Cautious steps: Limited growth to come from investments in infrastructure

While the 2010 football FIFA World Cup continues to crop up in conversation across industries in South Africa, it dominates the narrative in the construction sector unlike any other. The event, for which the government invested R28bn ($3.4bn), has become the major reference point for contractors, a peak from which their fortunes rapidly declined. A heavy inventory of infrastructure and real estate projects in preparation for the football tournament sustained South Africa’s construction industry at a time when contractors in other markets were scaling back and struggling to find work. However, post-World Cup, contractors’ margins have fallen sharply and new contracts have become much harder to come by. As such, 2011 proved a difficult year for the construction industry and, although the first tendrils of recovery have been spotted, the prospects for 2012 remain limited.

BOOM YEARS: The construction sector remains a critical component of the South African economy. The contribution of the sector to GDP was estimated at 3.2% in 2010, according to Statistics South Africa, while the industry employed 4.24m people in 2010, according to Industry Insight, a provider of statistics and analysis on the local construction market. The sector has long been a key engine of growth for the country’s economy. From the first quarter of 2003 to the third quarter of 2009, total investment in the construction sector witnessed double-digit year-on-year (y-o-y) increases for every quarter, coming in at 23.6% for the latter date, according to the “State of the South African Construction Industry Second Quarter Report” by Industry Insights. This was fuelled by a raft of public and private sector projects in both the building and civil works segments. For example, for the World Cup alone, the government spent some R9.84bn ($275.5m) on stadiums and their surrounding development, and a further R11.73bn ($1.4bn) on transport.

However, such levels of healthy and heady growth came to an abrupt halt in the latter half of 2010 and into 2011. According to Kevin Pickup, an executive at construction consultancy firm Davis Langdon, “We are going through a rough time commercially at the moment. I do not see commercial [real estate] picking up in 2012. We will see a squeezing on margins. The market will be very competitive over the next few years.”

In the buildings segment, the real value of plans recorded by larger municipalities decreased by approximately 2.1%, or R870.2m ($106.5m), in the first 11 months of 2011, compared to the same period of 2010, according to data from Statistics South Africa. The value of completed buildings for the same period also declined, by 5.9%, or R1.7bn ($208.1m), suggesting a tough environment for contractors both in terms of their current slate of work and their future pipeline.

MUTED DEMAND: This has not been helped by a depressed real estate market. According to Absa Home Loans, house prices are set to fall further in 2012. With high debt-to-income ratios and high levels of credit impairment, demand for new housing is currently weak, a fact reflected in falling real house prices across all segments in 2011. The appetite for commercial real estate is no better. Vacancy rates in office buildings in the central business districts of cities throughout the country are almost uniformly in double figures, while they are pushing towards 10% in many non-central districts. In the retail segment, rents have remained largely flat in 2011 and still well below pre-recession levels. As such, there is little incentive for private developers and investors to bring new projects to market.

“The construction industry has taken a major hit, and in turn, sales to contractors are down. Banks are also not lending to first-time home buyers, which makes it hard for both the building industry and the do-it-yourself market,” Johann Smidt, the managing director of paint firm ICI Dulux South Africa, told OBG.

While Pickup is more bullish about the prospects for civil works and infrastructure, the industry as a whole has witnessed a significant slowdown in contracts. For example, investment growth in civil works slowed from 14.7% in the fourth quarter of 2009 to just 0.4% in the first quarter of 2011, according to the South African Reserve Bank. According to Industry Insights, investment in civil works was expected to fall by 2% for full-year 2011 and by a further 15% in 2012. Indeed, total investment in construction was expected to decline by 3.8% in real terms in 2011, according to Industry Insights.

CONTRACTORS: This has had a significant impact on the business models of many contractors. “We were very fortunate with 2010. It gave a false economy and [contractors] were charging whatever they wanted. In 2010, the margins were too big and unrealistic. I think there will be a cutback on margins to the 6% to 10% [region],” Pickup said. He estimated that for World Cup projects, contractors were commanding margins above 15-20%. However, a slowdown in new tenders has led to a significant tightening as contractors compete for a smaller number of projects. According to Neil Cloete, the group CEO of Liviero, “Assuming compliance with tender conditions, contracts are awarded where the lowest price wins. Margins are determined by how hungry your competitors are.”

