"Leasing works best when organizations match the term of the lease to the amount of time they expect to use the equipment," says Frances O'Brien, research director, GartnerGroup Procurement Solutions Group, Stamford, Conn. "Any time a company does anything other than what it originally intended, it will incur additional costs. These costs will depend on what is done, the relationship with the lessor, and the underlying terms and conditions of the lease."
O'Brien's focus at Gartner is on distributed IT equipment procurement, negotiation strategies, leasing, asset management and life cycle management policies and practices. She spoke on the topic of leasing at the market research firm's IT Asset Management 2000 conference.
Trends drive decisions
As O'Brien sees it, there are several factors now forcing change in the leasing industry.
For one, technology is turning at an incredibly fast pace, having a dramatic impact on the economic life cycle of much of the equipment corporate buyers have responsibility for acquiring. What's more, management sees business value in IT.
At the same time, the Internet is impacting the industry. There now are online leasing companies where it's possible to get a lease in about three minutes. (Negotiating terms and conditions of the agreement still takes longer.)
Three, continued device proliferation means increased spending on technology.
Four, since leasing organizations are not making money from straight leasing, they are looking at different ways to finance equipment, i.e., utility-based leasing.
One of the changes these factors are forcing is industry consolidation.
"We see the manufacturer, or captive leasing company, ruling the day," says O'Brien. Aggressively looking for new business, they have a competitive advantage: blind discounting from the manufacturer parent. By virtue of their relationship with the equipment manufacturer, these leasing companies, i.e., Dell Financial Services, can create a situation whereby the financing can be more attractive. A downside: "Most organizations we speak to don't have this one supplier's equipment in their shop. So, if you have equipment from IBM, Dell, HP and Compaq do you want to set up a relationship with each of them or take the lease financing they're offering on other suppliers' products? Typically pricing is better for their own equipment."
Independent lessors, meanwhile, struggle to keep pace with the manufacturers. They can't offer pricing as aggressive. However, they are supplier neutral: From them, buyers can lease equipment from any manufacturer. They also offer such services as asset tracking. From a cost perspective, however, there's less of an advantage.
Best practices
"What we see happening is a complete and full disconnect between the technological life of an asset and the economic life of an asset," says O'Brien. The equipment is robust. Manufacturers offer longer warranties. On the other hand, economic life is shorter.
Take the PC, for example. A PC has a technological life of about four years. At 24 months, the economic life is much shorter. With a small market for used equipment, residual values fall. Technology is good enough for an organization to keep a PC for three or four years, yet buyers can only get an operating lease for 30 months. This makes little sense for the organization. "Purchasing needs to keep in mind that economic life drives the leasing decision," says O'Brien. "It also drives the operating or capital decision as well."
There are two types of leases: operating leases and capital leases. Operating leases are basically off balance-sheet financing. Here, lease payments are treated as an expense.
Capital leases are very much like financing. The life of the equipment is capitalized on the organization's books, and the lease payments are depreciated over time. "There are no criteria to tell you what is an operational lease," O'Brien says, "but there are for a capital lease. If it doesn't meet the criteria then it is an operational lease."
A lease is a capital lease if any of the following applies:
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The present value of the lease stream is more than 90% of the asset value using the lessee's incremental borrowing rate. This means that the lessor has to take a 10% residual value at the end of 36 months. "Now, there are suppliers who will craft for an organization an operating lease they call a 'synthetic' lease and will arrange the financing and it will be treated as an operating lease," says O'Brien. "These are difficult to come by. Many lessors don't want to offer them. So, as an alternative they are offering operating leases for 30 months. Well, if you want to keep that piece of equipment for 36 months, why have a 30-month lease? This is one reason leases fail."
Before entering into a leasing agreement, there are four questions a buyer should ask:
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What is the real replacement cycle of the equipment? Is it 36 months or less? Many organizations use leasing to force changes in management behavior. If management does not believe in a 36-month life cycle, it can't be forced into it with a lease just because the lease term is for 36 months. What tends to happen is the buyer ends up renewing or extending the lease, purchasing the equipment outright at the end of the 36-month period.
