Leasing: mature industry, new wrinkles; Equipment leasing offers time-honored arguments for risk avoidance, balance sheet management and outsourcing-type servicing. Interest rates and concerns over accounting treatment are making an impact in 2005.

Sometimes it seems that just about anything that could be leased already is--trains, planes and automobiles. Computer hardware and software. Power plant equipment, assembly line manufacturing gear. Ice cream makers, ovens for bakers.

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Then there have been some oddities that Shawn Halladay, managing principal of the Professional Development Division at the Alta Group, a lease consulting firm, has seen in recent years: cattle, retreaded tires, the global positioning system (GPS) devices on trucks. "Some strange things get leased," he says.

But leasing is certainly ingrained in corporate America, especially for items like heavy equipment, transportation vehicles and computer hardware. With such a mature industry, a few predictable things have come to pass. Consolidation has risen, just as it has in banking, and specialization has brought strong industry focus to specific vertical niches.

Statistically, leasing appears to have plateaued in terms of its overall penetration of the capital goods financing market. Statistics from the Equipment Leasing Association (ELA) bear this out: leasing's estimated 2005 penetration rate, or share, of 31 percent is the same as it was in 2000-1, and down slightly from its peak of 32.3 percent in 1992 (see table).

"The penetration rate is pretty constant at 30 to 32 percent," says Halladay. "In some [industry] sectors, it's much higher--Xerox probably leases 85 percent of their equipment." In certain areas of the world, he adds, there is room for growth in equipment leasing, and European companies, he believes, need to show more willingness to take some risks and invest in leasing expertise.

Changes in accounting that have bedeviled many areas of finance haven't convulsed leasing, either. The basic rules governing lease financing haven't changed since the 1970s--though some experts see some changes in the wind as international accounting convergence draws closer.

What has evolved, then, is a mature industry in which specialization and time-honored claims of advantages to customers rule the day. The basic economic reasons for leasing remain, says Ralph Petta, vice president of Industry Services for the ELA: avoiding equipment obsolescence, balance sheet management, putting the credit risk to the lessor and not having to deal with issues like remarketing used equipment.

"There are risks in owning the equipment," Petta says. "There are budgetary limits at corporate level, the issue of large capital expenditures, disposal issues. If you own it, the tendency is to keep equipment beyond its useful life." Halladay argues that "CFOs are getting more attuned to the fact that value is in the use of an item. For the most part, ownership is an issue."

"The biggest thing we see is residual risk," says Mike Lewis, executive vice president of First Fleet Corp. in Fort Lauderdale, Fla., a provider of trucks, trailers and similar leased equipment, mostly to Fortune 500 companies. "The distributor of fuel or groceries doesn't want to be in the used truck business."

One of the leasing company's biggest pitches is balance sheet management: many leasing transactions can be treated as off-balance-sheet transactions, which can be a huge boon in terms of lowering an organization's stated asset base and boosting returns. And while the Financial Accounting Standards Board (FASB) has focused critical attention on many off-balance-sheet arrangements, especially special-purpose entities (SPEs), leasing industry executives defend current practices.

"Companies that want [off-balance-sheet] treatment for economic reasons are not trying to hide anything or to game the system," says Petta. Very often, they have debt covenants or other restrictions that they need to abide by that makes it advantageous to take that financing off the balance sheet. "For them, off-balance-sheet financing is not about setting up a shell, but shifting the risk to someone else."

FIN 46, the accounting rule that governs off-balance-sheet financing, has changed the economics somewhat on "big-ticket" lease items like jet aircraft, rail cars and power facility equipment, says Halladay, but "big ticket is still being done."

"Restatements that are due to lease accounting have not been in the WorldCom vein," he adds. "They've been done because people have chosen to change because of shareholder optics, or the retroactive application of FIN 46." Krispy Kreme Doughnuts, for instance, elected to show a transaction as a loan rather than as a synthetic lease, he says; such a lease allows a company to control real estate without being required to show the real estate as an asset on its books.

The ELA's Petta believes that the accounting framework for leasing will change, and there will be less off-balance-sheet financing, given the impetus of the accounting standard-setters and the Securities and Exchange Commission (SEC) to limit such arrangements, which triggered the collapse of Enron. He said the ELA is expected to meet with the SEC soon to "clear up some misconceptions" the industry thinks the commission has about this accounting.

