Risk junkies

 

Why do contractors bother? The risks are high and the returns are small. Many major players in the market are diversifying into the services sector in a bid to chase larger rewards and spread risks. For those that haven’t, profit margins have remained stubbornly low – and sometimes disappear altogether.

Earlier this month, Australian contractor Multiplex announced £45m losses on Wembley stadium; in April it was the turn of the Japanese giant Kajima, which admitted £80m losses caused by problematic PFI school projects. Despite unprecedented levels of public sector spending and Egan-style partnering deals with private and public clients, the industry is still struggling to make money.

Low margins are partly a function of simple economics – in a crowded construction sector where supply outstrips demand, companies must compete hard to win work. For example, when design-and-build contracts heaped greater risk on contractors

in the late 1970s and early 1980s, they felt unable to raise costs for fear they would not win the work. One contractor says: “Design-and-build and traditional contracts have the same margin – which is insane, given that one is far riskier than the other.”

The raw deal: High risk vs low margins

Those prepared to gamble on construction find it an easy market to enter. Firms need little upfront cash and, as Simon Vivian, chief executive of Mowlem, says, “the fact that relatively little capital is employed means it is possible to operate at very low margins”.

Traditionally, a group’s contracting business was often used to bring in cash that would be invested in a profit-making subsidiary. David Taylor, a construction analyst at Tether and Greenwood, estimates that up to £60m of the £150m cash on Carillion’s balance sheet is “other people’s money”. Contractors operating in this way tend to carry little debt, their construction business effectively being their bank.

But if firms have little capital behind them, it also makes them vulnerable to any variation in ultra-low-margin projects.

High-profile failures seem to elicit little sympathy from industry watchers, though. Multiplex’s troubles at Wembley have been characterised as the direct consequence of a cavalier attitude to winning work – don’t blame the poor margins, blame the poor risk management. The real problem is contractors’ historic willingness to do almost anything to secure cash flow.

Vivian says Mowlem walked away from Wembley and the Millennium Dome. “We couldn’t price the risk. They are very hard, very fixed price, very wrapped contracts. We did Twickenham but on very different terms. If a client can get a contractor to take on all the risk, they will pass it over. There is always someone who thinks they can take it on and make it work.”

It’s no surprise that the City approves of a more cautious approach, as Stephen Rawlinson, an analyst at Arbuthnot, demonstrates. “You’ve got to accept that this is a low margin business. If you try for a profit of 10-15%, you could end up with losses of 10-15%. The hard bid tender merchants get taken for a ride by clients. Multiplex were desperate to make a splash in the UK so they went for a big showy stadium project and they came E E a cropper. Laing took on the Millennium Stadium [in Cardiff] for a fixed price when the spec wasn’t even agreed.”

Although some grow misty-eyed at the high-single-figure profits of the 1970s, others see nothing wrong with today’s modest levels, as long as the risks are reasonable. “We are not necessarily pursuing higher margins for higher margins’ sake,” says Vivian. “I am quite happy to have net 2% margins if the risk profile reflects that. We don’t mind having one or two high-risk projects. We bid recently on a project that would have a 20% margin, but it was a site that required significant piling next to sensitive telecoms power lines, so we had to build in a lot of contingency margin risk.”

Playing the odds

Vivian believes the industry as a whole has to look more closely at the risk profile of projects. “We have completely reorganised the way the way we look at the whole risk management process. We’re in the process of creating a risk management board at Mowlem, whereas previously there was very little centralisation. We are looking a lot more closely at what risks we are taking.”

Andrew Muncey, the former group managing director of Gleeson, agrees that there isn’t enough control of risk in building contractors. He left the company earlier this year, following the announcement that the construction division lost £16.6m in the second half of 2004. “Some people who have fairly low levels of ability have the power to sign off large projects. There is rarely an independent check, like the credit control departments that banks have.” The implication is that companies sign contracts that are exciting to those agreeing to them, but are simply too risky. By the time Muncey left, he had introduced a system where the UK managing director would vet every project.

Stef Stefanou, group chairman of subcontractor John Doyle, believes smart contractors ditched their cavalier working practices during the recession of the mid-1990s, when they realised contracting turnover would not bring easy riches in the property world. “They went through value engineering, creating trust between themselves and clients and subcontractors, offering a good service to clients to win repeat business, pricing jobs properly and not cutting corners to recoup money on claims.” Companies that failed to make the shift have largely disappeared, he says.

Others are not so sure that such contractors have vanished but, in the wake of a string of contracting disasters, predict that they will in the coming years. Construction is undergoing an evolution – those companies that don’t take unnecessary risks and concentrate on the value of the whole service package will survive, while their more precarious peers come unstuck. “Margins are increasing, but not in those companies who make the headlines. They will go out of the market and there will be fewer players but they’ll be more successful,” says an executive at a large UK contractor.

Bob Rendell, chief executive of regional contractor Leadbitter, which showed a £400,000 pre-tax loss in 2003, agrees. “We’re going through a period of consolidation. There are fewer contractors in the marketplace and the ones that have survived and have grown are better managed. I’m more optimistic now than I was five years ago in terms of the professionalism of the business.”

