The current article aims to highlight the key aspects of the business of construction companies. After reading this article, an investor would understand the factors that impact the business of construction companies and the characteristics that differentiate a fundamentally strong construction company from a weak one.
Key factors influencing the business of construction companies
1) Intense price-based competition in the construction business:
The construction industry is highly fragmented with a large number of players: regional, national as well as international competing with each other for winning client business. In India, there are hundreds of medium to large-sized construction companies and innumerable small-sized construction companies.
Rating methodology – construction by ICRA, October 2022, page 2:
The construction industry in India is highly fragmented with the presence of a large number of players. The sector is dotted with the presence of more than 150 medium-to-large sized entities and the participants also face competition from some international players.
Due to a large number of players, the construction players are normally divided into segments/tiers based on their size of operations: Large, medium and small. Such segmentation is prevalent in almost all markets including India as well as overseas.
Rating methodology for general construction by Japan Credit Rating Agency, March 2012, page 3:
The construction industry has a multi-tiered structure, with super general contractors at the top. Each tier has its own level of competition, and companies are increasingly separated due to large disparities among the tiers.
Within a segment of construction companies i.e. large, medium or small, it is difficult to differentiate companies because almost all the companies within a segment are able to provide similar non-differentiable services.
For example, in India, large construction companies like L&T, Shapoorji Pallonji, Tata projects, GMR, GVK etc. are all able to execute big construction contracts like the construction of airports, dams, power projects etc. Therefore, the final selection criteria by the customer among these big construction companies are also based on the lowest bid.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 2:
There are few factors that can differentiate general contractors with similar business scale, and price competition frequently occurs even among major companies.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 4:
As such, the segment is competitive, with contracts largely obtained through competitive bidding.
This signifies that in the construction industry, a high amount of differentiation based on business capabilities is not possible and at end of the day, every company has to face severe price competition reflected in the lowest-bid-based selection criteria for winning orders.
Due to non-differentiable services, even large construction companies with the ability to execute complex projects also find it difficult to have customer continuity. In the construction business, good relationships with customers can help in the smooth execution of awarded projects; however, it does not guarantee an automatic allotment of new projects.
For new projects, existing contractors have to again compete in the bidding process.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 3:
good customer relationships can also be a differentiator for a contractor, it doesn’t guarantee future work. Clients frequently replace incumbent contractors for new bids due to differences in price or technical know-how.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, pages 2, 3:
For public sector projects, competitive bidding takes place in principle, and such bidding has also taken hold for private sector projects. Customer continuity is therefore not strong.
As a result of the combination of factors, a highly fragmented industry with a large number of players with similar, non-differentiable services, bidding to provide the lowest price to the customers, the construction industry faces intense price-based competition, which impacts the profit margins across the entire industry.
Advised reading: How to do Business Analysis of a Company
The presence of a large number of players in the construction industry is primarily due to low barriers to entry and competition from international firms. Let us discuss both of them.
2) Low barriers to entry in the construction business:
The construction industry in general has low entry barriers for new players. This is because the key factors creating entry barriers in other industries like a large capital requirement for setting up operations and proprietary technology are not required in the construction business.
In the construction business, a new player can start operations without a lot of capital investment and can easily source the existing technology from the market, which is widely available. As a result, during periods of high demand, numerous construction players come up in the industry, leading to heightened competition.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 3:
Barriers to entry are relatively low in the E&C industry…A small E&C company typically faces low startup costs to enter a local market, and we view the industry’s capital requirements as low relative to other industries…. contractors often lack true proprietary technologies or designs that create barriers to entry in certain end-markets.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 3:
market fragmentation reflects low market entry barriers that are the result of initial investments being low and proprietary technologies not being needed to enter local markets
Players in the construction sector do not need proprietary technology because, in this industry, technological changes are very slow. The technology stays stable for a long time and becomes widely available before there is any new major technological breakthrough.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 4:
pace of technological change in the E&C industry is generally slow, and technological displacement is typically not a major risk factor.
Apart from the lack of the requirements of a large capital and proprietary technology, another factor leading to low entry barriers in the construction industry is the easy availability of subcontractors.
Due to high prevalent culture of subcontracting, construction companies keep their own operations asset-light and whenever they get additional business, then they easily hire more subcontractors to execute the projects.
Rating criteria for the construction industry by CRISIL, February 2021, page 11:
Therefore, several companies operate extensively through sub-contractors to increase the variable element of their cost structures.
This strategy of executing projects mainly through subcontractors significantly reduces the fixed-capital requirement by construction players. As a result, if any new entrant in the industry wins a big order, then it has the confidence of executing the same with the help of subcontractors.
An investor should note that even though subcontracting increases the ability of a construction company to execute large projects without a significant investment in machinery and equipment; however, it reduces the profitability of the company because the cost of outsourcing/subcontracting is higher than doing the job in-house.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 5:
Using subcontractors can reduce profitability while typically reducing financial risk
Advised Reading: Credit Rating Reports: A Complete Guide for Stock Investors
Nevertheless, such business dynamics lead to easy entry of competitors in the industry increasing the competitive intensity in the industry.
Another factor, which leads to intense competition in the construction industry is the entry of international players.
3) International competition in the construction industry:
Nowadays, many construction companies have expanded their operations in overseas markets. This is true for both, the Indian construction companies expanding to foreign countries as well as foreign construction companies entering India.
In the recent past, Indian construction companies have started entering foreign markets as the level of competition in the Indian market has increased significantly.
