Main contractors are under pressure to reform their payment practices, but with a business model that depends on their ability to hold onto cash, will speeding up payments push more of them to the brink?
In the period since Carillion鈥檚 collapse, as inquiries into what happened continue, the government has stepped up the rhetoric around fair payment by launching two significant consultations and by publishing, for the first time, data on individual firms鈥� payment records. Meanwhile, two listed contractors 鈥� Kier and Galliford Try 鈥� have been forced into rights issues to raise money to fix their balance sheets, while a third, Interserve, has fallen into pre-pack administration following shareholders鈥� refusal to vote for the company鈥檚 latest rescue plan.
What may not be immediately clear is how inextricably debt and fair payment are linked. Tony Williams, analyst at 黑洞社区 Value, says: 鈥淧ushing contractors to improve payment times is going to exacerbate an already very tender financial situation. If it happens, I don鈥檛 doubt there鈥檒l be more bankruptcies as a result.鈥�
Why? The reason for his prediction is simple: cash. Contractors have traditionally delayed payment to suppliers because it increases the cash they have sitting in the bank. But if they鈥檙e forced to pay more quickly, the reverse happens 鈥� cash is sucked out of their businesses. And it is lack of cash that causes businesses to fail.
The scale of the impact of changing business terms can be huge. Kier, for one, has already admitted it is investing 拢70m of cash in its supply chain to meet the challenge. And while Williams is not suggesting the largest contractors might fall, the fact Interserve has entered a pre-pack administration this week makes it a very live issue.
Moreover, a simple analysis of balance sheets conducted by 黑洞社区 suggests the top 15 contractors by construction revenue (including Interserve) could see up to 拢1.3bn of cash sucked out of their businesses if they moved to paying at the speed the government has specified 鈥� 30 days. So how likely is this to happen, and what might it mean for the industry?
鈥淕ood solid businesses are already going bust every week because they鈥檙e not being advanced money by their banks. This is a real red flag鈥�
Tony Williams, 黑洞社区 Value
Read: Does construction need a national regulator?
Read: Balfour and Kier still taking 50 days or more to settle up
Fair payment
Small businesses have been calling for government action to force big construction firms to pay more quickly for decades, without seriously changing practice on the ground. The biggest success, from subcontractors鈥� perspective, has been the increasing use in parts of the public sector of project bank accounts 鈥� mechanisms designed to ensure subbies get paid on time, with more than 拢10bn of work having now been channelled through them. But their use, as demonstrated by this week鈥檚 admission by the Department for Education that it is not currently using any, is far from universal.
However, the collapse of Carillion, which notoriously held its suppliers on 120-day payment terms and owed more than 拢1bn to subcontractors when it failed, has forced the government to increase efforts to solve the problem (see Fair payment, top right). This has coincided with the introduction of regulations forcing all large businesses to publish information about their payment practices, which has demonstrated how persistent the issue is. Not a single one of the UK鈥檚 biggest 15 contractors has an average payment time below the 30 days the government expects of its suppliers, with some of the largest 鈥� such as Kier, Balfour Beatty and Laing O鈥橰ourke 鈥� taking 50 days or more to pay on average.
Joe Brent, head of research at investment bank Liberum, said in a note produced in January that the current government assault on existing payment practices meant contractors鈥� financial models were having to change, adding that 鈥渋n most cases鈥� this will have 鈥渁 negative impact on cash鈥�. Last year the government floated the idea of preventing firms bidding for public sector work if their payment record wasn鈥檛 up to scratch, and, while that proposal looks unlikely to be implemented imminently, the government subsequently consulted again upon further measures (see box below).
Fair payment - in context
Since 2010, the government has made several attempts to ensure suppliers are paid quickly, including by using its procurement policies to encourage the use of project bank accounts. In 2015, it introduced legislation that mandated that UK government clients ensure 30-day payment terms through the top three tiers of the supply chain. This included the regulations that, from last year, have been forcing firms to publicly declare payment time information.
The government has also introduced a Prompt Payment Code, which requires signatories to pay all invoices within 60 days and work toward payment in 30 days, and which is backed by a Construction Supply Chain Payment Charter. (There are 2,250 signatories in total, including 29 contractors and housebuilders with turnover of more than 拢500m.)
In addition, two private members鈥� bills making their way through parliament are designed to outlaw retentions and mandate public sector use of project bank accounts, as has already happened in Scotland and Wales.
