MOST DANGEROUS GAME?
Customer financing seemed like a smart move when times were good. Now, it's wreaking havoc on corporate balance sheets.
By Ronald Fink

It's no secret that customer financing has backfired badly on telecommunications equipment suppliers. By the end of 2000, according to McKinsey & Co, nine suppliers - Alcatel, Cisco, Ericsson, Lucent, Motorola, Nokia, Nortel, Qualcomm and Siemens - had extended an estimated US$25.6 billion to service providers. Today, 24 of the 30 largest publicly traded telecom service providers are bankrupt, and write-offs for loans by suppliers to those companies are soaring as a consequence. Anywhere from a third to 80 percent of their loan portfolios is estimated to have gone down the drain; Lucent Technologies and Nortel Networks, for instance, are on the brink of insolvency, while many if not all the other suppliers struggle to retain their footing.

With trouble now spreading throughout the US economy, the nasty hangover of customer financing is by no means limited to victims of the internet bubble's deflation. Boeing Capital, for example, is now caught in the downdraft of United Airlines's bankruptcy after financing a significant proportion of United's aircraft. Liquidity concerns confront Ford Motors and Sears, Roebuck and Co because of the huge short-term liabilities they've taken on to finance sales in the face of sagging demand. Even General Electric, a master of financial services, is finding that lending to others is far more of a burden than almost anyone imagined it would be during the roaring 1990s (see box, "Whither GE?" below).

To be sure, these companies take a wide variety of approaches in their financing activities, reflecting fundamentally different objectives. For new economy companies such as telecom suppliers, financing is (or was) a tactical means of developing markets for new technology. It remains true for Dell and Microsoft as they seek to support more small and midsize businesses. For more mature companies, such as Deere & Co, Ford, and Sears, lending to customers helps sustain growth during periods of economic difficulty. And for more diversified companies, though none as much as GE, financing represents a strategic foray with indirect bearing at best on much of the rest of their operations.

Overall, corporate reliance on financial services is pervasive. A study of the Standard & Poor's 500 by Morgan Stanley in the US in June 2001 showed that even without taking into account leasing and vendor financing - or, for that matter, equity and pension investments - financial services accounted for roughly 25 percent of the index's total earnings. Morgan Stanley says the percentage has increased since then, to 28 percent.

And all companies involved in customer financing face the same basic challenge: how to manage both the leverage and credit risk that lending, leasing, and the like pile onto balance sheets, or spill into intricate but questionable off-balance-sheet transactions. "Whether it is selling underwear, jet engines, or routers," observes Steve Galbraith, chief equity strategist at Morgan Stanley in the US, "when a company begins to rely on the financing part of its operations to generate earnings, its risk profile almost by definition becomes more complex."

That's little or no problem during good times, when debt is cheap and the ability to repay it unquestioned. Even today, those with strong balance sheets, such as Microsoft, Cisco Systems, Dell, and John Deere, will find financing a competitive advantage. Yet customer financing by those in lesser condition now compounds concerns over their own creditworthiness. And the longer the US economy remains in the doldrums, the greater the risk for companies that ignored Polonius's injunction in Hamlet: "Nor a lender be".

Wider Spreads

"If you look at most financing entities," says Brent Callinicos, vice president and treasurer of Microsoft in the US, "they have a very leveraged model." One can, of course, use equity to finance customers. But that's more of a venture capital approach, which presents another set of risks entirely (and in any case is not viable under present conditions).

Cash on the balance sheet simplifies matters greatly. But who else is in the position of Microsoft, with US$43 billion at last count? (Its plans to start paying dividends will hardly put a dent in that hoard). Cisco comes reasonably close, with US$21 billion, so a bad US$485 million investment of both debt and equity in a telecom failure like Velocita is easy enough to shrug off.

For others, the challenge goes beyond leveraging up a balance sheet. Financing also exposes lenders to the creditworthiness of other parties, despite the most elaborate efforts, short of outright sale, to get assets off the books. As a consequence, many companies that lend to customers find their bonds trading at wider-than-average spreads.

Granted, the classic formulation by finance theorists Franco Modigliani and Merton Miller holds that debt is no riskier - and therefore no costlier - than equity, all things being equal. But the theory makes a famous exception for times of financial distress (as well as for tax considerations). Do wider spreads suggest companies now face such a time? "Absolutely," says Erol Hakanoglu, a managing director at investment bank Goldman Sachs in the US. "This is a moment when the exception is more than an academic footnote."