Rating criteria for the construction industry by CRISIL, May 2013, page 2:
Large construction companies have also diversified into international markets, mainly in the Middle East and Africa, because of intense competition in the domestic markets.
On similar lines, construction companies in other countries like Malaysia have also started targeting foreign markets because competition in the local market is increasing.
Rating methodology for construction companies by Malaysian Rating Corporation Berhad, October 2019, pages 2, 3:
increasingly competitive operating environment facing construction companies in Malaysia….A significant trend seen in the operations of large construction companies is the larger proportion of overseas projects being taken on, in some cases exceeding 50% of their order books
In many cases, a shrinking domestic construction market like in the case of Japan has forced Japanese construction companies to expand in foreign markets for achieving growth.
Rating methodology for general construction by Japan Credit Rating Agency, March 2012, page 1:
The general construction industry is by nature competitive, and the domestic market has long been shrinking.
Moreover, the Japanese construction market does not seem to have any good prospects for growth in the near future. It is expected to shrink over time.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 2:
When factors such as Japan’s declining birth rate and aging population and the fiscal difficulties of central and local governments are considered, the market will most likely contract over the long term and market growth is hard to foresee.
The credit rating agency, Standard and Poor’s has also highlighted in its rating methodology for construction companies that engineering and construction companies often expand to overseas markets in search of new business.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 3:
national boundaries often do not present a barrier to entry for E&C companies.
Whenever foreign construction companies enter the local market, they bring in large capital and advanced technologies, which further increases the competition in the local market.
In addition to intense competition, the construction industry also witnesses cyclicity, which adds to the troubles of construction players.
Further advised reading: How to analyse New Companies in Unknown Industries?
4) Cyclicity in the construction business:
The construction industry is completely dependent on other industries for its business. The demand for housing and commercial construction depends on the state of the real estate industry. Similarly, the demand for industrial construction depends on the capital expenditure done by corporates, which is affected by the general economic cycle of boom and bust. In addition, the demand from urban infrastructure and public projects depends on the investment policies of the govt.
Therefore, the demand for construction business goes through alternate periods of low and high demand resulting in cyclicity.
Rating methodology – construction by ICRA, October 2022, page 2:
The construction sector exhibits a certain degree of cyclicality, being dependent on the real estate and infrastructure development activities and also on the overall economic growth of the country. Further, the industrial segment depends on the capex undertaken by other industries, which is cyclical
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 13:
Property development and construction are highly cyclical.
Due to cyclicity i.e. alternate periods of boom and bust, construction companies witness alternate phases of increasing and declining revenues as well as profitability.
The cyclicity in the construction industry makes the business environment tougher because, during periods of low demand, existing players bid aggressively just to keep their operations running. Such business practices seriously hurt the profit margins and shut down many small construction players.
The credit rating agency, Standard and Poor’s has also highlighted such aggressive pricing practices by construction companies during down cycles.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 3:
During periods of low industry demand, lack of pricing discipline among industry players have hurt profit margins as some contractors bid and take on lower margin work in order to keep their workforce employed and avoid revenue declines
The credit rating agencies in Japan have also highlighted the risk of a severe increase in price-based competition among construction companies leading to economically unviable prices.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, pages 4, 7:
Earnings tend to swing widely because in a deteriorating operating environment, companies can easily slip into price competition due to difficulties in differentiation.
Profitability easily fluctuates with changes in the order environment, and there is a risk of engaging in unprofitable projects.
Advised reading: How to do Financial Analysis of a Company
The intense competition in the domestic markets eroding profitability during the down cycle forces companies to look at overseas markets. This in turn increases the competition in the construction industry at a global level.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 4:
As a result of the industry’s cyclicality, most market participants tend to extend operations outside their domiciled country.
In order to protect their business growth and profitability from the intense competition and cyclicity, many construction players attempt to diversify their business operations.
5) Diversification helps in the construction business:
To reduce the risk in the business model and also to lessen the impact of cyclicity, construction companies diversify their business model. Companies achieve diversification on many different aspects like geographical location of projects, business segments, number of projects, number of clients etc.
A well-diversified business model brings stability to the financial performance of construction companies.
Rating methodology – construction by ICRA, October 2022, page 5:
diversified order book provides stability to a contractor’s revenues because of lower reliance on a specific geographic region, client, segment, or project.
Geographically diverse operations like an entry into different foreign markets shield the company from down cycles in any one locality. This prevents a sharp decline in its revenue and profit margins across cycles.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 8:
Diversity across several continents and/or economic regions as well as an exposure to a number of uncorrelated segments can mitigate earnings volatility.
Geographical diversification also protects the company from political and regulatory risks from any single market. It also reduces the probability of a large impact due to natural disasters in any geography.
Rating methodology – construction by ICRA, October 2022, page 5:
geographical diversity in their operations have lower exposure to regulatory risk pertaining to a particular region. Geographical diversification also reduces the impact of regional economic cycles on the entity and allows it to cope better with delays in projects (and, therefore, cash flows) caused by natural events like floods, droughts and earthquakes in the affected areas.
On similar lines, companies achieve diversification by taking projects in different segments like roads, power sector, oil & gas, residential and commercial real estate sector etc.
A company having operations in many different construction segments is able to mitigate the impact of the down cycle in any single industry. It helps in reducing volatility in the financial performance of the company.
Rating methodology – construction by ICRA, October 2022, page 5:
diverse construction segments (such as roads, bridges, power plants, building, power transmission, oil and gas, railways, and irrigation) have a lower susceptibility to regulatory risks. Further, diversification also reduces the contractor’s exposure to demand volatility and competition in any specific segment.
