CONCRETE PROOF - JSE MAGAZINE

CONCRETE PROOF

Since the infrastructure spending spree before the 2010 FIFA World Cup, the heavy construction sector has been forced to seek profitability in diversification and cost-cutting

CONCRETE PROOF

With a combined age of some 360 years, the five biggest JSE-listed heavy construction firms have weathered SA’s political and economic crises like few others in any sector. What makes the resilience of Murray & Roberts, Wilson Bayly Holmes-Ovcon (WBHO), Aveng, Group Five and Raubex all the more admirable is that the construction sector is among the most cyclical. Few industries are as dependent on low borrowing costs, confidence and government investment to enhance revenues.

The infrastructure splurge in the run-up to 2010’s World Cup staved off the worst effects of the global financial crisis but the inevitable couldn’t be delayed forever. Since 2010 these big five, along with the others that make up the sector, have – unempirical as it is – matched that spirit of endurance to transform into lean machines. To achieve this they have taken a knife to under-performing subsidiaries and diversified geographically.

The global expansion has included putting more resources to work in the Pacific, particularly Australia, and preparing for more consistent work in sub-Saharan Africa. While the rest of Africa has been a growth area in global infrastructure development, this is not yet an unstoppable wave.

Commenting on the dynamics of moving to more robust construction markets, Andries Rossouw, a partner at advisory firm PwC, cautions that it costs money to make more money.

‘Diversification requires investment and fixed costs – then getting the positioning and timing right in order to get the benefits,’ he says.

Nevertheless, as a result of this geographic strategy and likely market share gains from smaller players in SA, revenues have mostly held up since 2010. Profits, however, have been under pressure as these big players have often cut margins to win work at home.

SA’s economic growth grinding to a halt and ratings agency downgrades have made it tough for a construction sector that grew too big for the market. Hefty fines totalling R1.46 billion for anti-competitive practices in World Cup stadia construction also slashed reserves. In November 2014, SA’s Competition Commission announced that WBHO, Group Five, Stefanutti Stocks and Basil Read will also face ‘fresh’ claims of collusive tendering for 2010 FIFA World Cup stadia before the Competition Tribunal.

Testing the market further, there is no sign of domestic economic reform anytime soon and interest rates are still on the rise. Government’s October 2014 medium-term budget decision to slow the growth in public spending, including cutting ‘non-essential spending’, is also harmful. Around the globe, mining, construction and engineering are struggling.

Despite pessimism that is difficult to dismiss, economies are cyclical and within the trough the seeds of recovery are sown – it’s just difficult to predict when they will germinate.

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‘Diversification requires investment and fixed costs in order to get the benefits’

ANDRIES ROSSOUW, PARTNER, PWC

While the Chinese construction boom, resulting in steep rises in commodity prices, continued through the 2008 global recession and its local aftermath (2009), eventually their demand softened in 2012. As a result, the earliest conditions for a possible recurrent pick-up – lower input prices – have emerged abroad but have yet to be felt in SA.

The wholesale prices of building materials such as steel and copper have plunged, albeit in US dollars, while domestically cement prices have struggled to keep up with inflation. Eventually, lower building costs may spur projects that were marginal at the peak of the raw materials boom.

Despite the gloom at home, across the border in northern Mozambique lies a potential $50 billion oil and gas construction zone, and the urban infrastructure that could follow it.

Bloomberg describes it as the largest gas find in a decade and the Financial Times has reported on authorities’ plans to build a new city in Palma around the liquefied natural gas plant to house 250 000 people. Progress is being made in finalising the politically charged regulatory groundwork but most construction is yet to begin.

The geographic earnings of Murray & Roberts, which was founded over a century ago, illustrates this downbeat view of SA – over 70% of revenue and profit is earned outside the country’s borders. The group has also been one of the first to recover since 2010, returning to (annual) profitability in financial 2013 after ‘big losses’ in the previous two years, said the firm.

