Feb 2002 Cover Finall

Interview with Mig Dobre: Improvement in the Back Half

Jan. 30, 2020
RER talks with Mircea “Mig” Dobre, senior analyst at Robert W Baird Co., about trends in the economy, pressures on rental rates in 2020, why the economy is fundamentally strong, stocking and de-stocking, and why he's a long-term housing bull.

RER talks with Mircea “Mig” Dobre, senior analyst - Machinery & Diversified Industrial at Robert W Baird Co., about trends in the construction and rental economies, pressures on rental rates in 2020, why the economy is fundamentally strong, how stocking and de-stocking changes the perception of economic and rental trends, and why he’s a long-term housing bull.

RER: What overall trends do you see in the economy in the coming year?

Dobre: My view of the economy is that we are going to see better growth than we saw in 2019. And I think that is a combination of fiscal support on the government side, spending is pretty solid. We’ll see a little bit of help from things such as the USMCA as well as hopefully a trade deal with China. The angle with China, as far as 2020 is concerned, is [not so much] that the Chinese impact is going to be immediately driving incremental demand in growth in the U.S. I think initially it’s going to be more of a factor of uncertainty being removed and allowing businesses to invest and do some of the normal things they would do with a growing economy. I think that’s going to help.

We’re also seeing that the housing market is showing some signs of green shoots, which in and of itself should help. When you combine all this with lower interest rates, this is a pretty attractive setup into 2020, so we feel pretty good about that.

What are your expectations for non-residential construction over the next year?

A bit of a mixed bag. Non-residential construction has a lot of different verticals in it, and when you look at some of the leading indicators, whether it’s the Dodge momentum index, whether it’s construction contracts, it certainly suggests that to us on the building side, it will slow a little bit. I would say slower activity than what we’ve seen in 2019. On the nonbuilding side, you have maybe better potential for growth: you think of street and highways and the like. A lot too, as always in non-residential, depends on the public funding side.

The one area that is a bit of a yellow flag on that end is the expiration of the five-year highway bill which, you might be aware, is going to expire early in 2020. My guess is that we are probably not going to see Congress pass another multi-year highway bill until after the 2020 elections.  

Which doesn’t necessarily mean we’re not going to have highway funding, because funding will be provided through stopgap measures. It simply means that we’re not going to have a five-year bill that allows a lot of visibility. Contractors and folks in the equipment world really appreciate having that visibility because then they know that the funding is there for them to be able to invest. I don’t think we’re going to have that in 2020, we’re probably going to have to wait until after the election in 2021 to have something that’s more permanent in nature.

What about the housing market?

You and I had a discussion a year ago about housing, how we are long-term housing bulls and we remain very bullish on potential for housing in the U.S. Fundamentally because when you look at the data, you see that since 2010 we have under-invested in the housing stock. There’s good reason for that, we all remember the housing bubble of the 2000s. That created a hangover, it created essentially a process of normalization, rationalization of existing housing stock, which made the 2010-11 timeframe as difficult as it was for people in that business.

We’ve seen some recovery off of that, no question about it, but the recovery has been very very modest. I for one am excited to see housing starts on an annualized basis are now above 1.3 million units, they are finally growing again aided by low interest rates. If you look at the November data, it was 1.36 million on an annualized basis, there was 13-, almost 14-percent growth on a year-over-year basis, and again housing starts leads the actual activity and the spend itself. So in 2020, we might start a little bit slow on the housing, because it takes a little bit until the starts per se turns into real construction activity, but as you look into the spring and summer months, you probably should expect housing to grow. We have it in our forecast to be slightly down but I’m holding hope that housing can actually grow next year. That’s going to be very important, not only for folks in the rental equipment market but also for the economy as a whole since housing is such a critical engine for driving growth above and beyond pure construction.

Housing drives demand for all sorts of other things, furniture, appliances, electrical equipment, things of that sort. New housing leads to private, non-residential construction, whether it’s grocery stores, gas station, all the support that is needed for that additional housing stock. So, I’m very hopeful that housing can surprise us to the upside in 2020 and if that’s the case, that should make this lull in nonresidential construction that we’re expecting relatively short-lived. We can see re-acceleration in 2021 off of that.

What about the oil-and-gas and petrochemical markets?

Oil-and-gas has become harder and harder to forecast because if you look at current oil prices, they would be consistent with additional investment in upstream as well as mid- and downstream capacity, yet as we’ve seen through a good portion of 2019, that’s not been the case. Rig counts have been declining. What seems to be happening in oil-and- gas is that operators are finding new creative ways to get the existing equipment to be more productive.

If you can do that, then you don’t need to increase the amount of equipment you have running. And for your readers as well as the companies that I deal with, that matters a whole lot. What we want here is an environment in which the upstream companies can continue to invest and increase the fleets that are operating in the field. You want more rigs and then obviously you want more rented equipment to support those rigs.

My sense is that oil price levels are consistent now with additional investment, it’s just hard for me to really pinpoint whether or not operators in the oil patch will remain stingy and look for additional productivity improvement.

