HOW DO THE PROBLEMS OF PUBLICLY-OWNED LEASING COMPANIES IMPACT YOUR COMPANY?

By Bruce Kropschot

Most readers of the Monitor have followed with interest the several initial public offerings of equipment leasing companies in recent years. However, you might not realize how the performance of publicly-owned leasing company stocks may impact the health of the leasing industry in general and your company in particular.

Let's look at the following stock market performance of the 7 equipment leasing companies that went public since May 1, 1997:

Average Decline

63.1% It is obvious that the last 7 equipment leasing company IPOs have been poor performers. Even the 2 giant companies, CIT and Heller, have declined over 30% since their IPOs. The other 5 IPOs in the past 3 years, which have declined an average of 74.8%, include 4 independent leasing companies and one new company, UniCapital, which went public simultaneous with its roll-up acquisitions of 12 independent leasing companies.

Industry-Specific Valuation Factors

There are a number of reasons why the latest leasing company IPOs, and public leasing company stocks in general, have been poor performers in a period when the overall stock market averages, until recently, have had phenomenal growth. The earnings and earnings growth potential of SierraCities.com (formerly known as First Sierra Financial), T&W Financial, LINC Capital and UniCapital when they went public were heavily dependent on continued use of gain on sale accounting for lease securitizations. The accounting rules promulgated by the Financial Accounting Standards Board require securitizations that meet certain tests to be accounted for off balance sheet with a gain on sale recognized. Many lessors and other securitizers structured their securitizations to meet these tests so they could record more income up front and keep securitization debt off their balance sheet. In 1998, this gain on sale accounting method lost favor among investment analysts who follow leasing companies, largely as a result of gain on sale accounting problems experienced by other types of specialty finance companies.

A number of sub-prime auto finance companies and home equity lenders were forced to take major bad debt losses when the loss reserves factored into their securitization accounting assumptions proved to be inadequate. Also, as interest rates declined in 1997 and 1998, many mortgage lenders experienced higher levels of prepayments than anticipated, necessitating a reversal of previously recognized securitization gains. A number of investment analysts and the investors who follow their recommendations fail to distinguish that it is much easier to forecast losses accurately in commercial lease transactions than in sub-prime consumer loans and that most commercial leases either do not permit prepayments or require prepayment penalties which mitigate against adverse securitization accounting adjustments.

Faced with increasing pressure from the investment community, SierraCities.com, T&W Financial, LINC Capital and UniCapital all announced in late 1998 and early 1999 plans to discontinue the use of gain on sale accounting for securitizations by changing their securitization structures. Going off gain on sale accounting for securitizations has greatly reduced earnings for these 4 companies, and it will take several years for earnings to recover to the levels they would have reached had the companies remained on gain on sale accounting. Since stock prices are heavily dependent on reported earnings and analyst forecasts, the adverse impact on the stock prices of these 4 companies has been dramatic.

Stocks of leasing companies have also suffered because the entire financial services sector has been out of favor while much of the attention of investors has been focused on internet-related stocks. The stocks of many strong banks reporting record profits declined over 40% from their peaks to their lows in the past year. There are investor concerns that the Federal Reserve Board's interest rate increases will eventually result in an economic downturn that would produce higher credit losses for leasing companies and banks. Investors are particularly fearful that those leasing companies who lease to less credit-worthy businesses will be especially vulnerable.

The possibility of a recession also increases investor concerns as to the continued availability of funding for some leasing companies. The international financial turmoil in the summer and fall of 1998 effectively closed down the lease securitization market and resulted in higher interest rate spreads over U.S. Treasuries when the securitization market reopened. Not having access to the lease securitization market for an extended time could be disastrous for those leasing companies that do not have adequate funding alternatives.

Company- Specific Valuation Factors

There are of course many company-specific reasons for movements in stock prices for the last 7 leasing company IPOs. SierraCities.com had outstanding market performance spurred by publicity about their e-commerce initiatives in a stock market enamored by almost any company labeled as an e-commerce company. However, SierraCities, which went public at 8, has sunk from 1998 and 1999 highs above 30 to around 4, likely due to investors' impatience for earnings and concerns about the poor performance of the entire leasing sector.

T&W and LINC both tried to find an acquirer amid growing credit losses and liquidity concerns. Neither succeeded in being acquired, and T&W is now in liquidation and LINC announced in March 2000 that it is downsizing and has made the strategic decision to de-emphasize its traditional leasing activities.

