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November 2008 >>
Executive Insights: Analysis and Advice from Surety Industry Leaders
Terry Lukow
Executive Vice President
Travelers Bond, Construction Services
When it comes to maintaining profit margins, the simple answer is to bid the job, not the competition. Too many contractors do not think about their market from a long-term perspective. Many firms load up on cheap work during poor economic cycles and, when the cycle improves, are not prepared to take advantage of a more robust construction environment because they have a backlog of marginally profitable work.
The most important resources a construction organization has are its human resources. All organizations have star performers and ones who are not yet at that level. The current economic environment will allow well-managed organizations to address marginal performers while retaining star performers. These employees consistently perform for organizations in good times and bad times.
The financial sector of the U.S. economy is going through major change and correction. Credit is a precious commodity in today’s business world. Contractors risk putting control in the hands of third parties that may be unfamiliar with the construction industry. Bottom-line liquidity provides organizations with more flexibility during challenging economic times to capitalize on market opportunities. Heavily leveraged companies have few opportunities when market conditions worsen. They have to take work at reduced margins to create the cash needed to service debt, which creates a vicious cycle.
Tim Mikolajewski
President
LibertyMutual Surety
The broad credit crisis is rapidly restructuring the American and global economic landscape. With mounting credit losses, many key banks and insurance companies have either failed or required a federal government bailout. As banks reduce lending and investors hold back investments in new ventures, commercial construction is grinding to a halt. In the public construction sector, the growing federal borrowing has increased borrowing costs for state and local governments, thereby reducing monies for schools, road improvements and other projects. While many contractors benefited from strong backlogs built up over the past several years, the accelerating reduction in new work is tipping construction into a down construction cycle.
To survive in this environment, contractors need to refine their business plans and be prepared to streamline operations without sacrificing their future. Outperforming the competition requires focused financial and overall management, smart estimating and bidding, and the commitment and retention of key people. Stronger contractors, who maintained liquidity and unleveraged net worth in the recent construction boom, will be better prepared to adjust to potentially reduced backlogs and profit margins. Less liquid and leveraged contractors will certainly face increased pressures to reduce expenses and generate volume to cover overhead. Well-managed contractors will avoid unnecessary risk, such as traveling out of known territories to bid work or experimenting with non-core construction disciplines.
With more bidders per project, contractors need to estimate well and know when to pass on a project. Bidding fewer jobs better may produce more profitable backlogs than widespread bidding.
As good people make a good business great, retaining talent is highly important. Maintaining the core operational team is critical to managing the downturn and being well positioned for the recovery.
Change is coming, and now is the time to reevaluate operations and adapt to the new construction environment. The vast majority of contractors are smart, well-disciplined builders and business managers. While some contractors will suffer, most are better positioned than in prior construction downturns to weather the coming change and survive for the long term.
Harry C. Crowell
Chairman of the Board
The Insco Dico Group
Having been a contractor for more than 50 years, this is not the first time I have been involved in a slowdown. To stay in business in rough times, I have applied various tactics, including taking jobs at cost (or less) while keeping crews intact and ready for the upturn. More than once, the slowdown was short and our crews were ready when the increase in new business occurred, but we were short on operating capital. That caused new expenses in acquiring capital to operate at our previous quantity. I learned to be more cautious in taking jobs at cost because there always must be profit in a job to take care of unexpected incidentals. After several of these experiences, I found it better to bid all jobs at a true price to ensure I could properly reward employees.
Whether to cut staff and how to retain key talent are critical decisions. Communication with key personnel, the surety and the bank is a necessity. Every contractor has indispensable employees, and these key staff should be the first people with whom the contractor discusses preparations for a slowdown.
A contractor also should meet with the surety company and the banker for business consulting. After these primary discussions, a contractor should be better equipped to make employee-related decisions.
David Hewett
Senior Vice President, Contract Surety Group
Zurich North America
The capital markets are very unstable at this time. The tighter the owner’s cash flow, the tougher the market is on the contractor. Capital investments always should be considered carefully, but especially when cash flow shrinks. Purchased assets need to be able to provide a return in a shorter time period.
The construction industry will begin to see some margin deterioration. The key will be to minimize this decrease and lower an organization’s cost structure to properly match the environment. Contractors need to maintain discipline and walk away from jobs that do not provide enough of a return to their companies. They also must focus on decreasing some of the risk of the work to minimize the downside. This includes fully vetting the owner, having good engineering/architectural drawings and reasonable contractual risk, and having a team in place that can execute the work successfully.
Contractors may chase work at a lower margin just to keep the firm busy, but this will slowly eat away at the financial base. However, usually the quickest way to lose money during these times is to pursue work beyond a firm’s capacity or expertise. It is easy to rationalize investing in a new opportunity, but this can easily overextend a company and lead to a major financial loss. Seeking new opportunities and diversifying operations can help a company through these times, but this should be done in a measured and calculated way given the risks inherent in the construction business.
