Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to today's introduction to IFRS 16 conference call. At this time, all participants are in a listen-only mode. There will be a presentation followed by a question-and-answer session, at which time, if you wish to ask a question, you will need to press star one on the telephone and wait for your name to be announced. I must advise you that this conference is being recorded today, Wednesday, 17 April 2019.
I would like to hand the call over to your speaker today, Joe Ryan. Please go ahead, sir.
Thank you. Good afternoon. Today, I wanted to just give you an outline in terms of the impact of IFRS 16 on Medicover, on our restatement of prior year numbers, and to make a few points about how that impacts us or doesn't impact us, and how we will be looking to go forward on that. So if I go to slide three, I'm going to talk about the background, about the summary. I have to assume a certain level of knowledge here in terms of participants, so I'll talk about key principles. Some people might be a bit more aware than others in respect of IFRS 16. I'll talk about the impact more generally, how it impacts companies, and then specifically in terms of Medicover and our business, and then look at the APMs and the impact on those, and a new APM as well.
Just turning to page four. Basically, nothing fundamentally changes. Our real cash flows aren't impacted. How we run our business is not impacted. Our reliance on real estate, which we use extensively with leases for our property needs, this doesn't change. And the economics of what we focus on and how we focus on that for our business doesn't change as well. Having said that, there is quite a significant impact in terms of balance sheet and how some of the financial numbers look. In common with many other businesses which use real estate leases for their property needs, the impact can be quite significant. Our balance sheet has increased with off-balance sheet commitments, which now come on balance sheet. And even some events which are probable to happen but haven't yet occurred contractually, they also come onto our balance sheet.
Operating profits and margins, that increases. And we will also have an increased volatility to our profit and loss account generally as we mark foreign currency property leases to market and revalue those periodically. And that will also have an impact in terms of volatility on the profit and loss account. The new standard is applied for year 2019 for periods starting on the 1st of January. So for us, that's the 2019 year. And the first numbers which we'll be reporting under the new standard will be our Q1 2019 figures. So fundamentally, the business doesn't change, and the objectives and performance measures internally that we use are unchanged. We have just sliding, turning now to page 5 and on the approach. You have two options in the application: fully retrospective and modified retrospective. We have chosen the fully retrospective one.
It's considerably more detailed exercise, but it has the advantage of providing comparability and context, which, given the scale of the differences and the changes in the numbers, I think is essential in terms of being able to understand and also for accountability to our stakeholders. The comparative year 2018 financial statements have been restated, and we've restated all the historical numbers going back as well, so we also have the comparative 2017 figures disclosed and the opening balance sheet for 2018, end of 2017. This has been a very comprehensive process. We've assessed over 3,500 lease contracts or modifications to leases, and this in some cases is going back 10 years. We've got circa well in excess of 100,000 data points and historical inputs that we've revised. It's been an 18-month program from start to finish.
And given that when this started off, there were no real systems to be able to manage this. They're still available commercially in the market. We even had to do some own development work to manage the divergence between local GAAP and IFRS accounting, as this is quite significant. And quite a bit of resources and also a certain amount of cost as well.
So just turning to page 6. David Tweedie, who was the Head of the International Accounting Standards Board that sets the International Financial Reporting Standards, one of the things that he would always complain about was that whenever he'd go to his meetings, and they'd be held all around the world, and so invariably he'd fly there. He'd say, "I flew here on an airplane, which is not on the balance sheet of the airline that I flew with." So he was a big proponent in terms of this balance sheet approach and this fundamental type of fair value and this whole concept which arrives today in terms of IFRS 16. The vision is to align the balance sheet assets to a situation which is quite similar if those assets were owned by the company outright and then financed with debt.
The perception by the standard setters was that the treatment of operating leases gave a lack of comparability between companies. You had companies with assets owned or without assets, more asset intensive, more or less risk, and the perception was that disclosures couldn't deal with this, that that was inadequate. We had disclosures in respect of operating leases and disclosed a certain amount of information. It was felt that that didn't really fill the gap, and there was also a belief that this would be relatively simple to apply IFRS 16 and not necessarily complex or costly. I think if you only had a few assets, that would be true that were leased. But when they start to run into the many thousands across lots of jurisdictions, then it starts to get a little bit more complicated.
