Capital Markets

Road to Riches?

Financing customers is a necessary evil for a growing number of companies. But it may do more harm than good.
Nikos ValanceAugust 1, 2000

Helping customers buy products is hardly a new idea. Such Old Economy stalwarts as Caterpillar, John Deere, General Electric, General Motors, and Ford Motor all have credit operations, sometimes separate from the parent company; sometimes they even help customers buy competitors’ products. A few, like GE Capital, venture so far beyond their parent’s manufacturing business that they’re entirely separate entities, and are considerably more profitable.

But customer financing hasn’t been the rule in the New Economy. With demand for high-tech products and services burgeoning and customers flush with cash, there has been little need for most suppliers to help customers pay for their purchases.

No longer. Competition is rising and traditional sources of corporate and consumer debt is drying up — at least in some important markets. So more high-tech companies have embraced the idea of lending to customers.

The trend is most evident in the telecom arena, particularly in Latin America and Asia, where privatization is spurring demand for new infrastructure even as the supply of capital remains weak.

But the trend raises a fundamental question about suppliers’ growth prospects: If they must finance sales, how strong is their underlying business? Four big suppliers that finance customers — Lucent, Motorola, Nortel, and Cisco Systems — declined to be interviewed for this story.

But Steven Levy, a communications- industry analyst with Lehman Bros. in New York, says that in the wireless market, especially the international sector, the big firms are winning market share due primarily to their deep pockets. That, he cautions, will eventually hurt their profit margins.

“The question becomes the sustainability of revenue,” says Levy. “When growth is due to better financing rather than technology, earnings could eventually suffer because they’re not getting a payback from R&D. That’s the real risk involved in vendor financing.”

Shifting the Risk

Meanwhile, however, the big companies’ practices are having a knock-on effect on smaller suppliers. And that is where the trend has significant implications for other CFOs, both within and without the telecom industry.

When the big guys in any market start lending heavily to customers, the smaller guys must follow suit or find other ways to compete. If, indeed, they choose to lend, they expose their own balance sheets to the fortunes of others, and then must decide how to manage the risk.

Much, of course, depends on how aggressive a lender decides to be. Most claim to turn away risky customers or send them back to raise more capital before doing business with them. Even when they do lend, they try to reduce their exposure as quickly as possible, through securitization.

So far, the technique has worked well enough for lenders to avoid grief from the credit-rating agencies. A study conducted by Lehman Bros. last year concluded that Lucent could double the amount of its customer commitments before Standard & Poor’s would lower its credit rating for the company from A to BBB.

However, securitization may not get a lender completely off the hook in the eyes of credit analysts. As of March 31, 1999, for instance, Lucent had a total of $4.4 billion in off-balance-sheet commitments to customers, according to Lehman Bros. But S&P still considers Lucent liable for that amount, because it holds a guarantee on the debt. Meanwhile, investors’ concern over corporate debt levels is growing.

Just how aggressive are the big suppliers? That’s tough to say for sure. Under U.S. generally accepted accounting principles, little data need be disclosed on these financing efforts, and so companies are often parsimonious about them in their financial statements. But wireless equipment suppliers are eager to see new entrants build up their infrastructure as well as help already-established service providers expand their existing networks. So they have been offering vendor financing for several years.

According to Lehman Bros., Lucent’s total on-balance-sheet customer- financing commitment more than doubled during fiscal 1999 (which ended last September 30) and stood at $7.2 billion as of last March 31. That represents roughly 19 percent of its fiscal 1999 sales.

Lucent is far from alone in tying itself more tightly to its customers’ fortunes. In the nine months ended last March 31, Motorola’s balance-sheet commitments to customers rose 34 percent, from $904 million to $1.2 billion. Cisco, which did virtually no customer financing until this year, had lent roughly $340 million as of last May 31.

Nortel alone has significantly reduced its balance-sheet commitments, slashing them from $3.7 billion for the quarter that ended last September 30 to about $2.9 billion for the period ended last March 31. But again, these figures show only how much of their commitment to customers the companies have not yet managed to lay off on others; total amounts may indeed still be climbing.

