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McKesson to Buy US Oncology; takes over $600 M of lease obligations November 1, 2010

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Lease Accounting, M & A Integration, Silicon Valley.
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Today, San Francisco-based McKesson, a medical supplies distributor, announced that it will buy Houston-based US Oncology, a provider of cancer drugs and administrative services to doctors.  The reported value of the transaction is $2.2 B , comprised of the purchase of the company stock for $560 M and an assumption of US Oncology’s debt obligations of $1.6 B.  The amount of debt is particularly relevant in understanding how much McKesson is “paying” (a slightly ambiguous term) for the company.  US Oncology has a huge amount of debt, and according to McKesson’s press release, “it is anticipated that substantially all of US Oncology’s debt will be repaid or refinanced”.

$2.2 B or $2.8 B?

Looks to me, though, that value-of-the-deal should be more like $2.8 B.  You need to include the $600 M of future operating lease obligations that US Oncology has … much of it related to space that will probably not be needed after a post-close consolidation of real estate portfolios.  A more accurate estimate of how much McKesson is “paying” (there’s that pesky, ambiguous word again) would include those obligations.  That would push the price up by 25% to $2.8 B.

Undoubtedly, McKesson knows US Oncology has $600 M of future minimum operating lease obligations; those obligations show up in the notes to US Oncology’s latest 10-K.  These minimum operating lease obligations are not, however, among the $1.6 B of long-term obligations referred to in press reports and which show up on the company’s balance sheet.  Yet, these operating lease obligations are as real as are the balance sheet obligations (or at least they are if you ignore the fact that McKesson might be able to disavow leases in a bankruptcy). 

If the lease obligations were on the balance sheet (as they will be once the new lease accounting standards are in effect; see below), then the reported value of the transaction would probably have been this more accurate number of $2.8 B.

Savings from consolidations

McKesson’s task will be to see how much of that $600 M obligation it can whittle down.  In its press release, the company said that “there is already an overlap between the goods and services provided by the two companies, and the combination will allow for cost-savings from shared operations”.  A large portion of those savings might come from consolidating the real estate portfolios of the two companies with the savings eventually realized either through the natural expiration of unneeded leases or through subletting or buying out of lease obligations.

The opportunity to find savings is large.  US Oncology has 5 M square feet of real estate or so it was reported a year ago when it awarded CBRE an exclusive right to provide real estate services.  McKesson, according to a report in 2007 that announced CBRE being appointed to provide services to McKesson, had 17.5 M square feet.   (Neither company discloses the square footage of their portfolios in their 10-K’s., something that will change significantly when the new lease accounting standard, with its required disclosures, is put in place.)

Millions of dollars of operating expenses are probably possible to be eliminated from the combined companies by reducing their combined real estate footprint.  Twenty-million-some square feet of space is a lot to work with and provides ample scope to find savings. 

And McKesson really should try to reduce that $600 M of lease obligation before the new lease accounting proposed by FASB and IASB comes into effect.

New Lease Accounting will put obligations on McKesson’s balance sheet

Those lease obligations that McKesson is taking on will not remain “off-balance sheet” forever.  When the new lease accounting being proposed by FASB and IASB comes into effect, probably in 2013 or 2014, whatever is left of those obligations will show up on McKesson’s balance sheet because there will be no grandfathering of existing leases.  A considerable amount might still be left because … even if all the leases expiring prior to 2014 were not renewed … according to the 10-K,  there would still be over $300 M of obligations due in 2014 and beyond.

In fact, the amount going on the balance sheet might even be considerably higher than the $600 M of obligations that existed at the end of last fiscal year.  That’s becauase the accounting boards are proposing that the amount of balance sheet obligations be based on the “longest possible lease term that is more likely than not to occur”.   That means McKesson would have to include, not just the minimum lease obligations on its balance sheet, but also the obligations related to extension periods related to options-to-renew that are likely to be exercised.  Who knows, if many of the leases expiring from 2010 to 2013 are renewed (perhaps because McKesson needs more time to implement a consoldiation plan) and if a lot of the leases have options-to-renew that are likely to be exercised, then the number going on the balance sheet could end up pushing $1 B.

A final note on lease accounting:  Reportage of the McKesson / US Oncology transaction is just another example of how the absence of lease obligations on balance sheets is problematic … particularly as more and more companies have more and more of their financial obligations in the form of operating leases.   And while we can probably assume that McKesson and its advisors fully understood that they were really “paying” $2.8 B for the company, not $2.2 B (even though its own press release used the latter figure), when others use the transaction as a benchmark for company valuations, they’re probably unlikely to adjust the price for the operating lease obligations. Balance sheets without operating leases, as now called for by GAAP, are way too imperfect.   Balance sheets are no longer meaningful.   Leases need to go on them … as they shortly will if FASB and IASB have their way.

To learn more about the new lease accounting, click here.


1. Tweets that mention McKesson to Buy US Oncology; takes over $600 M of lease obligations « Corporate Real Estate Strategy -- Topsy.com - November 1, 2010

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