U.S. Capital Goods and Equipment Financing Outlook:
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- Josephine Wood
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1 in association with: U.S. Capital Goods and Equipment Financing Outlook: A Focus on Essential Acquisitions The financing market for capital goods appears to be much improved relative to the depths of the most recent recession. There are buyers, but they tend to be limited to circumstances where the equipment is essential to continuing operations, new business opportunities or customer demands or can demonstrably improve efficiency. KEY FINDINGS Four out of five companies have made at least one capital goods acquisition of significant value over the past year and three out of four will do so in the next six to 18 months. Cash is playing the lead role in today s capital goods financing. Companies variously lease or buy depending on circumstances and many have formal processes for related decision-making. Vendor financing plays a key role in asset acquisition decisions. common driver was having sufficient financing in place as was the case for 54% of respondents. More than a third of these executives () said that the business need was simply too strong to delay. Closely related, 31% said that business opportunities required new equipment, and 30% said customer demand made such investments mandatory. A noteworthy finding is that for 31% of those who made such an acquisition in the past year, the capital asset delivered efficiency gains. In terms of past purchases, leading categories include IT infrastructure (45%), transportation/trucking assets (27%), telecommunications () and buildings/facilities (). FIGURE 1: Why did you acquire a capital good or business equipment? Had sufficient financing in place Business need was too strong to delay 54% Efficiency benefits of technological improvements justified the investment 31% Business opportunities required new equipment Most companies are still in the market (for capital goods) Looking back one year, more than four out of five executives (82%) say their companies have made at least one capital goods acquisition of significant value. Demand going forward appears relatively steady, with 78% indicating they will make such an acquisition within the next six to 18 months. Despite a broadly weak economy, those who went ahead with the acquisition of at least one significant capital asset in the past year did so due to a range of factors. The most 31% Customer demand made it mandatory to invest in new equipment 30% Competitor actions made it mandatory to invest in new equipment Capital assets were available at a significant discount 13% Other 2% Note: Executives could select more than one response. 1
2 The figures are broadly comparable when looking six months ahead and 18 months ahead. That is, 78% of companies are either very probable (54%) or likely () to make such an acquisition within the next six months. Over the 18-month timeframe, the figure remains largely unchanged at 79%: 53% very likely and 26% likely. Over the next six months, IT infrastructure is the most frequently cited category of capital goods acquisition. Here, 62% say they are very likely (28%) or likely (34%) to acquire such assets. Forty-six percent of respondents say they are either very likely (19%) or likely (27%) to take on significant telecommunications assets. Finally, 46% say they are very likely (30%) or likely (16%) to acquire office furniture or equipment. Demand for various categories of capital goods varies significantly by sector. For example, though only 30% of the overall sample is very likely or likely to acquire machinery over the next six months, the figure increases to 52% among industrial and/or manufacturing companies substantially higher than the rate among the general sample (30%). Similarly, 80% of healthcare companies say they are very likely (57%) or likely (23%) to make a significant acquisition of medical equipment in this instance four times the rate of the general sample (20%). Cash is playing the lead role in financing Rating agencies like Standard & Poor s and Moody s continue to report that corporations today are holding record levels of cash on their balance sheets. Survey respondents are parting with at least some portion of their capital, as 54% list cash as one of their most likely primary sources of financing for acquisitions of capital goods. The figure rises to 70% among healthcare companies and to 67% of industrial and manufacturing enterprises. The next most frequently cited form of financing is bank credit lines, used by 45% of respondents. Here the frequency increases to 60% at office equipment providers and 56% at technology companies. Balance-sheet financing is a primary financing tool at about one-third of companies (32%), followed by asset-based financing, or pledging the asset, cited by 27% of companies. Finally, lease financing weighs in as a primary financing tool for of respondents. In general, companies are working hard to put together a combination of sources to obtain the most efficient financing they can achieve. The most important part of the transaction is getting the right price 90% of what you can 1 This is based on a 1-5 scale where 1 = not at all likely and 5 = very likely. This convention for the use of the term very is relied upon throughout this report. achieve is by knowing the market and using up-front negotiation, says the transportation company executive. From there, cash is certainly part of any deal we strike, but we re doing all we can right now to conserve cash. Overall, says the executive, we ve been able to put together some efficient deals through a combination of cash, longstanding credit facilities and vendor-sponsored fleet financing. In the