Global Headquarters: 5 Speen Street Framingham, MA 01701 USA P.508.872.8200 F.508.935.4015 www.idc.com WHITE PAPER Lease Versus Purchase: More Than a Numbers Decision Sponsored by: IBM Global Financing William Roch June 2007 IDC OPINION With relatively low interest rates and worldwide liquidity at historically high levels, is leasing still a viable alternative to the outright purchase of information technology (IT) assets? IDC continues to believe that in many situations, technology leasing offers greater operational, strategic, and financial benefits than outright ownership. Most important, leasing provides a significant hedge against technological obsolescence and can assist in the disposal of equipment in an environmentally safe and secure manner. Leasing makes it possible for organizations to acquire up-to-date equipment while preserving cash and credit lines for more strategic business uses such as facilities expansion, increased research and development, sales force expansion, or receivables financing. SITUATION OVERVIEW Today's global economy offers new opportunities and challenges to businesses on all continents. Competitors frequently have widely diverging economics relative to wages, taxes, and utility and environmental compliance costs. New technology solutions can provide the competitive edge necessary for continued expansion and profitability, but only if organizations can implement them in a timely manner, often under significant budget constraints. IT may be seen as a financial burden because new technology solutions are typically expensive and may compete for the same capital as a manufacturing or distribution expansion. Conversely, insufficient capacity or inefficient computing resources can stunt growth or hinder profitability just as quickly as an inefficient manufacturing facility. Frequently, the company that waits until it can afford to purchase the right technology solution may find itself at a competitive disadvantage. Leasing can provide an answer to this dilemma. From the inception of technology leasing in the 1960s to today, leasing continues to help organizations of all sizes. Technology providers such as IBM recognize the importance of offering financing alternatives to their customers through IBM Global Financing (IGF). Today, IGF provides a wide variety of financial programs and services for both IBM and non-ibm technology assets on a worldwide basis. IGF offerings cover all aspects of technology financing and asset management services, such as short-term and long-term leases for large servers and peripherals, inventory financing for IBM Business Partners, and complete project financing for major technology implementations on a global basis.
With technology leasing approaching its 50th anniversary, there are obviously many satisfied users. Prior to examining the attributes that make leasing attractive to so many organizations, we offer a review of the generic types of lessors and the most common types of leasing arrangements. Lessor types. Three general types of lessors are involved in the financing of IT assets: captive, independent, and bank.! The captive lessor is a subsidiary of a manufacturer, and its primary purpose is the financing of its parent's products. The captive is typically heavily involved in product transitions, upgrades, remarketing, and disposal of older technology.! The independent lessor is not associated with a specific vendor; it finances equipment based solely on its merits and the financial strength of the lessee. This lessor may be small or large, regional or global, and privately held or publicly traded.! Bank leasing organizations cover a broad spectrum of the market, from a regional scope to a national scope. They provide an alternate funding source for a bank's clients, or they may target at specific markets or assets. Lease types. Many variations of lease financing are available. However, they are based on two general types of financing structures: the full payout (FPO) lease and the fair market value (FMV) lease. The choice of which type to use for a given portion of an acquisition is typically based upon the user's long-term plans for the asset involved.! An FPO lease is one in which the present value of the payment stream equals the acquisition cost of the asset. Options at the end of the lease typically include return, renewal, or purchase often for $1. The lessee is able to deploy and utilize the equipment, while the periodic payments ease the financial burden of making a large IT acquisition.! An FMV lease derives it name from the options available to the lessee at the end of the lease should he or she wish to retain the equipment. In addition to termination, the lessee has the option to either renew or purchase the assets at the FMV of the equipment; this value is often determined by an independent party. Additionally, various accounting guidelines may be applied to these transactions, which vary widely by geography.! Although not truly a separate lease type, the sale/leaseback financing option provides an opportunity for the end user to generate cash and at the same time retain the right to continue using the equipment. This lease is typically combined with either a current or a planned technology refresh, using installed assets, in effect, to finance a portion of that refresh. The sale/leaseback also can provide a vehicle to allow for the orderly disposal of equipment scheduled to be replaced at a defined time in the future. Sale/leaseback financing option provides an opportunity for the end user to generate cash and at the same time retain the right to continue using the equipment. It is often to the lessee's benefit to include all of the preceding options in a major technology deployment, utilizing a structure that is most advantageous from operational, accounting, and cash flow perspectives. Given this background, what factors should a technology buyer consider when determining the correct financing method(s) for new technology deployments? 2 #207113 2007 IDC
