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.
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.