One of the reasons investors have battered UniCapital's stock is investor concerns over the sustainability of its substantial trading profits in the cyclical business of selling commercial jet aircraft and engines by its Big Ticket Division. These concerns appear to have been warranted because UniCapital announced in May 2000 that it was taking major valuation write-offs in its Big Ticket Division and had decided to exit this business.

CIT's stock has been under pressure since it acquired Newcourt Credit Group in November 1999. The stock of Newcourt, also a public company, had fallen drastically before CIT first announced plans to acquire the company in March 1999 on investor concerns about Newcourt's credit quality, liquidity and earnings, and it fell further amid concerns that the acquisition would be called off because of Newcourt's lower than expected earnings for the first quarter of 1999. The acquisition was finally completed after the acquisition price was negotiated downward, but investors have not been kind to CIT's stock, possibly because of concerns about the ability of CIT to integrate such a large acquisition smoothly and the adverse impact on CIT's earnings of discontinuing Newcourt's extensive reliance on gain on sale accounting for lease securitizations.

Newcourt is not the only more-seasoned public leasing company to experience a significant stock price decline. Finova, which had been regarded as one of the best public leasing and commercial finance companies, recently hit a stock price low of under 8 in May 2000 after being above 62 in February 1999. The most precipitous part of this drop was in response to the news of a $70 million charge off of one bad account and investor concerns as to possible other credit problems and funding problems. Leasing Solutions is another once highly recommended stock that fell out of favor quickly when it reported substantial losses, due largely to overly aggressive assumptions on end-of-lease values for computer equipment on operating leases. The stock, which was above 30 in 1998, traded for a few pennies a share after filing for bankruptcy and being delisted by the New York Stock Exchange in late 1999. Prime Capital is another company where accounting surprises have caused a sharp drop in the stock price. From a 1997 high above 7, the stock dropped to as low as 0.25 in May 2000 due to recurring credit loss problems and resulting liquidity concerns.

The recent demise of two venture capital-backed leasing companies, BankVest and USA Capital, due to excessive credit losses and cash flow problems further hurts the reputation of the equipment leasing industry. The venture capital firms that invested in BankVest and USA Capital are likely to be very cautious on future leasing company investment opportunities, and the lenders to these two companies will likely scrutinize credit decision processes more closely for their other leasing company customers.

Implications for Other Leasing Companies

What are the implications of the dismal leasing company stock market performance and the failure of several public and venture capital-backed leasing companies for other leasing companies?

First, equity capital, the fuel that powers asset growth for equipment leasing companies, will be more difficult to obtain and more expensive. Privately owned leasing companies will be less likely to be able to go public in the next few years because of the poor results of the most recent leasing company IPOs. Privately owned leasing companies will also find it harder to attract venture capital due to the losses incurred on leasing company investments by several venture capital investors and the uncertainty as to when and whether a leasing company will be able to have an IPO to provide an exit opportunity for the investors. Those companies already public will experience lower stock valuations than they might have had; even if they do not have the problems of some of the other public leasing companies, there is guilt by association because investors have experienced too many unpleasant surprises from leasing companies. They will also find it harder and more expensive to raise equity through secondary stock offerings.

Second, some debt sources will drop out of the market and others will impose stricter lending standards. Leasing company cash flow could be adversely impacted if funding sources increase their spreads and/or reduce their advance percentages on their loans to leasing companies. A leasing company without a solid net worth and a long history of favorable static pool performance may be unable to access the securitization market, and many issuers will find securitization interest rates and conditions to be less favorable than they formerly were.

Third, acquisition prices for leasing companies will decline. Price/earnings multiples accorded privately owned leasing companies when acquired generally are related to, and often lower than, the price/earnings multiples of comparable public companies, so the decline in public leasing company multiples has a direct adverse impact on the value of privately owned leasing companies. Acquirers will be highly selective and will likely be extra careful in performing due diligence now that they have seen how quickly leasing company fortunes can change.

Companies using gain on sale accounting for a major portion of their lease originations will likely be penalized by acquirers in the valuation process. Most potential leasing company acquirers do not use gain on sale accounting, and they may find it difficult to justify acquiring a leasing company if conversion off gain on sale accounting produces a loss in the first year.

