Dude, You're Getting a Loan
Gretchen Morgenson
Published: July 17, 2005
ON any list of tech-stock hotties, Dell Inc. would certainly rank right up there. Dell, the computer powerhouse, reported revenue of $13.4 billion in the quarter that ended April 29, up 16 percent from a year earlier, and net income of $934 million, a 28 percent jump. Although its shares are down 2.8 percent this year, at $40.96, Dell is trading at a ritzy price-to-earnings ratio of 30, well above the average of 18 for the Standard & Poor's 500-stock index.
One of the fastest-growing elements of Dell's smashing direct-sales model is its financing business. Loans or leases from Dell Financial Services to Dell customers have soared 36 percent, on average, in each of the last six years and are now growing at twice the rate of Dell's overall revenue.
This business is a natural for Dell, which has flourished by eliminating middlemen wherever it can. Its financing operation is a joint venture with CIT Group Inc., a financial services concern, and generated revenue of $1.5 billion for Dell in the most recent quarter. In the 2005 fiscal year, which ended last January, Dell Financial Services made $5.6 billion in loans and leases. Dell owns 70 percent of the venture.
For years, Dell profited only on finder's fees it received when it referred a borrower to the joint venture. But now the company is expanding its role: it has set up a special-purpose entity that will profit by packaging and selling one-quarter of the loans or leases originated at Dell Financial in the current fiscal year. And it recently revised its deal with CIT. Now Dell has the right to buy the venture outright in three years.
To some degree, Dell's foray into financing is just another example of its quest for profit growth. But as one respected analyst has noted, Dell's financing business brings with it the potential for greater risks. While Dell has rarely disappointed its investors over the years, they should nevertheless be alert to the risks that captive financing units present to nonfinance companies.
The analyst in question is Toni Sacconaghi, at Sanford C. Bernstein in New York. He said that while financing transactions were now a very small contributor to Dell's earnings - an estimated $80 million in operating profits from the business in fiscal 2005, or 2.5 cents a share - five years from now, the finance business could generate $500 million in annual operating profits for Dell.
The trouble is, the landscape is littered with manufacturers that, in trying to propel product sales, pushed their financing units to make risky loans. Recall, for example, the crippling losses at Lucent Technologies generated by loosey-goosey vendor financing during the tech bubble.
Aggressive consumer lending can be equally perilous. Consider Gateway Inc., a former highflier in personal computers that began a full-throttle finance program in 2000. According to a lawsuit filed against the company in 2003 by the Securities and Exchange Commission, Gateway used the finance program to mask declining product sales. The company settled without admitting or denying wrongdoing.
Gateway's financing program was aimed at consumers who had been denied loans by the company before the program started. Although Gateway initially intended to finance only $10 million of such dubious loans, according to the suit, as computer sales slipped, the company made $30 million in risky loans to meet a revenue target.
Losses on the loans were soon clocked at around 35 percent, according to the S.E.C. In 2001, Gateway took a $100 million charge to reflect the troubled loans.
No one is predicting that Dell will follow Gateway's hazardous path. After all, Dell's market share is not declining; in April, its share of the global personal computer market was 18.5 percent, a company best.
But the fact remains that when a third party helps oversee such lending, as CIT does now, credit discipline is more likely to be maintained. When Dell buys out CIT, investors will have to be persuaded that credit standards will not be compromised.
"To the degree that Dell takes total control of it, they have to make sure they have the proper expertise in credit scoring and that they are not going to be bullied by the product organization," Mr. Sacconaghi said. "You really want the financing subsidiary to be arm's-length."
Brian MacDonald, Dell's treasurer, said that the company was well aware of the risks and had structured the business accordingly. For example, the finance company does not report to Dell's sales executives. "We'll make sure we have the appropriate checks and balances," he said.
Last week, Dell hired a veteran executive from MBNA, the credit card concern, to run its financial business, Mr. MacDonald said.
Dell could offload some of the risks associated with financing by packaging its loans into securities and selling them to investors, a strategy it now uses in its venture with CIT.
But there are risks in this business as well. If the market for such asset-backed securities dried up, Dell would have to hold onto the loans, taking on default risk.
"If we had problems selling into the asset-backed market we would have to fund those originations some other way," Mr. MacDonald said. "But we have an option to fund, not an obligation to fund."
At the moment, the special-purpose entity set up by Dell does not have to make any public filings. As a result, it is difficult for investors to track the operation.
Dell also intends to keep more loans on its balance sheet, although Mr. MacDonald declined to specify a percentage. Dell has a mountain of cash - almost $6 billion as of the most recent quarter. Deploying cash to make loans, Mr. Sacconaghi said, is not in the best interests of Dell's shareholders. Better to buy back shares or pay dividends.
Clearly, Dell's shift into lending may soup up profits and please investors. But there is no denying that Dell shareholders will have to monitor the financing business closely to satisfy themselves that the risks do not outweigh the rewards.
"I think they're doing it fairly prudently, but a financing business in and of itself bears some risk," Mr. Sacconaghi said. "You really don't get something for nothing."
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