UK construction: margin pressure
Contents 3 5 Part 1 Strong headwind Part 2 Anticipating the storm 1
Research methodology EY analysed available accounts of the top 100 private and public UK construction companies (excluding housebuilders) by earnings before interest and tax (EBIT) from January 2007 to January 2017, as well as data from Office of National Statistics (ONS) and Bank of England (BoE) 8 Part 3 Smooth sailing UK construction: margin pressure 2
3 Part 1 Strong headwind In the UK construction sector, margins are under increasing pressure during a time of unprecedented uncertainty
Margin pressure The construction industry has suffered from low margins for a period of time, and has struggled to recover to the pre-financial crisis levels. Whilst margins have had short periods of improvement, the overall trend over the last decade is one of decline. Analysis of available 2016 accounts indicate another drop in margins, potentially impacted by uncertainty following the Brexit vote. Higher margins in the UK construction sector tend to come from long-term relationships, such as fiveyear service contracts, rather than one-off building contracts. These long-term arrangements, such as for civil work, tend to be driven by organisations where establishing a relationship is key to accessing a pipeline of contracts. However, framework stability can also create a negative impact, locking in low pricing during a period of market improvement. This is evident as recent skill shortages and rising input prices have resulted in increased margin pressures for long-term contracts, with limited opportunity to pass on cost increases to customers. Moreover, firms with a predominantly UK focus can be seen to deliver lower margin results now down to approximately 1% on average than those with a predominant focus in other markets where margins have been on average 4% over the last five years. Figure 1: UK construction margins (top 100 firms based on revenue) 4.0% 3.5% Average EBIT margin (top 100) EBIT margin forecast 16 (based on sample of 25 that have reported) Linear (average EBIT margin (top 100)) EBIT margin 3.0% 2.5% 2.0% 1.5% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: Capital IQ, financial reports Figure 2: International margin comparison Min EBIT margin (last 5 years) Max EBIT margin (last 5 years) Average last 5 years 7.0% 6.0% EBIT margin 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% Australian based European based Global UK based (top 10) US based Source: Capital IQ, financial reports UK construction: margin pressure 4
Part 2 Anticipating the storm Anticipating the impact of Brexit on the construction sector 5
Brexit increasing pressure on margin Uncertainty following the Brexit vote led to a period of project delays and cancellations, which have put further pressure on pipeline and margins. In addition, the devaluation of sterling following the vote is starting to become visible as an increase in input costs, particularly on non-labour items. Furthermore, if in the longer run, EU migrant labourers who could represent as much as 10% of overall construction labour, start to leave the UK causing skill shortages, it is anticipated that labour costs will increase as well. Therefore, in 2017 we expect to see the following short-term challenges; 1. Project delays and cancellations 2. Cost inflation 3. Financing In the medium term (one to three years), these factors could trigger a prolonged sector downturn, at a time when margins are already historically weak. 1. Project delays and cancellations Even before the Brexit vote, the post 2008 fiscal austerity had hit the construction sector, through repeated delays by government in key infrastructure projects, although some of these projects are now starting to play out. Despite this, we believe the uncertainty and reduced investment appetite will lead to widespread delays in new projects in both public and private sector. The real growth rate of the construction industry is expected to fall to just 0.5% in 2017, before picking up again in 2018/19 and stabilising around 3% (see figure 3). It is expected that the majority of revenue for the next 6 to 12 months will remain constricted, with new contract profit not being realised in the initial contract period. Furthermore, this constriction could result in postponed upfront payments for new contracts (estimated at 4%-5%) leading to further working capital stresses. Figure 3: Forecast construction sector growth (2015-22) 160 140 120 4.00% 3.50% 3.00% Value bn 100 80 60 40 2.50% 2.00% 1.50% 1.00% % Growth (y-o-y) 20 0.50% 0 2015 2016f 2017f 2018f 2019f 2020f 2021f 2022f 0.00% Construction industry value ( bn) Construction industry value - Real growth (y-o-y) Source: BMI, ONS UK construction: margin pressure 6
2. Cost inflation Over the last two years, there has been a steady increase in construction input costs. With the recent devaluation of the pound by around 10% following the Brexit referendum, we expect the input cost inflation trend to continue, if not sharply steepen, its trajectory throughout 2017 (see figure 4). This view is supported by the CIPS Purchasing Managers Index (PMI) which has reported the strongest input cost inflation since 2008 in the nine months following the Brexit vote, largely linked to suppliers hiking prices due to higher costs of key import materials (e.g., steel, cement, bricks, machinery, etc.). Moreover, the one-off pricing impact of key energy items such as oil and gas, which are priced in USD, is starting to work its way through the supply chain as key wholesale hedging expires, exposing end users to higher retail pricing. We expect these factors to exacerbate the margin pressure even further, possibly by 1% or more, depending on how much of these costs can be passed through. Undoubtedly we expect to see increased client disputes as both construction contractors and suppliers attempt to protect margins. 3. Financing The construction sector has an increasing reliance on debt facilities. With ongoing financial market uncertainties linked to the US presidential election, the Brexit vote, and Eurozone stability, there is a risk that key financial stakeholders, such as debt issuers, may limit new exposure and become more selective on those companies they are willing to support in the future. This, coupled with the proportion of available committed headroom on committed facilities (down to 42% in 2015 from 54% in 2010, see EY Debt Deconstructed paper for further detail), may result in a reduction in the levels of debt available to support future projects and refinancing may be affected by more stringent debt covenants being applied. Planning for any upcoming refinancing event at an early stage and considering facilities across multiple markets will be crucial to limiting balance sheet risks. Figure 4: UK construction cost vs. GBP exchange rate index 126 } Potential impact of GBP devaluation 100 UK construction cost index 125 124 123 122 121 120 95 90 85 80 GBP FX index 119 75 118 Jan 14 Mar 14 May 14 Jul 14 Sep 14 Nov 14 Jan 15 Mar 15 May 15 Jul 15 Sep 15 Nov 15 Jan 16 Mar 16 Jul 16 Sep 16 Nov 16 Jan 17 70 UK construction cost index (2005=100) Sterling Exchange Rate Index Source: ONS, BoE 7
