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 with the many changes this will require, or hold the line 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 rental business will grow from $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 second in a series of three on “rentalnomics”— the new economy of rental. This paper goes into detail on the new business models created by the growth in rental and discusses how to successfully manage profits, cash flow, and market share. We will also discuss five reasons dealers should move to rent to rent (RTR) programs and explain why dealers, rental companies, and OEMs all can expect to encounter significant changes in how they attract and retain customers.

The first paper in the series provided key insights into the rental market and discussed the two methods used to account for rent to sell (RTS) and RTR transactions, and their effect on gross margin and ROI. In the third paper, we will focus on what rental leadership looks like and provide concrete recommendations and advice on how to succeed with your rental transformation.

New business models created by rental

New directions for OEMs

As discussed in the first paper in this “rentalnomics” series, if the increase in rental activity represents how 50% of the construction equipment in use moves through the supply chain, the supply chain as we know it will have to change; new business models will emerge from dealers, OEMs and rental companies to grow revenue, manage profits, and capture market share.

OEMs have to face the fact that if their dealer network is not heavily involved in rental, or if the OEM does not sell to rental companies, the annual demand for their products may decrease—in some cases, significantly. Demand may also decrease, if their dealers find that customers are demanding more rental equipment that they cannot deliver with an OEM’s current product line. This can cause an allocation of inventory investments across the network that result in smaller purchase orders than expected. A build up in rental fleets may even mean that a dealer cannot afford to carry as much inventory as it did previously.

On the plus side for OEMs, dealer rental fleets assure OEM’s of virtually 100% of the aftermarket parts business that dealers currently do not have. Since OEM margins on parts sales are significantly higher than equipment sales, this is a real plus for OEMs because it offsets lost margins from decreasing dealer equipment purchases.

According to the 2013 AED Product Support Opportunities Handbook, dealers currently only supply 6% of the installed base maintenance work and about 22% of available repair work. For dealers without a 100% absorption rate, these results are catastrophic. It should be noted that profitable rent to rent (RTR) operations can improve the absorption rate, and this creates an opportunity for a more aggressive pursuit of equipment sales. This is another reason to consider RTR as a growth strategy.

OEM’s have to review their strategic plans and supply chain participants (which may include rental companies) and determine how to best protect and promote their brand and dealer network while facing less demand from current customers who switch more of their machine utilization to rental instead of ownership. Both OEM’s and dealers need to understand this rental conversion and face the fact that what it means is less customer demand for ownership and more of rental.

OEM’s also have to realize that selling direct to rental companies can generate more brand awareness that attracts new potential customers to their dealership network to purchase equipment, parts, service and rental. OEM’s with the most to lose in terms of lost sales may need to consider equity ownership in their dealer network to protect their supply chain. This is taking place in dealer related industries where there are a limited number of large dealers available to cover major territories.

Dealers shift to RTR

It is tough to switch to a RTR program. But the results can be rewarding. Most dealers currently use RTS transactions and find themselves half way to being RTR providers. Chart 1, “Rental emphasis and profits” demonstrates how an RTR model can help dealers increase their profit margins.

Chart 2 reflects the balance sheet, sales, rental mix, margins by category and overall cash flow for both a typical dealer and a high-profit dealer, as reflected in the AED “Cost of Doing Business Survey.” The survey results were used to compile the operating results and balance sheet for the typical and high-profit dealer categories by referring to the sales mix and balance sheet make up.

The sales mix for each dealer was used to calculate inventory and fleet levels, along with the gross margins for the sales mix categories to demonstrate how RTR transactions can improve margins, absorption rates, and cash flow.

There is little doubt that RTR provides higher margins, cash flow, and EBITDA and, in turn, higher enterprise value. Dealers should take advantage of these new profit-driving transactions—if they can properly manage the RTR business.

How to do RTR right

Wanting to be in the RTR business is one thing. Actually doing it properly is another story. This is because RTR has to be aggressively managed to meet both time and dollar utilization goals; dealers that fail to do this run the risk of significant cash flow deficits. If there is one thing a dealer needs to know about RTR, it is that small changes in rental revenue, rental rates, or time utilization can produce large changes in cash flow.

Dealers will find that planning for a separate rental facility with its own technicians, trucks, and drivers is the best way to manage a rental operation. It avoids conflicts with the parts and service department, as well as with the trucking schedule. Not being able to keep rental units at maximum utilization is the difference between having a rental program and having a profitable rental program.

Building a rental fleet normally means financing rental equipment over a 60 or 72 month duration. Debt service payments have to be met from the rental revenues collected. Generating that 30% to 40% rental margin means cost controls must be in place to service, maintain, and transport the rental units. It also means that rental units returned on Monday have to be rent-ready on Tuesday. Rental units that need repairs have to be attended to immediately.

Many dealers find it very difficult to meet these standards because the rental department does not employ its own technicians and truck drivers. In those cases where these standards are not met, an examination of the RTR fleet probably produces unacceptable time and dollar utilization and thus a fleet that is nothing more than used equipment sitting around waiting to be rented or sold.

Five reasons why dealers should move to an RTR model:

• Customers demand more rentals.
• Dealers have to be prepared to serve the rental market.
• RTR improves the dealer’s absorption rate and bottom line profitability.
• RTR, properly executed, increases a dealer’s business value.
• RTR brings in new customers.

There are customers who still buy equipment like they did before. There are customers who now only buy core units with consistent high utilization rates and use rental to fill any remaining needs. But there is a good chance that as more contractors realize the benefits of rental, more will switch a bigger portion of their equipment utilization needs to rental.

Profitable dealers in the future will master RTR transactions for their core products and also offer a more diversified array of rental equipment, have a system in place to manage the rental business, and make an effort to raise their percentage of maintenance and repair work to raise their absorption percentage even higher. Since RTR is basically a service business, the dealers that provide the best service and rental experience will reap the financial rewards.

As they enter the rental space, poor performing dealers will find their balance sheets in shambles and cash flow disappearing. They will soon realize that poor performance on the rental front will drive business away because both dealer and brand loyalty are in play.

One way for a dealer to get into the rental business and avoid all of the transition issues we’ve highlighted would be to seek out and acquire a local or regional rental company and make use of their experience and rental expertise.

Rental companies beware

The market for rental services will become more competitive as OEMs and dealers gravitate to a RTR environment. As dealers respond to customer demands for more diversified fleet offerings, rental companies may find themselves facing off against well-capitalized dealers for new and existing customers, especially in cases where dealers represent core units currently used by customers. The national rental companies have a strategy to convert large customers to national accounts, which could now be at risk if the top OEMs offer similar programs to be carried out via their dealer network.

As this rental space gets more crowded, we may see partnering among rental providers of different types of equipment as a way to expand their collective fleet portfolio offerings. Since it is virtually impossible to cover every customers’ equipment needs, not to mention the capital that would be required to do so, these types of arrangements can lead to a win-win relationship for all parties involved.

Local or regional rental companies may also want to seek out a buyer or partnership arrangement with a large dealer with a regional presence and multiple locations.

The new reality

Dealers, rental companies, and OEMs all can expect to encounter significant challenges in attracting and keeping customers. It appears that rental customers have little regard for brand or dealer loyalty when they do not own the equipment. Dealers and OEMs that decide to stay with the status quo will have to deliver superior products and services with programs that somehow mitigate the benefits of rental. That’s a tough assignment, indeed.