Machinery and Equipment: It's Safe to Lend Again
By: Richard E. Schmitt, ASA, CVA, Chief Operating Officer, AccuVal Associates, Inc.
The U.S. economy, like most things, is different now than it was when it collapsed in late 2008. That's an oversimplification, but it's a point that should be affecting the lending market more than it is. Once-risky areas, defined by dramatically falling equipment and real-estate prices, can now offer major potential for banks that are willing to step past recession-induced fear and take a calculated chance.
Smart lending opportunities have arisen since the economy, including the manufacturing sector, started picking up in mid-2010. With business returning to about 75 percent of past levels in many of North America's staple industries, good-quality equipment has become scarce (due to the heavy shutdown and scrapping activities that took place in late 2009 and 2010). In the current economy, many businesses can now sustain the costs of going back to work and are showing a strong desire to regain lost market share if lenders will stand behind them.
Recession concerns versus misguided fear
Up until the recession's full onset in fall 2008, many financial institutions had been offering asset-based term loans to companies. These term loans could reach 70 to 75 percent of the liquidation value of the collateral and were a common component of loan packages pre-recession. But when machinery and equipment values across numerous industries dropped by about 50 percent in late 2008 and 2009, lenders commonly found themselves in a difficult position.
Lenders realized that the value of equipment they had lent against wouldn't regain substantial value until economic conditions improved. Accordingly, a number of them worked with the companies that could pay down loans eventually, but if they couldn't, some companies were sold to pay lenders out. Although there were a number of problem transactions, it is critical to recognize that the significant losses the banking industry took were far more attributable to residential real property and not industrial loans. Yet, lenders still focus on the stress caused by the rapid and real drop in collateral values, and many have yet to get over it when evaluating machinery and equipment as a component of loan packages.
Considering the economic climate during those years, the fear made sense. Metal-cutting machine-tool sales, for instance, plummeted from approximately $3.3 billion in 2007 to just more than $1.9 billion in 2009, indicating how poorly the manufacturing and machinery sector weathered the onset of the recession. As of late 2009, the manufacturing sector had lost 2 million jobs – more than any other industry – and cut more than 14 percent of output. None of those figures would or should have inspired lending confidence. However, nearly four years after the recession kicked off, the climate is different and should be financially supported differently.
Burgeoning demand and competitive secondary equipment market boosting values
Domestic producers are performing considerably well when compared to many manufacturers abroad. As of this May, Eurozone manufacturers had hit a 35-month low, and Chinese factories had weakened for seven months in a row. (It should be noted that Japan stands as a counter example, noting 5.7-percent increases of core machinery orders this April, compared to an expected 1.5-percent increase.)
Domestic machinery demand has picked up significantly, meaning that manufacturers are back to work, and often worthy of a lending risk. Caterpillar Inc., the world's chief producer of mining and construction equipment, has arisen as a success story from the recession. The company showed risk-adjusted gains of 4.5 percent between June 2009 and 2012. Since 2010, the business has built up factories in emerging markets such as China and Brazil, and analysts for Bloomberg have anticipated the company's earnings should more than quadruple for the three years through 2012. All this comes from a company that saw its net income drop a massive 75 percent (hitting just $895 million) in 2009.
By the time the industry started picking back up in 2010, companies that manufactured equipment had closed or right-sized – shutting down plants, liquidating assets and reducing their capacity to respond to economic conditions. Fifty-percent drops in production capacity weren't uncommon.
Now that business has begun to return, equipment manufacturers cannot keep up with demand. Lead times on new equipment can be six to 12 months or more causing companies to evaluate the benefit of expanding production to meet demand. Some that can add second or third production shifts are doing so, but that still doesn't address the need to upgrade or replace certain aging assets.
Equipment that was melted for scrap value or sent abroad is now in short supply. Companies are very willing to spend good money for quality used equipment, when and where they can find the machinery they need. This has helped return values in many industries to pre-2008 levels. In many cases, companies are even paying a premium above 2007 prices because of scarcity.
Large equipment purchases for industrial and materials manufacturing companies jumped by 37 percent last year, compared to about 17 percent for other industries. Minnesota-based Dynamic Sealing Technologies, for example, spent $450,000 on equipment in May 2012, compared to $800,000 for the entire year prior. The manufacturing-equipment producer noted 20-percent revenue growth last year, and it doubled its revenue in 2010.
While businesses are clamoring to get equipment back (and while eager auctioneers, used equipment dealers and liquidators are excessively competing to secure any liquidation opportunities to auction and to redistribute the equipment), productivity is suffering. The average production lead time rose to 8.8 weeks at the end of this March, compared to a low point of 5.4 weeks last December. With businesses eager to get back to work, that leaves profit motives high for lenders willing to address term debt.
A renewed opportunity for lending
A number of lenders are still playing it safe with machinery and equipment-backed loans, and in general, there's a shortage of term debt in the marketplace. The bottom line is that business is different now than it was in 2008 and 2009, but some banks remain leery about asset-based term lending. Some lenders are allowing it only as a smaller portion (20 to 40 percent) of the total loan facility, regardless of the value of the collateral assets. Other bigger banks won't lend term debt at all and have chosen to focus on the revolving assets, such as accounts receivable and inventory.
While no one can guarantee that the U.S. or other nations are safe from the wave of global economic concerns, there has been a significant right-sizing. The pent up demand is evident in many areas, and many companies while producing at sales levels and margins below 2007 levels, are much healthier. Fearing another recession only hampers business all around.
Market activity is brisk, especially in basic production industries, such as machining, stamping and plastics. There's a substantial opportunity to lend securely against term assets, as the ample (and sustained) demand for late-model used equipment shows.
There are always exceptions to the rule, and some industries such as lumber and cement admittedly haven't picked up. But for the average business and the average lender, the opportunities are noteworthy.
The current demands for term debt financing are there. If the assets are properly appraised under today's market conditions, and are part of a well-managed monitoring of market conditions and amortization process, equipment term financing can produce significant financial benefits to those lenders willing to get back in the game. Those lenders willing to assess the current marketplace for what it is now, not what it was four years ago, and take the risk, could reap significant financial rewards.
About AccuValAccuVal provides a broad range of valuation, advisory and asset management solutions that contribute to growth or help ensure survival. We appraise the business enterprise and shareholder equity; bonds; intangibles and intellectual property; machinery and equipment; inventory; real estate and accounts receivables in over 100 industries worldwide. Learn more at www.accuval.net.