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Ability to
Grow, Shrink
Quickly Is Key to Contractors’
By Michael Correra,
Managing Director,
Conway MacKenzie Inc.
D
uring most of the 2000s the
North American construction
industry has been in recovery
mode. The new millennium began
with the cogeneration power bust
post-Enron, followed by the residential
construction boom and bust, which
led to the Great Recession, and now
the oil bust. However, most distressed
contractors find themselves in trouble
less because of the macroeconomic
environment and more because of
overconfident and overzealous decision
making. This latest round of distress
fueled by the oil crisis, for example,
will certainly reveal the contractors
that bet the farm on the upside of the
rollercoaster ride in oil field services
and construction related to the fracking
boom and now find themselves on
the downside of that thrill ride.
Most failed contractors can point to
one or two particular projects that led
to their downfall. For the most part, the
failure of these projects resulted from
the contractor taking on more work
than it could handle. The ability to
expand or contract its operations easily
is vital to a contractor’s survival. Large
fixed-cost investments, aggressive or
loose bid procedures, and overburdened
and inexperienced project management
can lead to catastrophe. In addition to
Survival
its performance and safety record, the
most important factors influencing
a contractor’s success are flexibility,
liquidity, and the ability to ride out
the fluctuations in its workflow.
A review of the balance sheets of
successful publically traded contractors
reveals that most have very little
leverage relative to other industries,
are well-capitalized with equity, and
show predominantly sizable churns
of working capital. The contractor’s
balance sheet and cost structure
should be able to grow and shrink
according to its backlog of work, which
can be significantly volatile at times.
Unlike companies in other industries,
it is difficult to gauge a contractor’s
financial stability based on financial
metrics alone. The financial risk facing
contractors cannot be measured
solely by traditional leverage ratios
like debt to EBITDA or debt to equity.
In most instances, what may appear
to be reasonable or even conservative
levels of leverage for other industries
may not apply at all to a contractor.
For one thing, the true liability
of a contractor—completing the
work it has been contracted to
perform—is contingent and off
balance sheet. In some cases, these
contracts may be fixed price in
nature or carry liquidated damages
in the event of nonperformance.
Every project is characterized by
numerous moving parts that must be
coordinated and executed precisely
to achieve a successful outcome.
This leads to a second important point,
which is that past EBITDA performance
is not always the best proxy for a
contractor’s future performance. In
the world of construction, EBITDA
is a function of estimates because of
percentage of completion accounting.
Therefore, yesterday’s EBITDA may
just be tomorrow’s write-down.
What does that mean? In accordance
with GAAP, a contractor recognizes
its revenue based on a percentage
complete calculation. The percentage
complete is multiplied by the contract
value to derive the amount of revenue
recognized at a certain point in time. As
with all percentages, both a numerator
and denominator are required. In this
case the numerator is the actual cost
incurred to date on a project, and the
denominator is the estimated cost
of the project from start to finish.
If the estimated cost to completion is
too low, then the resulting percentage
continued on page 18
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2015
Journal of
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continued from page 18
Perhaps counterintuitively,
it’s during the boom times in construction that
contractors should be designing their turnaround plans.
continued from page 17
complete calculation will be too high.
Therefore, the contractor would have
previously recognized too much
revenue. When the estimated cost
at completion is adjusted upward to
reflect known changes or impacts
to the project, the revenue that was
recognized previously is adjusted
and a loss flows through the income
statement, adversely affecting EBITDA.
One sign to look for is significant and
quick growth in the “cost plus profit
in excess of billings” account relative
to other working capital accounts
on the balance sheet. Also known in
the industry as the “underbillings,”
this account is where future losses
may be hiding if too much revenue
was recognized based on poor
estimates. It’s not a given that all
increases in underbillings are bad;
rather, they are an indicator that
further investigation is warranted.
March
2015
Journal of
Corporate
Renewal
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In addition to the cloudiness of
percentage complete accounting,
a contractor’s EBITDA is based on
previously executed projects that may
have differed significantly in complexity
from those in its current backlog.
Every project is unique, with different
project owners, designs, contract
scope, labor, and other conditions,
including weather. To the extent a
contractor can mitigate these risks, it
increases its chances to perform the
work successfully and on budget.
perform after sustaining losses as a
result of unnecessary risk taking.
Bracing for Headwinds
For instance, successful contractors tend
to rely on work from known customers,
maintain consistent subcontractor
relationships, or even stay within the
same project size, scope, and geographic
footprint. This doesn’t mean a contractor
shouldn’t try to grow its business, but
it should do so opportunistically and
cautiously. Thoroughly evaluating
talent, understanding risks, and
expanding capabilities while
retaining the ability to shed costs
rapidly is prudent and advised.