However, last year the government鈥檚 procurement arm, the Crown Commercial Service, backed down on an April proposal to exclude poor payers from government work, saying in November that 鈥渘o conclusions could be drawn鈥� from responses and that 鈥渇urther consideration鈥� would be given to it. The business, energy and industrial strategy select committee lambasted the government鈥檚 performance on the issue in December, saying the Prompt Payment Code and charter were 鈥渃learly not having the desired effect鈥� and that late payment by large firms was 鈥渢otally unacceptable, unfair and constitutes a particularly disgraceful form of market abuse.鈥�
鈥淕ood solid businesses are already going bust every week because they鈥檙e not being advanced money by their banks. This is a real red flag鈥�
Tony Williams, 黑洞社区 Value
Is the government doing enough?
Groups representing subcontractors, such as the Specialist Engineering Contractors鈥� Group (SEC Group), are not convinced the government is doing enough. Rudi Klein, chief executive of SEC Group, says: 鈥淭hey鈥檙e publishing this data, but with no consequences flowing from it 鈥� then it鈥檚 really hard to see what value all of this has in terms of changing the culture.鈥�
However, John Morgan, chief executive of contractor Morgan Sindall Group 鈥� whose construction business pays on average in 44 days, with other parts paying much quicker 鈥� said: 鈥淚 think your payment record is going to become part of winning a public sector contract [鈥 It鈥檚 also market-driven 鈥� we need to pay well to attract the best supply chain.鈥�
Cenkos analyst Kevin Cammack said contractors working with the government appear to have been told to improve their efforts. 鈥淭hey鈥檝e been given the impression that they need to get payment times under 50 days at least to avoid the proverbial spanking,鈥� he said.
鈥淚 think it鈥檇 be very difficult to exclude them from bid lists, but you could see the government levying fines against those that don鈥檛 improve.鈥�
This pressure comes at an acutely difficult time for many contractors in the wake of Carillion, with their customers, suppliers and banks putting the spotlight firmly on their financial stability. With many having taken serious financial blows in recent years, arising out of jobs taken on during the recession, a number remain in 鈥渘et debt鈥� positions, meaning their cash in the bank is insufficient to fund their borrowing, were it all to become due. Announcing its rights issue last year, Kier made clear it had done so because its banks were reviewing their lending to construction businesses in light of Carillion鈥檚 demise.
It鈥檚 this focus that last month persuaded Morgan Sindall to release more detailed information than ever before on its daily cash position in a bid to demonstrate its robust balance sheet. John Morgan says: 鈥淟ots of stakeholders are really interested right now to understand more detail about contractor finances. Obviously the City, but also customers, the supply chain and those that insure them. Everyone is looking at it.鈥�
This means balance sheet strength is becoming a key selling point. As the Liberum note says: 鈥淐ompanies with strong balance sheets should be able to win market share.鈥�
But this presents main contractors with directly conflicting priorities: reduce their payment times to help their suppliers, or maintain cash in the business to demonstrate stability. Like UK banks after the credit crunch, under pressure from the government to not only increase lending into the economy but also rebuild their financial strength, both aren鈥檛 achievable at the same time.
Cash calculations
Contracting has traditionally been a good generator of cash, which has helped compensate for the thin margins. However, problem jobs and diversification into other cash-hungry activities such as support services and development have left some contractors with less cash or even net debt. While contractors can boost their cash balances by ensuring that they pay their subcontractors and suppliers more slowly than they themselves are paid, this can jeopardise the finances of those further down the supply chain.
It is possible to calculate the impact of this using figures in contractors鈥� reports and accounts. The 鈥渢rade payables鈥� figure, usually published within a note to the 鈥渢rade and other payables鈥� line in the balance sheet, tells you how much the contractor owes to its suppliers. With publication of the average time it takes a contractor to pay, it is possible to see how much these debts would reduce by, and thereby how much cash would be needed, if payment times reduced. So, if a contractor with trade payables of 拢50m who paid in 50 days reduced this payment time to 30 days, the trade payables figure would reduce to 拢30m. The cash cost to do it is the 拢20m difference between those.
The top 15 contractors by construction revenue, responsible for turnover of 拢37.6bn, report average payment times of 45 days. Undertaking this calculation on each of their most recent published reports and accounts suggests that moving to 30-day average payment terms would wipe 拢1.27bn of cash off their balance sheets. This would reduce the net cash of these contracting giants to just 拢100m in aggregate.
