Leasing Trends in the Server Market

Last week I told you about leasing trends in the IT market and explained that, despite the quickly dropping costs of servers and storage and low interest rates (which makes outright borrowing attractive), the practice of leasing IT technology is growing. This week I have some insight from the captive leasing units of the big four in the server market: IBM, Hewlett-Packard, Sun Microsystems, and Dell.

First, I want to review two common leasing terms, capital lease and operating lease, for those who are unacquainted with them. A capital lease has a lot of different definitions, but essentially it means taking out a lease on equipment, and the company doing the leasing (the lessee) treats the lease as if they were acquiring the equipment. To be a capital lease, a lease has to meet one of the following criteria (or many of them): The lease term has to be longer than 75 percent of the estimated economic life of the equipment. The lease gives physical ownership of the asset to the lessee at the end of the lease. The lease contains an option to buy the equipment at the end of the lease for its fair market value. And the present value of the lease payments (the sum of the payments at any given time during the course of the lease) is larger than 90 percent of the fair market value of the asset.

The other major kind of lease is called an operating lease, which is a lease that doesn’t meet any one of these criteria and that has ownership retained by the lessor. Such an operating lease arrangement is essentially renting the IT equipment, and typically spans a much shorter time than a capital lease.

In the computer business, the economic life of equipment is very short, which makes leasing tricky. But if you are a smart person with a spreadsheet, and know how to quantify risk and bargain hard, you can still make money setting up capital and operating leases for IT shops, while at the same time giving those companies some of the flexibility to dump IT assets as they see fit. In essence, when you lease IT equipment, you are paying someone to borrow money to acquire that gear and to assume the economic risks entailed with investing in technology. And this certainly does not come without a price tag.

IBM Global Financing is arguably one of the biggest leasing and financing organizations on the planet, with $35.9 billion is assets under one or another kind of financing and operating units in 40 countries worldwide. IBM not only finances servers and storage but, under its TOTAL financing program, also finances its software and services, and even the products of its competitors, into a single package. Ernie Fernandez, vice president of customer financing for the Americas region, says that in the United States, somewhere between 45 and 50 percent of the IT equipment that IBM sells to customers is financed, and that when the deal size gets up to $1 million or higher, about 60 percent of the equipment gets financed. “Organizations have a greater propensity to finance larger transactions,” he says. He says further that IBM has always focused on financing its core proprietary systems: the ES/9000-S/390-zSeries and AS/400-iSeries-eServer i5 lines. For these machines, about two-thirds of the boxes that IBM sells are financed in some fashion through IBM Global Financing. (This does not include the short-term financing that IBM gives to business partners and resellers, which in turn sell the equipment to customers.) In the xSeries line, about 40 percent of the big deals have some kind of leasing. But among smaller businesses, leasing only happens with 10 to 15 percent of the deals, because these companies tend to have weaker financials or are simply not sophisticated enough to realize that leasing is an option.

Fernandez says that IT leasing hasn’t changed much in the past 15 years, but that the one big change is that most leases now have IT technology upgrade provisions. This used to not be the case, and when companies did not do their capacity planning correctly, or had a business that was growing faster than expected, they often had to renegotiate a lease mid-term in order to get new iron. This is one of the worst positions a lessee can be in, and the lessor has the customer over a barrel. After much pressure from customers, and competition among leasing companies, these upgrade provisions have become the norm.

Fernandez says that companies that understand IT trends tend to use their cash to fuel their businesses and use leasing as a way to mitigate the risks of investing in IT equipment. He said that 36 months is the sweet spot for servers and storage, since that term roughly matches the economic and technical life of such equipment. Laptops tend to have shorter leases, since they have shorter lives, and point-of-sale equipment tends to have 60-month leases, because it tends to stay put for five years. Fernandez says that many companies that IBM deals with prefer operating leases to capital leases (because they keep the investment off their books and treat IT like an expense), but he is quick to add that IBM Global Financing does not give accounting advice to customers when it comes to picking a lease type or how they manage it in their books.