WHY LEASE? Historically, organizations of all sizes have looked at technology leasing as a way to conserve capital. Technology solutions are often expensive and typically compete for capital funding with physical plant improvements, new facilities, or market expansion opportunities. Due to its inherent flexibility, leasing offers innovative ways to acquire IT equipment that can reduce much of the risk and uncertainty in purchasing new technology and increase the leverage of the operating budget. However, IDC believes that the real benefit of leasing is in the opportunity it affords organizations to remain current with the latest technology available while having the ability to rapidly adapt to changing global requirements. Additionally, a lease can provide the opportunity to maximize cash flow and in some cases provide financing that might otherwise not be available. IDC believes that the real benefit of leasing is in the opportunity it affords organizations to remain current with the latest technology. Leasing especially the FMV lease has some unique benefits to the end user beyond spreading out hardware payments over a period of years. Potential benefits include the following: Technological currency. Organizations that lease often refer to the fact that they are able (or forced) to review their technology capabilities on a scheduled rather than reactive basis. In our global economy, most companies find themselves competing with emerging markets utilizing the latest technology. The newest, most operationally efficient solution is often a competitive requirement not a luxury. Refreshing solutions at lease terminations can address this requirement. Operational flexibility. Lease terms can vary from a few months to four or more years, depending on the asset class involved. New technology assets are typically depreciated over three to five years, while the actual projected useful life of the assets may be shorter. With two- to three-year technology cycles, leasing enables the user to take advantage of the continually improving price/performance curve rather than be locked into equipment that might become obsolete before it is fully depreciated. Conservation of capital. One of the obvious benefits of leasing is that it allows a company to conserve capital for investment in its business rather than in the infrastructure required to run it. Other methods of financing may require up-front commitment fees, down payments, or progress payments. Many organizations are subject to regulatory requirements regarding their financial liquidity as a percentage of their asset base. In these cases, leasing allows a company's assets to be invested in fluid financial instruments rather than in hard assets. 2007 IDC #207113 3
Operating expense versus capital expense. Dependent on local accounting and tax standards, the majority of FMV technology leases are written in such a way as to qualify as operating leases, making the payments operating rather than capital expenditures. Further, as the leased equipment is not included as an asset, a lease may have little or no impact on a company's ability to borrow and could improve key financial measurements such as a company's return on assets or debt-to-equity ratio. Payment flexibility. All leases provide payment flexibility tailored to the user's specific cash flow or budgetary requirements. Some lessors also can provide payment and term flexibility tailored to match either project or revenue-generation milestones. Further flexibility may be obtained by utilizing stepped or variable payments that match expected revenue or seasonal patterns. A payment deferral option provides the opportunity to delay payments for equipment until it can be put into a revenue-generating position. Upgrade flexibility. Leasing can provide additional flexibility when normal growth or new demands require the user to consider upgrading an asset. Where additional capacity or performance can be added directly to the original equipment, a lease can frequently be tailored to provide a predetermined periodic cost for the upgrade, based on the remaining finance term at the time of the upgrade. Upgrade provisions can be negotiated that define upgrade costs in terms of cost per unit of capacity and performance. Changing requirements. When circumstances change and the lessee finds it advantageous to keep equipment longer than originally anticipated either from a requirements or an operational perspective the lessee has the option to renew (often at a reduced rental rate) or purchase the equipment at the end of the lease at market prices. Conversely, lessors are always willing to entertain midterm upgrades or replacements, if business volumes justify this action. Residual value risk. Leasing transfers the risk of obsolescence to the