From our CEO Patrick Coghlan - On March 16 this year, an emotional Tracy Marais fronted a press conference at the Gold Coast headquarters of construction company, Condev Construction. Fighting tears, she announced that the company she and her husband, Steve, had founded, which had a $1 billion pipeline of developments, was being placed into voluntary liquidation. The collapse follows the high-profile voluntary administration of Brisbane construction company, Probuild, one of Australia’s largest builders, with a national pipeline of $5 billion, along with Melbourne-based ABD Group and Brisbane-based Privium Homes. A string of builders has recently followed, including Perth-based Home Innovation Builders and WA’s New Sensation Homes. James O’Donnell, CEO of Open Analytics, says the construction industry’s credit metrics, particularly insolvencies, are set to worsen in the next 12 months as the impact of collapses is felt. Like the rest of the Australian economy, the construction industry was getting back on its feet after COVID-19. But the sector has now been hit by a perfect storm of staff shortages and cost blowouts as inflation surges globally. Many of these forces, particularly cost rises, are beyond the control of construction companies. But construction also has major industry-specific challenges. As this report notes, construction has the worst late payment of any industry. About 12 per cent of construction businesses are more than 60 days in arrears on their payment to suppliers. The risk is that construction collapses cascade down, creating a chain reaction of failed businesses. That could have a serious impact on Australia’s economic recovery. In the wake of the high-profile construction collapses, there are calls for industry reforms and greater support from Government. But there are no guarantees those calls will be met imminently. As I noted in my commentary on the collapse of Probuild, there were many early warning signs that business was in trouble. Using our sophisticated machine learning technology and multiple subsets of unique data, CreditorWatch rated Probuild a high credit risk ratingV in October 2021, with its risk of default or insolvency significantly higher than the average Australian business, and well above the industry average. Ultimately, with serious cracks appearing in the construction industry’s credit foundations, our best protection is for all parties to be vigilant and look for early warning signs that construction businesses are in trouble.
A vital industry for Australia’s post-COVID recovery
- The Australian economy is at a crucial inflection point in its post-COVID-19 recovery. According to the March
2022 CreditorWatch Business Risk Index (BRI), Australian business activity is finally showing some green shoots
of recovery. B2B trade activity has increased for a second month in a row – up 55 per cent on its January low (though still down 35 per cent year on year). Credit enquiries were also positive, rising 45 per cent over the last quarter. But there are also negatives. B2B trade payment defaults and court actions have continued to rise in March, which signals an increase in business insolvencies in the short to medium term.
Despite the green shoots, the Australian economy is facing several challenges that could derail the recovery, including post-COVID supply chain disruptions, increasing inflation, looming rate rises and labour shortages.
A healthy construction sector is vital to a strong economic recovery and ongoing growth. The industry employs roughly 9 per cent of Australian workers, putting it behind only healthcare, retail and professional services in terms of employment numbers. “It is incredibly important for the Australian economy,” says CreditorWatch Chief Economist, Anneke Thompson.
Construction directly accounts for 7.5 per cent of Australia’s gross domestic product (GDP). But its indirect impact is also substantial, with the sector contributing
to building the likes of roads, warehouses, offices and hospitals that are needed to drive the economy.
A crisis in the construction industry has the potential to flow through to the broader economy. Thompson notes that many smaller operators secure their houses
against their businesses.
“So there is the flow-on impact to personal home loans/finance. The sector is not only important while the build is happening, but also for the economic benefit that the end product provides. If we can’t build enough hospitals, schools, roads, and houses now because the industry is in crisis, it impacts employment and economic growth years into the future.”
But credit cracks are looming
- According to the March 2022 CreditorWatch Business Risk Index (BRI), the construction industry has a relatively low probability of default at 3.9 per cent.
But as the high-profile collapses highlight, that outlook is under threat. James O’Donnell, CEO of Open Analytics, says he expects credit metrics in the construction industry to worsen with the industry hit by cost pressures and labour shortages.
“We have seen some big-name failures in recent months and the fallout from these events on smaller players is yet to be fully realised,” he says. “Cost pressures and
compressed margins don’t appear to be going away soon, so expect more insolvencies in this sector over the next 12 months.
