Storage Peer Incite: Notes from Wikibon’s November 6, 2008 Research Meeting
As I write this, the day after Barack Obama's historic election, the Dow Jones Average is down nearly 500 points, more than wiping out its Election Day gain. Obviously we are in a worldwide recession that will not go away soon, and with many entities approaching the end of their fiscal year, we can expect much tighter budgets and tighter capital markets in 2009.
In this financial environment, IT will face a major challenge finding the capital to pay for the technology it needs. Refresh schedules are likely to be stretched, which will create dependability issues and delay upgrades that can save energy costs while decreasing corporate carbon footprints. One major strategy for avoiding some of these problems is leasing. While not right for every situation, leasing can allow IT to acquire the use of the new technologies it needs without resorting to scarce capital, and in some cases even generate capital by selling and then leasing back existing assets. For vendors, a strong leasing strategy can rescue sales they might otherwise lose and establish a physical and financial footprint in customer shops.
Tuesday the Wikibon community explored the facts surrounding leasing in a Peer Incite call. The articles in this newsletter reflect and augment that discussion. G. Berton Latamore
On Election Day 2008, the Wikibon community gathered to talk about financing and leasing IT equipment in tight capital markets.
What’s changed? The premise of the call was this: At the beginning of the decade, money was cheap and the management of capital was less risky. Credit is now tight and a less fungible commodity. In a time of short capital, more than ever, in order to acquire or sell goods and services both consumers and vendors need a financing/leasing plan. Having a leasing strategy will help gain access to cash, avoid costly maintenance bills, lessen the chance of missing technology refresh cycles, or avoid blowing a sale. This market is a double whammy for users: 1) CFO's are tightening the belt and slashing budgets; 2) Financing is going to become a bottleneck to getting deals done. Companies without a financing/leasing strategy will face significant unforeseen problems. Trying to do the job today with yesterday’s technology could increase operating costs by 15%-20% for each year a refresh is delayed. These inefficiencies include higher costs for power, cooling, space, and maintenance as well as staff productivity decreases.
What are the plusses and minuses of leasing? Leasing and loans allow IT customers to acquire technology without incurring large capital cost outlays. The major benefits include:
- Matching benefits to costs – i.e. you pay as you go;
- Buffering technological obsolescence;
- Allowing transactions to be completed with no impact to the balance sheet;
- Improving use of cash;
- Simplifying disposal.
The tradeoffs are:
- Leasees must have good asset management practices in place to know what’s coming off lease;
- Leasing can limit flexibility – e.g. if you have a layoff, you still have to pay for leased PC’s;
- Leasing is a backend business, and you must find partners you can trust;
- Leasees must have processes in place to migrate equipment – the availability of data migration tools and technologies such as virtualization are critical.
The two main types of leases are:
- Operating leases – you don’t own the asset;
- Capital leases – you own the asset.
In order to qualify for an off-balance-sheet item, an operating lease must meet four conditions:
- The lease term must be less than 75% of the asset's useful life;
- The present value (PV) of rent must be less than 90% of the equipment cost;
- The lease cannot contain a bargain purchase option;
- There can be no title transfer for ownership of the asset.
Who are the purveyors of leases/financing options? Leasing is estimated to be a $260B business. Vendor leasing companies have been the primary source of funding and leasing. Generally vendors are the best source because their business is moving technology, and often they are motivated to do a deal. However, third party lessors have no particular stake in the deal other than the financial transaction and can act as independent advisors. Users should be aware that vendors are motivated to lock in a financial footprint and as such may or may not be the best option. The key advice for users here is: Like any acquisition strategy, don’t sole source – balance your supplier portfolio.
What are the important factors to consider in a lease? Users should understand the concept of residual value (RV). RV is the forecast of the future value of the asset. Customers need to have a rough idea as to whether the RV forecast makes sense. Do your research and make sure the RV is reasonable, fair, and aligned to your technology objectives. Customers should also consider:
- Managing the lease – how will the lease be managed, invoices verified, and terms adhered to?
- Tracking – who and how will the terms of the lease be tracked?
- Asset Management – to include change management, upgrades, physical location, etc.
The lease is all about the contract. Users should make sure they involve the right organizational constituents to execute a lease, including internal council, treasury, and legal representation. Other considerations that go beyond the lease rate itself include factors such as return provisions. For example, is the leasee required to return the asset in the original packaging rather than a standard commercial box; are there penalties for upgrading the asset (e.g. memory upgrades); is software transferable at the end of the lease; and are there any licensing nuances that need to be considered? Users should remember that everything is negotiable except the fact that you must make the payment.
Advice for vendors With capital markets changing, the means of payment is becoming even more important. There are two main decision points that occur in a sale: 1) I need/want the technology and can justify the expense and 2) How do I pay for the asset. Vendors must find partners with whom they can share a back-end relationship that can help finalize deals. There is often a concern that leasing slows down the sales cycle. In today’s market especially, leasing can accelerate the sales cycle by establishing a financial footprint and a financing framework that can then be leveraged for subsequent leasing deals.
