Shaky foundations

The construction industry is currently one of the success stories of British business. A thriving sector driven by a buoyant housing market and massive public spending, UK construction is now worth around £75bn a year.

However, 2004 could be a much bumpier ride for building, in the light of a slowdown in house-price rises and the Chancellor's decision to rein back some investment plans. A picture is also emerging of varying fortunes across different regions and within the various construction sub-sectors.

Historically, the construction industry has been very self-sufficient, with different companies and sectors trading with each other to help to compensate for any downturns the industry faced. But as more companies move towards specialisation and building trends across the country change, businesses need to protect themselves from over-exposure in potentially underperforming sectors.

There were over 1800 insolvencies in the industry in 2002, with similar figures forecast for 2003. And despite the generally upbeat outlook for the UK economy as a whole, there is a danger that construction failures could increase in 2004. So the watchword for this year is caution, with construction firms keeping tight control of their credit management to minimise risk.

Traditional strength

The British construction sector is one of the strongest in the world, accounting for almost 10% of the nation's gross domestic product and employing 1.5 million people. There are around 175,000 VAT-registered construction businesses in the UK, plus many smaller unregistered firms. Although the majority of construction companies employ less than four people, the sector is dominated by a handful of big household names like Bovis, Balfour Beatty and Taylor Woodrow.

UK construction is divided between a number of different sub-sectors, including newbuild, repair and maintenance services and construction materials. The building and maintenance areas of the industry are largely insulated from overseas competition, but the materials sector is facing growing competition from cheaper imports, with a number of UK providers having been bought out by foreign companies in recent years.

In the newbuild sector, the big engines for growth over the past few years have been housing and the myriad of government-backed Public-Private Partnership and Private Finance Initiative projects in the public sector. These have been a major plank of the government's investment in infrastructure and public-sector building since Labour began its second term in office. Although PFI entails a complex tendering process, those companies that persevered through the early days of the initiative have since been rewarded with valuable public contracts.

That pattern looked set to continue at least until the next election, but the apparent £10bn shortfall between government investment plans and revenue has forced the Chancellor to put the brakes on public spending. This could see a number of major public schemes scaled back, put on hold or shelved altogether. Civil engineer Jarvis announced at the end of January that delays in the award of four PFI projects had cost it £12m. The decision by Network Rail to take back in-house maintenance work previously carried out by private firms caused a significant fall in the share prices of contractors like Amec and Carillion.

Responding to a public tender is also time-consuming and costly, and is money down the drain if the contractor is unsuccessful. There have also been a number of instances where spiralling project costs during the tendering and planning phases have resulted in the abandonment of whole projects. And once a project has been confirmed, there can be long lead times between the agreement and when work actually starts, making the gearing of debt and funding difficult to plan.

Commercial and residential

Construction in the commercial market is also slow as businesses hold off investing in new buildings - especially in the manufacturing sector, where companies are suffering the after-effects of an extended slump that is only now, slowly, starting to turn around. There is still a glut of office space nationally, but the positive economic picture has had an impact in certain parts of the country - such as London, for example, where commercial lettings have risen by 20% in the past few months. Although there are still a lot of empty offices around the country, this shift could signal the start of a new wave of refurbishments, and even newbuilds.

There has been speculation that retail development is set for growth, partly in response to growing consumer spending. But the Bank of England's interest-rate rise in November was an attempt to cool down consumer spending, so the demand for new construction could be limited - especially as out-of-town shopping developments are currently out of favour with the government and struggle to get planning permission.

The housing market boomed for a number of years - fuelled by the lowest interest rates for a generation, low unemployment and a move by investors away from the stock market into seemingly more reliable bricks and mortar. In addition to new house-building, especially amongst the major developers like Persimmon and Redrow, the sector also benefited from homeowners wanting to improve their existing homes, adding value with major projects such as extensions and loft conversions.

But by the end of 2003, massive consumer spending had sparked fears that people were exposing themselves to unacceptable levels of debt - hence the interest-rate rise. Debt levels were reflected by record highs in mortgage lending - primarily borrowers re-mortgaging for better deals - and staggering amounts of equity withdrawal, worth up to 6.5% of consumer spending by 2002, with people borrowing against the value of their homes.

Despite positive signs in the economy, November's interest-rate rise, and the potential for more in 2004, led to much speculation about the imminent collapse of the housing market. House prices rose by an average of 15% last year, but there were wide regional variations, with property values rising by 23% in the north-west, compared with a fall of 5.8% in the south-east. For the coming year, various organisations are predicting slower growth of between 4%-9%, but again there is likely to be a great deal of regional difference. In fact, this slowdown could boost the dwindling numbers of first-time buyers, who are finding it difficult to get a footing on the property ladder - although even this possibility will be scuppered if interest rates go up too much.

Shortage

There is still a demand for property, as Britain faces an ongoing housing shortfall of between 200,000 and 250,000 homes. According to the big house developers, demand for new homes will be fairly consistent across the country, with a few 'hot spots' primarily within the M25. A move to more social housing will also have a knock-on effect, with a demand for new roads, schools and shops to service housing developments.

Yet planning permission is difficult to get for much-sought-after greenfield sites, and there are very tight restrictions in truly rural settings. However, there are signs that the government may try to revitalise the rural economy by relaxing controls on new housing, commercial and industrial developments, as well as allowing more extensions and change-of-use requests.

The buy-to-let market is also showing signs of regional slowdown, with marked differences between up-and-coming areas and traditional hotspots now suffering from oversupply. Buy-to-let has been a significant source of business in recent years for the refurbishment and maintenance sectors of the construction industry, as well for speculative investors buying new properties. Now that the stock market has been recovering for 12 months, the attraction of housing in a slackening market might wane.

Skills gap

One downside of the booming construction sector is a growing skills shortage, especially in trades such as plumbing. For many small companies this could be crucial, with growth being restricted directly by a lack of people available to carry out the work. The shortage also hampers the introduction of new materials using plastic- and fibre-based technology. These materials are ushering in a trend towards more pre-fabrication, which again requires a completely new skill-set.

More generally, failures of some major construction companies, including Ballast and Lilley, show how problems can occur even in boom times. The failure of the Lilley management buyout was brought about in part by the demise of its one-time parent company Sunley Turriff, whereas the collapse of Ballast came following the discovery of a pension-fund shortfall in its balance-sheet when subjected to the tough new accounting standards.

The new accounting standards are expected to be a problem for many industries, but are likely to affect construction firms particularly due to the absence of any other substantial fixed assets on building firms' balance-sheets to offset the damaging affects of pension-fund shortages.

Overseas, British contractors are not having such a good time of it - especially in post-war Iraq, where Amec has just lost out on another £1.2bn contract it had been expected to win.

In the UK, new construction orders were down by 2% during the quarter September-November 2003 compared to same period in 2002, although this figure was still up by 6% on the quarter June-August 2003. Of more concern, perhaps, is the evidence of price-cutting to win contracts - a sure sign of worry within the industry and a move that could impact adversely on profits in 2004 and beyond.

But it is certainly not entirely a picture of doom and gloom in construction for the coming year. My company remains confident of growth in the sector, and is positive towards risk generally and individual companies specifically. It will, however, be interesting to see how the sector develops over the coming 12 months - and how it deals with the changes and tougher times it faces.