Equipment Finance Enters a New Business Cycle

January 09, 2012, 07:30 AM

Filed Under: Economy

Since the beginning of the recession in December 2007, business leaders across the United States have been reviewing and interpreting what seems to be an endless sea of data in an effort to gain insights into what the future may hold within “their worlds.” The search for data and tools to accurately predict upcoming changes in the economy is certainly understandable because so much is at stake. Culling through and making sense of this vast amount of data can be a daunting task for even the most astute finance professional and business leader. And, determining which data are most meaningful is an equally difficult task.

To complicate the issue further, some of the data seems conflicting at times, and in many cases, its interpretation seems to require a degree in statistics. However, access to accurate data is necessary and important for business leaders to gain a grasp of the risks inherent in their operating environments. For this reason, the search for the best predictive tools never ends.

The commercial lending and leasing industry, like many sectors, experienced significant challenges over the course of these past four years, and today the leaders of these commercial finance entities require reliable data in order to predict risk, develop business strategies and create efficient operations.

For insights into what has been happening in the commercial lending and leasing industry and a view into where the industry may be heading in 2012, we turned to William Phelan, president of Chicago-based PayNet, Inc. PayNet maintains the largest database of historical lease and loan payment information based on the small business economy in the U.S. and publishes the monthly Thomson Reuters/PayNet Small Business Lending Index. This index measures the volume of loans to small businesses. PayNet also publishes a 30+ Day Delinquency Trend and 90+ Day Delinquency Trend from its proprietary database of commercial loans and leases. This statistical tool measures the percentage of loans to small to mid-sized businesses that are past due 30 and 90 (or more) days. Together, these two data sources provide many top decision makers in commercial finance with the information they require to make strategic business decisions.

Small Business Trends Are Leading Economic Indicators

The most recent Thomson Reuters/PayNet Small Business Lending Index reached a milestone rising to 106 last month. To put this in context, PayNet began tracking the Index in 2005 at 100. It rose to 133 in 2007 and abruptly fell to 66 by June 2009. The return to 100 stands as an indication of the business cycle traveling full circle since 2005.

New business volume appears to be picking up. The Index jumped 18 percent over last year and marked the 16th consecutive month of double-digit increases by millions of small businesses in the U.S. The increase in the Index and its positive run over the past 16 months is certainly a positive sign for the overall economy according to Phelan who says, “Small businesses can make investment decisions, decisions to step on the gas or slow down their businesses within a day or even overnight. This ability to quickly redirect strategy and the fact that small businesses make up such a significant portion of the GDP, means we have an excellent leading economic indicator in this Index.”

This Index is also viewed as a strong predictive tool according to Phelan who said, “The index has been statistically proven for predicting the direction of the GDP by two to five months. That’s why we feel the recent increase of 18 percent and consecutive increases are good signs of a continuing positive underlying trend in the purchase of capital equipment by small business.” Perhaps as importantly, the data shows that while in the past, purchases of replacement equipment was a key driver in the Index, more recently, real investment growth is evident. “The data shows that small to mid-sized businesses have gotten past the equipment replacement era and are moving into the era of real investment growth. Today, millions of small to mid-sized U.S. companies are willing to invest in expansion because they now have the financial capacity that did not exist three years ago and this is a big positive sign,” he said.

A New Phase Of The Business Cycle

Phelan believes the U.S. economy has entered into a new phase of the business cycle and this new phase is important for all lenders to understand, saying: “What we see now is that we have come full circle in the U.S. business cycle. We hit a new inflection point in the third quarter of 2011. Risk for lenders fell in 2011 to an all-time low where the 90 day loan delinquencies were 0.39 percent in November 2011. The last time we hit that low level was prior to 2005. Meanwhile, originations have been steadily increasing. So, we are in this phase of moderate expansion and low risk in the business cycle.” And Phelan believes lessors will become more aggressive in originating loans and leases because risk profiles have decreased so significantly in the market.

Small Business Confidence Is Improving and Is Critical

Small business represents roughly $7 trillion of the U.S. economy (about half of U.S. GDP). According to Phelan, the small business community is experiencing a recovery of confidence. “We are seeing 30 day loan delinquencies at 1.50 percent lower than they were in 2005 versus the low of 1.95 percent in the last cycle. When business owners know their balance sheets are in good shape, they typically have confidence in the future. This very low delinquency rate means we have higher quality businesses than we had in 2005, which gives business owners greater confidence in the future for their businesses.”