The year will probably start slow, there is hope for some improvement in the back half of 2020. A lot of the companies that we know and management teams that we talk to that have exposure in the oil and gas have a similar view where they are expecting better times in the back half of the year. But hopefully we can see it a little bit sooner than that.

What kind of effect are trade wars having on the economy and on the construction and rental industries?

Trade wars seem likely to continue, there are two main impacts here to talk about. One of them is a direct impact. Steel tariffs on components, on electronic and electrical components imported from China, necessarily mean that the imports going into machines, the cost of these imports has gone up. And as a result, manufacturers had to increase prices of the machines. It’s not just [construction] machines.

If you are out there operating, either putting equipment on rent, or renting equipment, you have seen tariff-related inflation almost across your business. There’s a clear negative effect that has on peoples’ bottom line. The trade wars seem likely to continue.

What impact have tariffs had on this industry – manufacturing and rental – over the past year and what do you expect for the year to come?

Predicting anything in terms of the trade wars has become almost impossible because policy keeps changing. I am not operating under the assumption that we are going to see material tariff relief in 2020 versus the levels that we have seen in 2019. If we did see some relief, that would be a nice positive upside surprise. But I advise your readers to operate under the assumption that the status quo in this regard will continue.

The second element to consider is not just the costs of the tariffs, but the uncertainty that this has caused and that goes into investment and confidence to deploy that capital. And we have seen hesitation on the part of companies as far as capex. Let’s talk about the rental industry in the U.S. You’re focused on your local market; you’re not dealing with the global economy. But if you have equipment on rent at an industrial customer and that industrial customer is pulling back on their operations or production volume, that impacts you. So, I think the impact has been indirect from this loss of confidence associated with uncertainty caused by trade. Clarity is going to go a long way, and it’s not so much that the new trade agreements have to be unwound and be brought back to where we were three or four years ago, it’s just that marketplaces need to know what the rules of the game are going to be. And they’re going to adjust their behaviors accordingly.

Finding that new equilibrium between U.S., China, Mexico and Canada, it seems like we’re making progress certainly with the USMCA. With China also we may reach some new equilibrium at some point in time early in 2020, I think that’s going to be very helpful.

Some rental companies expect a slower rate of growth in 2019, and some expect continued strong growth. Some rental companies are slowing down their capex for fear of a slowing market. What are your overall expectations for rental in 2020?

My view of 2020 is that the year should pick up as the year progresses. We’re probably going to start a little bit slow because with housing the leading indicators are good but current activity is slow, it’s still declining. With nonres, there’s some potential slowdown as well, oil and gas is not really accelerating either. The industrial portion of the market is slow, look at the PMI (Purchasing Managers’ Index) numbers, they are below 50 in the U.S., so we are starting a little slower but there is certainly potential for acceleration as the year progresses.

In the last Baird/RER survey concern over competitive pressures and rental rates seemed considerable. What are your expectations based on your knowledge of the market?

Absolutely, we found a lot of concerns on the survey. Your readers know very well that rental has always been a very competitive business. It remains that. What we see during periods when we had a lot of fleet investment, which has been the case coupled with moderating growth, is pressure on rental rates. There are also deliberate pressures on rental rates, which has been applied by the larger players in the market as they are fighting for market share and trying to wrestle some of that share from maybe smaller market participants. I really don’t expect the large players to be any less aggressive going forward than they have been in the past. The only thing that can alleviate the pressure on rates will be improvement in construction activity and in housing specifically. That can be the answer to potentially better rates in 2020. 

It seems like the dreaded “R” word is a major concern for a lot of people and has been for a while. But then again, it hasn’t happened. Any thoughts on what could trigger it?

That’s a really good question, and it’s one that I’m not sure I have perfect answers for, and I don’t think anybody does. We are in uncharted territory if you think about this business cycle. This business cycle started in 2009, we’re 10 years into it, this is the longest business cycle in modern U.S. history, and there is no roadmap at this point anymore to compare the current cycle with any prior one. But if one was to do that, the most glaring thing is not the duration of this cycle, but how shallow it has been. We’ve not had a lot of growth. The reason why we didn’t is because in the past 10 years we had a number of anchors holding us back. The housing bust and under-construction versus real demand, and that was a huge drag.

The commodity imposition of 2012 to 2015 that impacted everyone from farmers to the oil patch was also very real and it hurt. The U.S. government has gone through an extended period of austerity. If you remember the term sequestration, essentially the status quo of much of the Obama administration years, we’re finally seeing the government step up to the plate and doing more things on the fiscal side and spending, whether it’s defense or the five-year highway bill, there were things that were helpful in the last three to four years. But six out of the 10 years in this decade, we really haven’t seen much government spending, and that spending is really needed because at the end of the day, we’re talking about things like infrastructure that need to get done but haven’t really started to address that problem.

So really when I think about the 10 years that we’ve been through, I’m not finding any areas of excess in the economy, if anything we have had an excess of under-investment. As far as what triggers a recession, we can come up with all kinds of scenarios. But at the end of the day, I think it would be triggered by a crisis of confidence that people have vis a vis future growth prospects. If that happens because we have really onerous trade deals, if that happens because we have really bad policy from Washington, if that happens because some geopolitical problems come to the surface that the United States does not have the capacity to control, these are all things that can happen. But what’s different now I would say, unlike 2008, unlike 2000, I’m not seeing excesses like the dotcom bubble or the housing bubble have created.

