By Timothy Appleget, Director of Technology Services, and Scott Nelson, CDO, Tamarack Technology

“He who hesitates, shouldn't have.”

As business advice this quote from a popular New Zealand All Blacks poster from the mid-1990's is spot on. The uncertainties of COVID have created many unexpected events and much hesitancy in businesses of all types. The latest “We didn't expect that” in equipment finance is fat balance sheets. Government shutdowns and a deluge of cash from “quantitative easing” have created a perfect storm of supply chain disruptions in production facing discontinuous jumps in demand. The result has been price increases on used equipment driving higher residuals for almost everything – construction equipment up as much as 40%, class 8 trucks and trailers up by as much as 70%, farm equipment up 35%, and passenger cars up 39%. Whether the accounting has changed or not, higher fair market values of assets on leasing contracts represent a surplus on the balance sheet.

But the question, you say, is “How long will this last? What if prices come back down? Is our balance sheet really stronger?” According to Economist Frank Knight, uncertainty is a lack of knowledge which is immeasurable and impossible to calculate. He also said uncertainty is the only true source of profit because, unlike risk, uncertainty cannot be hedged.

If uncertainty is a source of profit, there is money to be made here. Clearly OEMs and vendors (dealers) have a chance to raise their prices on new equipment. John Deere raised ag equipment prices by 8% in 2021. But part of the reason used equipment values are so high is that the supply of new equipment has been constrained by the uncertainties in semiconductor fabrication and global supply chain logistics on everything from metal parts to manufacturing equipment. Unmet demand raises prices, but vendors must be careful that they do not train buyers to use other alternatives.

An Internet-search on “lease residual values” yields dozens of articles advising consumers with car leases on how to take advantage of their unexpectedly high residual values. The most common advice is to “buy out and resell” or “strike a deal with the dealer to capture the value.” Many retail lease structures empower the lessee when it comes to residual values. Similarly, an operating or FMV (Fair Market Value) equipment lease may empower lessee's with the opportunity to capture the increased value of assets by buying out their lease position.

Profiting from uncertainty requires action – usually quick, decisive action that others do not expect or see. Two things support such action: data describing the situation and insights from analysis as to what comes next. Those who have made the conversion to digital, data-driven operations are prepared to capture both and then profit from the hesitancy of others.

Let's consider how one such lessor might deal with an unexpectedly fat balance sheet. This lessor supplies the transportation market and has a portfolio of FMV truck leases. A typical mid-contract term entrant is described as follows:

Original FMV lease

  • 36-month term
  • 10% annual rate.
  • $100,000 purchase price
  • $20,000 residual value at 36 months
  • Monthly payment $2806
  • 24th payment just made
  • 5% WACC (Weighted Average Cost of Capital) for financial analysis

If we assume that the FMV of the vehicle covers the balance of funding during the lease, the lessor anticipated the truck to have a value of roughly $50,000 at month 24. But COVID market forces have raised used vehicle prices by 40% so the lessor has a $20,000 surplus on their balance sheet.

In this scenario, the lessor is aware of this surplus because they are monitoring auctions of used equipment via an external data feed integrated into their business intelligence framework. In this case the lessor is also capturing use and condition data from the asset via an IoT application so they have an ongoing assessment of asset condition. They monitor their original use assumptions for the residual value schedule of the lease. As a result, this lessor is confident that the identified $20,000 market lift is real, if not understated.

Next comes an analysis of the market situation. Some may view this as typical business process, but this lessor has prepared itself digitally to be agile – make quick decisions confidently based on data – so they are diligent in deriving insights on market behavior. They believe that this high residual situation will be sustained and not just a “temporary” COVID event. Their analysis points to semiconductor delivery times over 12 months and production lines running below capacity for almost a year creating a situation where supply does not demand for at least another 24 months. This lessor knows that trucking operators have been struggling to find vehicles and believes that be reticent to return or even sell a vehicle for fear of not having access to a replacement. Twenty-four months is a long time to wait for anything in business.

So this lessor has analyzed their portfolio and found all such mid-contract scenarios with high residuals. They contacted these lessees and made the following offer for immediate renewal:

Mid-term High Residual Renewal

  • 36-month term (60-month total)
  • 10% annual rate.
  • $70,000 purchase price (present residual value)
  • $5,000 residual value (at 60 months from purchase)
  • $2153 monthly payment
  • 5% WACC (Weighted Average Cost of Capital) for financial analysis

The renewal saves the lessee $652 per month (almost $8,000 for the last year of the original contract) AND secures access to the vehicle for another 36 months. The lessor gets 24 additional months of payment increasing the NPV of the payment stream at the time of renewal by roughly $41,000 and increases total cash received going forward by almost $29,000. The lessor's decisive action not only locks in the $20,000 market lift on the residual, but they also double that value with a “happy customer” renewal.

The uncertainties of COVID have created unexpected events and hesitancy in businesses and customers alike. Uncertainty offers opportunity as well as risk – like high used equipment prices and unexpected strength in balance sheets. But as the rugby players know, opportunity is fleeting so quick action is needed. This “high residual-to-renewal” example isn't about guessing or intuition. It's about using data to make quick decisions confidently before others. Lessees should consider their lease positions and future needs for the equipment; then act to capture the extra value the market has provided. Lessors should consider the position of their portfolio, the future of equipment demand in their space, and if the two align act to lock in the extra value that others will miss because they are uncertain it's temporary.

Data provides the ability to embrace uncertainty and, as Knight said, unlock the only true source of profit.

About the Authors

Written by

Timothy Appleget

Director of Technology Services

Tim Appleget is the Director of Technology Services at Tamarack Technology. In his role, he is responsible for the development and implementation of Tamarack's technology services offerings around data, IoT and workflow automation. An experienced equipment finance leader of technology and business operations teams, Appleget joined Tamarack in 2021 following more than two decades in equipment finance at Wells Fargo. During his tenure at Wells, he took on positions of increasing responsibility in which he developed an expertise in application and process development and support.

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Scott Nelson

CDO, Tamarack Technology

Scott Nelson is the Chief Digital Officer of Tamarack Technology. He has over 30 years of strategic technology development, deployment, and design thinking experience working with both entrepreneurs and Fortune 500 companies. Scott is a sought-after speaker and contributor on topics related to IoT and digital health. His involvement in technology in the local and national technology community reflects an ongoing and outstanding commitment to technology development and innovation.

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Tamarack

Tamarack Technology, Inc. is a leading provider of independent software, operational, and technology services supporting the equipment finance industry for more than 20 years.

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