Major derailments occur when a
contractor takes on work of significantly
broader scope and complexity, and
with unknown or unproven teams.
Significant investments to move capital
and resources into new markets where
a contractor has little experience
is another major culprit behind
contractor default and failure. Perhaps
counterintuitively, it’s during the boom
times in construction that contractors
should be designing their turnaround
plans. Although backlog and resulting
revenues may fall during a downturn,
savvy contractors recognize that real
growth and market share improvement
occur in down cycles. Well-capitalized
contractors seize opportunities left
behind by contractors that could not
Areas for consideration when
preparing for a downturn include:
Prepare for the Inevitable. Obviously,
markets do not increase forever.
Downturns are inevitable. A contractor
should develop a response plan that can
be enacted quickly when a significant
market downturn occurs. This involves
identifying individuals and teams that
are critical to the long-term viability of
the business and determining in advance
how to best consolidate crew sizes and
shed costs for underutilized labor quickly.
Consistently evaluating the financial
capabilities and management of the
company’s subcontractor relationships
is also important. It’s essential to know
whether the subcontractors retained
can also sustain a downturn. If concerns
about any of them arise, the contractor
should identify other subcontractors
that can transition quickly.
If the business is asset-intensive, like
that of a site development contractor,
expanding its fleet by using its available
revolving line of credit to purchase
every front-end loader the company
needs is not the best approach. Instead,
long-term capital should be used to
make long-term investments in assets
that will likely be used even when
work is at its lowest volumes and then
rent everything else. That way, when
it’s time to shrink, the contractor can
shed the weight of that yellow iron and
much of its cost as well. Renting may
cost a little more when times are good,
but the flexibility it provides will pay
massive dividends in down times.
Determine Core Competency. It is
surprising how many contractors don’t
know their core competency or choose
to stray far afield from it. A good example
is a contractor that is traditionally a
specialty subcontractor but, lured by
the prospect of higher profits, takes on
the role of general contractor on a new
project. Many mechanical contractors
and electrical contractors alike have tried
to make this jump with poor results.
Just because a contractor knows how to
execute projects well doesn’t mean that
it can effectively manage multiple trades
like a large general contractor does.
Instead, a contractor should identify
what it excels at and the teams of
employees that are critical to executing
that core competency. It should avoid
taking on work that is traditionally
outside its core competency simply to
try to make a quick buck or increased
profit. Before branching out, a contractor
must make sure it has the proper staffing
and capabilities to handle a new job that
is outside its traditional scope of work.
If a downturn occurs, the contractor’s
turnaround plan should involve quickly
getting back to its core competency to
ride out the cycle doing what it does best.
Maintain a Healthy Span of Control.
A contractor must understand the
capabilities and limitations of its
management and employees. There
is only so much a person can handle.
In an industry like construction, where
attention to detail and timely decision
making is required to bring a project in
on time and within budget, overstretched
resources can become a major liability.
As a contractor expands, placing
excessive burdens on top performers
is quite common. The contractor’s top
performers should be identified and
consistently relieved of unnecessary
burdens. If no one else can do the
additional work, then it’s not a good
idea to take it on in the first place.
It’s more important to have available
and capable resources to perform.
An organization’s structure should be
scalable so that it can retrench into a
smaller and effective unit quickly. It’s all
Michael Correra is a managing director with
Conway Mackenzie Inc. in New York. With almost
two decades of experience in restructuring,
reorganization, and bankruptcy advisory services,
Correra also opened Conway MacKenzie’s New
York office in 2007 and currently leads the firm’s
Engineering & Construction Group. He has a
bachelor’s degree in both finance and accounting
from New York University’s Leonard N. Stern School
of Business, is a CIRA, and holds a Certification
in Distressed Business Valuation (CDBV).
about people. Managers on staff should be
evaluated to determine if they can operate
in a leaner, more efficient environment.
Continuous improvement in the area
of information technology is essential.
However, a contractor shouldn’t
get bogged down by major system
rollouts. Having an effective process
in place is more important. Quicker,
easier systems can assist employees
in improving their span of control.
The Test of Time
The old saying that what goes up
must come down applies particularly
well to the volatility inherent in the
construction industry. The contractors
that succeed endure the test of time,
Mother Nature’s surprises, and the perils
that can arise from their own exuberance
while continuously planning and
preparing for what may come next.
Being flexible and identifying
business risks in advance of the
next looming crisis are critical to a
contractor’s survival, growth, and
prosperity. Because contracting is a
late-cycle industry, the indictors tend
to be everywhere. The next round of
economic volatility will undoubtedly
identify its share of contractors that
didn’t plan ahead and heed the signs.
J
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March
2015
Journal of
Corporate
Renewal
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