The construction industry can be the first to feel the initial throes of a recession and provide a bellwether for economic forecasts, as evidenced by the last major downturns in the mid-1980s and late 1990s. But for contractors, the current downturn exceeds what has been experienced in the past. It is no longer simply a case of having to batten-down the hatches or being more careful and deliberate in job selection. One of the most significant challenges to contractors in nearly a century is the uncertainty of future construction outlays brought about by budget cuts at the federal and state government levels.
Additionally, unemployment in most areas and across certain industries remains high. Reports suggest construction spending will be limited in the near term and the overall market for construction will continue to be extraordinarily competitive. These challenges beg the question: How do contractors survive?
Fundamentals of Job Selection
With fewer construction projects being let, three temptations begin to affect even the most risk-averse contractors: fill the void with a new type of work, expand into new territories or radically lower margins. Contractors should treat each of these options cautiously. Construction is a risky business segment, but not all risk is created equal. The temptation to undertake atypical work, expand territories or bid work at lower margins is understandable for contractors with minimal work on hand. However, contractors should strongly consider the potential long-term impact these decisions may have on a company’s existence, as the risk could far outweigh the short-term perceived benefit of securing projects.
One example of contractors pursuing work outside their niche is private industry contractors moving to low-bid public work. Many construction companies that turned to the public market found unfamiliar subcontractors, unknown (or inflexible) obligees and stricter regulatory requirements, which can lead to significant problems. To prevent or mitigate these situations, it is essential for contractors to talk to others with experience in areas outside their expertise, including their surety and peers in industry associations.
Looking outside of a firm’s typical territory also can present numerous challenges, including unfamiliar owners and local conditions. In addition, as a contractor travels further from its home base, being onsite to mitigate any problems that may arise becomes increasingly challenging. If travel becomes a necessity to secure work, some of these unknowns need to be diminished. Consider working on a job with a known owner or subcontractors, or, at a minimum, having a strong project manager onsite who can make significant, binding decisions for the company. Evaluating thin-margin scenarios is similar: A contractor should decide if the estimated margin is an adequate cushion for the unknowns that come with any construction project. Contractors need to ask if taking work with thin margins is worth the impact it might have on the company overall. Many construction owners who survived previous economic downturns chose to forgo jobs rather than risk their companies by taking work with thin margins.
Right-Sizing the Firm
Declining revenues or periods with little to no revenue often force contractors to look at the structure of their internal operations. Contractors must evaluate their operation so it continues to perform as profitably as possible and ensure the firm is operating with the right number of staff to remain competitive and to know which personnel are the most critical for the organization’s overall success. It is not just about cutting costs; rather, it’s about maintaining the best possible staff to ensure future success.
Right-sizing includes more than temporary personnel reductions to cut overhead expenses in the face of dwindling revenue; a contractor’s equipment and other hard assets also should be evaluated for their respective performance contributions. Cost accounting and analysis should be used to determine equipment utilization rates.
Only after an honest assessment of which pieces of equipment can be divested from the contractor’s balance sheet can the appropriate adjustments be made to fit the current market conditions.
Managing the Balance Sheet
With highly competitive markets often resulting in reduced revenues and lower profit margins, it is increasingly important for contractors to consider retaining as much of their asset base in highly liquid assets as possible. Liquidity in any market allows a firm to manage through short-term problems and puts it in a position to make decisions that are best for the long-term success of the organization. If liquidity is compromised, a manager may be forced to make a judgment call to maintain adequate cash flow to keep the company afloat, which could unintentionally harm the business.
Although large amounts of debt on a balance sheet should be avoided, it is important for contractors to consider what type of debt is manageable. For example, resist the temptation to pre-pay large amounts of bank debt with cash.
As long as principal and interest payments remain within the limits of a contractor’s pre-tax income, it’s important to try to retain as much cash as needed to offset the potential risks posed by declining revenues and profit margins. It may be an advisable tradeoff to pay more interest, which could allow for greater liquidity in the short term. Whichever action is taken, contractors should utilize their professional advisors to help make the best decision for their situation.
Sureties often talk about the “three Cs” of contractor evaluation: capital, capacity and character. Communication is a critical fourth component. Open, honest dialogue between the contractor and its surety can be immeasurable in this challenging economic environment.
Professional sureties can help a construction business grow or, in times such as these, help it remain in business. Successful contractors understand their markets and their clients and are adept at communicating with project owners. But while their senses are well honed to their current market, contractors may be unaware of changes in other geographic areas, potential risks of other types of work or the actual losses incurred by other contractors that made imprudent changes to their business model. Surety underwriters can offer valuable insight into the risks involved in proposed changes and can provide the consultative expertise to prevent what could be an extremely costly mistake.
It is crucial to communicate, through an agent or broker, the construction firm’s financial health or any unusually difficult financial or technical issue. A sound surety has a variety of risk management, financial and accounting resources to help overcome tough situations. It is imperative contractors continue to adhere to the fundamentals of risk management and mitigation and avoid taking any leap that could pose a threat to the business they’ve worked so diligently to build over the years.
Working closely with partners such as an agent, broker and surety can help contractors be well-positioned for the future.
Wednesday, December 18, 2013