Alan Johnston of CreditWorks talks about construction industry debt in 2017.
What are the main influencers of construction industry debt?
Hardware / construction industry debt levels are based on two main factors:
- Volume of sales made on credit, and;
- Regularity of payment for those sales.
while patterns of payment (payment profiles) (DSO) tend to be cyclical.
In that case when are the lowest periods of debt during the year?
The best payment profiles occur during the middle months of the calendar year, when attention (and money) is not diverted to the same extent, as it is between November to March. During the latter period, ‘distractions’ such as staff & customer holidays, Xmas spending, GST, and Withholding Tax all contribute to extended debt levels during this time.
How is the current building boom affecting these cycles?
2016 was no different with regard to the payment profile, however they were based on much higher debt levels than in previous years.
We all know that the country is in the midst of the biggest building boom we have experienced in modern times. The construction sector now makes up 10% of our GDP. As such, the level of capital required to commence and complete the many projects – both commercial and residential – is enormous.
And how does this influence or increase risk?
It is a well-known fact that one of the main causes of business failure is not due to a lack of work, but due to a lack of working capital – the inability to re-capitalise results in a “grow too big too soon” scenario, eventually ending in tears in most instances.
How can these risks be reduced?
Some lessons have been learnt from previous boom / bust cycles (1992 & 2008 spring to mind) where banks were heavily burnt due to over-lending to developers and consumers. Now they have rigid rules around the maximum levels of exposure in the various construction sectors, and this is impacting on developers and others when it comes to borrowing for these jobs. Not only that, but I have been told that most banks now employ their own QS’s to assess job costings, and particularly cost to complete situations, whereas in the past they may have relied on the costings submitted by the QS of the developer. Inevitably the banks QS will factor in a cost overrun and variation component when coming up with the final cost, which-while more realistic- does not do the developer who is seeking job funding any favours.
That’s the banks. What about the contractors themselves?
It is known that many contractors tender for jobs at very low margins-or in one instance I know of, no margin, to win the work. This leaves little or no room to move when costs escalate, and remedial work is required. As such the product providers, and sub-contractors are inevitably called upon to ‘sharpen their pencils’ and through cutthroat pricing and rebates, provide what little profit can be extracted from the job. They also inevitably end up hanging out for payment, at terms that are far from acceptable or agreed upon at the time the credit application, or sub-contractor agreement, is signed.
So what does the future look like? What’s your prediction?
As a lead in to my predictions, it pays to note that there have been over 150 construction company failures in the Canterbury region alone, since the start of 2016.
As we know, Auckland construction is booming like there is no tomorrow. Peripheral areas such as the Waikato and Bay of Plenty are experiencing construction growth at unprecedented levels. Wellington is active-particularly in the Earthquake damaged areas, and Canterbury -while coming off the boil in the residential sector – still has a lot of commercial development going on.
But the question has to be asked. Where is the money to pay for the developments going to come from, bearing in mind the factors outlined above? A lot of the builds are private developments, and not government funded. Even those that are, will need to have sufficient funds in their kitty to get them through to the progress and completion payments stage.
On top of this, there is one more HUGE factor that will impact on cash flow as from 1 April this year;
Retentions. As from 1 April, all retention monies must be held “in trust” in the form of liquid assets until due to be paid out. A breach of this trust requirement will have severe ramifications for directors who fail to put this money or asset aside. But given that, traditionally, these monies have been utilised in the business, and form a critical working capital component, there must be concern that come April 1, between 3 to 5% of all development costs (approx. $600M in today’s market) will need to be held in trust and effectively on call at all times. If this money has to be borrowed – and in most instances it will – then conservatively this will add another $30M in interest, and ultimately build, costs to the developers / contractors.
In summary: The buoyant construction times eventually must wind down. When they do, there will be a concerning aftermath, as Christchurch can attest to. At least while the construction market is busy, there is the ability to draw on funds from other jobs to keep the projects alive, and there is always the next job. While relying on future income to pay past debt is inevitably a slow death, nevertheless it does paper over cracks in a company’s finances in the short term.
Suppliers in the Hardware channel can expect to be further challenged on pricing, as they will on rebates. Suppliers can also expect to be pressured for extended payment terms, on the promise of volume business, albeit at low margin.
The sight of many cranes on the horizon doesn’t necessarily equate to greater cash flow or profit. Suppliers must be very aware of the dangers of operating in this market, contrasted against the lure of record sales.
Again the old adage: It aint profit till its paid for must come to the fore and this should be the catch cry for suppliers in the months to come. When will we see it? Hard to say, however I anticipate that DSO’s will start to climb before the end of the calendar year, and most certainly we will see an increase in debt levels during this time due to slowing payments and the supplier becoming the quasi-funder for these developments.
And amongst it all is an election, the outcome of which may change the whole building landscape from 4th September onwards….