Danger: recovery in sight

For the industry’s major contractors and specialists 2013 has been a pretty unremitting story of misery so far: redundancies, cut backs, profit warnings and a number of long-standing and well-known firms, such as Daniel Contractors, Rowecord and McCardle, going into administration. Hardly surprising, since construction output for the first quarter was at its lowest level for 15 years. Added to that has been Balfour Beatty’s £50m profit warning, contributing to a loss of 20% in the firm’s market value since the start of the year, with the contractor saying UK construction revenue is 23% lower so far this year than last. In the last week the news that both Emcor and Mitie have pulled out of the market for M&E work has simply underlined how difficult contractors of all kinds are finding it to make money in the UK.

Strange as it may seem, given all this, there are some contractors - the most forward-thinking types - that don’t think the recession is their biggest concern. No, it’s the recovery they’re worrying about. Surprised? The darkest hour, the saying goes, is right before the dawn - and many are starting to say so it is with the economy. Because while output is at record lows, the wider economy is showing sluggish signs of life. Housebuilders are once again enjoying bumper profits and ramping up output, while surveys of consultants such as the RIBA’s monthly survey of architects, which has been predicting widespread growth in workloads since October last year, show that those at the front end of the project cycle are already starting to see opportunities.

For the moment growth expectations are not dramatic. But however modest this improvement turns out to be, some contractors are saying it could be enough to prompt a significant shift in the power dynamics of the industry, from clients back to contractors and the supply chain, as demand for construction hardens amid limited capacity in the industry to deliver it. But while this may be welcome for some, it will also introduce huge new dangers to firms that may already be teetering on the edge. So what is going on, and what do you need to know in order to ensure your business isn’t caught out?

Capacity vs demand

That there are tentative signs of improvements in the economy is no great secret. In addition to the UK economy avoiding a triple-dip recession, both the Office for National Statistics and Building’s Barbour ABI/CPA construction index have picked up growth in new construction orders this year - with the latest index showing contract awards up 8% between March and April. In addition Deloitte’s quarterly London Office Crane survey last week reported construction activity in the capital at a four-year high. But with construction output a lagging indicator of economic growth, contractors and subcontractors are undoubtedly still experiencing huge pain. Received wisdom suggests they have another 18 months to two years to wait before things improve.

However, this is perhaps to underestimate how quickly sentiment is changing on the ground. At the root of the issue is the balance between demand and supply - more specifically, the demand from clients for construction services, and the capacity of the UK construction industry to meet it. With major restructuring programmes in the industry’s biggest contractors carried out over the past year, and continuing company collapses in the supply chain, capacity has clearly been cut. Crucially, capacity appears to have reduced further and faster, since 2008, than demand. Between the end of 2008 and the end of 2012, government figures show output in the industry dropped by 12.1% - a huge fall. But over the same period the number of people employed in the construction industry, a key indicator of capacity, fell by even more - 14.3%.  In 2012 alone 70,000 left the industry, with just 1.99 million workers remaining - the first time this figure has fallen below two million in over a decade.

The market is changing. People are getting busier, the trades are getting busier, and people are going in for work at a little bit of a higher level. I would say it’s a fragile recovery

Julian Daniel, Blue Sky Building

So with the industry’s capacity to deliver construction projects hugely reduced since the start of the recession, it is possible to argue that there is now less competition for each package of work than there was in 2008. So far it hasn’t felt like that, because with contractors initially attempting to hold on to turnover and staff, many have been bidding at negligible margins to get new work through the door. But this, say many, is changing.

Andy Hill, founder and managing director of contractor and housebuilder Hill Partnerships, says: “Contractors have realised that that level of bidding can’t continue, it’s not sustainable. People were losing money. So they’re starting to bid at more realistic levels that are sustainable for the whole supply chain.”

