UK Construction Barometer: Margins under pressure

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1 infrastructure, building & construction UK Construction Barometer: Margins under pressure industry focus. industry experience. industry insight. kpmg.co.uk/ibc

2 UK CONSTRUCTION BAROMETER: MARGINS UNDER PRESSURE How have the UK s major contractors fared under significant pressure? It has been a turbulent few years for the UK and global economies and the path to recovery currently remains unclear. The UK construction sector has been hit hard, recently slipping back into recession for the third time in five years. In 2012 alone the industry contracted by nearly 5 billion 1, creating a significant drag on the economy as a whole. Against this backdrop, analysis by KPMG of fourteen of the UK s largest contractors found a surprising picture of an industry successfully battling the storm over the first years of recession and only finally succumbing to sustained margin erosion from As a result average margins have remained broadly flat over the last five years. This appears to be principally due to the nature of long-term contracts and the resultant lag in the impact of recession, as well as the steps taken by companies to cut back costs. The diversified nature of many of these groups also appears to have assisted in keeping margins stable over this period. Between 2007 and 2010, it is maybe surprising to see that construction margins were actually on an upward trend, which offset tightening margins in other activities, such as support services and housebuilding. Our analysis suggests this could be due to construction divisions successfully removing cost faster than revenues were falling, as well as the impact of the lag between contract tender and profit realisation. As a result, the real crunch came in 2010 when most of the remaining contracts bid pre-recession reached completion. Our analysis suggests why companies in the sector are now having to revisit the programmes of cost efficiency that many hoped in vain would see them through to better days. There are however many contributory factors to the more recent margin pressure, not least the severe capital spending cuts by Government, coupled with substantially subdued private sector investment. This has resulted in a protracted decline in pipeline now plummeting at the fastest rate for three and a half years 2. Escalating competition has seen the balance of negotiating power shift in favour of the procurer with projects reportedly being bid close to or even below cost with reduced scope for more profitable contract variations. Construction costs have continued a 34 monthlong climb driven by considerable increases in fuel and energy prices 3. Since 2010 we have seen a scramble in the industry to stem the collapse of forward order books, underpinned by deliberate profit-sacrifice. This has resulted in a steady fall in the average construction margin for our sample group, with early indications being that 2012 results are not likely to buck this trend. However, despite these negative trends and all the gloomy industry headlines of compounding pressure, construction margins in 2011 were still, on average, some 0.5 percentage points higher than in At least for these major contractors the descent has fortunately been from a healthier start point. The overall range of construction margins is widespread, varying by up to 3.6% (excluding outliers). This is indicative of the differing sector focus, size and nature of projects and no doubt contrasting bidding strategies of the individual companies reviewed by KPMG. The spread tightened considerably in 2011 to just 2.5%, reflecting intensified market competition for a diminishing number of contracts. The volatility of construction margins over the period is also particularly evident. For many entities, it is a broadly similar picture of margin growth to 2010, falling thereafter, in line with the overall average. But it is not a unanimous trend. Not all have seen margins fall at the same rate since 2010, and indeed at least one continues to show margin growth into 2011 and beyond. Average construction margin rose to 2010, but now on a downward trend... Average Group and Construction margins % 3.0% 2.8% 2.6% 2.4% 2.2% 2.0% 1.8% 1.6% Average Group operating margin * Average Construction * Excluding anomalous entity with significant negative margin in 2008 segment operating margin *+ + Construction segment results have been normed. Individual construction margins show a mixed bag of results... Construction margin by company % 4.0% 3.0% 2.0% 1.0% 0% -1.0% -2.0% -3.0% -4.0% UK subsidiary/sub-group Private entity/group UK Listed entity/group Average * construction segment of international group operating margin (normed) * Includes all entities 1 Construction Products Association 2 Markit / CIPS Purchase Managers Index 3 Markit / CIPS Purchase Managers Index

