All types of construction and industrial equipment are moved through the supply chain using dedicated dealers, multi-line dealers, and more recently, equipment rental companies. Dealers and their original equipment manufacturers (OEMs) put contracts in place to annually purchase or sell both equipment and replacement parts to meet a defined market share for their territory. Dealers then sell the equipment primarily to industrial and construction companies, with the expectation of gaining warranty, maintenance and repair work, additional future equipment sales and rentals. This method of bringing product to market has been in place for at least 100 years. However, it’s in the process of a significant transformation because of an increased demand for rental units—which now accounts for a significant percentage of equipment being manufactured.

This rental transformation is forcing dealers and OEMs to consider how to deal with this change in their business model. They either need to embrace rental as a profit center, along with the many changes this will require, or hold the line by using dedicated dealers that primarily sell and service equipment.

Because of this rental conversion, sales volume and margin, as well as brand loyalty, are at risk for dedicated dealers as well as OEMs. In the end, rental conversion could materially impact financial performance and thus intrinsic value for affected parties involved in the supply chain. As a result, all entities involved in the construction equipment supply chain have to decide how they will deal with the growth of rental transactions, which are increasingly replacing customer equipment purchases.

About this paper

There is little doubt that rental is here to stay. The American Rental Association estimates that North American equipment rental revenue will grow from approximately $38 to $40 billion in 2014 to $50 to $53 billion in 2018. If you are the CFO or finance VP of a dealer, service, or rental company this paper is a must read to stay abreast of how to successfully support the financial side of your business during the rental transformation.

This paper is the first in a series of three on “rentalnomics”—the new economy of rental. This first paper will provide key insights into the rental market and discuss the two methods used to account for rent to sell (RTS) and rent to rent (RTR) transactions and the effect on gross margin and ROI of the two methods. In the last section in this paper, we will talk about how the disruptive forces in the industry can change your market share and brand.

Future papers will go into more detail on the new business models created by the rental growth, what rental leadership looks like and provide concrete recommendations and advice on how to ensure success with your rental transformation process.

Key insights into the rental market

Rental as a means to achieve optimum machine utilization and jobsite efficiency is here to stay for many reasons:

• It is cost effective.
• It is flexible—filling needs when additional equipment is required and allowing contractors to try before they buy.
• It makes better use of contractor capital.
• It relieves contractors of financing headaches
• It offers a better option for distant jobs.
• It provides access to specialty equipment that is more job-specific.
• It transfers most maintenance and repair costs to the rental company.
• It eliminates a contractor’s residual equipment value risk.
• It transfers technical knowledge requirements to the rental company.
• It reduces payroll costs, and leads to higher jobsite efficiency.

Rental equipment is supplied to contractors and industrial customers by both pure rental companies and equipment dealers who also sell equipment in contract-mandated territories. Rental companies have a sales mix that is typically 70+% rental, with the remaining sales represented by equipment sales and services. Rental companies are focused on rental transactions, meaning that both technicians and transportation personnel are dedicated to maintain and transport equipment.

Equipment dealers rent equipment using two methods: Rent to Sell (RTS) and Rent to Rent (RTR). RTR is comparable to the service a rental company would provide. RTS is primarily a financial merchandising tool that allows customers to rent a unit for period of 6 to18 months, and then decide if they will purchase the unit using a significant percentage of the rent as a “down payment” on the unit.

RTS transactions, if converted, provide dealers with a nominal margin similar to the margin on an outright sale. In comparison, RTR transactions generate higher margins, but require a separate rental fleet where units can remain in the fleet for 48 to 120 months, depending on actual hours of use on the rental unit, type of equipment, and recovery strategy. Where RTS transactions provide a 10% to 14% gross margin, RTR transactions can generate a 30% to 40% gross margin including operating costs and depreciation. Some rental companies try to keep units in their RTR fleets until they recoup up to 250% of original cost. In other words, if they buy a piece of equipment for $100,000, they will not sell it until rents plus the residual sale totals at least $250,000.

Because RTS transactions are more or less sales transactions that provide a customer with the ability to demo the unit and at the same time build equity in the unit, they do not lend themselves to the daily, weekly, or monthly rental options that a RTR transaction provides. As stated earlier, RTS transactions, if converted, provide a “sales transaction” return, which in a dealers’ sales mix provides the lowest return in the mix. On the other hand, RTS transactions that do not convert provide a fair RTR type return for two reasons:

• Because the rate is close to a RTR rate
• Because the unit is rented for extended periods of time

In reality, if 100% of RTS transactions never convert, a dealer is basically in a RTR business without the hassle of dealing with daily and weekly rentals until the non-converted units are transferred into the RTR fleet. In many cases, dealers in a RTS environment turn their non-converted RTS units faster than a rental company would, so that new units can be brought back into inventory for potential sale. When compared to the RTR example above, a RTS unit rented for 18 months would most likely recoup $111,000 to $114,000, requiring the sale of at least 2 units to match the RTR result over the same 18 month period. And if the one unit is used as a rental unit for 60 months 8 RTS units would need to be converted to match the cash flow from one 60 month rental unit.

There is no doubt contractors will still buy and own core units used in their business. Maybe not as many, but they’ll still keep a base number of units on hand. But with the benefits rental offers, contractors may find it useful to sign RTR agreements, use the units for the season, and then return them, thus leading to a lower conversion rate then in the past. Getting a new unit with no risk that can be returned when the job is completed, with no obligations, is a great deal for the contractor.