“All the key indicators, such as insolvencies and payments behaviour, point to some tough times ahead.” Ginette Muller, a Director of GM Advisory, says after record-low insolvencies in 2020 and 2021, insolvency numbers in construction have returned to pre-COVID levels. She says there appears to be an increase in smaller builders and subcontractors going under, along with the small pocket of larger entities. Muller notes that CreditorWatch sees problems in southwestern areas of Brisbane and the Gold Coast, and in Western Sydney. “This is consistent with what I’m hearing.”
CreditSource analyses and assesses the financial position of many construction sector companies each year, giving it visibility on both listed and private companies in the industry, from tier 1 to SME contractors. CreditSource CEO, Shavantha Mallawa, says the industry was already struggling with revenue reductions and a slowdown in growth due to COVID-19 lockdowns. Now reduced or stagnant revenue, coupled with sharply escalating costs, have resulted in reductions in profitability for most in the industry. “Several previously profitable companies have recorded losses,” he says. The companies with a strong balance sheet can withstand some losses, but many, and particularly smaller contractors, show signs of financial distress because of losses.” Residential construction companies have not faced as many challenges in terms of collecting receivables as commercial builders have, Mallawa says.
“This is due to project owners facing difficult trading conditions and business disruptions due to the pandemic. The commercial builders have seen average receivable periods rising.” Mallawa notes the average payable period of some builders has also increased, which indicates late collections by them have been compensated by late payments to suppliers and contractors. “The SME subcontractors we spoke to have complained of long delays to get payments and stated they tend to increasingly deal only with builders who pay promptly,” he says. “Also, there is a trend to concentrate more on government contracts as payment is guaranteed and is prompt.” At the same time, lenders are becoming more conservative with their lending policies to the industry, which means external debt levels haven’t been increasing.
A double whammy of costs and labour shortages
- The construction industry operates on thin margins, but those margins have been hit by a surge in costs as
Australia and the rest of the world has moved to a higher inflationary environment. “There is probably no industry
in Australia that has felt the challenges more quickly and acutely than the construction sector,” Thompson says,
adding that many construction products are sourced on international markets.
She notes a particular issue for the construction sector is that costs rises are being caused by both demand and supply side issues. On the demand side, COVID-19 triggered a renovation boom. The Australian Bureau of Statistics (ABS) recorded a 27 per cent increase in the value of residential building work done on alterations or additions.
On the supply side, ever-increasing costs are adding significant pressures on major building contractors through to smaller sub-contractors. Cost increases are being felt across the board, including building materials, labour, transport, storage and utilities. “It doesn’t look like pressures will come off prices any time soon,” Thompson says.
Rider Levett Bucknall (RLB) forecasts future tender prices through their Tender Price Index data series, and their forecasts show that each major capital in Australia is likely to face significant increases in their construction tender prices, with both Brisbane and Melbourne facing higher construction cost increases in the next three years than they have recorded over COVID-19, or even the preceding three years before COVID. If the war in Ukraine drags on, this will have an impact on prices globally because European supply will be impacted. “They will go looking to other markets to source products and drive up prices everywhere,” Thompson says.
Rising interest rates add further risk
- But those cost rises could create additional pain for the construction sector as the Reserve Bank hikes interest
rates to dampen inflation. Cost rises, not just in the construction sector, but across the country, are being fed
through to inflation. In the months ahead, Thompson says the Reserve Bank of Australia (RBA) is likely to increase
the cash rate target from the current record low of 0.1 per cent, to bring the inflation rate back within the target band
of two per cent to three per cent.
“So, the irony for the construction sector is that these cost pressures on tender prices are only going to be exacerbated by rising bank funding rates,” she says. “All developers in the country are exposed in one or another to bank lending rates, and with these increasing, and banks also placing an additional risk premium on the sector, we expect there to be further disruption in the sector as some contractors fail to meet their repayments.”
Thompson says higher rates are a major cause for concern, particularly at the smaller end of the industry. “Many of the larger construction companies will have hedging facilities as part of their finance, so that will provide some protection for current projects,” she says. “But it absolutely will change the feasibility of projects going forward from Mum and Dads renovating houses, all the way through to large-scale commercial developments.”
CreditSource’s Mallawa says the construction industry’s historically high gearing levels mean the looming prospects of interest rates increase the risks associated with the industry. “Should interest rates increase materially, many will not be able to service their debt obligations.”