Doug Hinkle
Chief Underwriting Officer
CNA Surety
Contractors facing excessive competition need a disciplined plan:
Realistically budget the expected volume of work. Don’t slip into a downward cycle of doing more work at a lower profit margin. With a realistic revenue budget, plan to reduce or structure the company’s overhead to be in line with its volume. Know the company’s best people and know where cuts should be made. The objective is to lower overhead without sacrificing quality of work.
- Know in advance the size and type of work that can be done most profitably. This information will help contractors analyze the work that becomes available.
- Review the estimating and field operations. Obtain consistent, highly accurate bids from the estimating department, and emphasize field productivity to produce as much profit out of the work as possible.
- Reduce capital outlays for fixed assets and consider selling excess equipment. Maintaining strong liquidity in the business provides an advantage over other contractors burdened with excessive overhead and equipment, leading to cash flow problems.
Steven F. Coward
President
Berkley Surety Group Inc.
Contractors must recognize that the extreme duress in the banking and financial sectors will create stress on owners and their ability to finance work. It is imperative contractors verify funding for projects and stay on top of collections. A disruption in funding at any stage of a project will be troublesome for most contractors.
It is difficult for a surety underwriter to rationalize a contractor taking a project almost at cost with only a 1 percent or 2 percent margin, but sometimes it’s necessary for survival. Only the best contractors can perform at low margins and still execute the work flawlessly.
To maintain profit margins, contractors must focus on project efficiencies and squeezing the most out of people, resources and systems to build better, faster and more efficiently. Pressure on margins will not be equal across the country, so no single solution exists. Management teams of the most adversely affected companies will have to realistically assess the gravity of the challenges they face and, in some cases, plan for the worst.
Although some experts believe the economy and industry will recover automatically once the housing sector picks up, the “problem behind the problem” may cause the current climate to persist into 2010.
Theoretically, "the 3Cs" should be simplified to cash, cash flow and common sense. The cash flow statement is one of the most underutilized statements in the financial presentation, and it is surprising how many contractors aren’t comfortable with it. Whether the knowledge comes from a good CFO or a construction CPA, many contractors would be well-served to understand this important aspect of their business. Now more than ever, contractors need to understand the cost of their product, shed debt and take great care to manage cash flow.
Rick Kinnaird
Chair of the Board
The Surety & Fidelity Association of America
Senior Executive—Surety
Westfield Group
Be selective when choosing projects to bid. Look for projects in which efficiency gains can be realized and the company may have a competitive advantage, whether it is geographical, familiarity with the owner/architect or past work on similar projects.
Contractors that develop good project teams are more apt to execute work flawlessly. A bottom line-focused contractor employs only the best personnel.
Be thorough when selecting subcontractors and utilize contracts with clear language to avoid contract disputes and unintended consequences.
Strengthening relationships with project owners during the construction process also adds to the bottom line when it comes time to close out a project. Shorter punch lists will allow for timely project closings and release of retainage.
Beyond right-sizing, improving efficiencies and other overhead cuts, get out of debt as soon as possible. As margins slip and the interest on debt obligations rises, paying off debt will become increasingly more difficult.
Contractors must stay competitive to retain talent, but that doesn’t mean they have to be the top paying company in the market. Many quality workers are looking for a workplace where they are challenged and paid a reasonable wage. Quality of life is important to many workers facing the current economy. The security afforded by a company that provides training and development, a safe positive work environment and long-term career paths helps attract and retain quality employees.
Michael P. Foster
Executive Vice President
Merchants Bonding Company (Mutual)
Quality contractors maintain profitability even during lean economic times. An important part of this process is customer service. By taking good care of the owner, the owner will be more inclined to award additional work. Also, managing the project is critical. Owners, architects, prime contractors, subcontractors and suppliers all must be on the same page. There is no room for mistakes or delays when margins are already slim.
Contractors need to work with owners to manage escalating materials costs. The owner must understand that it may be necessary to pay for certain materials upfront in order to lock in prices.
Contractors should constantly monitor their overhead. They need to determine what is absolutely essential and consider reducing what is not. Contractors need to identify their key people and determine methods to retain them, even if it means temporary changes in job duties, such as having an estimator work in the field.
Due to the problems in the banking industry, it has never been more important for contractors to maintain strong cash positions with minimal institutional debt. Changes in bank ownership or management can cause changes in lending practices, even when the contractor’s payment history is clear. Banks are restructuring credit facilities solely based on internal management changes. Contractors do not want to get caught in this trap.
Michael F. Greer
Vice President, Surety & Fidelity
Penn National Insurance Co.