Certainly, the climate for taking on more debt couldn't be much worse. In 2000, corporate debt relative to cash flow hit levels not seen for more than 50 years, according to data compiled by The Levy Economic Institute of Bard College in New York. And despite efforts to restore balance sheets, debt-to-cash ratios haven't come down much since then.

During tough times, leverage leads to a deepening conflict of interest between shareholders and bondholders. "We have to be sensitive to both sets of investors," acknowledges Malcolm Macdonald, treasurer of Ford Motor, whose credit operations help make the US company the world's largest corporate debtor.

Yet the need to finance customers may be unavoidable, as consumption remains weak and few companies have much pricing power. And while economists ponder the prospects for deflation, the US government's index of prices received by non-financial corporations has been falling since the third quarter of 2001. As Morgan Stanley's Galbraith put it in June 2001: "As companies...become increasingly involved in the financing of their core customers, it is not too far-fetched to suggest that manufacturing is becoming the loss leader of the profit chain."

But that's not the case in Detroit, US, where General Motors and Ford have offered zero percent financing on many vehicles for much of the past two years. How long they can afford to lend at a rate that's lower than the one at which they borrow is anyone's guess, but they may have little choice given the current slack demand. Ford Credit's three-year notes now yield almost 400 basis points more than Treasuries - more than twice as much as the average BBB-rated US corporate equivalent.

Discipline Matters

Despite heavy dependence on customer financing, some companies in mature industries have managed to sail through the credit markets relatively unscathed, thanks to the discipline they bring to bear on their operations. In some cases, that discipline was the product of painful experience. After Deere established financial services as a separate business unit in the mid-1980s, the agricultural-, forestry- and construction-equipment maker expanded its scope until it eventually financed everything from recreational vehicles and yachts to manufactured housing. "There were growth opportunities we thought worth pursuing," recalls Deere CFO Nate Jones.

But because the margins were smaller than hoped for, he says, the company concluded in 1998 that it was better off focusing on its core market of farm equipment customers. "This is [no longer] a portfolio-of-businesses approach as much as it is a customer approach," says Jones. "We're really focused on the customer base that's more traditional for John Deere."

About the furthest afield Deere ventures these days is to offer US customers credit lines they can use for purchases of other companies' products. And Jones is quick to note that Deere feels comfortable managing the risk involved. "We know what their business model looks like," he says. "We know how to credit score it. We've got very deep customer knowledge here." (See box, "Deere Prudence," below).

Companies in newer industries may find it easier to avoid spreading their wings too far. Consider Microsoft's customer-centric ambitions for Microsoft Capital, which has provided some US$200 million in financing since the program began some 18 months ago. Although Callinicos says there's no absolute limit on the amount of capital Microsoft is willing to deploy overall, he insists: "We have no desire to become a financial services company. We also have no desire to stretch much beyond the Microsoft revenue footprint."

With that in mind, Microsoft is focusing on small and midsize businesses that find bank financing for software purchases difficult to come by. "You're talking about a space where financing is not easily attainable, about financing intangibles," says Callinicos, "and when it is available, it might be extraordinarily expensive for some customers even though they may be a good credit. So it's all about doing something that makes strategic sense for Microsoft."

On the other hand, focusing on too few customers, even if solidly within one's "space," can be no less dangerous than venturing far beyond it. Again, telecom is merely the most obvious example. Boeing Capital has nearly 80 percent of its business in aircraft financing, at a time when potential buyers of aircraft, which can cost US$60 million apiece, are increasingly few. Accordingly, Boeing launched an effort several years ago to follow GE Capital's path to diversification (GE Capital derives only 5 percent of its revenues from aircraft leasing), but didn't get far before 9/11 sent the weakening travel industry into severe distress.

Securitization Blanket

To avoid such concentration, Microsoft plans to follow a "one-to-many model" and sharply limit its credit exposure to any one customer, says Callinicos. Microsoft's US$200 million in financing "represents thousands of companies," he says. Here Callinicos confesses to taking note of IBM's efforts to reduce its financial exposure to large customers by "pushing down into this space [smaller companies]." In that sense, of course, Microsoft's financing efforts can be seen as a defensive measure.

Many, if not most, companies that expose their balance sheets via customer financing try to limit, if not eliminate, their credit risk by securitizing the assets involved.

Among Ford's latest efforts are arrangements with third parties known as whole loan sales of auto receivables. The idea is to sell the receivables to investment banks so they will assume all credit risk. Ford's first significant deal sent US$3 billion last year to Bear Stearns, and the company is looking to do more such transactions, says Ford treasurer Macdonald. "It's another avenue of funding," he says, "and for a company of our size, that, I think, is the critical issue - having access to multiple sources [of funding]."

