Archive: March, 2006

The Perils of Customer Financing, A Xerox Case Study

This is the first in a series of case studies that will be used to highlight accounting issues of importance to investors.

Xerox recently raised $700 million in senior debt, more than it had originally planned. Recently Xerox debt has primarily corresponded with its finance unit. The troubles at GM indicate potential risks to this strategy. As noted at the Analyst’s Accounting Observer:

It sounds like GM is now taking action to clean up the portfolio values – probably a necessary step provoked by its efforts to shop around GMAC. Once you see this, you begin to wonder how much similar dross is floating around in the portfolios of other auto companies and other firms with captive financing subs.

So, is there any similar dross floating around in the portfolio at Xerox? On pages 3-4 of the recently filed 10K, the company notes:

Our business model is an annuity model, based on increasing equipment sales and installations in order to increase the number of machines in the field (“MIF”) that will produce pages and generate post sale and financing revenue streams. We sell the majority of our equipment through sales-type leases that are recorded as equipment sale revenue. Equipment sales represented 29% of our 2005 total revenue. Post sale and financing revenue includes equipment maintenance and consumable supplies, among other elements. We expect this large, recurring revenue stream to approximate three times the equipment sale revenue over the life of a lease.

So, the company sells most of its products on a lease basis that allows them to recognize the sale up front even though the proceeds will be collected over time. This can be as innocuous as a consumer taking out a loan to buy a car. However, investors always need to be careful (see the GM example) when a company offers the financing itself as opposed to having a third party finance the sale. There is likely to be more pressure to offer financing to shakier customers in order to make a sale, as well as an opportunity to bury incentives in the financing as opposed to recognizing them as price reductions on the income statement, which would lower the top-line sales figure. So while the fact that a company offers financing for its customers is not always bad, it is a signal for investors to dig deeper into the numbers. On page 7 of the 10k, we get further information:

We are required for accounting purposes to analyze these arrangements to determine whether the equipment component meets certain accounting requirements such that the equipment should be recorded as a sale at lease inception (i.e. sales-type lease). Sales-type leases require allocation of a portion of the monthly payment attributable to the fair value of the equipment which we report as “Equipment sales.” The remaining portion of the monthly payment is allocated to the various remaining elements based on fair value—service, maintenance, supplies and financing—which are generally recognized over the term of the lease agreement and reported as “Post sale and other revenue” and “Finance income” revenue. In those arrangements that do not qualify as sales-type leases, which has been starting to occur more frequently as a result of our services led strategy, the entire monthly payment will be recognized over the term of the lease agreement (i.e. rental or operating lease) and is reported in “Post sale and other revenue.” Our accounting policies related to revenue recognition for leases and bundled arrangements, are included in Note 1 to the Consolidated Financial Statements in our 2005 Annual Report.

So it is only the revenue reported as “equipment sales” that is recognized up front. Any supplies and services revenue are recognized over the course of the lease. In the case of leases deemed rentals, the equipment portion is also recognized over the terms of the lease. Xerox tells us that most of its revenue is from sales type leases, but rentals are becoming more common. All in all, the higher the equipment sales, the higher the future post-sale revenue should be. However, that is not what is happening. While equipment sales increased 5% in 2004 and 1% in 2005, post-sale revenue declined by 1% and was flat for those respective periods. Management could be making incorrect assumptions about the allocation of revenue between equipment sales and post-sale revenue, which would have give sales and earnings an artificial boost in the early periods but act as a headwind in future periods. Given that management bonuses (source: Exhibits 10(e)(4) of 10k) were based on sales (30% of bonus in 2005, target not met) and earnings per share (40% of bonus, above target) there is an incentive for management to report higher revenue in the current period.
Equipment vs Post Sale Revenue.gif

