Building up strength: Lessons to be learned about tendering and expectations as the economy recovers

As governments work to realign their development plans with current economic realities, and investors reshape business models with the same aim, the GCC construction sector offers a useful example of the importance of taking stock and moving on. While many construction markets in the Middle East have stalled in recent years, Saudi Arabia’s continues to move from strength to strength. Indeed, it remains one of a handful in the region that continues to offer a wealth of unfolding opportunities.

The figures are certainly impressive. At the end of 2010, the total market size of construction projects in the GCC region stood at $207bn, with Saudi Arabia representing a 52% share of this with projects valued at $107.4bn (followed by the UAE with a 21% share valued at $43.2bn). A more recent report from financial management and advisory firm Merrill Lynch placed Saudi Arabia’s share of the MENA construction pipeline at 46% in the 2012/13 period, with projects valued at $448bn in total. Indeed, in 2012 the Saudi construction market is expected to achieve more than 5% growth.

Size Matters

What Saudi Arabia has to its advantage is its size, not only geographically, but also economically and in terms of population. The largest economy of the GCC countries by far has a population of 27m, which represents nearly 75% of the total GCC population. A large and growing local populace means there will continue to be solid domestic demand for goods, services and infrastructure in spite of the global macroeconomic crisis.

Moreover, the country’s $622bn GDP is equal to nearly half of the total GDP achieved across the GCC. At the same time, Saudi Arabia is a giant in the hydrocarbons industry, as the largest oil exporter in the world and home to about 20% of the world’s proven reserves. In the last seven years the country has registered highly impressive compound GDP growth (around 4.1% on average), helped by strong oil prices; this is expected to continue in the coming years.

Diversification Strategy

The country’s diversification strategy, which aims to reduce dependence on oil revenues, has yielded substantial progress in recent years, with less than half of total GDP currently coming from oil. Indeed, faster economic growth, diversification of the economy away from hydrocarbons, job creation and social development top the list of the government’s priorities.

With this in mind, in 2010 the government approved a five-year SR1.44trn ($384m) plan targeting the development of the country’s human resources, as well as infrastructure in housing, education and transport. Taken as a percentage of GDP, this represents the biggest investment package announced by any of the G20 nations. This planned financial expenditure plays a big role in making Saudi Arabia an attractive investment opportunity for players in the construction market.

Buoyant Construction

As the planned investments are expected to lead to a private sector boom, the construction sector is therefore anticipated to be one of the most buoyant in the world. For those in the GCC construction sector, there is plenty of room for optimism for continuing successful business opportunities in the Kingdom.

Many Saudi contractors number among the largest in the region; while this means they are well placed to handle domestic contracts, the size and range of planned projects mean there will be significant opportunities for international contractors as well. Increasing private investment should provide opportunities for large foreign contractors to further increase their involvement in the country, and this is certainly what many are hoping to do, especially considering the diminishing opportunities elsewhere.

Wide Range

The government’s investment plans cover a wide range of sectors and include increasing the capacity of schools to 5.3m and universities to 1.7m by 2014, as well as building 25 new technology colleges and 50 vocational schools over the next five years. Additionally, the state is targeting the construction of 1m houses at a cost of SR250bn ($66.63bn) by the end of 2014, and will also be increasing the value of mortgages made available to nationals by the Real Estate Development Fund from SR300,000 ($80,000) to SR500,000 ($133,250).

Focus On Health

Improving the nation’s health care has been targeted through the allocation of SR274bn ($73bn) to a range of initiatives in this field. These include the construction of 117 hospitals, in addition to 750 primary health care centres, and 400 emergency centres.

Transport

Initiatives to upgrade the transport sector are already under way. More than SR46bn ($12.23bn) has been allocated by the government to overhaul the Kingdom’s three international airports in Riyadh, Jeddah and Dammam. Additionally, 31 airports have been earmarked for improvement by the General Authority for Civil Aviation.

Rail travel is also in line for major spending and improvement with the construction of the $6bn Haramain high-speed rail link and $5.3bn NorthSouth Railway. Meanwhile, in August 2012, the cabinet approved plans for a $16.5bn metro system to be built in Makkah. The Landbridge project – the first rail link between the Red Sea and the Gulf, estimated at some $7bn – is also in the planning stages and a procurement approach is expected to be announced by the government shortly.

To facilitate rising trade levels, all nine ports in the country are due to undergo improvements as part of a SR2.3bn ($613m) package, with the Kingdom’s largest port, Jeddah Islamic Port (JIP), on the Red Sea, targeted for significant work.

Powering Up

With an expanding population, the government has drafted a $80bn, 10-year investment plan for electricity infrastructure. A project expected to generate 20 GW of electricity capacity is currently under construction, with a total value of around $30bn. Meanwhile, a surge in power demand in the summer in 2012 that gave rise to blackouts in some cities, preceded news from the state-owned Saudi Electricity that it had awarded three contracts with a value of approximately SR700m ($187m) for the construction of two substations to boost electricity networks in Jeddah and the Medina area, as well as for cable extensions at plants in Riyadh.

The Wider Picture

Today, not only in Saudi Arabia but across the GCC countries, much focus is placed on the sensational scale of planned investments, yet there is another side to the construction market in the region that cannot be ignored – government-backed bail-outs that stretch into the tens of billions of dollars that have saved unviable and commercially challenged projects. These projects did not just exceed their planned budgets by marginal amounts, but rather surpassed them hugely. Indeed, the challenges that businesses in the Middle East have sought to understand, analyse, manage and overcome over the past few years have been, quite simply, unprecedented.