All told, Ford's securitization efforts have reduced its reliance on commercial paper from US$42 billion in 2000 to about US$3 billion at recent count, which has eased the anxiety among analysts about Ford's liquidity. "While we have myriad concerns about this credit," says Carol Levenson of Gimme Credit, a US-based independent bond research firm, "refinancing risk is not chief among them." But new rules from the US Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) could put a serious crimp in securitization. The rules require more disclosure of securitized assets, if not their actual inclusion on balance sheets. This has the banks up in arms, as it threatens not only to hurt their business but also to shed more light on their own exposure to its risks. At a minimum, the new rules could make securitization far more expensive.

Ford is far from alone in trying to lay off risk through securitization. Dell contends it takes no financial risk whatsoever when financing customers, because it does so through a joint venture with CIT Group (CIT), whose terms essentially call for CIT to take all the losses but only 30 percent of the profits, with the rest going to Dell. Never mind that the venture may soon move onto Dell's balance sheet as a result of new FASB rules regarding so-called variable-interest entities.

"The risks associated with that business won't change," insists a Dell spokesman. "The financial risks are not Dell's."

Microsoft is taking a similar approach with financing of products besides software by bringing in such third-party lenders as Household International and the Dutch Rabobank Group. "If we're financing a bunch of hardware as well as software and services and we don't like the [revenue] mix," says Callinicos, "I'd rather partner with somebody and help deploy their capital."

Rising Delinquency

At this point, it's difficult to assess the effect that greater disclosure has on companies that securitize assets, simply because so much depends on market conditions and investor perceptions. After another FASB rule regarding securitization took effect in 2001, Sears brought back onto its books US$8 billion in credit card receivables that it securitizes through a special purpose entity, along with US$8 billion in associated debt. And while the company says the change makes it easier for investors to understand its credit business, rising delinquencies nonetheless took Wall Street by surprise at the end of last year.

As a result, the retailing giant shifted Paul Liska out of the CFO position to oversee the credit division. Liska dismisses the related concerns of analysts about Sears's significant level of short-term debt, which totaled some US$9 billion at the end of September, in light of what they consider its weak free cash flow. Liska says the company's dependence on such debt poses little risk because most of the assets being funded are high quality, liquid receivables. Sears is, in essence, a credit card company. "We make money on the spread," says Liska. "You want us taking credit risk, but you don't want us taking interest-rate risk." And he contends that's exactly what Sears does, and doesn't, do - and that the credit operation is hugely profitable.

Still, the rise in charge-offs for bad debt troubles analysts even after improving in the quarter ended last December 31. "We found the increasingly high delinquency statistics disturbing," Gimme Credit's Levenson wrote in a recent report. "Sears desperately needs its credit operations to offset its rocky retailing results."

Can companies hedge away default risk? Experts say credit derivatives and surety bonds can be used in some cases. But insurers that sell these products are becoming warier, sending prices up and calling into question their efficacy.

Some companies are simply washing their hands of financial services. Last fall, Zurich-based ABB sold virtually all of its financial services assets to GE. The Swiss engineering firm plans to divest most of what remains, because the leverage it added to its balance sheet was unsustainable, says CFO Peter Voser. "It was becoming very clear," he says, "that maintaining a highly leveraged balance sheet to finance businesses over time, given the uncertainties in the financial markets, would be challenging - and even to a certain extent, depending on our credit rating, impossible."

No less threatened by the debt requirements of financial services, Tyco exited the business some six months earlier when it spun off CIT in the first half of 2002, recovering less than half of what it paid for the commercial finance business not even a year before. While governance and accounting scandals were at the root of Tyco's problems, the debt it took on to fund CIT left the company especially vulnerable to a loss of investor confidence.

Ford's Macdonald contends that financial services is a tricky proposition even for well-governed and -financed companies, unless they're somehow immune to the vicissitudes of the business cycle. "There are limits as to how big a financial services subsidiary you want to have," says Macdonald, "particularly when you're in a business that's inherently cyclical."

All of which goes to show precisely why, even in good times, stocks of banks trade at lower multiples of earnings and book value than those of other companies. Bear markets, of course, only increase the cost of capital. That makes it more important to figure out what price is worth paying to subsidize revenue growth, and how aggressively to do so.

Ronald Fink is a deputy editor of CFO, CFO Asia's sister publication in the US.