Grant Thornton LLP s 2007 Surety Credit Survey for Construction Contractors: The Bond Producer s Perspective depicts a market that, since digging out

Transcription

1 Grant Thornton LLP s 2007 Surety Credit Survey for Construction Contractors: The Bond Producer s Perspective depicts a market that, since digging out of a trench, is gearing up for

2 a promising future. In just two years since Grant Thornton last produced the survey, the surety industry has improved significantly. In 2005, the surety marketplace was on the cusp of recovering from the after effects of years of record losses, repercussions from Sept. 11, 2001, and the economic downturn of the late 1990s and early 2000s. Since then, construction volume has been on the rise, leading to improved productivity and profitability for both surety operations and construction contractors. The stabilization of the surety market, in turn, has bolstered bond producers optimistic outlook for the future. Findings from Grant Thornton LLP s 2007 Surety Credit Survey for Construction Contractors highlight bond producers attitudes about the current economy and surety market, the availability of surety credit now and in the future and what criteria need to be met to obtain surety credit in today s marketplace. On the cover: Tim Gillen is chief financial officer of Carl Bolander & Sons, a demolition and excavation company in St. Paul, Minn.

3 1 About the survey Grant Thornton LLP s 2007 Surety Credit Survey for Construction Contractors: The Bond Producer s Perspective was conducted with the cooperation of the National Association of Surety Bond Producers (NASBP), whose membership was invited to participate in the online survey between Dec. 11, 2006, and Jan. 9, NASBP members are professionals who specialize in providing surety bonds for construction and other commercial purposes to companies and individuals needing the assurance offered by surety bonds. A total of 257 completed surveys were submitted, with a margin of error of 6.1%. The findings of the current survey are compared to the 2005 Grant Thornton survey that was conducted in December 2004/January 2005 and, where appropriate, with the 1996 Grant Thornton survey. Bond producers were asked to characterize the sources of their own revenue according to types of clients. Seven in 10 (70%) reported that they do a major portion of their business with general contractors, which is comparable to the 2005 sample. One-third (33%) do a major portion of their business with specialty trades, down from the approximately half (47%) who did so in Nearly half (46%) do a major portion of their business in the utility area, up from 35% in As in 2005, slightly more than one-third (35%) of the respondents do a major portion of their business in the highway/heavy area. To gain an understanding of the size of the client base of the bond producers, respondents were asked to characterize the construction companies they serve by revenue size. Forty-five percent of the bond producers surveyed do a major portion of their business with very small clients (revenues of less than $10 million), while an equal number (44%) do a major portion with small clients (revenues of $10 to $25 million). Nearly four in 10 (37%) do a majority of business with clients with revenues of $25 million to $100 million. One-quarter (25%) do a major portion with large clients (more than $100 million in revenues), up from 15% in the 2005 sample. On average, respondents do business in 1.6 regions, although 71% do business in only one region. About one-third provides bonding services in the West Coast (35%), Southeast (33%) and Central (32%) regions. Three in 10 (29%) serve the Midwest region, and 23% operate in the Northeast. One in 10 (10%) operate in international markets. (Note: Total percentages exceed 100% because respondents may do business in more than one region.) Grant Thornton would like to thank all the respondents for taking the time to complete the Grant Thornton LLP 2007 Surety Credit Survey for Construction Contractors. Our thanks also goes out to NASBP for allowing us to poll their membership base and for providing valuable insight into the surety marketplace. Forecasts for a positive construction market combined with the industry s adherence to disciplined underwriting encourage NASBP member optimism about the future environment for surety credit. Richard A. Foss Executive vice president National Association of Surety Bond Producers

