As Kier’s annual results prove naysayers wrong and the firm lays out plans to improve cash flow, Hamish Champ reports on why contractors’ debt levels have risen recently and asks if debt is as big a problem as it seems
When Kier published its annual results last month, many expected the worst. Some had already taken a punt that the contractor was in deep trouble, by shorting its shares in anticipation of bad news and taking the chance to make a financial killing. In the end, the company calmed market nerves with its numbers, showing a 5% jump in turnover to £4.5bn and a 9% rise in pre-tax profit to £137m. While it admitted a 17% increase in year-end net debt to £375m, the firm offered enough in the way of assurances on how it would reduce this over the next two years to ease the pressure on chief executive Haydn Mursell and his colleagues. The shorters have mostly drifted off.
Concerns around Kier may have abated but issues around the way contractors operate remain. They are often heavily indebted, operating in volatile and competitive markets on wafer-thin margins.
Companies working in the public sector are expected to deliver projects to a high standard, on time and within budget against a backdrop of government spending still being ruthlessly cut back in pursuit of balancing the nation’s books. The flow of government money was not always so sluggish. A decade ago, lured by decent margins for a raft of public sector projects, a number of firms – Carillion being an obvious example – took advantage of historically cheap capital and piled into facilities management operations, some bolting on lucrative activity through acquisitions paid for with borrowed money.
Average net debt has risen […] but many failures can actually be attributed to poor working capital management, contract performance visibility and inappropriate maintenance of cash or liquidity buffers
Michael McCartney, EY
But times – and the economy – have changed. A decade on from the financial crisis, life is considerably tougher for many, including the contracting sector. Facilities management activity is nowhere near the profit-bearing beast it once was, thanks in part to government driving a harder bargain at the contract negotiation stage. Since funding for work has been scaled back, competition has become fierce, driving down pricing. Then there is the shadow of Brexit, with its unknown consequences beginning to slow deals.
So, what next for firms battling to reduce their debt while margins languish and government departments’ spending powers are still shackled by the nation’s own debts of £1.8tn? Is contractor debt the real villain of the piece or just one of numerous problems to hit the sector? Can the sector avoid being struck by another collapse like Carillion’s and is there any light at the end of the tunnel for contractors desperate to start making some decent money again?
Fears of Kier going the same way as Carillion may have ebbed, but the sector as a whole is still viewed as a concern. As economist Martin Hewes of Hewes Associates notes: “Everyone is on edge about the possibility of another collapse.”
Contractors are aware of how emotive the issue of debt can be, and in order to put an end to the bad headlines there is a noticeable push to tackle the problem. Balfour Beatty, now the country’s largest contractor, has made headway on its net debt, reporting earlier this year it had more than halved to £73m. And Kier’s own debt-reducing tactics – driven primarily through its “future-proofing” plans, which promise better cash flow and some small disposals – are, according to chief executive Mursell, expected to achieve its goal of average net debt of £250m by the end of its 2021 financial year.
But Kier and many other contractors have come in for criticism for a particularly sensitive type of debt: the money they owe suppliers. Rudi Klein, chief executive of the Specialist Engineering Contractors’ Group, takes a dim view of supply chain finance schemes operated by many main contractors. He says: “[Contractors] can’t go in low and beat up the supply chain to bail out their finances.” However, last month Kier’s Mursell defended the use of supply chain finance, which enables suppliers who pay a fee to Kier’s banks to be paid in 21 days rather than be subject to the usual 60-day payment terms. He maintains that the finance scheme is popular among suppliers, although the company has said it is looking to reduce its current £185m of supply chain debt to £150m-£170m.
Debt is relative
Michael McCartney, a capital and advisory director at financial services firm EY, says rising debt levels are an issue for contractors (see “How the debt piled up”, above). This is because if cash or available liquidity is not maintained at a sensible proportion to a firm’s overall scale, the company may be more susceptible to failure. He says: “Average net debt has risen across the sector in recent years, accommodated by lower debt funding costs, but many failures can actually be attributed to poor working capital management, contract performance visibility and inappropriate maintenance of cash or liquidity buffers.”
“When margins on public sector contracts get squeezed, companies try to become more efficient. But there is only so much firms can do”
Martin Hewes, Hewes Associates
And debt of itself need not be a huge concern. “It’s all relative,” says Tony Williams, chief executive at research firm Building Value, pointing out that firms can protect themselves by making sure they have the means to service the debt, and as a last resort can sell any decent assets they have behind them. Kier, for example, has its profitable housebuilding arm, which recently reported a 14% rise in annual operating profit to £26m on turnover of £374m. In any case, Kier says its recovery plan will address its debt levels and it has no intention of selling this part of the business.
The biggest problem for main contractors, according to McCartney, is onerous contracts. “The vast majority of firms can take on debt responsibly, but when it comes to underlying contracts there is widespread acknowledgment of risk exposure being skewed significantly towards contractors, many of whom have been operating on wafer-thin profit margins,” he says.