lessor while allowing the lessee to benefit from the use of the technology at a predefined cost. With a wide variety of vendors, configurations, and lease expirations, a typical lessor's technology risk is spread across a broad spectrum of clients. When this portfolio diversity is combined with an efficient remarketing operation, the lessee further benefits initially with a lower lease rate and later with an efficient source of additional capacity. Disposal risk. The disposal of equipment in an environmentally friendly and secure manner is increasingly an issue on a worldwide basis. Forecasts for PC retirements alone over the next four years are over 800 million units. In most cases, lessors can provide an option to assure the lessee that ultimate disposal will be handled using procedures that comply with all local laws. Additionally, the cost of secure data erasure/destruction can be contracted for at lease inception rather than being an afterthought at lease termination. The disposal of equipment in an environmentally friendly and secure manner is increasingly an issue on a worldwide basis. Forecasts for PC retirements alone over the next four years are over 800 million units. 4 #207113 2007 IDC
WHY PURCHASE? Having looked at the operational and financial advantages of leasing, we consider the set of circumstances under which a purchase would be the best business decision. Organizations that historically purchase IT assets cite a number of reasons that typically focus on the following areas: 1) the projected productive or useful life of the asset is longer than that of economically viable leases, 2) purchasing is simpler, and 3) previous leasing experiences have ended badly. Each of these reasons may be valid for specific situations or asset classes; however, looking at each shows that they should be reconsidered in today's global economy. Useful life considerations. Purchase may be the correct decision for situations in which users determine that the useful life of an asset in their environment is longer than that of an alternate lease scenario. An example would be the installation of a new system for a specific project. The technology may be robust enough that a fiveto seven-year operational life can be reasonably projected. Additionally, some assets offer the potential for significant upgrades in performance or capacity in excess of projected business needs. In these cases, a purchase may be the correct economic and operational decision. However, in all the preceding scenarios, a well-positioned captive lessor may be able to offer an equally attractive FMV lease as an alternative to a purchase. Previous experience may influence the estimated life span of equipment. An example would be the replacement of fully depreciated equipment that has been used longer than originally anticipated. Although fully depreciated equipment is often considered to be free, it usually is not. High maintenance costs, operational issues, and facility costs (space, cooling, power) can actually be more expensive than new, more efficient replacement equipment that utilizes lease financing. Outright purchase is easier. Assuming a capital budget exists for the acquisition, a purchase, on the surface, may be a simpler transaction. Leasing may require the additional step of choosing a financing source as well as a vendor. In cases in which an approved capital budget is not available, a lease with a fixed-priced purchase option might allow an immediate acquisition, along with its benefits, rather than deferral of both to a later date. Previous leasing experience. An issue for many organizations may be a past lease relationship that ended badly. There have been numerous situations involving the bankruptcy or change of ownership of a lessor, which caused a strain between the lessee and the new portfolio owner. End-of-lease issues is the most frequently cited reason that leasing is not considered. History can't be changed; however, these issues can and should be addressed during the current contract negotiations. Although a purchase may be the right decision initially, purchased assets may ultimately have an adverse effect on a company's ability to adopt new technology. Replacing a fully depreciated asset may be difficult to justify especially if accurate maintenance, support, and utility costs are not considered In contrast, leasing can provide multiple opportunities to take advantage of applicable new technology rather than be held hostage to a depreciation schedule or the approval of a capital budget. Although a purchase may be the right decision initially, purchased assets may ultimately have an adverse effect on a company's ability to adopt new technology. 2007 IDC #207113 5