Ordinarily, lease programs are set up to for lessees to take advantage of the accounting rules for operating leases, in which equipment ownership rests with the lessor and is given back after the end of the lease term. With an operating lease, neither an asset nor an obligation is reported. Instead, rental payments are recorded as rental expense in the income statement.

Lessors offering operating leases can benefit, too, however, by capturing financing dollars and enhancing customer loyalty--one reason why the major carmakers created divisions to lease vehicles many years ago. More recently, big software firms like Microsoft have developed their own leasing programs, and Dell Inc. has been partnering in a leasing program with CIT.

Another common appeal is almost akin to outsourcing: a leasing company offers to manage virtually every aspect of the company's equipment buying or maintenance program. Winmark Capital Corp., for instance, has a program called LeaseManager that offers project management through dedicated account managers.

The Minneapolis-based company provides customers with lease documentation, vendor management, installation monitoring and other related administrative services. It leases hardware and software with flexible rates and a commitment to "creative structure."

Some lessors also talk up leasing's potential tax benefits. First Fleet, for instance, promotes a technique commonly associated with accounting in the real estate industry: swapping of inventory, or what it calls a "like-kind" exchange. The company allows its clients to exchange their inventory for vehicles of "like-kind," thereby avoiding the tax penalties that would be imposed had the assets been sold.

The like-kind exchange approach also provides the added benefit of year-round tax leveraging, since transportation companies' operational needs rarely coincide with accounting procedures, says First Fleet CEO John J. Flynn. "We're talking about a program that saves our clients 2-3 percent of after-tax net present value, on average," Flynn adds.

One issue that could make leasing more attractive these days is the steady rise in short-term interest rates being engineered by the Federal Reserve Board. That hikes the cost of borrowing, and boosts the appeal of leasing. "It's kind of conventional wisdom, and it's generally the case, that as that happens, the use of leasing as a financing tool grows," says the ELA's Petta. "That's even more true in the small and middle markets."

"You don't like to see rates rise, but it is good for business," says Halladay. "It's not enough [alone] to kick leasing into higher gear, but it's combined with pent-up capital demand" after the economic down-turn of a few years ago.

But as companies look to lessors for the financing needs, they'll find fewer of them. Specialists have bought other specialists to build scale, and not many new entrants are venturing into the market.

"We've seen a lot of consolidation in the industry in the past few years," Halladay says. "A lot of folks are out there brokering deals, like an insurance broker. True lessors hold the equipment, and you don't see companies coming into that arena."

Trends and Forecasts for Equipment Leasing in the U.S. (dollars in
billions)

Year   Business Investment  Leasing Volume  Penetration Rate

2000        $796.00            $247.00           31.0%
2001        $697.00            $216.00           31.0%
2002        $645.00            $206.00           31.9%
2003        $697.00            $194.00           29.0%
2004*       $735.00            $220.00           29.9%
2005*       $800.00            $248.00           31.0%

Note: *2004 data are estimates and 2005 data are forecasts.
Source: U.S. Dept of Commerce, Economics and Statistics Administration,
Bureau of Economic Analysis, and Equipment Leasing Association of
America. Estimates and forecasts by Financial Institutions Consulting.

RELATED ARTICLE: The Variable Cost Appeal

First Fleet Corp. of Fort Lauderdale, Fla., a lessor of trucks, trailer and related equipment, wants to help companies manage their variable costs.

"What we look at is more than fixed costs--it's very important to look at variable costs. That's where we see breakdowns," says executive vice president Mike Lewis. Finance, purchasing and operations are typically involved in these areas, he says, but they don't always talk to each other.

"Many companies are razorsharp on fixed costs--they know their cost of capital and their IRR (internal rate of return)," he adds. "Our specialty is managing the variable costs. We're creating an ability to monitor and track variable costs. You can't monitor what you can't measure."

In trucking, he says, variable costs might include factors that would change the cost per mile, such as changes in fuel costs, equipment degradation and new technology. Updating technology is key, he adds, and has gained importance since the Environmental Protection Agency has adopted clean air rules for diesel engines.