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Taking the pulse of M&E contractors

7 Oct 13 The weight of positive statistics for the construction sector is accumulating with such speed that the industry’s doom-mongers may be forced at last to admit that the tide has turned.

According to the Office for National Statistics (ONS), the second quarter of 2013 saw new construction orders up 32.8% year-on-year and 19.8% on the first quarter of the year. The ONS also reported that July’s output was up 2.2% on June 2013 and 2% on July 2012, a trend reinforced by statistics from Markit/CIPS which showed that the August 2013 output rise was the largest monthly gain since September 2007.

The charge seems to be led by new construction, with a less rosy performance for the repair and maintenance market. Some concerns remain, with the RICS Building Cost Information Service showing that tender prices in Q1 2013 were 1.7% lower than Q2 2012, although higher than Q1 2012. Nevertheless, the consensus seems to be that pricing may at last be starting to bottom out. This may lead to a reversal of the falling profitability for major contractors revealed by our Top 100 report published last month. This showed that profit margins for these construction leviathans have fallen by 35% in the past year.

But how is this playing out for the UK’s building services market? The Company Watch data on the financial profile of UK M&E contractors reveal a financial profile for the premier league of this important sector, which marks it out as the best of the three sectors we have analysed so far this year. The research covers those companies with annual turnover greater than £50m that describe their business activity at Companies House as the being in the electrical, plumbing and other construction installation field – in other words, what we generally refer to as M&E. The sample comprises 48 companies in all.

Inevitably, profit margins are uncomfortably sparse at a wafer-thin 2%. This is even worse than for road builders and commercial builders, although even they only managed a paltry 3%. This means that the average contractor in our sample is making a profit of only £4.8m on turnover of £256m.

Concern remains at such a poor risk-reward ratio in an industry where a single rogue contract can potentially destabilise an entire business, as Hightex discovered recently after it ran into severe problems on its work to install the new roof on the Maracana Stadium in Rio for the 2014 FIFA World Cup. The companies we sampled may be making a total of £229m between them, but these businesses are utilising gross resources of just under £6bn and borrowing £417m to achieve that outcome.

With leverage still a hot topic in many other industries, such as retail and care homes, nobody could accuse M&E contractors of being debt junkies. On average, they borrow just 7% of their net worth, compared to gearing ratios of 39% for commercial builders and 32% for road builders. Indeed, half of them have no debt at all in their latest balance sheets. This is extraordinarily conservative by modern commercial standards. As with other construction businesses, this is probably driven by the awareness of the limited risk appetite of lending-capacity-strapped banks to commit to such a low-margin sector. It may also mean that activity levels are generally too low to require outside finance for working capital.

Turning to the overall financial health of our 56 largest M&E contractors, they are a picture of positivity. Company Watch calculates a health rating (H-Score) for every UK company, based on the interaction between seven key financial ratios involving profitability, funding and asset management. These are extracted from published financial information and processed through a mathematical model, which compares this data with the characteristics of companies that fail and those that survive. This produces an H-Score out of a maximum of 100. Any company with a rating of 25 or below is financially vulnerable. A score between 26 and 50 indicates a company that is financially off colour.

Over the past 15 years, more than 90% of all UK businesses which went into insolvency or underwent a financial restructuring were in this warning area of 25 or below at the time. Not every company in this red zone fails, because of remedial management action, but it is a clear indication of heightened financial risk for their clients, suppliers and service providers alike. Looking at the profile of the 56 M&E contractors on this measure, their average H-Score is 54, which beats the norm of 49 for all UK companies of similar size. As with the other measures analysed in this article, M&E contractors outscore their road building and commercial building brethren in this respect. The even better news is that only six (12.5%) of them are in the Company Watch warning area. Across the economy as a whole, the expectation would be that around 25% of any sample would be in this financial twilight zone. In fact, 60% of the sample have H-Scores of 51 and above, as compared to around 50% for all UK companies. Drilling down in more detail to potentially adverse financial characteristics, there are only two contractors with negative net worth and five are loss making.

Inevitably, all of these companies are in the bottom ten of our health score league table. The results of our research are certainly encouraging, but it is worth emphasising that our figures cover only the big boys of a hugely diverse M&E world, populated by thousands of smaller, under-capitalised players. These are inherently less strong financially and too often the victims of the supply chain squeeze and late payment culture, which remain a curse on the industry. For them, the future is far less secure.

But as things look up for construction in general, larger M&E contractors are well positioned financially to take advantage of the sunnier commercial climes ahead. And if the RICS interpretation of its own tender pricing data is correct, it suggests that financial reality is finally re-emerging from the fog of recession and government austerity, which can only bolster margins and at long last deliver meaningful profit returns.

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