Construction Industry Mega Trends Emerging from the Recession: What Every CFM Needs to Know
By Timothy R. Sznewajs & Brian A. Moore
The past five years have been among the toughest the construction industry has experienced: From a peak of almost $500 billion in revenue in 2008, nonresidential building construction fell to a low of less than $350 billion in just two years, and then improved only marginally through 2012, according to FMI’s Third Quarter Construction Outlook, 2013.
The engineering and construction sectors are now on the upswing. Multi-year growth for the nonresidential and nonbuilding construction markets appears to be stabilizing at 5% – higher than U.S. Gross Domestic Product growth. Many contractors are hiring again, and margins – albeit slimmer than optimal – have begun to return. Bid lists are getting a bit shorter, backlogs a little longer.
As the construction industry picks itself up and shakes itself off, it confronts a host of challenges and opportunities. The four trends altering the industry, most likely for the long term, are: a low-bid commodification mentality, technological innovation, plentiful and affordable domestic energy resources, and the integration of design with construction. These integral shifts open new doors for market participants and ultimately impact the construction services business model.
All construction firms – civil and commercial, general and specialty – are impacted by these four trends in some capacity. The challenge for CFMs is to understand them and adopt strategically sound, competitive responses that will position their companies to thrive in the construction industry of the 21st century.
Mega Trend #1: Low-Bid Squeeze Play
Although some construction procurement is taking place over the Internet on reverse auction sites, this practice has not been endorsed by major contractors. This is because owners have yet to see substantial savings and the open-bid approach presents a host of problems.
Construction is different from many other products and services sold as commodities. Most contractors – and even most buyers of construction services – would agree that construction services are not commodities, even though they are at times treated as such.
Through market surveys and interaction with clients, FMI regularly hears contractors and owners caution against blindly focusing on low price for construction projects, yet some persist. Responding to a recent FMI survey on construction delivery methods, one contractor commented on why contractors price at extremely low levels: “To keep their men working and maintain cash flow.”
Standard Structures, More Competitive Bidding
The pressure from project owners to treat construction procurement as a commodity continues, especially with highly competitive structures that are characteristically less complicated to build, have standard designs and prototypes, and can be fulfilled by a large number of builders.
Examples of these projects include:
• Housing (residential and multi-family)
• Chain stores/retail
• Office buildings (excluding high-rises and skyscrapers)
Complex Structures, Less Competitive Bidding
Buildings that are less likely to be treated as commodities include those that have unique designs, include innovative technology, present difficult building conditions, are mission-critical, or are significantly large in scope.
These buildings include:
• Chemical/industrial process plants
• Medical buildings
• Research facilities
• Power plants and other utilities
• Oil platforms
• Concert halls
For the more complex building projects, owners tend to be looking more for best value, thereby avoiding the risk of poor quality and missed schedules for these large, unique projects. For example, if a contractor fails to deliver on a stadium or power plant project, the cost in lost event revenue or production from missed schedules and poor workmanship can be tremendous.
The real risk in the low-bid squeeze play is that contractors will attempt to make up for negative profit projections by cutting corners, increasing the cost and number of change orders, and billing for extras. Competing contractors that don’t understand the low-bid landscape run the risk of going out of business.
Some markets will continue to place value on quality services provided by competent contractors. Increasingly, however, market conditions are pushing contractors to reduce fees, and it will be difficult to reorient project owners who have become conditioned to view construction services as discounted. These two factors continue to drive the market to the lowest common denominator – a vicious cycle that will be slow to reverse.
Mega Trend #2: Impact of Technology
While the engineering and construction fields unquestionably boast some of the most industrious, innovative, and creative professionals in the U.S., there is a lack of technological innovation in construction methods. After all, the basic inputs to the construction process – wood, stone, steel, and craftsmanship – have existed for centuries and will likely remain consistent for some time.
However, it is clear that construction tools and technology are changing dramatically. Broadband mobile communication and handheld processing power are radically altering the way GCs deliver projects.
