A sector hanging in the air
Since the start of 2018 the construction industry has been rocked by problems at main contractors. Last year's index found specialist contractors holding up well amid the turmoil, finance editor of Construction News David Price reveals how they have fared 12 months on.
As a snapshot of the period from the start of 2018 to roughly April this year, the 2019 Specialists Index looks positive.
The median margin for the top 10 contractors across seven disciplines stands at a healthy 4.2 per cent and the number of loss-making firms has fallen from 11 to nine.
Looking back over a five-year period to 2015 puts a different slant on things, though.
Revenue and margins have fallen for the first time in four years, and now looks to have been the high watermark for the market in this economic cycle.
We are now a decade on from the last recession, and as the market turns through its cycle, power swings between main and specialist contractors.
In recent years, specialists have been in the ascendance, as reflected in their growing margins, but this now looks to be in reverse.
Breakdown of the seven sectors
“The main contractors probably felt a little bit over a barrel 12 months ago,” DRS Bond Management director Chris Davies says.
“The boot is now on the other foot because, for a lot of the specialists, their order books are shrinking and therefore they get more desperate.”
This year’s Specialists Index covers a period that has seen the industry rocked by a series of tumultuous events.
Most of the 70 firms across the index started and finished their latest financial years sometime between January 2018 and April 2019. This is almost perfectly bookended by Carillion’s collapse on 15 January 2018 and Interserve’s pre-pack administration on 15 March 2019.
This major failure and a narrowly averted disaster have become emblematic of the tough conditions the industry has endured.
During the intervening time, other significant names, such as Lagan Construction and Dawnus have gone to the wall, while a number of major tier ones fight to reverse falling profit or bounce back from major losses
Last year’s index captured the early aftermath of Carillion’s demise, and remarkably showed the specialists had appeared to weather the storm. In fact, in 2018, they were thriving, with margins up and firms hitting multi-year highs.
The question was: could they continue to defy gravity? The answer from this year’s index is, no, they could not.
“It’s not an uplifting picture,” Rudi Klein of the Specialist Engineering Contractors Group says.
“The 2019 index provides a picture of an industry hanging in there.”
Total revenue across the specialist markets slipped 1.8 per cent, falling from £8.82bn in the 2018 index to £8.67bn.
Falling revenue, a consequence of falling demand, was seen on a broad base, with five of the seven sectors seeing a decline. Steel and building envelope were the two that managed to buck the trend.
More concerning than the widespread dip in revenue is the fall in total profit across the 70, which has dropped 2.1 per cent from £344m in last year’s index to £336.7m now.
Crucially, this is a greater decline in percentage terms than the revenue dip.
Looking at the impact this has had on margin reveals a worrying picture, with five out of the seven sectors seeing median margins drop.
Overall, the index produced a median margin of 4.2 per cent this year, a significant decline from the 6.7 per cent in the 2018 index.
Three elements have combined to bring the specialists back down to earth after the high point of 2018.
The first is weakening demand. In 2018 the value of new work output, excluding housebuilding, increased 0.1 per cent, according to the ONS, while new orders plummeted 12 per cent.
Much of this decline has been attributed to ongoing political uncertainty sapping confidence, especially in the private sector.
“Clients are extremely cautious,” Gleeds chief executive Graham Harle says. “We’ve certainly seen a decline in commercial office space and retail, which is, dare I say, toxic at the moment.”
Cautious clients are creating the second major problem for specialists. Contractors in all markets have reported problems with delays to jobs starting as clients take a wait-and-see approach to the market.
One product of this is a growing trend for incremental contracting.
Mr Harle says: “We invariably now see clients commit to, say, demolition, basement box and a lid on the basement and maybe incoming utilities.”
“So they’ll commit to an early works package, which will probably take 18 months to two years on large jobs, and that gives them time to reflect on the project.”
“Clients are extremely cautious. We’ve certainly seen a decline in commercial office space and retail, which is, dare I say, toxic at the moment.”Graham Harle, Gleeds
This enables clients to stop a job at certain stages without incurring any further additional costs. However, this flexibility for the client means uncertainty for the contractors.
A stop-start approach to development has an impact on the whole supply chain, Mr Harle says, with work and income becoming piecemeal and pipeline security evaporating.
The final drag on performance for specialists since last year’s index is the financial difficulties among main contractors.
The shadow of Carillion still looms large, but other significant main contractors have also fallen, with big impacts on local markets.
“In March you had Dawnus in Wales going down. That’s a Welsh equivalent, if you like, of Carillion because Dawnus was very big in Wales,” SEC’s Prof Klein says.
“That had a really big impact with almost £40m being owed to the supply chain.”
Northern Ireland-based Lagan Construction went in 2018, and more recently this year, Shaylor and Simons Group in the Midlands both went into administration.
Mr Klein fears things could get worse: “Last year we had over 3,000 insolvencies, and I think this year we’re going to end up with a figure worse than that.”
What comes next
With the start of November came the welcome news that the UK economy managed to avoid recession, with GDP growth of 0.3 per cent in the third quarter making up for the 0.2 per cent decline seen in Q2.
Nevertheless, those with long experience of the industry are seeing parallels with previous downturns.
Prof Klein says: “It’s probably the worst state it’s been in for many years, certainly since the recession.”
Chris Davies and his business partner Fiona Recker started DRS Bond Management in June 2009, towards the end of the financial crisis. The conditions he sees now remind him of the market around that time.