4 2 Competitive and economic environment Following a number of years of retrenchment, the construction industry is enjoying a definite upswing in fortune. Department of Commerce statistics report that construction spending totaled a record $1.198 trillion in 2006, up 4.8% from Specifically, in 2006 nonresidential building advanced 14% to $203.8 billion, with double-digit growth in hotel, office and manufacturing plant construction. Nonbuilding construction climbed 19% to $121.4 billion, with double-digit growth in highway, bridge and utility construction, according to McGraw-Hill Construction Analytics. Is it any surprise that the surveyed surety bond producers are optimistic? Nearly one-third (31%) of the bond producers indicate a positive outlook for the construction marketplace s current competitive environment, noting that it is better than a year ago. This is an increase from the 21% who considered the environment to be on the upswing in the 2005 study. One in five (19%) characterize the environment as worse than the recent past an improvement from nearly onethird (31%) in With consolidation and the weeding out of contractors that are either no longer in business or doing work that doesn t require bonding, companies looking for bonding today seem to be, overall, much more capable, dependable and bondable. Another positive sign is that survey respondents report that, on average, only about 8.5% of the contractors in their area appear to be experiencing unusual financial hardship, down from 14.6% in Major causes of financial difficulties among contractors* According to survey respondents, the most frequently cited reasons for contractors facing financial difficulties are slow collections (45%), low profit margins (44%) and insufficient capital/excessive debt (44%). These were the same reasons topping the list in 2005 and have plagued the industry for years. Although still in the top three, the strong market seems to have had an impact on low profit margins, which 64% of respondents cited as a reason for contractors facing financial difficulties in Slow collections 45% 57% Low profit margins 44% 64% Insufficient capital/excessive debt 44% 50% Mismanaging the business 44% 35% Inadequate controls 41% 38% Imprudent risk taking 37% 29% Onerous contract terms and conditions 37% Weak project execution 29% 21% Poor estimating 28% 21% High overhead 26% 34% Inadequate volume 21% 47% Change order volume 17% 19% Lack of available insurance coverage 7% High insurance premiums 5% *Percent of bond producers indicating each as a major cause of financial difficulty. An interesting trend appears to be developing: More than four in 10 (44%) bond producers cite mismanagement of the business as a reason for contractors financial distress, up from the 35% who saw this as a problem in 2005, and 28% in Paired with an upswing in the perception of imprudent risk taking (37% citing this reason, up from 29%), weak project execution (29%, up from 21%) and poor estimating (28%, up from 21%) as major causes of financial difficulties, these findings suggest that unsophisticated management may be at the root of these contractors financial problems.

5 3 Diligent attention to improving each of these areas can not only benefit the company s internal operations and financial performance, but also give construction contractors a competitive advantage. A further indication of surety bond producers positive outlook is that seven in 10 (70%) describe the economic environment for construction in the past year as improving. One in five (21%) are particularly positive, characterizing the environment as improving greatly. And, when considering what the next year has to bring, there is continued optimism. More than half (56%) anticipate an improvement and 27% anticipate no change. Economic environment (2006 vs. 2007) * Improving No change Declining 18% 11% 16% 27% *Due to rounding, total percentages do not add up to 100. Four in 10 (41%) bond producers are anticipating that the demand for bonds will increase in the next three years and 45% anticipate no change. This outlook may be attributable to the expectation of continued strong government spending and an increase in demand for bonds for private sector work. Bond producers are also upbeat about future aggregate surety capacity. Two-thirds (65%) anticipate an increase in capacity, while 19% anticipate a steady state. This means that the next three years should see more bonding for new projects, while greater aggregate capacity will be available for more and larger projects. Again, high optimism underscores the perception of the continuation of strong surety and construction markets. 56% 70% The past year also saw a change in the nature of who is seeking the security of surety bonds. More than four in 10 (42%) bond producers indicate an increase in the number of private sector jobs for which contractors were seeking surety bonds. When looking at the future of private sector jobs, 40% of bond producers anticipate an increase in projects involving surety bonds and 49% expect the level to hold steady. It is likely that owners are realizing the benefits of requiring surety bonds for private projects. Not only does surety bonding confirm both the contractor s credibility and ability to complete the job, bonding may also provide a competitive edge when it comes to acquiring new jobs. Financing for the larger industrial and power projects requires the security of well-managed, profitable construction firms. Construction sureties, in turn, insist on granting credit only to these financially stable contractors. Mark Loper President and chief executive officer AZCO Inc., Menasha, Wis.

