The construction market looks a lot different depending on your vantage. While conditions have been soft for manufacturers, dealers and rental companies, those on the supply side have seen sales increases. John Crum of Wells Fargo Equipment Finance’s Construction Group examines the trend of risk transference in the market and how it has resulted in optimal conditions for contractors.
The overall market conditions in the construction equipment industry can best be described as a mixed bag, and your views on it depend greatly upon which channel your business falls into. If you are a manufacturer, dealer or rental company, you may be experiencing some softness in your business. Over the past five years, many businesses on the supply side have been able to increase sales volumes, in part, by focusing on expanding the availability of rental equipment. This has been in direct response to the changing business philosophies of the ultimate end-users of their products.
The result has been transference of risk from a broad base of end users to a more concentrated risk with dealers and rental companies. The latter are now assessing the risk created over this period. Some are holding fleet levels steady rather than increasing them while others are implementing strategies to shrink their fleets. This is having a pass-through effect on the manufacturers that supply them — recent earning reports from the major OEM’s have confirmed this.
That’s not to say the news is all bad. One segment of the market has benefited from this transference of risk. Contractors and end-users of construction equipment are enjoying a period of time that many might look back on 10, 20 or 30 years from now and remember as “the glory days.” Three major business factors support this situation.
Available Work for Contractors
There is work out there for contractors. What may surprise many is private construction has led the way with sharp increases in spending dating back to 2011 and continuing at least through August of this year. There are pockets of weakness in the industry, particularly with the continued sluggishness of oil and gas and the early signs of softening in state and local construction spending.
That said, according to the U.S. Census Bureau, through September 30, 2016, the total value of all construction put in place was up 4.4% versus the same period in 2015. Private construction was the largest contributor with the value of all private construction up more than 6.8% for the same period. Public construction was down 2.2% during this time. While there is noise in the market and much uncertainty, even the recently released Dodge Data & Analytics construction outlook forecast for 2017 reports positive, but more modest, expectations for 2017. Overall, for contractors and end users of construction equipment, work has been, and is, available.
Favorable Interest Rates
The second major business advantage for contractors, and all consumers of debt, is the historic low level of interest rates to fund their businesses. The five-year treasury yield was at 4.64% 10 years ago. On October 25, 2011, the five-year treasury rate was at 1.01%. If a contractor took out a $1 million loan on a fixed rate for five years, the difference in the index alone put almost $100,000 back into their business over the life of the loan.
Today, the five-year treasury yield is at 1.29%. The change in floating rate debt is more dramatic. The 30-day LIBOR rate was 5.32% in October 2006, 0.25% in October 2011 and today stands at 0.53%. For simplicity, if the average rate was 0.32% over the past five years, a contractor with a $1 million average balance on a line of credit would have an additional $250,000 to use for business.
The third factor is the way contractors are managing their equipment fleets and the response of dealers and manufacturers. The Great Recession taught many costly and tough lessons to contractors who were on the front line of the economic collapse. Starting in 2008 and continuing through 2010, most contractors had to face agonizing business issues head on, including bloated overhead and too many employees and equipment fleets that were not only sitting idle, but that were declining in value faster than they had ever seen.
The first problem was the easiest to address. Expenses were cut. Purchases were cancelled. The second, while at times heartbreaking and painful for those involved, could be accomplished without an additional economic loss to the contractor. As a result, thousands and thousands of construction workers were laid off.
The third problem was more complicated. It was common for equipment to be worth less than its stated value on the books and, in many cases, less than what was owed on it. The decisions contractors had to face and the economic pain it caused have left a permanent mark on how they think about using and acquiring equipment.
Rental was already very popular before the recession, and it is even more so now. Contractors still need, and will continue to buy, equipment, but the bar has been permanently raised for purchase decision making. They are demanding options and flexibility more than ever. They need and want to use more equipment, but they are demanding that someone else take at least part of the economic risk associated with owning equipment. They have found many willing partners.
With the encouragement and support of their manufacturer partners, rental companies and equipment dealers have significantly expanded their offer ings. Whether it is in the form of short-term rentals, or longer-term leases with multiple return options, contractors have received what they demanded. As a result, the balance sheets of providers have increased significantly over the past five years along with their leverage. End-users have effectively shifted much of the burden and risk associated with equipment ownership to others.
For contractors, the result of these three business factors has been increasing revenues, decreased overhead, lower leverage, lower interest expense and lower risk in the event of another downturn.
While contractors are better positioned, rental companies are beginning to examine their businesses to avoid a concentration of risk in their rental fleets. They don’t want to be stuck with a problem similar to what the end-users faced — too much equipment and not enough market. There is more late model equipment available than in previous years. Due to the build-up of the fleets over the past five years, an increasing competition for rental utilization is starting to pressure rental rates. Under-utilized assets are sold. Compounding this is equipment that was previously deployed to the energy industry that has made its way to other parts of the industry.
The final pressure point is the return to the market of equipment that was on 12- to 36-month leases. Some major manufacturers have noted in recent earnings calls that this is something they are beginning to experience. We are seeing some dealers and rental companies hit the pause button as it relates to expanding and, in some cases, replacing their rental fleet assets. This pause is having a negative effect at the manufacturer level with sales volumes in some cases stalling or decreasing. As dealers have slowed their purchases, manufacturers have been forced to increase incentives to stay competitive, cutting into their overall margins.
What’s the bottom line? Contractors emerged from the recession smarter, leaner, with more options and better positioned for fluctuations. It remains to be seen what the future holds but our 2017 construction industry survey of equipment professionals will help us understand what lies ahead for contractors, manufactures and dealers. In the meantime, contractors should enjoy the “glory days” while they are here.
Ivory Consulting’s CEO Scott Thacker provides advice and counsel to equipment lessors and lenders on the best ways to improve customer satisfaction and profitability using modeling and pricing techniques. His colleague David Holmgren contributed to this article.
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