3 Construction revenue floundering... Margin growth (%pts) Our analysis illustrates group revenues have actually shown a small compound growth averaging 7.4% over the last five years for the sample group. However, this is all based on growth in the first year to 2008, with subsequent years largely flat or falling. This against a backdrop of an average compound decrease in construction revenues for the same period of some 1.1%. When the type of business is considered several other trends are also evident (although due to the population size these may be more indicative than conclusive): Reliance on construction activity: of the sampled population it is those diversified companies, where construction segment revenues account for less than two thirds of the total business, that have seen the most consistent revenue and margin growth. Interestingly, this is the case for both the construction segment and the overall group. Size of business: there were less obvious patterns here, although in general the larger companies have more consistently shown growth, particularly in revenue terms. LISTED PRIVATE UK-SUB Ownership structure: listed entities appear to have focussed on maintaining or growing revenue, which has translated well for group margins but offers a more mixed picture for construction margins. Private and foreign owned businesses have shown a clearer inverse correlation between revenue and margin growth, suggesting a strategy of sacrificing revenue in the pursuit of superior margins may be being successfully employed here Group Construction segment (normed) Zero growth bars due to lack of data Average growth Revenue growth So what next? - Protecting margins remains key for the near term... 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% Group LISTED PRIVATE UK-SUB Construction segment (normed) Zero growth bars due to lack of data Average growth Industry pessimism for the year ahead is now at its worst since the near-record confidence lows at the end of With forecasters not predicting a return to growth until at least , the construction industry remains acutely fragile. On the whole the UK s main contractors appear to be standing firm. Certainly where businesses have reacted through re-organisation efforts, these exercises have been credited with steadying their operating margins as they emerge. Getting the right client mix for the business has also been credited with helping protect margins and pipeline over the five year period, as has involvement in large-scale infrastructure projects. What is marked is the variety of strategies adopted and levels of success with which these appear to have been implemented. But looking to the future, in the absence of a silver bullet to reinvigorate order books, what are contractors and their supply chain doing to bolster their bottom line? Cost efficiency transformation programmes at group, divisional and project levels; Restructuring, both from an organisational and financing perspective; Pricing and bidding strategies that focus on true value drivers of end-clients; Project value engineering; Diversification into new markets and geographies; Increased consolidation and joint ventures to facilitate access into specialised sectors; and Re-focussing on growth sectors such as energy and transport infrastructure. Despite hopes for green shoots from Government announcements in late 2012, there was little promise for the near term with continued uncertainty as to when the demand changes will come for the sector. As 2012 results are announced and forecasts for 2013 and beyond come under the spotlight, construction companies will need to redouble their efforts if they are to prevent margins sliding further in the continued harsh market conditions. 4 Markit / CIPS Purchase Managers Index 5 Construction Products Association

4 The information contained herein has been analysed from the accounts and related information of fourteen of the UK s major contractors that was publically available at December This information has been adjusted where necessary for comparison purposes, for example to norm segmental information for discrepancies in treatment of adjustments such as non-allocated costs, joint venture profits and amortisation of intangibles. Should you wish to discuss any of the information further please contact one of our experts: Andrew Marshall Partner, KPMG in the UK +44 (0) andrew.marshall@kpmg.co.uk Infrastructure, Building & Construction: BUILDING VALUE Providing integrated services across audit, tax and advisory with vision and independence, KPMG s Infrastructure, Building & Construction practice know what it takes to drive value across the industry and its supply chain. By bringing together sector-focussed disciplines we provide optimal solutions to identify & mitigate risk, control and reduce cost, manage cash, improve margins and identify growth opportunities to help support and strengthen organisations to succeed in challenging times and beyond. Tas Papasolomontos Senior Manager, KPMG in the UK +44 (0) tas.papasolomontos@kpmg.co.uk Richard Threlfall UK Head of Infrastructure, Building & Construction Partner, KPMG in the UK +44 (0) richard.threlfall@kpmg.co.uk For general information: Jessica Leng Senior Business Manager Infrastructure, Building & Construction KPMG in the UK +44 (0) jessica.leng@kpmg.co.uk

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