Finance and Accounting Isn't for Cavemen

by Stephen Mulva, CII Director

I’ve become very concerned with the financial health of the capital projects and maintenance industries. Today, the Fortune 500 counts only seven (7) engineering and construction companies in U.S. business. In the past year, these companies collectively produced 1.8% profit on $77 Billion of revenue. These are poor results, limiting the stock price and market capitalization of some of our industry’s “blue chip” companies. This situation is especially worrisome because the 23.8% increase in the Dow we’ve seen in 2017 (through mid-December) has occurred despite our industry’s general lack of contribution. It is imperative that the companies and associations in our business work to remedy this situation and it starts with a much more progressive and informed use of finance and accounting.

Billion Dollar Buyer Tilman Fertitta once said “Don’t ever let your business get ahead of the financial side of your business. Accounting, accounting, accounting. Know your numbers.” For the past 21 years, I’ve tracked the profitability of the top three or four publically-traded EPC contractors and I’ve found that, on average, they make about 310% of their profits from 40% of their projects (ordered most profitable to least profitable). 60% of these firms’ projects lose 210% of their annual profits. The problem isn’t just trying to avoid contracting for unprofitable work (which would certainly help), but it’s that there’s a fundamental disregard for the business aspects of executing capital projects and maintenance work. I should note that this problem is endemic not just to EPC firms, but to facility owners as well. We’ve got to be much more sophisticated in our use of money.

Let’s start with terminology. Our industry creates assets, not projects. An asset can be something physical, like an operating plant or building, or it could be something as simple as cash. An owner generally authorizes the creation of new assets as a way to grow the revenues and profits of the company organically. However, there are other levers to grow a company. Share repurchase programs and mergers and acquisitions (M&A) can also bring profits, but since they’re not generated from within the firm, they are considered forms of inorganic growth. Owners are constantly weighing the benefits of each form of growth, but increasingly, they’re finding that building a new asset is so expensive or risky that they choose other paths to profitability. On the other hand, many EPC firms have resorted to grow through acquisitions by borrowing money to “buy” another firm’s project backlog. This is a tragic development for our industry. In fact, it’s classically known in cost and managerial accounting as a downward demand spiral, or death spiral.

That sounds gloomy and it is. The basic problem is that our industry is continually living off what I call the “wrong side of a dollar” – the borrowing side and not the accumulation side. We put work in place and then bill for it, sometimes on 90 or 120 day terms. This causes an opposite inflationary spiral wherein suppliers, distributors, subcontractors, GC’s, CM’s, and EPC’s must increase the price of their goods and services. Add to that interest payments from recent M&A activity and it’s easy to see why our industry is awash in debt. But how do we switch over to the accumulation side of the dollar? How do we use what money we do have to work for us?

Owners’ Engineering, Construction, and Facilities (E/C/F) groups should reorganize themselves and try to function as a profit center. Putting new assets in place typically takes a lot money which can come from cash on hand (i.e., retained earnings) or debt or equity financing. To stay on the accumulation side of the dollar, the new or modernized assets should be, relatively speaking, about 40% smaller (based on capacity) and begin generating returns in half the time. When this happens, cash from new assets could be reinvested. An E/C/F department would begin functioning more like a real estate developer that accumulates and redeploys its wealth. E/C/F groups could even have both internal and external clients. Their focus will change from asserting control to leveraging advanced technology and suppliers to become efficient and profitable. But more than anything, an owner’s key differentiator will be their ability to have low capital requirements. This necessitates having effective working relationships and an efficient commercial model between an owner and their numerous product and service providers.

To move to the accumulation side of the dollar, firms which provide planning, engineering, construction, and maintenance goods and services should move to a leasing model as quickly as possible. Here’s why:

The capital required by the product and service provider companies is immense and it is a one-time event. This can present funding challenges to the purchaser which, most of the time, isn’t even the asset’s ultimate owner. Instead, funding hurdles are passed through myriad arrangements of suppliers, sub-suppliers, distributors, and subcontractors.
If the providers receive repayment for their goods and services over years instead of days, they can incorporate the attendant costs of using their own money. This enables the product and service providers to increase earnings while slashing initial costs to the asset owner.
If the EPC firms and other providers can retain some equity in the assets they are helping to create, they can obtain another source of revenue.
By innovating to create a product that is leased, the service and product provider community may retain tax advantages through depreciation charges across an increased asset base.
Products and services will become optimized for a specific service life. In the leasing economy, the function of the offering is more important than the offering itself. Replacement intervals and lifecycle costs become a main objective function, not an afterthought.

CII and CURT are working to improve the business, finance, and accounting acumen of the great people employed today in our industry. But, we’re also positioning the industry for a brighter future by creating a new business model/platform, something we call Operating System 2.0 (OS2). Originally, OS2 had the goals of 35% cost reduction, 50% schedule reductions, and 60% Return on Capital Employed (ROCE). But, if we get it right, the economics demonstrate that the industry will increase its total volume of new projects by 250% and profitability will expand by over 300% for most incumbent firms.

Our industry is in the business of creating assets and new organic growth opportunities for all stakeholders and shareholders. To accomplish these objectives, we’ve got to work smarter. The business of our projects can’t be managed like a Caveman with a checkbook – money in and money out – not anymore. We have to think and act like business people. We need to speak the language of finance. For the past several decades, our industry has emphasized the planning, technical, managerial, and work process dimensions of our projects – at the expense of the numbers and the assets keeping us in business. Forty percent (40%) of the cost of creating a new asset is currently wasted on transactional costs. It’s not a sustainable model. We have to employ the best business, financial, and accounting concepts and we’ve got to do it now. I know that we can create the new financial products and services needed to move our industry to what’s next. The first step is coming out of the cave!

Date posted: February 9, 2018