Similarly, companies executing a large number of projects whether within the same or different construction segments have a lower risk in their business. A concentration of business in a few large projects exposes the company to a higher risk of any issues related to the execution/progress of any single project.
Rating methodology – construction by ICRA, October 2022, page 5:
Excess exposure to a few large-sized projects can lead to high project concentration risk for a construction entity.
In this context, it is essential to understand that while executing any project, a construction company is faced with many factors that are completely out of its control.
Rating methodology – construction by ICRA, October 2022, page 6:
Some of the factors that can lead to delays in project execution and which are beyond the control of the contractor are climatic conditions/ topography, unavailability of the site, lack of environmental clearance, absence of other requisite approvals, change in Government policies/regulations
Therefore, construction companies should not concentrate their business on a few projects. As per the credit rating agency, ICRA, a construction company should limit its exposure to the top 5 projects at less than 65%-70% of its order book.
Rating methodology – construction by ICRA, October 2022, page 5:
ICRA, in its analysis, calculates the contribution of the top five projects to the contractor’s total order book; higher values (typically more than 65-70%) indicate high project concentration risk
Construction companies can bring diversification in their business along other aspects like the number of clients, which helps in limiting the risk of credit risk i.e. risk of receipt of money from the customer. In a well-diversified customer profile, the bankruptcy of any one customer does not impact the business significantly.
Construction companies also diversify their order book in public and private sector clients. This is because the public sector/govt. orders do not face the same cyclicity linked to economic cycles as private sector orders. A diversification between public and private sector orders mitigates the impact of general economic cycles on the business of construction companies.
Rating methodology – construction by ICRA, October 2022, page 6:
Public sector orders, on the other hand, provide more stability to revenues as they are relatively less prone to economic cycles. Furthermore, the counterparty credit risk is generally lower in case of public sector orders compared to private sector orders…A healthy mix of public and private sector projects help provide the contractor a more stable revenue stream and better working capital cycle.
Similarly, within projects, if a company has a mix of fixed price and variable price contracts, then its profit margins stay relatively stable when its raw material costs change.
Fixed price contracts do not allow for a pass-on of an increase in raw material costs to the customers. Therefore, the contractor has to bear its impact. Such contracts have a high risk of turning into loss-making during upcycle of commodity prices. On the contrary, variable price contracts transfer some of the risks of a raw material price increase to the customers by the way of “cost plus” contracts.
Variable price contracts protect the operating margin of the contractor; therefore, such projects usually have a lower profit margin than fixed price contracts, which exposes the contractor to a higher risk. Therefore, normally, fixed-price contracts have a high-profit margin at the time of signing.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 4:
Contracts that successfully shift these risks away from the contractor to the customer (such as cost-plus contracts) tend to be less profitable.
However, the actual profit margin is only assessed after the project completion, which might turn out to be entirely different.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 5:
the final profitability of a project will not be fixed until the completion of construction.
Similarly, a construction company may diversify its business across complex projects, which have a higher profit margin and a higher execution risk and simple projects that have a lower profit margin but can be completed easily.
Rating methodology – construction sector by CARE, December 2020, page 6:
operating margin will be higher for entities executing complex and niche projects.
Therefore, a diversification of the business of a construction company on different aspects like geography, clients, number of projects, construction segments, type of contracts etc. helps to reduce the risks in its business.
However, an investor should also note that like in any aspect of life, an over-diversification may not do any good for the construction company.
An over-diversification in construction segments may indicate that the company does not specialize in any particular segment, which may impact its order wins.
An over-diversification across geographies and several projects may make it difficult for the company to execute its projects efficiently and increase the execution risk.
Many times, construction companies diversify into real estate development, which exposes them to activities like project launches, sales, customer relationships etc., which contain additional risks. In many instances, construction companies are not able to manage these risks and in turn, fail e.g. Jaypee group.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 13:
DBRS Morningstar views involvement in property development as credit negative to an E&C company’s business risk profile because of the increased exposure to risk
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 5:
real estate business that seeks to recoup investment in a short period of time is particularly susceptible to market fluctuations and tends to have large risk exposures.
Similarly, construction players who enter into the build, operate and transfer (BOT) projects face risks like funding and revenue risks like the growth of traffic, which they had not taken while doing the construction work. Such enhanced risks have many times led to project failures and losses.
Rating methodology – construction by ICRA, October 2022, page 8:
BOT projects are also exposed to various other risks that are typical of projects like funding risk during under-construction stage and revenue risk or O&M related risks once a project becomes operational.
In addition, BOT projects require significant capital investment by the company, which is locked for a long period, which impacts the financial flexibility of the company to take on new construction projects.
Rating methodology – construction by ICRA, October 2019, page 11:
As the BOT projects require a sizeable equity investment and have long gestation periods, the capital gets locked in for a long period of time….For weaker projects, an adjustment is made in the net worth of the entity.
Therefore, an investor should be cautious while analysing the diversification attempts by construction players in other segments/industries.
Advised reading: How to Identify if Management is Misallocating Capital
6) Scale matters; big gets bigger in the construction business:
In the construction business, large-sized companies enjoy many advantages.
The first and biggest benefit is that for many projects, size/net worth is a qualifying criterion for bidding. Therefore, only companies larger than a minimum size are eligible to bid for such projects.
Rating methodology – construction by ICRA, October 2022, page 3:
The scale of the entity in terms of revenues and net worth is an important eligibility criterion when larger projects are bid for.
