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Beware the Recovery: What History Teaches Contractors and Sureties

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In 2008 I predicted that the recession would be deep and long. I said so in seminars and few people believed it.
 
In questions from the audience at those seminars, staff from sureties asked, “Where are the failures?” I said that the failures come at the end of the recovery. Now we’re starting to see more failures.
 
No one liked the recession, but some contractors and sureties are going to hate the recovery, too. Companies will fail at a faster rate than anything we’ve seen since 2008; inflation will rear its ugly head, too.
 
The construction market recovery is going to be a financial struggle for most contractors because growth eats cash and many have been straining financially during this unprecedented downturn.
 
Contractors, as a result, may have difficulty financing the growth.
 
I’ve been studying the construction economy during past downturns over a period of 40 years and what I’ve learned is conclusive. The unprecedented length and depth of the recent market slowdown has produced extremely aggressive pricing, changes in owner attitudes and declining margins.
 
During much of the recovery margins will remain low because aggressive bidding continues until the appetite of construction organizations has been satisfied.
 
The research also confirms that the failure rate of construction enterprises is three times worse during recovery than during the downturn.
 
That bears repeating: three times worse during the recovery than the downturn. Contractors need be warned and understand how to approach the dangerous period ahead.
 
History Is No Mystery

In a shrinking market the ideal would be for each contractor to accept proportionately less work so that market share of each business is maintained. However, there is a tendency in our industry to resist any reduction in sales, often strenuously, and to fight vigorously for the fewer available projects, driving down prices for everyone.
 
 

SCHLEIFER

The tendency persists, perhaps even stronger, through initial and intermediate stages of recovery when every project looks like the last project we may see. Trying to maintain volume in a declining market is, in effect, an attempt to increase market share and any increase in market share is universally “bought” at a cost.

Trying to be the first business to return to prior size creates the same effect, limiting profit potential and magnifying risk in an already risky business. This exposure is compounded by the fact that in each stage of recovery, particularly after a sustained downturn, labor shortages and material cost escalation and shortages drive prices higher.

Why? Some laid-off construction tradespeople and managers who have vacated the industry do not return or return only after confidence in a sustained recovery. Material manufactures and suppliers, who have suffered the same financial difficulties as contractors, are forced to cut back capacity and hold the line on prices. Regaining the capacity requires investment and takes time, causing material shortages that lead to rapid price increases.
 
Manage Cash Flow Judiciously

To survive the recovery, contractors must avoid losses, keep their capital bases intact and avoid diminishing the equity in their companies. That means that they must manage cash flow judiciously during the recovery to remain financially viable and credit worthy.

Also, contractors need to develop effective strategies to deal with the significant cash flow demands of growth, particularly after a protracted weak market. They must resist engaging in the “feeding frenzy” and aggressive bidding with small margins during early recovery.
 
Prospering in cyclical markets and surviving both a recession and recovery in the construction industry starts with recognizing what is happening in the marketplace. The results are totally predictable and have occurred without fail in every industry cycle for the last 40 years.
 
If history repeats itself, contractors attempting to make up for lost ground will load up on cheap work increasing their risk in already difficult circumstances. We cannot control the market, but we can control our response to it.
 
Thomas C. Schleifer, Ph.D. is a management consultant, author and lecturer. A research professor at Del E. Webb School of Construction, Arizona State University, he can be reached at tschleifer@q.com or 480-945-7680.

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