A Profitless Boom?
15 March, 2022
We all know builders are busy. Demand for new housing has boomed just as supply chain blockages paralysed the industry’s capacity to deliver.
So far, the main effect of this strange confluence of events has been to slow progress on building sites. But it potentially sets up much deeper problems.
One is a so-called ‘profitless boom,’ where unforeseen cost increases eat away builders’ margins on fixed-price contracts. This situation can leave a builder both busy and broke.
It doesn’t take much to tip from a profitless boom into an ‘insolvency crisis.’ With fewer new contracts getting signed, builders can find themselves with insufficient cashflow to finance their now-profitless projects.
A lot of people are getting worried about this doom loop leading to record numbers of company collapses in 2022. We’ve already seen some big players fall over during this pandemic, including Privium Homes and BA Murphy Constructions.
But what is the data telling us?
Profits are actually booming.
Make no mistake – somebody is making a lot of money. Quarterly profits for the construction industry jumped 27% during the pandemic:
Now, these figures represent the average of all construction firms and mileage always varies. For example, it’s been put to me that small businesses are suffering more than larger operators who are better placed to shield their margins from cost increases.
Yet here too, the data tells a different story. Statistics from accounting platform, Xero shows that year-on-year sales for small construction businesses has been as much as 20% higher than usual during the pandemic. Not only that, overdue payments are at the lowest level on record.
This is not the picture of an industry experiencing a ‘profitless boom.’
Insolvencies are normalising.
The smoking gun is insolvencies, and there is no doubt that they’re creeping upward. The AFR ran an article recently scaremongering about a 40% jump.
But we need to keep this in perspective.
Under normal circumstances, around 400 construction firms go into administration every quarter. During the pandemic, that figure was halved.
Why? Because the government placed a moratorium on insolvent trading – effectively allowing otherwise bankrupt firms to continue operating.
That moratorium expired on 31 December 2020, which you’ll note from the below graph is when insolvencies began to rise.
Statistically speaking, about 1,000 firms were granted a stay of execution in 2020. Those firms are now facing the music and are starting to roll over.
This is not necessarily an indication of a growing insolvency crisis. More likely, it simply reflects a return-to-normal after some highly unusual government policies held bankruptcies artificially low.
Builders are passing on cost increases.
How is it possible that we might avoid the doom loop of a profitless boom turning into an insolvency crisis?
Quite simply, we pay for it. The below graph makes the point.
The blue line shows that housing construction costs increased 14% during the pandemic. To put that into perspective, it took six years for costs to increase that much prior to the pandemic.
Yet the red line shows that builders have by-and-large passed these cost increases onto their customers.
So even though building costs are rising steeply, firms aren’t allowing them to cannibalise their margins. Instead, these cost increases are being absorbed by the end-user.
First half of 2021 was an insolvency trap.
Despite this generally positive picture, risks do remain.
A close look at the chart above shows there was a period of around 3-6 months at the start of 2021 when the costs builders and trades paid for materials diverged sharply from the prices they charge their customers.
This is the insolvency trap.
Any collapses we do see arising from this pandemic are likely to be those that got into trouble during this short period where businesses were wearing cost increases.
However, the speed at which businesses adjusted and started passing-on these increases means we probably won’t see the tsunami of insolvencies that many are concerned about.