6 4 Construction surety credit availability The surety industry s return to profitability and strong demand for construction are considerable incentives for surety companies to remain in the marketplace and seek opportunities to provide qualified contractors with surety credit. One-quarter of bond producers (26%) report that it is easy to obtain surety credit for their construction clients today, though an equal number (26%) say it is difficult. While this may not appear at first to be an optimistic assessment, it s a far better situation than was reported two years ago. In the 2005 study, half (49%) of the bond producers found it difficult to obtain surety credit for their clients and only 12% found it easy. This improvement may, in part, be attributable to the condition of the surety industry itself. In 2005, the industry was faced with a tight market, surety companies closing or being acquired and reinsurance companies abandoning the market. In 2007, the market has stabilized and construction projects are on the rise, fueling surety bond producers optimism. Optimism for the future is high, as well. Nearly four in 10 (37%) bond producers anticipate that it will be easy to obtain surety credit for their clients next year and only 21% anticipate that it will be difficult. While small and emerging contractors are, at times, benefiting from the improved construction environment, their lack of established business processes and lack of a history of successful projects make it difficult for them to obtain the necessary surety credit. Ease of obtaining surety credit (construction clients) Easy Difficult A year ago Today A year from now 16% Bond producers surveyed report that small and emerging contractors comprise, on average, 22.7% of their construction clients. Nearly four in 10 (38%), however, report that these clients make up 10% or less of their business, and half (49%) report that they make up 15% or less. While surety capacity is growing, sureties are not widely positive about tapping into this capacity for their small and emerging clients. The majority (55%) of the bond producers surveyed agree that surety credit for these clients is difficult to obtain today. 21% 26% 26% 37% Ease of obtaining surety credit (small or emerging construction clients) Easy Difficult A year ago Today A year from now 9% 14% 20% 44% 55% 63% 43% In terms of obtaining bonding by project, surety bond producers consider hazardous waste (89%), petrochemical (53%) and power plant (41%) projects difficult to bond. These types of projects are more complex and come with uncertainties that aren t typically associated with more traditional jobs. On the other end of the spectrum, bond producers consider governmental (63%), heavy/highway/transportation (58%), water/sewer (55%) and commercial/ industrial (58%) projects easy to bond.

7 5 Construction surety credit requirements Contractors looking to capitalize on the robust construction environment can still expect to face a thorough evaluation of their company s financial status and operating capability when seeking surety credit in the coming years. They need to be aware of what criteria bond producers use and what steps they can take to qualify. Bond producers are in nearly universal agreement that financial characteristics are important in obtaining surety credit. More than nine in 10 consider the strength of the balance sheet (96%) and financial statement presentation (93%) to be important factors in obtaining surety credit for their construction contractor clients. Similarly, company history is a key dimension. Eight in 10 (81%) bond producers cite a history of successful projects as an important criterion in obtaining surety credit, while an equal number cite consistent profitability (77%) or experience in the particular type of project (78%). General management is one area that, if ineffective, can lead to financial problems. Two-thirds (67%) of the bond producers cite the reputation of the firm and/or principals as important criteria. Nearly three-quarters (72%) cite the expertise of the management team as important. General accounting practices is another area of attention. Use of a certified public accountant (CPA) with industry knowledge is seen to be important by three-quarters (74%) of the bond producers. About six in 10 cite financial statement disclosure (60%) and accounting policies (56%) as other important criteria. Important criteria in obtaining surety credit* *Percent of bond producers citing each factor as important Strength of balance sheet 96% 98% 90% Financial statement presentation 93% 97% 91% Equity 87% 92% 75% History of successful projects 81% 81% 68% Debt 79% 81% 71% Experience in type of project 78% 75% 67% Consistent profitability 77% 78% 63% Use of CPAs with industry knowledge 74% 75% 68% Expertise of company management team 72% Reputation of firm and/or principals 67% 66% 65% Claims history 60% 67% Financial statement disclosure 60% 65% 70% Accounting policies 56% 63% 59% Experience in geographic area 55% 59% 43% Size of over/under billing 54% 55% 36% Overhead expenses 37% 47% 35% Contract volume 28% 36% 33% Succession planning 28% 30% Safety record 14% 16% 20% CFO having CCIFP designation 3% Regardless of the condition of the market, construction companies that are professionally managed and fiscally responsible have already laid the necessary groundwork to obtain surety bonding. Tim Gillen Chief financial officer Carl Bolander & Sons, St. Paul, Minn.

