Tips for Leasing, Buying Drilling Rigs
Adding rigs and other large equipment to a fleet is a major decision. Contractors need to consider how much they can afford to pay, how to best structure the terms to leave some cash flow intact, whether to lease or buy, and a host of other questions. Often, these decisions have a major impact on a business’ near and long-term financial health and revenue potential.
To sort out some of these issues, we spoke with Shawn McGill. He works with Epiroc Financial Solutions USA LLC as business manager, USA. Epiroc Financial Solutions, of course, is the financing arm for Epiroc and its associated distributors. But the discussion here is broad enough to benefit contractors buying equipment from any manufacturer and working with any banking partner.
Our conversation is edited for space and clarity.
Q. First off, who are you and why would readers want to hear from you?
A. I’ve been in the industry for over 35 years. When I graduated from college, I went right to work in the financing and leasing business. My first job was with the Hertz Corporation, which everyone knows, and it wasn’t car leasing at the time. It was the Hertz Equipment Rental Group, and I was in their collections field. … Along the route, I switched from collections to credit and credit to sales and then sales to management, and then to where I am today running the captive financing arm in the United States for Epiroc AB, which is the holding company over in Stockholm, Sweden. We are a spin-off of the Atlas Copco Group, formerly known as the Atlas Copco Mining and Rock Excavation business.
Q. Walk me through the acquisition process of a new rig. What are the steps the contractor needs to take?
A. All of our sales are done either through an authorized distributor, which also could be known as a dealer. We just like to use the name distributor in our modeling, or it could be done through a direct sale by one of our own sales people. I guess it all depends on what section or region of the country that particular end user or quarry or whoever is purchasing or acquiring our equipment [is in]. So, based on those facts, at the captive financing arm of Epiroc, which was formerly known as Atlas Copco Customer Finance, the procedure is this: The customer decides, “Hey, I want to purchase this … and I wish to know if there are financing or leasing options available through the manufacturer.” The answer is, of course, “Yes.” That’s why we have Epiroc Financial Solutions. At that point, either the distributor salesman or our own direct sales person would be in contact with me. I am kind of the first step. So they would come to me and they would say, “Hey, ABC Quarry is interested in acquiring a piece of Epiroc equipment in the drilling side of our business, and they would like to speak with you to know what options they might have.” And that’s how the process starts.
Q. What are the pros and cons of buying and financing versus leasing?
A. If you’re not aware … there are many changes coming in the laws of lease accounting as a principle in the United States, right? I’m sure you’ve either written articles or have had, you know, other articles written or talked about by businesses. And I guess that this is a sweeping change that is occurring from an accounting basis — it might be on a global basis, to be very honest with you. But the accounting bases are changing. … How you qualify it, how you account for it, and what sort of depreciation or tax benefits you can take are all changing at the end of this year and the beginning of next year sometime. It’s still to be determined as far as official dates, but the the government and the accounting boards have been telling customers to look into — especially, you know like CFOs and accountants and stuff like that, tax advisors — to look into what that’s going to look like.
So, believe it or not, you would think that the market would be retreating as far as their needs or interest in leasing. I’m seeing quite the opposite right now. I’m seeing a lot more customers asking for leasing options. … When you define a lease, what are we speaking about? Are we speaking about an operating lease, which a lot of companies call a true lease? Or are you talking about a stated purchase option, guaranteed purchase option, which could also be classified in a lot of ways as a capital lease, right? So with a capital lease, you either have a stated purchased option amount, whatever that might be, or it reverts to maybe $1.