A dealer cannot be a pure rental company because they have sales and product support obligations that require some level of inventory to meet their OEM contract obligations. They can, however, build a RTR operation to meet customer demand; using the non-converted RTS units to start to build a RTR fleet. This of course may not sit well with OEMs because it would mean these RTR units remain in the fleet longer and thus delay replacement purchases of new units.

There is little doubt that better profits and cash flow result from keeping rental units for 6 to 8 years, thus producing 200% to 250% of gross proceeds; those proceeds include rents plus the residual sale, and a net cash flow return of 1% per month over the life of the unit in the rental fleet.

The Associated Equipment Distributors (AED) annual Cost of Doing Business Survey for 2014 indicates that high-profit dealers (the top 25% of participants in the survey) had greater investments in RTR equipment and higher gross profit margins when compared to the typical survey participant (based on all participants in the survey). The report demonstrates changes in operating results as RTR activity increases. It uses four categories of RTR activities, (see chart 1 below). It’s worth noting that the overall company margins increased as the percentage of RTR transactions increased as a percentage of total sales.

The American Rental Association (ARA) estimates that North American equipment rental revenues will grow from $38 to $40 billion in 2014 to $50 to $53 billion in 2018.

For the five years from December 2013 to 2018, ARA is estimating a 34% increase in rental activity. Rental transactions generally produce annual rental revenue in the range of 25% to 30% of original equipment costs. Thus, $38 billion of 2014 rentals is supplied by a $127 to $150 billion rental fleet at cost. Annual fleet additions at these levels would generate on average of approximately $25 billion of equipment purchases in 2014 and $35 billion in 2018—a significant percentage of US equipment production.

The top five rental companies, such as United Rentals (URI), only represent 25% of the rental market as of January 2014. A combination of dealers and rental companies provide the balance of the rental volume. ARA’s Top 100 Rental companies run the range from URI’s $5.5 billion to about $12 million for the 100th listed rental company. Although there has been significant consolidation in the rental market, dealers and local rental companies still provide the bulk of rental transactions to construction contractors and industrial users.

ARA’s Equipment Rental Penetration Index indicates that 50+% of equipment in use in 2014 is made up of rental units. Let’s just say this figure represents the percentage of equipment cost in rental company fleets against the total cost of equipment in the market at a point in time. ARA, with the help of IHS Global Insights and Rouse Analytics, can estimate the cost of rental equipment from rental billings and the total cost of construction equipment from US Census Bureau data.

There is little doubt that rental is here to stay. Contractors will still own their core units that they use on a consistent basis, with consistent basis meaning a 60% to 70% or more of time utilization on an annual basis. But the shift to rental for remaining jobsite equipment needs will continue. Both rental companies and dealers have educated contractors about the cost of owning and operating construction equipment. In addition, dealers have educated contractors about the cost of using in-house service technicians when compared to dealer personnel, especially in those cases where dealers have multi-tier labor rates that match work to the level of expertise required.

And it is no secret that contractors have a serious issue about properly allocating equipment costs to jobs for accounting purposes. A contractor, knowing his/her true cost of owning and operating equipment has far less reluctance about renting because the rental cost is close to ownership cost and gets charged 100% to the job via rental billing without any other complicated accounting to worry about. Yes, rental is here to stay.

Disruptive forces in the industry

A recent Forbes Insights Survey of CEOs in the distribution business indicated that two of the top risks they face are:

• Loss of market share
• Products losing value in eyes of customers

Does a loss of over $200 billion in equipment sales cause a loss of market share for dealers? How about OEMs? Even rental companies have to worry about increased competition from dealers and other rental companies. In the end, it is the equipment dealers who have the most at stake in this game, especially if they have weak product support revenues. OEMs are still selling equipment; it is just a question of who is buying it. And those OEMs who do not find favor with the rental companies may find themselves losing market share because they are not getting their share of the rental fleet business and because their dealer network is reducing purchases because the demand for new product sales has diminished.

The loss of market share and intrinsic value of a brand for both dealers and OEMs can be directly related to machine utilization through rental rather than ownership. Dealers and OEMs who find themselves in this position will have to restructure their supply chain to protect market share and enterprise value.

Some industry leaders will say that this round of increased rental activity is a result of the depression we went through starting in 2008, and that it will reverse itself once the economy recovers back to 2007 levels. Michael Kneeland, CEO of United Rentals was asked about this possibility in an interview on CNBC, and replied that after every downturn in the last 10 to 15 years, the level of rental at the peak of the subsequent recovery was higher than when the recession started. In other words, there may be a slight reversal but not enough of one to reverse a significant percentage of the incremental rental activity.

The new normal

Rental is becoming the new normal and we see this transition in everyday life. If we assume that rental is here to stay, then the supply chain for equipment distribution needs to change. Both dealers and OEM will have to adjust their strategies and plans to include rental as part of their growth strategy.

If contractors are really only primarily interested in machine utilization and 100% up time, what does that mean for construction equipment dealers? What strategic changes do dealers have to make to compensate for the potential lost revenue and current pricing advantages they have? Follow the “rentalnomics” series to find out more about: the new business models created by the rental growth, what rental leadership looks like, and concrete recommendations and advice on how to ensure success with your rental transformation.