the amount that the plan is underfunded will likely have the most material impact on the financial ratios and standing of the firm.
Second, the discount rate the firm chooses to use to compute the benefit obligation, and finally the firms projected expected rate of return on the pension plan. Capital Lease Analysis According to Boeing’s most recent 10-K, the company states property, plant and equipment (PP&E) at $8,931 million which excludes all operating leases (Exhibit 1). However, after making our adjustments we found an increase to PP&E of $1,509 million or 16. 90 percent with the addition of operating leases stated in company’s footnotes of their 2010 annual report. Boeing’s long-term debt also increased by 13. 5 percent which demonstrates to investors that the company is significantly more risky after the conversion of operating leases. These adjustments would also increase the company’s expenses in earlier years for any plant or equipment leased as capital leases are depreciated over time, therefore creating a decrease in net income in earlier years. Boeing’s financial risk ratios were also impacted by converting all operating leases into capital leases. The Debt to Total Capital Ratio increased from 68. 36 percent to 69. 04 percent and the Debt to Equity Ratio increased from 16. 38 to 16. 90 (Exhibit 1).
It is imperative for the company’s corporate finance division to closely manage their long-term debt by minimizing the capital lease values on the balance sheet as Boeing’s debt covenants could be broken should these ratios increase above the lender’s limits. Lockheed Martin Corporation has negligible capital lease obligations and were not listed in the 10-K. For the fiscal year of 2010 the company had previous off-balance sheet arrangements to make payments under majority operating leases. In addition, Lockheed has $1,299 million in operating lease obligations, and when added back on the balance sheet, increased net PP&E by 28. 2 percent (Exhibit 2). Lockheed’s long-term debt was also substantially impacted by the leasing adjustments as it increased 25. 88 percent. Lockheed Martin’s financial risk ratios were also affected by our adjustments as the Debt to Total Capital increased from 89. 43 percent to 89. 80 percent and the Debt to Equity increased from 8. 46 percent to 8. 81 percent (Exhibit 2). Majority of Lockheed’s leased properties are furnished by the United States Government, and they are contracted under short-term or cancelable arrangements, hence the smaller Debt to Equity ratios compared to Boeing.
Lockheed is heavily reliant on the financial stability of the US Government to continue operating under US government owned properties. Pension Obligation Analysis In the case of Boeing almost all of their employees are covered under a defined benefit pension plan, with the exception of non-union employees hired within the last 3 years. In addition to the funding of the pension plan Boeing must also fund a medical benefits plan for retirees. According to the most recent 10-K, Boeing’s pension plan is currently underfunded by $9. billion dollars, which certainly has a material impact on the liabilities section of the balance sheet. Additionally, Boeing makes the following assumptions when it comes to the discount rate and expected rate of return: * Discount Rate: 5. 3% * Expected Rate of Return: 7. 75% This is significant as Boeing’s expected rate of return of 7. 75% is currently outpacing the S&P over the last year by about 7. 75%, as the S&P actually lost less than 0. 1% over the last year. While it is entirely possible that over the long run the 7. 5% expected rate of return will be accurate management may very well be overestimating and the pension plan could be even more underfunded than what they are reporting. Lockheed Martin’s employees were also covered under the defined benefit plan until 2006; this is excluding union workers who are still covered. According to Lockheed’s 10-K their pension plan is currently underfunded by 10. 4 billion dollars. Lockheed makes the following assumptions when it comes to the discount rate and expected return: * Discount Rate: 5. 9% Expected Rate of Return: 8. 5% Similar to Boeing, Lockheed’s expected rate of return of 8. 5% is significantly outpacing the S&P over the last year. Lockheed faces a problem in that they will be facing a larger pension expense in the future because of the recent poor market performance and the slide of the discount rate year to date. For 201,1 Lockheed estimates a 5% increase in the pension fund, which would offset all the assumed earnings growth, and in order to fulfill the required funded plan by 2018 the company would have to contribute 2. billion annually. Conclusion: In conclusion, our team was surprised by the minimal impact of capital leases on both Boeing Company and Lockheed Martin Corporation’s financial risk ratios. Even though both companies had double digit percentage increases of PP&E and long-term debt, the total assets and liabilities were affected by less than three percent for Boeing and less than four percent for Lockheed Martin, hence the minimal changes in their financial risk ratios.
To our team’s surprise however, both Boeing Company and Lockheed Martin Corporation’s pension plans were significantly underfunded as defined benefit plans by $9. 8 billion and $10. 4billion, respectively. These sizable underfunded values will require huge contributions to the plans in future years. As good financial analysts we would be remiss if we did not mention that operating and capital leases and pensions are just two of many choices a firm may explore while trying to make their financial statements as attractive as possible to the market and investors.
Firms may attempt to smooth earnings through honey pot accounting, list as many unsustainable gains as possible on their cash flows, achieve off balance sheet financing, and attempt to recognize revenue early. When forecasting future earnings for Boeing and Lockheed Martin, all of these areas are subject to potential adjustments when analyzing and valuing the company’s earnings (EPS) and stock prices.