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Is there any leveraged payback from a leasing deal? For example, the organization may not have a predefined life cycle but it may roll out a notebook PC, in the belief that it will reap x amount of dollars in business profit.
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Does the organization have the means to track the equipment throughout its life cycle? That is, not just the physical asset, but the contractual asset.
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How stable is the organization's application base? Equipment installed today needs to be robust enough to run the application in the future. An example is Windows 2000. A lot of organizations went out 18 months ago and leased PCs with 32 MB of RAM. Equipment running Windows 2000 needs at least 128 MB of RAM. So, what is a buyer to do? Does he or she purchase or lease the upgrade? Either way it's going to cost more money and leasing may not be the best answer. "So, if your organization's application base isn't stable and you answered yes to any of the questions, leasing may not be the best low-cost alternative for you," says O'Brien. "You may want to look at purchase."
O'Brien does the math with a 30-month lease for a PC. Monthly payment is $65. "Now, what happens with PCs? A PC is not just a single asset. Within one organization, there may be thousands of them. So, at any point in time, an organization has to expect that 100% of the assets are not going to make it back to the leasing company at the end of the lease term. Terminating the lease at 18 months costs the organization $1,930. If the PC costs $2,000 and there are thousands of them in the organization, leasing may not look like such a good deal.
A second scenario: Replacing the equipment after 30 months costs the organization $1,950. That is what it is trying to do.
What if the organization plans to keep the equipment for 36 months? Extending the same lease for 36 months costs $2,340.
No retirement plan would cost $3,120.
Leasing software
O'Brien compares software leases to the loch ness monster. "A lot of people talk about it, but it's really not there. It's a misnomer," she says. "It's not leasing, it's financing."
Software is not a tangible asset. It's a right to use the license. There's nothing for the lessor to secure. No title is transferred. Only permission to use is given. Most software licenses are not transferable. Most licenses are not normally transferable to an independent lessor. There's nothing tangible to finance. There's no residual.
Software licenses are basically unsecured loans to users. Buyers considering software leasing need to focus on the economics of the transaction. Bank financing may be a better alternative.
Leasing companies offer financing solutions. Organizations are trying to finance e-commerce initiatives. As many corporate buyers well know, real e-commerce initiatives are expensive (hardware, software, integration). Some of the leasing companies' solutions are good in some cases. In others, buyers may be getting things they don't need. O'Brien suggests that buyers unbundle the solution and determine if the services are necessary.
Bank financing may be a cheaper alternative. The problem is banks are not always willing to finance software because again there is nothing to secure. Scrutinize loan covenants-there may be restrictions on minimum leasing payments. Look at the suppliers themselves. Can the supplier provide it all? A lot of time the answer is no. They may have terrific financing programs, but no staffing.
Another alternative is an ASP (application service provider). An ASP is an outsourcing arrangement in which the organization pays a flat monthly fee to run an application externally and connect to it electronically over the Web. This way, an organization can rent or finance the software, rent or lease the hardware. There is a multitude of combinations, and questions that need answering:
Who holds the license rights? What are the rights upon termination? Who holds the data? Can the organization get its data back if it's sharing a server with someone else? What is the organization's access time? How secure is the data? Who else has access to it? What other restrictions are there? What happens if the organization wants out? What if the supplier wants out? How can the organization protect itself?
There's no one best solution, says O'Brien. "Most organizations find a mix is an appropriate solution. Corporate buyers should look at lease financing, the cost of capital, different supplier proposals and how that will impact the business. Look at the cost of the program, not just the initial cost, but the cost of the entire contract. Looking at details behind the contract may find that pricing is substantially different. Are additional resources required to manage the transaction? Will the organization have to have people tracking things more than they have in the past? What else is involved to make the financing solution right? The world is changing at a rapid pace."
What are the organization's forecasting requirements over the next six months? The next 12 months? The next five years? Can financing accommodate changes? Look at the assumptions built into the financial analysis. How valid are they? What happens if the interest rate rises? How will that impact the deal? How valid is the deal going to be in the future?
O'Brien suggests that buyers look at their organization's portfolio of leased assets. Again, what happens if 100% of the assets are not returned to the leasing company at the end of the lease? What if only 90%, or 70%, is returned? How is that going to impact the decision?
