Want Credit? Then You've Got to Pass The Reality Sniff TestBy Kim Phelan
Article Date: 01-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.
…which means trading in fictional hopes for sound financial planning. And easy credit won’t be cropping up anytime soon.
The scarcity of accessible credithas ranked high on the distributor's list of woes throughout 2009 and will continue to be a source of frustration for many well into 2010, yet another layer that's blocking business like a sticky film of plastic-wrap. You can see money on the other side of the banker's desk, but darned if you know how to get through to it.
From the distributor's point of view, credit just dried up beginning fall of 2008, for both themselves and their contractor customers. From the banker's perspective (CED spoke to three of them), their credit standards haven't changed a mite – instead, it's the financial performance of their construction industry borrowers that have changed, and dramatically so. In fact, it appears both perspectives are valid, but with one key caveat: Banks always had standards, but for a long period of time they were not adhered to by many institutions; and while no one denies that the practice of imprudent, easy credit led to the foul circumstances in which we find ourselves today, it was a system that ‘trained' both dealer and contractor as to the definition of creditworthiness.
And it was an unsustainable definition.
It created a mindset that money would always be easy to tap. It was a system that caused construction industry borrowers to expect access to capital based solely on their past history of on-time payments and longtime friendship with their banker. And while the relationship and communication between banker/lender and dealer/borrower is still vitally important today, the criteria for credit approval has recoiled back to where it probably always belonged – lending standards based on (1.) high quality financial information produced by a good CPA familiar with the construction industry; (2.) right-sized operations that have been pruned down for profitability in the current market, which is expected to be the "new normal" for the unforeseeable future; and (3.) a well-developed business plan that holds up to a bank underwriter's scrutiny, based in solid facts and evidence rather than on the dealer's determination or good intentions – an achievable plan that can be broken down and assigned to various branch and department managers and salesmen who can both believe it and execute it, says Ron Riecks, president of Wells Fargo Construction.
In other words, the distributor's financial business plan has got to pass the "reality sniff test," Riecks says.
"Too many people aren't through the process of right-sizing their business, so they're still producing red ink," he said. "No financial partner is going to make more credit available while the business is hemorrhaging money…I haven't changed my parameters, but I have a heck of a lot fewer clients who qualify for credit. It's really that simple: Are you making money or are you losing money?"
Besides these important criteria, banks also use a grading system to evaluate borrowers, according to Mark Killpack, senior vice president, BOKF Equipment Finance. A score of 1 would basically be a cash-secured loan, but it's typically in the range of a 4 or 5 where more distributors live, he says, which means that the company's total liabilities are between two and four-and-a-half times its tangible worth. A grade of 5 would mean the business' liabilities are more in the vicinity of three-and-a-half to four times the company's net worth.
Because every bank is regulated by the Office of the Comptroller of the Currency (OCC), more than ever they are keenly focused on preventing loans that will turn into losses.
"The bank has to account for its losses," said Killpack.
Some companies, for whom cash flow may be tight but in which new debt may have been deemed supportable in former days, have been hurt by the economic collapse to the point of deficit equity, says Jeff Whitcomb, vice president, sales, Peoples Capital and Leasing Corp, which lends for contractor purchasing and for dealers' rental fleets.
If a company is trying to borrow several times what they're worth, as a banker or credit analyst you look at this and say, ‘If this deal goes south, there's no equity there so I'm completely going to take a bath on that,'" said Whitcomb.
And lenders have taken quite enough ‘baths' in 2009 to teach them how to keep out of hot water.
Which is why bankers like Ron Riecks at Wells Fargo, a former 30-year veteran with CIT's former construction finance business, say it's highly ironic to hear President Obama's conflicting messages to the public, to the banks, and to the federal bank regulators.
"When Barack Obama gets on TV and says we need to get the banks to lend, you need to know he's just kidding," Riecks said wryly. "He has told the regulators to make sure the banks are making prudent loans. It makes a great sound byte, but he's got to get the regulators in the room and say, ‘You've got to encourage the banks to make more loans,' and until that happens, the easy credit of days gone by are gone – maybe forever.'"
Restructuring in this Market
Clear consensus did not emerge about whether or not the plummet of the construction equipment industry has reached a floor – Riecks seemed rather inclined toward pessimism on that point, and Whitcomb leaned more in an optimistic direction, though they certainly agreed that bank requirements are not going to alter. Killpack, on the other hand, sees some positive indicators, but nothing to do handstands over.
"Auction values seem to have leveled off over the last four to six months," he said. "They don't seem to be coming back up much but they don't seem to be falling anymore. That seems to indicate we may be on some kind of a floor. I don't see anything in the near future that's going to get us off that floor, but maybe that's because I live in Arizona where there's a jillion homes for sale! But housing prices may be starting to firm. And stimulus is coming. I haven't see much of it yet, but I think it's coming."
Dealers and contractors alike are attempting, in many cases, to restructure their debt in some fashion.
"I'd say over half the phone calls I get are for refinancing," said Whitcomb. "We do get quite a few requests on the dealer side, as well, to refinance dealer-owned rental fleets. Most are being declined," he added, "but they are making progress," meaning that in some cases the timing is close but not quite right. After looking at the numbers together (in one example Whitcomb cited) banker and dealer came to the mutual conclusion that a few more months of profitable performance were needed.