In October 2014, Murray & Roberts chairwoman Mahlape Sello said the firm had come to the end of a three-year ‘recovery and growth’ strategy. ‘Significant progress has been made on the recovery phase of this strategy but the growth phase has to some extent progressed at a slower than anticipated pace,’ Sello said.

She added that while the decision to increase investment in Australia through oil and gas engineering contractor Clough had already been financially positive, overall group performance has been ‘somewhat dragged down by depressed South African trading conditions’.

PWC confirmed industry net profit margins had halved in 2013 from the 5% to 6% on the back of the global economic boom and run up to the World Cup.

‘The contraction in the global construction industry and in particular in SA post 2010, has increased competition and eroded margins to the longer-term average of between 2% and 3%,’ PWC said in a review of the JSE-listed construction sector.

For Murray & Roberts, the completion of the R4.4 billion Clough acquisition represents a continuing strategic shift towards the international market to focus construction and engineering in natural resources, including energy and water supply.

It is easy to see why Murray & Roberts took its controlling stake in Clough to 100% during the year to June 2014. Clough, which makes up the group’s oil and gas platform, generated an operating profit of R1.03 billion. This is more than double the operating profit generated by the three other divisions: construction, mining and energy. Net profit in the year to June climbed R257 million, from R1.004 billion to R1.261 billion. Revenue was up R1.830 billion, from R34.209 billion to R36.039 billion.

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According to Sello, while the group was poised to take advantage of the potential offered by the resources sector in the rest of Africa, there were still too few plans ready to be executed. ‘Mozambique remains a specific neighbouring target country based on the significant opportunity associated with the imminent oil and gas developments,’ she says. This neighbouring geographic diversity is important as the oil and gas industry matures in Australia.

While earnings at WBHO declined in financial 2014 on account of its loss-making Mozambican pipe business Capital Star Steel SA (CSS), the group stood out for its positive performance in SA construction. WBHO disposed of CSS due ‘prevailing difficult market conditions’.

WBHO was also unusual for highlighting that ‘margins have recovered’ on its SA building jobs but pointed out this was ‘to industry norms’. Local order books were also at record levels, the firm said. As a result it was able to pick the most lucrative jobs and had hired more staff. CEO Louwtjie Nel said: ‘We experienced good growth in the Australian and South African private building markets.’

Operating profit from SA was the largest contributor again, taking over from the rest of Africa. Despite group profit on a continuing basis expanding, when taking into account the deconsolidated steel business, profit in the year to June fell from R612 million to R423 million.

Another company founded more than 100 years ago is Aveng, which has the third-biggest market capitalisation after Murray & Roberts and WBHO. The crisis following the 2010 FIFA World Cup hit Aveng much later and the firm is still in the middle of a ‘recovery and stabilisation’ phase.

Aveng chairman Angus Band said in an update at the group’s annual meeting in November 2014 that trading continued to be ‘difficult’.

To avoid a short-term cash crunch in July 2014, Aveng raised R2 billion after issuing convertible bonds. In addition, the group sold the Electrix business for about R1.4 billion and the process of disposing of the majority of the group’s property portfolio in SA is ‘well advanced’, says Band. The liquidity boost was not just to cover legal disputes – a common and often costly exercise sector-wide – but also to raise funds to invest in expansion.

Despite the temporary liquidity problem in 2014 and poor market conditions, Band said the Aveng ‘mining and manufacturing businesses yet again delivered solid performances’. Group earnings swung from a profit of R459 million in the year to June 2013 to a loss of R376 million in financial 2014. Revenue was up 2% to R53 billion.

Group Five – like Murray & Roberts – has recovered since the aftermath of 2010. The difference, however, is that revenue at the firm is predominantly South African.

Despite the widespread view that the local market is tough, Group Five managed to lift both profit and revenue in the year to June 2014. Attributable profit climbed to R401 million from R258 million and revenue from continuing operations was up 39% to R15.3 billion.

Group Five had initial success in embarking on ‘strategic diversification’, away from mining and transport towards energy and ‘oil and gas’.

