The double squeeze – What the downturn means for contractors

The economic downturn. It’s not as bad as it was – it’s worse. And as the chill tide reaches the contracting sector, firms are finding that they have to struggle with both ends of the supply chain. Upstream, clients are using the buyer’s market to bargain down the contract sum. Downstream, materials price rises are making estimators’ jobs increasingly stressful. The result? Contractors are bracing themselves for plenty of pain as they head into 2009.

Inflationary pressure

Usually the effect of a downturn is ameliorated by falling demand, which leads to deflation. This time round demand is remaining strong, thanks in large part to the Chinese economy, which is growing at 8%, and thereby underpinning global prices (for example, China consumes 35% of the world’s supply of steel). Demand-led inflation is being aided and abetted by the unprecedented cost of oil, which is pushing up production costs. This net effect is that when main contractors come to let the works packages months after they have won the contract, they find the specialists’ prices have risen.

“We simply haven’t seen these conditions before,” says Vaughan Burnand, chief executive of Shepherd Construction. “We’ve got a scenario in which prices would normally go down. But they’re not. It’s a disturbing anomaly.”

Just how disturbing is clear from the statistics. Between 1996 and 2003, materials inflation was about 1.5% a year. This year and next, prices are expected to increase well ahead of that. Analysts have forecast a 40% rise in steel prices and, at the beginning of March, copper prices reached a 12-month high of $8,730 a tonne.

Whereas once upon a time it was possible to source materials from abroad to lowering costs, these days, that is less of an option. Michael Ankers, chief executive of the Construction Products Association, says:

“You think prices are expensive in the UK but when you look at France, Germany, China – it’s the same. Globally there’s little escape from this situation.”

And he adds that the situation will get worse: “The impact of the energy and raw material prices have still far from fully fed through the system and there are increases to come. We will see contractors under pressure in the next few months.”

A rock and the hard place

A few months back, some were arguing that the downturn was a mere blip. Nobody is running that one any more. As clients start to cut back on projects and even retender them, contractors are realising they are unlikely to escape unscathed.

Paul Hodgkinson, chairman of Simons Group, says: “A lot of our customers are challenging us to make sure projects are coming in at a lower cost as a result of their own budgeting requirements. And the inflationary costs at the same time mean that we are feeling a double squeeze.

“We’re working on the basis now that this situation is a seismic shift that won’t correct itself quickly.”

For some, considerable damage has already been done, as last week’s profit warning from Morgan Sindall shows. The fit-out market in particular, traditionally the first to suffer when belts are tightened, is suffering as retailers put work on hold until the consumer spending picks up.

Styles & Wood has been one fit-out firm under pressure. Ivan McKeever, its chief executive, says: “I’d say we first noticed a softening in our order book in the first three months of this year. But the real impact has been since April. Decisions were taken to postpone significant schemes.”

“We’ve just had £8m cut out of a big Manchester housing job we were doing,” adds Burnand. “We’ve been told just to do the shell now, not the fit-out.”

Other firms have also had unpleasant last-minute surprises. Another major contractor says two schemes it was working on were pulled back recently – one just as it was about to go on site. The explanation from the client was that it was retendering the job to get a better price.

Survival skills

Contractors are taking the downturn philosophically. “It’s key to respond positively,” says Hodgkinson. “You just have to drive costs down in the normal way but work harder at it. We’re unpicking projects to pinpoint where we may be able to make cutbacks. It’s the normal squeezing process with the added pressure of a suffering market. It’s about working out the best way to overcome that extra pressure.”

Burnand adds: “This situation is a real concern as base materials rise. For plastic pipes we’re looking at a 12.5% increase next year. And yes, we’re under pressure as everybody is trying to get more money off. But I’ve faced difficult times since I came into the industry and we’ll face them again.”

Another option for contractors and housebuilders is to look to public sector work in general and social housing in particular. Morgan Sindall said in its profit warning that it would be switching more resources to this sector.

But as Building recently reported, getting onto these public sector lists is difficult if you do not already have a foothold, and competition is increasing as more and more firms seek refuge in this sector.

For some, even a successful switch to social housing can be problematic: “Social housing is much more closely linked to private housing these days,” says one senior source. “I saw a situation recently where someone was all set to build a big residential tower block. The social housing was all at the top and the private at the bottom. Building the social housing would have been no problem at all funding-wise but it had to be scrapped because the bottom of the tower couldn’t be built. It’s a ridiculous situation to be in.”

Winners and losers

Commentators admit that there are groups who could do well, such as big contractors like Carillion and Bovis Lend Lease that are on long-term public sector frameworks, and who are finding their supply chain desperate for work.

But for others the double squeeze is set to continue. “By the time money does start flowing more freely people will still be very concerned and cautious,” says Ankers. “Things have gone down so quickly that when the economy picks up people who’ve got money may not want to spend it until they feel more confident.”

“It’s not looking good for some sectors,” adds another industry source. “If I were working on a high-rise building I think I’d be tempted to throw myself off it!”

Survival of the fittest

On a lone positive note, some are suggesting that the current situation could have a Darwinian effect on the industry: “Good businesses strong enough to stand up to this situation will survive,” says John Frankiewicz, chief executive of Willmott Dixon. “The market will sort the good from the bad, the strong from the weak.” However, this is likely to provide cold comfort for those struggling to avoid extinction.