Business Irish

Thursday 19 July 2018

A building sense of concern for Ireland as Carillion collapses

The construction group's collapse raises fundamental concerns for the sector that Irish building companies must heed, writes Fearghal O'Connor

Despite the remarkable recovery of the Irish construction sector which has seen a profusion of cranes on the Dublin skyline, the industry faces growing unease over current business models following the British firm’s demise. Photo: Getty Images
Despite the remarkable recovery of the Irish construction sector which has seen a profusion of cranes on the Dublin skyline, the industry faces growing unease over current business models following the British firm’s demise. Photo: Getty Images

Fearghal O'Connor

Sometimes England's difficulty is Ireland's difficulty too. History suggests that the collapse of a major British construction firm should, at the very least, give industry executives in Ireland - growing giddier with every new crane in the Dublin skyline - some pause for thought.

Irish contractors have staged a remarkable recovery, but there are some warning signs in the implosion of Carillion. While major Irish contractors have returned to rude good health as the economy has taken off, well-informed sources point to some similar challenges to those faced by Carillion. But to see how troubling tidings from across the Irish Sea are easily ignored, recall the mood of detachment in Ireland in September 2007 following the run on Northern Rock, the first on a British bank in 150 years.

"The nature of what happened at Northern Rock, given its business model, is unique," said one Irish analyst. "I'm sick to death of people writing off the Irish economy and next year could easily see the Celtic Tiger roaring more loudly than many pessimists think," said another. Fifteen months later Finance Minister Brian Lenihan was ushering in the extraordinary bank guarantee.

Northern Rock had been the canary in the coalmine that most people ignored: some construction analysts believe that Carillion also provides a similarly well-timed warning shot.

The recovery position

But first, the good news. The last number of years have been remarkably positive for Ireland's building industry as it has grown and modernised.

A report from global infrastructure experts Aecom last week said that the sector's output value grew by 18pc in 2017, with a further 14pc growth to €19.5bn expected in 2018.

A Carillion worker. Photo: PA
A Carillion worker. Photo: PA

A DKM report previously showed that the industry has hired 60,000 people since 2013 and may hire another 100,000 to fulfil growth potential. And there is plenty of potential: at full capacity construction should account for 12pc of GDP but currently accounts for just 7.5pc.

A new 10-year national investment plan may help to bridge that gap and fuel further expansion. But as Carillion management found out in recent months, rapid expansion brings its own serious challenges and the period after a recession is as dangerous as the one before.

Modernise or Die

The collapse of Carillion - the biggest of the so-called tier one contractors that dominate the industry in Ireland and the UK - was not a huge shock to everyone. Last year, industry expert and Cast Consultancy CEO Mark Farmer produced a detailed report for the British government entitled Modernise or Die.

"That report appears to be particularly prescient this week which is sad," he told this newspaper. "I was putting down a challenge to the construction industry, but you never want to see the scenario we had this week with Carillion."

Carillion's failure at the peak of a construction boom in the UK illustrates the issues: "In a downward market, the model puts pressure on the supply chain. The tier one contractor fixes a price for a job and the costs of delivering on that contract may actually reduce in a downward cycle as subcontractors compete for work. That is not necessarily the case in an upward market."

Farmer says the model is also prevalent in Ireland, but this country lags the UK by about two to three years in the overall cycle. "You are coming out of a deep downturn into growth. You have to build more homes, more infrastructure, more commercial and it's really important for Ireland and the Irish construction sector that lessons are learned from what we have seen in the UK," he said. Farmer's assessment of the UK construction sector will bring little comfort to those in the sector here: Carillion is evidence of fundamental systemic problems in the UK, he said.

"To see a business with a £5bn turnover fail because it ran out of money within eight months of its first profit warning is alarming. It shines a light on one particular area of weakness in the model - the fact that tier one contractors effectively subcontract out so much of the physical construction work on their projects."

Under this model, tier one contractors tender for huge projects but subcontract out up to 80pc of the work. Subcontractors in turn use labour agents to hire workers and at every stage a margin is added to the price, challenging the model's efficiency. Carillion took this model to extremes, but it is a standard practice, developed over the last 40 years as a way for big contractors to defend against an increasingly cyclical market.

"The major advantage is avoiding big overheads in a downturn. The burden of cyclicality is passed down the supply chain as subcontractors actually employ many of the workers on their own payroll, thus bearing the risk. The model can work when you have a very well-run business, pricing in the right margin. But, done poorly and used to create cash flow through large turnover as a smokescreen for a fundamentally unprofitable business, it is like a Ponzi scheme," he said.

