Standard & Poor's specialized focus on leasing analysis specifically addresses the leasing activity of a finance company. Criteria are outlined in a leasing addendum that supplements the general finance company rating methodology. This allows for a more focused credit assessment of leasing companies, as well as leasing subsidiaries of independent finance companies, utilities, banks, and corporates. The additional criteria pertains to lessors that are involved in operating and capital leases.
Because of the significant impact that accounting standards—and especially tax regulation—have on the economic viability and strategic direction of the leasing business, "accounting changes and tax considerations" are included in the methodology's industry risk section. This section focuses on the relationship of the industry to the economy and the possible impact of various economic scenarios, including ramifications of legislation. In addition, the asset quality section considers a detailed credit analysis of a leasing company; analysis of the asset quality of a finance company focuses on the composition of the company's portfolio regarding type, mix, diversity of receivables, and evaluation of growth. Under the diversity section of the methodology, Standard & Poor's also examines a company's assets for diversification of lessees. The absence of a well-diversified base of borrowers or lessees of equipment would contribute to a lower asset quality assessment of the credit.
The analysis of a finance company's growth also includes as part of its assessment a company's strategy for expansion beyond its current market. Increasingly, finance companies are expanding globally in search of growth, as many domestic markets have matured to a point where they no longer provide enough business to support the natural run-off of a company's asset base. Global expansion for a finance company is rapidly becoming a competitive necessity, particularly as it relates to remarketing equipment on lease, repositioning equipment, and meeting the needs of customers with increased global focus. Expansion is occurring into Mexico, Europe, and Asia by both consumer and commercial finance companies. As a result, Standard & Poor's examines how a company pursues its overseas expansion—whether through a new independent venture or through a joint venture partner. If expansion is done independently, Standard & Poor's evaluates if a company can successfully leverage off its existing franchise and the success rate of previous competitors. International expansion through a joint venture arrangement is scrutinized to determine the structure of the arrangement, the role of the participants, and the company's expectations from the relationship.
Leasing Criteria
Operating lease versus financing lease.
Additional leasing criteria, which apply to all equipment types, include an analysis of the type of leasing, whether an operating or a direct finance lease under FASB 13, or a sale leaseback transaction. An operating lease, or true sale lease, generally has a shorter term, a higher annualized lease rental rate, and a higher residual risk position relative to a direct finance lease. The residual risk is determined by comparing the originally booked equipment residual value to the fair market value of the equipment at the end of the lease term. A higher initial residual assumption implies more aggressive pricing at the lease initiation. Under this pricing structure, the higher residual value may not be realized at lease termination. This is the type of liberal initial residual setting that would not be viewed favorably by Standard & Poor's.
Direct finance leases are commonly full payout leases, and the lessor recovers its equipment cost over the course of the leasing transactions, often as early as at the end of the first or second lease term. With a full payout lease, there is no residual risk. Since no residual is initially booked up-front, the pricing component captures the entire cash flow of the transaction.
Credit quality of lessee.
When analyzing leasing activity of all equipment types to determine a lessor's credit rating, Standard & Poor's evaluates the credit quality of its lessees. This analysis focuses on the diversity of lessees and the creditworthiness and consistent credit caliber of the lessees.
Global remarketing capability.
As previously discussed, lessors are evaluated for the depth and breadth of their global remarketing capabilities and franchise. The ability to place equipment as it comes off lease is critical to any mainstream leasing activity. Profitability depends on the placement of equipment, which in turn, hinges on demand. Lately, the demand for various equipment types overseas has been particularly strong. By comparison, the U.S. demand for certain equipment types, especially airplanes, has stagnated with market saturation.
Residual risk and realization trends.
In addition to residual risk considerations (see "Operating Lease Versus Financing Lease" section), Standard & Poor's looks at trends in residual realization for all equipment types as a percentage of original equipment cost recovered.
Cash flow adequacy.
Cash flow adequacy is of paramount importance in analyzing a leasing operation. As part of its analysis of cash flow adequacy, Standard & Poor's uses several cash flow ratios that measure the operating cash flow of the business relative to expenditures, specifically to total debt, capital expenditures, and capital expenditures minus proceeds from sale of equipment. These ratios are analyzed on an absolute basis and on a trend basis to sufficiently depict operating cash flow at both a specific point in time and over a period of time.
In addition, the ratio of future cash flow from existing contractual receivables as a percentage of net leased assets measures the cash flow due from existing leased assets at a point in time, divided by its net book value, serves as a measure of payback and indication of equipment age. The traditional earnings before interest, taxes, depreciation, and amortization and interest coverage ratios also are incorporated into Standard & Poor's analytical framework.
Liquidity.
In its analysis of the strength of a leasing company's liquidity management capabilities, Standard & Poor's examines additional criteria to the liquidity management criteria in the finance company general methodology. First, Standard & Poor's examines the useful life of the relevant equipment type to determine the extent the asset in question could be sold to raise cash to meet the lessor's obligations or liquidity needs. The marketability of the equipment or the resale value provides an additional source of funds for repayment to meet unforeseen cash requirements. Obsolete equipment, such as high-technology equipment or equipment with limited salability, provides a lessor a source of cash for repayment if there is a cash squeeze. Second, the leases that the lessor has written for its lease duration and its maturity ladder are examined. Standard & Poor's looks for a spread of lease duration or average life of the leases to avoid any type of lease concentration. Moreover, the lease maturity ladder, or expiration of leases over time, is scrutinized for a spread of maturities.