Along with now-ubiquitous smartphones and tablets, the following innovations are becoming more commonplace:
• Relatively lightweight laser scanners that render intensely accurate, multi-dimensional “as-built” drawings in minutes
• 3D printers that can fabricate a permanent building element in a matter of hours
• Truly paperless project sites where drawings, change orders, claims, and dispute “paperwork” are transmitted from office to jobsite to owner using integrated applications
Technology adoption in the field is inarguably altering the expectations of services that contractors provide to owners. The sheer efficiency with which information can be shared and processed demands that businesses change.
For construction market participants and the CFMs who lead them, there is not as much emphasis on finding the next best technology; the important issues relate to the culture and structure of an organization and its flexibility to incorporate technology that ultimately improves the value proposition for customers. Contractors need to decide if any new technology under consideration will do the following:
• Improve the building process for owners
• Increase coordination with upstream and downstream subcontractors and trade partners
• Provide a stimulating environment for innovation
Leading contractors routinely pose these challenges to their management teams. The pace of technological change in construction services will only quicken in the years ahead, and contractors must be prepared to address how change will impact the services they provide to project owners.
Mega Trend #3: North American Energy Revolution
It has been known for decades that the U.S. possesses some of the world’s largest reserves of oil and natural gas, according to various industry and government publications, including studies from the U.S. Energy Information Agency (EIA). However, extracting these resources economically has been a challenge.
However, recent technical advances in horizontal drilling and hydraulic fracturing have made oil and gas accessible, transforming the global energy landscape and, more importantly, the U.S. economy. U.S. oil and gas production is booming and will have a major effect on nearly all sectors of the economy, specifically engineering and construction. 1
Due to these innovations, U.S. dependency on foreign fossil fuels is being shattered. Significant investment to support fuel-related economic activity is underway and will continue for the foreseeable future. For example, according to the Oil & Gas Journal, expenditures from 2011 to 2013 on crude pipelines will increase from $1.4 billion to more than $23 billion. Natural gas pipeline construction and upgrades will more than double to over $15 billion in the same timeframe. For a full breakdown, check out the U.S. Energy Construction Market Capital Expenditures sidebar.
U.S. crude oil imports have declined by more than two million barrels per day since 2005. In the past eight years, the U.S. has gone from being a net importer to a net exporter of refined petroleum products. More significantly, the U.S. has recently surpassed Saudi Arabia as the world’s low-cost producer of ethane, a natural gas liquid (NGL) that is the primary building block for the many intermediate chemicals, plastics, and resins used to manufacture thousands of consumer products. Natural gas prices in the U.S. are one-fourth of the cost in Europe and one-eighth the cost in China. The economic implications for U.S.-based energy producers, the petrochemical industry, utilities, and industrial manufacturers are enormous.
The benefits of increased domestic energy production extend well beyond the U.S. oil and gas industry and are having an immediate positive impact on U.S. heavy industry, power generation, transportation, and consumer product manufacturing. These activities are being funded by private investors and have significant economic impact on a growing number of regions throughout the U.S. This privately funded activity will be the lead driver of growth in U.S. engineering and construction activity for the next several years.
The implications of these energy-related trends for the U.S. engineering and construction industries are significant. Design firms, pipeline contractors, and multi-trade industrial firms are experiencing tremendous demand for their services. Many U.S. and Canadian pipeline and industrial firms are growing by as much as 50% per year. As a result, these firms are expressing a growing level of concern about how to address shortages of skilled labor in western Canada and the U.S. Gulf region.
The energy revolution now taking place in North America is multifaceted and complex. Tremendous access to untapped energy reserves, increased access to cost-effective alternative energy resources, and a renewed focus on energy efficiency are some of the components of this revolution. While the energy sector is diverse – and in many ways far removed from the work of most engineers and contractors – seismic shifts in this “energy space” will ripple through the construction industry for years. Existing market participants cannot meet this demand for infrastructure, and larger and less experienced companies from the more traditional realms of construction have already embarked on myriad strategies to enable further energy market participation. For more information, read the Powerful Energy Facts sidebar.
