The South African construction industry is tough and competitive with listed contractors struggling to generate returns. Nevertheless some indicators show that there are pockets of growth and the trick is seemingly to find those pockets.
Craig Shapiro, investment analyst at Obsidian Capital, points out that building and civils order books of the big contractors “look challenged”. On a year-on-year basis Group Five reported in December an 18% reduction in their order book, Aveng a 13% reduction in their South African order book, Stefanutti Stocks a 3% reduction, and Wilson Bayly Holmes-Ovcon (WBHO) a 13% reduction in their building and civil engineering order book, he says.
Shapiro says private fixed investment continues to decline with the low business confidence in SA. “As a result building plans passed by the private sector are starting to trend downwards.” He says public fixed spending, although fairly resilient, has been focused on smaller projects rather than the traditional mega-projects which the big contractors used to enjoy. “These smaller projects are being awarded to smaller, unlisted and empowered contractors rather than the big listed contractors.”
The South African Forum of Civil Engineering Contractors (Safcec) State of the Industry second quarter report illustrates the change in two-year order books of medium and large contractors as follows:
Source: Safcec State of the Industry Report Q1 2017
Shapiro says another effect of the scarcity of large projects has been the margin squeeze experienced by some of the larger contractors. “With tenders becoming increasingly competitive, contractors are being forced to reduce pricing on projects. This has resulted in razor thin margins on some projects, as well as the risk that potential mishaps on projects are not accounted for in the pricing which would result in problem and loss-making contracts.”
A case in point is Group Five that in a trading statement on Monday attributed its expected loss per share and headline loss per share of “at least 590 cents” for the year ended June 30 2017 to the settlement of a pipeline project in favour of a client.
Shapiro says both Group Five and Aveng have suffered loss-making contracts, which has resulted in margins below zero for some of their larger divisions.
He says that in contrast to the slow building and civils market, “there seems to be a lot of activity in roads and earthworks, where Sanral is busy”.
In this area, Raubex and WBHO are benefiting, Shapiro says. “WBHO’s order book in their roads and earthworks division is up significantly, offsetting the decline in buildings and civils and contributing to an overall increase in their SA order book.”
Raubex, which derives almost half its profit from road construction and road rehabilitation, has maintained its SA order book at fairly steady levels, he says.
According to the Safcec State of the Industry report, road construction contributed almost 48% of industry revenue in the first quarter of this year.
Source: Safcec State of the Industry Report Q1 2017
The strong road construction market has also benefited construction material suppliers and companies like Afrimat and Raubex continue to grow, Shapiro says.
He says earthworks activity has also been boosted by higher commodity prices, which has resulted in increasing mine-related work for some companies. “WBHO’s order book reflects the benefit of more mining-related work off a very low base. Aveng’s mining order book grew over the last six months, with prospects for better profitability with improvements in the commodity cycle.”
The Safcec numbers show a marked increase in the first quarter of this year in earthwork activity from less than 1% of industry turnover to 5.5%. Surface earthworks (mining) has however contracted in the first quarter.
Is road construction therefore the sweet spot in the South African construction industry?
Shapiro warns that bidding on road projects has become increasingly competitive as contractors are looking to diversify into this area. Margins in roads are higher than in buildings and civils, but more contractors entering this space has resulted in some margin pressure. “In this environment, both WBHO and Raubex work hard to maintain margin and pricing, and only take on work at what they consider adequate margin.”
Safcec’s report further warns that after having increased by an average of 55.6% year-on-year in 2016, the value of road contracts out to tender fell by 13% in the first quarter. “Considering the high contribution of road construction to the civil contracting industry, this could have a profound impact on turnover in the industry,” Safcec warns.
Shapiro says investors should also consider the big contractors’ offshore operations, especially in Australia.
WBHO derived 30% of their operating profit from their Australia operations in their 2016 financial year, he says. “Although Australian profit was down in the first half of the current financial year due to a problem contract, this is unlikely to recur. Going forward, WBHO’s Australian business looks sustainable and will recover from the problem contract and can grow further – their Australian order book was up 14% in in the first half.”
In contrast McConnel Dowell, Aveng’s Australian business continues to be loss making and burning cash, Shapiro says. While Aveng’s Australian division is still performing incredibly poorly, they are still awaiting claims decisions on some very large historic loss-making contracts, he says. If these claims decisions come out in Aveng’s favour, there could however be a massive cash boon for the company. “The size of this potential cash boost is very large relative to Aveng’s current market cap.”