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BANKING ON IBM

IBM Z10 mainframes are expensive.  Prices start in the vicinity of a million bucks and there is no ceiling.  A single fat machine can cost upwards of $25 million, and hardly anyone will get just one, because large mainframes are acquired in clusters.  If history is a guide, most z10 customers will lease rather than buy the machines.  But changing tax laws and tumultuous financial markets aren't making this easy.  If IBM Global Finance (IGF) can't provide compelling lease deals, prospective customers might not simply go elsewhere for financing.  They might instead put off moving to the z10.

The key issue for all the parties-IBM, its IGF unit, and the big organizations that want new big iron-is not whether the z10 is fine computer.  That's pretty much a given, and because it's the latest series it will offer performance, features, and value prior generations cannot.  Moreover, most mainframe shops are truly committed to the mainframe, for a mix of positive reasons and legacy obligations.  Nonetheless, even if there's no doubt about if there will be progress at most mainframe sites, there's also no certainty about when.  There's also a degree of uncertainty surrounding how to pay for the system, because the cost of leasing versus purchase might not always favor financing, and in some cases (but not very often) there may be more attractive financing alternatives than those offered by IGF.

Once a mainframe customer decides to lease rather than buy, IGF is always a candidate.  Sometimes it may be the only candidate; banks and third party lessors are not strong contenders at the moment, for reasons that customers should study as they make their choices.  Even when there are alternative financing sources available, IGF, as a unit of IBM, has some powerful advantages.  Still, customers do have some influence, and may know that IGF has to strike a balance between its own interests and those of the customer, a role that can be more complicated that it would be for truly independent lessor.

The companies that acquire big iron don't like to be insulted, and a poorly conceived lease proposal can be a corporate insult, impugning the creditworthiness of the client or in effect telling the client to do business on IBM's terms or not at all.  And that's just one delicate aspect of the leasing process that IGF must address for every big ticket lease it writes.

It is possible for IGF to succeed politically but still fail to meet a customer's financial expectations.  In that case, the sale might proceed but the financing will not.  This creates a potential problem for IBM, or, put more positively, leasing provides at least two benefits to Big Blue.  First, it's a good source of revenue and profit; IGF is a very successful banker.  Second, leasing gives IBM an addition dimension of influence over the rate at which customers move forward.  There's a secret ingredient in every well-conceived vendor lease deal: room for the lessor to maneuver.  This flexibility can be used to increase the rate at which the installed base is churned.  For example, a lessor can offer trade-in incentives that allow the customer to alter what would otherwise be rigid lease terms.  This sort of deal can be a powerful way for a captive lessor to press customers to move ahead, and it is a tool that can't be applied in situations where the user owns its mainframes.

For seasoned managers of mainframe shops, all these aspects of leasing are old hat, so most of the time leasing would not be a hop topic and instead remain just one facet of a migration strategy.  But this year the US government has implemented some big tax incentives aimed at boosting the acquisition of capital assets by business, and this gives the financial aspects of a mainframe acquisition or upgrade greater importance.  Basically, this year the buyer of a mainframe in the USA can write off 60 percent of the equipment's cost; formerly the first-year depreciation allowed for this class of was 20 percent.  This can work out to a pretty nice tax benefit.  Lessees don't get the faster depreciation, which is available only to the equipment owners.  But lessor, who are owners, get the benefit and they can pass some savings through to lessees in the form of lower lease rates.  That is in fact just what IGF says it will do as it finances z10 acquisitions.

The amount IGF will pass along to a lessee comes down to cases.  Every IGF mainframe lease is individually tailored to the particulars of the situation.  Among the factors that come into play are the lessee's credit rating, the nature and value of the assets, and the length of the lease.  And, then there's a matter of what the market, or in this case the individual lessee, will bear.  Mileage will vary, perhaps considerably.

In a recent presentation, IGF showed by example how it passed through the accelerated depreciation in the case of one hypothetical US customer.  IGF gave the lessee a choice between taking the price break in the form of a reduced monthly payment or alternatively as a delay in the start of lease payments.  In this example, IGF said the lessee could pay nothing for three months and then kick off a lease at the rate that would have prevailed in the absence of the accelerated depreciation charge.  IGF's example involved a $5 million z10.  It was offered for $136,750 a month for 36 months before the government economic stimulus package became law; now the same deal could be done for $135,000 a month or under terms that cost the lessee nothing for three months and then $136,750 a month for another 36 months, bringing the total length of the lease to 39 months.

A company that wants to lease is clearly getting some benefit under the new US depreciation rules, but a company that buys outright could end up with lower costs than a lessee.  It's up to the user organizations finance specialists to choose between leasing and purchase.  A lot depends on how well the user company can really use the rapid depreciation to offset taxes.  It also depends on whether the buyer has the cash or can get it cheaply, and whether that cash might be more wisely used for some purpose other than acquiring a mainframe.  Operating leases don't show up on balance sheets, so they don't diminish corporate borrowing power.

IGF also showed by example why it believes a lease can save the user a lot of money compared to purchase.  Again, this was just an example, and what worked in a PowerPoint show might not work in a real world situation.

