Managing through a downturn when credit is tight and access to capital markets is limited is nothing new for today’s E&C executive. However, unlike the previous four recessions of 1980, 1981, 1990 and 2001, a rapid return to a normal credit environment and open capital markets for the construction industry is far from certain.

While the federal government reports the economy to be technically out of recession, the near-term outlook for the construction industry is bleak, credit remains tight and large infusions of equity capital from primary and secondary offerings remains unlikely. Why? There is significant risk of a double-dip recession, and the outlook for the construction industry appears weak in the eyes of Wall Street and commercial banks.

The unsustainable housing bubble triggered the last recession, resulting in an unprecedented mortgage and consumer debt crisis that is yet to play out. Household credit defaults continue to wreak havoc on Wall Street and the banking industry, in spite of the billions of dollars the federal government
is spending to backstop these industries. For example, the FDIC reported that 157 U.S. banks failed in 2010, up 13% over 2009. Moreover, there is an enormous amount of commercial mortgage debt scheduled to mature in each of the next three years. Much of this debt was placed toward the end of the real estate bubble and is currently residing in the nonperforming loan portfolios of commercial banks.

In response, banks are tightening underwriting standards, calling contractor loans and, most significantly, not inclined to lend in capital for commercial development at a time when so many troubled assets remain in this sector. In short, the E&C firm’s local banker may not be inclined to do business, assuming the bank itself is still in business.

So what about the equity markets? While FMI believes that within the next decade several new public E&C companies will be created, the near-term outlook for significant primary and secondary offerings involving these firms is tied explicitly to economic recovery fueled by accelerated investment in infrastructure and robust consumer spending. The near-term outlook as we start 2011 does not look promising.

The post-WWII U.S. economy has been driven by unimpeded consumer spending and accumulating
consumer debt since the mid-1940s.

However, in spite of falling prices and record low interest rates, American consumers are neither spending nor borrowing. To the contrary, U.S. households are deleveraging at unprecedented
levels. Total household debt peaked in the second quarter of 2008 at $12.5 trillion and has since declined by more than $1 trillion. Moreover, total nongovernmental (private) debt in the U.S. has been declining since the first quarter of 2009. Those households that can pay down debt are doing so, primarily by not spending. Correspondingly, those consumers who cannot manage their debt burdens are defaulting and filing for personal bankruptcy at alarming rates.

These are not favorable short-term trends for U.S. industry. In response, large corporations are hoarding cash, cutting costs and slashing payrolls. In fact, the past recession saw the greatest decline in the percentage and absolute number of job losses of any recession since World War II. The official U.S. unemployment rate is slightly less than 10% and the actual unemployment rate may be higher. If the U.S. economy is indeed on the rebound, the recovery is a jobless one. Moreover, consumer spending will not reverse its downward course in the absence of sustained job creation. The lack of top-line corporate growth and new job formation does not bode well for opening the equity markets to the E&C sector due to weak fundamentals, such as high commercial vacancy rates, dismal new home sales, weak manufacturing spending and falling tax revenues.

The performance of E&C sector stocks reflects this outlook. After collapsing in 2008, E&C sector stocks have not performed well along with the broader market.

Earnings multiples of E&C sector stocks will take time to recover and will only do so in line with sustained economic recovery. In the interim, accessing the equity markets for new capital is unattractive because the corresponding valuations are low and the appetite for new issues in general is weak.

However, there is a silver lining for E&C firms with strong balance sheets and plenty of cash. Specifically, it is an ideal time to be a buyer. The number of distressed contractors and firms heading to bankruptcy continues to climb. Firms with experience taking over troubled operations or even companies in bankruptcy should have numerous opportunities in 2011.

Perhaps of greater interest is the many well-managed E&C firms with concentrated ownership among aging baby boomers that will need to sell within the next few years. Given that we are at or near the bottom of the industry downturn and owners are coming to grip with realistic valuation expectations, the
opportunities for cash-rich E&C firms in a position to buy are plentiful.

As the economy inevitably works its way toward some form of sustained recovery, it is reasonable to expect that part of the new normal will reflect further consolidation among banks, greater concentration among the large E&C firms and limited access to the public markets by the lion’s share of the construction industry. And, while we believe a few new public E&C firms will be created in the coming years, the majority of capital and liquidity will take the form of consolidations among buyers and sellers within the industry.

Written by Wm. Christopher Daum

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