- But despite a tough macroeconomic outlook, the industry is also grappling with industry-specific problems.
GM Advisory’s Muller says some argue that a big factor in subcontractor failures is ‘retentions’ where developers
insist on 5 per cent to 10 per cent of each progress claim being held back until the job is finished to ensure that
any defects are properly funded. Even when that hurdle is tackled, it often takes 12 months to finally get paid.
“It is at the end that the majority of the job’s profit is actually realised – so funding and carrying costs incurred,
especially if they are rising rapidly, can significantly impact the profitability of the subcontractor or builder.”
But delayed payments also seem to have become entrenched. Open Analytics’ O’Donnell notes a long-standing challenge faced by the construction industry sub-contractors and suppliers is persistent
delayed payments. Based on CreditorWatch’s customer payment data, about 12 per cent of construction businesses are more than 60 days in arrears on their payment to suppliers. That proportion is way above
any other sector and represents almost a normalisation of late payment in the industry.
Calls for industry reforms and support
- The industry’s woes have led to fresh calls for industry reforms and government support.
Muller says policy reform in the building and construction industry depends on the state. In Queensland, she says,
there is a grassroots push by subcontractor groups for the abolition of retentions and preferences and calls for the
urgent introduction of builders to hold progress claims in trust accounts (now delayed for a further 12 months).
Muller is supportive of some of the proposed changes by the Federal Government in relation to preferential
payments; these are part of its Simpler and Fairer Insolvency Processes announcements.
Under the reforms, transactions that either amount to less than $30,000, or are made more than three months prior to the company entering external administration, will no longer be able to be clawed back, provided those transactions involve unrelated creditors and are within the ordinary course of business. “A challenge we face at present is a different regime for personal bankruptcy, small business and larger enterprise, as well as the special rules for sectors such as construction in Queensland,” Muller says.
“Continued streamlining and simplification are for the better, as long as it strikes a balance between those who take the risk, those who loan the money, and those in the middle, just trying to earn a living.” But there are also calls for government to provide support to the industry. Open Analytics’ O’Donnell says for the construction industry to start to show an improvement, we would need to see a moderation of inflation and an end to labour shortages. But a potential lifeline could be government investment. “With an election in 2022 and the need to rebuild flood-affect areas in NSW and Queensland, there is potential for some much-needed government funding to support the construction sector.”
CreditorWatch’s Thompson says Australia also needs to begin to de-risk exposure to offshore materials. “I think what we have learned over COVID, and not just in the construction sector, is that we need to be more self-sufficient as a country,” she says. “I would suggest that, going forward, we should make sure we have some minimum capacity to produce these goods in Australia. That might involve government providing some sort of incentive or financial assistance to set up production locally, but in the long run, anything that helps to smooth over supply chain issues locally will be economically beneficial.”
- But with no guarantee of imminent reforms or support, industry players and those linked to the industry need to
protect themselves and be aware of early warning signs of companies entering financial difficulty. CreditSource’s Mallawa says a good hard look at the financials of many of the companies that went under
recently would have shown the inevitable coming well in advance.
An example is Privium Homes, a Queensland-based home builder. Mallawa says Privium continued to sign contracts and grow revenue, often competing on price and ignoring cost escalations. Consequently, the company went from making a modest profit in 2019 to a substantial loss in 2020. While the company generated substantial revenue, the capital base was small and not strong enough to sustain losses. In fact, despite the revenue growth in 2020, the balance sheet shrunk in that year, Mallawa notes “The 2020 financials of the company showed clear signs of financial distress,” he says. “The company went into administration less than 18 months after publishing its 2020 financials. Their insolvency left a trail of destruction including hundreds of unfinished homes and scores of unpaid suppliers and subcontractors.”
Mallawa says that, traditionally, the construction industry has been one operating with low margins. “As a result, the industry has been ill-prepared for the recent supply chain disruption led price increases. Our analysis of financials of both large and small construction companies shows profitability coming under enormous and unsustainable pressure.
“Companies with strong balance sheets and liquidity will survive the current crisis, but many others will be compelled to close shop. Suppliers, subcontractors and customers must have a good understanding of the financial position of the construction companies they deal with.”