Foreign acquisitions: troubled waters ahead

With capacity under pressure and Tier 1 contractors showing signs of vulnerability, overseas competitors are scenting opportunity, writes Elaine Knutt.

A bulging pipeline of future infrastructure projects; a chronic housing shortage; commercial sector clients flexing the pent-up demand after the downturn years… and a string of Top 20 contractors reporting continued losses, margins at sub-2% levels, cash reserves decreasing, insolvencies continuing, skills shortages biting. Eighteen months after the end of the recession, just at the point when it ought to be happily building sandcastles, the industry’s confidence is pretty shaky.

But, viewed from across the sea, the very conditions described above look distinctly appealing. We’ve already seen a recent wave of contracts awarded to names that previously never been seen on a UK tender list. Now, with signs that the business model operated by many Tier 1 contractors is failing and leaving them vulnerable to acquisition – and also suggestions that some clients are delaying or shelving projects due to a capacity crunch – will more overseas contractors move in to snap up a slice of the UK’s predicted output growth?

Certainly, Construction Manager found no shortage of construction experts arguing that a greater share of UK construction output could soon end up in the hands of overseas-headquartered firms, whether that’s by contract wins, corporate acquisitions, joint ventures and alliances, or entry into the UK via co-financing of infrastructure projects. By value, 64% of the UK’s £411bn infrastructure pipeline is due to be privately financed – creating an invitation for asset rich or state-sponsored contractors to enter the UK market.

One person qualified to judge is Richard Threlfall, head of infrastructure, building and construction at KPMG, who says he’s “inundated” with approaches from Chinese businesses. “It’s exactly as you would expect – we’re seeing a huge amount of interest from overseas contractors. It’s been bubbling under the surface for a few years, but I’d be surprised if we didn’t see a significant player move into foreign ownership in the next year. A number of UK contractors are in poor shape, while the Far East and China see a significant pipeline of work with programmes like HS2.”

Graham Robinson, director of Global Construction Perspectives and global business consultant at Pinsent Masons, takes a longer-term perspective, but also sees a shift coming. “In 10 years’ time, in 2025, the UK sector will be more international, and more concentrated on bigger companies – you’ll need size to tackle some of these infrastructure projects. Below the top four in the market I think some of the smaller ones will be attractive [to overseas players]. And if I had to name a handful of countries, it would be China, Korea, Spain, Italy, France and Germany.”

As Robinson says, large balance sheets will be needed to take on some of the infrastructure projects coming on-stream – such as HS2 and Crossrail 2 – and here we’ve already seen the increasing role of foreign bidders (see below).

“The trend we’re already seeing will continue – with overseas players responding to the challenge. Also, we have a lot of major programmes arriving at the same time, which accentuates the skills issue,” says Murray Rowden, chairman of Constructing Excellence and head of infrastructure at Turner & Townsend.

Rowden believes that some UK contractors are “sticking not twisting” on risky infrastructure bids – thanks to full order books from lower-risk frameworks and long-term relationships. “So either clients will have to accept a limited number of bidders, or we’ll see bidders change shape, with relationships striking up between global ownership organisations – the owners can create a route to market.”

He’s referring to the increasing dominance of overseas owners in the UK’s utility and transport sectors. For instance, Spain’s Ferrovial owns Heathrow Airport, France’s EDF is dominant in the energy sector, Thames Water is held by investors from Australia, Abu Dhabi and China.

Of course, weak results, lack of capacity and a bulging pipeline don’t necessarily predict a wave of overseas arrivals: the industry and economy could simply accept lower output, clients could accept the need to pay more, or contractors gradually become more productive by adopting more technologically driven solutions.

And consultant Jason Farnell tends to the view that many struggling with “legacy” issues are still adjusting their strategies. “Until you’ve got a steady boardroom, planning future strategy is very difficult. Last year we had the changes, this year the consolidation, and next year working out a plan.”

But even if that’s the interpretation you lean towards, there’s still an increasing sense that the industry’s long-term structural problems – of skills, payment, productivity – have all come home to roost at the same time, highlighting vulnerabilities that others could exploit.

Meanwhile, growth forecasts that should be a cause for celebration – the Construction Products Association is forecasting total growth of 21.7% between 2015 and 2019, giving the UK an annual growth rate  roughly twice that of France or Germany – are instead raising awkward questions about capacity. 

Hand-to-mouth margins

If Top 20 names in UK contracting are at risk of losing market share to overseas competitors it’s because their business model is coming under unprecedented pressure. The recession’s hand-to-mouth margins have persisted, because higher bid prices at the front end have been eaten up by construction cost inflation. In recent results announcements, construction margins were revealed to be 1.1% at Interserve, 1.2% at Galliford Try and 0.3% at Morgan Sindall. The average, return on sales in 2014/15, according to a Glenigan/BIS analysis of data filed at Companies House is 2.8% – compared to an astonishing 9.9% in 2009.