There's also a belief that this would increase transparency and comparability and that the utility of these changes will be beneficial. It will probably lead to quite wide-ranging changes in business practices. Acquisitions, a lot of those are based on an EBITDA number. Regulators, regulatory capital will be affected. Taxation, you get divergence between IFRS basis and some countries you can use that or not. Users, analysts, and banks need to do a lot of work, so I'm sure there's a few analysts listening in as well who will need to do some work to update their models. Rating agencies as well, and also in terms of banks with debt covenants.
Just turning to page 7. Just want to talk through some of the basics for IFRS 16. To illustrate this, on the right-hand side, I have some examples, some graphs. These are for a 20-year, so quite long real estate lease, and really just to emphasize the differences that this generates between the previous accounting and the current accounting. Inception, you have an asset and a liability that come onto the balance sheet that weren't there before. The lease liability that comes on is the discounted future payments that you're likely to make under the lease. This roughly equals to the asset at inception on the balance sheet. There are some small differences in terms of the asset, but I won't go into those. Now then, over the lease life, you treat these two things, the liability and the asset, slightly differently.
The asset, the right-of-use asset, is depreciated on a straight-line basis. The lease liability, you repay. You repay that as you pay the lease down. But you also incur a notional interest on this lease liability, which increases that. So it follows the typical profile of an amortizing loan. So if you look on the right, on example number one on the slide 7, you can see here you have a straight-line reduction triangle there, the darker blue numbers at the top. And then you have a lighter blue number at the top, which is the reduction in the lease liability. And you can see that these two diverge in terms of the balance sheet. And you get a difference in terms of the balance sheet approach and how they're treated.
Now, what is common for a lot of leases is that they will have indexation. Indexation isn't recognized at inception. That's recognized as you go because you can't really foresee what that will be. So the lease liability and the asset is adjusted when those events occur. And as you can see on the right-hand side of the lower graph, example two, you can see that this effect actually increases and magnifies the difference between the balance sheet items for the right- of- use asset and the liability.
So just turning over to page 8. You can see here in terms of the income statement, we have this straight line that you see on the right-hand side. You have at the top right-hand side of the graph, you have the straight-line amortization of the right of use asset depreciation. And that is a constant charge. But then you also end up with the interest charge, which is imputed. And that goes through the profit and loss income statement as well. And if you add those two together, you get the red line.
And you can see that over time, that red line will decrease. And you can compare that to the blue line. And you can see that that is the rental charge that otherwise would have been charged through the income statement in the past. And you can see that at the front part, the red line is higher than the blue. So you're getting effectively a front-loading of the cost of the lease. And that is dilutive to earnings per share. And at the end of the lease, you get an accretion to EPS. You get a difference where the income statement charge is lower. So you don't get an even charge for the lease over the life of the lease. You get a changing charge through the income statement. And that can be accretive or dilutive for earnings per share. Now, this is an example of a single lease.
However, you always have a portfolio. So on a portfolio basis, you may get a mixing of those. So the other factor which impacts us is the unrealized foreign exchange gain. If you have a foreign exchange-denominated lease liability, which we have a number of for Medicover as well, you then will revalue the lease liability on a periodic basis to the market foreign exchange rate, and that means that effectively, if the exchange rate weakens of the currency area you're working in, say Poland or Romania, then you will get effectively an acceleration of the lease cost that you otherwise would have incurred over time, and the volatility comes because the exchange rate goes up and goes down on a quarterly basis, and that will increase the foreign exchange gain or loss volatility.
One thing to understand is, though, that over the life of the lease, there isn't any change. The amount that you ultimately pay is the same for the lease, and the amount that goes through the income statement is the same, so ultimately, there is no change. However, in how it's presented, there's quite a bit of change. Operating profit always will increase, and that is because of the split between the depreciation, which is charged as part of the operating costs, and the interest, which is then below operating profit, and profit before tax and earnings per share will be impacted depending on the lease maturity, so the portfolio impact, where if you have a younger portfolio of leases, then you will have a larger front-loading than if you have a more distributed or a back-ended portfolio of leases.
So that impact would also be magnified if you have indexation. And the lower graph on page 8, you have there an indexation example. And you can see there the impact of an indexation, which is quite common in leases. That will tend to magnify the phenomena. Medicover, we grow quite strongly. As you can see, over time, you can see our growth organic. So we will be having, and we do have new leases coming on. And the faster we effectively grow, then the more that you will see an impact in terms of a front-loading of the lease costs.