These figures should only, however, be used as an illustration of the impact of moving payment times, and not a prediction of exactly what would happen in the real world. The calculation is limited in that it assumes no change in the time the contractor itself is paid, and that the whole business moves uniformly and immediately to 30 days. In reality this would be likely to happen in a piecemeal fashion over a lengthy period. The average payment figure reported may also cover inconsistencies 鈥� for example, if the firms already tend to pay their larger subcontracts earlier, this would limit the impact of the move.
Finally, the average payment time figures reported in many cases do not cover the same time period as the 鈥渢rade payables鈥� figure used.
Cash out
黑洞社区鈥檚 analysis of the top 15 UK contractors by construction turnover shows how serious this dilemma is. Using most recent published results, and assuming these firms moved their whole businesses from paying at their declared average payment time to 30 days, the change would suck out 拢1.27bn of cash. This is only just shy of the 拢1.37bn total net cash reported on those firms鈥� balance sheets. It would affect different firms differently 鈥� the higher the average payment time now, the bigger the effect on cash of moving to 30 days (see Cash calculations, above).
In reality any change to payment times would only happen over several years and is likely, at least initially, to affect only UK public sector workload. It is possible, too, that contractors鈥� own clients might improve their speed of payment, offsetting the cash lost to their suppliers.
A more detailed analysis of four contractors in Liberum鈥檚 note, factoring in the proportion of public sector work undertaken by contractors, estimated that Balfour Beatty was likely to see an outflow of 拢125m, Kier of 拢120m, Morgan Sindall of 拢50m and Interserve of 拢30m (a calculation made before it fell into administration but still relevant as it continues to trade). Liberum鈥檚 conclusion is that all these firms can afford these outflows 鈥渁part from possibly Interserve鈥�.
However, not all businesses of all sizes would necessarily be able to afford this hit. 黑洞社区 Value鈥檚 Tony Williams, says: 鈥淭his analysis shows that if payment terms move dramatically, then one way or another this does have very big cash impacts for businesses. Good solid businesses are already going bust every week because they鈥檙e not being advanced money by their banks. This is a real red flag.鈥�
Cenkos鈥� Cammack is not so bearish but admits any move could be 鈥減otentially pretty painful to the balance sheet鈥� if it 鈥渉ad to be done in a limited time鈥�. 鈥淢y view is the government will look for staged reductions; it鈥檚 incumbent upon them to give notice so people can adjust,鈥� he says.
SEC Group鈥檚 Klein cautions against advancing too much sympathy to embattled contractors, given specialists鈥� vulnerability to late payment. 鈥淢ain contractors will say they need their supply chain鈥檚 cash as part of their business model,鈥� he says. 鈥淲ell actually, they鈥檝e had it pretty good for a long time and it needs to change.鈥�
Balfour Beatty and Kier both claim that things are already changing, with a spokesperson for Balfour Beatty saying the firm was 鈥渢otally committed to fair payment鈥� and was already taking steps to improve its performance. A Kier spokesperson said in a statement that the firm was 鈥渃ommitted to significantly reducing our current payment days as we respond to the changes in public sector procurement鈥�.
And there are potential upsides for contractors to moving to a new way of doing business. Paying suppliers earlier reduces your liabilities, which makes your working capital position look healthier, while simultaneously reducing the chances of one of your suppliers failing. And it is likely that margins would need to increase to compensate for the loss of cash 鈥� with Liberum鈥檚 analysis suggesting they could even double.
Klein says: 鈥淚f this change is going to be realistic, it鈥檚 quite possible margins will go up. However, by changing the way procurement is done, there are other huge savings to be found.鈥� Liberum鈥檚 Brent says a higher margin, working-capital-neutral model for contractors will, ultimately 鈥渕ake the sector more investable鈥�.
Morgan Sindall Group鈥檚 Morgan says: 鈥淭here鈥檚 a huge debate since Carillion about whether the contracting model is broken. It isn鈥檛. It just doesn鈥檛 work when companies have got average daily debt.鈥� Clearly, while it is too late for Interserve, many in the industry would welcome the arrival of the sunlit uplands of higher margins and stronger balance sheets. However, those with long payment times and immediate concerns over cash may struggle to negotiate how to get there.
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