As contractors know, many things can go wrong during the course of a project. While all contractors need to be proactive in adjusting to market conditions, taking work at profit margins below the overhead level is not good business. Making it up on volume is a recipe for bankruptcy.
Throughout any cycle, some contractors always earn good margins. These contractors add value; they provide creativity and quality that others don’t. They work with owners to improve plans and come up with value-adding ideas. This doesn’t happen overnight—developing a strong reputation takes time.
When taking work at margins below overhead costs, a contractor has no room for the normal problems that are part of the construction business. No construction project is without a level of uncertainty. When this uncertainty is magnified by the inability to pay for contingencies, trouble is ahead. One bad job can be the first domino that starts a cataclysmic chain of events leading to early retirement. It is better to lose a defined amount of money, (i.e., your G&A), than to gamble with the uncertainty of zero-margin jobs.
Henry W. Nozko Jr.
President
ACSTAR Insurance Co.
With less work available, the number of contractors bidding each project increases, reducing the chances to gain contracts with desirable margins. Although fewer and farther between, opportunities to win projects with desirable margins always exist. As a consequence, contractors should prepare themselves for executing less work by reducing variable and fixed overhead, or reducing staff and selling non-essential equipment, trucks and real estate.
One way to offset escalating costs of materials and services is to engage in early commitments. While bidding a project, make commitments to key suppliers and subcontractors to purchase their equipment and services in exchange for a commitment to freeze quoted prices if the company wins the contract.
To reduce operating costs, contractors might consider outsourcing payroll and other computer services, preparation of shop drawings, project scheduling and safety control, as well as leasing equipment versus owning it. Such procedures could help adjust variable costs to match available work. Attach salary increases and bonuses to specific performance results to help control costs while maintaining opportunities for good employees.
Reduce the volume of business to preserve working capital and reduce debt. Cash can be generated from receivables by adopting aggressive accounts receivable collection procedures. Negotiate lower retention provisions in construction contracts. Also, adhere to a credit approval procedure for new customers, which could reduce slow-paying (or non-paying) customers.
William Maroney
President
National Association of Surety Bond Producers
Senior Vice President
City Underwriting Agency Inc.
To maintain profit margins in the competitive bid market, it is imperative to have a handle on the production ability of company personnel and subcontractors. Taking advantage of an early completion bonus can add to profit levels, as can strategic associations with subcontractors and suppliers.
The conundrum contractors face in an economic downturn is retaining key personnel. Labor costs are a major factor affecting a contractor’s operations. A contractor must make difficult choices to reduce its workforce in sparse times, but also to preserve key personnel. While it is business savvy to manage work flows, it also is prudent to keep key people in a company’s sphere of influence.
Cash management in difficult times is the key to survival for any contractor. Carefully manage accounts receivable and accounts payable, and take advantage of discounts provided by suppliers. Be sensitive to cash flow advantages available through the contract, such as accelerated payment terms. Also, only use bank debt as needed and do not overreach.
The surety will scrutinize cash flows more closely as the economy declines. Work with the carrier and professional surety agent to keep everyone on the same page. Make sure there are no surprises.
It is imperative to use a professional surety bond producer to establish a surety program. Regardless of whether this is the client’s first foray into the surety market, a professional surety agent will be integral to the success and operation of any surety program.
William A. Marino
Chairman and CEO
Allied North America
Successful contractors develop strategies for identifying and dealing with changes within their market. As new opportunities dwindle and profitable backlogs begin to shrink, contractors must revisit strategic and operational plans and adjust accordingly. Good planning—making logical target market adjustments and rationalizing overhead—should allow well-managed firms to weather the downturn.
It’s been said that cash flow is the lifeblood of a contracting organization. Regardless of the prevailing economic conditions, contractors must have a vibrant cash management plan to position themselves for long-term success. Critical from a bond producer’s perspective is the selection—and effective utilization—of a professional construction-oriented CPA firm to help develop and implement procedures for monitoring and improving cash flow.
Cash flow and cash flow problems develop from many different sources. An effective cash flow strategy must be comprehensive—taking into account billing and collection procedures, project selection, contract terms and conditions, and change order management—to allow contractors to develop reasonable forecasts of receipts and disbursements.
Most surety underwriters consider capital credit an essential element of a qualified contractor. Credit lines can provide a bridge in managing cash flow. However, long-term reliance on short-term bank borrowing will raise red flags with underwriters and suggest possible issues in the contractor’s cash management, accounts receivable and other work in progress.
Michael J. Cusack
Senior Vice President, Managing Director and Operations Board Member
Aon Construction Services Group
In a softening construction market, the most effective way to maintain margin, or reduce the compression of margin, is to establish strong customer relationships in the months and years leading up to the changing economy. Differentiate services by delivering quality and maintaining schedules to build confidence with owners. When owners have no doubt their jobs will be completed on time, in accordance with all standards of quality and without incident during project close-out, they will allow a contractor to earn a higher margin in a tight economy.