If a company is not large in size, then it can only act as a subcontractor to large companies in such projects.
Rating methodology – construction by ICRA, October 2022, page 2:
Apart from the big players, there are several small players in the industry…their participation is restricted to smaller projects and many work on a subcontract basis.
Due to size-related bidding qualifying criteria, large-sized companies usually enjoy better profit margins than small-sized companies.
This is due to two factors. First, as discussed above, large and complex projects usually have a higher profit margin than smaller, simpler projects. This is because, simple projects have much higher competition and lowest entry barriers than large complex projects, which many times require specialized skills and equipment.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 4:
Competition is especially intense as price is the key consideration for relatively simple projects, such as general contracting, building, and road construction, that do not require specialized expertise. Barriers are higher for companies involved in more large-scale industrial or civil projects that are more capital intensive and often require specialized equipment and proprietary technologies.
Rating methodology – construction by ICRA, October 2022, page 3:
larger entities, generally bid for larger and complex projects, which offer better margins
Rating methodology for general construction by Japan Credit Rating Agency, March 2012, page 3:
Middle-sized and smaller general contractors more frequently receive orders for less-profitable condominium buildings.
Second, the profit margins of direct contracts with customers have a higher profit margin than subcontracts.
Rating methodology – construction sector by CARE, December 2020, page 4:
Order received through direct participation is usually associated with higher margins vis-à-vis sub-contracted ones.
In addition, the clients also prefer to award long-duration, large, and complex projects to big construction companies with a strong financial position because it avoids the probability of contractor-related problems later on, which might otherwise require a replacement of a contractor with a lot of operational and financial impacts.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 6:
clients are reluctant to award contracts to lesser known companies that may not have the experience to successfully execute a contract…With large projects, which can sometimes extend for years, clients seek assurance that they will not have to change contractor mid-project due to a contractor’s financial distress.
This comfort of customers in dealing with large-sized construction players gives them a distinct competitive advantage. As a result, large companies have a higher negotiating power over their suppliers and subcontractors and also enjoy economies of scale which enhances their profitability.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 7:
size and market position determine market strength and the ability to benefit from economies of scale.
6.1) Access to working capital financing:
The large size of a construction company helps it in raising financing as well. Construction companies do not require a lot of fixed capital investment; however, they require a lot of working capital. This is in the form of non-fund-based facilities like bank guarantees that need to be submitted at each stage of the project starting from the bidding stage (bid guarantee), execution stage (performance guarantee) and later on for releasing of retention money.
Rating methodology – construction by ICRA, October 2022, page 11:
Bank guarantees (BG): These are required typically towards bid security (given at the time of bidding), performance security (given after contract is awarded), and against the release of retention money during the defect liability period (post completion of the project). For construction entities with long execution cycle and defect liability period, the BG requirement keeps on adding over time.
Apart from non-fund-based working capital (primarily bank guarantees), a construction company also requires fund-based capital to mobilize equipment and manpower to start a project, purchase raw materials and fund its operations until the money is received from customers.
As a result, a construction company requires a significant amount of working capital to run its business.
Rating criteria for the construction industry by CRISIL, February 2021, page 11:
Construction companies have sizeable funds tied up in working capital.
Rating methodology – construction sector by CARE, December 2020, page 2:
Construction contracts are associated with relatively large working capital requirement (mainly non-fund-based). Delays in receipt of dues from clients along-with delays in project execution results in receivable and inventory build-up and increase in working capital requirements.
Due to a large requirement of working capital for construction projects, the availability of working capital financing becomes a key limiting factor in the growth of construction companies.
Rating methodology – construction by ICRA, October 2022, page 11:
availability of sufficient working capital bank lines as a key credit factor as in the absence of the same, the company is unable to take up new projects. This can also have an adverse impact on the company’s ability to efficiently execute the ongoing contract since during the execution phase
Therefore, large construction companies have better access to working capital financing from both lenders and capital markets and are at a competitive advantage.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 3:
large construction companies often have better access to third-party capital and letters of credit, which are often necessary for large projects and are an advantage during difficult market conditions and competitive bidding processes. Scale is therefore a main rating driver for companies in this industry.
As per S&P, the ability to timely access working capital is a key competitive advantage for large construction companies.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 3:
access to capital and surety bonding, which is often required for larger projects and is typically more available for larger companies, can be an important differentiator
Small-sized construction companies suffer from a lack of access to financing, which affects their business growth.
Rating methodology for general construction by Japan Credit Rating Agency, March 2012, page 5:
Meanwhile, middle-sized and smaller general contractors in particular have limited hypothecated assets, and external financing is not always easy for many of them.
Therefore, large-sized construction companies enjoy many competitive advantages and their strong market position positions them in a favourable position for new orders.
Rating methodology – construction by ICRA, October 2022, page 3:
scale of a construction entity’s operations indicates its relative market strength, operating flexibility, and its ability and expertise to undertake large projects.
Advised reading: How To Analyse Operating Performance of Companies
6.2) Access to skilled manpower:
Apart from working capital, hiring skilled manpower is also a key area for construction companies especially while executing large & complex projects.
Rating methodology – construction by ICRA, October 2022, page 6:
Attracting and retaining skilled manpower is also one of the key challenges for contractors, as is the training of human resources, given the increasing complexity of projects.
Retaining skilled manpower is difficult in the construction industry because the working conditions in the construction industry at the site are very harsh and workers may need to work in places, which are difficult to reach, with basic facilities and away from the comforts of city life.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 4:
The working environment surrounding skilled workers is harsh compared to other industries.