Turning to page 9 and talking specifically a little bit about our portfolio of leases with Medicover, we use a large amount of real estate, as in common with many other businesses. We are a business where we service largely the public. And as such, we need them to access our doctors, and we need physical premises to service them. The nice thing about real estate leasing is that it gives you access to an alternative class of capital: pension funds, insurance companies, long-term investors. And they will typically be invested into real estate portfolios and funds. So it's almost a separate asset class, really. And that generally means then we can get access to longer-term capital at attractive prices to effectively finance those leased assets that we use.
Lease leverage, and for Medicover, if you look at just the lease leverage, the impact of this, it's around about 4x for the end of 2018. So if you look at the lease debt versus the EBITDA change, that's a ratio of around 4x. But this is pretty much almost really a reflection of the maturity of the lease portfolio, as it is a factor in terms of the intensity or use or reliance on leased assets, the way the standard works, and the contractual basis of the assessments. That really means that that's really what you're looking at when you look at the balance sheet side.
We have an expansion over 2018. We have brought on less mature leases. We've put some new ones on. But also, we haven't renewed quite a few of the existing leases. So the existing portfolio has got a little bit shorter. And that's been offset by new leases that we've brought on. So we've gone down from that lease leverage from 4.3x at the end of 2017 to 4x at the end of 2018. And that's not because we've done anything particularly special or changed the business. It's just the way our lease portfolio works.
And if you look at the graph at the bottom there on slide 9, you will see here the sort of profile of the lease portfolios that we have. And you can see that peaking around about four years. We have around about 300,000 square meters of lease space, around about 300 meters average. And then we also, on top of that, own about 50,000 square meters of space, which we own and is on our own balance sheet. So about one-seventh is owned outright, and six-sevenths is leased. And we have about 57% of the leases and 73% by value, which are Euro-denominated. And if you compare that to about 25% of our revenues being in countries which are euro countries, you can see there we have a certain exposure in terms of the lease liabilities. We're about half of the leases being not matched to the currency of the country of operation. And that will bring in volatility to our results.
Why we have to sign those leases in foreign currencies is that's just a market-specific feature. It's pretty much the way the market works and also the asset class of the investors behind it making those investments. So that's pretty much what we have to put up. We can't really change that. And about 40% of the leases are indexed. So Euro CPI, for example, or local indexation. And we have some few strange outcomes as well. We have land taxes in Poland, which are considered leases because of the way they're structured in Poland, perpetual usufruct. And previously, we treated those as a levy as taxes. And the impact is about EUR 5.6 million of additional lease liability for that alone.
Turning to page 10, we have disclosed at the end of 2018 in our financial statements our undiscounted minimum lease liabilities. That is different from the lease liability disclosed here in the financial statements of about EUR 124 million . And that is inclusion of things like this land tax, which wasn't treated as a lease before, inclusion of lease extensions, which we're likely to exercise, probable, discounting where the number reduces by the interest rate. And then also, we've excluded certain items as well according to the standards, such as short leases of less than a year or low-value items of less than EUR 5,000 . And so we provide comparative numbers. This sort of reconciliation to what we disclosed before is less really of an issue.
Turning to page 11, we then have, when we're determining the lease liability, the interest rate which we use in terms of discounting. This can be quite a complicated issue under the standards. Depends on many issues: lease commencement, the length of the lease, type of asset, currency, credit standing of the entity that's signing the lease, or the country. A lot of factors go in. For Medicover, the average which we use is, which is at the 31st of December, the average for the leases is 4.8%. We have a very wide range. We have some anomalies at both ends in terms of outliers, very low rates in one particular lease, and a very high rate in terms of another one, which was that of Turkey when they were going through their crisis. Medicover, we don't provide any lease enhancements to the landlords. Pretty much whoever is signing the lease, whichever operating entity, is signing it on a standalone basis. No guarantees or cross defaults.
The impact of this is that this increases the interest rate which we use for discounting. And you see here, we use 4.8% on average. And the impact of this is that as you increase the interest rate, it shifts some of the costs from being depreciation into interest. This is quite a rigorous process we have to go through in terms of determining this with various models and historical data points. And so it's quite a detailed process.