WHAT TO LOOK FOR IN A LEASE PARTNER Choosing the right lessor is one of the most critical steps in maximizing the benefits of any leasing arrangement. The typical "lowest rate" criterion often provides suboptimal or even unsatisfactory results. The following criteria are suggested as universally applicable: Financial strength. Financial strength is important both in providing initial marketrate financing and serving as insurance should unanticipated requirements arise during the lease term. Today's global economy requires significantly more flexibility to address corporate acquisitions, increased transaction volume, or significant operational consolidations. Technology expertise. Today's complex business environments require more sophisticated solutions for organizations of all sizes. Most solutions require high degrees of vendor cooperation over a long time frame. The lessor should be prepared to finance all aspects of these solutions including hardware, software, implementation, and infrastructure regardless of vendor, geography, or term requirements. In the hardware area, strong reconfiguration and remarketing capabilities not only can lower the initial lease rate but also may provide a source of economical upgrades and capacity expansions in the future. The lessor should be prepared to finance all aspects of these solutions including hardware, software, implementation, and infrastructure. Terms and conditions. All leases contain common language regarding obligations, default, representations, and warranties. Flexibility must be provided in areas such as notice period, renewal terms, upgrade options, and return provisions. In some cases, the right of limited substitution may be negotiated, while in other cases, advantageous upgrade provisions may be more important. Administration. The ability to administer multiple lease schedules easily, ideally through a Web interface, is increasingly important as the volume of equipment and the number of locations multiply. Detailed information by schedule, lease start and end dates, notice periods, and locations are invaluable in managing a leased infrastructure. Disposal capability. Clear options for the disposal of equipment, in an environmentally safe manner, should be presented by the lessor. Additionally, options that provide secure data erasure or destruction should be contracted for at lease inception rather than considered when equipment is being returned. The preceding points represent the major areas that must be considered prior to entering into a business relationship with any new financing source or when considering leasing for a new technology not previously deployed. 6 #207113 2007 IDC
IGF AS A LEASE PARTNER When the financial, operational, and technology issues surrounding the financing of technology assets all point to a lease, why should IGF be selected as the lessor? Financial strength. As one of the largest financing organizations in the world, IGF has the capability to provide competitive rates either in an international currency such as the dollar or euro or in local currencies if required. With an investment-grade credit rating, IGF obtains funds below market rates, which results in lower lease rates for the user. Worldwide scope. IGF offers direct leasing services in over 42 countries around the world and several financing products for multinational customers. Some of these services include:! An International Lease and Finance Agreement (ILFA) is available for larger customers that require a single set of terms and conditions. (These would cover the basic conditions that are found in the Term Lease Master Agreement or TLMA.) IGF offers direct leasing services in over 42 countries around the world and several financing products for multinational customers.! Asset management solutions are available in Europe, Asia/Pacific, and North America that enable customers to centrally manage their global leasing portfolios on a country, regional, or global basis. Additionally, IGF financial sales executives, who cover multinational corporations' headquarters, act as the coordination point for multinationals with centralized operations. Contract flexibility. IGF offers a variety of lease structures and payment terms that can be tailored to any situation. Payments may be structured on a monthly or quarterly basis, and they can be either level or stepped in a manner to match anticipated revenues. Each line item on a lease schedule can be handled separately at the end of the lease renewed, purchased, or returned eliminating the inflexibility of the all-or-nothing approach. In addition to FMV leases, IGF offers $1 buyout options as well as special financing for IBM's On Demand offerings. Finally, IGF's standard master agreement includes casualty insurance in the lease payment, eliminating an additional complexity for the lessee. Administrative capability. IGF offers lessees the opportunity to manage their portfolios online using the IGF Customer Centre lease management tool. This On Demand business tool supports clients managing their leased asset portfolio from origination to end of lease. It is available in select regions, with 24 x 7 access using common Web browser software. The Customer Centre provides access to a database of leased assets and includes a complete repository of information for each schedule under lease. In some instances, equipment schedules can be originated, installation acceptances are generated, and end-of-lease options are finalized online. 2007 IDC #207113 7
