UAE’s construction sector can ride the storm

To say that the region’s construction companies are going through a rough patch is an understatement. On April 5, Reuters reported that a prominent UAE-based construction company missed payment on its recently restructured debt.

In December 2015, Pinsent Masons, the law firm, in its annual GCC construction survey reported a sharp drop in optimism compared to the prior year, and more strikingly the “sharpest annual decline in optimism” since the survey began nearly a decade ago.

Construction is a cyclical industry and this regional downturn is driven by low oil prices, simmering political tensions, and a collective uncertainty around various global issues, such as China’s slowdown.

In the aftermath of the 2008-09 global financial crisis, GCC governments rightly decided to invest in the diversification of their economies, which meant significant capital projects. A stellar example is the plan to create 14 industrial cities across Saudi Arabia.

However, the sharp fall in oil prices since late 2014 and the medium term downward bias has had a major impact on government incomes and spending, akin to applying hard brakes on a speeding vehicle. As a result, payments are being significantly delayed, long term contracts revisited, and banks have become more cautious in lending.

This is a dangerous mix for construction firms.

What company management teams do during each stage of the cycle lays the foundation for differentiation versus the competition. Smart managers know that sustainable competitive differentiation and scale are created not just during a growth phase but also during downturns.

During an up-cycle, managements must watch out for risks created by customer concentration, spreading management bandwidth too thin, extending into projects requiring newer capabilities and depletion of cash headroom. Adding too many complexities makes businesses susceptible to more serious repercussions when a down-cycle begins.

Practicing conservatism in both accounting estimation of profitability, which is especially relevant for publicly listed businesses, and treasury operations will ensure an adequate cushion is available for a soft landing when business conditions turn.

During a down-cycle, the biggest risks facing a construction business owner are adopting an aggressive pricing to win business and underestimating customer credit risk. So, a surgical approach to doing business is advisable.

Management teams should focus their efforts on select segments, capabilities and customers, cutting off the rest until conditions improve.

A quote from John Maynard Keynes is important to remember here: “Markets can remain irrational longer than you can stay solvent”. Keynes said this in the context of short term trading but there are lessons to be drawn for cyclical businesses given the volatile global environment we live in.

Shareholders and their diversified boards bring a wealth of knowledge from external environments and must share this with their senior managers. These insights can act as lead indicators to tailor their strategy and protect their business.

Boards must also watch out for early warning signs of deteriorating business performance.

These could be increasing balances in ‘costs in excess of billing/billings in excess of costs’ accounts; depleting cash buffers; a rise in instances of actual project profitability markedly lower than estimated profitability; reducing operating cash compared to a change in profitability; delays in account finalisation; increasing numbers of disputes on project quality and variance claims.

A combination of these symptoms should prompt swift action from an engaged and informed board. If the board has reason to believe that management is not being adequately objective or transparent, it should not shy away from launching its own investigation to assess both business and management performance.

Taking this step can be vital in protecting shareholder value.

A significant portion of bank balance-sheets in the region are tied to the fate of the construction industry, as it plays a meaningful role in the regional economy and banks provide most of the liquidity to keep the wheels turning. Some of the early warning signs discussed above are available to banks so they too should alert their credit departments to start tightening the screws.

There are lessons to be learnt for regional lenders around how they addressed distressed loans in the last financial crisis. A borrower defaulting within a relatively short period since signing a debt restructuring requires introspection from its lenders on the time taken, processes followed, and general approach adopted during the previous restructuring.

In the UAE, while we await formalisation of a Bankruptcy Law, the Central Bank, UAE Banks Federation and individual banks can take multiple smaller steps to adopt a dominant and proactive role to rescue a distressed business and preserve their own capital.

The recent “mini-insolvency law” developed by the UAE Banks Federation for select smaller firms is an example of a positive shift in thinking, but for larger cases more meaningful steps are required.

The UAE has a vibrant economy and will ride this downturn out. But, a number of construction businesses may be lost in the process if appropriate steps are not taken to manage the prevailing business conditions and alleviate their pain. What those steps are is perhaps the topic for another discussion.

The writer is Senior Director at Alvarez & Marsal Middle East.