Top 3 things users should consider:
- Leasing is a back-end business, and you can’t enter into contracts lightly. You need a management team that is committed to the process. Especially in tight markets, management reviews need to be more stringent to ensure that the particular financing option makes sense.
- With budget constraints, be aware of which financing alternatives exist and get a general agreement between the CIO, CFO, treasury, and legal. Have an open dialogue with these constituents.
- Understand the differences and parameters between capital leases and operating leases and make sure you’re not in default of loan covenants or exposed to audits that will force you to restate financials.
Action item: In a tight 2008/2009 credit market, leasing is becoming an increasingly necessary option for customers to deploy. However customers should balance their financial strategies with leasing, bank loans, and acquisition as viable approaches to aligning financial, technological, and business goals. In order to fully exploit leasing strategies and avoid unnecessary costs, customers should ensure that asset management systems are in place and fully operational.
Footnotes: Sample Lease Agreement
In order to acquire goods and services or turn capital assets into leased ones, users need a comprehensive financing/leasing plan. Financing is already becoming a bottleneck to getting deals done. Companies without a financing/leasing strategy will face significant unforeseen problems. Here are some key areas to address in developing such a plan:
- Organization -- Users should make sure they involve the right organizational constituents to negotiate and execute a lease, including purchasing, internal council, treasury, legal representation, and outside consultants. Leasing is a back-end business, and you can’t enter into contracts lightly. You need a management team that is committed to the process. Especially in tight markets, management reviews need to be more stringent to ensure that the particular financing option makes sense. With budget constraints, be aware of which financing alternatives exist and get a general agreement between the CIO, CFO, treasury, and legal. Have an open dialogue with these constituents.
- Relationships -- Establish or revisit relationships with multiple lessors and financing arms of major equipment vendors. Develop trusted “partnerships” with them. Existing relationships may mean nothing in the current financial climate. Several major financing companies just completely stopped doing deals this past meltdown October. Credit is tight, rates are up, and everything takes forever. Get master lease agreements in place with several sources. Even small financing vendors should be included. Try to be joined at the hip with your financing partners.
- Lease Management – Timing is everything. When a lease starts matters because when a lease ends matters. Managing a lease requires an ongoing effort that tracks the lease, ensures the terms of the lease are followed, and alerts the organization well in advance to an event that is approaching. Invoice verification is mandatory and often a headache. Users must also ensure that equipment coming off lease is properly configured, decommissioned on time, packaged, and shipped according to the terms of the lease. Users have historically done a poor job of this, making the lessors very happy because they can then charge penalties. Also, bear in mind the possibility of sub-leasing hardware assets and the frequent non-transferability of associated software.
- Asset Management – Good asset management disciplines need to be in place to ensure you know where the physical assets are, what the configuration is including upgrades, and when they are going off lease. These disciplines must provide ways to work closely with change management teams.
- Negotiations -- Everything is negotiable including when the lease starts and when you start making payments. Users should remember that everything is negotiable except the fact that you must make the payment. Clever negotiators can even make a capital lease look like a operating lease.
- Capacity on Demand – Always a disguised form of financing, it is a simple way to finance upgrades.
Action item: Users should develop a comprehensive finance/leasing plan and avoid happenstance financing
Today’s challenging economic conditions are driving IT organizations to develop a viable financial strategy which almost always includes leasing. Lease expiration management is in itself a strategy. Several organizations within IT and the business including the CFO, treasury, CIO, capacity planners and members of the IT staff must work together to insure a cost-effective technology transition at lease expiration time. Leasing makes it possible for companies to acquire up-to-date equipment while preserving cash and credit lines for more strategic business activities. Leasing has a lower impact on budgets than purchasing and therefore provides companies with the opportunity to realize operational savings and productivity improvements in a timely manner.
Two types of leases are most common for data storage equipment. An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership but also want to return equipment at lease-end and avoid technological obsolescence. An operating lease usually results in the lowest payment of any financing alternative and is an excellent strategy for bypassing capital budgeting restraints. A capital lease is classified and accounted for by a lessee as a purchase and by the lessor as a sale or financing, if it meets various criteria such as the lessor transfers ownership to the lessee at the end of the lease term or the lease contains an option to purchase the asset at a bargain price.
Lease expiration means that several organizations or departments will need to communicate. Often on little notice, the IT staff will be pressed into action as many businesses wait until the last minute to react when a lease expiration date arrives. The IT staff has to be ready with the resources at the right time to go through these financially forced actions and conversions. In addition, new technologies or higher than expected data growth rates can force a technology change before a lease expires, indicating that capacity planning may be a key part of this process. The IT staff checklist for a storage lease expiration includes but is not limited to the following activities:
- Data needs to be re-located or migrated to new or existing targets;
- Expiring storage equipment needs to be eradicated for legal purposes;
- Equipment may need to be physically removed from premises;
- New systems must be installed and tested;
- Energy systems must be re-balanced to accommodate newer technologies;
- Staff resources must be available for the transition to succeed.
In any case, organizational linkage is a requirement - not an option!
Action item: Although the financial benefits from leasing are the key issue, there is more to a successful leasing strategy than a good price. The cost of coming off of a lease late can make the deal less attractive. Leasing strategies should include participation from key IT stakeholders to insure that the economics of a compelling lease deal aren't lost by not being prepared at expiration time.
