Risk and working capital management key to navigating any slowdown in construction activity

The Performance on Construction Index (PCI) fell below 50 in June and July 2022, indicating the industry is in contraction.

Following two years of high demand in the construction sector, interest rates and increasing concerns on the economic outlook have combined with supply side pressures to reduce new orders, which were down 7.5% in June 2022 and fell by a further 2.5% in July. This decrease was driven predominantly from the housing construction sub sector, which is coming down from record demand peaks on the back of HomeBuilder last year. Despite an apparent slowdown, the strong work in hand and pipeline will keep home builders busy until at least the end of the year and possibly beyond.

The reduced demand will help mitigate the impact of the recent input price increases, which appear to be stabilising based on input price data, albeit at a peak. Global supply chain issues also appear to be easing. Labour market conditions have also improved slightly with the construction capacity utilisation index reducing to 80.6% in July. It has averaged 83% since January 2021, compared to a long run average of 73.8% (since January 2008). Hopefully the recent resourcing headaches and increasing instances of staff and management burnout start to stabilise.

The recent supply challenges and rising input prices have sparked a debate on risk profiles, with many builders demanding better margins from developers to compensate for the delivery risk that they take. We see this as a positive for a highly competitive industry often besieged by high risk, low margin work and would encourage builders to continue to focus on margin when assessing strategic growth opportunities.

Working capital management has been less of a focus over the last few years, with government stimulus, low interest rates and leniency on outstanding tax payments resulting in strong cash flows for many companies. This may change with rising interest rates and the ATO actively pursuing overdue debts, issuing 120 Director Penalty Notices per day in July.

The historical method of stretching suppliers when cash flow is tight is more difficult in the current environment, with the Security of Payment Act and the recently implemented Payment Times Reporting Scheme (PTRS) limiting the ability of large companies to stretch smaller suppliers. Comparative analysis of the data submitted under the PTRS on the payment terms and times for small businesses in the construction industry highlight that this scheme is already seeing results, with 18 of the 21 business sectors within the construction industry either maintaining or decreasing their average standard payment terms by up to 6.9 days.

More rigorous counterparty due diligence is already standard for government and large contractors and we predict all areas of the industry will increase their focus on this as construction insolvencies rise. Looking ahead, cash and working capital is likely to be the next pinch point, and strong management teams should tighten working capital processes and ensure robust cash flow forecasting to understand the cash runway and create resilience against future shocks.