Undoubtedly this year has seen a distinct increase in confidence and although few would be reckless enough to state categorically that the good times will roll again, workloads are beginning to pick up.
Only recently house builder Bellway reported orders up 27% on last year, while the National Specialist Contractors’ Council said business enquiries amongst its members are now at a six-year high. Our survey of the Top 100 contractors, based on figures for 2011/12, doesn’t reflect this newfound optimism. In fact, if anything, the picture that emerges is one of chronic stagnation with revenues more or less static and profits in decline. See full table in our Market Data section (here)
A few contractors are indeed going great guns – but that’s the minority. Most are operating on wafer-thin margins and some are really struggling. And while actual insolvencies seem to be on the wane, there is a growing number of ‘zombie’ companies that are simply ticking over, servicing debt and nothing more.
In the run up to last summer’s runaway Olympic success, much was made of the risks and rewards from it for the UK construction industry. Would almost a decade of planning, creation and delivery of major projects turn out to have delivered boom or bust for the main contractors and their legion of subbies? Just how well would this building bonanza insulate the sector from the continuing carnage in the economy caused by government austerity and from the frustratingly slow pace of implementing promised infrastructure spending?
This year’s list of the Top 100 Construction Companies reveals a distinctly mixed picture of falling margins, widespread stagnation and some sad failures. Once again, the total turnover of this premier league of contractors has hardly moved, rising just 1.1% since 2012. More worryingly, their profitability has fallen sharply, with total profits falling by a third from £1.2bn to only £791m, reflecting increasing concerns about margins squeezed by low bidding and excessive competition encouraged by clients.
As a result, profit margins have also fallen by a third in the past year from a marginal 1.97% last time to a seriously miserly 1.29% in the latest figures. These companies are deploying total assets of £36bn and have a combined net worth of £9.2bn, so they have a rate of return of just 2.17% on assets and only 8.62% on capital employed. Given that these are supposedly the most efficient operators in the sector, with the greatest bargaining power on bidding prices and input costs, there must be some serious doubts about the validity of the UK construction industry business model, most especially for those further down the food chain.
The best profit margins are enjoyed by a top five of Stepnell (10.7%), Dawnus (9.7%), Bechtel (9.1%), Amey (7.9%) and Interserve (7.7%). The pressure on profitability is confirmed by the fact that only 35 of the companies have improved their margins, while 64 have seen them worsen. If this trend continues into 2014, there are bound to be further casualties as lenders and other creditors look more closely at their ongoing commitment to such a marginal sector. And there will be more consolidation, though this is more likely to be as the more secure large players pick off smaller competitors than through mergers between major contractors.
As always in a sector that accounts for a fifth of all UK insolvencies, there have been failures since our review last year. Northern Ireland based Patton failed last November, leaving suppliers and other unsecured creditors owed £15m. Daniel, headquartered in Manchester, went into administration in May this year, this time with debts of over £27m. Lorne Stewart rescued part of Rotary after its Australian parent company failed. There has also been consolidation, most notably with Kier beating off competition from Costain to acquire May Gurney.
There has been considerable movement within the Top 100, with 41 companies increasing their ranking on turnover and 40 dropping down the table. The biggest companies have largely held their positions, with the major gainers further down the table. Lorne Stewart is the biggest winner, climbing 17 places. Other notable risers are Winvic (13), Carey Group (12), Dawnus (12) and Eric Wright (12).
The losers are led by McLaughlin & Harvey, which falls 21 places to 80th, and Barr down 20 to 73rd. They are followed by Midas (-13), Longcross (-11), GF Tomlinson (-10) and United House (also -10).
Looking at perhaps the more important measure in these uncertain economic times, ranking by profit, there are 50 risers and 47 fallers, indicating a much more volatile picture, which illustrates how fortunes can change so quickly, quite often as the result of a limited number of problem contracts. In fact some of the changes in the table are startling.
Taking the winners first, the stars are a clutch of companies that have climbed over 50 places in the table: Miller (up 59), VolkerWessels UK (+58) and NG Bailey (+55). Other major risers are Ardmore (+38), Renew (+33), McNicholas (+29) and Sisk (+24). Heading in the opposite direction are City Building Glasgow, tumbling 63 places from 19th last year to 82nd this time. Severfield-Rowen has fallen 60 places, followed by Mabey (-56), United House (-45) and ISG (-27).