Special programs. IGF provides a wide variety of options across a broad range of hardware, software, and services offerings. Predetermined upgrade/expansion costs, short-term capacity increases, midlease flexibility, and special low-rate financing offers are just a few of the options. Recent offerings have included deferred payment options and zero-percent financing. Specialized desktop offerings are also available that provide per-seat pricing and can include a wide variety of specialized support and asset disposition services. Portfolio expertise. With an extensive portfolio of IBM and other vendors' equipment, IGF has unique remarketing capabilities that maximize the value of returned equipment benefiting the lessee through lower lease rates. These capabilities include the ability to offer refurbished equipment to users and IBM Business Partners desiring a more cost-efficient solution. IGF can also offer hybrid systems (a mix of new upgrades on remarketed basis), field upgrades, and spare parts with equal proficiency. Asset recovery. Through its Global Asset Recovery Services (GARS), IGF offers the lessee the option to transfer the burden of complying with environmental and regulatory issues surrounding the disposal of obsolete computer equipment. Available in select geographies, GARS manages a world-class reverse logistics operation that optimizes the resale, dismantling, and reduction of IT equipment to its basic commodities for recycling. Anything of value, from components such as disk drives to resources such as precious metals, is removed to be sold. The remainder is disposed of in compliance with state, local, and regional environmental guidelines, such as those of the Environmental Protection Agency (EPA) in the United States or the European Community WEEE Directive. Through its Global Asset Recovery Services (GARS), IGF offers the lessee the option to transfer the burden of complying with environmental and regulatory issues surrounding the disposal of obsolete computer equipment. CHALLENGES Although the potential benefits of leasing are many conservation of capital, payment and term flexibility, and the flexibility to obtain the benefits of new technology on a regular basis there are issues that could negate some or all of the benefits. IDC feels special attention should be given to the following: Unanticipated end-of-lease costs are caused by missing a termination notice, lost or damaged (incomplete) assets, and so forth. In some cases, these costs are incurred because the lessee misses the notice period (often six months prior to the termination date) or because the lessee is required to renew unwanted items because of their placement on a particular lease schedule. IDC believes that many of the issues outlined earlier can be mitigated or eliminated by a more in-depth analysis of a lessor's administrative capabilities. The lessee's ability to monitor and manage its lease portfolio with lessor-provided tools such as Customer Centre should be a prerequisite to entering into a new relationship. Where possible, provisions should be included to address the lessee's operational inability to return an asset. 8 #207113 2007 IDC
Poorly negotiated terms and conditions may result in unacceptable operational or financial consequences, either during the lease or when an unanticipated change is required. Some potential problem areas include the financial consequences of an early termination, change of lessor management control, or higher-than-projected upgrade costs. These issues are often intentionally left vague by both parties, with disappointing financial results. As a lessor, IGF has worked to mitigate these risks by providing the following in the normal course of business:! Line-item termination, renewal, or purchase options at the end of the lease, combined with a 30-day notification period! Assured upgrade pricing and availability! A 14-day grace period at lease end, providing the lessee with additional operational flexibility in managing an asset's return As with any major business decision, a thorough understanding of the risks and their potential costs is most valuable when undertaken during the negotiation phase of an acquisition rather than in crisis mode. CONCLUSION Nonfinancial issues such as mitigation of technological obsolescence and disposal of assets in an environmentally friendly manner must be considered at the same time as the more traditional lease versus buy financial calculation is made. Leasing provides additional operational flexibility and an easier migration path to new technologies and can eliminate asset disposition issues while freeing up capital for other critical business investments. Leasing all or portions of a complex deployment can be the solution when there is a business need for rapid technological change to grow, remain competitive, or restructure. Organizations of all sizes can benefit from leasing because it makes new technology more affordable on a limited monthly budget. Fast-growing companies that do not have extensive credit histories may be able to acquire equipment quickly by utilizing a lease. With the continued emphasis on operational efficiency and improved productivity, leasing offers companies of all sizes a solution for acquiring new technology at minimum operating costs. Although not the ideal solution for every acquisition, leasing should be considered during any major application implementation review, operational review, or new technology assessment. Copyright Notice External Publication of IDC Information and Data Any IDC information that is to be used in advertising, press releases, or promotional materials requires prior written approval from the appropriate IDC Vice President or Country Manager. A draft of the proposed document should accompany any such request. IDC reserves the right to deny approval of external usage for any reason. Copyright 2007 IDC. Reproduction without written permission is completely forbidden. 2007 IDC #207113 9