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  • UK construction: consolidation aheadCounterparty risk

  • UK construction:consolidation aheadCounterparty risk

    In this report

    p2Executive summary

    UK construction: consolidation ahead

    p8Construction risks pose a threat to government, real estate and infrastructure investors

    p4The UK construction industry

    p10What can counterparties to the construction industry do to mitigate these risks today?

  • UK construction: consolidation ahead

    p12Change is on the way consolidation is likely

    p16Conclusion: We see a dramatically different industry by 2020

  • Executive summaryThe current economic tail wind and more certain project pipeline including significant opportunities in areas such as infrastructure and house building should provide a backdrop in which the UK construction industry thrives. This is not, however, the case.

    UK construction: consolidation ahead

  • Industry structure and company-specific challenges remain a barrier to a more operationally and financially robust construction sector. The top 25 UK construction companies turned over 42b last year and delivered an earnings before interest, tax, depreciation and amortization (EBITDA) margin of 2.6%.1 In contrast, Europes top 10 operators turned over 132b and recorded an EBITDA margin of 8.4%. Return on invested capital (RoIL)for the UK organisations totalled 0.4% in 2014 with only 3 of 25 participants exceeding 5%. The sector remains handicapped by risk across the contract life cycle, weak portfolio management, poor cash management, margin pressure and flawed structures and procedures.

    A weak construction industry poses significant risk to the major counterparties to the sector, including government, real estate and infrastructure owners and investors. Cost escalation and, more importantly, contractor risk are growing concerns. These entities need to incorporate market, stakeholder, operational and capital key performance indicators (KPIs) into their ongoing due diligence procedures.

    Without change, these issues will likely be accentuated in coming years as the project pipeline continues to grow for an industry that is ill-equipped to handle the increased workflow.

    By 2020, we believe the construction industry will, however, change. We see significant consolidation ahead. This should be led by the handful of high-quality operators that exist today but may be initiated by interest from overseas. Entities from Southeast Asia, Sovereign Wealth Funds or continental European operators are all likely to be interested parties. The result will be a very different industry, one that we believe could contain as few as five leading players, each with revenue in excess of 5b return on invested capital (RoIC), of 5%+ and a likely 50m minimum project threshold.

    For counterparties to the sector this consolidation will almost certainly reduce the risk associated with construction. This is likely to come at a financial cost. It may, however, be a financial cost worth bearing if it reduces the downside risks associated with projects running into difficulty. Ultimately, a construction sector that is both financially and operationally stronger will be of benefit to all.

    1Source: company accounts analysed by EY

    42bTop 25 UKconstruction companies turnover 2014

    132bTop 10 Europeconstruction companies turnover 2014

    5brevenue each,from five leading players

    In excess of

    3UK construction: consolidation ahead

  • 1.The UK Construction industry

    4 UK construction: consolidation ahead

  • Construction sector still under severe pressure

    Industry structure remains a barrier

    Construction businesses are the sum of current contracts. Their profitability should be relatively immune to market cycles if contracts are appropriately priced and delivered. The health of the broader economy should then act as a multiplier in periods of growth.

    The current economic tail wind and more certain forward order book including significant opportunities in areas such as infrastructure and house building should provide a backdrop in which the UK construction industry thrives.

    This is not, however, materialising. The industry remains under severe pressure. Rising costs are well documented but we believe the problems extend further and are a combination of industry and company-level issues.

    There are 41 UK construction companies that individually turn over in excess of 250m. Of this group, 15 companies turn over more than 1b. Below that, there are 56 entities turning over between 50m and 250m. The industry structure creates a highly competitive bidding process. In the extreme, projects are won on zero-margin terms with an expectation of profiting from add-ons. This may or may not materialise, potentially putting these contracts at risk.

    UK construction industry

    top 1002

    26bTotal revenue (1.7b avg)

  • Company challenges are yet to be resolved

    Financial results continue to be disappointing

    Construction companies remain handicapped by inefficient supply chains and flawed internal management structures. These issues are accentuated by outdated and inadequate IT systems. We see five prevailing challenges.

    Risk across the contract life cycle

    Portfolio management

    Cash management

    Margin pressure

    Front- and back-office structures and procedures

    The result is supply chain failures and business structures that are incapable of providing adequate insight to management around project performance and risk appraisal. While management has been successful at maintaining total revenue in recent years (winning new contracts), without adequate project-level visibility at a central level, businesses continue to be at risk of a handful of failed projects eroding cumulative gains elsewhere. The potential for fraud also remains a real threat.

    Cost pressures are accentuating the problem. Contractors, SMEs and civil engineers all report increasing cost pressures, which are squeezing margins. Labour cost is a particular burden, rising 25% in the last 10 years.3

    The impact is being seen in financial results. In 2014, the top 25 UK construction companies turned over 42b for an EBITDA margin of 2.6% and a combined profit before tax of 437m (1.0% of turnover). In comparison, the 10 largest European construction companies turned over 132b and delivered a combined EBITDA margin of 8.4%.

    Selling, general and administrative (SG&A) costs as a percentage of revenue for the top 20 UK operators improved in FY14 to 6.3%. The ratio improvement was, however, driven more by turnover growth than cost reductions. Absolute costs, for companies where comparable information is available, declined just 3% in FY14. An SG&A ratio for the industry of more than 6% is, in our opinion, still too high.

    RoIC for the UK industry totalled just 0.4% in 2014. Only three organisations achieved returns in excess of 5%. This mirrors the longer-term trend; the listed construction sector has not produced an annual RoIC in excess of 3.5% in the last 10 years.

    The UK construction industry

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    3 Source: Labour costs per hour www.ons.gov.uk

    6 UK construction: consolidation ahead

  • UK construction companies: key financial metrics

    A number of very strong businesses exist, as the chart below highlights. These organisations provide an operational and organisational template for the industry. Furthermore, we see that many of the issues holding back weaker performers are relatively easy to resolve.

    Antiquated processes around setting up new contracts, for example, create layers of overhead that industry participants have yet to eliminate. A solution to this is implementing organisation-wide processes and controls, supported by IT systems capable of delivering real-time insight management teams.

    123456789

    101112131415161718

    Net working capital as a % of revenue

    Relative to averageFinancial metrics of the top 18 construction companies by revenue, relative to the average4

    SG&A costs as a % of revenue

    RoIC EBITDA marginCompany Rank

    Average -6.8 7.1 1.2 3.3

    4Source: EY

    7UK construction: consolidation ahead

  • The current condition of many UK construction companies presents a risk that extends beyond the construction industry. We see significant counterparty risk to a wide range of organisations, from government and local authorities

    to real estate and infrastructure owners and investors. This will likely be accentuated in coming years as the project pipeline continues to grow for an industry that is ill-equipped to handle the increased workflow.

    2.Construction risks pose a threat to government, real estate and infrastructure investors

    8 UK construction: consolidation ahead

  • Cost escalation

    Contractor risk

    Rising costs, particularly around labour, are a well-documented and valid challenge. The fragmented nature of the construction industry allows investors to lock in favourable terms up front, but bulging order books, staffing challenges and, to a lesser extent the cost of raw materials result in cost and also time overruns being a very real threat.

    Both cost and time overruns potentially have material consequences for commercial projects. This is either through eroding returns via additional expenditure or delivering schemes too late into the industry cycle.

    We believe the structural change that we see transforming the construction industry will help resolve this (see section 4). Fewer companies, with better operating structures and more pricing power will reduce the need to underbid