Riecks's approach to a restructuring request follows a similar vein.
"We start by looking at your plan," he said. "What's your forecast, what are you going to do and how; give me projections for next year by month and then two to three months by year; give me balance sheet and P&L forecasts for that period. Once I see what your plan is, then we can talk about whether we can restructure your debt or not."
In one unfortunate instance, Riecks said a distributor who thought his plan was well developed, in fact had too many excavators in his inventory – his plan for moving them out in 2010 and '11 was to sell 75 percent of them, despite the fact that he hadn't sold any in the last 12 months, Riecks recalled.
"I asked him how he was going to do that, and he said ‘We'll work harder at it.' That's not a plan – it's a hope or a wish." Riecks says in cases like these, the cold hard fact is that dealers must liquidate iron at auction, taking the hit on profit in exchange for removing the crushing weight of fleet interest rates.
He adds that every situation is unique. He has seen distributors with their plans literally written on the back of a napkin, prepared on the airplane to meet with him, as well as plans that were not sufficiently thorough or deep.
Whitcomb says financial preparation cannot be overemphasized.
"The No. 1 thing [dealers] can do is to hire a very good accountant who knows your industry and get them to do an audit or review," he said. "I'm amazed at how many companies still send me non-accountant prepared financials. It just won't fly in this market."
Whether seeking debt restructure or a brand new borrowing relationship, while financial reporting, planning and performance are all paramount, helping the lender thoroughly understand your business as well as your very specific circumstances is not to be overlooked either. And if your lender is not well acquainted with the construction equipment distribution business, Killpack recommends inviting as many from the institution out onsite as possible.
"I call it on-the-job training," he said. "You need to get them out there and get their shoes dirty. The bankers need to understand what goes on, what your short- and long-term goals are, what's your agenda – do they understand what absorption means? In this way dialog begins to happen. They'll ask questions and you'll be able to answer them."
What Are Your Choices?
Apart from being viewed generally as part of a high-risk industry, those doing business in the construction equipment space are somewhat limited in their options for seeking capital. Banks, and a few remaining finance companies are the primary sources left for credit. Whitcomb says, however, that he believes some lenders will re-emerge back into the market, thus possibly making credit more available to the middle market due to more competitors. He said that CIT has relisted and emerged from bankruptcy, which could have an impact, although Wells Fargo bought the total construction lending division of CIT in 2007; also, Peoples has purchased Financial Federal, an acquisition Whitcomb says will broaden their scope. In addition, he cites the growth of SG Financial and PNC Financial Services as possible indicators of lenders that may return to the construction market, and he has seen clues that Key Bank may be trying to rebuild. All these, he reiterates, could have bearing for middle market companies primarily.
Apart from these options, another consideration is leaning on your manufacturer for help.
"The new normal might mean if a dealer represents a financially sound manufacturer, he may have to turn and look to them for some inventory support," said Killpack.
Other alternative sources for capital might include:
A Word About Credit and Customers
Mezzanine debt, a third party or sometimes division of a bank that becomes a minority partner in exchange for a few million dollars, for example. It's expensive money, though, says Killpack, at 14 or 15 percent.
Factoring, companies that buy your receivables – also costly and again, less of an option due to construction's classification as risky business right now.
Private equity, which can be forged on your own or identified through a third party facilitator, such as FMI Management Consulting in Denver or Brookwood Associates in North Carolina.
It isn't credit, but it's cheap cash and available: Liquidation of assets, including equipment, real estate, and your own commercial buildings.
As much as dealers want their customers to succeed in acquiring credit so they'll ultimately resume buying equipment, dealers themselves must exercise greater caution in how they grant credit, as well.
Fact is, distributors as a whole have probably been more lax than they should have been in doling out generous sums in credit in their product support business – lax in terms of the dreaded credit application.
Hal Ernest, association partnership director, Coface Collections North America, says distributors underutilize the credit application in a couple of ways, none of which they can really afford to do. He urges dealers to really know whom they are doing business with, even if it's a customer they've had for years. Every credit application should be thoroughly completed, and dealers should even consider asking for a personal guarantee. Most say they're embarrassed to ask or assume it won't be given – but Ernest insists that you won't know if you don't ask, and if you get the personal guarantee you can be certain you will be at the top of the contractor's list when he decides who he's going to pay first.
"Sometimes I sit in awe and think, ‘How in the heck did you even give these people credit,'" he said, reflecting on companies for whom Coface has performed complex customer credit reports.
He said it's also a problem when the dealership only contact the three references a customer has listed on a credit application, noting the unlikely scenario that a delinquent customer would give you any but his most glowing vendors.
"They're going to give you their best," he said. "You have to go out and find the worst.
"I'm trying to encourage every single person to re-evaluate every single relationship you have," Ernest continued. "Going forward, don't take anybody for granted, and on larger orders, please run credit reports."
He said as many as eight out of 10 companies don't run credit reports to save $30 to $100 depending on the complexity of the report, yet they'll give thousands worth of credit without any assurance of being paid.
Monitor receivables closely, be a stickler on credit applications, and use credit reports. On the positive side, better understanding of customer credit ratings can demonstrate to the dealer that he may be underselling some customers.
"You may be offering $100,000 line of credit, when in fact that customer has a platinum rating and you should be offering them $250,000."
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