At the Crossroads of a Slowing Economy

by By Carl Chrappa Nov/Dec 2019
Carl Chrappa discusses falling equipment prices and 2020 predictions with a note of optimism: this too shall pass for companies that prepare. We have enjoyed historic growth in the economy and its resulting benefits for nearly a decade. Equipment sales and production have accordingly ramped up. Low interest rates have also helped. However, faced with the fallout from tariff disputes, geopolitical issues, a potentially hard Brexit and a dysfunctional U.S. Congress, this may be coming to an end.

Carl Chrappa,
Managing Director, Asset Management,
The Alta Group

Have good economic times led to an over production of equipment with negative value implications? If the economy declines, will residual values follow? Is there a growing residual value risk? This article will present several examples of residual value risk scenarios and counter measures based on current and future conditions.

Residual Risks

Residual value analysts must consider a multitude of things that could affect future values. The most difficult forecasts come during a time of change and uncertainty, such as we have now entered. For example, consensus forecasts for the U.S. economy show that last year’s gross domestic product (GDP) growth rate of +2.9% will fall to +2.2% this year, then drop to +1.7% in 2020, before rising to +2.0% in 2021. Likewise, investment in equipment (an important element of equipment finance) is expected to fall from a growth rate of +6.8% last year to +1.4% this year and to -0.3% next year, before increasing to +2.5% in 2021. Lastly, the consensus is for new light vehicle sales to drop by 400,000 units to 16.8 million this year and next versus last year’s total of 17.2 million. This sales decline has implications for the machine tool, plastics, steel, rail, truck and allied industries.

Tariff disputes are also having an impact on the global economy to the point where a United Nations forecast notes that global economic growth will moderate this year to 2.3% (revised from 2.7%) from last year’s 3%. To make matters even more interesting, a World Trade Organization forecast indicates global trade growth will fall from +3.0% last year to +1.2% this year. All of this will certainly have an impact on our economy and equipment values. For example, if the rate of trade growth declines by 60%, surely that will be reflected in values for marine vessels, containers, automobiles, railcars, trucks and trailers, aircraft, and manufacturing, to name but a few.

A review of past tipping points shows that used equipment values can and have dropped by 20% to 60% when the market turns sour. The good news is those values usually recover in a relatively short period of time. However, the bad news is that as the economy softens, estimated residual values will almost certainly fall.

Ripple Effects

As the slowdown hits the industrial sector, business failures will increase, throwing more and more equipment into an already soft market. Commercial Chapter 11 filings in September jumped by 33% year-over-year (y/y). In addition, according to ACT Research, shipping company failures have increased to 640 for the first half of this year, removing 20,075 trucks from the road. This compares to 175 failures last year, taking 1,550 trucks off the road. Will this cause values to soften? Already, auction values have dropped by 20% to 25% and wholesale prices by 15% to 20% y/y. Growing inventories are a cause for concern. The volume of Class 8 sales has also fallen by almost 15% y/y, and YTD sales volume has dropped by over 11%. Additionally, trailer orders have been falling, and total production is expected to fall by over 15% next year.

Physical conditions of leased equipment could also slip as lessees try to stretch and preserve cash. Furthermore, utilization could increase from lessees trying to do more with less, again leading to lower residual values. This should be considered in setting values, especially for weaker credits.

The change in equipment markets is already underway. The Institute for Supply Management Purchasing Managers’ Index (ISM PMI) fell to 47.8% in September, its lowest level since June of 2009, giving credence to a potential market malaise. Exports continue to drop; used truck values at auction in the first eight months of 2019 decreased about 8% from 2018 levels, and Class 8 trucks hit the fourth consecutive month of record new truck inventories. Prices have started to fall to the point where ACT Research warned, “It’s pretty clear the next chapter of this story will not be a happy one, and it will also have an impact on equipment demand in adjacent sectors, such as construction, oil field and gas, farm making and industrial.”

Very high production and sales levels of Class 8 trucks and trailers, in the area of 25% to 35% above the historical mean, may cause values (as a percent of original cost) to fall three to seven years hence from their current norm, as higher than normal lease returns flood the market.

Used prices in the oil patch have already declined by well over 10%, as the rig count fell in October by about 19% y/y. In addition, this year, U.S. oil exports to China have fallen by approximately 125,000 barrels per day. The implications are obvious.

In addition, used car prices have already started to decline, and new cars are being discounted through sales incentives on the order of 10%, pushing used prices down as bloated inventories of unsold cars dilute the primary market. In September alone, new car sales volume fell y/y by 12%.

Not to be outdone, trailer orders have plunged by 51% in 2019 as of this writing. Latest construction equipment values have also fallen by over 5% and are trending lower. More concerning is that U.S. railroad traffic (carloads) declined in October by a stunning 8.5% y/y, while y/y intermodal shipments fell by 5.8%. Overall, year to date total rail shipments have declined by 4%. Thus, industrial goods shipments by rail have fallen significantly, soon to be carried over into the trucking and marine sectors.

Anecdotally, in the second quarter of 2019, major U.S. banks set aside 9% more for loan losses than in the same quarter of 2018.

Counter Measures

In view of current conditions and market forecasts, leasing companies should closely follow and prepare for end-of-lease (EOL) terminations. Proper preparation is a must. The leasing analyst must know a fair price for the equipment. Also, return and maintenance provisions should be considered and adhered to. If inspections are made, damage estimates can also be taken into account and added to residual value realization.

What to do? If all or most EOL sales have been logged into a database, then a statistical analysis can be made and assumed future residual value (RV) estimates might be lowered by one standard deviation. This may have already been contemplated by lessors who book at orderly liquidation value (OLV) or 80% of OLV.

To summarize, it is clear a business correction is underway, and the economy is softening. Used equipment values have already fallen in many classes and forecasts call for greater impacts in 2020. So, an ounce of prevention is worth a pound of cure. Analyze end-of-lease terminations and return and maintenance provisions more carefully now and in the months ahead. Also, employ third-party valuation and remarketing firms that understand equipment leasing and have a long history of providing satisfactory work results. Make sure to understand the value of different asset classes in today’s uncertain economy. Shore up appraisals, valuations and lifecycle asset management strategies with data, not just opinion. And remember, no matter what, this too shall pass for companies that take the appropriate counter measures.

Finally, besides “black swan” events impacting the economy, we might be surprised by a few “white swan” events to come, such as a settlement of the U.S./China tariff talks, the passage of the Surface Transportation Bill and/or the U.S./Mexico/Canada Free Trade Agreement (USMCA). Maybe even lower interest rates as well. Time will tell.

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