In such a situation, construction players need to pay significantly to the skilled workers to retain them. As a result, large construction companies with the strong financial position are at an advantage to pay a premium remuneration to skilled manpower.
Apart from the above, during economic downturns, large construction players, many times, compete aggressively on price and even go down in the project hierarchy level and bid for smaller projects, which are otherwise bid only by smaller players. In such cases, the smaller players face tremendous pressure and many of them shut down their businesses.
Rating methodology for construction sector by Rating and Investment Information, Inc (R&I), Japan, August 2021, page 2:
When demand is declining, competition for orders is also found across the hierarchy, as exemplified by major companies’ move to acquire projects of a scale and difficulty that would normally be handled by semi-major companies, for the purpose of maintaining a network of partner companies.
Therefore, in the construction industry, large-sized companies enjoy many competitive advantages and in turn, big players keep on becoming bigger.
7) Normal financial analysis is not very useful for construction companies:
Construction companies use different accounting methods like the “percentage of completion method (POCM)” or the “completed contract method (CCM)” with many management assumptions.
Rating criteria for the construction industry by CRISIL, February 2021, page 5:
construction companies can and do adopt varying accounting policies for income and profit recognition, analysis of accounting policies is a critical first step in their financial risk analysis.
Many times, we find it very difficult to assess the actual state of the business on the ground from the reported financial statements of construction companies. It is primarily due to the following reasons.
A construction contractor’s business is an accumulation of all its projects under execution. Unless each of these projects is assessed individually, the complete business position of the construction player cannot be understood. From the publically available information, we find it difficult to assess whether these projects have key factors like land acquisition, govt. approvals etc. in place. We have always been sceptical about the cost estimates shared in the publically available information whether these are the real ones or there have been escalations, which companies usually hide from stakeholders.
The construction players usually have many subsidiaries and the assimilation of subsidiary financials into the main company leads to many areas of accounting manipulations, which always raise an alarm in business assessment.
The revenue of the construction players is derived from the cost incurred by them as these companies use a percentage of completion method (POCM) for revenue recognition. The revenue declaration has no linkage to the actual cash that a construction player might or might not receive. Many times, using the percentage of completion method (POCM), construction companies show even that part of the project work in revenue whose bills are not sent to the customers, which gives rise to “Unbilled Revenue” in the balance sheet. Many times, there are disputes between the stage of the project claimed by the construction player and the Govt Departments/project allottee who have to release the payments etc. It cannot be assessed from the publically available information how the situations are on this front.
Rating methodology – construction by ICRA, October 2019, page 8:
When projects get delayed, claims for idling of resources and cost overruns are submitted by the contractor and in some cases counter-claims are lodged by clients. Such disputes usually take a long time to get resolved. A construction entity that recognises such claims as revenues without the final settlement is viewed negatively by ICRA.
POCM usually has a threshold of project completion stage for the start of revenue recognition. Before this stage is reached, no revenue is recognized even though the project work continues. In addition, the cash from customers is received only at reaching specific milestones/timelines. Therefore, construction companies do not have a steady flow of revenue and cash inflows like other industries.
In addition, an inflow of cash from the customer may be much delayed than its recognition as revenue in the financial statements. Therefore, the usual financial ratios used in other industries do not provide the best interpretations for construction companies.
Rating criteria for the construction industry by CRISIL, February 2021, page 5:
Revenue and cash flow of construction companies could be lumpy given the nature of business. Additionally, there could be a sharp distinction between cash flow and accrued income. Therefore, conventional techniques of ratio analysis are often not sufficient to ascertain the credit worthiness of a construction company.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 9:
Project execution risk inherent in the E&C industry can cause high variability in reported results.
In a normal financial analysis, we focus a lot on long-term debt while determining the leverage levels of any company. However, construction companies usually have a low long-term debt because they have a small amount of fixed assets, which can be provided to banks as a security for long-term debt.
Instead, construction companies rely a lot on short-term working capital debt for both; running their day-to-day operations as well as for financing their long-term assets.
Rating methodology – construction by ICRA, October 2022, page 13:
construction companies generally have limited access to long-term funds…companies often face asset liability mismatch with higher long-term assets compared to the long-term liabilities
As a result, the normal financial analysis relying primarily on long-term debt is not highly relevant for construction companies.
Rating methodology for construction companies by Malaysian Rating Corporation Berhad, October 2019, page 6:
Traditional measures focusing on long-term debt have lost much of their significance, since companies rely increasingly on short-term borrowings. It is now commonplace to find permanent layers of short-term debt, which finance not only seasonal working capital but also an ongoing portion of the asset base.
Moreover, under many contracts, customers provide a sizable mobilization advance to construction players, which is effectively a debt, that the construction players use to finance the purchase of equipment and mobilization of machinery and manpower to the project site. As a result, many times, the most significant liability of a construction contractor is not the debt from the financial sector but advances received from its customers.
Rating methodology – construction by ICRA, October 2022, page 11:
Some contracts have the provision of mobilisation advances (generally 10% of the total project value)…these can have a bearing on the entity’s financial profile, depending on whether these mobilisation advances are interest-bearing or not
Therefore, at times, leverage ratios focusing only on long-term and short-term debt from lenders do not provide meaningful information about construction companies.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 6:
DBRS Morningstar recognizes that debt-related financial metrics are not as meaningful.
