Colin Oldfield: Live now, pay later

It is quite a few decades since plant hire, or equipment rental, could be considered a ‘sunrise industry’. It is an industry, in the main, linked inexorably to the construction and associated support industries, such as oil and gas, and other infrastructures activities. It is, because of its customer base, a highly cyclical and volatile industry. It is a business that requires dynamic management to glean the best results from long term assets.

Unlike the car rental industry, where business entry is very difficult for small operators, due to the huge discounts enjoyed by the big players, it is relatively easy to enter the plant hire market, due to the flatter discount structures available from the original equipment manufacturers, and accordingly, it is more difficult for a national operator to gain the commercial advantage, over their smaller, usually local competitors, that they need to underpin profitability, although a well-run larger company should have the advantage of economies of scale.

Within the industry it is rare to see signs of operating innovation, as any improvements in design are available to all, accordingly it is the mix of equipment, and of course the actual operation of the business that determines the degree of success. It is essential, therefore, to build up operating reserves when the market is buoyant, in order to protect the company in times of market decline. The Plant Rental “graveyard is full of companies who never recognised the possibility of a market downturn.

When one looks at some of the current major players in the industry, I consider that there is little evidence to suggest that dynamism, the ability to change, is very much in evidence, and it appears that accounting policies are possibly considered more important in driving the direction of the businesses than the actual operational practical requirements that really should be the bedrock of the business.

It is a very good manager indeed who has the nerve to slim down a fleet before the downturn actually begins. This action is rarely taken and so, when the phone stops ringing, utilisation slows, hire rates are depressed, and the plant disposal market dries up, in effect a ‘perfect storm’ is generated. The car rental industry suffers similar downturns, however they can unload their stock which was bought at highly discounted prices, into the retail car trade, but there is no similar route available to the plant hire companies. The result is that although they can dispose of old plant, they have great difficulty moving mid-life equipment unless they are prepared to take big losses or, if they have acceptable cash flow, they can hold on to their equipment and wait for better days.

In the past it was normal to depreciate general, mid-sized plant using a reducing balance method, with large equipment such as cranes depreciated over a longer period on a straight line basis. With regard to general plant this meant the cost of depreciation would reduce as the maintenance costs rose. It would appear that several years ago this policy was changed, and most of the larger companies now utilise a straight line depreciation policy, whilst also, more tellingly, extending the forecast operational life of the plant assets in their fleets.

This of course makes it much more attractive to purchase new equipment and to expand the fleet holding, because while all other costs will remain the same, the lowered depreciation costs will immediately inflate profits and strengthen balance sheets until the equipment is disposed of. It does not ultimately matter, on the face of it, what policy is used, because real depreciation remains the difference between the purchase cost and the proceeds from disposal, but it really does make a significant difference at any one moment in time, prior to actual disposal. It really has been a policy of ‘kicking the depreciation can down the road’.

Reducing the cost of depreciation during the first few years will encourage an expansion of the fleet, resulting in a significant improvement in margins, and provided that the business continues to expand, the effects of reduced profits on ultimate disposal will be more than made up for by the increased gross margins generated during the operational life of the equipment, however, when the market declines a rental company could have an excessive inventory, which, being potentially overvalued, will be difficult or expensive to reduce. Another result of the depreciation policy change is that, because of the reduction in operating cost, it enables companies to hold or reduce rental rates. The result is that the real beneficiaries are the rental customers, and not the companies actually holding the equipment.

Without actually interrogating individual companies, one can only use their published accounts as a means to determine their depreciation policies. One thing that is pretty sure, is that, whatever the narrative in their published accounts, the actual charge will differ for most companies, even for the same identical equipment. Accordingly we have VP, writing their equipment off over a period of 3 to 14 years, to an estimated “residual” value. Aggreko, which does have some quite big equipment, operates an 8-12 year span down to zero, whilst Ashtead Group writes its fleet down for periods between 3 years and 20 years, and then this down to a residual of 10% to 15% of cost. It is difficult to consider this to be a conservative policy,

It is worth noting that in their latest accounts the total plant fleet of Ashtead was valued at 70% of original cost, VP’s at 56% and Aggreko’s at 34%. Both Ashtead and VP have invested heavily in new equipment in recent years and this will have skewed their ratios somewhat, but at 56% of original cost the value of VP’s fleet looks rather high, whilst the 70% of Ashtead equipment appears anything but conservative. Aggreko’s ratio looks reasonable due to the longer life of much of its equipment.

It may be argued that as all the companies have recorded profits on the disposal of plant assets that this indicates a de facto case for the efficacy of their depreciation policies, but this is not necessarily true. The retention of over-valued equipment will negate a book loss, and more importantly the disposal of equipment to suppliers in exchange for new equipment may result in enhanced value for what may be in some cases ‘worthless equipment’. This book benefit will undoubtedly result in the new equipment purchased entering the fleet asset register at an inflated value, which will ultimately have a dilutionary effect on future profits.

Another key determinant of actual company value is goodwill. The premium paid over book value when businesses are acquired relates, of course, to the perceived real value in the eyes of the purchaser, and it is normally amortized over a reasonable period after acquisition. It should be noted that the ratios of goodwill, when related to net asset value is 14% at Aggreko, 34% at VP, and 50% at Ashtead. These ratios could be considered significant, particularly as the respective market capitalisation of the respective companies is, when expressed as a multiple of book value, 1.6 at Aggreko, 2.4 at VP, and 4.2 at Ashtead. In relation, therefore, to depreciation policy and valuations on tangible fixed assets and goodwill, it could be argued that in some cases net asset values would be significantly reduced if they were brought in to line with market valuation.

It should be remembered that within the last fifteen years more than one large company, both in Europe and the USA, failed to complete an attempted sale when business was poor. I think it is fair to speculate that this could have been as a direct result of due diligence undertaken by the potential purchaser highlighting the gap between the book value and the market value of their non-current assets. It could be concluded therefore that as the industry has, particularly in the US, had a good run during the last four years, that it may be a good time to increase their reserves to prepare for any storm clouds ahead. It is obvious that where book values are inflated it can enhance a company’s apparent, profitability, value, and of course it’s share price. It is therefore essential to be cautious, when determining the likely true value of a plant rental company.