Curiously, quite a few companies succeeded in being turnover winners and profit losers, suggesting that gaining market share but risking being a busy fool is as big a problem for construction companies as in other sectors of the UK economy.
No fewer than 16 of the Top 100 fell into this category. The opposite approach of focusing on less but potentially more profitable work is almost as prevalent, with 15 companies falling in the turnover rankings but rising in terms of profitability. But the lead time for most major work means that these outcomes will be the result of strategic decisions taken long ago and in some cases, of course, will be down to factors outside the control of management. And which contractors have had the best year since our last review? Perhaps not Balfour Beatty, which has seen profits tumble by 70% even though it continues to be by far the largest UK builder. There are so many ways to judge, but perhaps the accolade should go to Interserve, which grew margins by almost 5% and saw its profits almost triple to £183m. On a smaller scale, Keller doubled profits to £43.5m on higher revenues and fatter margins.
At the other end of the scale, eleven companies slipped into loss or saw previous losses worsen, the two most obvious being Keepmoat and Enserve declaring losses of £473m and £78m respectively. Severfield-Rowen saw a £30m turnaround to a loss of £21.7m, while Spie Matthew Hall’s previous loss of £4.4m worsened by almost £20m. There are 13 new entrants in the table, all but one filling the bottom places by turnover. The striking feature of many of these is a rapid turnover growth, often of more than 20%. In some cases, profit growth has not kept pace as is so often the case with rapidly expanding businesses. The highest debutant is Winvic, which comes in at 77th.
Whither the construction sector leaders in the year ahead? The latest ONS figures show healthy 1.4% quarter-on-quarter growth in output for Q2 2013, while the Construction Products Association is predicting a rise of 2.7% in output for 2014. All indications suggest that the industry will be busier in the months and years ahead. But there must be severe doubts as to whether this will be profitable growth. Margins and return on capital may continue to be under pressure and there could well be another rash of losers in our 2014 Top 100 table.
There's more to life than just making profits.
There is an unhealthy tendency for pundits reviewing the performance of leading companies in most sectors to look little further than the profit and loss account, with a particular emphasis on revenue growth. Management can be even worse, focusing most closely on operating profits as though depreciation, interest costs and taxation are somehow nothing to do with them. They too often forget the old saying: ‘top line vanity, bottom line sanity’.
Nevertheless, the balance sheet is where the most fundamental issues affecting a troubled company are usually lurking. Of course profits matter, but they are only a small part of what makes up the financial DNA of a healthy company and they won’t rescue a struggling one, at least not in the short term.
An established method for judging the financial strength of a business is to look at seven key financial ratios and the interaction between them. One is profitability, but there are three more involving the funding structure and another three concerned with the asset profile. Mix them together, employ mathematical wizardry and out comes a health score: the Company Watch ‘H-Score’ expressed as a score out of a possible 100. Over 50 is above average; 25 or less is a clear signal of vulnerability – what Company Watch calls the Warning Area. Over the past 15 years, one in four of the companies in the Warning Area have gone on to either file for insolvency or undergo a major restructuring. Company Watch ran the rule over the Top 100 construction companies to see how they measured up. At the top of the class are 10 contractors in the upper quartile, with H-Scores of 75 and above. All have profit margins well above average for the whole list (1.29%) - in fact only two are below 5%. These are not the biggest companies in the sector, suggesting that in this respect smaller may be more beautiful.
The best score is for Stepnell, the West Midlands builder and civil engineering contractor, with a remarkable 93 out of 100. Not only does it have the highest margins (10.7%) in the whole Top 100, but it earns a very healthy 24% on its capital employed, it has a very strong working capital position and its borrowings are well structured. It ticks pretty much every credit rating box. Stepnell is run a close second by Thomas Armstrong, which is rated at 91. Based in Cumbria, this business has been going since 1830. Its margins and return on capital are slightly lower, but it is cash-rich and asset-strong.
At the bottom of the league are 19 companies in the Warning Area with H-Scores of 25 or less. Here the most common features are losses, though fortunately only one on the scale incurred by Doncaster builder Lakeside and its Keepmoat brand which, in its chairman’s own words, had an very challenging 2012, filing a loss of £473m. Two of the larger contractors – Enterprise and Galliford Try – feature, the latter to some extent a victim of its business model with its high inventory lock-up. The message from this analysis is that while our Top 100 construction companies may be the biggest in terms of turnover, they are a really mixed bag as regards their overall financial health. Taken as a whole, however, they are close to being perfectly average, with a combined H-Score of 48 this time round, very slightly down from 49 a year ago.