Turnover for the industry decreased by 5.6% y-o-y in September 2011 and 1.2% between June and September 2011. Net profit before taxation was also down by 19% in September 2011 compared to the same period of 2010, according to Statistics South Africa. This has made it increasingly difficult for many smaller firms to survive. Liquidations in the construction industry increased by 32.8% in 2009 and 4% in 2010. This shows little sign of slowing down, with liquidations in December 2011 up 13.3% on the same month in 2010.

FEELING THE PINCH: Even the larger construction companies are feeling the pinch. In January 2012, Murray & Roberts, one of South Africa’s big five construction firms – a grouping which includes Murray & Roberts, Aveng, Group Five, Basil Read and Wilson Bayly Holmes-Ovcon (WBHO) – announced a R2bn ($244.8m) rights offer to cut debt and fund future growth. Announcing the decision in a statement to the press, the firm’s CEO, Henry Laas, said, “We have high levels of debt in South Africa and restricted cash offshore. We can operate, but cannot grow with the balance sheet the way it is.” The company announced losses of some R1.65bn ($202m) for the year 2010/11.

The other big players operating in the sector have been faring little better. In its interim report for the six months leading up to December 2011, Group Five, South Africa’s fourth-largest construction firm, announced a decline in operating profits from continuing operations of approximately 40% to R219m ($26.8m). In a statement to the press, its CEO, Mike Upton, said, “The overall group performance during the period was impacted by delayed construction revenue due to contract postponements and client scope changes in South Africa… Based on our positioning in the key infrastructure growth sectors of power, mining, oil and gas, water and transport, and in the concessions market for specific projects, we expect a slow recovery in group activity levels from the second half of 2011.” In November 2011 the company told Reuters that it had slashed 500 jobs in the last five months in response to poor domestic conditions. This follows the trend being witnessed throughout the industry, with employment in the sector falling by 6.4% in 2010.

EYE ON FOREIGN MARKETS: South Africa’s heavyweight contractors are looking at ways to compensate for the slowdown in the domestic market. Both Group Five and Murray & Roberts have stated that they will increasingly look outside the country for new projects. Upton told Reuters in November 2011 that the company wants to rebalance the order books to 40% cross-border work. In October 2011 approximately 34% of the company’s R9bn ($1.1bn) of secured work was outside South Africa, with the main focus on Southern Africa, West and Central Africa, and the Middle East.

This trend seems to be evident throughout the sector. Malcolm Lobban, the CEO of engineering and construction firm Sanyati, told OBG, “Overall, the future lies cross border as there are better returns to be made and political developments are lowering risks. But we are not turning our backs on South Africa.”

Another contractor, WBHO, the third largest in the country by market value, reported in July 2011 that 2010/11 was the first in the company’s 41-year history in which it made more revenue outside South Africa than inside. Some 52% of WBHO’s revenue was from foreign markets; however, this was not enough to prevent a 23.2% drop in profit to R788.8m ($96.5m).

With high global commodity prices, WBHO is picking up significant work on the rest of the continent in mining infrastructure contracts. For example, the company is working on an $80m contract for infrastructure works, including the construction of railway lines and a 122-km road, at the Tonkolili iron ore mines in Sierra Leone. The company is eyeing the markets of Ghana and South Sudan for further mining-related contracts.

