Companies, People, Ideas
False Front
Elizabeth MacDonald, 10.14.02

Be wary of any balance sheet propped up by a synthetic lease--even if the name at the top sounds very solid. Like Iron Mountain.

In an age of accounting scandals, balance sheets have to be above reproach. That's why so many companies are undoing "synthetic leases." Many, but not all.

By the Numbers
Synthetic Fans
The companies here have these outstanding leases.
Continental Airlines
$324 million
H.J. Heinz
$220 million*
Human Genome Sciences
$200 million

Synthetic leases are concoctions by creative accountants that effectively enable corporations to borrow money without admitting they are borrowing. To get a headquarters building or some other capital improvement, the corporation agrees to make lease payments that look for all the world like mortgage payments. Indeed, on tax returns the transaction is often treated as a property purchase financed with a mortgage. But on the balance sheet shown to shareholders, the asset and the debt are nowhere to be found.
In the past year Cisco Systems (nasdaq: CSCO - news - people ) and 3Com (nasdaq: COMS - news - people ) have spent $1.9 billion to unwind synthetic leases. HealthSouth (nyse: HRC - news - people ), the operator of rehabilitation clinics, paid $207 million to liquidate two of the tricky things. The accounting abbots at the Financial Accounting Standards Board are contemplating rules that would force all companies to put these financings on the balance sheet and the cash flow statement.
All of which makes Iron Mountain (nyse: IRM - news - people ), the fast-growing data repository with the hot stock, something of an odd duck. It's standing pat with its synthetic leases. "If people are spending cash to unwind them for the sake of optics, I think that would be an overreaction," says Chief Financial Officer John Kenny from the Boston headquarters. "For us, synthetic leases are very good business."
Good indeed. Iron Mountain stores paper, computer disks, microfiche, blueprints--you name it--for 150,000 customer accounts. On the information superhighway, quips a report from Hoover's Online, Iron Mountain provides the multilevel parking garages. Its shares trade at $26, or 35 times this year's expected earnings.
But it takes a lot of money to pay for those parking garages, not to mention trucks and computers. Iron Mountain has piled $1.5 billion of total debt, without even counting the synthetics, atop shareholders' equity of $915 million. Until recently it was losing money--a cumulative $86 million from 1999 through 2001. But it keeps in Wall Street's good graces with big cash flow, in the sense of net income before extraordinary items plus depreciation. Last year that number came to $126 million on revenue of $1.2 billion. Subtract $197 million for capital expenditures, and you get a so-called free cash flow of minus $71 million for 2001.
The true picture is worse, says James Chanos, the short-selling sleuth who was one of the early bears on Enron. Chanos, who runs a New York City hedge fund that is short Iron Mountain, says the company's great cash flow stems in part from Iron's merger with a competitor, Pierce Leahy, in 2000. And, he says, Iron's heavy use of synthetic leases keeps its capital expenditures artificially low and inflates its free cash flow. During 2001 Iron Mountain used synthetic leases to add 16 properties worth $78 million. Count those properties in the capital expenditure total and the cash flow deficit grows to $149 million.
In a typical deal, Iron Mountain signs a lease for five or six years, at the end of which it has to either refinance, buy the properties or fork them back to landlords along with a cash settlement that reflects shifts in the property's value up or down.
John Kenny says that if the FASB gets its way--forcing the capitalization of leases like these--the impact would be smaller than Chanos predicts. Instead of running up debt, he says, the company would just switch to so-called operating leases, which don't have to be capitalized. With these leases the tenant is free to decamp from the property at the end of the lease term, typically with no termination payments.
Iron Mountain's bullish story: Once you get a customer's records stored, the monthly fees turn into a cash machine. And the big cap-ex is to expand the company: Only $25 million of the outlays were to maintain existing service levels. Everything else represents either growth or the refinancing of old warehouses in order to reduce occupancy costs.
Chanos' bearish case: "With any company that holds itself out to be a cash flow story, you have to watch capital expenditures closely. Depreciation is real." At minimum, Chanos is right that this is a riskier stock than it seems to be. He may even be right that it's headed down.