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Expansion Takes a Pause as Small Businesses Re-Tool

Date: Jun 13, 2013 @ 08:00 AM
Filed Under: Economy

Earlier this month, Equipment Finance Advisor caught up with PayNet’s President and Founder William Phelan to gain his insight on a variety of issues facing small business lenders and borrowers.

Equipment Finance Advisor: When we last spoke in February, you noted a steady, albeit slow, state of expansion in the final quarter of 2012. However, in the first quarter of 2013, the Small Business Lending Index (SBLI) fell for three consecutive months representing a 15% decline thus far in 2013. Most recently, the April SBLI showed a reversal of the trend registered in the first three months of 2013. Can you shed some light on this?

William Phelan: We saw a big pop in April and that’s nice, because as you point out, the growth trend line had been negative in 2013. This reversal was a very good sign for the economy as it represents small business expansion which means economic growth.

As for the numbers, the SBLI jumped 17% to 110.5 in April and began the year at 116, so no real growth has occurred this year. The good news is delinquencies remain muted. We just don’t see any significant movement in overall credit risk … delinquencies remain relatively flat. And flat on both new volume and existing portfolio credit risk shows the resiliency of U.S. business given all the recent changes.

Equipment Finance Advisor: Given these findings, what is the biggest “take away” for the equipment leasing and finance industry?

Photo of William Phelan - President and Founder - PayNet Incorporated

Phelan:Well, the question to me remains, “Are we in a new era of risk?” It’s evident that today’s economy has fundamentally changed from the pre-recession economy. There are many more issues for bankers and leasing companies to deal with now. The regulatory environment will mandate less risk taking for financial institutions.

The data signals the beginning of a new cycle of credit risk. Credit risk is hitting the low point with the Small Business Delinquency Index registering 1.26% last month … that’s far lower than it was before the recession. At the same time, we have new regulations in place to make sure that financial institutions don’t take a dive off the cliff again. That’s had a muting effect on the amount of risk-taking at financial institutions. And that’s a challenge given the fact that the economy is in slow growth mode while leasing companies want to expand. There’s this dual pressure of greater scrutiny on risk while having to grow earnings at the same time.

Equipment Finance Advisor: How deeply do you feel the effects of sequestration and the austerity measures initiated by the Federal government have impacted the performance of the SBLI in the first quarter of 2013? Will these effects be in the short-term or will they continue to impact small businesses that rely on government spending?

Phelan: When you have a government that has a $3 trillion budget, you can’t avoid feeling the effects of its actions. But the beauty of the U.S. economy is its adaptability. As we witness the government cut backs, we’ll see businesses jump in to fill in the gap. So there’s a bit of a push-pull dynamic, but ultimately these small companies will start to serve parts of the market where the U.S. government may be exiting so that less crowding out of private enterprise will occur.

So, I think sequestration is probably a short-term drag for both small businesses and the equipment finance industry but long-term opportunities will emerge.

Equipment Finance Advisor: We note that seven out of the ten largest states are experiencing a rise in loan delinquencies. Is the service sector taking a bigger hit in these states and now carrying a higher “multiplier effect” on the overall economy since we last spoke?

Phelan: PayNet did a study last year that shows a long-term shift from a manufacturing-based economy to a more service-based economy. We see the big three sectors – transportation companies, construction companies and manufacturing companies – making up a smaller share of the U.S. small business economy than they did in 2001. The decreased share of the private economy is material. Their share decreased from 35% to the mid-twenties, which is a rather big shift over ten years.

There’s a systemic change that’s occurred over this ten-year period, but the data tells us more shifts are afoot. It’s the changing business environment where companies are adapting to this new world of regulation, transparency, and scrutiny. All businesses must integrate these changes into their business processes. Changing business processes is hard and expensive work particularly for the smaller firms that lack the resources of Fortune 500 companies. Expensive business process changes for smaller firms may partly explain the sluggish growth of the U.S. economy. Large companies can adapt more easily, so the stock market is doing well. Smaller private businesses are holding back on aggressive expansion as we see in the SBLI. While credit risk looks good in aggregate, we do see sectors like transportation and construction having some challenges across a broad number of states.

The transportation sector in California, Illinois, Michigan, Pennsylvania and Ohio is showing the largest rise in financial stress. For example, loan delinquencies in Illinois and Pennsylvania have risen anywhere from one-third percent to one-half percent in those states respectively. That’s quite a material rise, so now may be a good time to be a bit cautious to stretch for extra yield or loosen the credit box in the transportation sector.