Getting in with the big boys

Rendell believes better educated clients will help to improve the health of the contracting sector, and he attributes this in part to government initiatives to award contracts on best value rather than lowest bid. “Clients are starting to look at the whole package – health and safety, modern methods of construction – rather than just the tender price.”

Clients are also bringing in contractors earlier, allowing them to better calculate and manage the risks of a project. He does add a note of caution, though: “This is if the economy allows it to happen. If the economy goes into significant decline, it’ll go back to a dog-eat-dog world.”

Partnering and framework agreements are often cited as a way to place contracting on a sturdier footing. Stuart Doughty, chief executive of Costain, says the company has secured 50% of its future turnover in five-year contracts with utilities companies, reducing risk and providing a guaranteed income. “We avoid lump-sum fixed-price contracts,” he says. “We’re focusing more on the relationship between us and the client: there’s more long-term security of margin.” Yet even this can have its problems, as Doughty concedes: “The cash flow is secure and the costs are agreed, but the problem is then the rate of volume, rather than the amount of work itself.”

Leadbitter’s Rendell believes such deals offer welcome opportunities to plan work, but is not entirely convinced they will improve profits. “There are a huge number of different procurement routes being used at the moment, but they’re all based more or less on some form of competitive bidding. Even when you’re in a framework agreement, clients are quite rightly looking for improvement in price on later projects because you’re on a learning curve.”

Frameworks don’t always guarantee the frequency of work: some of the 12 firms involved in the Department of Health’s Procure 21 have yet to win their first project under the programme. But John Beament, chief executive of Longcross Group, says its deals with retailers such as Tesco, Sainsburys and Boots do mean it can be sure of a large chunk of work, albeit one without a fixed value. “It’s more guaranteed than competitive tendering,” he argues. “We can forward plan for the year and keep our margins tight, and we can also pass this security down the supply chain to other people.”

The PFI has also been adopted as a surrogate investment model by some contractors. Balfour Beatty, the biggest quoted contractor and something of a stock market darling whose profits increased 15% to £150m last year, generates its returns by investing £200m in PFI projects. This is fairly typical among the larger players. “We have invested our capital heavily in the PFI – we have £200m in it,” says chief executive Ian Tyler. Shepherd Construction does something similar and chief executive Vaughan Burnand estimates that it makes £5m a year from every £10m it invests.

Beyond investment, there is some debate about contractors’ future involvement in PFI, particularly after the UK arm of Kajima reported in April that it had taken a £80m hit on PFI schools. PFI provides margins of about 5% and has certainty of design while on site, because of the complexity of early negotiations. Specification changes are less commonplace than on traditional contracts.

However, the high margin represents the reward for the early risk of bid costs and lengthy negotiations. What is clear is that enough companies will be risk-averse enough to leave the market, helping to sustain high margins for those who decide to remain.

Alastair Stewart, analyst at investment bank Dresdner Kleinwort Wasserstein, believes PFI deals do cut the risk of starting work on unfinished designs. But he adds: “Contractors should be careful of one-off PFI schemes, such as building a laboratory, for example. Schools and hospitals are a much safer option because there are cost benchmarks to follow.”

John Doyle’s Stef Stefanou says contractors still have difficulty pricing the construction portion of PFI deals correctly because they must work from outline drawings with too little detail, or have too little say. “In some cases, it’s the money people who price it rather than the contractors. PFI teams tend to be led by a money person or a legal person or both, rather than a construction person.

Views differ on whether design-and-build contracts are good or bad for margins. While some contractors complain that they can no longer claim back for architects’ delays, Stewart believes taking responsibility – and therefore control – is a positive shift for builders. “Design changes often result in the biggest losses for contractors. In other words, the prettier the contract in terms of design content, the more likely it is to go wrong. The risk of cost overruns goes up when there is a high design content and when the architect is in charge. Design-and-build schemes are a far less risky option for contractors.”

A winning option?

The quest to stabilise uncertain profits has also led to a scramble for the supposedly safer territory in the support services market. But again, not everyone is convinced. One contractor argues that margins are no higher for support services than for construction these days and dismisses diversification as little more than “window dressing” to please stock-watchers. Others believe the trend is not sustainable. “The more people who go into it, the more competition there will be and the more pressure is put on margins,” says one.

“A number of big names go for volume. Some are almost creating the same problems all over again, trying to get as much work as possible by pricing low,” says another.

At Mowlem, which has streamlined its construction business and moved into support services, Simon Vivian begs to differ. “You have to remember that this is a huge sector. It covers basic facilities management from posting a guard on a gate and providing a cleaner to the more sophisticated FM deals. Some parts of that sector are very competitive and, as a result, some of the margins are not much higher than construction.

“However, if you can provide a sophisticated service that few others can offer, you can achieve good margins. I would suggest that sensible margin ranges in support services would be 3.5-4% for the basic FM contract to 10-15% in a specialist deal. Even at the lower end, you still get good margins compared with construction.”

Perhaps this sums up the fundamental problem with the contractor’s lot. As Leadbitter’s Bob Rendell says: “People have got into the habit of not properly valuing the service that the construction industry brings to clients.” Whether firms choose to look at their methods of engaging with clients or alter their business model to take advantage of other opportunities, it is this that needs to be addressed.