However, if we have learned anything over these past few years, we learned that confidence has proven to be fragile and sensitive to many factors, and confidence in the economy from the small business owner’s perspective is critical since small businesses make up such a significant percentage of the U.S. economy. Phelan agrees, saying, “It’s all about confidence. If we could remove some of the uncertainty in the marketplace, we will stay on track.” According to Phelan, some of the uncertainties that could negatively impact confidence include the uncertainty surrounding the future of the accelerated depreciation rules. “The discontinuation of this tax policy could drive small businesses to stop making capital equipment purchases,” says Phelan who added, “The accelerated depreciation rules are a big driver for small businesses today.”

Confidence in Europe is also a big driver according to Phelan. “The EU crisis has not hit small businesses in the U.S. yet, but another credit crisis of any type will hurt confidence and could force business owners back to the bunker where they will again hoard cash. That would certainly knock us off track.”

The events in Washington, D.C., are also of concern. According to Phelan the explosion of the U.S. deficit is causing uncertainty for small to mid-sized businesses. “When you have a federal government running a $1.5 trillion deficit, business owners know it has to be paid for with either higher taxes or higher interest rates. So the events in Washington certainly create uncertainty, and if the situation evolves where small to mid-sized businesses will be hurt, then we could be heading for bad days for businesses in general. But, if we can solve the problem, then we can likely avoid a spike in interest rates as well as a spike in tax rates, and avoidance of either increase will be good for business and good for equipment leasing.”

Equipment Sector Performances

Various equipment sectors served by equipment finance companies and banks have experienced differing levels of recovery and in some cases, retrenchment over the past 12-18 months. For example, agriculture is currently outperforming other sectors. “This results from high commodity prices and strong export demand,” says Phelan who adds credit quality in the agriculture sector is also strong and continuing to improve.

According to PayNet, other sectors enjoying signs of a comeback include construction. PayNet just presented to a group of F500 CEOs on the manufacturing and transportation industries. Construction sub-sectors such as specialty trades, heavy construction and commercial construction each are demonstrating strong signs of recovery. Transportation has also demonstrated a strong recovery with the strongest growth in the Class 8 truck category. Meanwhile, retail equipment investment stalled according to Phelan, with a significant hit dealt to retail grocers. To this point, Phelan offered, “There’s consolidation going on in the retail grocer sector with large discounters such as Costco creating competitive pressures. As a result, small retail food stores are having a hard time.”

According to Phelan, the hardest hit sector in 2011 was the medical sector where the decline in equipment investment occurred not only in new equipment investment activity, but also in the number of medical business start-ups. “We track start-ups in health services and we also track the amount of equipment investment in health services. Overall investment in this sector was down 19 percent year-over-year. It’s an eye opener and we believe it’s a result of uncertainty. There seems to be a clear lack of confidence in the direction of healthcare services in the U.S. and there is certainly a consolidation of services where smaller hospitals and municipal hospitals are experiencing budget cuts. This combination of uncertainty about the future of health services as well as uncertainty surrounding the healthcare system in general is affecting capital investment within this sector.”

Looking Toward 2012 And Beyond

Phelan believes the new business cycle we have entered will prove positive for equipment finance companies and banks focused on equipment investment. “We see three big trends continuing as we enter 2012 for lenders: continued steady growth (but not explosive), a stable risk environment, and a continued pursuit of operational efficiencies in the credit risk/portfolio management side. We see many customers looking to meet new regulatory challenges through efficient ways to risk rate their portfolios at a reasonable cost. Lenders and lessors must continue to invest in operational efficiencies in the credit risk side as we move into this new business cycle.”

Additionally, Phelan believes the leading default indicators provide a positive view into the future of equipment finance saying, “From AbsolutePD which is our leading default forecast, the macro-economic data combined with the loan and lease data shows default risk falling from 6.2 percent in 2009, down to 2.6 percent in 2011, stabilizing at 2.7 percent in 2012.”

In 2011 Phelan and PayNet remained optimistic about the industry while the media called for a double-dip recession. Phelan says “Commercial equipment lessors did not face Armageddon like some segments of banking and finance. Equipment leasing companies have proven to be prudent managers of risk through these cycles. There was certainly some pain over the past few years, but commercial equipment leasing and lending overall performed well through the economic downturn and should continue to improve in 2012.”

2012 is shaping up to be a new phase of moderate growth with low risk, according to PayNet’s leading indicators. Phelan also noted, “The key question is when the next inflection point in the business cycle shows. Several obvious bad actors exist right now that could kill confidence just when the economy is healing. It would be a shame if equipment leasing had to take another hit.” Stay tuned.