Turning to page 12, we have here a bridge between previously net profit reported before the application of IFRS 16, so EUR 26.5 million for 2018. And we add back the previous charges for rent, EUR 30.9 million , which were charged in the P&L account under the previous standard. And we take away the new depreciation of the right-of-use asset, EUR 26.6 million . So you can see here a gap.
Part of that gap is then filled by the interest, EUR 5.6 million, being the interest charge on the right-of-use lease liability. We have a new factor in here as well, which is then this foreign exchange loss for 2018, EUR 1.4 million. That is the acceleration of the costs from the future into the current period. Then we have an impact in terms of our deferred tax of some EUR 400,000. We come out at EUR 24.2 million net profit restated for IFRS 16. You can see there the reduction.
If I turn then to page 13, on the balance sheet, we had net equity pre-IFRS 16 of EUR 232.9 million. Then we now recognized the right-of-use lease liability, which reduces by the net equity EUR 125.4 million. We then have some changes to working capital, accruals, and prepayments under the old straightlining system. Those are subsumed within the lease liability, so those disappear. So an increase of 1.3%. And then we have the right-of-use asset, which we bring onto the balance sheet. So that's 116.4 million. And then we also have some adjustments to deferred tax, EUR 1.3 million, which gives us then a net equity balance of EUR 317.5 million after the application of IFRS 16.
Just turning to page 14, you can see here the restatement and also the restated 2017 figures and the net impacts here. Just one point to make here is we have EUR 2.3 million adjustment for the profit for the year. And then a large part of that reduction in net profit is actually the foreign exchange movement, EUR 1.4 million in other financial income expenses.
And turning to slide 15, you can see here in terms of the assets, the impact on the asset side of the balance sheet, EUR 116.4 million increase in fixed assets. And turning to slide 16, you have here the split out between the current and the non-current lease liabilities, so about EUR 124 million in total. And the impact in terms of EUR 6.4 million on our net equity.
And then turning to slide 17, in terms of the cash flow, the impact here at the bottom is that there's no change in terms of the cash flow. But you have a decrease in terms of the profit before tax. You have then an increase in terms of the adjustment for depreciation. And so you therefore have an increase in terms of operating cash flow here for 2018. Operating cash flow increases by EUR 30 million to EUR 74.4 million. There's no change in terms of the investing side of the balance sheet. But there is then in terms of the financing side, which is the repayment of the lease liabilities, EUR 24.5 million in 2018, and the interest which is imputed on those lease liabilities, EUR 5.5 million.
Turning to slide 18, so in terms of specific numbers for Medicover operating profit margin, this increases from 4.4% to 5%. So this is the rent being removed and partially offset by the depreciation of the right-of-use asset. Earnings per share, this reduces to EUR 0.167 from EUR 0.185, around about a 10% reduction. This is the front-loading of the costs compared to the prior standard. And also, it's in the upfront recognition of the FX impacts on future lease liabilities that will be paid in the future. And that is quite a significant part of that reduction in terms of the earnings per share.
Adjusted EBITDA, this increases from EUR 63.2 million to EUR 94.1 million, margin increasing from 9.4% to 14%. And this is basically the increase due to the rent costs being excluded, which were previously part of that. To compensate for this mismatch really between the cash generation of the business and the new EBITDA with the new standard, we are introducing a new alternative performance metric. And this is adjusted EBITDA inclusive of the lease costs. So we call this adjusted EBITDA. Under the new standard, this would be EUR 61.9 million , so a margin of 9.2%. And if you compare that to the adjusted EBITDA we reported last year under the previous standard, that was EUR 63.2 million. So a margin of 9.4%.
You can see here a reduction in the adjusted EBITDA versus the previous standard EBITDA. And the difference comes from that front-loading impact in terms of the new standard. And then also some minor impacts in terms of finance leases, which are treated in the unified model in the same way as operating leases as well.
Turning to page 19, in terms of for our financial position, net debt increases by the lease liabilities from EUR 93.4 million to EUR 218.3 million. And cash flow from operations increased to EUR 74.4 million from EUR 44.4 million. And that's the rent payments. But the important point to note is that net cash flow doesn't change.