Part of the reason for this change in attitude is that with staff and overheads cut to the bone, contractors don’t need to generate turnover simply to feed the machine. In addition, cash reserves in the industry are at a low level, meaning firms can no longer risk winning work that doesn’t generate a profit. Rudi Klein, chairman of the Specialist Engineering Contractors Group, says: “Cash balances are the lowest they’ve ever been and there’s a dawning realisation that they need to re-think their business models. It seems to have finally entered contractors’ heads to be more selective as they’ve got nothing to play with.”
Hence Balfour Beatty’s publicly stated decision to bid for less UK work in order to drive up margin. One chief executive at another major contractor says: “We’re bidding a fraction of the volume of projects we were bidding a year ago. We’re only going in where we know we’ve got a really good offer and we can make a good margin.”

Julian Daniel, former head of construction at Lend Lease and now managing director of construction specialist Blue Sky Building, says: “The market is changing. People are getting busier, the trades are getting busier, and people are going in for work at a little bit of a higher level. I would say it’s a fragile recovery.”

These factors taken together are leading to inevitable speculation about the impact on tender prices. “The reality is inflation will follow, and clients are starting to see inflation coming through in bids,” adds Daniel.

For example, last week Land Securities in its annual results said it was remaining “vigilant” on monitoring construction costs, which it said “will increase rapidly with a sustained upswing in activity”. Emma Cariaga, development director for the firm’s London portfolio, says: “Our view is that construction costs will increase quite rapidly. As developers start to come back into the market costs will rise, although who knows exactly when that will be.”

Richard Steer, chairman of consultant Gleeds, says he is just starting to see the same thing: “With the failure of numerous subcontractors and main contractors, when an upturn in workloads materialises prices will go up due to a shortage of skilled providers. However, as it has been a particularly difficult and long recession, things will still take two years before they look very much better for contractors.”

The possibility of rising prices shouldn’t be overstated - it hasn’t yet filtered through to official forecasts, with Davis Langdon, for example, predicting flat tender prices for 2013 across the UK. But the increasing likelihood of it is starting to change attitudes throughout the supply chain. The chief executive at a major contractor, for example, says: “The boot is suddenly on the other foot in terms of our relationship with subcontractors - we really need them. And likewise with clients to us; the clever ones are starting to court us, knowing there’s limited capacity in the market. “

An upturn allows subcontractors to be increasingly selective about which contractors they choose to work for, potentially allowing them to turn down work or submit higher prices if they don’t trust the client to pay on time, or without quibbling. SEC Group’s Klein says: “The main contractors are starting to realise there’s a limit to which they can beat up the supply chain.”

Cash balances are the lowest they’ve ever been … It seems to have finally entered contractors’ heads to be more selective as they’ve got nothing to play with

Rudi Klein, SECG

While all this raises the prospect of better times to come, it also brings with it serious dangers. In particular main contractors that have won fixed-price work at low cost at the bottom of the market may find themselves struggling to deliver it as subcontract prices harden - putting their businesses at risk.  Subcontractors who have felt abused by main contractors’ payment practices during the recession may even indulge in score-settling if the relationship is not properly managed.

This risk is exacerbated by the fact any new work coming through at better margins will be mixed in with all of the other low margin work, meaning it will take a long time to feed in to greater profits, all the while requiring precious cash and investment in preliminary costs. In previous recessions recovery has actually been the most dangerous point of the cycle in terms of builders going bust. Blue Sky’s Daniel says: “The risks are somewhat increased, particularly wherecontractors have bought work at sub-optimal levels and are still struggling to get paid.

“Contractors are also only going to expand on genuine opportunities, not on a hope of growth. That means capacity will recover slowly, increasing the tendency for contractors to try to deliver projects on a shoe-string. But there’s a risk to trying to operate with reduced resource - you’re more likely to run into problems on the jobs.”

Daniel says contractors need to keep as close to their supply chain partners as possible, particularly as clever clients are very keen to know that “first division” specialists are in their contractor’s supply chain. Falling out with a supplier can, in this situation, be a real barrier to winning work.

Given the danger to contractors during a rebound in work, it is important that now, more than ever, you attempt to work in partnership with your suppliers so they will help you when you need it. Which could - given the signs - be sooner than you think.