But since then, the opportunity to make money by managing clients’ cash has been much reduced. “The industry traditionally survived on low margins by having substantial cash, but at the moment main contractors are suffering from low margins AND low cash, and that’s not just because of the position in the economic cycle,” says KPMG’s Threlfall. “Clients are getting smarter, so the opportunities to make a killing on a project are reducing, and framework agreements are stripping the scope of profit potential.”

But main contractors are still taking on considerable price and programme risks while their ability to offset these has reduced. “The downside [of main contracting] hasn’t gone away – they’re still carrying considerable risks. The upside/downside balance has changed, and project bank accounts are piling on the further pressure,” adds Threlfall.

Then there’s “skills shortages”, a problem foreseeable even as around 10% of the industry’s workforce exited during the recession, but only now making itself felt. According to the recent Glenigan/BIS report, the industry has in fact made better use of its smaller workforce since the recession: productivity in terms of net output per head has climbed from £45,000 in 2007 to £61,300. However, these productivity gains are slowing.

As Glenigan economist Tom Crane explains: “Construction companies found a way of hanging on to their best staff – so the workforce became more productive. But to get back to pre-recession levels of workload, there are no more [workers] to be found. So the ceiling is still ahead of us.” This means that realising the output growth forecast by the CPA either requires an influx of new workers (possibly from the EU) or a major leap in productivity – which would require new ideas and new investment in the contracting sector.

As University of Westminster construction department reader Stephen Gruneberg says, skills shortages are arguably a consequence of market failure in the contracting model: training and investment in skills is low because of fragmentation and reliance on specialist subcontractor SMEs that don’t train and can’t afford higher wages. “Poor margins lead to skill shortages and low productivity – if labour is cheap, you don’t buy expensive equipment, so it discourages investment.”

And the effect of skills shortages is just as likely in the management or client teams as at site delivery level. “Everyone in the industry will say they are struggling and there’s a lot of poaching going on, which is unhelpful,” comments Richard Threlfall. “But it’s indicative of not having a direct employment model and not looking after staff – you can’t expect them to stay loyal. Network Rail is suffering with a high number of posts unfilled, so you see how debilitating the lack of skilled labour can be.”

Overall, main contractors’ resourcing difficulties, lack of appetite for risk and increasing selectivity on projects could be leading to a capacity crunch: figures from Barbour ABI suggested that the value of projects being put on hold is rising, especially in London and the south east, while the ONS also recorded a 12% drop in commercial orders in Quarter 2 2015, challenging the growth trajectory that has been forecast. At the same time, construction price inflation is rampant.

At Arcadis, head of strategic research and insight Simon Rawlinson explains what could be going on: “There’s what I call a virtual constraint – companies don’t have the resources to bid on projects, so rather than do the full detailed design work, you put in a larger price. The overall consequence is it takes longer to convert projects – they get to the second stage of two-stage bids and then drag on. It slows things down, because projects aren’t viable.”

But if contractors are pricing ever higher to keep one step ahead of inflation, while also having to dig deeper to pay for staff to resource the project, some projects could become impossible to deliver within clients’ budgets. In that scenario, clients will search for alternative solutions – including overseas.

That’s the analysis of Murray Rowden of Constructing Excellence and Turner & Townsend. “The price point for a built solution is moving into the territory of being unaffordable: in other words, there’s affordability versus what the market can provide. So clients will take the lead and search out organisations that have better processes and can drive investment in productivity,” he argues.

Limited takeover options

So what exactly could next year bring in terms of overseas arrivals? Robinson points out out that there are very few quoted UK contractors in the first place, limiting options even for hostile takeovers, while it’s even harder to make a privately held contractor – such as Sir Robert McAlpine, Wates or Willmott Dixon – an offer they can’t refuse. So he sees joint ventures with established UK players as the most likely route to market for overseas corporates – continuing a trend that’s already becoming established.

“I wouldn’t discount [acquisitions] happening – there are bigger international contractors out there looking to access the UK growth. But JVs are a way of bringing additional skills on board: to form a JV, you need to bring skills, knowhow and technology – or additional balance sheet strength to spread the risk. We’ve already seen a lot of JVs form around projects such as Crossrail, HS2 and Hinkley Point C. The next step on from that is the formation of longer-term alliances – which might lead to merger or acquisition.”

At KPMG, however, Threlfall doesn’t share this analysis. “JVs are lower risk, and an easier short-term strategy,” he acknowledges. “But these [Chinese] companies have the money to acquire outright, which puts them in a stronger long-term position. I think an acquisition is likely that one of our main contractors will be acquired in the course of 2016.”

Of course, no one can predict a volatile future with any accuracy. For instance, the forecasts of Germany’s output growth were made before the recent influx of up to 1 million refugees, a factor likely to upwardly revise growth projections – and make it less likely that German contractors might look overseas.

But in UK boardrooms, it looks as if many directors who ought to be enjoying a period of growth, investment and stability will instead be looking over their shoulders. Of course, any overseas deal or alliance is likely to bring benefits to both parties. But after struggling through the recession, and improving performance on so many fronts, it’s hardly an achievement if the profits from the UK’s construction output increasingly flow to the exchequers of other countries.