Turning to page 20, the leverage side is obviously an important part of the IFRS 16 application, and I think where a lot of focus is. EBITDA under the previous standard and why it was used and why people relied on this, and ourselves included, is that it's a measure of the cash generation of a business, and that's also why it's used extensively with debt covenants as well. Now, Medicover, we use a lot of leases for real estate. We don't intend to change that. It gives us access to the class of asset financing. It matches to the profile of what we're doing, and the important metric for us is our ability to generate cash for each business after lease costs, so that's why we are really coming back to this adjusted EBITDA, which gives a similar result to the previous standard EBITDA, and that's why we're going to be using this as a measure, which we can reconcile back to the IFRS disclosed figures for investors and also for our performance measures.
There is a different treatment to the finance leases from the old EBITDA. This is relatively small and really of no consequence for Medicover, but you still have this distortion of the front-loading of costs versus straightlining in the adjusted EBITDA, but it is a number which we can reconcile back to the disclosed figures, so I think it is useful. If you look at the net debt leverage ratios, as reported last year, we were at the end of last year, we were a 1.6x ratio net debt to EBITDA, and now, if you look at non-lease financial debt, i.e., excluding lease liabilities, divided by EBITDA, this is still 1.6x. And that is because those numbers fundamentally are quite similar, EBITDA to the old EBITDA, and the debt is quite similar as well.
If you look under the new standard net debt to EBITDA, this has increased from 1.6x to 2.4x ratio. As I stated before at the beginning, the ratio for just the lease liabilities and the adjustments in terms of EBITDA is around about 4x for the end of 2018, which has come down from 4.3x at the end of 2017. Now, banking covenants are on the old standard, so frozen GAAP, so no impact. I expect to see in new debt facilities coming on that will be some new measures. We'll yet to see what those will be, and we already have about, as I said, one-seventh of our real estate on balance sheet already.
T urning to slide 21, just to finish up here. Nothing fundamentally changes. Our real cash flows has no impact. How we run our business has no impact. [audio distortion]
Please stand by while I reconnect your speaker. Thank you. Mr. Ryan has joined us.
Excuse me on that. The line dropped there. So in summary, nothing fundamentally changes. Our economics are the same. Our reliance on leases is the same. The balance sheet changes. We get this increase in the balance sheet size from our off-balance sheet commitments coming onto the balance sheet. Operating profit increases. Margins increase. Volatility is the profit and loss account will increase with the foreign exchange mark-to-market process. We will be applying that now in our numbers, which we'll release at the beginning of May for Q1. And our objectives and our performance measures won't change. And our expectations in terms of our growth rates won't change.
So if I could hand over now for questions.
Thank you. Ladies and gentlemen, if you wish to ask a question, please press star one on your telephone and wait for your name to be announced. Star and one for questions, ladies and gentlemen. We have a question coming from the line of Caroline Ebbend from Danske Bank. Your line is now open.
Hi. I have a question on the division. So you have EUR 27 million impact from depreciation on lease assets. How is that divided between the divisions?
The impact is roughly similar on both of the divisions.
Yeah, 50/50.
Yeah. They're about 50/50 in terms of how they operate. So you don't have very much difference between that.
Yeah. Okay. Thank you.
Next question comes from the line of Kristofer Liljeberg from Carnegie. Your line is now open.
Yeah. Thank you. Also on the business areas, will you report the new EBITDA with leases or the adjusted figures for them? What will the focus be?
Yeah. So we will disclose the EBITDA number under the new standard and we will then reconcile that to EBITDA, which will be the metric which we're focused on, being similar to the previously reported EBITDA. The reason why we can't really report a previous sort of standard number, even though we work it out and we know what it is, is that we wouldn't be able to reconcile that back to the disclosed figures. By using the EBITDA number, we disclose all of the interest and the depreciation for lease liabilities and right-of-use assets, so that's readily reconcilable back to the disclosed figures. It then becomes easier for you to track and to keep a measure on, and that will be disclosed for the divisions.
Will you also show the lease effect separate in the financial net, considering the further increased volatility FX will have?
Yes. I imagine that I will be commenting on that every time we disclose. As you can see here, the impact for 2018 was a negative number. It was a positive number for 2017. So I expect that this is going to be up and down and up and down every quarter.
Okay. That's good. Thank you very much.
Ladies and gentlemen, once again, if you wish to ask a question, please press star and one.
I think that's it. We don't probably have any more.
Once again, it's star and one if you wish to ask a question. There are no questions at this time. Please continue, sir.
Okay. Thank you very much. Thank you all very much. Wishing you all a good day. And we'll speak again on our release on the 3rd of May. Thank you.
Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may also [audio distortion]