Perspective - Blog

The Catch-22 facing UK construction businesses

The UK’s construction sector is a challenging one in which to operate and yet the reality facing businesses looking to diversify into other areas is that this is a whole lot easier said than done

07/06/2019

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

This may sound improbable, given the cranes that populate the towns and cities of the UK, but construction is a challenging sector in which to operate – and has been for some years now. That has been a driving reason why a number of businesses, such as Carillion, Interserve and Keir Group, have tried to diversify – not always successfully, and on occasion downright disastrously – into the world of support services.

For its part, Galliford Try has made a rather better fist of switching focus, to the extent that it is arguably now seen more as a housebuilder, with a construction business attached – a subtle but important distinction. Even so, the transition is by no means proving a smooth one for the company, which was forced last year to make a call on its shareholders for £150m by way of a rights issue.

Then, last month, Galliford Try revealed it had experienced difficulties with some construction projects – notably cost overruns at the £1.34bn Queensferry Crossing in Scotland – and was thus instigating a sweeping review of its construction business. The company also announced annual profits were expected to be £30m to £40m down on analysts’ then-consensus forecast of £156m – which was not well-received by markets.

Falling out of favour

There are plenty of reasons why investors do not like construction businesses these days although two prominent ones are that, broadly speaking, the sector is extremely competitive and unattractively low-margin. The problem facing any construction company with ambitions to be something else, however, is the comfortable bed of capital that most such businesses traditionally enjoy.

This capital position is initially provided by a construction business’s customers but, as we have discussed in articles such as Carillion’s collapse, is then often enhanced by the ability to dictate when the business’s suppliers are paid. As we say, that is a very comfortable position to be in from a funding perspective – and a very tricky one to give up.

That is because, when a company looks to sell or shrink its construction business, it has to accept it is not actually going to end up with any of the money it used to have sloshing around its balance sheet. Either that gradually flows out to the company’s suppliers as it winds the business down or else, if the company is selling up, the cash has to move with the rest of its construction assets to sit with the new owner.

Indeed, one of the reasons Carillion started to accumulate debt was by setting about scaling back its construction business five or so years ago. Any construction company downsizing in this way will see large outflows of working capital and that in turn can lead to the debt position of the business increasing – and, while that did not cause the end of Carillion, it is fair to say it was a key part of the beginning of the end.

Now, to be very clear, we are not saying Galliford Try is in anything like the same position as Carillion; only that, if it is looking to shrink or exit its construction business – which is normally what companies mean when they say they are undertaking a strategic review – that will not necessarily be as easy as it sounds, either financially or practically.

Lessons learned

The wider lesson to take from Galliford Try’s recent history is that, just because part of a company accounts for a small percentage of its profits, it does not mean it cannot be a very significant part of its balance sheet. If you looked at Galliford Try on the basis of profits alone, you would presume it was mainly a housebuilder – and yet the construction arm dominates the company’s overall financial position in other important ways.

This leads to something of a Catch-22 situation for UK constructors who wish to diversify into other areas: they cannot look to strengthen their business by offloading the part with the weakest prospects without taking a hit on cash and thus weakening the business as a whole – albeit hopefully only in the short term.