You have probably heard the claim that contracting and project management is a ‘low margin’ business?
How can this be, with companies making a better return than Apple? …and yes, I do mean that Apple!
This article, continues my occasional series, looking at the surprising profitability of the construction industry. Here I look at the Annual report of Mace, a UK-based project and construction manager.
In 2016 Mace increased turnover to £2 billion, making a profit before tax of just under £10M. At face value, making £10M on £2B of sales looks paltry. In fact this is exactly what they said “the construction sector as a whole … is currently not generating a sustainable level of profits.“.
And in the past two days, high profile leaders in the UK have been arguing this point, as reported by The Telegraph, and summarised in this table…
“I’m not worried in the slightest about the reduction in margins for major and extremely well-resourced contractors,”
“I think it’s a sign that the public sector is getting a good deal at last. Indefensible margins have been cut down to size, I’m not concerned at all.”
Lord Adonis, chairman of the UK’s National Infrastructure Commission
“Construction …is currently not generating a sustainable level of profits.”
“…quite simply, this situation is no longer sustainable”.
‘Wafer-thin margins are not sustainable’
Executives from Mace, Balfour Beatty, Midas
In 2015 Mace made a return on sales of 2% – as they say “Hardly worth getting out of bed for”! In 2016 they made 0.5%.
In looking at Mace’s figures, I think the previous year – 2015 – is more representative of business as usual. As Mace’s report says 2016 is significantly impacted “…as a result of project losses on a small number of our construction projects“.
This is a common risk of the construction industry – it only takes a problem on 1 or 2% of your projects, and your whole profit can be wiped out. It is one of the main reasons many contractors worry about winning too much business. You have to quickly recruit new staff, and your senior management team becomes stretched trying to oversee all the projects, which in turn increases the risk of a contract failure.
But is this really a bad result?
Businesses make money from the investment made in setting up and running the business. They invest in people, methods, assets and working capital. They spend money before they earn anything.
The headline figures reported in the media, and those referred to when the directors talk about industry margins being unsustainable, are usually Return-on-Sales (profit divided by sales). This is more like a sales tax, than a return on investment, and it bears very little relationship to value-added. Surely the industry is not claiming it “adds more value” just because the project client chooses premium fittings over budget ones?
Investors (and the UK government when measuring the economy), don’t look at return-on-sales when they assess a business’s profitability. They compare the profit made to the financial investment used to run the business – return-on-capital-employed.
So how does Mace do on this count?
Equity = money the owners invested/have left in the business.
Capital Employed = Equity + other long-term sources of finance. It also = Total Assets – bills you have to pay soon.
Oh, la-la! 53% profit margins. From a construction contractor! Not too shabby eh?
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Mace’s return-on-equity in 2015 was about the same as Apple’s… and they made nearly twice Apple’s return-on capital-employed. Apple has long-term debts roughly the size of their annual profit. Mace runs its business without owing anything to the banks.
I’ll say that again: In 2015, Mace made nearly twice the profits of Apple, measured as ROCE.
A quick glance at other US-based giants reinforces this picture of success.
Even in 2016, the year Mace’s results were impacted by a small number of problem projects, they still managed 16% ROCE – not that far from Apple’s 25%.
The UK’s Office for National Statistics publishes information about the profitability of the whole economy. And guess what they use? Return-on-Capital-Employed.
And how did Mace fair compared to the rest of the UK economy?
Source: UK ONS, Statistical bulletin: Profitability of UK companies: Jan to Mar 2017, published July 2017. The ONS benchmarks are based on Gross Operating Surplus, which is usually a higher number than the profit number used for Mace & Apple. The effect of this is to underestimate how much more profit Mace and Apple make compared to the average.
So I guess the bad year doesn’t look so bad after all – Well above the UK private sector average, and only fractionally under the service industry average, of 17.7%.
This picture of corporate strength and profitability is common across many in the construction and EPC industries. And it makes perfect sense. When clients work with designers, contractors and project managers, what they are buying is their ability to do something- their people, systems, and methods. They have not had to invest in factories or shops to manage your project. They do not usually have to risk millions of their own money in the project, and they are not buying the materials and sub-contract services needed well ahead of time. They only commit to these when they have a firm contract from the client that guarantees they will be paid. Walmart can’t decide to order from their suppliers only when the shopper decides to buy something.