Other Companies’ Products

So far in the telecom industry, says Lehman Bros., lending to help customers purchase a competitor’s product is not all that common, though that, too, is starting to change. According to Lehman Bros., Lucent has committed to finance $2 billion to WinStar (the most to any one customer as of May 1999), and the telecom service provider is using at least part of that to buy other companies’ equipment.

The idea is that financing purchases of competitors’ products will increase total demand so much that sales of one’s own will ultimately benefit. And the bigger lenders are often willing to lend as much as 200 percent of the cost.

Such deep pockets cannot help but put pressure on smaller equipment manufacturers. Tellabs Inc., of Lisle, Illinois, a communications-infrastructure builder, for example, began financing customers in late 1997, though CFO Joan Ryan insists that wasn’t necessary to keep up with the Joneses. “We’ve never felt hindered by size,” says Ryan. “Our technological superiority and our customer relations are what make us strong. We have never felt we’ve lost a customer due to financing.”

But with more than $1 billion in cash on its balance sheet, Tellabs is prepared to compete head-to-head with the market giants, asserts the CFO. “The only difference between what we offer and what the large players offer is that they will provide greater than 100 percent financing for a given transaction,” she says.

Granted, some smaller firms feel no need to finance sales to much, if any, degree. “We don’t need to offer vendor financing to meet the needs of the majority of our customers,” says Keith Pratt, CFO of Advanced Fibre Communications Inc., a telecommunications-systems maker in Petaluma, California. “We’re competing on the basis of a better product and a nimble and responsive organization that can meet the needs of our customers.”

Pratt clearly worries about the risk involved in the vendor financing business. “If a big company with an aggressive stand on financing takes a position that turns sour, it’s less visible on the bottom line. As a small equipment provider, we take a more conservative view. We want to avoid that.”

So much so that the company might turn away a potential customer that needs financing. “We generally tread pretty carefully,” says Pratt. “If a start-up’s only source of capital is vendor financing, then its business plan is not as robust as it should be. It’s most likely that we’d stay away.”

Yet even Advanced Fibre will help secure financing. “We’ll work with less-experienced smaller customers and help make their case to a third-party supplier of capital,” says the CFO. “But it’s not a core piece of our business.”

Peer Pressure

But Advanced Fibre may belong to a distinct minority. Linthicum, Maryland-based Ciena Corp., another smaller telecom-equipment manufacturer, is currently considering its first vendor-financing agreements. “We think it’s important,” says CFO Joe Chinnici. “With certain accounts we do need to look at vendor financing as part of a strategy to compete. But we’re not as big as Nortel or Lucent. We can’t go head-to-head with them.”

Instead, says Chinnici, Ciena focuses on “other differentiators,” including what he contends is a distinct product and technology combined with effective services and support. But, he says, “vendor financing is important, especially in certain markets.” Latin America is one, and it’s an area where Ciena plans to do more business. “It’s more the norm there, so we’ll have to look at it and probably have to do it,” he says.

Lehman’s Levy, for one, doubts that wireless vendors can continue to maintain much of a hands-off approach. “It’s an escalating issue,” he says. And he is especially concerned when vendors act as lenders of last resort. “The odds of them doing a better job than financial-service providers are low.”

Some analysts are more sanguine about the trend. “The vendors understand the market, and they understand their borrowers’ business needs and their business models better than banks do,” says Christin Armacost of S.G. Cowen Securities Corp. in Boston. And she notes that most of the companies don’t have large write-offs when it comes to vendor financing. “So,” she says, “it must be mostly successful.”

But Levy fears that failures may lie just ahead. “If they’re not winning based on the merits but based on the balance sheet,” he says, “at some point they’re going to run out of money to use to finance, and growth will slow down.”

And that, of course, assumes the economic expansion will continue indefinitely. If it heads south instead, customer defaults may have an even bigger impact.