Special Report: Bang for your Buck

Brooke Wisdom

March 4, 2011

As aging equipment requires replacement, determine what financial options will work best for capital investment.

by Therese Dunphy, Editor-in-Chief

Since the construction market collapsed in 2008, operators have shown unprecedented levels of cost consciousness, and rightly so. In an industry where the profit per ton often can be calculated to the right of the decimal place, every penny truly does count.

To keep costs down, many operators have extended the life of the iron in their plants, and it made sense. As production requirements dropped, equipment usage also fell. When replacement equipment was needed throughout 2010, nearly three in four operators chose to buy used equipment rather than new. But high-quality used equipment is becoming scarce, and existing iron continues to age. Eventually, new equipment will be purchased, and operators should understand how to get the biggest bang for their buck.

When is the right time?

Consumer confidence aside, there are a number of objective parameters that influence equipment procurement decisions. Each of these can drive an operator’s decision on when to make capital investments.

One consideration is the relationship between maintenance costs, replacement costs, and production requirements. Each type of equipment has a natural maintenance cost curve based on site-specific factors such as the operating environment, mineralogy, and preventive maintenance. Experienced operators develop metrics that indicate how many hours of use or tons produced a piece of equipment typically logs before maintenance costs begin to climb and equipment reliability begins to drop. As that metric nears, many opt to replace equipment rather than risk unplanned downtime.

Another factor is the operator’s balance sheet. Before purchasing new equipment, an operator should evaluate if he has enough product demand to cover current equipment costs and if cash flow is sufficient to invest in new equipment. Caterpillar Financial Services, in conjunction with various dealers, has offered seminars to help its customers understand their financial position, tax considerations, and cost/benefit analysis of repairing versus replacing equipment. In today’s business environment, some financing groups want strong ties with their customers.

“Our focus with customers is that we want to have a relationship with them,” says Mike Rankin, U.S. vice president of CE Financial Services, the captive finance arm of Volvo Construction Equipment. “In the finance business, equipment funding is a little bit volatile. It’s good that your lender knows you and you know them so that when things get a little tough, if you need some help, you can communicate effectively.”

Who is the right partner?

The shrinking number of players in the financing market has created a challenge for some operators, and today’s lending standards may pose stricter requirements than those of a few years ago.

Units Financed

ELT Magazine, a publication serving the equipment financing market, reports that new business volume fell from $116 billion in 2008 to $81.1 billion in 2009. At the same time, lenders faced a 40-percent increase in delinquent accounts (90+ days) and a 129-percent increase in charge-offs. However, the equipment financing market began to turn the corner in 2010 with a 23-percent increase in new business, while late pays and charge-offs declined by approximately 40 percent.

“Lenders are becoming more confident in qualifying people for low-cost financing,” says Tim O’Brien, marketing manager for Case Construction Equipment. “We think the big majority of new machines will be financed.”

“There’s a lot more positive out there right now than there was a year ago,” Rankin adds. “I can see a huge difference out there.”

2010 Units Financed

While the lending market is improving, it is not without its casualties and consolidations. Case and New Holland merged to form CNH Capital America, and Wells Fargo acquired CIT group. Some private banks exited the equipment financing field. But while there are fewer players in the market, financing opportunities do exist.

Operators are increasingly likely to turn to captive lenders (subsidiaries set up to provide lending for a manufacturer’s customer base) for their financing needs. Over the last five years, more than two thirds of mobile equipment financed for aggregate operations has been financed through this market segment.

“One of the advantages of captive is that they’re in the market during good times and bad,” Rankin says. “Captives have stayed committed. We’re real proud of the fact that we’ve done a lot of extensions and modifications and restructures to keep Volvo customers in business during this downturn.”

What’s the right finance option?

To select the right financing, operators must assess their own needs, business strategy, and goals. “It’s real important to understand what you’re trying to do as a company, and then match that to your funding structures,” Rankin explains.

For example, an operator with cash on hand and no desire to incur long-term debt might opt for a cash deal or make a large down payment with a short-term finance period. It could then take advantage of the tax benefits available through equipment purchase.

Another operator might be concerned about cash flow. If lower monthly payments are its top priority, it could select a lease option. In this case, the lender retains the tax benefits. Two traditional lease options include a fair market value (FMV) lease and a fixed purchase option (FPO) lease. With the FMV, the lessee can purchase the equipment for the current fair market value at the end of his lease. With a FPO, a purchase price is determined at the outset of the lease.

“All of the banks and captive financing options are a little bit different, but, generally, what you find is that the FMV will give you a little higher residual because the risk cuts both ways,” Rankin says. “On an FPO, the customer is only going to buy when it’s to their advantage.”

Another important consideration is the length of the financing period. Operators should consider the number of hours of use or tons produced before the equipment’s maintenance curve jumps and finance it correspondingly. “The typical length of the finance term is 36 to 60 months,” O’Brien says. “But we see some 72-month loans, too.”

For longer loan periods, it’s important to make sure that the lessee has a long-term perspective on the business. “The important thing is to match the finance to the business needs so you don’t have a 60-month finance contract and a 12-month or 24-month perspective on your work,” Rankin says. “You need to match those up.”

He recommends including an early out or early purchase clause with longer finance terms to increase flexibility and suggests that operators review financing agreements for pre-payment penalties.

“A lot of people tend to think that my dad, or my predecessor, or I have always funded it this way,” Rankin says. “As we come out of this downturn, I think it’s good to look at the big picture and everything that’s available instead of just how it has been done in the past.”

If operators can determine their business strategies and tailor their financing options accordingly, they will be penny wise. AM

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