end, executives indicate that the ratio of cash and/or cash equivalents (trade-ins, etc.) to total transaction value is approximately 57%, leaving loans or leases to make up the remaining. This ratio is relatively consistent across all industries evaluated. Also worth noting, for many, the ratio is driven less by what is available in the market and more by the corporate balance sheet. As Mark Mey, CFO of offshore drilling-focused Atwood Oceanics, explains, We really don t do any of what you would call capital equipment financing. We fund everything at the corporate level. FIGURE 2: What are the most likely sources of primary financing for capital goods or business equipment? Cash Bank credit lines Balance sheet financing Asset-based financing (pledging the asset) Vendor-provided financing - lease or debt / loan Lease financing Other 0% 27% 32% 45% Note: Executives could select more than one response. FIGURE 3: Approximately what percentage of capital goods or business equipment acquisitions will likely be financed with a lease or loan? 57% 54% Cash and/or cash equivalents (e.g., trade-in) Lease or loan 2
3 Vendor financing can play a key role Whether in the form of a lease or a loan, more than three out of five executives (62%) say the availability of vendor financing plays either an important () or a very important () role in their acquisition of capital goods. Three out of five executives (64%) say they have chosen one or more vendors based on their ability to provide financing and 47% have ruled out one or more vendors based on their inability to offer this service. Survey respondents have, in the past, acquired a wide FIGURE 4: What sort of assets have you acquired using vendor-provided financing (e.g., loans or leases)? Over the next year, what sort of assets are you likely to acquire using vendor-provided financing? IT infrastructure 32% 32% Transportation/trucking equipment 29% Machinery Telecommunications infrastructure 23% Manufacturing equipment Office furniture/equipment 21% 20% Have not accessed vendor financing 17% Buildings/facilities Medical equipment 11% 13% Construction equipment 12% Note: Executives could select more than one response. Have acquired Will acquire range of assets using vendor financing, including IT infrastructure (32%), transportation assets (29%) and telecommunications equipment (). Over the coming year, similar numbers will again tap vendor financing to acquire similar assets. And while 30% of the sample will be in the market for no more than $100,000 in vendor financing (13% under $100,000 and 17% under $25,000), 38% will be seeking $1 million or more (7% over $10 million). Total cost interest rates plus fees is the most critical determinant for choosing to access vendor financing, described as highly important (52%) or important (27%) by 79% of survey participants. However, there are other factors that can variously add to or subtract from the value of a vendor financing program. These include: Ease of application: Customers see value in streamlined application and approval processes. Fifty-seven percent of executives say that ease of application is either highly important (21%) or important (36%). Ability to customize payment schedules: Fifty-four percent rate the ability to customize payments as either highly important () or important (32%). Value of additional services: Vendors often bundle additional services into a financing package. This might be as simple as electronic invoicing or as sophisticated as usage tracking and maintenance alerts. Half of executives view such services as highly important (15%) or important (). Other determinants of the value and quality of a vendor financing program include the availability of online tools for managing the transaction, as well as end-of-transaction features such as salvage, disposal or data-wiping. Finally, corporate customers also consider the quality of the customer service experience in assessing the all-in attractiveness of vendor-financed assets. In short, by moving beyond the mere provision of financing, there are many means by which such programs can add value within a customer relationship. Flexibility in lease vs. buy decisions begs formal policies When it comes to the choice between leasing or outright purchase, executives say they have tendencies but few absolutes. That is as it should be, says Professor 3
4 Lease versus buy: It all depends The most important negotiation in any capital goods acquisition is the price, says Linda Allen, a professor at Baruch College s Zicklin School of Business. What is the value being placed on the capital good? Today, says Allen, even though banks are choosing to sit this one out, they re hoarding their cash, capital goods are still depressed, and therefore it s largely a buyer s market. But getting a good deal on price by no means ends the decision-making. Now you have to determine how you re going to finance the acquisition, says Allen. And here, the right answer on all-in costs is going to depend on a wide range of circumstances. For example, even if a company has plenty of cash available, they may want to hold that in reserve, continues Allen. Or alternatively, there will be times when a company will want to throw the financing of a capital asset to one of its banks as a means of keeping the relationship going. This can be lucrative for a bank, says Allen, and it s a way to make sure they re there for you when some other deal where you really need their help materializes, perhaps in M&A. It is also worth noting that two companies can be presented with identical financial alternatives asset price, lease rate, finance cost, etc. and yet reach different conclusions. One company, for example, might prefer leasing because they don t want to have to deal with maintenance or