In any event, IGF talked about a hypothetical customer with a borrowing cost of 5.5 percent, which is very good, and assumed that the lessee's tax rate is 38.25 percent.  To factor in the cost of the user organization tying up money in equipment it buys (if it decides to purchase rather than lease), IGF stipulated that the user company's return on investment was 10 percent.  The deal was an operating lease that ran 36 months and the costs were based on an end-of-term salvage value that would be 5.5 percent of the equipment's initial value.  (An operating lease provides for an end-of-term buyout option at fair market value, an amount that cannot be fixed at the beginning of the lease.  The 5.5 percent salvage value used in the calculations was just a stipulation put into the example so the calculations could be completed.)

The deal used in the illustration, according to IGF, could have two methods of acquisition, purchase or lease, and two end of term choices, keep the system or return it.  IGF did its comparative cost analysis by turning sums that will be paid or received in the future into their net present values; that's the beancounters' way.  The results in this case show that leasing, compared to buying and then selling, can save the user a substantial sum if the system is taken out of service at the end of the lease.  If the user instead believes it will want to keep the mainframe for longer than 36 months, the results are different, but IGF believes that leasing still gives the user an advantage, even if it's a small one.

IGF says that in this example the net cost to the user of buying and then selling the machine would be $983 per $1,000 of initial cost.  However, that's without figuring in the way the expenditure would offset corporate intake for tax purposes.  With tax figured in, buying and then selling 36 months later would cost the user company $601 per $1,000 of initial cost.  IGF claims that a 36-month lease would cost this user only $879 per $1,000 of face value, and only $544 after taxes.  In both of these cases the user has no machine at the end of the deal.  The company is going to have to get another mainframe to keep its applications running.

If the company decided to buy the machine and keep it the cost would be $1,037 per $1,000 of initial cost; it's more than $1,000 because funds tied up in the equipment cannot be used for other purposes, and that is a cost.  The after-tax cost, says IGF, would be $632 per $1,000.  Leasing (and buying the box at the end of the lease) shaves the pre-tax cost a bit, to $1,019, and the after-tax cost to $631.  These costs are higher than those that arise when a system is bought and later sold or leased and then returned, but of course without a resale or return the user company has the computer at the end of 36 months.  It's up to the user company's technology strategists to decide how much that mainframe will really be worth three years in the future.  If it can give the user company a year or more of computing power at no cost (except for maintenance), that additional 16 percent after-tax cost (compared to IGF's lease-and-return cost) might deliver a lot of value.

In addition, that three-year-old mainframe could be worth a lot as a DR machine or as a Linux server; it doesn't have to be running live legacy workloads to earn its keep

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Because an old mainframe is as good as new one for some purposes, and because IBM really wants to sell new hardware, a company that can explain to an IBM sales rep why it might not want to return its old z box could end up getting offers it would never otherwise get.  Because IBM has so much market power these days no user will have the kind of clout some users had twenty years ago, when IBM had two hardware competitors and a few dozen rivals in the used computer trade pitching their wares at Big Blue's best prospects.  Still, with mainframes expensive and money scarce, a lot of big shops are obliged to explore possibilities the might ignore under more favorable conditions.

It is with the possibility of customers who want a bit more value and flexibility in mind that IGF is lately pushing midstream upgrades.  This is one type of deal it has always offered, but these days it's doing so with considerable vigor.  There are benefits to both lessor and lessee when a deal has to change in the middle of its term.  This usually happens because the user needs a big power bump or has to achieve a previously unplanned consolidation.  For purposes of discussion, the typical story involves a shop that is something like halfway through a 36-month lease when it decides to get an upgrade.  Most often, the solution is to turn on more engines in the installed box, and IGF is happy to finance the upgrade as an add-on to the original lease or as part of a deal that extends the original term.  But in some cases the customer may want newer technology, which right now might mean moving from a z9 or z990 to a z10.

Among other choices, IGF is pitching a safety net upgrade, an arrangement in which IBM brings in a new z10, gets it running, and gives the user time to get all the software in place.  Only then would the user switch production to the new machine and let IBM take back the old box as part of the transaction.  The lease would finance the new machine and also incorporate the unpaid balance of the lease on the old box.  However, because the z10, like every other IBM mainframe, gives more bang for the buck, the deal could end up giving the customer more MIPS at a lower monthly cost.  This outcome is possible because stretching of the deal on the first machine (from its original 36 months to 54 months, for instance) combined with the 36-month financing of an upgrade is very easy for IGF, which has no trouble finding a home for the big iron it takes out.  That used equipment, might, for instance, become a relatively inexpensive platform on which a services deal is built.

Right now, these deals are easy to get, or at least IGF seems to be making noises in that direction.  But they ought to be.  With the z10 IBM ought to be able to slash the cost of manufacturing its mainframes because the z boxes have so much in common with the higher volume p boxes.  And IBM is only going to get more efficient at making these machines and their successors.  There's not much reason for IBM to pass along the bulk of its manufacturing cost savings to customers.  Mainframe buyers seem content to pay a premium for their machines and if the price/performance gap between mainframes and other platforms widens, well, hardware is only a small part of it.  Mainframe shops spend a lot of money for software and support, too, also at high prices.  They believe there simply is no practical substitute for their big iron systems, and that the big iron offers unmatched value even at a high price.

The price of mainframe systems has always led critics to forecast doom for IBM's flagship servers.  Predictions of the imminent death of the mainframe seem to arise in computing from time to time and so far they have always turned out to be wrong.  That doesn't mean the mainframe won't fade away (or become a firmware image of its former hardware self) one of these days, but IGF figures it's a safe bet that there's going to be a mainframe leasing business, and a big one at that, for at least the next few years, which is as far out as its deals reach.

— Hesh Wiener March 2008


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