Mobilization advance received from customers is usually for exclusive use for a specific project. Therefore, even though a construction company may have a large cash balance; however, if it comprises a project-specific mobilization advance, then it cannot use it for meeting its cash obligations for other purposes like debt repayment.
Therefore, simply looking at the cash balance of a construction company may not give a good picture of the available liquidity.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 13:
general contractors with large fixed-price contracts, often have sizable advanced payments that will be worked off over a relatively short period of time as the project moves from the engineering phase to the procurement and construction stages. Thus, simply focusing on total cash balance does not present the full liquidity picture.
Moreover, many times, relying on usual financial ratios like debt services coverage ratio (DSCR) and free cash flow (FCF) may also lead to erroneous conclusions.
Rating methodology for construction companies by Malaysian Rating Corporation Berhad, October 2019, page 7:
debt service coverage and free cash flow…Interpretation of these ratios is not always simple, higher values can sometimes indicate problems rather than strength. There is no correlation between creditworthiness and the level of current cash flow.
Therefore, while analyzing any construction company, an investor should always remember that an analysis of normally presented financial statements may not present a true picture of the business position of the company.
Advised reading: Detailed Analysis Of A Company: A Framework
8) Special ratios for analysis of construction companies:
Looking at the unique features of the business model of construction companies, some ratios seem to provide some insights into their business position. However, an investor should remember the cautions highlighted in the section above while making interpretations and take any decision after corroborating multiple ratios using data from multiple sources.
8.1) Order book to sales ratio:
A ratio of the unexecuted order book and current sales shows the visibility of business for the near future.
A higher ratio may indicate that the company has a sufficient unexecuted business, which it can execute and generate revenue over the next few years. However, a higher ratio may also indicate that the company has execution problems and is not able to complete current projects to start work on new projects.
Moreover, a high ratio may also indicate upcoming execution challenges that a company may face if it is not able to increase its execution scale and efficiency.
Rating methodology – construction sector by CARE, December 2020, page 5:
A very high order book to sales ratio may be a constraint from a credit perspective, if the company does not have adequate resources to fulfil its contractual obligations or may also be an indication of some delayed/stuck orders.
A lower ratio may indicate that the company is not able to win new orders to create a steady pipeline of new projects for future business. Though it may also indicate a very fast execution of current projects; however, it may also be a sign of the deteriorating market reputation or competitive position of the company due to which it is not able to win new projects.
As per DBRS Morningstar, this ratio is usually between 1.5 to 2.0 times for construction companies.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 13:
company’s backlog position through its backlog-to-revenue ratio that will typically fall between 1.5:1 and 2.0:1.
Moreover, in this ratio, an investor should be cautious while using both the parameters i.e. order book and sales. Regarding order books, management always uses subjective assumptions while reporting the data. It is always subject to debate when an order should be included in the order book; when a letter of award is received? Or when a company is declared the lowest bidder? Or when all necessary permissions to start the work are received? And so on.
Rating methodology – construction by ICRA, October 2022, page 4:
while assessing the size of the order book, adjustment is done for slow-moving or stuck projects, which are unlikely to contribute to the revenue in the near term.
Similarly, for sales, an investor should always closely study the assumptions regarding at what stage a company recognises the executed work under revenue. Whether it waits for an acceptance of the bill by the customer? How it treats revenue disputes by the customers?
8.2) Bid success ratio:
It is a ratio, which indicates out of the total bids for new projects submitted by a company, how many it has won.
A high ratio may indicate that the company is a low-cost, efficient construction player. However, it may also indicate that the company is bidding aggressively for new projects in a desperate state to earn more revenue. If this is the case, then many of these projects may prove unviable/non-profitable in future leading to losses.
A low ratio may indicate that the company lacks the technical and financial position to meet customers’ requirements. It may also indicate that the company has a high-cost business and it is not able to compete with its peers.
An investor may compare the bid submitted by the company with its competitors to assess whether the company is resorting to aggressive bidding to gain new business.
Rating methodology – construction by ICRA, October 2022, page 6:
Whether the project is secured through aggressive bidding…evaluates the difference between the top two bids (lowest bid or L1, and second lowest bid or L2) for the tender in case of competitive bidding.
8.3) Asset turnover ratios:
Asset turnover ratios are calculated in different forms sales to gross block ratio, sales to net block ratio etc. These ratios indicate whether a company has invested a lot of money in owning equipment for project execution or it relies on subcontracting.
A lower asset turnover ratio may indicate a large investment in the equipment by the company i.e. self-reliance in execution. However, it may also indicate an underutilization of its equipment.
A higher asset turnover ratio may indicate increased use of subcontractors by the company for project execution.
If a company relies more on the self-execution of projects by investing money in equipment, then it would earn a higher profit margin. However, during the downturn, idle equipment will hurt its financial performance.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 9:
Vertical integration can provide direct access to strategic raw materials at a low cost in some instances, creating an advantage in times of high capacity utilization or when raw materials are in short supply. However, it can be a burden when industry capacity utilization is low due to relatively high capital intensity.
On the other hand, increased reliance on subcontractors for project execution increases the financial and operating flexibility of the company; however, it reduces its profit margins because subcontracting is costlier than in-house execution.
Rating methodology – construction by ICRA, February 2013, page 2:
Other factors such as subcontracting also increase a company’s operating flexibility, but at the same time reduce its operating profitability as well.