Q. My understanding is that you didn’t depreciate a lease. Is that correct?
A. You are correct. There’s a reason for that. The reason is that when you do a lease, the lease is actually owned by the financial institution. … We operate just like a bank or lending institution, and all of the requirements and all the banking regs — everything that goes into transactions — are still applicable. But when you’re talking about leasing, there really is at least two types of leases. To simplify it: It’s either a fair market value purchaser, bargain purchase option, at the end of the lease, which qualifies it by accounting standards and by IRS standards as an operating lease. Which goes back to your question. Yes, it’s an off-balance sheet expense because what happens is Epiroc Financial Solutions buys or purchases the equipment from the distributor or from its own entity, Epiroc USA LLC. It buys the equipment from them and leases it back to the end user customer. Therefore, the end user customer — the quarry, let’s say — has no rights. [It’s] almost like renting the equipment from us. They have no ownership. Therefore, they cannot depreciate it, in fact, because they don’t own it.
Q. Then there’s this other type of lease?
A. I call it a capital lease. It has a stated purchase option in the agreement. So in the operating lease, it says there, “Mr. Customer, you have a few options at the end of the term.” And the term could be anything, right? … We go everywhere from you know, 12 months to 60 months on average, but I have done 72 months and I have done 84 month deals, depending on the situation at hand and the requirements of the customer. Based on those parameters ... it’s a stated purchase option in the agreement that says, at the end of the term … you may purchase this equipment for $1. At the end of the 60-month term, you may purchase this equipment for $500, or so on.
I’ll write whatever is agreed upon in writing up front, and that is actually put into the lease, and that qualifies it as a capital lease. One of the things you have with that is that both accounting principle and IRS standards will look at that and say, “Well, you know, that’s awfully close to a guaranteed purchase, and therefore, you might not be able to write that off. You might not be able to take certain tax benefits, because it’s a stated purchase option.”
With an operating lease, there’s nothing in writing on the contract that talks about a dollar amount. It talks about, at the end of the term, you may purchase the equipment for its then fair market value. Or, you may agree to extend or renew this lease for an agreed-upon term. So they can say, “Listen. I want to keep it for another 12 months, and I’ll continue making the same payments and can you give me credit toward reducing the principal amount, the reduction of the final amount?” We usually do that. Or, [they could say,] “I don’t wish to pay for this any longer, and I’m going to turn it back in to you and walk away from it with no penalties. I will give the drill rig back.” That’s an operating lease.
Q. So a capital lease that mentions dollar amounts and an operating lease are treated differently from an accounting perspective?
A. Exactly. Again, the one thing I want to state here is that we, as a company, especially Epiroc Financial Solutions, are not authorized to give tax advice. … We always tell the customer to please check with their tax advisor or their accountants for what works best for them and for their books.
Q. But you’re saying that this treatment is changing under accounting standards?
A. Regulations are being put into place which will change the financial accounting for such operating leases that we’re talking about here. … There are some talks about what will be classified as a capital lease and what’ll be classified as an operating lease, and I think the laws are talking about saying, “Listen, we’re going to wipe all of that out and it’s just going to be one lease. Everything’s going to be considered a capital lease going forward, and you’re not going to be able to take advantage of the same write-offs.” Everything is really owned by you. That’s, in a nutshell, the gist of what I’m hearing about the new rules and new law.
[Editor note: The change in accounting standards discussed here is International Financial Reporting Standard (IFRS) 16, which goes into effect in 2019. It covers most leases for assets over $5,000 in value or for terms 12 months or longer. Consult an accountant about whether it applies to current and future leases your business may have.]
What’s interesting about this here, Jeremy, is that … I’m starting to see more and more quotes for leasing options than ever before, which I thought it would go the opposite, right? If we’re having all these tax law changes and everything saying, “Hey, I’m not sure what you’re going to be able to write off or not.” Why are people coming now and asking for more? I mean, I think that I’ve had more lease quotes done in 2018, than I think I’ve had combined over the previous two years, 2016 and 2017.
Q. Just to speculate, is that a function of price? With Tier 4 compliance and with the cost of sheet steel and things like that, cost for equipment is going up.
A. That’s a great point, and I think you’re onto something here. It’s not for me to question a customer when they call. I’m in a service business, right? To say, “Oh, wait a second, why do you want to do that?” Or, “You know the laws are changing there, right?” Now, we do sometimes have that conversation where somebody says, “What do you think about these tax law changes or changes in the accounting method?” I say, “Listen, everybody — every single customer, every single business — is starting to face that so, obviously, my advice to you will always be, please check with your accountant or your tax advisor for what is the best scenario for your particular business needs.”