Part 3 Smooth sailing Anticipate and prepare for the downturn to stay ahead of the storm UK construction: margin pressure 8
Building business resilience The uncertainty in the UK construction industry means there has never been a greater need for a company to challenge its own business resilience. Active management is key to responding to this harsh environment, with focus on operational and strategic levers to improve margins, from both a quick win and longer-term strategic perspective. We do not underestimate the importance of several factors unique to the construction sector that may constrain the level of potential achievable upside, such as restrictions on overheads allocations due to specific contracts and JV/partnership arrangements. These factors will need to be taken into account in any optimisation programme. Figure 5: Operational optimisation levers Size of circle represents estimated impact on margins Core system upgrade (e.g., ERP) Acquisition and consolidation (including vertical integration) Complexity to implement Working capital Procurement cost out Wave 1 SG&A process optimisation SG&A resource rationalisation Tighten contract and customer acceptance process Wave 2 Strategic category/ supplier management Wave 3 Innovative technology implementation, (e.g., BIM) Time to realise benefit 9
Wave 1 quick wins Initial focus on quick win initiatives to realise cash to support longer-term operational and strategic improvements; Working capital: Improve working capital through standardising and enforcing payment terms with key suppliers (see UK construction: Consolidation ahead Cash takes centre stage ). Procurement cost out: Reduce indirect and direct procurement spend by renegotiating with suppliers, as well as demand side levers such as reducing/stopping demand through tighter controls. SG&A process optimisation: Reduce SG&A costs by stripping out unnecessary processes and implementing continuous improvement initiatives (e.g., Six Sigma). Tighten contract and customer acceptance process: Ensure robust customer and supplier contract take on criteria and processes, to control risk exposure and increase average returns. Wave 2 key operational changes During wave 1 start planning for key operational changes to ensure longer-term resilience to market uncertainty, including cost-benefits analysis, key stakeholder, and dedicated delivery team; SG&A resource rationalisation: Reduce SG&A costs through optimising overheads, reviewing increased usage of outsourced shared services, and increasing technology to improve efficiency. Strategic category/supplier management: Drive further cost savings by centralising key spend areas and adopting a category management approach, in order to aggregate spend and standardise demand. ERP solution implementation: Increase visibility of financial performance across the entire portfolio to aid better decision-making through an ERP implementation. Wave 3 strategic review changes Establish panel to review strategic options that will fundamentally change the position in the market place; Acquisition and consolidation (including vertical integration): To stay ahead of competitors and maximise shareholder value, management needs to make a clear assessment whether to focus on consolidation or being successfully acquired, including options to move upstream in supply chain to increase control over cost base and product/service quality. Innovative technology implementation: Explore increased use of technology to drive operational efficiency and ensure on-time/budget projects (e.g., BIM), and implement frequent review of the strategy for disruptive technologies. UK construction: margin pressure 10
EY Assurance Tax Transactions Advisory Key contacts Russell Gardner Head of Real Estate, Hospitality & Construction Ernst & Young LLP +44 20 7951 5947 rgardner1@uk.ey.com Michel Driessen Partner & Markets Leader, Transaction Advisory Services Ernst & Young LLP +44 20 7951 8792 mdriessen@uk.ey.com Mathieu Roland-Billecart Partner Transaction Advisory Services Ernst & Young LLP +44 20 7951 5206 mrolandbillecart@uk.ey.com Ian Marson Director Operational Transaction Services Ernst & Young LLP +44 20 7951 3596 imarson@uk.ey.com About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. About EY s Global Real Estate, Hospitality and Construction Sector Today s real estate sector must adopt new approaches to address regulatory requirements and financial risks while meeting the challenges of expanding globally and achieving sustainable growth. EY s Global Real Estate Sector brings together a worldwide team of professionals to help you succeed a team with deep technical experience in providing assurance, tax, transaction and advisory services. The Sector team works to anticipate market trends, identify their implications and develop points of view on relevant sector issues. Ultimately, this team enables us to help you meet your goals and compete more effectively. 2017 EYGM Limited. All Rights Reserved. EYG No. 01949-174Gbl EY-000012925-01.indd (UK) 04/17. Artwork by Creative Services Group London. ED None In line with EY s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice. ey.com Combined with a strong decline in working capital and increases in debt levels, indicators point to a structural weakness in the construction industry UK construction: Consolidation ahead Cash takes centre stage Whilst the construction industry has historically enjoyed strong cash and working capital (WC) performance, there has been a strong decline in Cash to Cash (C2C) days since 2010. Amongst the top 10 construction companies, the C2C days deteriorated from -24 days in 2010 to -12 days in 2014 (Source: publicly available financial statements). This is due to decline in trade receivables and customer advances as customers have paid late, negotiated longer terms and reduced levels of upfront case payments. Debt deconstructed The evolution in debt financing in the UK construction sector From a debt financing perspective, many contractors have seized the opportunity to access low historically low interest rates since the financial crises, as well as increasing accessibility to non-bank financing markets. Whilst this has helped the sector battle through tough times, it has also increased net debt levels across the sector, manifested through increase in total debt facilities. In 2015 these credit facilities reached a EBITDA multiple of 10.5 for top ten contractors, up from 6.9 times in 2009.