Australia’s construction companies have tended to hide behind the performance of construction projects and the construction industry.
But in today’s economy, there is no real place to hide. The share price of some our major Australian construction businesses would signal that they are fully priced and show no great prospects for a leap in shareholder value any time soon. Most are trading around their 10-year averages - CSR and Boral are good examples.
Another to observe is Lend Lease, one of Australia’s leading construction operations. The company’s market capitalisation at the end of January this year was AU$7.55 billion. They were ranked 42nd in Australia’s top 100 companies, a little ahead of Mirvac at AU$7.032 billion and James Hardie at AU$7.132 billion. They were way behind 31st-ranked Stockland at AU9.724 billion, but some way ahead of Fletcher Building at AU$4.339 billion, Boral at AU$4.164 billion, and BlueScope Steel at AU$2.639 billion, which held 98th position amongst our ASX top 100.
Outside of these publicly listed companies are a number of large privately owned constructors. They make up the Tier 1 constructors in Australia. One wonders how they would be valued and how their share prices may have fared over this period. The big challenge for these businesses all boils down in my view to their value proposition. What’s in it for their customers? And then what’s in for shareholders? That is the big story for 2016.
Like all other businesses, construction companies must demonstrate they have viable long-term customer orientated value propositions that can translate into quality shareholder earnings. There’s been considerable recent shareholder value destruction while most publicly listed constructors wrestle with their essentially undifferentiated offerings and commodity like business models. I liken most of these businesses to the James Bond franchise. Their boards hire a new Bond, pay him a package and freshen up a script that’s a bit worn since Ian Fleming first created the fictional James Bond character in 1953.
The most vertically integrated construction enterprise is Lend Lease. The company provides a good case study. Technically, Lend Lease enjoys a dominant market position from which it offers large public and private organisations a low level of delivery and transaction risk. These clients pay a premium - perhaps more than they appreciate - but risk is risk. However, that risk swap premium does not necessarily translate into shareholder earnings. Lend Lease is as risk-averse as its customers. The construction operations indicate that at best it achieves low margin returns after passing most risk down to its consultants and contractors.
Other factors erode residual construction business margins. Lend Lease is a very high cost operator. Some insiders are resigned to a view that the company “only gets a run on projects that are bizarre, unique or in some way without typical cost constraints.” Lend Lease ties together a vertically integrated set of services that include construction, project formation, finance, deal packaging and investment management. Controlling all these margin points should be rewarding. But construction in Australia is not that simple.
The construction industry is lucky to have the level of insights that Lend Lease shares with their investors. This insight is not available with other Tier 1 contractors and developers, so it’s pretty hard for Lend Lease to benchmark with peers or to show where they have a measurable competitive advantage. With the pending sale of Laing O’Rourke’s Australian operations, perhaps more insights into construction performance benchmarks may become apparent, but the construction industry is doggedly measurement resistant.
Lend Lease’s Australian construction business turned over AU$5.912.7 billion and delivered a profit (EBITDA) of $152.4 million in 2014/15. That’s a mere 2.58 per cent. But perhaps the value was trapped somewhere else in the business? Lend Lease’s construction operations made up 76 per cent of the Australian revenue. The company reported a total group turnover of AU$13,298.6 billion, delivering an after tax profit of $618.6 million or 4.65 per cent. There’s a bit of cross subsidy going on. The company’s 2015/16 development pipeline looks promising, but it will be interesting to observe the impact of the Aussie construction business on group earnings.
Following five years of restructuring the business, Lend Lease now reports that it has completed moving through a Restore, Build and Lead market positioning strategy. Investors may expect that the development pipeline will deliver solid earnings over the next two years.
All constructors publish safety KPIs as an industry performance comparator. Safety is a delivery risk of the highest order. Lend Lease employs more than 12,400 people around the world, so there are a lot of people to keep safe. Lend Lease’s employees deliver about $50,000 of profit after tax per annum. But other business defining metrics seem to be more opaque and less comparable. These could usefully focus on the productivity big picture.