The UAE has certainly been the hardest hit in the GCC in terms of projects that have been cancelled or placed on hold. The total value of cancelled projects in the UAE reached $170bn in 2011, with most of these relating to real estate. These market conditions have led developers to revisit their project strategies. At Deloitte we have seen many developers consider the following strategies for troubled projects: continue to develop the asset with minimal effort and cost with the intention to enhance value in the long term; liquidate the project; or conduct a fire sale of the assets.

Certainly the past few years in the business environment in the GCC region has served as an important source of reflection, and this has in turn given rise to a number of lessons from which those involved in the construction sector will have learned going forward. At Deloitte, we have examined these lessons and have broken them down into five distinct areas: reflect, review, refocus, reinvest, and rebound.

Reflect

Reflecting is about taking the time to consider that the GCC is not immune to global market dynamics, with the impact of the global economic crisis having taken its toll on the region. The effects taught those in the construction industry that previously high levels of anticipated returns and margins are now a thing of the past, and, further, that throwing money at projects in a bid to rush them to market only serves to decrease the likelihood of achieving the returns projected in initial business models and feasibility studies.

Review

When a value leakage occurs between partners in the construction value chain, the taps of liquidity are forced shut. At this point the whole premise of partnership to deliver a project can be lost as a sense of self-protection, and finger pointing begins. If the value chain in a project is locked, the time for reflection arrives. The realisation might dawn that the project partners may not have the solution, or perhaps, even worse, that they may lack the knowledge or ability to correct the situation. It is only by reviewing the situation, asking ourselves tough questions and analysing all of the relevant data that we will be able to answer the pressing question of what actually happened and formulate answers that can be used as a starting point to set our businesses back on track toward recovery.

Refocus

In those cases where it is clear that our current operating model is not conveying a robust picture for success, the time comes to admit that change might be necessary. At this point it is salient to modify our perspective – in other words, we must refocus our strategy and ideas for investment. It is also time to reflect on what it is that our business and our commercial partners do well so that we are able to factor this into our long-term view of how to maximise value and returns.

Reinvest

Reinvesting is one way to ensure the value of opportunities on offer can be maximised. It could be reinvesting in your company, in your human resources, in technology or governance. Certainly looking at the billions of dollars planned to be spent on infrastructure, it makes economic sense to invest in order to capitalise on this planned growth.

However, while investing wisely will offer its own rewards when pursuing new income streams, it is important to also keep an eye on costs. Even if annual turnovers are not as high as they may have been a few years ago when the economy – and particularly the construction sector – was stronger, it is worth making efforts to maximise potential returns, receivables and claims, as well as to embrace technology with a view to increasing the ability to deliver projects more efficiently, thus increasing value.

Rebound

Despite the clear opportunities for development, which are integral to the growth of the economy, a number of factors pose risks to the successful outcome of these plans. Among these factors are unemployment and inflation, which can have a major impact on the overall economy.

In some GCC economies, even in spite of these underlying factors, there are projects in the pipeline that are now either in their initial planning phases or which are being resurrected after previous suspension. However, investors are more likely to begin focusing their attention on stronger markets within the region, specifically those with oil- and gas-based economies, such as Saudi Arabia, which have the funds to inject into industry and infrastructure.

The Complexities Of PPPS

Although public-private partnerships (PPPs) may be part of the solution, it is still early days for the market’s recovery, and it will take some time to help the construction sector take full advantage of the value of such cooperation. PPPs involve an additional layer of complexity to ensure the interests of all stakeholders are aligned. For many governments in the region, which are increasingly focused on being more efficient with their capital and on managing their risk, the PPP procurement methodology allows for greater transparency, longer-term relationships and larger deals.

The question therefore remains as to whether the market is truly ready for PPP projects. Do potential bidders know the opportunities and risks of engaging with a regional government body? Are they aligned? And, most importantly, are bidders evaluating the opportunity correctly?

The challenge will be in ensuring that all stakeholders have the same expectations. Governments often have a 20-year, non-profit-focused aim on a project, as it may feature as part of a wider government strategy. Private sector partners, however, have a short-term profit focus and much tighter timelines within which they have to perform.

For these reasons, PPPs can be particularly challenging. The process requires sensitive stakeholder management, intensive financial modelling, delicate planning and, most importantly, a dynamic private sector to complement the process.

Evolution

Governments have the will and motivation, as well as the acumen, to drive the evolution in procurement to meet objectives, especially when it comes to infrastructure. Whether it is a PPP, privatisation or even a long-term concession agreement, governments are working with industry specialists to prepare, evaluate and run a transparent partner selection processes. This is indeed an evolution, and one that should be embraced intelligently.

The opportunity is significant for bidders/partners, but one must tread carefully, as this path is new and still riddled with legacy issues. Care is advised when using this tool, as well as ensuring you select the right advisor to guide you on the path ahead.

It is clear that the past few years have proven that there is no miracle solution to the challenges faced by the GCC construction market today. Instead, time-tested philosophies of having good business sense, responding to the market needs and making the most out of possible investments are the most effective ways forward, especially when coupled with having a long-term view of every decision being made.