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Leasing and Speciality Finance Companies Part I: An Introduction to Leasing and Lending

Reviewed by a Financial Institutions Group Investment Banker

What is Leasing? What Do Leasing Companies Do?

In a nutshell, a leasing company provides a physical asset for corporations that want to increase their capacity in return for regular payments. This way, a business can use assets without buying them outright. Leasing companies are financial institutions that act as intermediaries as they own the assets (possibly through leverage themselves) and rent/lease them out at a rate that allows them to earn an acceptable return on capital.

Many large banks have leasing arms – so did conglomerates such as General Electric.

The lessor is the owner of the assets and the lessee is the one receiving the assets under the contract. The physical assets range from light duty trucks and passenger vehicles to large industrial equipment.

The key difference between vehicle purchase and leasing is that in a lease the company has an option to either return the vehicle to the leasing companies or purchase them for the residual value after the primary term (usually 2 to 4 years).

Differences Between a Lease and a Loan

When you lease a vehicle, you essentially have the right to use it for a predetermined number of months. At the end of the term, a lessee may return the vehicles after paying any end-of-term charges. In the case where the company wants to purchase the vehicles, it can pay the additional price that was agreed upon and claim the vehicles. On the other hand, a financing arm provides a loan to commercial clients to finance the vehicle purchase over a period of time.

The monthly payments on a lease are usually lower than monthly finance payments on the same vehicle because you are paying for the vehicle’s expected depreciation during the lease period, plus a rent charge, taxes and fees. There are both advantages and disadvantages to leasing vs. financing.

Leasing allows lessees to increase their cashflow and frees the users of the burden of paying a large amount of cash upfront. Another key different to notice is that leasing allows users to use the assets without incurring any debt.

Because a lease is usually classified as an expense and not as a debt, lessees do not risk their credit going down. However, leasing is typically more expensive over the long term than purchasing assets upfront. Lastly, lessees do not have full legal rights of the assets being used and should carefully follow the terms outlined in the contract.

How Does a Leasing Company Make Money?

  • Financing profit: one of the primary ways that leasing companies make money. High financing profit means that higher interest rate was charged to companies that are leasing out vehicles. For example, a leasing company borrows money at an interest rate of 15% per annum and charges a lease interest rate of 20%, then their financing profit would be 5% per annum. Since this industry is very competitive, a lot of the firms often price their lease rates with little to no finance profit. This inevitably drives them to look for other profit sources which leads to the next point.
  • Service and other revenue: This includes fuel cards, accident management services and maintenance services revenues. Also included in service and other revenue are syndication fees, which represent commissions received when the company facilitates a lease arrangement between a lessee and a third-party lessor.
  • Prepayment penalties: these are incurred when a lessee exercises its contractual rights to terminate the lease early. In such a case, the leasing company will charge a lessee an amount that is equal to its predetermined termination value. By structuring the termination value, the leasing company can generate another stream of profit.
  • Excess use charges: another way the leasing companies make money. When the vehicles are returned in good condition, the end of lease sale profit will be much higher. To ensure that the vehicles are maintained properly, the leasing companies set out strict guidelines on how to use the equipment or vehicles. If the guidelines are not followed, the company can charge penalties, which are paid at the end of the lease.

What is Floor Plan Financing?

It is one of the ways to finance the vehicles by using the lessee’s funds to finance the vehicles from lenders. The loans are usually secured by the vehicles purchased as collateral, and it is an effective way to finance the inventory without paying cash. Through this, retailers or leasing companies can have the inventory or vehicles in stock as opposed to selling it from a catalog, and boost sales and profits by streamlining the inventory acquisition.

Corporate Valuation for Leasing and Finance Companies

As for the valuation of these financial institution companies, the bank and insurance valuation techniques can be used in most circumstances even though the capital regulation tends to be national and less strict than for banks and insurance companies.

Free Cash Flow to Equity/Levered DCF

You can perform a Discounted Cashflow Analysis by valuing the present value of the future cashflows that the existing contracts will generate, and separately valuing the new businesses that the company is planning to launch. The latter estimation is usually done through discounting the future results of expected new contracts or by just using a multiple that is based off the comparable companies.

Beyond the techniques mentioned above, it is also important to note that leasing companies’ assets and earning power are as relevant as the cashflows it is generating.

The valuation of finance companies should be carefully conducted through a thorough analysis of the business’ strategy, national industry structure and the forces influencing it, as well as macroeconomic environment.

To give an example, if a portfolio of vehicle lease contracts were negotiated in conditions that differ significantly from the current prevailing market conditions on the market valuation date and there was no hedge against such change, an analyst would need to assess the impact of the situation.

Finance companies often operate as a subsidiary of banks or other large financial institutions, and because of that, depending on the purposes of the valuation, it is needed to analyze to what extent the cost and conditions of financing for the company are affected by being part of the larger financial institution. In other words, a valuation specialist would need to assess the leasing company’s stand-alone capacity of raising financial resources.

It is important to note that instead of valuing the firm by discounting expected cash flows prior to debt payments at the weighted average cost of capital, it is more standard to value equity by discounting cash flows to equity investors at the cost of equity.

Estimating cash flows prior to debt payments or a weighted average cost of capital might be problematic when debt and debt payments cannot be easily identified, which is usually the case for financial services firms. That being said, equity could be directly discounted by discounting levered cashflows to equity at the cost of equity. The cashflow to equity is the cashflow left over for equity investors after debt payments have been made and reinvestments needs met. This is the main reason why P/B and P/E multiples are used rather than value multiples such as EBITDA.

Also, financial leverage is another dimension that makes financial services firms differ from other industries. Banks or specialty finance companies tend to use more debt to in funding their businesses so their leverage ratio is usually higher than most other firms. Because of this, small changes in the value of the firm’s assets (or interest rates) can have a material impact on the equity value.

Finance Company and Leasing Valuation Multiples

In practice, for these so-called “Specialty Finance” companies, the bank and insurance valuation techniques can be used in most circumstances even though the capital regulation tends to be less strict than for banks or insurance companies. The metrics used to value a leasing/financing companies are Price to Book multiple (P/B) and Price to LTM Earnings (P/E).

According to SNL Financial, a leading platform for Financial Institutions research, the average P/E and P/B as of the end of year 2017 were at 11.2x and 0.89x respectively for Auto Finance companies. In addition, the same metrics for Leasing companies were 11.8x and 1.11x.

Other key financial metrics when analyzing leasing companies include Tangible Financial Leverage, Book Value per Share, Tangible Book Value per Share and Intangible Operating Margin.

Going back to why it is hard to estimate the cashflows for financial services firms, it is because unlike manufacturing firms that invest in plants, equipment or other fixed asset, financial services firms invest in intangible assets such as leaseholds and licenses. As a result of that, the investments for future growth are often classified as operating expenses in accounting statements. Consequently, a traditional way of estimating cashflow may be problematic.

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Brian
Brian
Brian is a fourth year student studying actuarial science at the University of Waterloo. He was an analyst (Co-op) at OMERS Capital Markets in the Insurance Investment Strategy Group. Prior to that, he interned at Mercer as a summer analyst in the Financial Strategy Group. Outside of school and work, Brian enjoys playing squash and soccer.

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