Meanwhile, the revenue attributable to finance income declined 6% in both 2004 and 2005. Excluding currency benefits, the decline was 10% in 2004 and 7% in 2005. On page 5 of the Management Discussion and Analysis, the company attributes these declines to lower equipment lease originations and a corresponding decrease in finance receivables. Part of the decline may have been required as a result of the company’s debt rating. On page 12 of the 10k, Xerox notes:

Our current credit ratings result in higher borrowing costs, which in turn may affect our ability to fund our customer financing activities at economically competitive levels.
The long-term viability and profitability of our customer financing activities is dependent, in part, on our ability to borrow and the cost of borrowing in the credit markets. This ability and cost, in turn, is dependent on our credit ratings. Our access to the public debt markets could be limited to the non-investment grade segment, which results in higher borrowing costs, until our credit ratings have been restored to investment grade. We are currently funding our customer financing activity through a combination of capital market offerings, third-party funding arrangements, including General Electric (“GE”), Merrill Lynch, and De Lage Landen Bank, cash generated from operations, cash on hand, other secured and unsecured borrowings. Our ability to continue to offer customer financing and be successful in the placement of equipment with customers is largely dependent on our ability to obtain funding at a reasonable cost. If we are unable to continue to offer customer
financing, it could materially adversely affect our results of operations and financial condition.

It is encouraging that there are third-party lenders willing to accept some of the credit customers. However, they may be able to choose which customers they accept, leaving Xerox with the higher-risk accounts. Further, if placing equipment is so dependent on financing it suggests that some sales may be weak ones. In fact, an alternate explanation for the decline in finance income would be that the company is offering very low cost financing in order to secure sales that can be booked up front (boosting reported financial performance and the associated management bonuses) in that period.
The decline in finance income is even more mysterious when you look at the allowance for losses on finance receivables. Each year the company estimates how much of its future financing receivables will go uncollected as bad debt. This bad debt provision is subtracted from financing income. Since the provision covers multiple years, the bad debt provisions accumulate into a balance called the allowance for doubtful accounts. Whenever a customer fails to pay, the actual bad debt is charged against this provision rather than against income in the period the debt goes unpaid. If actual bad debt exceeds (is less than) the estimated bad debt, the allowance for doubtful accounts will decline (increase). In the case of Xerox, the allowance for doubtful finance receivables declined by $9 million in 2003, $39 million in 2004 and $47 million in 2005, meaning that actual debt losses exceeded management’s estimates by those amounts in those years. Taking 2005 as an example, if the reported loss had been increased by $47 million ($33 million after applying a 30% tax rate) to reflect the actual loss, net income excluding one-time items would have been $875 million rather than $908 million – a decrease of 3.7%. Diluted earnings per share (EPS) from continuing operations would have been $0.87 rather than the $0.90 reported. Given that even the $0.90 was the lowest end of management’s beginning of year guidance of $0.90-$1.00, would management have received the 40% of their 2005 long-term incentive plan bonus had they used an estimate of bad debt that more closely matched the actual loss?
Finally, on page 13, the company offers a further risk statement relating to the overall level of customer financing:

Our substantial debt could adversely affect our financial health and pose challenges for conducting our business.
We have and will continue to have a substantial amount of debt and other obligations, primarily to support our customer financing activities. As of December 31, 2005, we had $7.3 billion of total debt ($3.0 billion of which is secured by finance receivables) and $724 million of liabilities to trusts issuing preferred securities, which includes $98 million recorded as a component of Other current liabilities. The total value of financing activities, shown on the balance sheet as Finance Receivables and On-Lease equipment, was $8.3 billion at December 31, 2005. The total cash, cash equivalents and short-term investments balance was $1.6 billion at December 31, 2005.

At best Xerox is generating the majority of its sales through customer financing, and there is some risk to such sales. At worst, erroneous estimates may be resulting in reported earnings being higher than they should have been in recent periods. Investors should understand the ramifications of Xerox’s lease program (or that of any company they are considering an investment in) before making their decision.