Capital to invest in new equipment has been relatively easy over the last technology cycles. The priority was to install equipment to enable revenue producing projects. Those days seem to be over. IT projects will have to compete for funds. Cost saving initiatives will be a priority, and within IT capital saving will be a priority. Leasing will become a tool to help manage tight capital budgets.
Every user department will be combing its IT budget looking for line items to cut or reduce. For CIOs, the management focus has shifted or will shift from return on investment (ROI) to return on assets deployed (ROA). Key questions that will be asked of every project are:
- Do we need to invest now?
- Can we extend the use of existing assets to enable this initiative?
- Can we use lower function/lower cost equipment (i.e., modular instead of high-end storage)?
- Can we delay the delivery of new equipment?
The key technologies, processes and procedures likely to help the today’s data center are technologies that enable flexibility of deployment, and improve return on assets deployed. Examples of these technologies are:
- Virtualization Both server and heterogeneous storage virtualization allow better utilization of installed assets and early retirement of assets that are expensive to power, maintain, and manage. Heterogeneous storage virtualization platforms, such as IBM’s SVC, Hitachi’s USP V/VM series, EMC’s Invista and LSI's SVM, enable faster data migration to new storage arrays, which can help postpone installation of new storage and delay capital requirements. These storage technologies also enable existing storage array assets to be re-provisioned as tier-2 or tier-3 storage (usually without software), facilitating the delay of new technology purchasing. Moving from LUN management to virtual storage space management significantly simplifies the complexity and reduces the cost of storage management.
- Thin Provisioning This technology is now available from many vendors, including 3PAR, Hitachi, Compellent, NetApp, EMC, IBM’s SVC and XIV, HP, Sun, and now LSI. When combined with storage virtualization, this technology allows better utilization of storage, driving utilization from less than 40% to potentially over 80%.
- Asset Management Software and Procedures Key to improving return on assets deployed is to understand how well server and storage technologies are being deployed and utilized, and when those assets are scheduled to come to the end of leases and/or are due for replacement. Adequate performance and financial metrics need to be in place and understood to drive effective asset management.
Action item: As recession bites, capital becomes scarce and leasing become commonplace, CIOs and CTOs will move their focus from maximizing ROI to improving return on assets deployed (ROA). To enable that to be achieved for storage and servers, implementation and exploitation of a well managed flexible virtualized infrastructure has become a business imperative.
The fact is that there are ways for organizations to structure leases that can both meet the balance sheet needs of the organization and at the same time build in flexibility. They’re a form of hybrid lease. Here’s how it works:
The driving force behind operating lease qualification is FASB 13, an accounting rule. This rule is fairly flexible in the requirements of reaching operating lease qualification. As a result a number of hybrid structures are available. One of the key attributes of any such hybrid is to pass the FASB 13 standard of the present value of the rents being less than 90% of the equipment cost. The definition of minimum term allows for the use of early termination options as a way for the 90% rule to be satisfied.
Another method that can be used to move around the FASB requirements is to have an asset that has long term excellent residuals, for instance Cisco equipment, and to have a five-year operating lease with a four-year early buyout option. Because the buyout is an option, it is not included in the FASB calculations. This structure allows you to set an early buyout option number that is consistent with what you believe the cost of money should be for the term chosen and the risk which exists for the leasing company.
Action item: It is very important in managing your leasing activity that thought be given to getting rid of equipment at the end of the lease. If you don’t believe that you have the ability to manage the asset to a specific return date, then, if you need to have an operating lease, you should consider working with partners and establishing hybrids like those described above to help you through the accounting maze.
Footnotes: Contact David Burmon
Access to capital to fund IT acquisitions in general and storage specifically has been pretty good in the past several years. This has led some vendors to conclude that leasing partnerships were of little value. Recent sentiment is that modern technologies delivering superior cost efficiencies would essentially sell themselves.
As pointed out in today's Wikibon Peer Incite call, this is all changing. With tight credit markets, how to pay for the deal is going to be an increasingly important part of the sales motion. For smaller suppliers, this means potentially getting locked out of important discussions or losing deals as a result of financing snags. What today is viewed as a hiccup could become a much more substantial hurdle to getting deals done.
There are several options for smaller vendors, including forming relationships with leasing companies or setting up an internal program by hiring a leasing expert with deep industry expertise and a substantial Rolodex. This action in and of itself doesn't ensure success. Often smaller suppliers will still be locked out of these discussions because customers will have their own leasing arrangements with existing finance firms. Many resellers and smaller customers are less prepared for and more vulnerable to tight credit markets and having a leasing / financing capability will become viewed as table stakes by these partners.
Action item: Leasing and financing capabilities have long been an offering from large vendors including IBM, HP, EMC, NetApp, and Sun. Smaller companies such as 3PAR have formed leasing partnerships without much traction to date. Nonetheless, smaller suppliers should take 3PAR's cue and form similar relationships as this capability will become increasingly important as the money gets tight and off balance sheet transactions become more attractive to customers.
Footnote: Details of 3PAR's leasing partnership