Many factors, including the weather, conspiring against construction recovery

Many factors, including the weather, conspiring against construction recovery
Jason PrestonOctober 30, 2012

A range of well-documented external factors have put the construction industry in Australia under enormous pressure: falling building approvals; lower private sector investment; high competition driving down margins; the end of the Australian government’s stimulus package; even the La Niña weather patterns in 2010-11 – all have conspired against recovery in the construction sector after the GFC.

Construction companies have been able to absorb the hits until now, calling on reserves squirreled away on more profitable projects.  In better times, losses on some projects have been able to be offset by gains on others.  For many firms, however, the buffer has been exhausted and every piece of bad news now falls straight to the bottom line.

With traditional sources of work drying up, the light that attracts attention continues to be the mining and resources sector, with a perceived insatiable demand for development at much higher margins.  However, servicing this sector is not without its own risks and often requires significant forward investment and development of relationships to get into a competing position. In Australia, increasing demand for large mining and infrastructure projects has resulted in companies placing single or joint bids for very large design and construction contracts.

Here are some insights from our recent engagements in the sector:

Five signs of distress

Many issues rise to the surface in times of distress.  Listed below are some recent themes we’ve encountered:

 1. Slow collection of variations and claims

Management’s ability to progressively negotiate and collect variations and claims as they arise is a fair indication of their general project management skills and focus on cash management.

In situations where variations are left unapproved or allowed to accrue until the end of a project, our experience is that amounts become difficult to collect.  The builder often has limited leverage at this point as the job is complete and legal recovery avenues are often unattractive, particularly with the lure of more work from that customer.

2. Under bidding and rubbery accounting

Bidding for a job on a low margin in the hope that additional profits will be made from subsequent variation work is dangerous practice during a market downturn.  Not only does it make it harder for management to know the true position of the business, but it can also put pressure on project managers to consider window dressing the profit, either by drawing profits into earlier periods, or by bringing revenues from variations to account well before they satisfy the required accounting definitions.  Accuracy of the bidding process is key. If the bidding and estimating process is flawed or inaccurate, projects may be accepted that will result in a loss being made even without any problems (which are almost inevitable) with the execution of the project itself.

If revenue is being recognised on variations that have not been submitted, acknowledged, accepted as valid with a clear indication of payment, then it is unlikely to satisfy the accounting standards and any associated profit should technically be written back.  This appears widely misunderstood.

3. Poor, or non-existent, cashflow forecasting

Many businesses in this sector, including ASX-listed companies, claim that the nature of construction projects makes cashflow forecasting too difficult and therefore of no use.  The attitude is often that “the project is profitable so we just need to finish the job and cash will flow”.  However, projects can be very working capital intensive and if the cash isn’t there to pay subcontractors, progress slows making collections difficult – the start of a negative cash spiral.

The absence of cashflow forecasting by project means that management is unable to effectively forecast the cash requirements of the business.  A simple phasing of expected profit is often insufficient, particularly if based on expected progress on the job rather than cashflows, which are usually materially different.

Management of advance payments is key to ensure that positive cashflow projects are not funding projects that are a cash drain, to the extent that this eventually negatively impacts the stronger performing projects.

Failure of profit to translate into cash implies a working capital issue: either delays in debtor receipts or tightening of creditor terms.  Any negative press can quickly exacerbate this position.  It also can be an indicator that the builder is inflating project profit by booking unapproved variations or contractual claims, or that the client is unhappy with the work.

4. Declining work in hand

Work in hand is a metric commonly quoted by construction companies to demonstrate future revenue secured by the volume of work ahead, and therefore the viability of the business going forward.  However, there is no defined method of calculating this number and it is therefore open to a very broad interpretation depending on the desired outcome.  Do you only include new and existing contracted work?  What about a signed letter of intent?  Verbal agreements?  How should annuity revenues be reflected?  The results can greatly change the picture presented externally.

A better test is whether new work won in a month exceeds monthly billings.  In the current challenging environment the answer will often be “no”, which may indicate that market share is falling, business development is lacking, or the business is trying to enter a new market (e.g. mining).  A falling order book can add pressure to reduce margins to secure new work leading to the dangers mentioned above.

5. Large project risk

Large infrastructure and mining projects may impose a level of risk disproportionate to the size of the company’s balance sheet, particularly if the project takes on design and construction risk at a fixed or guaranteed maximum price, or has potentially large liquidated damages exposure.  Hence, any problems on a single project can have a large impact on the company’s results.  Riskier still are large projects in new regions, industries or type of construction.  Businesses are used to contracts being off budget by 10% to 20% (or more) because across a portfolio it often evens out; but as projects get bigger and more complex, that variation can swamp the company entirely.

This risk can be mitigated by entering into a lower risk contract such as cost plus, or schedule of rates, or via alternative structures that do not expose the group.  Alternatively, adequate corporate governance and visibility at board level commensurate to the risk involved is key.

 


Case studies

A selection of our recent assignments in the construction industry are noted below:

Hastie Group Limited

Hastie is a large ASX-listed construction services company that failed to recover after the GFC as margin erosion, losses from international operations (principally in the Middle East and Ireland) and poor accounting practices all combined to trigger large profit downgrades and an immediate requirement to restructure its banking facilities.

On behalf of the banking syndicate, we undertook detailed independent business reviews across the business, including some detailed on site reviews of project cashflows in the Middle East, to support a restructure of the group’s facilities.  Our investigations uncovered significant flaws in project accounting practices and historical profitability.

Further profit downgrades and a lack of new work won, combined with allegations of fraud, resulted in the group entering voluntary administration on May 27, 2012, and McGrathNicol appointed receivers and managers of selected group entities.

Reed Constructions Australia

Reed is one of Australia’s best known private construction companies. We undertook an independent business review for the secured lender of the Reed Group, which indicated that the company was overly reliant on the collection of large, unapproved variations and an expansion into an unproven mining services sector.  A lack of cashflow forecasting left the group unable to respond to a cash shortage when receipts failed to materialise.

Our recommendations in relation to the group’s working capital and cash forecasting assisted management in working within its existing limits, however subsequent failed negotiations with external parties resulted in the main construction entity being placed in voluntary administration on June 15, 2012.

Project Block

An ASX-listed company with significant overseas interests directly engaged McGrathNicol in 2010 and 2012 to investigate ongoing cash funding requirements from these international locations, which were a significant drain to the Australian business.

Following time spent with local management in the international offices we were able to identify a fundamental flaw in the cashflow forecasting process and provide an independent view of each project and likely future receipts.  Australian management has been able to make changes in strategy to manage these risks appropriately going forward.

Project Balmain

As advisers to a banking syndicate of two 50MW multi fuel co-generation power and steam plants under construction, we were able to facilitate a restructure of the project’s debt package and, following the insolvency of the lead contractor due to material cost overruns, assist in negotiating terms with a new sub-contractor and putting in place a funding structure to complete the project.

Jason Preston and Jason Ireland are both partners at boutique advisory firm McGrath Nicol.

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