Construction’s zombie army grows
The number of contractors in negative equity, with debts they may not be able to repay, has increased – and it’s putting even more downward pressure on prices.
Construction industry insolvencies account for almost a fifth of all UK corporate failures but, after a peak in 2009, they are back to pre-recession levels despite the continuing downward pressures on pricing and profitability in the sector. Low interest rates and a cautious approach by creditors unwilling to crystallise losses at a time of low asset values can be cited as the main reasons.
Another factor is the lack of growth in the sector. History teaches that insolvencies peak about 18 months after a recession ends, as recovering activity levels expose a lack of working capital. We may be out of recession, but any growth in construction is distinctly patchy, just as it is elsewhere in the economy. But the real story is told by startling statistics from Company Watch research into the number of UK construction businesses that have liabilities at least £5,000 greater than their assets. These have escalated steadily since before the recession, rising by 121% since 2008.
Essentially these companies just about manage to service their debt – but not reduce it – and as such they can’t invest, they can’t grow and are barely clinging to life. There are now 26,076 of these ‘zombie’ companies compared to only 11,821 five years ago. Even more worrying, the total by which their liabilities exceed their assets is now £5.4bn, more than three times the level in 2008. So not only are there more of them, but the scale of their negative equity is rising even faster. The only other sectors with higher levels of net liabilities are media, business services and financial services. These companies fail one of the two solvency tests set by the insolvency legislation, but can continue provided that they service their debts, or at least persuade their creditors not to take enforcement action against them. But they drive one of the great evils of the construction sector: suicidal pricing. The one thing they must have to survive is activity and cash flow, so business must be won at all costs. Unfortunately, this makes an escape back to financial health nearly impossible. This behaviour does nothing to keep the construction playing field level. Companies pricing to make a profit are competing with those prepared to bid at a loss in an attempt to keep afloat. In normal economic times, more of the zombies would have failed – that’s commerce’s version of tree clearance to ensure a healthy forest. What we are seeing instead is too much competition on an unfair basis. Stronger contractors risk having to be busy fools, at even lower margins than usual, just to stay in the game. And it doesn’t help that too many clients still buy on price with scant regard to financial viability.
Any one of the 26,000 zombies could fail at any time, tipped over the edge by one contract loss too many, by an impatient creditor or simply because of management battle-fatigue. How many of them are in the supply chain of our Top 100 Construction Companies? This poses a constant supply chain integrity issue, not helped by an understandable loyalty within the industry to long term subcontractors and suppliers even when financial problems occur. Quite apart from the disruption, too often main contractors end up carrying the financial can for bringing in replacements to complete the works. But fortunately, only four of the Top 100 qualify as zombies themselves, one of them only very marginally (see right). Financial stress is never far away for builders. It seems that it is growing at an alarming rate as the UK economy bumps along the bottom with the occasional uncertain upward blip. The recovery might indeed have started but there will still be consequences. The only question is when, for whom and how serious.
Only four of the Top 100 construction companies have negative net worth, the commercial equivalent of negative equity, and they are the only companies in the list that can be described as zombies. They are:
• Lakeside 1 (Keepmoat): This company has now made total losses of £853m in the last five years, although around £400m of this is from non-cash accounting adjustments to write down the value of its substantial intangible assets. The balance sheet shortfall is now £319m, compared to £152m last year. But its debt is well structured as long term and, while working capital is thin, it is still just positive. Rank by turnover: 23/100
• Morrison Utility Services: Morrison has made cumulative losses of £26m in the past four years, creating net liabilities of an equivalent amount, up from £21m last year. The good news is that its debt is well structured, it has substantial cash balances and a strong working capital profile. Rank by turnover: 28/100
• SGN Contracting: This subsidiary of Scotia Gas Networks declared a loss of £6m this year, which turned the previous surplus into a deficit of £3.3m. More significantly, its parent company has a deficit of £747m. Rank by turnover: 64/100
• City Building Glasgow: This limited liability partnership was spun out of Glasgow City Council’s building department in 2006. Its current shortfall is £82m and is caused by the deficit on the pension scheme it inherited. The latest accounts state that this is a long-term issue that does not impact on current trading. Rank by turnover: 66/100