Exercise discipline in pricing work and avoid the temptation to acquire work only for cash flow purposes. If margins deteriorate materially, right-size overhead to provide the best opportunity to remain profitable during down cycles.
In this slowing market, firms will be faced with difficult and, at times, emotional decisions regarding workforce reductions. Companies will have to trust that a good reputation and ongoing commitment to the most productive employees will allow them to manage successfully through a soft cycle. A firm’s integrity during a down market will help it build out from its core when the market recovers.
Rick English
Vice President and Chief Operating Officer
Hub International Northwest
Nonresidential contractors facing competition should stay the course and not feel compelled to underprice their work. Most new entrants ultimately will find commercial construction to be a more challenging arena. In the meantime, contractors with experience in commercial construction should continue to focus on ways to make their business more efficient without sacrificing margin. While a difficult market presents challenges, it is also an opportunity for all business owners to objectively evaluate their operations and make necessary improvements to enhance long-term viability of their organizations.
Liquidity, profitability and leverage are the three key areas of surety analysis, and adding debt—especially during a softening economic environment—would be detrimental to a contractor’s surety program.
Maintaining and repairing tools and equipment is an alternative to buying new, and if debt-burdened equipment is not being used, it likely should be sold.
Also, for contractors that qualify, retainage bonds should be posted at the beginning of jobs. This enables contractors to "bank" and use this cash during the course of the project, as opposed to having it held by the owner.
Clint J. Diers
Vice President, Surety
Thomas Rutherfoord Inc., an Assurex Global Partner
Develop and maintain a diverse mix of clients so one distressed market will not overly affect results, and focus on controlling expenses. Predictions of a market slowdown have come to fruition, and contractors that strengthened their balance sheets in recent years are positioned to weather the downturn. Many contractors have lessened the impact of the general market change because of their relationships with a diverse group of owners. These relationships have continued to provide niche sources of work and profit.
To maintain profit margin or at least reduce the impact of the current market, contractors should be ready to make tough decisions that include reductions in field and equipment expenses, as well as general and administrative staff expenses. A down market presents an opportunity to gain more efficiency by culling out weaker staff, reducing unproductive overhead expenses and unloading underutilized equipment.
With more quality employees available, it may be possible to restructure schedules for better efficiency and reduce overtime costs. Also, project managers can share equipment and gain incentives. These can be tough decisions, but certainly can strengthen the overall company more quickly and effectively than waiting and hoping the market will bounce back.
Steven Raffuel
Surety Practice Leader
Conner Strong Companies Inc.
A wise contractor will focus on maintaining the net return, not the gross margin, by managing overhead vigorously, tightening cost controls and becoming even more selective about the type and size of projects the company undertakes. In addition, limiting work to known project owners, architects and engineers reduces risk and provides a greater opportunity to build one’s way to a better margin.
Escalating material costs are a problem, and many contracts do not allow a contractor to recoup such costs. Nonetheless, a contractor should not shy away from trying. A contractor can better manage the impact of such escalations by ensuring the contract includes very specific schedules with a fixed time to buy these materials. If the schedule slips through no fault of the contractor, the contractor needs to have contractual protection and a remedy to recover the additional costs.
Cash is the barrier between being in or out of business. Maintaining liquidity and paying bills promptly will create more surety credit, better subcontractor relationships, performance and pricing—and as a result, more work. Having liquid staying power protects the contractor from private sector financing default and becomes the means to weather difficult projects, owners and economic times.
Jeffrey Moore
Director, Management Consulting Services
Navigant Consulting, Inc.
Today’s economic environment is becoming more difficult for construction companies. The general economic outlook for builders is not a rosy one, with many projections calling for further economic hardships. However, the good news is that we see progressive construction companies benefiting from more challenging economic times.
Successful companies tend to seek guidance in four general areas during trying economic times: benchmarking, people, strategic planning and marketing.
During strong economic times, corporate weaknesses are often overlooked. Big revenue numbers can hide managerial inefficiency. As the economy enters its trench of the business cycle, weaknesses will be exposed, and developing strengths will become critical.
Economic downturns present an opportunity for leaders to cull their people, keeping the most talented players while removing historic underperformers. It also affords time for further training of key personnel that may not have been available during busier periods.
A tightening economy provides an organization with time to focus on customer service, market drivers and the organizational restructuring that differentiates a firm from the competition. Through strategic planning, contractors can develop a methodology for providing quality products in growing markets.
In a sluggish economy, it is important to develop a marketing initiative to inform clients of your approach to the changing marketplace. These efforts will better prepare your organization to deal with economic uncertainty, and remain focused and profitable when the tide turns.