For many of us in the construction industry during the Great Recession, it seemed like the pain would never end. The thought of good times was nowhere on our radar. However, good times have returned, and many people think that they will continue without end. But like anything else in life, times change; and there are lessons to be learned from our past. The U.S. is currently approaching the longest period of economic expansion on record. While I am not predicting a recession, the question is not if one will come, but when. History shows that recession always does.
For this article, I thought that it might be helpful to look back on some actual distributor situations that Wells Fargo handled during the Great Recession and pass on lessons we learned from companies of varying revenue sizes. To do this, I contacted senior leaders in our Equipment Finance Portfolio Group, and others who weathered the recession storm.
Generally speaking, the Great Recession began in December 2007 and ended in June 2009. It descended on us faster than most expected and lasted longer than prior recessions that many business owners had experienced during their careers. The 1990 and 2001 recessions each lasted eight months. Due to the length and severity of the most-recent recession, many business owners did not react quickly enough to avoid some major issues that made the difference between success and failure. Some financial and operational decisions that could have helped were implemented too late.
DECISIONS ON MAJOR EXPENSES
MONITORING HUMAN CAPITAL
this is a clear measure to pinpoint for review, but hard for an owner to adjust. Loyal owners are reluctant to layoff longtime employees. Also, gauging how many people are needed to withstand a slowdown is not an exact science. The risk: You could lose quality employees whom you will need when times turn around.
If a location is underperforming and significant savings can be achieved, this is another difficult measure for owners to consider during tough times. They want to have their equipment and product services available in as many locations as possible to serve customers and increase their base. Manufacturers also often want distributors to offer their products as widely as possible. Some dealer agreements also may include a set number of sales locations.
There is a saying, “Your first loss is your best loss.” Many dealers held on to equipment thinking that values would rebound. In many cases, they actually fell, and losses increased.
A study, conducted in September 2009 by IHS Global Insights for the Associated Equipment Distributors and Association of Equipment Manufacturers, painted a bleak picture:
• Over the course of the recession, the construction equipment industry shed 37 percent of its workforce. By comparison, auto manufacturing and dealership jobs were down by 16 percent, while job losses in the finance and insurance industry amount to 6 percent of their workforce.
• Construction equipment spending fell by more than 50 percent compared to its peak in 2006.
• Economic output of the equipment industry — including manufacturing, distribution and maintenance —contracted by nearly 40 percent and resulted in the loss of approximately 550,000 jobs. That’s 8 percent of all jobs lost since the start of the recession.
In hindsight, it is easy to say that owners should have moved sooner to reduce headcount and locations. However, while you are in the middle of a situation, you rarely have the luxury of knowing outcomes in advance.
Equipment levels were also a major driver for most dealers — whether it was inventory for sale or rental fleet units. There are many issues that can help create a debt-to-asset imbalance:
• When equipment assets are rented, there is a need to be disciplined in applying a large portion of rental payments received against the loan principal balance. Failure to do so during the recession frequently resulted in some dealers being upside down on the asset when it was sold.
• If machine inventory secures a borrowing-base loan structure, and is based on net book value (NBV), failure to properly depreciate carries a similar risk. Particularly when running a rent-to-sell model, be sure that your depreciation method adequately reflects the market conditions you are in. Many dealers use the greater of straight-line depreciation or 80 percent of rents (or a different percentage if standard to your collateral type). During the great recession, some dealers who relied solely on the percentage of rents to depreciate their inventory found themselves with NBVs higher than appraised value on assets due to slow rental activity. With the appraised values lower, some borrowing bases were in over-advance situations that led to defaults and liquidity issues.
• When inventory that has a lien is sold, be sure to exclude the receivable from your revolving line borrowing base. If you don’t exclude it, you will be borrowing a second time, with only one set of proceeds to pay off the inventory loan and the amount borrowed on the accounts receivable. below 100 percent, it begins to erode the profit from equipment sales. Generally, a ratio of less than 80 percent is cause for concern. At this point, cutting costs should be entertained — whether it be employee, location, carrying costs of inventory, or interest expense.
MONITOR THE COST OF THE RENTAL FLEET
If assets begin to require maintenance too frequently to be covered by the rental return, consider selling them.
MONITOR RENTAL FLEET UTILIZATION
While utilization calculations vary, generally, unit utilization of between 70 percent and 80 percent is optimal, while a measure below 65 percent, may be of concern. While one or two months below this threshold may not be a problem, a long-term, low-utilization rate means the interest expense, insurance and storage may be costing more than potential future lost rentals. Utilization is measured in many different ways — days rented per month, rental rates to historical cost, and rental rates to book value. However utilization is monitored, it must always be considered when determining whether or not to cull fleet.
Asset-backed lending structures and equipment lines of credit often have structures that allow the lender to monitor performance on a regular, typically quarterly basis. While these structures help protect the lender, they also provide a benchmark for dealers that may help them get through a downturn. Some of the structural elements can include regular equipment appraisals and financial covenants. Examples of financial covenants include overall balance sheet leverage, and cash flow coverage. The appraisals help set equipment valuations against which the dealer can borrow, help determine advance rates, and help keep debt levels due on inventory manageable.
Another big factor during the Great Recession was product concentration. If a dealership focused solely on one product line or industry and had single-purpose equipment, it may have suffered more losses than a dealership that was more diversified across varied industries.
It has been said that the Great Recession was an once-in-a-lifetime event, but recessions are inevitable. Learning from the past, and continuously practicing sound and prudent business practices, may help your company get through the next one more easily than the last.