One of the reasons why Hewlett-Packard bought Compaq was to bolster its services business, including captive financing. According to Irv Rothman, CEO and president of HP Financial Services, that unit has $9 billion in assets under lease and about 100,000 customers. He says that, before the merger, about 60 percent of the assets were under HP financing and about 40 percent came from Compaq, but it stands to reason that Compaq supplied the bigger customer base of customers who were under financing. Rothman says that HP Financial Services does about $4 billion a year in new equipment financing and that the unit generates approximately $2 billion in revenues for HP and, in fiscal 2003, brought about $79 million to the company’s bottom line.

An interesting aside. In Europe, HP owns its own bank, the HP International Bank of Ireland, which allows it a very low tax rate because European countries like banks, which in turn means that HP can offer very aggressive financing to European companies. About 40 percent of HP’s leasing and financing assets are in North America, another 40 percent is in Europe, with the remainder in Asia/Pacific and Latin America.

HP does not offer dealer and reseller financing, and does not offer financing for PCs, laptops, and other consumer products. Rothman says that only about 12 percent of small and midsized businesses in the HP base use financing, and if he had his way it would be at least twice that. But the bulk of the financing that HP does is for midrange and enterprise servers and related peripherals, like storage and networking gear. HP customers use a mix of operating and capital leases, and he says that, generally, the more “soft costs” there are in a deal (meaning training, shipping, software, and services, in contrast to hard costs, like the actual hardware), the harder it is to get an operating lease from HP.

HP Financial Services, like the captive financing arm of IBM, does a healthy business in trading second-hand equipment that bears its label. Rothman says that HP acquires about 1.5 million units of IT equipment a year (including some of gear of its competitors), and that anywhere from 30 to 40 percent of HP Financial Services profitability is driven from reselling this second-hand equipment. This seems to imply that HP, just like IBM, essentially sets the price of used HP equipment.

Paul Perricone, director of Sun Microsystems Finance in the United States, says that more than 70 percent of Sun’s accounts in the United States use leasing and financing for at least some of the deals they do with Sun. On a worldwide basis, leasing and financing penetration varies by country, ranging from 10 to 20 percent of the deals that Sun does in some countries to 30 to 40 percent of deals in other countries. (Captive leasing companies are experts at being vague, and are also sensitive to selective disclosure issues.) As is the case at IBM and HP, customers doing big deals tend to lease more, and there is a higher attach rate of leases on servers and storage, particularly midrange and enterprise boxes, than on the other gear that Sun sells.

Perricone says that Sun Microsystems Finance has about $1.5 billion in lease assets right now, which is a considerably smaller asset base than either IBM or HP have. Among Sun customers, operating leases are the preferred leasing instrument, although some customers still use capital leases. He says that a 36 month term is the typical term of a lease among Sun’s customers for the same reasons that IBM and HP push that term: it roughly matches the technical life and economic life of IT equipment. As a vendor facing a product transition often does, Sun has been offering customers who knew its UltraSparc-IV servers were coming to market special financing terms (below-market lease rates, two free payments, and even more complex deals) with upgrade options if they buy UltraSparc-III servers today.

When the people at Dell caught wind of last week’s story (yes, Dell executives read The Four Hundred, maybe to get good ideas), they immediately got a representative from Dell Financial Services on the horn to talk about the financial services that the company offers to its consumer and commercial customers. Dell’s financing arm is a joint venture with financial services giant CIT Group, which has $50 billion in assets. Dell and CIT Group established Dell Financial Services in 1997, and since that time the two have financed and leased over $18 billion in IT equipment. In 2003, Dell Financial Services had total leasing and financing originations of $4.7 billion and managed $4.5 billion in assets. Dell does not break out consumer and commercial financing as separate items to the public.

Laura Thomas, a spokesperson for Dell Financial Services, says that Dell offers the standard fair market value buyout or $1 buyout leases to companies, which are standards in the IT industry. These leasing options allow companies to switch out their technology after two or three years, if that is how they like to manage their IT shops. Dell also offers a 10 percent buyout lease, and even offers a straight loan option for customers to acquire servers and storage. Starting in July, Thomas says, Dell will begin a pilot program to offer a revolving line of credit for small and midsized businesses. This will function like any other line of credit (such as a home equity line of credit) that many people have. Dell has been offering such lines of credit to consumers for years so they can buy small ticket items like PCs and laptops.

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