As 2009 moves into the final quarter, the surety industry finds
itself feeling like coastal residents in the Southeastern United
States monitoring a Category 5 hurricane in the Atlantic Ocean.
Other than some brief thunderstorms, the weather has been relatively
calm. But there is a lot of trepidation about where the storm will
hit. Will it still be a Category 5 or reduced to a tropical storm
when it reaches land, and if so, how long it will last and how much
damage it will cause?
The Eye of the Storm
According to Associated General Contractors (AGC) of America’s economist,
Ken Simonson, the macroeconomic outlook for the non-residential
construction industry is not encouraging. There will be some bright
spots generated by either public spending or private investment
that is driven by demographics, such as healthcare, or policy, such
as energy.
But there will be heavy competitive pressure for the available work,
due to sharp declines in other segments.
According to Mr. Simonson, the primary economic influences that
are fueling the impending storm are:
- The municipal bond market is now working, but bank lending
has not returned.
- Banks have primarily used the bailout funding to shore up
capital, instead of lending purposes.
- Regulators are heavily scrutinizing loan portfolios and
forcing reserve increases.
- Lenders are requiring upwards of 40 percent equity from
the owner, before they will finance a project.
- Vacancy rates for offices, retail and hotels continue to rise.
- New properties cannot adequately cash flow on a pro forma
basis at the new vacancy rate levels.
- Developers and owners are unable to attract investors or
lenders.
- Banks also re-underwriting existing construction loans.
- If the property no longer cash flows satisfactorily in
the revised pro forma, the bank is requiring an additional
equity injection from the owner or is pulling the loan.
- Tax revenue short falls at the state and local government
levels will drive deeper spending cuts.
- Significant portion of – the stimulus funding has gone to
balance budgets, instead of construction spending.
- No job growth—the unemployment rate reached 9.5 percent
in September, up from 6 percent a year ago. Without job growth,
consumer spending will not grow, which will continue to put
pressure on retail spending and tax revenues.
As a result, private non-residential construction will decline by
10 percent in 2009. Retail, office and hotel renumeration will suffer
far deeper cuts, ranging from 25-45 percent. Residential spending
will decline by 27 percent. Public construction spending will post
a 3 percent increase in 2009, as roughly $20 billion of stimulus
funded highway projects will impact the 2009 figures.
In spite of the stimulus funding that will boost public construction
activity, non-residential construction spending is expected to decline
another 5 percent in 2010. Residential is actually expected to increase
by 5 percent in 2010, due to a rebound in single-family housing.
McGraw-Hill Construction is projecting an 11 percent increase in
total construction starts in 2010, as they predict a 30 percent
increase in single-family units. Multi-family construction will
continue to decline, as a result of financing issues and over supply
caused by unsold homes entering the rental market.
Fiscal results for 2009 will be very mixed for construction companies.
Profitability will depend on how much 2008 work they carried into
2009, which market segments they serve, and where they operate.
Surety industry results did reflect a sharp increase in the loss
ratio during the second quarter. The isolated thunderstorms have
either been caused by project financing issues that caused cash
flow problems for the contractor or occurred in regions of the country
hit hardest by the economic crisis, such as Michigan.
Expected Change in Construction Spending, 2009
Companies who are tied to the building sector are generally feeling
the impact of the sharp drop in spending on their backlog levels
right now. This sector faces the biggest challenges, as contractors
struggle to maintain backlog by compromising margins and assuming
more risk. They also have more exposure to distressed project financing
on jobs in progress, which could interrupt cash flow in the future.
On the other hand, contractors in the highway and infrastructure
industry have generally been able to sustain or even grow backlog
levels. Unfortunately, margins have not improved, due to increased
competition from firms that historically concentrated on private
infrastructure projects moving into state and municipal work. Also,
companies will likely push to build backlog in 2010 and early 2011
while the work is available, given the uncertainty for this segment
beyond mid-2011.
The combination of reduced construction spending, margin pressure,
acceptance of more risk and liquidity issues provides the catalyst
for a “shake out” of contractors who lack financial resources to
survive or lack the management leadership to assess risk and implement
the necessary adjustments. The length and severity of these economic
conditions will be a significant factor in determining if the surety
industry encounters a Category 5 hurricane or a milder tropical
storm.
Stimulus Funding for Construction, 2009-2011
Tidal Surge Protection
Tidal surge protection for both the construction and surety industries
is being provided by the $787 billion stimulus package, which includes
$135 billion for construction spending. While the stimulus package
may not stop the storm from reaching land, it should provide a barrier
to hold back catastrophic flooding, which gives the surety industry
the confidence to ride out the storm.
To date, about $20 billion of funds have been used for highways,
but very little of the building-oriented funds have been awarded.
The vast majority of stimulus funding will be awarded by mid-2011,
so any improvement in construction spending after 2010 will need
to come from the private sector, increased state and local spending
or another federal stimulus package.
If the broader economy does not start to respond to the federal
spending by the second half of 2010, 2011 will likely see more reductions
to construction spending. Even if there is a rebound in 2011, it
will not improve fiscal results for most contractors until 2012.
The results will be mixed, depending on market segments.
Riding the Storm Out
Earlier this decade, the surety industry was hit hard by contractor
defaults, which caused the industry to be extremely unprofitable.
A significant cause of the last debacle was lack of underwriting
discipline and over extension of surety credit, creating extreme
difficulty for sureties to manage their way through the cycle without
incurring substantial losses. By comparison, the industry was hit
by a tsunami, instead of a hurricane. There was minimal advance
warning, the industry was unprepared and no tidal surge protection
was in place. The consequences were catastrophic.