They’re speaking our language

Overseas names are a familiar sight on UK infrastructure projects

High Speed 2

According to New Civil Engineer, the line-up of bidders for HS2 features a high number of European names, many of them relatively unfamiliar.

Spain’s FCC Construcción, Dragados and Acciona as well as France’s Eiffage are joining the more familiar French firms Vinci and Bouygues in the hunt for £9bn of design and build work on phase one of the £43bn scheme.

Spanish giant Dragados is understood to be teaming up with its German sister firm Hochtief – both are part of Spain’s Grupo ACS – while FCC Construcción is teaming up with Murphy and Laing O’Rourke.

UK newcomer Acciona is still understood to be forming its team while Bouygues, still relatively new to infrastructure work in the UK, has formed the Align joint venture with Sir Robert McAlpine and VolkerWessels.

Eiffage, which built the Millau Viaduct, has teamed up with Carillion in an extension to an agreement struck in 2009 for the two firms to collaborate on new nuclear in the UK.

Costain is expected to bid with Swedish-headquartered Skanska.

Project promoter HS2 Ltd revealed earlier this year that the £43bn project was attracting companies that had never worked on UK infrastructure before.

“It is the type of competition we were looking for,” HS2 Ltd commercial director Beth West told NCE in February. “There are some new entrants to the UK market, which is good as they bring experience from overseas.”

Airport City Manchester

Carillion has formed a joint venture with the Beijing Construction and Engineering Group (BCEG) to deliver the £650m Manchester Airport City development.

BCEG’s deputy general manager Ma Tieshan is a CIOB fellow who has hailed the project as a “symbolic shift of entering the European market”.

He has also outlined BCEG’s plans to take on more “high end” projects in developed countries and to learn from working alongside Carillion. BCEG also has a 20% stake in the office, hotel, manufacturing and logistics scheme as an investor.

Swansea Bay Tidal Lagoon

China Harbour Engineering Company (CHEC), a subsidiary of the state-owned China Communications Construction Company, was named preferred bidder for the £300m contract to carry out the marine works for the proposed £1bn Swansea Bay tidal lagoon.

It will be responsible for the construction of the 10km sea wall as part of the tidal power station planned in Swansea bay.

According to Tidal Lagoon Power, the delivery of the project “will kick-start a programme of Chinese investment into UK infrastructure”.

Thames Tideway Tunnel

London’s £4.2bn super-sewer project is to be delivered by three consortiums including foreign partners: the £746m central contract has been awarded to a joint venture between Spanish-owned Ferrovial Agroman UK and Laing O’Rourke Construction, while the £605m eastern contract went to a joint venture of Costain, Vinci Construction Grands Projets and Bachy Soletanche.

But the full list of bidders illustrates the project’s global appeal. These included a Spanish-Korean Dragados and Samsung joint venture; a Swedish/German/French tie-up in Skanska-Bilfinger-Razel Bec; a Hochtief and Murphy JV, and a bid from Bouygues Travaux Publics.

Aecom comes to London

If mainstream construction suppliers are experiencing a capacity and resourcing crunch, then that creates opportunities for all kinds of newcomers to the market – such as Aecom Construction Services. A construction management operation to complement the firm’s existing client-side programme management team, it was set up just 12 months ago, and is now preferred bidder in two-stage negotiations on three London commercial schemes.

Richard Whitehead, managing director of programme management and major projects, and John Hilton MCIOB, head of construction services, explain that ACS in effect brings Aecom’s US Tishman brand and capability to the UK, although Aecom has built an entirely home-grown team. Hilton and other colleagues are alumni of Bovis Lend Lease, bringing their knowledge of the local supply chain and market to the new business.

But ACS knows it has to do things differently to operate in a world of rising costs and declining skills – such as achieving above-market margins through  better technical solutions.

“Our value proposition is the depth of our technical expertise – we call it technical-led delivery,” explains Whitehead. “We’re an integrated construction businesses, we can do design, pre-construction and construction all in-house. It gets projects to site quicker, with better thinking and better constructability. If we need to solve a problem, we can easily get half a day’s advice [from a technical expert elsewhere in Aecom] to solve a problem.”

Hilton also says that it’s trying to build relationships with a group of smaller specialist sub-contractors, after finding that its direct competitors in the market had in many cases exhausted the capacity of the go-to names in Tier 2.

Whitehead, speaking from a client-side perspective, sees both the challenges and opportunities of today’s market. “The industry seems to have reached capacity, tender returns are higher, and schemes are becoming less affordable. At the front end, we’re struggling to get bid lists together, and jobs are becoming expensive.

“But there are also opportunities – clients will increasingly try and find someone who can do it differently. Projects will be value engineered, and reappraised, so contractors need to put more thinking into it. So it’s creating an opportunity for us in building a construction management business.”