Mega Trend #4: Convergence of Design & Construction
Over the past few years, FMI has observed a continuing trend in which architectural, engineering, and construction firms are conjoining through a variety of efforts. Mergers and acquisitions (M&A), partnerships, consortia, and organic growth are all contributing to integrated A/E/C firms. The primary drivers for this phenomenon are owner demands and the need for businesses to grow and thrive.
Although owner demands in any period could be summarized as “faster, better, cheaper,” they often change during periods of economic volatility and are magnified during prolonged economic cycles. The rise of design-build and related delivery methods in recent decades has largely been a response to the need to reduce project completion times. New delivery methods also tend to address improvements in project collaboration and conflict reduction. Indications of A/E/C convergence can be seen in the rising variety of construction delivery methods from design-bid-build to design-build, construction management and program management, and the most recent entrant, integrated project delivery (IPD). All of these methods have variations that suit specific owner needs, and may even have specific marketing elements trademarked by industry firms to differentiate their services from the pack.
FMI has routinely surveyed project owners for many years, and one of the perennial standout requirements mentioned by owners is the increasing need for greater collaboration. If owners are in the driver’s seat in the current demand-side economy, will they simply continue to press for lowest price and expect all the other benefits to fall in line? Some will. However, FMI’s most recent study of owners indicated that, although they are taking advantage of a low-bid environment, owners are not abandoning their approach to best-value procurement.
Another sign that there may be a distinguishable trend toward consolidation, as well as a growing divide between larger and smaller firms, is the number of companies larger than a given size compared with all others. In 2006, the top 21% of ENR’s Top 500 Design Firms represented 75% of the total revenue. In 2011, this figure increased and the top 22% of firms took in 82% of the revenue. In 2011, 16 firms with more than $1 billion in annual revenue represented approximately 52% of Top 500 revenue. Compare this with the fact that in 2006, 13 firms of greater than $1 billion in annual revenue represented only about 37% of total revenue.
In 2006, 46 firms with more than $1 billion in annual revenue represented approximately 54% of ENR Top 400 Contractors revenue, while in 2011, 54 firms represented more than 60% of total Top 400 revenue. Changes in revenue distribution between these two years show that only a few firms in the middle moved up due to natural growth and mergers, while many more moved down. Comparing the Top 400 firms’ revenue against total nonresidential construction put in place for 2006 (48%) and 2011 (a little more than 50%), it’s clear that, although this list does produce a significant portion of annual construction, there is a good deal of distance to go before there is as much consolidation among contractors as there appears to be in design firms.
It is expected that more large owners will be looking for full-service firms or groups of firms that can work together seamlessly, as with IPD contracts. This will be especially necessary in the case for projects in the “mega” size range. Looking at the number of transactions in the engineering and construction space since 2007 (for both the U.S. and Canada), there have been 170 instances where construction companies bought engineering companies and 133 instances where engineering companies purchased construction companies, according to Capital IQ.
While many of the firms involved in these transactions were not on the Top Contractors lists, many on the buyers’ side have been larger firms. M&A have cooled somewhat since the peak in 2008, yet FMI expects this type of activity to continue as owners seek new services and capabilities and A/E/C firms prepare strategically for future market changes.
As with many fundamental trends, there is no conclusive short-term evidence of combination of design and construction services under a single roof. Rather, there is a regular drumbeat of activity in this direction driven by competitive pressures and owner demands.
Contractors must be vigilant to observe the actions within their industry and ensure that their suites of engineering and construction services are compelling to owners relative to the competition.
Impact of Post-Recession Trends on Contractors
In today’s market, some contractors are struggling to grab a foothold, and many are losing key staff and clients in the process. In contrast, other construction companies are gaining traction, building backlogs, running very profitably, and gaining new areas of specialization.
So what is the secret? Why are some companies doing really well, while others are just barely surviving? The answer is that companies doing well are leveraging strategies to deal with the changing marketplace in their own contexts.