“What we saw then, and what we’re seeing again now, is a quite appreciable slowdown in the progress of new-build work and a shift towards landlords refreshing their existing property portfolio rather than trying to build out speculative schemes,” Mr Davies says.
Perhaps the best indicator of where the specialist sector is heading is the experience of the early works contractors.
“Those involved in the enabling, the demo and the early-stage groundwork are now seeing signs of distress in their numbers,” Mr Davies says.
Our demolition and ground engineering top 10s have both seen revenue drop by around 6 per cent since last year, with pre-tax margins down 1.3 per cent and 4.7 per cent respectively.
These difficulties are likely a sign of what is in store for the medium and finishing trades, Mr Davies warns.
“It’s almost as night follows day,” he says.
If early-work firms started suffering problems with demand and on new jobs in March 2018, Mr Davies says, by about September 2020, every trade in the supply chain will have felt it.
One of the emerging trends in last year’s index was an increase in direct contracting between clients and specialists, often through a construction management approach.
It now appears to have been a rather short-lived trend. “Is it [construction management] happening at the moment? It’s very, very low usage,” Mr Davies says.
For clients and their funders, risk aversion is now key.
Gleeds boss Mr Harle says: “Funders generally prefer design and build because the funders always prefer a low-risk approach, even if there’s a slight premium up front.”
Regardless of the contractual approach, clients have been forced to become more engaged with the supply chain in the wake of failures and problems at main contractors.
Prof Klein says: “I see a movement in client thinking and the need to ensure payment protection in their supply chains.” This engagement is provoking some to procure
the most expensive packages directly, he adds.
“You might not call it construction management, but certainly there’s more direct engagement,” Prof Klein says.
Amid the problems facing the industry there are some markets that look more promising and could help soften any slowdown.
“You’ve got good underlying public sector spend, education and health in particular have a strong pipeline,” Mr Harle says, although he adds that any new projects will now be delayed until after the general election.
It is not all doom in the private sector either. Mr Davies highlights student accommodation and budget hotels as two markets where demand is expected to remain strong in the coming years.
Mr Harle says there are also pockets of strength in different regions and sectors. “Within London itself, it’s [strong] at Nine Elms and Canary Wharf in particular, and some of the big Thames gateway projects,” he says.
“We also see Manchester is still very hot for residential and PRS in particular, and ditto Birmingham.”
There is also the long-hoped for unleashing of pent up demand if a positive resolution to the Brexit uncertainty is found and some political stability is achieved.
Thrive, survive or die
Businesses cannot afford to plan based on best-case scenarios, however.
Many of the firms in the index have lived through more than one downturn and Mr Davies hopes the experience has taught them to hunker down before any potential storm hits.
“My assumption would be that they see what’s coming and they’re preempting it; they’ve adjusted the cost base to suit, they’ve narrowed the turnover and profit expectations,” he says.
Contractors that have a reasonably strong balance sheet with good levels of cash, and particularly net cash, will be best placed to ride out any downturn, Mr Davies adds.
Encouragingly, four out of the seven specialist sectors show an increase in cash reserves, with the total for all 70 in our index increasing to £692m from £680m last year’s.
The need to maximise liquidity to ensure short-term survival could come at the expense of long-term prosperity, however, as SEC’s Prof Klein warns the need for cash is likely to trump other objectives.
“The investment plans they have had – for example, investing in new technology or extra machinery – are going on hold,” he says.
"All the things that the government is talking about – getting into robotics and into 3D modelling – all this digital innovation is not being done”Rudi Klein, SEC Group
No business can be blamed for prioritising survival, but such moves could be a hammer blow to some of the loftier aspirations we hear for the industry.
Prof Klein says: “All the things that the government is talking about – getting into robotics and into 3D modelling – all this digital innovation is not being done.”
Some firms appear to be taking more desperate measures to deal with falling demand.
Instances of contractors buying work by bidding with undeliverable prices in order to get new jobs in and cash flowing through the business are growing, Mr Davies says.
Two years ago, the price spread between bidders on a £10m job, for example, might have been around £400,000, Mr Davies says. That has widened and the difference between the highest and lowest bidder now could be as much as £2m, he claims.
Whether those who win work on breakeven – or even negative – margins can then win better-paying jobs in short order before any losses crystallise remains to be seen. It depends on timing the market, which is, as Mr Davies says, incredibly difficult and down to luck more than judgement.
Those who get it wrong could pay a huge price.
A turning point
The 2019 index appears to mark a turning point for specialist contractors, with margins and revenue dipping noticeably after several years of growth.
Such shifts are a fact of business life, however. As you will read in the individual coverage of the different specialists, many are well aware of what they are facing and are planning accordingly.
Challenges may abound, but opportunities are afoot as well.
We see evidence of specialists such as Careys, JRL and Keltbray diversifying into other markets.
Mr Harle says this is in part a response to client demand to package up chunks of work with one supplier. If this continues, then more specialists could see their power and influence with clients grow.
A shift towards offsite and modular construction and the rise of digital design could also herald opportunities for specialists to gain weight on projects.
For these innovations to yield benefits, specialists need to be brought in earlier to collaborate on design.
“We need early engagement with these specialists, and clients are willing to pay for that advice,” Mr Harle says.
The troubles presented at the moment will pass, and those who are pragmatic and trade sensibly stand to reap the benefits when the market turns again.