Construction productivity should be a front line issue for Lend Lease. A 20 per cent productivity improvement across the group (with most of it coming from construction) could lift after tax profit per employee to over $60,000 per annum. The same number of employees working more productively could help lift group after tax profit up to $744 million.
Lifting construction productivity in Australia is not just about taming unlawful union activity. There should be no delusion about the need to first look to improving off-site management effectiveness and internal business systems. These must translate into how projects are better specified, designed, procured, organised, measured and how more efficient construction methods are planned well ahead of workers commencing on-site. With clear strategies to improve construction productivity, Lend Lease and other Tier 1 contractors would then be positioned to put meaningful productivity lifting EBA proposals on the table.
On the face of the numbers, one might ask why Lend Lease is still in construction?
Despite the company’s ability to leverage its vertically integrated business model by employing modern construction technologies such as Building Information Management (BIM) systems and Design for Manufacture and Assembly (DfMA) following the recent announcement of a start-up entry into timber building construction, it's hard to see a direct correlation with intended productivity improving KPIs. Like its construction peers, Lend Lease is measurement resistant. There is no published data on what the company’s projects are costing, their productivity or their performance against independent bench marks.
I would imagine that the emerging costs of Lend Lease’s Barangaroo project in Sydney exercise the Risk Management Committee as much as their safety KPIs. If these are material to the construction and development pipeline bottom lines, why are they not reported?
It seems to me that Lend Lease is in construction to manage industrial risk. That is the premium they pay to have direct control over Enterprise Bargaining Agreements (EBAs) with the CFMEU. Its why Lend Lease EBAs are amongst the first to get settled and why they often become the baseline for industry-wide pattern bargaining by the CFMEU afterwards. The other Tier 1 contractors are in the same boat; they cannot afford delivery disruption.
The CFMEU boasts that they have not traded a single productivity benefit in the last EBA round. All the while, the cost of construction EBAs have increased at more than twice the rate of the nation's rate of inflation for the last 10 years. Lend Lease are a soft target. Yes, a good safety track record is important, but being in control at EBA time is paramount.
Improved construction productivity would also improve the potential economic performance of Lend Lease projects for investors. As Lend Lease and other Tier 1 contractors look to future growth in urban renewal, aged care and other social infrastructure projects such as affordable housing, schools and health, the cost of any productivity lag will require a higher level of public cross subsidy and recurrent debt than justified.
Consecutive governments have turned a blind eye to this public value leakage. Governments just want to announce projects, transfer the risk of getting them build and be on stage when they are delivered. These days, many of the projects that Lend Lease and their peers undertake are so large that the public has no way of determining if they are value for money. The treasury folk know, but it appears they just don’t want to tell.
So where to from here in the year of construction company stories?
Again, Lend Lease does some of the heavy lifting by the insights it shares. At last year’s investor briefing, the company shared its insights into the longer-term prospects of the global Tier 1 urban renewal market and the related opportunities. Sydney and Melbourne rank well down on the potential for major urban renewal opportunities going forward. The table presented at the investor briefing was instructive.
Perhaps Laing O’Rourke may concur, as they put their Australian operations up for sale. Possibly CIMIC (formerly Leighton) were feeling that Australia’s post-mining boom construction stimulus may be running out of steam when they put John Holland on the block and sold to Chinese infrastructure and engineering company CCCC International Holdings last year. CCCC have already signalled they intend entering the infrastructure and residential development market in Australia. Perhaps they can see an opportunity to be more cost competitive than some of the institutionalised construction locals.
Irrespective, 2016 will be a big year for construction company stories. The market's competitive dynamics are now starting to change. Just ask a few of the private Tier 1 constructors and materials manufacturers who are now busy off shore reshaping their future construction manufacturing and supply lines.