Look at the timing: "Don't give away all of the organization's negotiating leverage," says O'Brien. "Once the contract is signed, and the leasing company begins delivering the equipment, all negotiating leverage is gone. Make sure terms and conditions are flexible. An organization needs flexibility to do business in the future. And, who has control?"
Many technology buyers pick suppliers on price. "You could be getting a very expensive deal," says O'Brien, who suggests that buyers closely evaluate terms and conditions of leasing contracts. Take, "fair market value," for example. Determine how the lessor has come up with it. Unless the buyer "gets it nailed down in the contract, it will be whatever the supplier wants it to be." Another thing that buyers should look at is system installed value. How much is that piece of equipment worth to the organization installed and running on the desktop. This figure can be up to 400% higher than fair market value.
No computer fairy
Many leases today have technology refresh options. There is no real consistency among programs offered. In general, with a 36-month lease, a lessor provides an option for a lessee to replace all or some equipment after 24 months. Still, O'Brien says, "there is no computer fairy. At the end of 24 months the lessor doesn't come and put new computers on the desktops for nothing. The lessee still owes for that third year. How a lessor calculates that figure may vary from 25% to 30% of the original cost of the equipment. Buyers need to understand that a technology refresh program is "insurance."
What does it take to be successful? Some 50% of corporate buyers walk away from leasing because it fails to meet their expectation. First, the buyer has to match the term of the lease to the amount of time the he or she expects to use the equipment. Next, the buyer has to understand motivation for leasing. Is the organization using leasing to put in a disciplined routine to help recycle equipment sooner? Is it trying to force technology change?
O'Brien suggests that buyers negotiate the cost of the equipment at the time of the lease. "Negotiate the contract terms. Make someone responsible for managing the lease contract. An organization doesn't want to find out two days before the lease is up that the lease is expiring. (Optimum amount of time is 90 days.) One best practice is that every month someone runs an asset-management report (in addition to other financial statements) that shows exactly what equipment is coming off the lease during the next six months," says O'Brien. "That gives you time to plan your next procurement and it really helps you to be successful in a leasing program."
It's important that the buyer understand what he or she is signing, says O'Brien. What if there's a dispute? What is the conflict resolution procedure? How does the organization end equipment through a lease? What is the acceptance criteria? Some contracts transfer title when the equipment is ordered, not when it's delivered or shipped. If it arrives broken, the lessee still has to pay.
Asset substitute is a good provision, says O'Brien. What happens if one particular asset is lost? Can another asset of like kind be substituted? A lot of lessors don't provide this unless asked. Some limit it to 30% of the asset.
What are the notification periods? The lessee needs to notify the lessor 180 days prior to the end of the lease term of his or her intentions. If he doesn't, the lessor may renew the lease for another year. Another issue is default. Many contracts consider 10 days delinquent default. What the contract should state is that the organization is in default 10 days after receiving written notification from the lessor. It's a point that can be negotiated, says O'Brien.
Buyers also need to understand upgrade options. Oftentimes, if an organization wants to upgrade, it must do so with the lessor's currently marketed program.
Supplier management is key to a successful leasing program. Keep the lines of communication open. "If there is something you don't understand or if you're having a hard time meeting commitments, call the supplier," says O'Brien. "They may have some good suggestions on how to run your program better. It may be something as simple as giving a lessee instructions on how to pack the equipment."
Analysis of financing choices
Cost
Risk
Flexibility
Timing
Control
SOURCE: GARTNER
Putting it all together
To be successful:
SOURCE: GARTNER
Operating vs. capital leases
Operating leases:
The lease payments (monthly, quarterly, annual) are treated as an expense for the lessee.
Finance lease accounting (capital lease):
The equipment is capitalized on the lessee's books, and depreciated.
The lease payments are treated as a loan.
The interest (explicit or imputed) is expensed on a monthly basis.
Accounting criteria for an operating lease:
A lease is a capital lease if any of the following applies:
The lease transfers ownership of the asset at the end of the lease term.
The lease contains a bargain purchase option.
The lease is longer than 75% of the product's economic life.
The present value of the lease stream is more than 90% of the asset value using the lessee's incremental borrowing rate.
SOURCE: GARTNER |