Equipment Types Factored Into Leasing Analysis
What distinguishes the criteria in the leasing addendum from those in the general rating methodology is the major addition to the asset quality section of criteria specific to equipment types with different quality performance dynamics. These include:
Aircraft
Automobile and light-truck fleets
Intermodal cargo containers
Railcars
Trucks
Computer equipment
Aircraft lessors.
The fleet demographics of aircraft lessors formally include an analysis of its age, aircraft type, and noise compliance (Stage II or Stage III). Newer fleet, more marketable planes, and aircraft that meet Stage III noise requirements (aircraft that meet certain noise requirements, which must be phased in by the year 2000) are given a more positive weighting. Furthermore, analysis of aircraft residuals focuses on two areas. The first is an analysis of residual realization experience, which compares the residual value of the aircraft at the time the equipment was booked to the realized residual. This analysis also assesses the company's aggressiveness or degree of conservatism in booking its residuals.
The second area of analysis focuses on the aircraft lessor's global remarketing capability. A stronger global remarketing presence reduces an aircraft lessor's residual risk, in that an aircraft lessor can more easily and quickly place the aircraft back on lease because of a larger pool of potential lessees in the global market compared to domestic markets. Standard & Poor's has seen heightened leasing activity in Asia, particularly China, where demand for aircraft is growing far more rapidly. With the U.S. aircraft market's persistent doldrums and the resulting difficult domestic aircraft placement market, much of the future growth in the aircraft leasing business is expected to come from overseas lessees.
Automobile and light-truck fleets lessors.
In analyzing fleet lessors, Standard & Poor's considers how effective the lessor is in providing service to its fleet customers. The service element of the business is critical to the rating because in all the finance companies that Standard & Poor's has rated to date, the credit risk has been minimal because of the strength of the lessees' Fortune 1000 client base. The proliferation of corporate downsizing and restructurings, somewhat mitigated by the trend toward corporate outsourcing, has led fleet lessors to search for more avenues for incremental growth. As such, fleet lessors are beginning to target individuals through some type of affiliation (affinity groups), as well as small businesses. Both of these targeted customers have a greater potential credit risk relative to the typical higher-rated, investment-grade credit ratings of Fortune 1000 companies. Consequently, this potential higher credit exposure would be a concern and carefully monitored by Standard & Poor's.
Intermodal cargo container lessors.
With container lessors, concern is mostly with the lessor's equipment positioning risk. The critical success factor in this business is the lessor's ability to move containers to meet customer demand in a timely and low-cost manner.
Two major factors affect equipment positioning risk. The first is the global trading environment, which is defined as the global import-export trade environment. The second is the type of product transported, which affects the type of containers used. For example, the two most common types of transported containers are dry box containers and refrigerator containers. Dry box containers, which are just plain boxes, are distinguished from refrigerated containers, which transport refrigerated products such as food.
The sophistication of the leasing company's equipment tracking technology also is important, as it is a major determinant in advancing the placement of containers and it affects the cost component.
Intermodal cargo container lessors are differentiated from railcar lessors (see "Railcar Lessor" section) by the higher degree of credit risk associated with intermodal cargo container lessors. Container lessees are almost exclusively shipping companies; many shipping companies historically have had weak credit fundamentals, and several have reached the stage of bankruptcy.
Railcar lessors.
Aspects of the credit analysis of railcar lessors parallel the analysis of container lessors. Like container lessors, Standard & Poor's is concerned with a railcar lessor's equipment positioning risk, the level of sophistication of the company's tracking technology, and the type of product transported. However, Standard & Poor's perceives railcar lessors to have fundamentally less credit risk than container lessors, since railcar lessors hold long-term leases—the equipment type often stays with the railcar lessee for its entire life, unlike intermodal cargo container leases, which can have a term as short as one day. Moreover, railcars typically have gone with the acquiring company with a corporate change in ownership, and the equipment has continued to remain on lease to the lessee. Additionally, the credit quality of railcar lessors is much higher than that of container lessors, because railcar lessees, which include chemical and oil companies, have much higher credit quality.
Truck lessors.
The framework for analysis of truck lessors focuses on the depth of its dealer network as a source of new business. Additionally, a truck lessor's ability to provide fee-based service enhancements is crucial as a source of revenue growth. These services may include:
Cellular phone services
Maintenance assistance program
Financial and performance data reports
Transportation logistics consulting
Driver leasing
This trend of offering fee-based services also is prevalent among automobile and light-truck fleet lessors.
Computer equipment lessors.
Standard & Poor's examines computer equipment lessors for the demonstrated strength of its remarketing capability. The distinguishing feature among computer equipment lessors is the depth and breadth of the remarketing franchise, since this directly affects the lessor's ability to move the equipment, generate cash flow, and recoup its investment in the equipment. The larger and dominant companies—such as the captive subsidiary IBM Credit Corp. and the independent company Comdisco Inc.—have global franchises and can move larger ticket items that most smaller players in this market cannot. Thus, these companies have an enormous competitive advantage over the myriad of smaller firms in this very fragmented market.
