UK Construction – What’s the Cause for the Crumble?

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Last month, Galliford Try, the parent firm of Morrison Construction, revealed they were anticipating a drop in profits of £30-40m, partly due to adverse settlements and delays on major infrastructure projects.

This follows a pattern of profit warnings from a construction sector that appears to be crumbling. We have already seen Carillion and Interserve collapse, with the former becoming the largest bankruptcy in British history, leaving creditors and Carillion pensioners facing huge losses and placing thousands of jobs at risk.

In the case of Interserve, after entering into Administration on 15th March this year, a rescue deal was agreed where ownership was transferred to their creditors, HSBC, RBS and a few hedge funds. It’s easy to see who the real winners are from the collapse of the outsourcing giant; the Government, for instance, are still happy to offer contracts.

Where some fall, others will always rise, but what exactly has gone

Would investors be advised to avoid a sector looking like Jenga on puppet strings? On the other hand, canny traders banking on Interserve’s fall has undoubtedly cashed in rather handsome profits. I guess it all depends what the end game is…

As a disclaimer, I must state I am not offering personal advice here. Investments can come with sharp vicissitudes in fortune so all I can suggest is seeking advice if you are unsure as to whether an investment is right for you. As we have seen with the collapse of such industry giants, past performance is not always a sure guide to future prosperity.

An inevitable fall from grace?

Construction is, of course, an intensely competitive industry. With such high demand, you find the bread and butter of most construction groups lie in subcontracting the actual building work out to third parties. Until we step into something akin to ‘Back to the Future’, construction services tend to be pretty standard and as a result, bidding wars mean companies feel compelled to work on the smallest of profit margins in an attempt to secure business. The problem with this lies in the increasing prevalence of fixed-price contracts with little
or no room for error.

Take Galliford for instance, who have been running on an operating margin of 0.9% in recent years. This creates intense pressure to take on probably more contracts than is sensibly feasible, especially when you consider that even small increases in un-anticipated costs have the potential to wipe out profits.

Consider this: a £200m contract for Galliford would be expected to generate an operating profit of around £1.8m, however even an unprojected 5% increase in costs would eviscerate £9.9m. To put that in perspective, that happens to be the equivalent of the potential profit from £1.1bn worth of contracts.

With this in mind, it’s easy to see why construction groups probably take on far more than is logistically and financially feasible. Thinking holistically, when also considering the mighty amount of outsourcing that is occurring, you can see how just one break in the chain can lead to fairly catastrophic results.

Although Galliford has pledged to honour their public contracts, this will likely
come with an expected 350 job losses across the UK, catalysed by adverse settlements and delays in major infrastructure projects. It’s worth remembering that Galliford’s tiny margins are far from unusual. Even Balfour Beatty, one of the major players in the sector, is now seeking ‘industry standard margins’ in its UK construction business of 2-3%.

The problem with a debt-riddled foundation

Since most construction work is subcontracted out, the ability of companies to consider contracts as assets all depend on successful delivery. As Carillion learned, if a company is then in urgent need of raising capital, these contracts can be rather difficult to sell. Once you sprinkle in some hazardous debt, the foundations will likely crumble every time.

Only yesterday we heard how Kier Group’s shares fell sharply after Finance Director Bev Drew announced she would leaving after the company delivers its full-year results for the year ending 30th June. The last year has seen Drew oversee multiple crises, as Kier Group sought to strengthen their balance sheet after mounting debts saw them become the most shorted stock on the London Stock Exchange late last year.

With both customers and shareholders becoming increasingly nervous about the effect of large debts on long term viability, it’s easy to see why companies are struggling to sell off contracts. As I mentioned before, you have to look at this holistically. Just one break in the chain and what may have once been perceived as an unshakeable pillar of the industry can come crashing down. Sometimes it all lies in the debt…

So how about building upon a rock?

It seems a fact of life that shares rise and fall, but here are some tips
that could reduce the chances of any real lasting damage:

 Seek specialist solutions

In an industry of tight margins, look to specialists who are able to charge a premium. Less competition = Higher margins. This places you in a better position to absorb losses that will inevitably occur in the business.

 Look to the balance sheet

It may be worth looking for businesses with assets on the balance sheet, although this would mean the company is likely involved in more than just construction contracting. This can allow for assets to be sold or borrowed against when the going gets tough! Consider Galliford Try for instance; although currently suffering,
their balance sheet looks rather healthy in terms of property assets and a relatively modest amount of debt.

 Beware of falling knives

Some investors buy shares in a company which have just fallen dramatically, hoping to cash in on short term recovery. This is commonly known as ‘catching a falling knife’ and therein lies the clue.

This is an extremely high-risk strategy because there is often no way of knowing whether the shares could fall further. Some, of course, have the inside scoop but for many, it can be a slippery the slope on which you may never quite cut the butter.

Written by George Acer

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however, WH has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing.

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