UK: Contractors – Tower Or Topple?

Last Updated: 6 December 2011
Article by Deloitte Real Estate Group

Most Read Contributor in UK, August 2017

Market context

Latest outlook indicates further downside

Ongoing global economic uncertainty continues to present a testing environment for the construction sector.

Although the volatility and accuracy of construction data has been challenged in recent months, there is little doubting the overall downwards trend. The latest Office for National Statistics figures show construction output fell 0.2% between July and September 2011. The outlook going forward is weaker still, with the impact of the government spending cuts beginning to bite hard. The Construction Products Association recently forecast that 2012 will be the first full year to see the impact of the cuts, with output set to fall by 3.6% as the private sector struggles to fill the void in overall industry output. Growth in total construction output is now not expected until 2014.

Some bright lights...

There is some good news for infrastructure contractors. The government's recent promise to implement a "gear change" in efforts to get large state-backed projects such as rail, road and broadband improvements funded and underway may offer some hope. Energy related construction is also expected to deliver material growth as a result of the newly confirmed nuclear programme and a number of large renewable energy projects.

.... but not enough to shine through the overall gloom

However, for many building contractors the outlook is not so bright, given ongoing uncertainty around planning reforms, significant cuts to spending on new schools and hospitals and constraints around mortgage availability and housing stimulus programmes. It is too early to tell whether the recently announced Ł400m 'Get Britain Building' initiative will kickstart house building and infrastructure development.

If public sector opportunities are looking sparse, the Q3 2011 Deloitte CFO survey, provides little cheer for those targeting the private sector. The survey suggests that corporates are becoming increasingly defensive in their outlook, with capital expenditure becoming a lesser priority as CFOs aim to protect their balance sheets. Alarmingly, many CFOs entered 2011 anticipating that capital spending would rise during 2011/12, but now believe this will decline over the next 12 months, with the appetite for risk having fallen at the fastest rate for four years.

Work awarded prior to, or during the early stages of the recession, has now completed and therefore securing a sustainable forward order book at decent profit margins is key to supporting future trading. Given the fiercely competitive market and the material fixed cost base of many contractors, the risk of "buying" work to keep busy remains present with the knock-on adverse impact on profit margins exacerbated by rising input costs.

Required response

In response, most contractors have already undertaken some form of restructuring or downsizing in order to reduce overheads whilst focusing their remaining resources on sectors that continue to drive opportunities to operate profitably. The 'supercontractors' in the UK market have the scale to compete in areas where they wouldn't have needed to pre-recession and strong balance sheets mean they are also able to diversify throughout the supply chain to capture profitable niches by organic growth or by acquisition.

However, for the mid-tier and/or regional contractors, the ability to re-focus resources into alternative sectors that will yield profitable future work is more difficult and, if not already addressed, decisive action should be taken now to ensure these businesses are being effectively managed.

Warning signs

  • Poor quality, insufficient or "layered" management information that loses key messages between the site and the Board
  • Failure of management to address below target divisional performance
  • Operating profit not translating into cash, indicating an over-recognition of contract revenue
  • Management incentives focused on P&L performance, rather than cashflowmetrics
  • Significant numbers of recent contract wins may indicate "buying" work at unsustainable levels
  • Resilience of the balance sheet to withstand a sustained downturn in workload
  • Market rumours around project performance and supply chain payment complaints
  • Increasing advance payment requests from the supply chain
  • Signs of key clients making significant reduction in supplier numbers
  • Evidence of reputational damage emerging from press coverage
  • Reducing staff numbers across management and delivery functions
  • Increasing numbers of claims (for or against the business)

Top 10 questions to ask management teams

1. Is there confidence that commercial and financial reporting and controls are providing an accurate reflection of the business and not masking the true financial position?

2. Are formal guidelines in place for the recognition of turnover and profit, or are claims/variations being recognised without certainty of recovery?

3. What proportion of revenue comes from government contracts and are the "tyres being kicked" to ensure the forward order book is both realistic and reflective of the impact of public sector cuts?

4. Are cost and programme to complete forecasts being stretched, based on expectations that a contract will always turn the corner?

5. Are realistic margins being secured against new turnover and will they deliver sustainable and long term financial performance?

6. What is the business doing to diversify and counter its exposure to public sector cuts, and are delivery and contractual risks of pursuing a diversified strategy fully understood?

7. Are trade insurers continuing to support the business, or are there reduced credit facilities and increasing demands for advanced payments?

8. How will the business address demands for renegotiating long term contracts and what can it do to minimise this potential impact?

9. What has been done to reduce overheads and "right-size" the business for future operations?

10. Does the business have strategies in place for the immediate mitigation of reputational damage?

What should you be doing now?

  • Take action. We expect a challenging market in the near term
  • Tough trading conditions are likely to be experienced across the sector, affecting main contractors, sub-contractors, plant hire companies and material suppliers
  • Mid-tier, regional contractors are likely to be hardest hit – particularly those lacking a diverse portfolio of work
  • Challenge management around how they plan to address the current market pressures
  • In order to maintain good health, the most significant issue for management is the need to balance short term cash requirements with the security of long term and sustainable turnover.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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