Given this recent history, it would be understandable if surety
companies started evacuating in a state of panic. Fortunately, that
is not the case. While there is concern about the underlying fundamentals
of the construction economy and the impact it will have on their
profitability, surety executives are confident that they have the
ability to avoid the catastrophic losses suffered during the last
downturn.
Their confidence is founded on solid principles, not arrogance.
In addition to having the luxury of advance warning, most sureties
have improved their risk management methods and business models.
Some examples include:
- Implementation of actuarial-based credit models.
- Provides underwriters with a much better quantitative tool.
- Senior management can more effectively set policies and
manage their portfolio of accounts.
- More emphasis on contractual risk analysis and transfer.
- Focus has been on profitability, not market share growth.
- More disciplined underwriting.
- Sticking to proven fundamentals.
- Surety executives have focused on a “weeding out” process
over the past 12-18 months in preparation for this storm.
By enhancing their quantitative capabilities (financial benchmarking
and performance indicators), sureties have enabled their underwriters
to focus more attention on the qualitative characteristics of each
contractor. Their priority will be to evaluate each client’s management
capabilities and business model to reach a comfort level with the
qualitative aspects of an account to validate their quantitative
analysis.
The market realities for contractors will ultimately affect the
sureties. The reality of the economy for the next 18 months is that
wrong decisions will be exponentially more damaging to contractors’
results and their ability to survive than during moderate or hot
economic climates. It simply is much harder to recover from a bad
decision when the availability of work and margin are not sufficient
to soften the impact.
Consequently, a surety’s results are going to be more heavily tied
to the ability of their clients to avoid bad decisions than the
underwriter’s ability to make good financial underwriting decisions.
Contractors should anticipate and embrace more interaction and collaboration
with their surety partners. Surety underwriters will rely on more
objective information to evaluate their clients’ ability to assess
and manage risk, avoid bad decisions and make necessary adjustments
before it is too late. Accordingly, we recommend the following actions
to instill confidence and proactively manage your surety relationship:
- Communicate Openly, Honestly, and Regularly
- Provide your business/strategic plan.
- How will you adjust to the market?
- Provide microeconomic view—how does your situation
differ from the big picture?
- Emphasize experience and capabilities of executive,
project and financial management staff.
- Collaborate about potential new business initiatives.
- Geographic expansion.
- Different project delivery methods.
- Changing scope of work or type of owner.
- How are you going to manage increased risk?
- Getting paid.
- Subcontractor default.
- Banking environment.
- Tighter margins.
- Enable “Forward Looking” Analysis
- Provide substantiated projections of profitability and backlog.
- Manage expectations—discuss what actions you will take in
the future based on actual results vs. projections.
- Have an A, B and C plan.
- Establish communication plan with surety partners.
- What information would be most beneficial for you and
the surety?
- Frequency of information and meetings.
- Understand the Surety’s Quantitative Analysis
- Review analysis to make sure everyone is on the same page.
- How does your company compare to your peers?
- Which ratios or performance indicators are negatively
impacting your credit score?
- Address Bank Debt
- Demonstrate to your surety how you will service or
reduce your debt load.
- Backlog and profitability projections vs. covenants.
- Cash flow projections vs. covenants.
- Planned capital divestitures or expenditures.
- Financial condition of your lending institution.
Sureties realize that well-managed construction companies
will survive this storm. They will emerge stronger and better
positioned to capitalize on the economic failures of weaker
competitors. The survivors will benefit from the operational
efficiencies that the market forced them to create, better
profit margins and a better work force. The key to maintaining
your surety’s support is communication that enables
them to make a comprehensive business decision as a partner,
instead of an underwriting decision as a creditor.
| Table 1: Expected Change in Construction Spending 2009 |
| Power is expected to show a 9 percent increase in 2009 and continue at
about that same pace in 2010. This is mostly driven by retrofitting current
plants to produce cleaner energy, wind farm development and transmission
lines. |
| Manufacturing will actually show a 30 percent increase in 2009, as
companies close facilities and consolidate plants. This will drive some “one-
time” expenditures, so this market will likely decline by 5-10 percent in 2010. |
| Highway spending will be up 3 percent over 2008 and likely up another
3 percent in 2010. |
| Sewer/Water is actually expected to show a 1 percent decline in 2009, due
to regulatory hold ups and the Buy American Act. However, this market should
post at least a 5 percent increase in 2010 as the stimulus money cuts loose. |
| Retail will be down 40-45 percent in 2009, but seems to be flattening out. If
single-family housing improves in 2010, it should begin pulling the retail sector
back up in late 2010 and 2011.
|
| Office segment is off 26 percent in 2009 and not likely to improve any time
soon
|
| Education sector is likely to dip slightly for 2009 and will not improve in 2010.
Reduced property values will cut down district funding, poor economy will
make bond issues difficult to pass and higher education is facing budget issues
and decreased donations.
|
| Hospital/Healthcare will be up 8 percent in 2009 and should continue to
grow at the same pace in 2010. Uncertainty created by healthcare reform may
slow spending temporarily, which will cause pent up demand.
|
| Residential spending is expected to increase by 5-10 percent in 2010, but will
be completely driven by single-family construction. Multi-family will continue
to decline due to financing issues, increased supply from unsold homes and
unemployment.
|
| Table 2: Stimulus Funding for Construction,
2009-2011 |
$49 billion—Transportation
- $28 billion for highways
- $18 billion for rail/light transit
- $2 billion for airports
|
$35 billion—Buildings
- $7 billion for DoD
- $6 billion for GSA
- $6 billion for other federal properties
- $8 billion housing
|
|
$30 billion—Energy/Technology
- Clean energy retrofits
- Wind farms
- Transmission
- Expanded broad band capacity
|
| $21 billion—Water/Environmental |
|
