Stakeholder confidence is vital to any business, but it is crucial for those reliant on winning and delivering contracts. This is the challenge facing the construction sector, where confidence has been tested by a succession of high profile restructurings that have highlighted corporate vulnerabilities as well as deep-rooted structural weaknesses.
The brightest spotlight has fallen on main contractors, but a lack of confidence in the top tier of the supply chain affects the entire sector, leaving no-one immune. So, this week we want to look at what’s behind the fall in confidence and how contractors can rebuild it.
FTSE Construction & Materials sector profit warnings have already hit their highest first half level since 2012, with over a month to go before the mid-year point. Warnings from the ‘Heavy Construction’ sub-sector, containing main and sub-contractors, are as high as we saw in the last recession. These warnings led to an average first-day share price fall of 18% in 2019, up from 14% in 2018 and 10% in 2017.
Construction activity has dipped sharply in the last month according the latest PMI data, with April’s cost inflation accelerating to its fastest level since November 2018. But, average margin levels for the top 100 contractors have remained mired at or below 2.5% for many years, with main contractors operating at much lower levels – whatever the economic backdrop. Any sector that operates at such low margins is structurally vulnerable to adverse events.
The root of this margin issue lies in the imbalance of risk and reward found in many construction contracts. If contracts are appropriately priced, with sufficient contingencies, they should provide contractors with a buffer to absorb moderate price rises and disruption. Adverse events aren’t inevitable, but this is an inherently unpredictable working environment, from the basic unknowability of what lies beneath the ground, to the complex interfaces between different packages of work. Predicting outcomes is fundamentally difficult – a problem that is further compounded by disputes, which add to the dislocation between projected profit and cash conversion.
Given these intrinsic difficulties, it’s vital that projects remain on track and management are aware of any issues before they become material. But this isn’t easy for main contractors, who tend to have a decentralised business with many layers of management and sub-contractors between the boardroom and the construction site. This gap makes it harder for management to spot operational and financial issues quickly and prevent them escalating.
Low-margin contracts are by no means the only issue causing sector distress, but they also contribute to a series of negative feedback loops which put further dents in the sector’s health and in stakeholder confidence. They limit investment in training and research and development, which could increase productivity. Difficult contracts put a strain on main contractors’ working capital, delaying cash flow through the supply chain with a detrimental impact on contract delivery and results.
The stakes are high. Debt providers and equity investors are looking for sustainable businesses with a clear strategy and predictable cash flows – especially in more uncertain times. In a recent blog on this site, we explored the problems of raising and refinancing capital in stressed areas of the economy as banks move to a risk-off stance. Customers are also more cautious following recent sector failures, with the government under pressure to ensure that their main contractors are financially stable.
Companies that aren’t in compliance with government regulations, such as the Prompt Payment Code, also face being excluded from government contracts. The penalties for getting it wrong are growing, for company and auditor, as construction sector accounts come under greater scrutiny.
Building stronger foundations
Below we outline a three-step approach to address these issues and regain stakeholder confidence. This is primarily written from the perspective of a main contractor, although there are themes that apply across the whole sector and beyond – including other companies exposed to the contract cycle, such as support services.
It’s hard for any board to make good decisions if it is constantly firefighting or if it lacks accurate information.
As a priority, stressed companies need to establish a cash culture alongside an assessment of cash position and cash conversion. It’s also important that businesses move quickly to regain capital stability through raising new capital or debt restructuring. Throughout this process they should be engaging as early as possible with stakeholders – shareholders, lenders, suppliers, customers, sub-contractors – to keep them informed. It’s increasingly difficult for construction companies to regain trust once they have lost the confidence of their investors and customers.
Reliable management information is essential. It’s vital to have the right systems and people on the ground to ensure that the board can form an accurate view of their business. Every construction business– whatever their current position – needs good understanding of which contracts are the most problematic now and which are vulnerable to further problems so they can take prompt action. This includes making realistic provisions and keeping stakeholders informed.
Governance and discipline comes from the top. Boards need to set the tone on contract discipline and management to minimise the risk of negative surprises.
There should be board-level oversight of contract negotiation, with a multi-group approach to manage the balance between risk and reward. Stronger negotiating discipline, combined with closer management and better management information, should limit the number of onerous contracts and limit the number and impact of problems that arise through the life of the contract.
Turnaround programmes also need to go beyond limited cost cutting, whose benefits are often eaten up by cost inflation. Main contractor’s primary costs lie are found in projects, not in the centre. Therefore, the focus of any turnaround strategy should be on operational improvement.
One of the biggest areas that contractors need to address is how they deploy limited capital.
Most contractors currently work across multiple geographies, sectors and project types. We expect to see contractors define their core business more closely, based on their optimum balance of risk and reward. For instance, UK companies need to assess if the rewards are sufficient to balance the increased risks of large-scale projects or the additional strain on working capital of operating in the Middle East. This may leave gaps in the market for others to fill.
Defining and trimming down to a core business will help lower complexity, improve delivery and allow contractors to deploy capital into areas that improve productivity, for example by focusing on innovation and digital tools that assist with monitoring project sites and improving safety.
It won’t be easy to dispose of non-core businesses in this climate. Boards will need to decide if they are willing to sacrifice value now to redeploy this capital. There will be tough decisions ahead.