VideoIt'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 $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 of the other suppliers struggle to retain their footing.
We, along with others, predicted as much more than two years ago. But with trouble now spreading throughout the economy, the nasty hangover of customer financing is by no means limited to victims of the Internet bubble's deflation. Boeing Capital Corp., 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 Motor Co. 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 Co., 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 "Whither GE?" later in this article.")
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 that for Dell Computer Corp. and Microsoft Corp. 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 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 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, "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 U.S. 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, "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 $43 billion at last count? (Its plans to start paying dividends will hardly put a dent in that hoard.) Cisco comes reasonably close, with $21 billion, so a bad $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 Goldman, Sachs & Co. "This is a moment when the exception is more than an academic footnote."
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