“A House of Cards based on cashflow”
The vertical commercial construction industry is at a precipice. In less than 6 weeks that precipice will crumble and there will be very few, if any locally based larger national main contractors not in receivership or liquidation. Even the most iconic brands are at risk. A very senior figure in construction has described the industry as nothing more than “a house of cards based on cashflow”. Today, Naylor Love CEO Rick Herd reinforced that sentiment by releasing a statement asking for government intervention saying the problem is that vertical construction is low margin and high cashflow. He claimed that many small to medium sized companies are at a high risk of collapse without Government support. However the biggest insolvency risk is to the thinly capitalized largest main contractors. The writer is aware that today startling information prepared by a senior group in the construction sector, was circulated around Government showing the devastating effect of the shutdown. In summary, a larger main contractor turning over $15 million per month would go from earning $600,000 per month margin (ie 4 % net margin which is desirable but rare) to losing $3.9 million per month. The figures allow for the wage subsidy and paying staff at 80%. There are a number of larger main contractors whose turnover is double, triple and even quadruple this $15 million per month, and consequently will have the same proportional devastation in red ink. Naylor Love as one example are reported to have turnover in excess of $700 million nationally.
The essential problem is that the majority of larger construction firms have very little assets or balance sheet strength, often on the advice of their accountants. There is zero probability that the majority of firms turning over $15 million per month have a spare $3.9 million in cash. Resilience is non-existent, and insolvency is not far behind. To put this into perspective, larger main contractors celebrate when they can achieve 2 % EBITDA for the year, let alone 4 %.
So why is this a big problem? Because at 2 % EBITDA ($3.6M on $180M turnover) the 4-week shutdown will consume more than the entire margin for a year. If the shutdown is 8 weeks – its 2 years of margin, ie $ almost $8 million that has gone forever: negative cashflow, insolvency and ruin beckon for many.
Adding another layer of stress to the situation, as a result of the judgement against the Mainzeal directors, directors are acutely aware of their personal liability should they allow their company to trade while insolvent, and if the company is insolvent they have no option but to call in the receivers.
Razor thin capitalization is the principal reason that margins remain low in the industry – because the only way firms can achieve an adequate return on capital invested is to minimize the capital invested and maximize the revenue. The effect of this is firms with little or no cash reserves or assets performing projects of $50 million, $100 million and more. The evidence is all around. Myopic project managers and quantity surveyors then advise clients that anyone wanting a return in excess of 3 % is price gouging.
Contractors with more assets, liquidity and balance sheet strength who consequently require a better return are – were – at a significant disadvantage. Contrary to the claims of Mr Herd, a higher proportion of the small to medium companies are better capitalized and generally more conservatively managed than the larger Tier 1 and 2 firms, and will better withstand the shutdown.
However, there is a solution to the impending devastation, and it is simple. Clients and their advisers on major projects must step up and honour their contractual obligations to pay main contractors their delay costs when contracts have been suspended due to the shutdown. This would enable a number of the contractors to at least survive. Most if not all standard forms of contract have terms similar to NZS 3910, the most widely used form of contract which at Section 6.7.1 states “ If the suspension of …the Contract Works becomes necessary, the Engineer shall instruct the Contractor … to suspend the progress.. of the Contract Works”.
It further states that all costs due to the suspension of the work are to be paid to the Contractor by the Principal, by treating the suspension as a variation. This might seem odd or even unfair to the layperson, but as a veteran of many similar disputes, I can absolutely confirm that this is the case. A future article will explore this further.
It is a sad indictment on the ethics of project managers, engineers, and even Crown departments and local bodies, including the Christchurch City Council, who have either not responded, written to contractors refusing to suspend the work or saying before they instruct the suspension of the contract works they want to “negotiate”. In the current climate it is more than sad – it is despicable. If more major contractors collapse, the effect not only on their staff but already severely stressed subcontractors and suppliers will mean financial ruin for many, and no doubt mental health problems and suicides will also result.
Major clients of the construction industry, and especially Crown and local bodies must heed this message: now is not the time to call in the lawyers to delay, deny and defend indefensible positions. Clients must look at the bigger picture – the entire viability of the upper end of the sector is in doubt, thousands of livelihoods are at risk, and it is far better to pay some hundreds of thousands now in legitimate delay costs than have a very high risk of contractor insolvency and consequent massive increases in cost bringing in other resources to finish the project. Recent history is littered with such examples where main contractor insolvencies during construction have caused massive increases in final project costs to clients.
There is no doubt that incompetence and mismanagement cuts a wide swathe through the industry, but now is not the time to focus on that. The commercial construction industry is at risk. Listen to Jacinda – if you can’t be kind, at least do the right thing. It’s in your own interests.