According to Willie Meyburgh, the CEO of construction and engineering company Stefanutti Stocks Holdings, mining projects are currently a common source of work abroad. “Most of our work in the continent is won directly through following major mining clients. We would like to bid directly for government projects north of the border, but it is extremely difficult to compete on price with the Chinese, who also benefit from stronger intergovernmental relations and official support in these countries,” he told OBG DOMESTIC WORKS: Within South Africa itself, the limited growth in the construction sector is likely to come from infrastructure projects including those related to the mining sector. According to a report by market researcher Business Monitor International in the second quarter of 2011, “The demand for South African coal from Asia, which shows little sign of slowing, is prompting investments into mining activity and by extension support infrastructure. There is added urgency, as infrastructure bottlenecks are creating congestion at export points. Both infrastructure at the mine and expanding freight transport (partly by Transnet) are creating some value for the construction industry.”

INDUSTRIAL LINKS: This assessment was born out in President Jacob Zuma’s February 2012 State of the Nation speech. The South African president said that Transnet, the government-owned freight transport company, would spend R300bn ($36.7bn) over the next seven years to expand rail and road capacity for the export of coal, iron ore and manganese. Zuma said, “The massive investment in infrastructure must leave more than just power stations, railway lines, dams and roads. It must industrialise the country, generate skills and boost much-needed job creation.” This investment will be crucial in helping the government meet the National Planning Commission’s call to boost mining’s contribution to GDP from 6% to 10%, outlined by Trevor Manuel, the minister in the Presidency in charge of the National Planning Commission, in February 2012.

This emphasis on mining follows plans in the 2012 budget to spend R845bn ($107.5bn) in the next three years on infrastructure. Such plans constitute an increase in comparison to 2011, when the budget called for R846bn ($102.8bn), and are evidence of a renewed focus on civil works and infrastructure projects.

CIVIL WORKS: There has been a gradual reversal in the make-up of the construction sector. In 2008 some 59% of all construction activity was in the building ( residential and non-residential) segment, with public (civil) works making up 41%, according to Statistics South Africa. However, by the fourth quarter of 2010, civil works accounted for 62.2% of total construction spending.

Indeed, there has been some uptick in this segment, with the number of civil work contracts awarded witnessing three consecutive quarters of growth up to the first quarter of 2011, according to Industry Insights. Total investment in construction works climbed from R166bn ($20.3bn) in 2009 to R175bn ($21.4bn) in 2010, with public corporations spending an average of R45bn ($5.5bn) over the past five years. General government spending averaged R55bn ($6.7bn) in 2009 and 2010, while the private sector spent R25.3bn ($3.1bn) in 2010, according to Industry Insights.

Indeed, government and public bodies are likely to represent the main client base for contractors over the medium term. Alongside plans for transport expansion and upgrades through Transnet, the government is also seeking to improve social infrastructure and utilities in the country. Increasing electricity generation capacity is high on the government’s agenda, after years of underinvestment in the sector left the country with a dangerously low reserve margin in 2010.

POWER GENERATION: Under the Integrated Resource Plan for Electricity drafted by the Department of Energy in 2011, the country will add 14,000 MW in generation capacity by 2020. The majority of this, more than 70%, will come from new coal-fired power stations. This new capacity is expected to meet future electricity demand and provide a 15% reserve margin. The plan also incorporates the potential for further expansion beyond 2018, with the possibility of 8400 MW of wind, 8400 MW from photovoltaic solar, 1000 MW from concentrating solar, 2609 MW from imported hydro sources, 6250 MW from coal, 3910 MW for open-cycle gas turbines, 2370 MW from closed-cycle gas turbines and up to 9600 MW from nuclear energy.

Such an ambitious inventory would provide ample work for the local construction industry. Indeed, some within the sector believe that these plans could revive its flagging performance. However, there is doubt that they will actually be realised to schedule, given the difficulties of securing financing and problems with sovereign guarantees in the current economic climate.

FOLLOW THROUGH: Such concerns regarding future growth are not only confined to the utilities sector. While the government has emphasised that bodies such as Transnet are strong enough to fund their infrastructural development plans, questions have been raised about the ability to execute these projects.

“The South African government has promised increased infrastructure spending, but the industry keeps waiting for this to materialise with diminishing optimism. Furthermore, the government is often slow to pay and smaller contractors that are dependent on cash flow are going bankrupt,” Meyburgh told OBG.

