Caveat investor: Would you buy shares in a construction company?

Simon Murray
03 February 2015

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Simon Murray’s not sure and wonders if the contracting business model is broken.

As Lady Bracknell might have put it had she had shares in Balfour Beatty, “To issue one profit warning may be regarded as a misfortune, to issue six looks like carelessness”.  Events at Balfour’s have been painful for investors and management alike and should be causing us to question whether these problems are limited to one company or are widespread amongst UK contractors.  We should be asking ourselves whether there is a systemic problem with our contracting business model.

"There is nothing wrong with making money by trading. The problems arise when traders have insufficient knowledge of the market, when trades are complex and when a company does not have accurate information about all the trades they have committed to.  Unfortunately, UK construction companies have all three of these problems."

Construction companies come in different shapes and sizes, but at the heart of most companies is a contracting business that wins contracts through competitive tendering and then sub-contracts the parts of the project to specialist suppliers.  UK construction companies have sold their plant, laid off the skilled workers that used to build projects and become traders.  They make slender margins from the difference between the price they tender and the prices they obtain from their suppliers and along the way they try to generate positive cash flows.

There is nothing wrong with making money by trading.  For centuries British companies have thrived on trading everything from tea and spices to iron ore and oil.  The problems arise when traders have insufficient knowledge of the market, when trades are complex and when a company does not have accurate information about all the trades they have committed to.  Unfortunately, UK construction companies have all three of these problems.

Construction is an opaque market.  When contractors submit tenders to clients or invite bids from sub-contractors, the transactions are usually confidential.  So when they are putting tenders together they have little information about current prices in the market and what information they do have is either based on discussions with suppliers or is out of date.  Contractors can’t consult a screen to get current prices in the market and instead rely on the judgements of their commercial managers.

Construction projects are complex transactions in which contractors have to integrate the work of their sub-contractors in design and on site.   Unfortunately this process is complicated by the practice of dividing projects into dozens of sub-contracts in pursuit of the lowest prices.  Commercial practices are creating complexities that most contractors struggle to manage within the slender margins they can command.  Which is probably why we hear so many clients asking, “Who is the integrator”.

Contractors compound these risks by organising their businesses around semi-autonomous project teams and giving them considerable latitude in forecasting the outcomes of their projects.  In most companies these forecasts are matters of judgment and are subject to all the biases that commercial managers working under pressure are subject to.  Should we be surprised when commercial managers working in the same part of the business display similar optimism in their forecasts?

So what is to be done about this?  Well, a starting point for reform would be for clients to follow London Underground’s lead and procure projects on the basis of maximising value rather than minimising cost.  And the public sector could take a lead and publish details of all of their tenders and of the sub-contracts procured by the successful bidders.  But in the end UK contractors are going to have to reform themselves by creating a business model for contracting that adds value and commands appropriate margins.

Simon Murray is director of  the Acumen 7 network