Topics: Forensic Accounting, Investing 101, Stock Market, Technology, Xerox (XRX) | 1 Comment

Bird Flu

MIT’s Technology Review tells us that the H5N1 bird flu strain may be less likely to mutate into a human-transmissible form than previously thought.

There has been a fair amount of hand-wringing over this recently, particularly by bearish economists who worry that a deadly flu outbreak would keep people indoors and thus have a chilling effect on the economy.

But the math just doesn’t suggest it will be that bad. If everyone stayed home for two weeks (4% of the year) and there was simply no economic activity, it would take a year’s worth of normal growth off of GDP. And there is a fair amount of economic activity that would simply be on auto-pilot during that time. Mortgage payments would be made. Many paychecks would continue to be paid. So even the 4% seems a stretch. Add in the fact that in a typical year only 10-20% of people get the flu and we are now talking about a small fraction of a percent if just those people stay home.

For flus that are not treated by the flu shot, such as this strain, one of the best ways to prevent an outbreak is for sick people to stay home. If you are concerned about the bird flu and your boss is the type who insists on sick people coming to work, your best bet may simply be to change jobs. Wouldn’t you rather work with people interested in your well-being anyway?

Topics: Economy, Healthcare | No Comments


The drop in Adobe shares following Wednesday’s earnings announcement was blamed on a number of factors, ranging from earnings to acquisition expenses. We don’t believe a word of it. As we said here, the reason shares are underperforming is because of their product cycle.
Take a look at the chart. The two annotated points are the release dates of the first and second versions of Adobe Creative Suite. The stock rose dramatically leading into the release but faltered afterward, as the 18-24 month product upgrade cycle suggested that following the immediate increase in sales things would slow down. Since Wall Street likes to look ahead about 6 months, the time a new product is released makes for a good time to sell.
Adobe slide.gif

Now, according to our theory, the shares should be rallying ahead of the release of Creative Suite 3. So why do we blame Wednesday’s slump on the product cycle? We chalk it up to conflicts between rumors. Will the CS3 launch occur in late 2006 or  early 2007? The six-month date discrepancy calls for a short term pause before the shares rally again.

Topics: Adobe Systems (ADBE), Software and Programming, Stock Market, Technology | No Comments

Yahoo Upgraded at UBS

Bill Cara has a link to the report.

Yahoo is the most widely used Internet portal and advertising has only recently begun a very long-term shift away from traditional media and toward the Internet, not unlike the 20-year (and still going) shift from broadcast television to cable.

As TechDirt points out, Yahoo can use its brand name and existing services to take share from traditional information providers. Whether it is voice over IM taking share from the telcos or video services taking share from old media, Yahoo is in the cat-bird’s seat in the early stages of each transition due to its large existing base of users.

However, new media is still media, and short term we are concerned about a slowdown in consumer spending. That, in turn, would reduce the amount companies spend on advertising – including online advertising.

Topics: Uncategorized | No Comments

DELL to Offer AMD Chipsets

So the rumors were true, and DELL has bought high-end PC maker Alienware. Most likely, having Alienware as a subsidiary will enable DELL to offer AMD processors under the Alienware brand while remaining faithful to Intel under the DELL logo. Such a move would address one of the concerns investors currently have.

Update: Dell confirmed as much.

Topics: Uncategorized | No Comments

The Yellow Brick Roadway and The Economy

YRC Worldwide (YRCW), formerly known by the fantastic Yellow Roadway merger (between Yellow’s acquisition of Roadway and their later acquisition of US Freightways) is by far the largest less-than-truckload (LTL) transportation provider in the US. On Wednesday they lowered earnings guidance partly due to expense overruns.

However, the real story appears to be that their expenses were in line with their expectations but revenue was not. Per the press release, “In addition to general competitive pressure, some of our large retail customers have made significant inventory adjustments in the quarter, which have impacted our business levels.”