Indeed, a number of projects have been put on hold and public-private partnership (PPP) developments cancelled. In 2011, Group Five reduced its opportunity pipeline by R20bn ($2.4bn) from R138bn ($16.9bn) as a result of PPP cancellations and delays.

This has been a persistent problem, with the number of projects postponed in the first quarter of 2011 up approximately 49% on the same period of 2010, according to Industry Insight. The government is now trying to address this issue, establishing in July 2011 the Presidential Infrastructure Coordinating Commission to monitor infrastructure projects throughout the country and ensure their timely delivery.

GOVERNMENT EXPENDITURE: The efficacy of this commission will indeed be crucial for the health of the construction sector. Neville Gurry, the executive director of the South African Federation of Civil Engineering Contractors, told Engineering News in February 2012, “Turnover on the industry is highly sensitive to government expenditure, being the largest client in the industry. Budgetary allocations have remained relatively stable, despite cuts were announced in the 2011/12 budget. However, we have seen a number of projects being postponed in recent years for various reasons, including the lack of the necessary expertise in government to mobilise and implement projects.”

It would certainly be a good time for the government to execute these projects, given that construction costs are expected to rise going forward. According to Medium Term Forecasting Associates, a local construction research firm based in Stellenbosch, tender prices began to increase in 2011 (4.5%) and are expected to rise more rapidly through 2012 (12.1%) and 2013 (16.3%). Building costs for residential buildings increased by 6.3% and for commercial and industrial buildings rose by 7.2% y-o-y in October 2011. These hikes are the result of rising input costs and a weaker rand, which has pushed up the cost of imported materials. Building material costs increased by 4.4% in the year to October 2011, while diesel fuel was up by 34.7% in the 11 months from November 2010.

Rising costs of materials have been achieved despite the slowdown in demand. “From 2008 to 2011, the construction materials industry moved from a shortage of domestic capacity to excess capacity, but overall the market grew in 2011 by 3%,” Thierry Legrand, the CEO of cement firm Lafarge (South Africa), told OBG.

Given that there are few cost-plus contracts in the market and that margins have already been tightened significantly over the past two years, contractors have had little choice but to attach these costs to their tender price. The cost of labour is a particular issue. As labour can account for more than 35% of the cost of a development, with land at approximately 15% and materials at 50%, there is significant pressure costs.

COST ADVANTAGE: However, the cost of construction in South Africa is still competitive with the region. According to Davis Langdon’s “Property and Construction Handbook Africa 2011”, the cost of building an average multi-unit residential high rise in Johannesburg stood at $940 per sq metre against $1450 per sq metre in Abuja, Nigeria and $1490 per sq metre in Luanda, Angola. Indeed, only Accra, Dar es Salaam, Kampala, Nairobi and Dakar were cheaper cities on the continent to build. Similarly, an average high-rise office tower cost $1250 per sq metre in Johannesburg against $1530 in Abuja and $1630 in Angola. As such, the cost of development is one of the positives that can currently be drawn from South Africa’s construction sector. While developers and government clients with the financial muscle may look to exploit these conditions, contractors will hope that the first signs of price increases point to the beginning of a recovery in the sector.

OUTLOOK: Indeed, it has been a difficult 12 months for South Africa’s construction industry. While the World Cup masked the full impact of the global economic crisis, contractors were exposed to its ramifications in 2011. As the economy slowed and the flow of work linked to the hosting of the FIFA event dried up, contractors were left to make do with a dwindling list of projects. With housing demand subdued, consumer spending down and business confidence knocked, the real estate sector has offered far fewer contracts.

Developer caution persists, suggesting that this trend may remain for some time. As such, contractors are looking to the government and its ambitious infrastructure programme for future work. These public contracts offer a glimmer of hope for the sector, but even here a track record of public tender postponements and cancellations has left many firms wary. For many 2012 will therefore be a year of survival, picking up small contracts and keeping overheads to a minimum, while the bigger players may increasingly look further afield.