Further advised reading: Asset Turnover Ratio: A Complete Guide for Investors
8.4) Using total outside liabilities for calculating leverage:
Construction companies use a mix of long-term debt, short-term (working capital) debt as well as customer (mobilization) advances to fund their operations and assets. All these sources of money are outside funds, which come to the company with obligations. Therefore, while calculating leverage, an investor should not ignore any of these aspects.
In its analysis, the credit rating agency, ICRA uses total outside liabilities (TOL) for calculating leverage.
Rating methodology – construction by ICRA, October 2022, pages 9, 10:
For construction companies, a sizeable liability is in the form of mobilisation advances from clients, hence the TOL/TNW ratio gives a holistic view of the leverage
- Total Outside Liabilities = Total Debt + All Long-Term and Short-Term External Liabilities such as Deferred Tax Liability, Creditors and Other Liabilities
Moreover, an investor should not forget that at any point in time, a construction company has issued numerous bank guarantees for its obligation under the bidding process, project execution and operations. All these bank guarantees are a big contingent liability for the company, which may become actual financial liabilities if it is not able to perform well on its obligations.
Rating methodology – construction by ICRA, October 2022, page 13:
These bank guarantees form a sizeable part of the contractor’s contingent liabilities.
Moreover, while assessing the total leverage of a construction company, an investor should always keep in mind the double leverage when a construction player takes a debt at the holding company/higher-up subsidiary level and infuses it as equity in a project executed by lower-down subsidiaries/joint ventures/associate companies.
Rating methodology – construction by ICRA, February 2013, page 7:
In case of debt fund raising by HoldCos to fund equity investments in the SPVs, the concept of double leveraging gains importance which results in reduction of the developer’s effective financial commitment in the projects and consequent increase in the lender’s exposure to project risks.
8.5) Importance of cash flow-based parameters for construction companies:
In construction companies, accrual and cash flow-based performance parameters differ significantly because, in the case of the percentage of completion method (POCM) accounting, recognition of revenue in the profit & loss statement (P&L) may not align with the milestone-based cash payment to be done by the customer. In addition, a customer may even dispute the stage or quality of the work done by the contractor.
Therefore, a company may report a significant revenue and profit in the P&L whereas the customer may not be obligated/willing to make any payments.
Therefore, in the case of construction companies, it becomes essential to focus on cash flow-based parameters.
One such parameter used by Standard & Poor’s is free operating cash flow (FOCF) to debt.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 12:
Free operating cash flow (FOCF) to debt as the preferred supplemental ratio…FOCF, which is determined after changes in working capital and capital expenditures, may be a more accurate measure of a company’s cash flow in relation to its financial risk profile.
However, the business of construction companies is such that even the cash flow sees large fluctuations due to large changes in the working capital year on year.
Key credit factors for the engineering and construction industry by Standard & Poor’s, November 2013, page 12:
E&C companies demonstrate volatile discretionary cash flow. This is often due to large working capital swings as well as unexpected and often large cost overruns.
Construction and construction materials rating methodology, Scope Ratings GmbH, Germany, January 2022, page 9:
construction companies generally have high and volatile working capital requirements during project cycles.
As the working capital position of a construction company influences its cash position significantly, therefore, any changes in the parameters impacting the working capital of the company like inventory and receivables should be analysed in detail.
Any increase in inventory or receivables of the company may be a sign of a stuck project or a weakness in the financial position of the customer.
In light of challenges in using routine parameters and ratios in the assessment of construction companies, an investor may use other information points to assess its financial strength.
Further advised reading: Free Cash Flow: A Complete Guide to Understanding FCF
8.6) Pledge of shares by promoters:
Pledging of shares by promoters is an important parameter, that an investor should always focus on while analysing any construction company. This is because, if the promoters have used their shareholding in the company to take loans for their personal purposes, then they may attempt to get a higher cash flow from the company in the form of higher remuneration or dividends to repay their loans, whereas these pay-outs may not be in the best interests of the company.
Rating methodology – construction by ICRA, October 2022, page 13:
measures of an entity’s depleting financial flexibility, one relates to a high share of pledged promoter shareholding. A sign such as this may imply that the entity might be persuaded to distribute high dividends or support the promoter group through other means to the detriment of its own credit profile.
Moreover, if the promoters have pledged a large proportion of their shareholding then the lenders may hesitate to give loans to the company because any default by promoters to their lenders may lead to a sale of promoters’ stake by their lenders. It may even lead to a change in the control of the company, which may have further detrimental effects on the company.
Rating methodology – construction by ICRA, October 2022, page 13:
If the promoters fail to repay their loans (availed by pledging of shares) or top up collateral when required, the lenders could sell the pledged shares. In some cases, this could trigger a change-of-control clause in the rated entity’s bond indentures or loan documents and require it to redeem its debt ahead of schedule, creating a liquidity squeeze, besides affecting fresh capital raising ability
Therefore, an investor must focus on additional parameters like the pledge of promoters’ shareholding while assessing construction companies.
Advised reading: Share Pledge by Promoters: A Complete Guide
9) External factors impacting construction companies:
The execution of projects by construction companies is influenced by numerous factors, which are beyond the control of construction companies. Many of these factors are related to nature i.e. difficult access sites, and natural disasters impacting project execution; however, others are more regulatory and socio-political.
Construction projects are influenced by govt. policies regarding land acquisition, public investment, labour laws, and project approvals like environmental approvals where a company and its management may not have full control.
Due to the labour-intensive nature of construction work, construction companies are susceptible to any changes in labour laws. In one instance, in Malaysia, where the construction industry was highly dependent on illegal migrant labour, the entire industry was severely impacted when the govt. implemented a crackdown on illegal migrants.