The 4Cs of Strategy
A well-executed strategy development process is focused on a deep understanding of all the components that define the company’s current and future context. These components include the economic climate, customers, competitors, and capabilities (known as the “4Cs” of strategy, which is FMI’s strategy development model).
A rigorous data collection and research process is required for each component:
• Climate: Learn and understand all the external factors and forces that are beyond company control but have an influence on the company. These include economic forecasts, surety industry trends, commodity prices, politics, demographics, regulatory issues, globalization, and technology.
• Customers: Markets require more than a cursory review of what the senior management team knows about clients. Objective facts about changes in buying behaviors that relate to budgets or selection criteria, growth in current and adjacent markets, unmet needs of target clients, and preferred positions of contractors are critical in determining future market opportunities.
• Competitors: Learn and understand as much as possible about competitors (e.g., entry and exit strategies, management changes, aggressiveness in key markets, primary business strategies, and relationships with key customers or suppliers).
• Capabilities: These include all the internal considerations such as strengths and weaknesses, unique capabilities, drivers of value within the business, ownership aspirations, access to resources, and employee engagement.
Armed with this information, a company should be able to identify immediate business needs, pinpoint strategy themes, and determine where and how it will compete in the future. Once potential strategies are identified, managers should ensure that they make sense.
They can do this by looking at whether the company has the required leadership, skills, systems, structure, and financial resources to execute the strategy.
An honest assessment should begin by answering the questions that follow on the next page:
• Does the company have the right leader(s) to set direction, align resources, and inspire the troops?
• Are current organizational skills, abilities, and systems in place to support the initiative?
• Is the organizational structure conducive or will it hinder the effort?
• Can the company support the financial investment required to realize success?
Periodically, senior executives should look at the company and assess how well the strategy accounts for changing trends in the industry. A good place to start is by asking a few critical questions:
• Is the company’s strategy based on a true source of competitive advantage?
• Is the strategy putting the company ahead of industry trends?
• Are the biases of the senior leadership team hindering the strategy?
• Is strategy based on facts or conventional wisdom?
If the answers lead to an uncomfortable discussion about the strategy, then the executive team must consider changes that will enable the company to get in front of industry trends.
The one constant of a free market economy is that customer preferences and demand drivers will constantly change. It is important to recognize the trends that ultimately shape the market, understand the impact they will have on business, and develop a proactive strategy to address the current market and the future.
Construction industry firms that embrace change based on the four market trends and use them to their advantage will be the most successful companies of the future.
1. Beyer, Calvin E., and Bradbury, David. “21st Century Gold Rush: Emerging Risks for Contractors in Shale Oil & Natural Gas Development.” CFMA Building Profits (September/October 2013).
TIMOTHY R. SZNEWAJS is a Managing Director at FMI Capital Advisors in Denver, CO, where he works with construction industry firms, focusing on mergers and acquisitions, ownership transfer issues, and strategy development.
A previous author for CFMA Building Profits, Tim is actively involved in several construction industry groups, including CFMA, AGC, ABC, and others. He serves on the steering committee for the AGC/CFMA Annual Construction Financial Management Conference, as well as on the Education Committee of CFMA.
Tim earned a BS in Economics from the University of Notre Dame and an MBA from Northwestern University. He is a 2012 winner of The M&A Advisor’s “40 under 40” award; he also holds a General Securities Representative license (Series 7) from the Securities and Exchange Commission and FINRA.
BRIAN A. MOORE is a Principal with FMI in Raleigh, NC, where he focuses on consulting with contractors and construction materials producers on various strategic, organizational, and operational issues.
Prior to joining FMI, Brian was a business developer with an environmental consulting and contracting company, where he performed market and competitive analysis to support strategic geographic expansion.
Brian holds an MBA in General Management and Operations Management from Wake Forest University and a bachelor’s degree in Communication from Valdosta State University. He is a member of the AGC, American Society of Concrete Contractors, American Road & Transportation Builders Association, and National Ready Mixed Concrete Association.