“It will be interesting to see how the government’s procurement regime evolves going forward, to ensure risk-reward balances remain sustainable in the long term while still delivering value for money for the taxpayer.”
Cenkos’ Kevin Cammack agrees that debt is only part of the problem and says the risk lies in contractors taking on more work with ultra-competitive bids in order to generate higher cash flows. And Building Value’s Williams also makes the point that when the trading environment shifts and a key job goes wrong, things can change for the worse very quickly: “It only takes one howler to bring the whole thing down.”
Pressure from spending cuts
Of course, contractors’ uphill battles to turn a profit and control debt levels are a reflection of the economic times. “Austerity has been the main problem. When margins on public sector contracts get squeezed, companies try to become more efficient. But there is only so much firms can do. Client spending is key and [in the case of public sector work] the client is broke,” says Hewes.
While some contractors report seeing parts of the public sector increasing investment – Kier highlights a 3.4% increase in NHS spending, which it believes will provide “a pipeline of opportunities” – the government has been reducing spend across the board. Public sector construction work made up just over 10% of all new construction work in 2017 but across the year it fell sharply, down 14% on 2016, according to the Office for National Statistics.
And with a period of uncertainty ahead, in part driven by Brexit, customers in much of the private sector are more cautious than ever. Commercial construction in 2017 was a quarter of all work last year, but that was down by 8% on the previous year.
Major infrastructure is the great hope for many contractors. Experian’s latest data (see page 46) shows output in Q2 of 2018 is up 5% on the period the previous year. Yet there appears to have been a wobble in August, according to IHS Markit/CIPS Construction PMI – with civil engineering work down for the first time in five months because of a slowdown in infrastructure projects.
So, what is the solution? Many industry leaders highlight procurement as an area in which positive changes can be made. Ann Bentley’s CLC report Procuring Value stated that the industry could save £15bn a year by overhauling procurement, requiring clients to move away from defining value as lowest price.
Some contractors have already taken action – earlier this year Balfour Beatty announced its regional construction business was going after fewer fixed-price contracts and had grown the number of target cost contracts and framework agreements it was getting involved with. It noted these required early contractor dealings with a customer “to ensure greater clarity around scope, schedule and cost which, in combination, reduces delivery risk for all parties”.
Clients can do their bit too, SEC Group’s Klein says, by giving some assurance that the job a company is taking on will at least be profitable, while firms need to be realistic with pricing, so be prepared to walk away from unprofitable work. Klein is also supportive of insurance-backed alliances, also know as integrated project insurance – which was the approach taken on a new-build project at Dudley College in the West Midlands. This type of approach offers all-risk insurance for contractors with defects liability, as well as covering cost overruns, and means margins are secured for the participating firms.
Robust business planning is also essential, not least taking into account potential cost increases such as on wages and material. Industry sources say some contractors previously underestimated national living wage increases – the advice is that firms resist the temptation to make positive assumptions in their business planning.
And insiders say contractors are tightening up on risk management, with financial officers having a greater influence on the jobs they decide to bid for. At the same time, contractors are introducing better governance, and in some cases bringing in independent advisers to sit on their risk committees. So with more controls in place, contractors are developing more sophisticated business practices.
Productivity is another area with the potential for contractors to make great gains, with offsite manufacturing and automation are held up as the big game-changers. Contractors are already delivering offsite to an extent – offsite fit-out is a clear example, with the likes of Wates producing fully fitted bathroom pods for their residential schemes. But investment is needed to introduce modern methods at scale, and at present tier-one contractors’ investment in research and development lags way behind other sectors.
In this post-Carillion era, contractors’ debt piles are bound to cause concern, but the big challenge for these firms is not only balancing the books, it is coming up with strategies to innovate their way to profitable growth. Crack that and their debt worries could become a distant memory.
How the debt piled up
Years of very low interest rates have allowed contractors to avail themselves of cheap borrowing to help them get into new markets while times were good – and, recently, to navigate more challenging market conditions.
But as EY’s Debt Reconstructed report in 2016 pointed out, such access to liquidity has served only to fuel net debt levels across the industry – net debt referring to when a firm’s balance sheet shows borrowings are more than its cash. The report highlights how this manifested itself through a hefty increase in total credit facilities. In 2015, the latest year for which figures are available, total disclosed facilities were 10.5 times combined net income for the UK’s top 10 contractors – a huge figure – up from 6.5 times in 2009.
And it is not just the level of borrowing that raises eyebrows – it is where the money comes from. Financial experts point out privately that while contractors have been taking on debt, domestic banks, although still active, have grown increasingly cautious. So some contractors have gone overseas, notably to lenders in the US, as well as going for private placement notes – where a form of debt is “sold” directly to an investor – which carries a higher rate of interest.
Most industry observers agree that while Carillion’s cash position was parlous when it folded – it went into liquidation with a mere £29m in the bank while net debt had soared in the summer before its collapse to £695m – much of the reason for its demise was to do with the type of contracts it took on and, arguably, the quality of decisions made by its senior managers.