Thought leaders approach most topics walking the line between being first with an idea and having recognized peers supporting/validating the idea. We approached the first article in this series (When uncertainty hits the balance sheet: High Residuals) with that usual balance in mind and are happy to report that we have company in our observations as well as novelty in some of our recommendations.
As you will recall from our previous post the government response to COVID has created an economic situation wherein a large infusion of cash into the markets combined with shutdowns on the supply side – both labor and logistics - has created demand that manufacturing cannot meet. The result is too much money chasing too few goods – inflation. Used equipment prices are up as much as 80% in some equipment classes. For some lessors, this has unexpectedly created “fat balance sheets” from higher, real carrying values.
Recently, Tamarack attended the Acquired or Be Acquired (AoBA) conference held by Bank Director – one of the biggest shows each year now for community banks. In the opening keynote Tom Michaud of Keefe, Bruyette, and Woods gave an overview of the banking industry and forecast for 2022. From my work with Reliance Bank, I knew that PPP and Quantitative Easing had dumped huge amounts of cash into the economy and much of that made it to deposits in banks. However, I was a bit surprised to find that it had created problem for banks in the form of excess deposits on the balance sheet.
Banks, particularly community banks, work hard to put their deposits to use generating income from loans – usually mortgages and commercial/industrial. Typically, community banks strive to maintain loan-to-deposit ratios of 80%-90%. In 2021, the industry's ratio fell to 63% due to the increase in deposits from stimulus and a lack of loan demand due to COVID uncertainty. Community bank leaders at the AoBA 2022 were anxious and received much advice on how to best put their balance sheets to work – by market, by product type, by partnering, etc. An interesting takeaway for me came from discussions on observed reductions in loan delinquency warranting new approaches to credit to take advantage of balance sheets. Community banks, a key partner of leasing companies, find themselves in the same “fat balance” sheet situation post-COVID.
Carl Chrappa, senior managing director of The Alta Group, recently made the similar lessor balance sheet observations in an article in the Monitor Daily. Chrappa provides a analysis of the supply chain situation by equipment class. Not all classes have seen price increases, but many classes of small to mid-ticket items, e.g., shipping containers, trucks, and construction equipment, have seen price increases as high as 80% year over year. The persistence of this situation is informed further by his 2022 “What's Hot/What's Not” report for the ELFA. In that report he forecasts the highest demand and opportunity for finance companies with Construction, Trucks/Trailers, and medical equipment. The analysis, when combined with semiconductor and raw material availability data, suggests that equipment prices, used and new, for these classes is going to remain high for at least a couple of years.
Chrappa advises lessors to focus on “end of lease” situations. He notes many lessees are going to be “willing to buy out end-of-lease assets for the temporarily high prices because they have an immediate need for trucks, containers and construction equipment.” He advises caution booking high residuals on new leases those classes as typical lease terms, 3-5 years, could out distance the supply chain issues. Its business as usual when estimating residuals. Some may try to take advantage because they believe the prices will hold for the duration of the lease, but others will stick to present schedules.
We are aligned with Chrappa on both his analysis and recommendations. But we have one actionable addition. We recommend that lessors not just be aware of the end-of-lease high residual situation but act to lock in the high residual values inflating balance sheets. By offering end-of-lease or mid-lease customers who might be afraid of losing access to equipment renewals lessors can improve cashflows for the customers while converting high residuals via longer payment streams. We did the math and showed how renewal offers can convert an additional $20,000 of value on an FMV truck lease to $41,000 of NPV while saving the customer $652 per month over an extended period. The mutual benefit to lessor and lessee not only improves the immediate cash flow needs of the lessee but demonstrates a proactive partnering on the part of the lessor to the long-term best interests in the relationship.
“I told you so” is never a good message for thought leaders, but we find comfort in confirmation of our analysis and recommendations. We're comfortable repeating the message from our first post: “He who hesitates, shouldn't have.”