Bringing it all back home

Farmer believes that the model creates a false sense of scale for some tier one companies. "Carillion has proven that using other people's money to fund cash flow for projects is a very fragile model. And the most worrying thing is that this is not just a Carillion issue. It is a generic issue that most of Carillion's peer group utilise, including some of the big Irish contractors."

The Irish construction industry needs to look at the implications of Carillion, said Farmer. He does point out that Carillion faced a range of very specific issues of its own, for example a problematic pension fund. Nevertheless, some issues highlighted in Carillion's accounts in recent days are reflected in those of other major construction companies, including in Ireland. For example, the growth of short-term debt as a proportion of turnover owed to and owed by Carillion to others in the construction industry illustrates the stresses and strains of the subcontracting model. An analysis of the most recent accounts of major Irish contractors suggests a similar rise in short-term debt.

Turnover has risen substantially at Irish contractors. For example, group turnover at John Paul rose from €160.8m in 2015 to €268.2m in 2016, while profit before tax went from €1.7m to €5.6m, according to its most recent set of financial accounts. Nevertheless, despite this increased profitability, amounts owed within a year to John Paul's own trade creditors such as subcontractors grew from €30.9m or 19.2pc of turnover in 2015 to €70.4m or 26.2pc of turnover in 2016. Likewise, the company's own debtors within the construction industry owed it €20.9m - or 13pc of turnover - within one year in 2015 and that more than doubled to €48.2m (18pc of turnover) in 2016.

Mullingar-based Bennett Construction also saw a big jump in turnover, up 36pc to €131.2m in 2016. But it too saw the proportion of debt owed within one year to trade creditors rise in 2016 to €56.4m - 43pc of turnover - compared to €29.1m or 30pc of turnover in 2015.

John Sisk's balance sheet showed only a small amount of such debt. But in 2015 its parent company Sicon was owed €149m on contracts, or 13.6pc as a proportion of turnover, and this rose to €181m, or 16.5pc, in 2016.

Money owed to BAM within one year for contract work rose to €69.6m in 2016 from €55.4m. As a proportion of turnover, unpaid contract work due within a year went from 14.4pc in 2015 to 19.3pc last year, despite a 6.7pc fall in turnover.

BAM's own trade creditors were awaiting more short-term debt in 2016 (€96m or 26.6pc of turnover) compared to €84m or 21.8pc of turnover in 2015. BAM - which is a subsidiary of a massive Dutch company and which has won numerous major contracts here including the Children's hospital and the Boland's Mill project - states in its most recent accounts that a key risk to its business is its "ability to properly evaluate the cost of projects at tender stage, the control and recording of these costs during construction and our ability to recover these costs under the prescribed payment terms of our contracts".

These metrics do not suggest a Carillion-style meltdown for any of these companies, but they do illustrate the dynamics of the subcontracting model, although legislation has been introduced here to strengthen protection for Irish subcontractors. Another trend that appears in the accounts is the rising cost of labour. At John Paul, for example, the average wage at the company rose 6pc between 2015 and 2016. Average wages at Bennett in 2016 were €77,130, up 15pc on 2015, while at BAM average wage rose 4.8pc to €77,218. At Sicon, average wages actually fell slightly from €80,199 in 2015 to €77,893 in 2016 but compensation to key senior management and directors rose from €1.8m in 2015 to €2.8m in 2016. These wage rises do not take into account a 10pc wage rise across the board for tradespeople due to a Sectoral Employment Order instigated in October.

This newspaper contacted major Irish firms for comment. A spokesman for John Sisk & Son said that the company's initial assessment of the Carillion situation was that "there is no direct adverse impact on Sisk".

"We are liaising with our common subcontractors and material providers in the UK on a daily basis to understand the challenges they face and we will help them wherever we can. Clearly the issues with Carillion have been well-documented and the construction industry needs to take heed and learn those lessons. It is a really difficult time for the people working there and it certainly creates challenges for some major projects in the UK," he said.

Sisk has very robust risk-management processes for pre- and post-construction which "ensure we manage our costs and bidding process very closely to ensure we can deliver sustainable returns on our projects," he added.

A lack of sophistication

Construction companies may need to examine their business model, but industry observers believe that their biggest customer - the public sector - also must change its ways. One industry expert insisted the public sector has "a lack of sophistication" in how it deals with contracts.

"Public sector bodies invariably go for the lowest price tender and that just encourages contractors to pitch low," he said.

