It may be the ultimate cautionary tale for IT executives exploring ways to get their customers to spend more.
When wireless-network equipment vendors Motorola and Nokia lent more than €3 billion in October 2000 to Telsim, a Turkish mobile-phone company, few expressed concern. After all, the two technology giants had been financing Telsim for years, and not a single repayment had been missed. Motorola even owned two-thirds of the operator, a stake it acquired as collateral for the latest loan. What could possibly go wrong? Plenty – so much so that Motorola and Nokia are now suing the powerful Uzan family that effectively controls Telsim for fraud under US anti-racketeering laws.
Like many cases of alleged fraud, the details are murky and complex. But the lawsuit filed against the Uzans in January 2002 alleges that they moved cash from Telsim into separate entities and went to extraordinary lengths to avoid paying it back. The Uzans deny wrongdoing and are countersuing.
For Motorola, the ill-fated Telsim deal represented by far its biggest single exposure to vendor financing – a routine practice in the telecommunications industry whereby vendors boost sales by loaning network equipment, handsets and sometimes even cash to operators, before transferring the loans to banks or the capital markets once their risk has declined. Motorola, along with many other vendors of telecoms gear, is now drastically tightening its financing policies amid fears that the Telsim default is an extreme but far from isolated case.
In the IT sector, the reverse is occurring. Many IT vendors feel compelled to adopt increasingly aggressive sales techniques to encourage users to spend on new hardware, software and computer services. The danger: that bad debts among IT users will rise as a result.
It is not difficult to see why vendors are being forced along this route. On one hand, they have to fight off fierce competition from other companies that, possibly like them, flooded the technology sector during the boom years of the late 1990s. On the other, they must come to terms with IT decision-makers generally reigning in their budgets during the present economic downturn.
It may seem self-evident, but during a recession it is more likely that a vendor’s client will default on repayments. Yet more vendors are lowering the threshold for customers wishing to lease even some of their most expensive products and services. And that is the paradox facing vendors today.
Take Cisco Systems. At an analysts’ conference in 2001, shortly after the US networking giant took a €315 million quarterly charge for bad debts, CEO John Chambers revealed that the company’s financing arm, Cisco Capital, would become increasingly aggressive in its leasing programme, offering 0% financing on some of its products.
One of the dangers with such an offer is that it saddles the vendor with a large proportion of high-risk customers. But Cisco’s move appears to be designed as much to snuff out its competition as it is to raise new revenues. Such cut-throat sales tactics are made possible by Cisco’s healthy balance sheet. It has an estimated €23 billion cash and asset pile.
Being drawn into a price war relating to financing arrangements can have serious implications. Take the case of Lucent Technologies and Nortel Networks, both of which brought themselves to the brink of disaster after adopting an aggressive financing stance during the race to sign up 3G network-supply contracts in Europe in 2000.
In addition to 0% financing, Chambers also signalled a fresh push into operating leases – one of the more conventional forms of IT financing (see Customer financing options). He believes the virtue of operating leases is that they enable a vendor to recognise revenue over a longer period of time, thereby increasing visibility and smoothing out future earnings growth.
But Chambers omitted to mention the other obvious attraction of operating leases – that they can help Cisco overcome its notorious inventory problems. “The company can keep the product on its books as an asset but not as inventory, thereby mitigating any pesky days-of-inventory problem,” wrote New York-based analyst group Grant’s Investor in a 2001 research note. “Not only that, but the asset is depreciated just like property, plant and equipment.” That allows Cisco to raise profitability by excluding the depreciation expense from its pro-forma financial results.
Cisco Capital is by no means the only vendor finance business initiating aggressive sales tactics during the IT spending downturn. Some vendors already provide zero-percent financing on commodity items such as personal computers. Others offer loans that are not recoverable in the event of the customer going bust (so-called ‘non-recourse’ arrangements), while yet more are rolling out ‘utility’ finance deals, in which the reward is linked intrinsically to the success of the customer as well as the project itself.
There is nothing new, of course, in hardware vendors financing their clients. But for perhaps the first time in the history of the technology industry, finance deals on all products, including software licences and IT services contracts, are the norm.
“Customers are now more likely to go for financing than not,” says Jeff Smith, European vice-president of sales operations and offerings at IBM Global Financing. “We have seen a particularly big increase in customers that are looking at utility arrangements. Software [leasing] has been another dramatic growth area for us.”
It was virtually unheard of for IBM to offer financing arrangements on software as little as five years ago. But now perhaps half of all software deals contain financing of one sort or another, he says. Equally, the proportion of IBM hardware sales containing financing has risen from about 30% in the early 1990s to as much as 75% on certain products today. As a result, the finance arm is now arguably IBM’s most influential business, serving customers in more than 40 countries, managing about €44 billion in assets and providing more than €51 billion in new financing each year.
Those are colossal figures. But IBM is not alone in offering a complete range of financial services and computer services ‘solutions’ to its customers.
Constantin Salameh, managing director of HP Technology Finance, which also provides financing on software as well as systems, believes the most significant offer to emerge in the last 12 months has been utility finance. These arrangements are being snapped up not only by enterprises but also by public sector agencies – which like the fact that such deals make their suppliers more accountable.
This appears to be helping HP win European e-government contracts. In Bulgaria, for example, HP Technology Finance formed an alliance with HP’s consulting division and local suppliers to fund and install a new passport system. The finance business provided $24 million (€27.6m) and the Sofia government is paying the loan back in instalments whose size is largely determined by the number of new passport applications processed.
How utility arrangements and other financing deals are accounted for is open to interpretation. Critics say that any perceived lack of transparency will intensify the scrutiny of many technology companies’ financial reporting methods in the wake of the Enron and Global Crossing scandals. But the IT financial services industry insists there are no “skeletons lurking in cupboards”. Alan Townsend, financial product sales manager of Sun Microsystems Finance, says that accounting for finance deals at Sun is done “conservatively” and that revenue from long-term leases, for instance, is recognised as each instalment is paid, rather than at the beginning of the payment period.
Ultimately, as finance divisions of vendors seek to outdo each other with yet more attractive offers, the danger is that their own insurers and banking-sector financiers will begin to ask whether the risks are getting out of proportion to the dwindling rewards. The end result of this process, it would seem to many, is a larger proportion of defaults and an acceleration of industry consolidation – with smaller vendors unable to match the offers of their cash-rich competitors.
Townsend is not sure that there is an alternative strategy available even to the industry giants. Asked if the various financing arrangements had truly raised spending among hard-pressed CIOs, he replied: “I am not prepared to discuss the amounts generated by these deals. What I can tell you is that we are driving significant revenues from them.” But his following remark sums up the state of affairs perfectly: “Without these kinds of deals, our customers would not have been able to spend with us. It’s as simple as that.”