8 6 To help their construction clients meet bonding criteria, bond producers also act as advisors, sharing their broad knowledge of the marketplace and understanding of the bonding process. Given bond producers focus on the financial and risk management of a contractor s business, it s no surprise that 93% frequently advise their construction clients to prepare proper financial presentations. Nearly nine in 10 bond producers also recommend using CPAs who are familiar with the industry (89%) and producing interim financial statements (87%). Almost six in 10 (58%) advise their clients to use bonded subcontractors. These recommendations are related to increasing the sophistication of the contractor s financial operations so that problems can be detected early, ensuring protection is provided against possible future claims. Communication is also key. Threequarters of the bond producers frequently advise their clients to communicate potential problems early in the process (77%) and 67% recommend that they improve the quality of their job status reporting. Slightly fewer advise clients to improve the frequency of their job status reporting (61%). One area in which bond producers have pulled back on frequently advising clients is reduction of overhead expenses: 30% report frequently recommending that contractors reduce their overhead expenses, down from 50% in The large drop may be attributed to an increase in the number of jobs that contractors have taken on in the past year. Overhead is spread across the increased number of jobs underway and, Steps to secure bonds* thus, is not nearly the problem that it was before the market upswing. Surety bond producers are also less frequently advising clients against undertaking expansion plans. Slightly more than one-third (35%) frequently advise limiting entry or expansion into new business areas, down from the 44% who were making this recommendation in Three in 10 (30%) report that they frequently recommend that contractors limit their entry or expansion into new Prepare proper financial presentation 93% 95% Use CPAs familiar with the industry 89% 92% Produce interim financial statements 87% 94% Communicate potential problems early 77% 82% Improve quality of job status reporting 67% 78% Improve frequency of job status reporting 61% 63% Develop a succession plan 59% 56% Use bonded subcontractors 58% 66% Develop a business plan 53% 53% Establish a buy/sell agreement 46% 47% Limit entry/expansion into new business areas 35% 44% Reduce overhead expenses 30% 50% Limit entry/expansion into new geographic areas 30% 41% Seek joint venture partners on projects 11% Seek co-surety 2% *Percent of bond producers who frequently advise contractors to take each step. geographic areas. This is also down from 2005 (41%). These findings suggest that construction contractors have begun to regard bond producers advice against expansion. And with the increase in construction volume, contractors are likely less frequently looking for new opportunities beyond their current business areas and markets.

9 7 Another critical phase in the bonding process is the evaluation of a contractor s capacity. Nearly all (96%) agree that the amount of working capital is an important financial factor in this evaluation. About nine in 10 agree that backlog levels (90%) and a history of consistent earnings (86%) are also important factors to consider. The financial statements prepared by the construction client is another important piece when it comes to the evaluation of the contractor s capacity. Nearly all bond producers agree that a set of financial statements should contain a contracts-in-progress schedule (99%), be prepared using the percentage-ofcompletion accounting method (98%) and contain financial disclosures/footnotes (94%). It is not unusual for a restriction to be placed on a contractor by a surety company. Such restrictions are strategic in nature and, ultimately, in the contractor s best interest. Bond producers report that personal guarantees (73%) were the most frequently cited restrictions that sureties have placed on construction clients in the past year. Ten percent of the bond producers, however, report that sureties have not placed restrictions on their construction clients in the past year. Bond producers are in widespread agreement that, based on their experience, the vast majority generally more than 80% of bonding relationships require personal indemnification. This high percentage is attributable to personal indemnification s implicit assurance that the company s owners are intent on fulfilling their obligations on the project. Important financial measures* Amount of working capital Backlog levels History of consistent earnings Debt to equity ratio Working capital ratio Quick ratio Underbillings to equity G&A expense levels Days revenue in accounts receivable G&A expense to equity ratio Days revenue in cash Days costs in accounts payable *Percent of bond producers who indicated that the measure was important in the evaluation of contractors capacity. More than two-thirds of the bond producers (68%) anticipate that there will be no change in the personal indemnification requirement in the next three years. The remainder is equally divided between those who anticipate that the requirements will become more demanding (16%) and those who believe that the requirements will become less demanding (16%). 28% 25% 23% 36% 46% 51% 65% 80% 77% 90% 86% 96%

10 8 Conclusion The downturn in the surety market during the late 1990s and early 2000s has come to an end. After years of losses and an industry shakeout and realignment, key industry indicators in 2007 give good reason for optimism for the near future. In 2005, the market was in a state of relative turmoil, undergoing dramatic changes after years of enormous losses. Sureties were closing down, while others were combining operations via mergers. Reinsurers were also leaving the market or placing tighter restrictions on their risk assumption activities, creating additional uncertainties. Since then, the surety market has changed considerably. Some reinsurers have returned to the market and new ones have emerged. This stabilization, in combination with profitable surety operations in a thriving construction environment, has surety bond producers looking forward to a promising future. Despite the anticipated growth in demand and availability of surety capacity, however, there is no indication that the evaluation process is changing. Bond producers are clear about the criteria by which they are measuring a contractor s ability to perform. Contractors know they must focus on more than field operations to survive. Those that concentrate on intelligent professional management and improve their processes are more attractive to both sureties and prospective clients. The storm appears to be over, and the future of the surety bond industry is once again encouraging. Construction companies will likewise prosper if they are competently managed and can present financial data and a business plan to prove their capability to sureties and the marketplace. Surety bond producers renewed economic optimism combined with their projected increased demand for bonds in the booming construction marketplace depict a favorable future for both sureties and construction contractors. Construction companies must continue to pay strict attention to their company s financial well being and operating performance to ensure their ability to attain bonding will remain viable now and in the future. Tom Novosel National managing partner, construction, real estate and hospitality industry practice Grant Thornton LLP

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