Now, to answer your question honestly, yeah, we’re getting a lot of people asking about leasing versus financing. I think your point is valid, Jeremy. I think that … the customer is starting to look at the rising costs of machines in general, equipment in general. I think that they are concerned about maybe looking at a drill rig that once cost X, but now really costs Z. I mean, forget Y. It’s jumped right from X to Z. It’s just the way it is today, right?
I think that it’s a two-fold answer here: Pricing is going up, and I think customers are really concentrating their efforts on cash flow today. … I can tell you I’ve looked at a lot of different transactions with a lot of different variations, but I think what it comes down to, at the end of the day, is can you afford the monthly payment of that drill rig and when you go to put that to use, can you make money utilizing that drill rig and be able to pay for the monthly payment and then, above that, have your profitability taken care of? That’s really, I think, the bottom line question.
Q. What are the criteria you look for to determine credit worthiness for financing and leasing options?
A. The standards have never changed. It’s the normal blocking and tackling, as I call it. … The standard is to ask for a signed credit application. If you have one on file within, let’s say, the past five years, I get an updated credit app on file signed by the customer. Then, the normal requirement on transactions greater than $250,000 in costs — which, let’s face it, most drill rigs are greater than $250,000 — is that we ask for the last two years audited or reviewed financial statements, or U.S. tax returns, obviously, and most recent interim financial statements, like a balance sheet and income statement for some period of time here in 2018 — January to June, January to July, something like that since we’re now here at September.
I’m not going to ask a customer to go and get audited statements done and spend money on that. Most customers use QuickBooks today, and that’s certainly acceptable. We’re trying not to stress the customer out too much, if you know what I mean.
Q. What does a typical financing solution look like in terms of payment period and interest rate? What are typical down payments?
A. I don’t think there’s anything that’s typical today because every customer that comes to the door is a new situation and new opportunity, and we treat it as such. That’s one of the things that we really have enjoyed here at Epiroc, is the ability to have our own captive financing arm. One of the things that we think we bring as a company is the total solution: the product, the service, the parts, the warranties, the extended warranties and the financial services to be able to do all of this. We don’t say to a typical customer, “Listen, you can only do this for 12 months,” or, “You can only do this for three years,” or whatever it is.
We will normally look at transactions between 12 through 60 months with exceptions to be looked at individually for longer terms, normally six or even seven years. We have done those before. Transactions, obviously, are all over the board. I think our lowest product, to be very honest with you, which is a breaker by the way, is like $10,000. And, no trade secret here, our big Pit Viper, which is a standard in our rotary drills for blastholes, those are over $5-million units today. So we have a wide variety of range to finance, and we have a wide variety of customer base. … We cater to customers that are husband and wife ownership, and we have some of the biggest names in the marketplace as well. …
I would say the interest rates range from anywhere in the low fives to the upper sixes based on credit worthiness. We have recently switched our model to what I would say is more of a credit risk basis based on, you know, if the customer is very, very credit worthy, then he’s probably going to be in the 5 percent, 5.25 percent range. If that customers is newer in business and not as seasoned, or maybe has had some nicks on the credit in the past, it’s not an automatic “no.” We might charge a little higher interest rate based on the risk analysis. …
We like to ask for some money down, if possible. Normally, we like to get 10 to 15 percent down payment in most cases. We at least ask for it and talk about it with our customers. But I would say that today, I have as many customers with no down payments and 100-percent financing or leasing, whatever you want to call it, as I do the people who put down payments. What I have found is, for the really creditworthy customers, do you really need to get 10 or 15 percent down? Probably not. But for customers who are credit challenged, new in business or have had some credit history problems, having that 10 or 15 percent skin in the game, as I call it, has been very helpful in us getting transactions approved.