Tough times in a weak economy

Apio’s Francis Kingston discusses the distressed state of the construction industry, and the risk it poses to businesses and insurers.

Construction industry guarantee insurance with Apio

Anyone who follows the news will know that the South African construction industry is in a dire state, with prominent listed companies entering business rescue and thousands of jobs at risk. The country has entered a cycle of low infrastructure spend, certainly an all-time low in the past 10 to 20 years. A lack of investment, poor project planning, and possibly, bad project management, has led to a bleak outlook from a profitability point of view.

If you look back 10 years to the time during the Soccer World Cup, the industry was at an all-time high, but generally speaking, it’s been on a downward spiral ever since, from a spending, jobs and general project point of view. The weak economy, with low economic growth forecast at less than 1% this year, a high unemployment rate and more competition in the sector has impacted major construction companies.

Government and the parastatals are a significant player in the construction industry, not only in terms of new projects, but also in maintenance and upgrades, particularly to roads and water infrastructure. Big projects such as the Medupi and Kusile power plant projects were planned many years ago, and with escalated costs and completion date overruns, these project budgets are depleted. If the government is going to finance additional costs for completion of the two projects, as it has indicated it will, there’s precious little money in the budget to finance maintenance projects and other infrastructure projects that might provide a boost to the sector.

Regrettably, the industry has not future-proofed itself successfully, opting instead for cost-cutting measures when the project flow first started slowing. This has led to a scenario where margins have decreased along with little room for error, putting a lot more pressure on the balance sheet and cash flow. Combined with a skills shortage, increased competition and slow paying by government departments, cash flow has been seriously impacted and other projects put into jeopardy. A combination of these factors has put tremendous strain on the construction industry.

The downstream effect of big companies going into business rescue cannot be understated. Sub-contractors are unlikely to be paid what they’re owed, or have to take a much-reduced amount, which in turn leaves them unable to pay their suppliers on time. It starts at the top and affects thousands and thousands of employees and other people throughout the industry. I believe there will be tougher times ahead, particularly as more of the big contractors struggle to maintain their businesses.

This trend will take years to reverse. Projects are planned years in advance, funding must be secured and issues such as instability in the labour market, our international credit rating and the lack of certainty around land issues combined with the upcoming elections mean that local and international investors are holding back from making long-term investment decisions.

One of the biggest products for this sector is performance guarantees, linked to the successful completion of projects on time and to scale. When companies cannot complete a job, the guarantee is called up and large amounts of money may be paid out, typically anything between 10% and 30% of the contract value.

Subcontractors are at risk when main contractors don’t pay them, as this inhibits their ability to complete the project. At this point, the guarantee they have is at risk because of non-completion. Clients must be mindful that although they may be doing a great job, if they’re not getting paid, they’re at risk. Here, credit insurance policy plays a much bigger role for companies. (See our earlier blog for a detailed discussion about credit insurance.)

With a credit risk insurance policy in place, you will at least have some recourse to get a portion of the outstanding costs back, which helps with cash flow and longer-term viability of the company. The Insurance Guarantee alternative will assist you with managing your working capital requirements while still meeting your contractual obligations to the beneficiary.

We’ve reached a place now where simply being a big-name brand or a listed company doesn’t mean a company is risk-free. Knowing your clients and who you’re doing business with is vital. Problems in the industry affect the cost of securing guarantees. Insurers are far less flexible, and it becomes challenging to renegotiate rates in a ‘hard market’ where insurers have been hit by large payouts on guarantees and high claim rates.

While these types of cover should ideally have been considered in more prosperous times, it’s important to understand where you are from a situational point of view and work with your broker to obtain the best guarantees and credit insurance applicable for your company.