This, according to Orla Hegarty, assistant professor at UCD's School of Architecture, Planning and Environmental Policy, is a major problem for the industry and for anyone who bemoans the poor delivery of critical public infrastructure.

She cites the example of then Minister Alan Kelly's announcement in October 2015 of a plan to build 1,500 social housing units at six different sites in five different local authority areas through a public private partnership (PPP). Two-and-a-half years later, the contract for the first batch of 500 units - valued at €100m - is still under negotiation with a short list of contractors. It smacks of a Carillion-style approach to the delivery of vital social infrastructure.

"In terms of procurement, this is the slowest and most expensive way to build housing," said Hegarty. "The bigger the contracts the longer they take. These sites could have been left as smaller lots and tendered amongst local SME builders. "By doing that they may have got better prices. Competition between SME contractors is an incentive to build well and establish a reputation for future contracts from the local authority down the line. The construction of these 500 houses could have happened within months of the announcement in 2015 and the houses could have been built and occupied last year."

But, says Hegarty, whatever major contractor ultimately wins the big PPP contract will bring management expertise and finance, but often subcontract the job out to the same SME builders and their subcontractors who could have bid for the work directly in smaller lots.

"In large outsourced contracts, the government department or agency may have little if any control over who those subcontractors are and weighing up their record on safety, or employment practices, or construction quality. When control of the supply chain is outsourced it is often entirely driven by price."

The British government is facing massive problems because it had so many of these types of contracts with Carillion. Similar contracts are used here too. Currently, according to figures compiled by industry analysts Linesight, the Government has more than €1.2bn worth of PPP contracts at various stages across sectors, including education, student accommodation, transport and social housing. A number of these, for example the social housing, the Grangegorman DIT campus and a DAA-backed hotel at Dublin airport, have faced delays of one sort or another.

"Effectively, with these types of PPP contracts, you pay a premium for deferring payment and extending out the contracts for many years.

"The social housing bundles include maintenance for 25 years. Ultimately it means you outsource decision-making and have less direct control over quality and specifications."

There was an inevitability around the collapse of the type of model that Carillion was operating, argues Hegarty. The business had been failing for some time.

"PPPs were established here on engineering contracts: on a roads contract there are fewer things to go wrong, it is easier to assess future costs, they are lower risk.

"But buildings like schools, hospitals and housing are far more complex, construction risks and future costs are difficult to price. So bidders walk the line between risking their business if their estimates are inadequate or charging a premium to cover all eventualities. There is no in-between."

The complexity of construction contracts and their long-term nature brings a significant amount of risk. Some risks are better retained and managed, allowing contractors to bid more competitively and with greater certainty about what is included. But, said Hegarty, what the Carillion experience shows is that risk is never really outsourced because ultimately it can fall back on the taxpayer. Contracts need to be monitored closely, she said.

The principal driver of PPP is to bring in private finance in order to remove capital spending from the government balance sheet, despite the fact that contractors must pay much higher rates for funding in the markets than the government.

"The rising market is putting pressure on construction contracts because projects that are on site now were priced when labour and skills were more readily available. This is starting to bite and it's a test of a Department of Finance strategy introduced 10 years ago to change the nature of construction contracts in the public sector. These contracts prioritise cost certainty over value and put more risk out on to the contractor instead of the government body carrying the risk," said Hegarty.

That, she said, leaves it to contractors to work out, for example, whether there will be delays on a job, or if there might be rock underground or if a grid connection might be delayed or any number of other things that can unexpectedly add cost to a construction projection and it leaves it to them to price in that risk.

"When the market collapsed in 2009, contractors started to take a gamble and stopped including allowances because they wanted to put in the lowest possible price so that they would get the job. I believe that we are now seeing that issue play out as the market improves," said Hegarty. "Some contractors who tendered for jobs a couple of years ago at very low rates are now finding it very hard to deliver and very hard to get subcontractors and suppliers at those rates. They have made commitments on contracts that may now be below cost and they are probably finding it quite painful. Some of that is down to the market rising but some of it is down to the way construction contracts were changed.

"Client bodies have to realise what is realistic. If a contractor is doing something that is below cost, all that happens is that inevitably materials may be substituted or corners may be cut.

"It is therefore in everyone's interest to actively manage procurement with a much longer-term focus on the building rather than the build: this means managing better in-house by supporting the people in the agencies who are best placed to manage risk and prioritise good quality and value for money."

Applying such principles of longer-term sustainability to the newly rebuilt edifice of the Irish construction sector is likely to prove crucial to the entire economy in the years to come.

Sunday Indo Business

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