Ability to Grow, Shrink Quickly is Key to Contractors’ Survival
Managing Director Michael Correra recently authored an article entitled “Ability to Grow, Shrink Quickly is Key to Contractors’ Survival” that was published in the March 2015 edition of the Turnaround Management Association’s Journal of Corporate Renewal. The full text of the article can be read below or in the PDF here, and the complete issue of the Journal of Corporate Renewal is available here.
During most of the 2000s the North American construction industry has been in recovery mode. The new millennium began with the cogeneration power bust post-Enron, followed by the residential construction boom and bust, which led to the Great Recession, and now the oil bust. However, most distressed contractors find themselves in trouble less because of the macroeconomic environment and more because of overconfident and overzealous decision making. This latest round of distress fueled by the oil crisis, for example, will certainly reveal the contractors that bet the farm on the upside of the rollercoaster ride in oil field services and construction related to the fracking boom and now find themselves on the downside of that thrill ride.
Most failed contractors can point to one or two particular projects that led to their downfall. For the most part, the failure of these projects resulted from the contractor taking on more work than it could handle. The ability to expand or contract its operations easily is vital to a contractor’s survival. Large fixed-cost investments, aggressive or loose bid procedures, and overburdened and inexperienced project management can lead to catastrophe. In addition to its performance and safety record, the most important factors influencing a contractor’s success are flexibility, liquidity, and the ability to ride out the fluctuations in its workflow.
A review of the balance sheets of successful publically traded contractors reveals that most have very little leverage relative to other industries, are well-capitalized with equity, and show predominantly sizable churns of working capital. The contractor’s balance sheet and cost structure should be able to grow and shrink according to its backlog of work, which can be significantly volatile at times. Unlike companies in other industries, it is difficult to gauge a contractor’s financial stability based on financial metrics alone. The financial risk facing contractors cannot be measured solely by traditional leverage ratios like debt to EBITDA or debt to equity. In most instances, what may appear to be reasonable or even conservative levels of leverage for other industries may not apply at all to a contractor.
For one thing, the true liability of a contractor—completing the work it has been contracted to perform—is contingent and off balance sheet. In some cases, these contracts may be fixed price in nature or carry liquidated damages in the event of nonperformance. Every project is characterized by numerous moving parts that must be coordinated and executed precisely to achieve a successful outcome.
This leads to a second important point, which is that past EBITDA performance is not always the best proxy for a contractor’s future performance. In the world of construction, EBITDA is a function of estimates because of percentage of completion accounting. Therefore, yesterday’s EBITDA may just be tomorrow’s write-down. What does that mean? In accordance with GAAP, a contractor recognizes its revenue based on a percentage complete calculation. The percentage complete is multiplied by the contract value to derive the amount of revenue recognized at a certain point in time. As with all percentages, both a numerator and denominator are required. In this case the numerator is the actual cost incurred to date on a project, and the denominator is the estimated cost of the project from start to finish.
If the estimated cost to completion is too low, then the resulting percentage complete calculation will be too high. Therefore, the contractor would have previously recognized too much revenue. When the estimated cost at completion is adjusted upward to reflect known changes or impacts to the project, the revenue that was recognized previously is adjusted and a loss flows through the income statement, adversely affecting EBITDA.
One sign to look for is significant and quick growth in the “cost plus profit in excess of billings” account relative to other working capital accounts on the balance sheet. Also known in the industry as the “underbillings,” this account is where future losses may be hiding if too much revenue was recognized based on poor estimates. It’s not a given that all increases in underbillings are bad; rather, they are an indicator that further investigation is warranted.
In addition to the cloudiness of percentage complete accounting, a contractor’s EBITDA is based on previously executed projects that may have differed significantly in complexity from those in its current backlog. Every project is unique, with different project owners, designs, contract scope, labor, and other conditions, including weather. To the extent a contractor can mitigate these risks, it increases its chances to perform the work successfully and on budget.
For instance, successful contractors tend to rely on work from known customers, maintain consistent subcontractor relationships, or even stay within the same project size, scope, and geographic footprint. This doesn’t mean a contractor shouldn’t try to grow its business, but it should do so opportunistically and cautiously. Thoroughly evaluating talent, understanding risks, and expanding capabilities while retaining the ability to shed costs rapidly is prudent and advised.