We see the same story in the construction sector, but not as pronounced. In other words, the deterioration of credit quality in states like Illinois and Pennsylvania is not as great in this sector. And the reason I reference these states is because they serve as bell weathers for the U.S. economy. When these big states start to exhibit some clear trends in delinquencies, especially in construction and transportation, that tells us something is going on out there.

Equipment Finance Advisor: Are any sectors expanding?

Phelan: When we look at the data, we see the agricultural production sector growing, especially among cash grain farmers. There are a few reasons for this growth. The U.S. is still the breadbasket to the world, and we’re producing wheat further north than ever before. Today, you can run a 50,000 acre farm with fewer than 10 people, and that’s pretty incredible when you think about it. We are also seeing building contractors and materials companies hanging in there and actually starting to expand a bit. In heavy construction, we note a 10% increase in their lease originations through April. So there’s some decent expansion in those sectors.

On the flip side, and as far as services sectors go, insurance brokers aren’t investing heavily in technology and new servers. Retail food stores are holding back as well with little investment in furniture, fixture and equipment. The health services sector remains a bit of a puzzle where we see that sector holding back in investment in capital type projects. One possibility is a good deal of uncertainty around the new health care laws and how they will be implemented.

Equipment Finance Advisor: Do you have any observations to share about which geographic regions are preforming better than others?

Phelan: On a regional basis, we’re seeing the North Central and Western regions standing out. Minneapolis, Chicago, St. Louis and San Francisco are all performing well in terms of the amount of investment over the prior 12 months. Minneapolis has expanded its investment in capital equipment at a 15.2% year-over-year rate and Chicago is at a 9.7% year-over-year rate.

What strikes me about the data is that places like Chicago and Minneapolis are low-risk areas, yet they have demonstrated the highest expansion rates. Debt growth with low risk contradicts traditional credit assessment. Conventional thinking typically says that if you borrow a lot of money, you will be at risk. But the data tells us the opposite is true at least over the last few years. For example, Minneapolis-based businesses are top investors in property, plant and equipment and are actively borrowing, but their risk profile is the lowest of all of the Fed regions. So you really need to be able to understand how to assess companies from a risk and reward standpoint.

Equipment Finance Advisor: Is there any explanation for this dynamic?

Phelan: Well, higher credit quality companies are able to access capital more easily … that’s a part of it. Just look at the blue chip companies. The same holds true for smaller companies as well. High quality companies are able to put more profit to the bottom line. One possibility is that higher credit quality companies are higher quality companies in their business models, operations and know-how. So while some regions are exhibiting growth, overall the Small Business Lending Index is on a negative trend even while interest rates remain very low. Meanwhile the big public companies and large middle-market companies are issuing bonds and taking on debt at a faster rate. But small businesses aren’t biting on the cheap debt… they’ve held back for a variety of reasons … the slow growing economy, modest sales expectations and the pace of new regulations.

Equipment Finance Advisor: How do you think all of this bodes for small businesses in terms of CAPEX? Do you see CAPEX picking up or remaining relatively flat?

Phelan: You really have to look at the pockets of growth. You can get a sense for CAPEX expansion by looking at the pluses and the minuses. The big plus is that equipment finance companies enable productivity. Productivity improvement remains a big driver for U.S. business. U.S. companies will follow the trend toward higher productivity and that means more equipment.  The minus results from the high cost of business process redesign I mentioned earlier. In addition to that, a lot of private money was pulled out of the economy with the reinstitution of the higher payroll tax. In the end you have one big positive and some negatives. I think the good news is that the negatives are most likely short term and the positive – the financing of productivity – will last for a long time. Once administrative processes are re-tooled, companies can start to invest in capital forming projects that will create opportunities for equipment finance companies to increase volume.

Equipment Finance Advisor: Overall, you seem optimistic. Do you have any concerns?

Phelan: Our sense is that the expansion phase of the business cycle is mature, and our biggest concern is that it comes to a halt altogether. We are not calling it a contraction, we are seeing a pause. And this pause could continue while businesses work through the issues I discussed earlier, and as consumers get used to less money in their paychecks. From what the data is telling us, these doldrums could continue at least for another two to five months.

However, the good news is that credit risk will remain low for the rest of the year. Also, when you hit these businesses with a stress test, such as the stress scenarios utilized by the Fed, the stressed default rates are much lower than in 2008 and 2009. That means business borrowers are tougher, they haven’t taken on a great deal of new debt, and they have de-levered their balance sheets. Balance sheets of U.S. small businesses remain well positioned to invest heavily when demand rises for more of their goods and services.  Equipment finance companies need to be patient during this pause because expansions don’t have to end from old age.

Equipment Finance Advisor Staff Writer
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