obsolescence, whereas another company prefers to own because they have a core competence in maintenance and improvement. Bottom line, says Allen, drive hard on price but then take a hard look at all of the surrounding elements. Know the interest rates. Know your own cost of capital and alternative uses. Get your engineers to weigh in on the salvage value. The calculations may be straightforward, but as Allen concludes, you have to understand your own business and its abilities and priorities. Linda Allen of the Zicklin School of Business at Baruch College. A sophisticated company will take a close look at any major transaction to determine what makes the most sense in each instance. In general, there are too many variables that play a role, and while there are certain assets that might lend themselves more to leasing or purchase, that won t necessarily hold constant. approaches vary The survey reveals that practices and preferences the numbers of those tending to favor leasing, favor buying or exhibiting no preference are highly dependent on the category of capital good. In the case of transportation assets, for example, tend toward leasing, 30% tend toward purchase, and say their approach varies. By comparison, when acquiring office furniture or equipment, only 12% tend toward leasing, 46% tend to favor purchase, and 41% say the approach varies. FIGURE 5: Financing by asset type Tend to lease Machinery/manufacturing equipment Construction IT infrastructure Office furniture/equipment 12% 16% 19% Telecommunications Medical equipment Transportation Buildings/facilities Tend to use debt (purchase) Approach varies 34% 38% 46% Note: Numbers may not add to 100% per asset type due to rounding. Note that the above are tendencies, not absolutes. Moreover, for most asset classes, the most frequent description of orientation is that decisions vary. What this 30% 33% 41% 41% 41% 39% 39% 34% 4
5 points to is the need for an array of clearly defined decision criteria and processes. Four out of ten executives say their companies processes for evaluating lease-versus-buy decisions are in fact either highly formalized (16%) or formalized (). In other words, these are companies in which policies dictate the sorts of analysis and approvals that must take place according to well-established guidelines. A Northwest-based energy services company provides a good example. According to a procurement manager, For capital goods with prices of $10,000 to $35,000, there are a range of questions that have to be answered some dealing with the pricing and terms, but also who is approving the acquisition. The approvers in each instance are bottom-line accountable people, and they fully understand the tradeoffs between leasing and purchasing. It s their call and, yes, choices vary. As the cost of a capital asset increases, there are more considerations [such as] what business are we going to generate with this equipment? It shouldn t just be some manager s whim, we need formal review. Also, should we fund this at corporate? Are there other suppliers? What s the expected life, what are the maintenance costs, what is the salvage value, if any? Accordingly, approvals escalate: [for us] there are thresholds at $35,000, then $70,000, and then anything beyond $100,000 needs the approval of the CFO. Of note, says the manager, availability of capital goods within energy services and therefore all-in costs can be volatile. It s boom and bust, and when people are scrambling for what they need, the focus isn t on getting the best pricing or financing but rather on just getting the equipment into the field. Also, the executive explains, in boom times, it pays to have been a good customer all along, because otherwise, suppliers aren t going to give you much attention or service. So it s not always just the price or just the terms it s the value of a relationship. Other companies in the survey exhibit less formalized processes. Over a third (), for example, are midpoint on the continuum from highly formalized to not at all formalized. That is, their policies aren t ill-defined, but perhaps there is less of a focus on strict compliance. Meanwhile, a quarter of executives say their processes are informal with 6% of these describing their policies as not at all formal. The failure to define and follow formal policies, says Linda Allen, could lead to some less than optimal choices. FIGURE 6: Formality of lease-versus-buy review FIGURE 7: At which cost level does a proposed transaction require closer analysis? 15% 1% 4% 5% 6% 16% 40% Note: Numbers may not add to 100% due to rounding. Like the energy services example above, nearly three out of four survey participants (73%) say their companies use cost triggers that push an acquisition toward more rigorous review. Of this group, say the trigger is between $100,000 and $499,000. Sixteen percent, meanwhile, say their figure is between $500,000 and $999,000. From there, 17% say the trigger is over $1 million, and 16% say $2 million or more. 17% $0-99,000 $ ,000 $ ,000 Over $1 million Over $2 million Over $5 million Over $10 million Over $20 million Note: Numbers may not add to 100% due to rounding. Formal Neither formal nor informal Informal A wide range of executives participate in lease-versusbuy analysis and decision-making. The most frequently cited among these are the CFO (63%), CEO (55%) and COO (29%). However, other oft-cited executives include the controller (), the CTO/CIO (), and the treasurer and heads of business units (each weighing in at 17%). As for who makes the final call in lease-versus-buy decisions, 42% say that role falls to the CFO, followed by the CEO (30%). Of note, among technology firms, the CTO/CIO makes the final decision in 19% of instances (over three times the rate within the general sample). Regarding specific issues contributing to lease-versusbuy decisions, the most rigorously examined variable is the impact on cash flow. Here, 74% say they look closely at cash flow with 49% saying they, in fact, look very closely. Another key variable is the cost of capital, examined closely by 65% of survey participants 32% saying 5
