If a car owner doesn't pay back his car loan, the repo man usually arrives in the dark of night to take back the automobile. If a homeowner defaults on his mortgage, the bank forecloses on and seizes the house. The car and the house serve as the collateral for the financing organization-they can be cleaned up or cleaned out, as it were, and resold. But what if a company defaults on a loan for a multimillion-dollar SAP ERP software purchase? Or can't repay IBM Global Financing for the hardware, software and services that it bought two quarters ago?
Does a Repo Man sneak into the data center and take back the servers and installation CDs?
As it turns out, hardware is just like a four-bedroom house in Houston or 2008 Toyota Camry: It can be "repo'ed," refurbished and resold by the vendor or, perhaps, put out on eBay. "We can take back equipment," says Fred Clarke, a spokesman for IBM Global Financing. "We can refurbish and resell them on IBM.com or through a broker network, and really recapture the residual value on that equipment."
Software, though, is not as tangible as a mainframe: Software cannot be resold and has no collateral value. "Software is pretty much a loan," says Clarke. "There's nothing you can do with software once you've taken possession of it."
Tech vendors offering their own financing, such as IBM, Oracle and Cisco, and those that rely on financing partners, such as Microsoft, could soon start to see red numbers associated with their customer financing deals. That's because defaults on technology loans, which allow customers to purchase computers, software and other tech gear, have spiked this year, The Wall Street Journal recently reported. One financing company told the Journal that businesses are now defaulting on loans for tech purchases "all the time."
Nearly half of businesses' capital spending is on IT products, and companies and governments annually spend almost US$1.8 trillion on technology, according to a recent New York Times article.
Therefore, a sharp increase in IT-related defaults, combined with even deeper cuts in businesses' IT spending, could have disastrous economic consequences.
For the software vendors, in particular, the "repo" recourse is of negligible value. "If a customer defaults, Microsoft Financing and its finance partners may take the appropriate legal action, on a case-by-case basis," writes Laurinda Hoffman, who works for Microsoft's public relations firm, via e-mail. (Microsoft Financing is not a financial services company; the software giant uses third-party underwriters to determine customers' credit-worthiness and to facilitate loans.)
So while Microsoft and its financing partners, such as CIT, have few options to recoup a loss, their defaulting customer is left with the Microsoft software. "A default may result in the customer holding an invalid license for Microsoft products," Hoffman writes. In other words, while the relationship with Microsoft will surely sour, the customer still has the usable software.
"Would You Like a Low-Interest Loan with that ERP Software?"
Many tech vendors are sitting on stockpiles of cash amid this historic economic downturn-Cisco, for example, has nearly $27 billion. Some vendors that offer financing deals have recently stepped up their sales pitches, with a level of aggressiveness usually reserved for car dealerships and home-appliance retailers' advertisements.
In September and October, IBM announced a series of low- or below-rate technology loans, some that included no payment or interest due for 90 days. Oracle offered a "Time Is Money" promotion in November, with "no upfront capital expenditure" and "no payments or interest for 90 days."
Not to be outdone, Microsoft announced in mid-November a "0% financing offer for 36 months for new, qualifying customers of Microsoft Dynamics ERP and CRM solutions." (For more on ERP and CRM software, see the Enterprise Software Unplugged blog.)
"We are working closely with our customers and partners to proactively enable them to preserve their capital resources to ride out the current economic situation," said Kirill Tatarinov, corporate VP of Microsoft Business Solutions, in announcing the new financing options," while making an important strategic investment in their future."
IBM's Power to Lend Billions
IBM's Global Financing is the largest IT lender in the world, with 125,000 customers and roughly $34 billion in assets. According to Clarke, the division delivers between 9 percent to 13 percent of IBM's overall profitability. The division was "created to push IBM hardware," he adds, "the mainframes, the big servers that cost a lot of money." Global Financing also resells off-lease or retired equipment, as well as any gear that is repossessed because a customer defaults and "where we can't work out a deal," Clarke says. In either case, IBM employees or third-party partners physically take back the equipment, load it on trucks and bring it to one of IBM's 22 refurbishment centers located around the world. "That, by itself, gives us the ability to offset our credit risk in the event that a customer defaults on hardware," Clarke says.
As to the IBM software that typically is bundled in an IBM "solutions" deal, Clarke admits that "it's a bit riskier" than the hardware loans, but "we adjust for that risk based on the interest rates we charge."
Clarke stresses that IBM has "a very, very conservative approach to lending. We don't allow ourselves to lend to anyone and everyone," he says. "And that's why we've been untouched by all the different ups and downs" over the years.
The Microsoft Financing business accounts for less than 1 percent of Microsoft's total company revenue, according to the company. (Microsoft wouldn't comment on its financing partners' default rates. Oracle Financing public relations declined to be interviewed for this story.)
IBM Global Financing's default rate, according to its most recent third-quarter earnings report, increased from 1.1 percent to 1.3 percent. In Q3 earnings remarks, IBM CFO Mark Loughridge said that we "we closely monitor the credit of our clients-and adjust as needed. It's important to remember that the majority of the assets we're talking about are in support of critical IT operations and have substantial value."
Forrester Research principal analyst Ray Wang says that defaults on technology loans historically haven't been too big a problem for vendors that offer financing options. IBM's Clarke says that "this is not an everyday occurrence for IBM."
But with software, especially, it can be tricky business. "That's been the toughest part of software financing: there's nothing to put as collateral. What's the collateralization mechanism?" Wang says. "And this is why traditional software financing is a specialized field."
Even with economic uncertainties and credit turmoil still unfolding, IBM's Clarke says the financing division has seen a noticeable uptick in customer inquiries about financing options. "We are being more prudent in how we're lending, and we are definitely looking at credit quality of the customer set, which is something that we've always done," Clarke says. "But we have money to lend."