Entering engineering construction: sizing a new sector and testing build against buy
PROPERTY, INFRASTRUCTURE & CONSTRUCTION · GROWTH STRATEGY · MERGERS & ACQUISITIONS
The situation
A major construction business had a problem that looked like success. Its Asia Pacific arm was forecast to compound profit after tax at 22 per cent a year, from A$11.6 million in 2005 to A$19.6 million by 2008. On any ordinary reading that is a business performing well. Set against the group, it was going backwards in the only way that mattered, because even after three years of that growth the region would still account for only about a tenth of global profit. Growing quickly and shrinking in relevance at the same time is an uncomfortable position to hold in front of a board.
The reason sat in the sector mix. Around eighty per cent of the workload came from commercial, retail and residential building, and all three were flattening. Office approvals had been trending down for eighteen months, high density residential commencements had fallen by nearly a quarter in a year, and retail was steady but hard to grow beyond an existing pipeline. Meanwhile the Australian construction market of more than A$80 billion divided into three roughly equal thirds, and the third with the strongest forecast growth, engineering construction, was one the business had almost no presence in. A target had also come into play, which meant the question was about to be answered by whatever was available rather than by what the strategy required.
The work
Retained to validate the sector strategy, design the entry options and evaluate the acquisition candidate. Four strands:
Sized and forecast the sector rather than accepting that it was growing. Construction Forecasting Council data put engineering construction ahead of both alternatives on every horizon, at around 11.5 per cent average annual growth to 2006, 5.5 per cent to 2009 and 6.5 per cent to 2012, against roughly 4 to 4.5 per cent for non residential building and 3.5 per cent for residential. Cyclical, plainly, but large and durable enough to build a business on rather than to ride.
Segmented it and picked the ground. Transport infrastructure ran at about A$7.6 billion a year of commencements, a third of the sector, with roads alone at A$6.3 billion, and carried a committed pipeline of A$24.6 billion with a further A$26.5 billion identified. Resources supported around A$4.1 billion a year, about 17 per cent of the sector, against A$13 billion of projects in place and a potential pipeline of A$61 billion, though the cycle was close to its peak. Government and public private partnership work was approaching A$20 billion, roughly A$9 billion of it already contracted. Rail and heavy industry were selected on the ground that mattered most, which was that historical returns in transport infrastructure ran at about twice those of traditional building.
Tested organic entry against acquisition on the same basis rather than treating the available target as the strategy. Organic entry was costed for the investment required and, more importantly, for lead time, since barriers to entry in these segments are about credentials and licences as much as capability. Acquisition was assessed for what it uniquely bought, which was speed and critical mass. The comparison was made explicit so the board could see what it was paying for rather than simply approving a transaction.
Built an assessment framework for the target and applied it honestly. Attractions were set out as strategic fit, availability, the critical mass that only acquisition delivers, a potentially favourable price given the vendor’s circumstances, and limited separation difficulty. Against them sat the risks: the likelihood of undiscovered contract problems in a business whose parent had issued repeated profit warnings, the execution risk of having to buy the whole thing and on sell the parts that were not wanted, cultural fit across a largely blue collar workforce, contract retention, and selective hiring as a standing alternative. A preliminary valuation was built on sum of the parts multiples, lower for construction and higher for support services, and cross checked against a sales multiple.
The work was then compressed into a single board paper carrying the sector case, the entry options, the target assessment, the valuation range and the recommended next steps, on the basis that a decision of this size should be capable of being read in one sitting.
The outcome
A sector case built on forecast data rather than on the general impression that infrastructure was busy, with engineering construction shown to outgrow both building sectors on every horizon out to 2012 and to be large enough to matter at group scale.
Two priority segments selected on evidence. Rail and heavy industry, chosen because the pipeline was committed rather than mooted and because historical returns in transport infrastructure ran at roughly double those of the traditional building work the business already did.
Build and buy set against each other on the same basis, with organic entry costed for investment and lead time and acquisition valued for the speed and critical mass it uniquely provided, so the route in was chosen rather than defaulted to.
An acquisition paper with identified acquisition attributes and risks. Future proposed analysis of probable undiscovered contract problems, the execution risk of buying the whole business and on selling the parts that were not wanted, cultural fit, and selective hiring as an alternative organic growth strategy.