6 very closely. Three out of five executives (60%) say their companies also look closely at return on capital 29% saying very closely. Other important factors include balance sheet implications (58%), depreciation (57%), maintenance costs (57%) and taxes (53%). Responding to FASB In 2010, the U.S. Financial Accounting Standards Board (FASB), in conjunction with the International Accounting Standards Board (IASB), published a set of proposals to alter accounting for leases. Though the impact would vary from industry to industry and from asset to asset, in general, the rules, as described, would increase administration and costs and therefore potentially reduce the utility of operating leases. Survey participants are understandably concerned, but vary in the degree to which they are responding. A plurality () are relatively passive, saying they are watching such developments closely and are preparing to adjust their processes accordingly. Another 27% are taking a wait-and-see approach. And while 13% say they are not at all concerned, 16% say they are actively participating in FASB s processes in an effort to influence ultimate decisions. FIGURE 8: How closely do you examine the following factors in your leaseversus-buy decision-making? Cash flow Cost of capital Return on capital Balance sheet implications Depreciation Maintenance costs Tax Value of services bundled into a transaction Potential asset obsolescence Timing of payments/flexibility of structure 47% 45% 53% 58% 57% 57% 60% 65% 74% 2 2 Percentage equals those who rated this issue either 4 (closely) or 5 (very closely). Capital goods or capital goods services? According to Michael Singh, CEO of Miami-based Telkom Caribe, U.S.-based providers of technology and related capital goods are being undercut by more aggressive competitors from Asia and even Europe. The banks don t want to lend anymore we all see that, says the telecommunications infrastructure-focused executive. But even sellers themselves are hoarding their own cash, refraining from using their own balance sheets to provide vendor financing to would-be customers. And that s how they re losing business to Asian, Indian, Chinese and Eastern European sellers who are more long-term focused and are working to provide financing. As for the lease-versus-buy equation, we look at product life cycles to determine our desired approach, says Singh. For example, if it s cable, something we re going to sink into the ground, that s something we purchase. Alternatively, if it s a piece of technology that can become obsolete, or if it s a power generator or a backup generator, something critical that could break down, that s where we prefer a lease. Correspondingly, service is one of Singh s core focuses when evaluating a provider. If you re running a major piece of equipment in the middle of a rain forest an air conditioner for a control room, for example if that breaks, you need it fixed in a hurry. Here, says Singh, we have providers who will have their technician on the way the same day with a part straight from their warehouse. So in essence, says Singh, we view leasing of capital goods as a service proposition. 6
7 Making the most of market conditions The economy is not yet churning. The market for capital goods, though much improved from its depths, remains relatively flat. Yes, many have acquired a capital asset in the past year and similar numbers will do so over the next six to 18 months. But lingering questions about the economic and regulatory climates are undoubtedly suppressing overall demand. For buyers, many flush with cash, this could present an opportunity to negotiate a good deal on assets that can go a long way toward improving efficiency or perhaps growing top-line revenues. Along the way, be certain to look closely at all the factors that weigh on the overall cost, appropriateness and effectiveness of any capital acquisition. Sellers, meanwhile, can use these results to fine-tune their value propositions. Are they incorporating the right mix of features into their products and services? Are they providing would-be customers with the appropriate information necessary to fuel both their acquisition and financing analyses? And finally, could a seller do more in the way of providing vendor financing? ABOUT THIS RESEARCH The insights and commentary found in this report are derived from both a survey instrument and personal interviews. The survey, conducted on behalf of CIT a leading provider of financing to small businesses and middle market companies by Forbes Insights from April through May 2012, was completed by 279 executives. Key demographics include: Executive title: CEO/President (19%), CFO (23%), SVP/VP/Director (23%) Company size: $10 million to $99 million (48%), $100 million to $249 million (), $250 million to $499 million (12%), over $500 million (13%) Industry: Those represented include industrial/manufacturing (19%); communications (16%); technology (15%); office equipment (15%); logistics and trucking (12%); energy, mining and construction (12%); and healthcare (11%). Interviews were conducted with six executives with active roles in capital goods acquisitions along with a professor from Baruch College s Zicklin School of Business. Whether they spoke on or off the record, CIT and Forbes Insights extend their gratitude to these executives. Forbes Insights 60 Fifth Avenue, New York, NY
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