What trends do you expect in availability of capital in 2020?

As an investment bank, Baird, we are in the capital business, helping people access capital. What we have seen is that capital is available and has been available in 2019, I expect it to be available in 2020. Availability is not the issue; the issue is the cost. And that’s where we have seen some challenges as interest rates froze, you’ve seen that impact the housing market. There have also been some challenges in the back half of 2019 in policy uncertainty, especially in trade. If you remember in the fall -- in particular in October -- trade talks with China looked to have deteriorated quite a bit. There was a lot of skittishness with regard to funding the more cyclical portion of projects available. This seems to have started to normalize. Policy, visibility and stability go a long way to ensuring that capital is available.

As we look into 2020, resolution for USMCA, resolution for China trade I think is going to be positive. The one thing I think that’s holding us back some is the natural uncertainty that comes with a presidential election that happens every four years. But if truly something can get inked with China, I do believe that capital availability will be better in ’20 than what you had in ’19.

What trends do you expect to see in the labor market as far as construction is concerned?

It’s going to remain tight. You know it’s tight, your readers know it’s tight. Competition for talent remains very fierce. This applies to construction as well as every single sector of the United States, I don’t care if it’s tech, healthcare, or finance, finding and keeping qualified employees is critical. And I’ll say this about the rental industry and I’ll say it about my own business, in capital market finance, it is critically important to invest in your employee base, and match their skillset with the evolving capability of your equipment suppliers. That equipment is getting more sophisticated, that equipment can do more than it ever could if you have the right people operating it, the right people maintaining it, and the right people who understand how to sell the benefits of that equipment. I think that’s the challenge. And you can pretty much use that paragraph for the next 10 years.

In your research note you talked about destocking being a drag on earnings and the beginning of a destocking process extending through the first half of 2020. Please explain this phenomenon, its impact and significance. Impact on our readers in the rental market?

What ends up happening, the stocking versus de-stocking essentially refers to what middlemen do with inventories, and if you think about it, virtually every industry is operating through some set of middlemen. Some are called wholesalers, others are called dealers or distributors or in some cases even the rental industry is a bunch of middlemen, they are stocking equipment that they purchased from an OEM, then they turn around and put it out for rent to an end user. The level of stock that middlemen have matters a whole lot because changes in that level of stock can exacerbate the actual underlying demand that a manufacturer experiences. To the upside or the downside.

To apply some numbers to it, say the market is growing 5 percent. Demand is growing 5 percent, but a construction equipment dealer senses that the market might grow more next year, or equipment is not readily available because OEM production schedules are extended. That dealer then has incentive to say “OK, if the market is growing 5 percent, I would like to build some stock inventory so I’m going to order 10 percent more equipment for the market and another 5 for me to keep on the lot.”    

The same thing can happen when middlemen expect OEM prices to go up. They want to buy before the price goes up. So, they buy for stock. If you’re a manufacturer, demand can appear to be incredibly good, and it’s not so much because sales to the end user is good but because that middleman has reason to build stock. The same thing happens on the down side which is what we’re experiencing right now where a lot of the middlemen – wholesalers, distributors, rental companies – have built stock in 2017 and 2018, driven by a combination of factors including expectations for higher equipment prices, issues with actual equipment not available because production schedules at OEMs were not ramping up quickly enough. Stock has been built up and these middlemen have realized that they had frankly more than enough stock given the actual end market, sales to end users that were slower than initially anticipated.

So you have the whip effect where the middlemen are de-stocking, demand for manufacturers’ product is declining more than what the actual sales to end users would be. In some ways this is a mini de-stocking recession if you would, where some manufacturers, take Oshkosh, the owner of JLG – JLG is saying that their business for next year may be down as much as 14 percent. Terex is saying that their AWP business, Genie, is going to be down 10 percent. Well, how on earth are these businesses down 10, 14 percent, if you don’t have a recession? The answer is de-stocking.

You’ve got people in the channel who are essentially even. Though there is still end-user demand growth, they have too much of this equipment on hand so they are reducing their orders. That’s the challenge, and that’s what we’re going through right now. With wholesaler inventories experiencing sequential declines, the third quarter of 2019 marked the beginning of a destocking process that is likely to extend through the first half of 2020.

Do you have any closing thoughts?

I’m going to close by simply saying this: We have reason to be optimistic about 2020. There are some challenges and I think the year starts slow. There are still questions that are unanswered as far as the big issues of the day, primarily China trade, and of course we do have the 2020 presidential election. Underneath it all though, leaving some of these questions aside, I think the economy remains in a really good place. Demand for investments is there, and if you look at capital, it is available and it is still relatively inexpensive. These are all very good ingredients for continued growth and really the only thing in my mind that can de-rail that are a shock such as the ones that we talked about earlier in regard to the recession questions that you asked.