More liquidations to come as cashflow becomes critical
Recent news that Armstrong Downes Commercial had gone into liquidation is, unfortunately, likely to be only a harbinger of further business failures in the construction industry over the next couple of years. Armstrong Downes’ collapse follows the liquidation of a smaller firm building townhouses in Auckland, OD 2019, which blamed project delays, COVID-19, and increased costs for its insolvency.
These companies’ failures reinforce the maxim that, in business, “cashflow is king”. The vast bulk of the time a business can be operating profitably, but it is unable to keep operating due to an inability to meet its immediate financial commitments.
Both boom and bust can be bad
In the construction industry, the boom-bust nature of the cycle means that businesses are potentially more susceptible to cashflow issues than firms in other parts of the economy. Problems tend to arise close to the turning point of the cycle. The most obvious example is a drop-off in demand meaning that there is not enough activity to go around for everybody. Firms can find themselves over-resourced with too much labour and capital, or they can be stuck with cost structures that have expanded as revenue has risen. A failure to adequately address these issues and slim down the company can result in the ultimate “rationalisation” of the firm going out of business.
One of the most egregious examples of construction companies being hit by weaker demand conditions came between 2006 and 2009, associated with the collapse of the finance companies followed by the Global Financial Crisis. Several residential developers during this period were at least partly reliant on new deposits on future projects to provide the cashflow for dwellings that were already under construction. When demand for new housing softened and there were fewer new buyers coming in the door, the lack of genuine solvency in the companies was quickly exposed. Activity fell away sharply, developments stopped almost overnight, and a lot of people lost a lot of money.
A less intuitive outcome is the dynamic when construction activity is expected to grow strongly. In this situation, firms might look to scale up in anticipation of the increase in work that is “just around the corner”. Any delays to the expected pick-up mean that the company is stuck with a higher wage bill, and possibly other costs as well, while still waiting for the commensurate increase in revenue. Anecdotes about this type of situation were common following the 2011 Christchurch earthquake as firms waited for the inevitable post-quake building boom. Delays in Earthquake Commission assessments and pay-outs, or the very slow progress on non-residential or infrastructure projects reliant on government funding, caused a lot of frustration and angst among businesses that had positioned themselves in preparation for the lift in activity.
Now it’s mostly about costs, delays, and more cost increases
This time around, the dynamics are a bit different. For many construction businesses, the last two years have been a frustrating cocktail of lockdowns, other project delays, labour and skill shortages, capacity constraints, disrupted supply chains, materials shortages, and sharply rising costs. Government support, in the form of the wage subsidy and the COVID-19 Support Payment, has helped alleviate some of the immediate cashflow issues. But the structuring of contracts, which are often based on a fixed price, means that the cost risks tend to be mostly borne by the builder, so it is arguably surprising that there have not been more firms caught out by the unexpected surge in costs.
With residential building cost inflation pushing up to 18%pa, delays to projects can quickly translate into cost overruns. Add in the fact that delays also mean that businesses have a lot more of their money tied up in half-finished developments, and the combined cashflow and profitability implications of the current operating environment are challenging, to say the least. In the residential space, it is possible that only the combination of sunset clauses and very strong house price inflation have enabled some firms to keep operating. With house prices now falling, that backstop is now much less viable. Although contract structures are, in some cases, changing to reflect the current more inflationary environment, and providing more scope for cost increases to be passed on, the risks faced by construction firms remain heightened.
Furthermore, we can also add in the likelihood that residential construction activity will peak within the next year (notwithstanding the surprising strength in the latest consent numbers for March). As a result, construction companies could face dual cashflow pressures, from the mix of project delays and cost increases running into a period of significantly weaker demand, creating pressure for cost cuts or business downsizing as we saw in 2006-2009.
I see a bad debt rising
Feedback from clients over the last few months has indicated that, although businesses in the construction industry are keeping a close eye on their credit lines, there had been little evidence of a pick-up in overdue accounts. As one business said, builders are keen to maintain a good relationship with suppliers because of the difficulties in obtaining materials. Given supply chain disruptions, the last thing you want to do is make it even harder to source product by failing to pay your bills on time!
The NZIER’s Quarterly Survey of Business Opinion provides a quantitative snapshot of overdue debtors in the building sector. The survey results for the experience of firms over the last three months, with regard to overdue debtors, is shown in Chart 1. Having remained low throughout most of the last two years, it’s interesting and concerning to note that the incidence of overdue debtors has reportedly lifted over the last nine months.
Responses in the March quarter show the highest level of overdue debtors since 2011. The survey results are not yet as high as they were in 2000, and the net figure is less than half the level reached in 2008 during the Global Financial Crisis. However, we expect things to deteriorate further throughout the next 12-24 months, particularly with cost and capacity pressures showing few signs of easing.
Things are about to get even rockier, and in this environment, you’d be well-advised to think carefully about who you do and don’t extend credit to.