Mircea “Mig” Dobre, Senior Research Analyst, Diversified Manufacturing & Machinery at Robert W. Baird, is optimistic about current rental demand, the benefits of tax reform, the m&a environment and the availability of capital. However he points to the cyclical nature of the industry and growth sustainability, cautioning us to consider certain pitfalls. RER’s Michael Roth spoke with him recently.
RER: Baird’s most recent rental survey [with RER] reports an expectation of 2 to 4 percent overall construction growth in ’18. Overall, how do you see the economy growing in the coming year?
We’re on firm footing exiting 2017 and going into 2018. If you look at a number of the metrics that I think are relevant in assessing growth, from industrial activity to consumer confidence, all of them are pointing to a pickup in growth in 2018. Things are looking up, but the only question is how sustainable this acceleration of growth is going to be. We know that tax reform is going to help further boost things, at least in the near term in 2018. The question is whether or not this is sustainable in 2019 and 2020, but at least for the next 12 months we’ve got a pretty positive outlook.
What kind of GDP growth do you expect?
My best guess is we’re probably looking at GDP growth north of 3 percent and if it comes to fruition, that’s going to be a big deal, because we really haven’t seen a full year of growth north of 3 percent in the better part of a decade. It’s going to feel very very different, not just for rental industry but for every American than it has in quite some time.
On construction specifically, we look at multiple facets of overall construction spending. We look at residential, we look at nonresidential, and we’re watching private activity versus government spending, state and local as well as federal. When we look at residential, to start there, we think this market will continue to grow albeit it’s going to slow a bit from what we’ve seen in the last couple of years. We’re thinking that this market will grow 4 to 5 percent in 2018.
The challenge here is multi-family housing -- after really reaching levels that we haven’t seen since the 1980s -- is starting to slow. I think that has to do with some saturation in some larger urban areas, places like New York, places like Denver where rents have been eroding, and activity is taking a bit of a step back. The fact is that urban areas where you’d typically see large scale multi-family development are also the ones in which state and local taxes are relatively high, and the new tax structures that we have in place [limit] the amount of deductions that you can take.
Multiple respondents to our rental survey in the Northeast and California for instance have said that that they’re concerned with the impact that state and local tax deductibility might have on the real estate market, we think that’s going to continue to play a role particularly in these multi-family developments in highly concentrated urban areas.
The single family front continues to improve, and essentially what we’re thinking is that it will more than offset the declines that we’re seeing in multi-family. This market continues to grow, in the high single digit percent.
On the nonresidential side, growth here has tapered. Our sense is that even though activity seems to have slowed a bit, this is basically a temporary lull rather than the beginning of a more significant downturn. Residential has a tendency to lead nonresidential activity, so as long as residential remains positive, and particularly should we actually see some real momentum developing on the single-family side of residential, we think that eventually in 2019 that catches up with broader non-res activity.
Within nonres, the government component is the wild card. We expect an uptick in activity on one of the biggest spend areas, street and highway versus the last couple of years, and that’s notwithstanding any infrastructure stimulus or anything coming out of Washington. It’s less clear that we can have the same kind of lift on the remaining portion of government spending here -- education, health care and such – given budgetary constraints. So, we’re still thinking growth, but given some changes within the mix of construction activity, expect a bit of a slowdown versus what we have seen in ’17, with potential for re-acceleration in 2019.
What do you see in industrial, petrochemical, oil and gas?
Very robust growth. Both industrial and petrochemical are in the best shape they’ve been in since 2013-14. We expect mid- to high-single digit activity growth in 2018. On the industrial side specifically, changes in the tax code might end up having a very long tail because they really provide incentives for manufacturers to consider re-shoring production. In short that essentially means adding productive capacity in the U.S., which would be beneficial to the rental industry longer term.
How do you see rental rates and rental demand evolving in 2018?
Rental rates expectations are north of 3 percent for 2018 growth. You can say that’s a little bit optimistic, but when you look at the charts you’ll see that in 2015 and ‘16 there was a lot of slack demand. Too much equipment was sloshing around and competition was very high. We’re starting to see the end markets firming to where utilization of equipment is improving significantly. That impacts rates. So rate growth expectations essentially have normalized back to where they were in the 2012-13 timeframe before the oil-and-gas downturn. Again we need to keep expectations in check not to get ahead of ourselves, but I definitely think rental rates are going higher. We’re probably going to start out of the gate with something like in the low single-digit range.
For rental companies interested in expanding – either adding to fleet, adding branches, making acquisitions, etc. – will capital be relatively easy to obtain in 2018? Available and affordable?
Yes on both accounts, available and affordable. Interest rates we know -- you see on TV if you watch CNBC or the nightly news -- have been coming up, but the fact of the matter is they remain very low from a historical standpoint.
So a quarter or a half of percent move in overall interest rates, that’s less of a hindrance or less of an issue. In terms of availability, capital is broadly available if you look at data coming from the Federal Reserve that systematically polls loan officers as to whether or not they are loosening or tightening credit standards. By and large credit standards continue to loosen which is consistent with an economy that is doing quite well. So capital is available, it is relatively easy to obtain and it still is relatively cheap.
Rental companies appear to be optimistic going into 2018 expecting high demand from their customers. Will that likely translate into a lot of spending on fleet growth?
