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Restructuring News – Construction: October 2018

Restructuring News – Construction: October 2018

In this issue of KPMG’s Restructuring Services newsletter, we focus on the potential opportunities and headwinds in the construction sector.


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Construction workers looking at plans

This edition looks at the top headlines in the construction industry, including:

  • Construction output growth is being predominately lead by an unprecedented infrastructure boom on the eastern seaboard.
  • Residential building construction sub-sector continues slowdown.
  • Business investment is expected to continue to drive growth in the non-residential sector.
  • Margins are decreasing as input costs increase.
  • Increasing working capital needs, particularly for the smaller companies.
Chart 1: Australian construction sector breakdown over time

Uplift in construction led by infrastructure boom

Key points

  • Unprecedented infrastructure boom – the eastern seaboard is in the middle of an unprecedented infrastructure boom which is driving significant activity in the engineering sub-sector and supporting trade and supply chains. This is expected to increase in 2018 and beyond, underpinned by large transport projects such as the rail crossing removal (VIC), Westgate tunnel (VIC) and Sydney Metro – City and Southwest (NSW).
  • Tier one contractor constraints – the level of infrastructure projects is leading to concerns about the capacity of Tier 1 contractors and their supply chains to meet demand.
  • Not all construction companies will benefit – construction companies that don’t have exposure to infrastructure projects will find it challenging.
  • Recent volatility in the engineering sector – the engineering sector has trended favourably in the last three years, with extreme swings in recent quarters due to the one-off import of massive LNG components.
Building (residential and non-residential) and engineering output (YoY change)

Building and residential output

Key points

  • Residential construction slowdown – following the peak of residential building approvals two years ago, the residential building cycle is experiencing a downturn with the number of new houses built falling at the end of 2016. The growth rate of new other residential dwellings fell after last year’s highs in Queensland, NSW and Victoria.
  • Declining foreign investors impacting pre-sales – industry feedback suggests total residential building construction work will fall over within the next few years, as a decline in foreign investors hits pre-sales. The impact will particularly be felt in the 'mining states' of Western Australia, Queensland and Northern Territory, which have been further impacted by the decline of the mining industry over the past 5 years.
  • Increase in non-residential activity expected – business investment will drive activity in non-residential building activity (outside of mining) including commercial offices, retail and industrial buildings required to provide education, tourism, health and aged care and accommodation services.
Chart 3: Residential and non-residential building construction output (YoY change)
The slowdown in the residential building sector may be further impacted by the current Royal Commission inquiry on lending practices. Regulatory changes in this area will particularly hit builders who target urban sprawl developments, where homeowners are often able to borrow up to 95 percent of the value of the property.

The cost of doing business is increasing

Key points

  • Construction input costs have continued their steady rise – input costs increases are exceeding inflation. Rising energy costs are a key factor.
  • Increasing input costs are not being passed through in full and impacting margins – EBITDA margins of the top 100 Australian listed construction companies have deteriorated over the last 4 years, as a consequence of increased cost price pressures.
Construction sector input costs (indexed to 100)
Residential and non-residential building construction output (YoY change)
Companies experiencing low and/or decreasing operating margins are facing additional pressure with growing labour costs. Declining margins will increase pressure on longer term contracts, due to above-trend cost escalation over the duration of the job. Smaller companies who base prices on the historical cost of delivering similar jobs will be exposed.

Balance sheet strength: top performers vs. bottom performers

Balance sheet strength for top performers is likely to come at the expense of the bottom performers in the construction value chain.Provided the construction sector has an interrelated supply chain of materials and labour, the tactics of one will often impact another company up and down the value chain.

When comparing the payables (DPO) performance of the top 10 companies, to the receivables performance (DSO) of the bottom 10, it can be seen that an improving cash performance of the top companies may be causing cash and working capital pressures for those at the bottom. The differential in payables days for the top 10 and receivables days for the bottom 10 is now the widest it has been since 2013.

DPO Top 10 companies v DSO Bottom 10 companies
As the pipeline of residential building slows, cash flows will be squeezed as cash outflows are needed to finish off existing work and cash inflows from advanced payments slow.

Construction sector lessons and actions

In order to come out as a winner in the construction sector, we have outlined below lessons to learn and actions to take for all participants in the construction sector value chain.

Lessons to learn

  • Do not sacrifice margins by chasing additional revenue. Ensure business units and tendering teams are measured against profit, risk, and cash rather than revenue targets.
  • When tendering for future work, make sufficient provisions for the potential future volatility of input costs.
  • Avoid venturing outside your core business to seemingly more attractive sub-sectors where outside specialisms or understanding is required. This will impact your ability to deliver a project at a margin that adequately reflects the risk exposure.
  • Avoid accepting onerous projects risks where your clients are seeking an increased transfer of risk to the contractor.

Actions to take

  • Challenge your corporate strategy and ensure it is fit for the current economic climate. Ensure your strategy clearly focuses on competitive advantage, risk management and profitable growth, rather than pure revenue growth.
  • Identify and refresh tendering controls to ensure profit and risk remain within your strategic parameters.
  • Assess and refresh project control systems on an ongoing basis to ensure they are as simple and relevant as possible, and aligned with broader business strategy.
  • Conduct early independent reviews of potential problem contracts to gain an in-depth and realistic understanding of the potential range of costs to complete.
  • Invest in technology to assist with diagnostics, monitoring and real time reporting.

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