However, as SA’s renewable energy contracts came to an end later in the financial year, there was an uptick in more recent contract awards in local real estate, mostly corporate and retail work.

‘This resulted in a further concentration of the order book,’ the group said. Outgoing CEO Mike Upton cautioned ‘construction margins remain thin’ due to spare capacity in the industry.

Referring to government work, Upton reiterated the oft repeated refrain that there were bureaucratic delays in government infrastructure projects. Statistics South Africa data published in 2014 confirms declining new public construction spending in financial 2011 and 2013 but does not show that it has collapsed.

Group Five said it was disappointed that less than a quarter of revenue in financial 2014 was from the rest of Africa and its small Eastern Europe business, but remained upbeat that Africa was forecast to have the fastest construction growth after Latin America.

Raubex, another firm with an improved financial performance in 2014, illustrated the significant underpin domestic government work provides to both itself and the sector. Raubex said the volume of roadwork available remained ‘healthy’ despite competition that led to low margins. This view can be extended to the importance of a stable South African National Roads Agency (Sanral) – whose financial model has been challenged by consumer opposition to road tolling – to the economy.

According to Raubex: ‘The progress made by Sanral in expanding its strategic network of roads previously under provincial administration is encouraging and is expected to support a healthy volume of maintenance work in future.’

Raubex CEO Rudolf Fourie told Business Day that the securing of two Zambian road projects, including one virgin route, will boost margins in 2015. Raubex revenue in the half to August 2014 gained 15.7% to R3.73 billion. Profit was up from R182 million to R194 million.

Among the smaller constructors, Calgro M3 has been the outstanding player, rising from the development market of the JSE, the AltX, to the Main Board. What is all the more remarkable is Calgro M3’s focus on low-cost housing, which has been the graveyard of many start-ups that hoped for huge opportunities from government’s massive housing roll-out since 1994.

For most of the smaller players, however, surviving post-2010 has been even more of a struggle than for their sector peers.

Protech Khuthele was among those specialising in government-funded housing that failed. Sanyati Holdings and Sea Kay Holdings make up the other two firms suspended by the JSE. All three companies are in liquidation.

Stefanutti Stocks is turning itself around, lifting its net profit from R67 million to R89 million in the first half to August 2014, after shedding loss-making projects.

Basil Read appointed a new executive team in 2014 after the struggling firm had been operating without any permanent top executives. This included new CEO Neville Nicolau, a previous head of Anglo American Platinum, BDLive reported.

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Meanwhile, interim earnings at Esorfranki collapsed, the firm reported in November 2014. A month earlier, the company also gave the market a negative surprise after it announced the sale of its founding core business – the geotechnical unit – for R500 million.

While it is clear that bigger contractors survived both the global and local recessions, questions about future near-term performance remain unanswered.

With building input costs falling in developed markets, much will depend on the performance of the rand, which remains vulnerable due to the twin deficits on trade and the fiscus.

Lower building costs over the short-term have the ability to kick-start projects put on hold, but exactly when is far from clear. The risk is that the world will follow Japan and Europe into an extended period of ‘bad’ deflation where product prices simply keep declining because there is no demand.

A common view emanating from the heavy construction sector is that the SA market continues to offer pockets of growth, but that overall near-term prospects are unexciting.

‘I agree with this assessment,’ says Old Mutual Investment Group’s ELECTUS boutique construction analyst Gustav Schulenburg. ‘However, the pockets of growth in South African infrastructure are dwindling fast as the economy slows down.’

Ultimately, much may depend on the successful implementation of Mozambique’s multi-billion dollar gas projects. The country faces pressure to ensure surging tax revenues are spent on infrastructure for its citizens and not squandered.

If Mozambique can get that right, it might be the best opportunity for the ongoing building of roads, water supply systems and shopping malls long after the flurry of construction activity in gas pipelines and plants is over.

By Tom Robbins
Image: Mr.Xerty © www.nomastaprod.com