Keep in mind, the original guidance was for $1.00 – $1.05 in EPS, and the new guidance is for $0.65 – $0.70. That is not a little miss. Sounds like one or more fairly large retailers are cutting back orders and working down existing inventory. That, in turn, suggests possible weakness in the consumer sector. And that, combined with this, could mean a significant slowdown in GDP ahead.

Topics: Economy, Stock Market, Transportation | No Comments

The Case for Dell

The Consumer Electronics Stock Blog has a piece on mixed signals coming from DELL. Much of DELL’s recent price weakness (at least so far as the buzz would have one believe) is a result of the dramatic slowdown in its growth rate over the past few years. It is certainly true DELL is no longer a hypergrowth story. Comparisons to Google or even Apple are meaningless.
So the question is not whether DELL is a growth story, but whether it is a GARP or value story. And here investors may be missing the forest for the trees:

  1. Hasn’t a rejuvenated Hewlett Packard taken share over the last year? It has certainly taken share of investor dollars. But market share? Try again. HP’s growth rate has stayed well below 10% and most of its profits are coming from the printer, not the PC division. HP has turned around fairly dramatically, but its best quarter of growth is comparable to DELL’s worst.
  2. Are people moving to Mac? Not yet. Not in the numbers that would impact DELL.
  3. Is the exclusive relationship with Intel hurting as AMD chips gain share? Hmm… possibly. But DELL isn’t sitting on tons of inventory. If the lack of Intel chips hurts, all they have to do is pick up the phone to order from AMD. They would lose some marketing incentives Intel provides in exchange for exclusivity, but don’t for a second think DELL isn’t ruthless enough to cut the cord if it is in their interest to do so.

Meanwhile, the forest is a vast international opportunity (DELL derives two thirds of its revenue in North America, compared to one third at HP) and a stock trading at a free cash flow yield of 6% while growing in the low double digits.

Topics: Dell (DELL), Hewlett Packard (HPQ), Stock Market, Technology, Uncategorized | No Comments

More Bad News For Tech

Perhaps not surprisingly, Microsoft (MSFT - Annual Report) has again delayed the release of its next generation of Windows, which is called Vista. While MSFT has a reputation for delaying software releases, this project had already been postponed and had features removed in order to meet the new date.

The bulls continue to believe that business spending, half of which goes into technology, will take the baton as the consumer slows. But the most likely reason for a major technology upgrade to happen is that there is something worth upgrading for. The feature cuts had already made it less likely that Windows Vista would be that catalyst, and now the delay makes it less likely that business spending will recover in time to offset a consumer slowdown. Perhaps the bright spot in this is that it reduces the likelihood that buyers will postpone normal upgrades as they wait for the new operating system.

Topics: Microsoft (MSFT), Software and Programming, Stock Market, Technology | No Comments

Merrill Lynch Thinks Intel Price Cuts are Coming

Picked up on a Business 2.0 blog. Of course, there are always price drops with semiconductors. However, there are signs (look here for a follow-up) that the coming months may be tougher than normal. This would be, of course, bad for Intel. On the other hand, it would be a much-needed benefit for DELL, whose lean inventory allows it to profit more than other makers from declining technology prices – the faster they drop, the better for DELL.

Topics: Dell (DELL), Intel (INTC), Semiconductors, Stock Market, Technology, Uncategorized | No Comments

Erring on the Other Side of the Verizon Story

The New York Times had a piece saying Verizon is growing by building rather than buying. One might think this concurs with our thesis that Verizon will not by Qwest. Quite the opposite. It is hard to categorize a firm created by the mergers of Bell Atlantic, Nynex, GTE, Vodafone/Airtouch, MCI (not to mention the ill-considered near merger with NorthPoint) as a builder rather than a buyer. Our point was just that a particular acquisition of Qwest appears to make little sense and instead would signal (to us, anyway) that Verizon was in a weak position.

Topics: Stock Market, Verizon (VZ), Wireless | No Comments