It should also be noted that SierraCities.com and UniCapital were the 2 major acquirers of leasing companies in recent years; together with LINC and T&W, these 4 recent IPO companies accounted for about 50 acquisitions in less than 3 years. None of these companies are likely to make leasing company acquisitions in the near future. Leasing company acquisition pricing will thus be further dampened because some of the more aggressive bidders in the past are no longer in a position to consider acquisitions.

Despite reduced acquisition prices, many privately owned leasing companies likely will choose to be acquired in the next few years. Their pressing needs for equity capital and lower-cost debt sources do not allow them to wait until the IPO market is again receptive to leasing company stocks.

Avoiding the Pitfalls

What can your leasing company do to avoid the highly publicized pitfalls experienced by so many publicly-owned leasing companies and a few venture capital-backed companies? The leasing industry's credibility is at issue, and it is in every leasing company's best interests to work to restore that credibility with equity investors and funding sources. Leasing companies cannot achieve acceptable profitability and growth levels without access to new equity investors and competitively priced debt.

Credibility is based upon trust, and that trust must be earned. Leasing companies need to be candid with their investors and lenders; bad news should be disclosed sooner rather than later. Accounting practices should be conservative and not aggressive. Bad debt reserves must be maintained at adequate levels and residual valuations should err on the low side.

It may be tempting, especially for public companies, to use aggressive accounting practices when necessary to meet earnings targets. However, the ramifications of losing credibility are so severe that no leasing company executive should ever consider issuing financial statements that are misleading. Investors and lenders have reason to be skeptical about leasing company accounting practices. Companies that are not forthright in their financial reporting hurt not only themselves but also the entire leasing industry. Investors and lenders want to be involved with leasing companies that have a history of consistency and predictability of results.

Why is it that public leasing companies, with their greater access to capital, appear to get into more financial difficulties than the larger privately owned leasing companies? There is pressure from the investment community on public companies to achieve earnings per share growth each quarter. Managing a leasing company for short-term profitability is often not in the company's best interests. A leasing company should be willing to sacrifice short-term profitability to invest in activities that will produce superior returns over a 3 to 5 year time horizon, but this is easier said than done at many public companies. The use of gain on sale accounting, although proper, means that companies have to increase lease originations each quarter in order to maintain earnings growth. Public companies using gain on sale accounting may have more temptation to relax credit standards to meet the quarterly lease originations goal.

Just as a leasing company cannot be successful over the long term unless it maintains its credibility, it also cannot be successful without a strong and cohesive management team. Management must emphasize strong credit controls, because bad credit decisions are the leading cause of leasing company crises and failures. The next economic downturn will likely claim a number of leasing companies whose management did not have the strength to say "no" to credit submissions they should have declined. Management must be profit driven, not volume driven. Too many leasing companies appear overly anxious to win the lease rate battle while not realizing they are losing the war, because without an adequate return on equity a leasing company will not survive over the long term. Many leasing companies lose control over expenses during good times; enlightened management will maintain tight budgetary cost controls at all times. Management needs to develop long term market strategies and financial plans and then ensure that the company develops the diversified and competitive debt sources and the equity backing required to achieve those plans.

Every leasing company has a stake in improving the credibility of the leasing industry. The problems of a number of publicly-owned and venture capital-backed leasing companies reflect poorly on the potential of the industry for equity investors and lenders. To help restore the industry's credibility with capital sources, leasing companies need to follow conservative accounting practices, make timely and complete disclosures to investors and lenders, maintain strong credit controls and manage for long-term profitability.

* * * * * * * * * * * * * * *

Bruce Kropschot is President of Kropschot Financial Services of Stuart, Florida, a merger and acquisition advisory firm for the equipment leasing and financing industry that he founded in 1986. He left the firm in late 1997 to become Vice Chairman - Mergers and Acquisitions of UniCapital Corporation, where he was also President of UniCapital Business Credit Group; in April 2000 he returned to Kropschot Financial Services. Kropschot Financial Services has arranged over 125 acquisitions of equipment leasing and specialty finance businesses and has been ranked as the leading provider of merger and acquisition advisory services in this sector. Previously Mr. Kropschot was President and an owner of Master Lease Corporation (now known as De Lage Landen Financial Services) and Executive VP of HBE Leasing Corporation.

Mr. Kropschot is a CPA and holds BBA and MBA degrees in accounting and finance from the University of Michigan. He has served on the Board of Directors of ELA, EAEL and UAEL and is a founding member of International Merger & Acquisition Professionals, an organization of leading M&A intermediaries located throughout North America and Europe.