Major derailments occur when a contractor takes on work of significantly broader scope and complexity, and with unknown or unproven teams. Significant investments to move capital and resources into new markets where a contractor has little experience is another major culprit behind contractor default and failure. Perhaps counterintuitively, it’s during the boom times in construction that contractors should be designing their turnaround plans. Although backlog and resulting revenues may fall during a downturn, savvy contractors recognize that real growth and market share improvement occur in down cycles. Well-capitalized contractors seize opportunities left behind by contractors that could not perform after sustaining losses as a result of unnecessary risk taking.
Bracing for Headwinds
Areas for consideration when preparing for a downturn include:
Prepare for the Inevitable.
Obviously, markets do not increase forever. Downturns are inevitable. A contractor should develop a response plan that can be enacted quickly when a significant market downturn occurs. This involves identifying individuals and teams that are critical to the long-term viability of the business and determining in advance how to best consolidate crew sizes and shed costs for underutilized labor quickly. Consistently evaluating the financial capabilities and management of the company’s subcontractor relationships is also important. It’s essential to know whether the subcontractors retained can also sustain a downturn. If concerns about any of them arise, the contractor should identify other subcontractors that can transition quickly.
If the business is asset-intensive, like that of a site development contractor, expanding its fleet by using its available revolving line of credit to purchase every front-end loader the company needs is not the best approach. Instead, long-term capital should be used to make long-term investments in assets that will likely be used even when work is at its lowest volumes and then rent everything else. That way, when it’s time to shrink, the contractor can shed the weight of that yellow iron and much of its cost as well. Renting may cost a little more when times are good, but the flexibility it provides will pay massive dividends in down times.
Determine Core Competency.
It is surprising how many contractors don’t know their core competency or choose to stray far afield from it. A good example is a contractor that is traditionally a specialty subcontractor but, lured by the prospect of higher profits, takes on the role of general contractor on a new project. Many mechanical contractors and electrical contractors alike have tried to make this jump with poor results. Just because a contractor knows how to execute projects well doesn’t mean that it can effectively manage multiple trades like a large general contractor does.
Instead, a contractor should identify what it excels at and the teams of employees that are critical to executing that core competency. It should avoid taking on work that is traditionally outside its core competency simply to try to make a quick buck or increased profit. Before branching out, a contractor must make sure it has the proper staffing and capabilities to handle a new job that is outside its traditional scope of work. If a downturn occurs, the contractor’s turnaround plan should involve quickly getting back to its core competency to ride out the cycle doing what it does best.
Maintain a Healthy Span of Control.
A contractor must understand the capabilities and limitations of its management and employees. There is only so much a person can handle. In an industry like construction, where attention to detail and timely decision making is required to bring a project in on time and within budget, overstretched resources can become a major liability.
As a contractor expands, placing excessive burdens on top performers is quite common. The contractor’s top performers should be identified and consistently relieved of unnecessary burdens. If no one else can do the additional work, then it’s not a good idea to take it on in the first place. It’s more important to have available and capable resources to perform.
An organization’s structure should be scalable so that it can retrench into a smaller and effective unit quickly. It’s all about people. Managers on staff should be evaluated to determine if they can operate in a leaner, more efficient environment.
Continuous improvement in the area of information technology is essential. However, a contractor shouldn’t get bogged down by major system rollouts. Having an effective process in place is more important. Quicker, easier systems can assist employees in improving their span of control.
The Test of Time
The old saying that what goes up must come down applies particularly well to the volatility inherent in the construction industry. The contractors that succeed endure the test of time, Mother Nature’s surprises, and the perils that can arise from their own exuberance while continuously planning and preparing for what may come next.
Being flexible and identifying business risks in advance of the next looming crisis are critical to a contractor’s survival, growth, and prosperity. Because contracting is a late-cycle industry, the indictors tend to be everywhere. The next round of economic volatility will undoubtedly identify its share of contractors that didn’t plan ahead and heed the signs.