There has been slow and steady improvement in the surety industry in recent years, mirrored in the U.S. economy and other related financial markets.
In the not-so-distant aftermath of the economic meltdown of 2008 and now the poor performance of the stock market in 2015, the surety industry offers a positive outlook for 2016, but one that is significantly challenged by factors that influence the construction and commercial business markets.
Astute contractors have not abandoned the lessons learned in the recent post-recession recovery. Construction firms today are leaner and meaner, with a focus on bottom-line results. An overall acceptable profit margin for efforts expended is mandatory. However, owners’ expectations are still in a buyer’s market mode, interest rates are artificially low, fuel and material prices are cheap, technology applications are ever improving and there is a painfully growing worker shortage. Going forward, successful firms will cautiously continue to grow their operations with an eye on “doing more with less.”
The sign of a true economic recovery is the return of acceptable profit margins. Although there has been a continuous increase in “put in place” construction revenues since 2010, the return of project margins has declined significantly during the same time. The “Gross Margin Gap” between revenues and profits is now at an all-time high. A number of contractors have refilled their revenue backlogs with thin gross profit margin work in an attempt to regain market share. To add more stress, overhead expenses that crept up in 2008 have continued to increase faster as a percentage of revenues in recent years.
Unemployment and Interest Rate Shuffle
As the U.S. economic activity improves, there’s a challenge to find great people at all levels. The speed at which the labor market is healing has been a long crawl since the peak in 2010. In the seven expansions since 1960, the average low trough in the unemployment rate has been 4.5 percent. Compared to October 2015’s seven-year low of 5 percent, the U.S. unemployment rate still has a way to go. If joblessness continues its recent pace of decline, it will reach 4.2 percent a year from now and 3.8 percent in 2017. That would be enough to prompt the Feds to keep raising interest rates in the hope of engineering a soft landing.
Sound good? Not so fast. The problem is that the U.S. central bank has rarely achieved that feat. The average recession since 1960 occurred just eight months after unemployment hit its low. That would leave the U.S. economy with a significant recession risk in 2017. For investors that fund development projects, that also raises the threat of the stock market correction that has occurred in all major recessions in the past 50 years.
Today’s cash-strapped public and private owners are shifting greater risk onto contractors through onerous contract terms with non-traditional project responsibilities. The evolution of project delivery systems has surpassed design-build projects to more challenging methods of integrated project delivery (IPD), gap financing and P3s. In these high-breed risk-sharing approaches, attention to the potential expanded and long-term exposures to risk must be identified and addressed. Contractors must be alert to new risks, resist these new risks whenever possible and keep costs low to stay profitable. The financial consequences of the risk-shifting can hit generals and subcontractors hard. Subcontractors first feel the financial squeeze because they have to cash flow their own work and are the furthest from the project funds. Long drawn-out litigation disputes are costly to all parties from direct and indirect costs that strip away the already thin project profit margins.
Success in 2016 and Beyond
In order to be successful in the future, contractors need to focus on what they know best: their core competencies. Contractors need to highly discriminate on project selection. New opportunities need to have an acceptable profit margin to risk exposure. Avoidance of unknown project elements, contract terms, partnerships and problematic owners should all be traded for the best opportunity projects that have a high probability of making money and generating positive cash flow. Technology needs to be mastered and leveraged at all aspects of a company to maximize efficiencies and productivity. Collaboration, communication and driving best practices across all operations will bring improved ways to equal improved results. By trading in revenue growth goals for a keen eye on exploiting high margin projects with low risk factors, contractors can realize the long-term sustainable business model of simply growing profits.