Yes, there are two elements here. The first one is that as we’re entering into the year, rental companies already have good solid expectations for 2018 from a fleet spend perspective. The survey shows roughly 7 percent growth expectations for 2018 in terms of fleet spend. But it’s also interesting if you talk to industry participants, you’ll see they are very positive on the impact from tax reform. Keep in mind that we’re not just talking about a lower headline tax rate -- from 35 to 21 percent -- we’re also talking about immediate expensing of equipment purchases. People are starting to realize and recognize that benefit.
There’s a lot of optimism that’s already out there surrounding the tax bill, but market participants have still yet to figure out what it truly means and how big a needle mover it’s going to be for their bottom lines. So I actually expect spending on equipment to continue to gradually migrate higher as the year progresses, as companies recognize that activity is on solid footing, demand is certainly there, utilization and rental rates are pretty good, and after talking to their CPA, and their attorney, it looks like they have to consider the various ways in which they can really save on tax on their bottom line, including this equipment purchase expensing that they didn’t have before.
And what is going to help this industry too is that we’re not just talking about new equipment, this applies to used equipment as well. For the smaller independent operator who might not always go and buy that brand-new piece of equipment, this is going to be a tremendous help. I for one am really happy that the tax code has included that because we need to do the best we can to support these small business owners.
What are your expectations for the earthmoving and aerial markets in 2018?
In terms of demand both of them are good. The one thing that stands out to me is that it appears the access market has tightened significantly in 2017, so all of a sudden we are looking at utilization rates that are more than normalized. That’s going to support overall growth and rental rate growth too in 2018.
In terms of actual equipment volume sales, we think in earthmoving, volumes will remain really robust still in 2018 in the U.S. and Canada. It looks like we exited 2017 with about 14 percent volume growth; we’re thinking 12 percent growth is pretty likely in 2018. As you look at access equipment, we’re looking at slightly lower growth, about 8 percent growth, but it’s still considerably higher than what we’ve seen in the past few years in access equipment. One of the differences between access equipment and earthmoving, even though the access equipment market seems to be tighter given the high utilization, investment in access equipment over the past seven or eight years has actually been pretty good with growth over this period being higher and more stable than earthmoving.
For me as an analyst looking at it from a cyclical standpoint I would essentially call the access equipment business as being above a normalized or mid-cycle level. So going forward, growth from a base like that has a tendency to a be a little bit lower or lagging something like earthmoving equipment that has seen far more significant challenges in the last three years.
Do you expect the rate of consolidation in the rental market to be somewhat similar in 2018 as in the past couple of years?
I believe the rate of consolidation in the rental equipment market is going to actually pick up -- if you can believe that -- in 2018 and 2019. And a lot of it has to do with the market being still fragmented, demand broadly speaking is pretty good, and of course I’m going to bring it right back to taxes. There are provisions in the tax code that essentially allow the buyer of a business -- so think of someone buying a rental business -- to take all the assets they are acquiring, used and new within that business, and treat that portion of the acquisition as an expensable item in the year in which they are closing the transaction. This is a really big deal. If you operate a rental business and you’re thinking about buying out the guy in a town next to you, buying that business and being able to take all the equipment that business has on the lot and recognize that as a taxable expense in the year that you close the transaction, it’s a very big tax shield for you the buyer.
I think what’s going to happen here is you’re going to see strong players, profitable players in key markets attempt to consolidate that market with good quality competitors and fully utilize all the advantages that the tax code puts forward.
This is not just something that’s going to happen in 2018, but for the next five years we have very attractive provisions in this tax code that are going to drive consolidation. It’s a very interesting time and at the end of the day these kinds of provisions can benefit both buyers and sellers.
Are you seeing relatively smaller players looking to buy other companies as opposed to an increase in larger companies acquiring? It will benefit them too?
It’s going to benefit everyone. The giants will continue to consolidate. They are not going to step back; if anything they’re going to pick up activity. I would argue that there’s room for privately held mid-tier companies to do the same thing.
There seems to be high optimism as 2018 begins. What are some of the potential pitfalls rental people and others in this industry should watch out for?
Biggest pitfall is a classic one, be careful with the amount of debt you take on. Yes things are good, and could potentially get better as growth accelerates, but during boom times as we all know, the industry can go through excesses, and those excesses are too much iron in the parking lot and too much debt on your balance sheet. So once again, be careful with that. It is a risk; things do change in this industry.
And not to make this all about taxes, but one of the changes that have been introduced in the tax code is a limitation on the amount of interest that a business can deduct. Not to say that this is the end-all be-all of why businesses incur debt but it just requires more scrutiny as to how much leverage one should put on a business.
Another potential pitfall stems from policy and political volatility in Washington and even at the state level. We are seeing a lot of changes. I look at NAFTA in particular as something that is very relevant for border states that are reliant on that trade and for regions where farming (crops and livestock) are a big part of the economy. These activities support industrial activity and construction, so I think changes to trade agreements could potentially have adverse affects. It remains to be seen, but it’s a risk that ought to be considered.
And lastly, I would say input costs: Be mindful that with unemployment down, it’s getting harder to find good employees, and I think that challenge only gets amplified in 2018 and 2019, and it’s going to be something to contend with particularly for your operators in urban areas where there’s a lot of competition for labor.
That’s already being seen in construction markets, the lack of qualified workers.
I would agree. Here in Wisconsin for instance if you go talk to a machinery builder, JLG up in Oshkosh or Manitowoc Crane or Caterpillar they’ll tell you “I can’t find welders.” So things are pretty good but those are the constraints.
So just like the last recession, don’t become over-leveraged, right?
Isn’t it crazy how we always forget those very simple lessons?