Rating methodology for construction companies by Malaysian Rating Corporation Berhad, October 2019, page 2:
The crackdown and repatriation of illegal workers by the Malaysian government in 2004 showed how vulnerable some construction companies were to labour shortages that arose as a result of this action.
Moreover, processes like land acquisition and local labour issues have the potential of escalating into social issues, where knowledge of the local socio-political environment becomes essential for any company.
Due to the importance of local knowledge in the selection of projects and their execution, regional players have an advantage over outside companies. To counter the lack of local knowledge, many outside players attempt to gain local knowledge by appointing local subcontractors. However, at times, a lack of local knowledge becomes a cause for project failure.
As per DBRS Morningstar, these risks are a major reason for the failure of overseas construction companies in any market.
Global methodology for rating companies in the construction and property development industry by DBRS Morningstar, November 2022, page 12:
companies suffering project-related losses in developing countries, DBRS Morningstar observes that these losses are caused by one or more of the following (1) underestimation of project costs and risks (possibly caused by a longer permitting process, labour and subcontractor unavailability, higher labour and material costs); (2) malpractice or nonperformance of local agents, partners, or subcontractors; or (3) lapses in risk management practices, allowing regional managers to bid for and execute suboptimal projects.
While construction companies do not have a significant direct impact on the environment due to their construction activities, which are limited to soil and water pollution at the project site; however, in case, the project is stuck in environmental issues, then it may impact the project significantly.
Rating methodology for construction companies by Malaysian Rating Corporation Berhad, October 2019, page 8:
Environmental liabilities and serious legal problems restrict flexibility, as a major lawsuit against the company would result in suppliers and customers shying away while the company’s access to capital may also be impaired
Therefore, an investor should assess each project of a construction company to find out if any of them is facing environmental, legal, regulatory, social or political challenges.
Summary
Overall, the construction business is highly competitive where numerous local and international players compete with each other by offering the lowest possible price to the customer. New players can easily enter the industry because it does not require a large capital investment as players can easily hire equipment on lease and people on contract. In addition, players save on large investments by engaging subcontractors.
The construction business does not require any proprietary technology because the prevalent technology is widely spread and easily available. Therefore, a large number of players enter the sector during good times and similarly a large number of players exit during tough times.
The construction industry depends on other industries like real estate, manufacturing, public investment in infrastructure and govt. investment policy for its business. Demand from all these sources is cyclical and witnesses alternate periods of high and low demand. Therefore, the construction business faces cyclicity with alternate periods of increasing and decreasing revenue and profit margins. During downturns, many players go out of business.
To avoid the impact of cyclicity and to reduce risk in the business, construction players diversify their business in different geographies and construction segments, across many projects, public & private sector customers etc. An increase in diversification brings stability to the revenue and profitability of the companies.
However, excess diversification dilutes the competitive advantages of specialization and also exposes the companies to risks that may be outside their competence. Many times, construction companies have failed in their attempts to expand into real estate/property and BOT project development.
In the construction business, a large size of operations provides many advantages. Big companies easily qualify to bid for large, complex projects that are more profitable. Large companies have better access to financing for the smooth running of the business as well as growth. They can hire and retain skilled manpower better and also enjoy economies of scale and better-negotiating power over their suppliers and customers. As a result, most of the time, big gets bigger in the construction business.
Construction companies follow different accounting practices for revenue recognition like percentage of completion method (POCM), contract completion method (CCM) etc. The nature of the construction business and its accounting convention is such that most of the time, the profit and loss statement based on accrual accounting does not properly reflect the on-ground business position.
Moreover, construction companies rely primarily on working capital debt and mobilization advances to fund their operations and assets, unlike long-term debt in other industries. Therefore, normal ratios and parameters do not provide good interpretations for construction companies.
As a result, special ratios are used to analyse construction companies with a special focus on cash flow-based analysis. Order book to sales ratio, bid success ratio, asset turnover ratios, total outside liabilities, cash flow-based ratios, in-depth working capital analysis and other parameters like the pledge of promoters’ shareholding are used to ascertain the financial and business strength of construction companies.
However, despite all the efforts spent on doing such financial and business analysis, still, many factors that are beyond the control of companies but have a significant impact on project execution, demand the attention of investors. Such factors include local socio-political and legal aspects. Construction companies are exposed to regulatory, labour, and environmental challenges and in turn need a lot of knowledge of the local environment for successfully executing projects. Lack of proper local knowledge has led to losses for many international construction companies.
Therefore, an investor should always keep in mind these multiple aspects of construction companies to understand the true picture of their business position.
- Intense price-based competition from domestic and international players
- Low barriers to entry
- Cyclicity in the business
- Diversification helps to stabilize performance
- Large business size offers competitive advantages
- The normal financial analysis does not provide many useful insights
- Special ratios are needed for analysis: Order book to sales ratio, bid success ratio, asset turnover ratios, total outside liabilities, cash flow-based ratios, and in-depth working capital analysis
- Many external factors impact project execution like socio-political, legal, regulatory, environmental and labour related
We believe that if an investor analyses any construction company by considering the above parameters, then she would be able to assess its business properly.
Regards,
Dr Vijay Malik
P.S.
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Disclaimer
Registration status with SEBI:
I am registered with SEBI as a research analyst.
Details of financial interest in the Subject Company:
I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.
2 thoughts on “How to do Business Analysis of Construction Companies”
Sir, please share how to do an analysis of a logistics company.
Thanks for your suggestion, Raju.