2015 Trade Contractor Outlook

While the market opportunities and profitability for most trade contractors continued to improve in 2014, the industry was still far from the record years that many experienced between 2005 and 2008. Based on construction industry-specific data from the Risk Management Association’s Annual Statement Studies, average operating profit as a percentage of revenue improved for the second year in row for four major types of trade contractors. The table below illustrates average operating profit as a percentage of revenue for several types of specialty contractors: roofing, drywall, HVAC/ plumbing and electrical contractors. Combining these various trades, average operating profits improved from 2.25% in 2013 to 3.10% in 2014, representing an increase of approximately 38%. While this may sound significant, these numbers are slightly over half of the profits that many of these same firms were making in 2007 and 2008. Overall, the profitability trend for trade contractors is encouraging, but margins remain relatively low for the risks associated with being labor-intensive.

Heading into 2015, FMI sees many of the same trends of the past several years continuing; however, several are becoming more pronounced. Specifically, the major trends that will impact trade contractors in the coming years include the following: „Commercial building segment continues to be a buyer’s market. „ Demand for management and field talent far exceeds supply in many markets. „ Being a union trade contractor is becoming increasingly less desirable for many firms.

Commercial Building Segment Continues to Be a Buyer’s Market

The supply of commercial contractors and commercial construction capacity is still larger than the demand for construction services in this segment. Competition for large projects among large general contractors (GCs) and construction managers (CMs) is still extremely fierce. On larger commercial building projects, the construction fees that GCs and CMs are getting remain thin. Most GCs and CMs cannot operate their businesses profitably at these levels, so they must look for ways to enhance their margins. Many accomplish this through creative risk management techniques, buying major equipment directly and engaging in aggressive buy-outs with trade contractors. For GCs and CMs, finding trade contractors willing to cut prices to the bone is not difficult in most markets. In some cases, the GCs and CMs are forced to use these low bids simply to win the project. These aggressive buying practices are forcing many trade contractors to use highly optimistic, best-case production assumptions in their estimates. The resulting estimates, with tight labor budgets and margins, are often not adequate to cover the true overhead cost of the trade contractor. Assuming that the project starts on time and is well managed and coordinated by the GCthe best case scenario. This is leading some of the larger trade contractors to realize that a strategy to reduce unprofitable revenue is often a great way to improve the bottom line.

Demand for Management and Field Talent Exceeds Supply in Many Markets

Trade contractors are increasingly being drawn into the oil and gas sector, requiring firms in other sectors to develop a talent pipeline to bring in new workers. While the oil and gas sector currently suffers from the same labor shortages as other industry sectors, the relatively higher wages offered are creating a migration of workers into oil and gas, expected by FMI to grow to 10% of the entire construction labor force by 2017. See the article “The Talent Shortage: Impacts Across the Industry” at the head of this section. Based on the expected future growth of the industry and the large numbers of baby boomers who will retire over the next decade, this trend will continue for the foreseeable future. Contractors that do not aggressively invest in recruiting, engagement, retention and development will likely choose to contract out work or may cap the firm at a level of revenue sustainable within its limited resources.

Being a Union Trade Contractor Becoming Less Desirable for Many Firms

While there is no perfect data that measures the percentage of construction work installed by union and nonunion tradesmen, all evidence suggests that the percentage of work by nonunion workers in the U.S. is increasing. This may not be the case in all markets, but looking at the entire country, there is a definite trend in this direction. In some markets, competing as a union contractor is becoming increasingly difficult. Several forces seem to be driving this trend, including the following: „

Economic decision by owners — With many unions continuing to negotiate for higher wages, benefit packages and work rules that often impact the trade contractor’s cost structure negatively, nonunion firms continue to gain a competitive advantage. This plays out in the decision-making by owners when evaluating the cost of building. If union Contractor A can safely and adequately deliver the project for $X and nonunion Contractor B can safely and adequately deliver the same project for 90% of $X, the owner with high economic criteria is likely to choose Contractor

Significant unfunded union pension liabilities — Many union trade contractors are facing significant unfunded pension liabilities. This trend is unsustainable for many and further impacts / CM, the trade contractor may be able to produce a small operating profit. However, even a minor problem on the project or changes to the best-case assumptions made by the subcontractor when preparing a bid can have significant negative effects. At the margins that most trade contractors must operate in today’s market, any project variable or impact that requires them to spend 5% to 10% more than their estimated labor can quickly create a break-even or loss situation on the project. While this trend is simply the result of supply and demand, owners are squeezing everything possible out of project budgets, causing a cascade of pressure down through the supply chain. FMI is seeing the most successful trade contractors addressing this trend in a number of different ways. First, the more successful firms are being selective about choosing projects to pursue, passing up opportunities that will not result in profitable work under their cost structure. Some firms have learned that turning down unprofitable work may be as impactful to the firm’s overall profitability as the projects they choose to bid. Second, for the projects they do choose to pursue, they are using more realistic production rates based on historical data from completed projects and not based on speculating about the desirability of being signatory to a union.

Perceptions of the union — Many construction trade unions suffer a less than positive image in the industry. Regardless of the reasons, this image often influences the desirability of working with unions in the eyes of contractors and owners. While some unions are working hard to change this image and partner with contractors and owners, there are some major legacy issues to overcome.

Not only do these issues impact existing union contractors trying to compete in a challenging environment, but they also have a strong influence on the valuation of union trade contractors. All other factors being equal, the pool of potential buyers for a union trade contractor, as well as the price that an acquirer is willing to pay, is smaller for a union firm than for a nonunion firm in today’s market. There are certainly exceptions to this, but few firms want to make an acquisition that presents the multiple challenges that come with owning and managing a union firm. As a result, owners of union trade contractors may have fewer options for transitioning ownership of the business.

With the strong headwinds that most unions in the U.S. are currently facing, maintaining or growing market share will likely be an ongoing challenge. At some point, the overall construction market, made up of owners, designers and contractors, will ultimately determine the best value for the industry, whether it be union or nonunion labor. Those unions willing to partner with the industry to make some difficult changes regarding legacy pension plans and provide a highly trained workforce capable of improving productivity may find great opportunity. For others choosing to resist the market forces and changes described above, the future is not as bright.

For trade contractors, this year’s trends are a mix of good news regarding improved earnings and some ongoing challenges. In spite of these challenges, the top-performing trade contractors that are capable of adapting to these trends are still doing well. In a recent Construction Financial Management Association (CFMA) Benchmarking Study, the top 25% of specialty contractors had 2013 operating profits of 6.91%, compared to a 3.48%, average among their peers and competitors. Not only did this study illustrate that bestin-class trade contractors are making significantly higher profits (98%), but also the numbers reinforced the fact that striving to be an average contractor may be not be a very challenging goal.

Scott L. Kimpland is a director with FMI Corporation. He can be reached via email at [email protected].