Have you ever heard anyone say something like this? Whilst this may be what they genuinely believe, it is also rather misleading.To earn the headline bank interest rate you have to leave your money in the account for 365 days. Is that what companies do with their sales income, leave it untouched in their bank account for a year? Hardly! For this comparison you should really be looking at working capital – the amount of time the company has to commit their cash until they get paid by their customer.
Say you have to tie your money up for a month to run your business. If you earn 0.5% in the month, you are earning 6% for the whole year.
This is the idea behind “return on… working capital” in the Mace table.
The construction industry has a relatively easy time on working capital – certainly compared to many other industries that require a significant up-front investment. Once a project is underway, most contractors generate what is known as a “cash lead” – they are paid more by the client than they have had to pay out. Not by much, but enough. Most contractors have negative working capital, in that they owe more than they are owed. The only reason Mace has positive working capital is because they have quite a lot of cash on their balance sheet – again like many construction companies do.
In Mace’s case they tie up about £20M in working capital – about 4 days of sales. So the profit they made in 2015 on the working capital they have to provide is the equivalent of 162% over a year. Even in the ‘bad year of 2016, their profit worked out at a return on working capital of over 50%. Much better than putting this money in the HSBC Bank!The ONLY basis to say the industry has low margins is return-on-sales. And this just isn’t that important to serious investors.
I also think that the actual value of sales (ie the project cost) distorts the financial accounts.
Mace is typical of most managers and contractors, in that over 80% of their contract value is bought in from subcontractors and suppliers – their added-value contribution is only on the 10-20% of the value that is not subcontracted. Whilst contractors can influence this supply base to some extent, it is mainly coincidental to what they do, since it is mostly driven by the project the clients wants delivering.
If you saw Mace as a pure consultancy company – ignoring the client’s money that they happen to spend on the project – then they don’t have £1.8B in sales, they have £350M of sales of their services. So even if you do want to measure return on sales – they now make 10.4%! Not too shabby.
I’ve estimated Mace’s purchases from data in their accounts. It might be slightly out, but it won’t be a million miles away
I also find it interesting to see what profit they are creating relative to their commitment to staff. After all is it not said that…
“People are our Best Assets“?
So why dont we treat them like an asset, and compare the profit to the annual cost of employing people?
If you do this for Mace you find that that they make 11% in 2015 (£36M profit on an annual staff bill of £330M). Now of course, it is unlikely that Mace has a fixed 12 month commitment to all these staff – the figures include short-term and contractors. If the average contractual commitment was say 6 months, their profit is 22% return on this commitment. And this is probably conservative.
I call this measure Return-on-Investment in Employees. A much better measure of a service company than return-on-sales.
Oh, and even in the “poor year” of 2016 with the “losses on a small number of our construction projects”, Mace had a return on capital employed of 16%. I would be delighted if my savings and investments made that in a bad year!I can see a few disadvantages if the construction industry started to measure itself as I suggest it should
But these are a price worth paying to stop us worrying about the wrong issue (profit margins), and to put our attention where it matters – finding ways to deliver projects better, faster and at lower costs.
Do that, and more clients will be happy for you to make more money.
If you want to make more money, get better at what you do.
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I’m only an engineer, not an accountant. I think I’ve understood my education in finance, but who knows. If I’ve misunderstood something obvious, I’d love to be corrected.
Until then, I stick by my case: Worrying about return-on-sales is a distraction. The industry has more important things to worry about.
I’m not saying that construction doesn’t have its risks either. Taking on fixed-price contracts, where your only have true control over 15-20% of your cost base is definitely a high risk, and should attract a risk premium. But clients don’t have to buy their projects like this, and they would get much better results if only they stopped pushing risk onto their supply chain. Clients can get faster and lower-cost projects, whilst at the same time the supply chain can make higher profits.
Ian is a consultant who helps clients to improve the performance of their capital projects and programmes. Before becoming an independent consultant, his experience included 15 years working as a project manager on capex projects, 10 years in procurement, including being chief procurement officer for a large construction company, and 10 years management consulting with niche consultancies in supply chain and procurement.