Construction activity rebounds from post-World Cup dip

South Africa’s contractors, who comprise one of the continent’s more robust and largest construction sectors, have had to navigate a challenging few years. While significant infrastructure spending has been planned for the medium term, order books, while busy, have yet to provide the dramatic rebound that has been hoped for. “After the 2010 World Cup, the industry has been treading water,” Norman Milne, president of the South African Federation of Civil Engineering Contractors (SAFCEC), told OBG.

South Africa’s construction sector benefits from strong fundamentals, but has had to grapple more recently with reputational scrutiny, a slowdown in big-ticket infrastructure work, and falling margins, prompting some firms to focus their efforts outside of their home turf. However, this has helped to stoke the growth of smaller and newly established contractors, who are tapping into a steadier stream of smaller projects and stand to pick up proportionally more public sector contracts as the government looks to foster sector transformation.

Growth in public sector spending is affected by funding shortages and a current account deficit (see Economy chapter), while larger consumers – such as the mining sector – are reducing capital expenditure (see Mining chapter).

Despite the lingering uncertainty, there are signs that momentum is swinging in a positive direction. A number of state-owned enterprises (SOEs) are beginning to implement and break ground on projects that for years have stalled at the discussion and planning phase. In response to these delays, entities such as the Presidential Infrastructure Coordinating Committee and a chief procurement officer, have been established to fast track delivery.

FDI

While a large proportion of inbound capital has flowed into service sectors in recent years, such as US-based Walmart’s R16.5bn ($1.56bn) acquisition of Massmart or China’s ICBC $765m purchase of a stake in Standard Bank, South Africa's programme of infrastructure investment has also been a pull for investors, according to a recent UN report. The UN Conference on Trade and Development’s (UNCTAD) World Investment Report for 2014 said FDI flow into eastern and southern Africa in particular was being driven by infrastructure investments and international and regional "market-seeking”. FDI flows into Southern Africa almost doubled in 2013 to $13bn, according to the report, thanks to record-high flows in South Africa and Mozambique.

In recent years, the South African government has made a concerted effort to shore up infrastructure, establishing a handful of large-scale long-term capital investment programmes, including the 2012 National Infrastructure Plan (NIP), under which the state plans to spend R4.3trn ($407.21bn) on new and upgraded infrastructure across the transport, energy, water, sanitation, health and education sectors over the course of a 15-year period.

Major transport projects expected to progress under the NIP include a R16.3bn ($1.54bn) initiative to revitalise the rail network, a R15.2bn ($1.44bn) plan to update and expand provincial bus lines and a wide variety of other initiatives in the areas of maritime, surface and air transport.

Dumi Jere, head of strategy for Africatalysts, said infrastructure, especially utilities development, would continue to attract capital investment into South Africa. “What assisted South Africa’s attractiveness was the independent power programme that the country has launched,” Jere told media in August.

The Renewable Energy Independent Power Producer Procurement Programme (REIPPPP) was initiated in 2011 – one of the core initiatives under the Policy Adjusted Integrated Resource Plan of 2010. This initiative promises growth in both large-scale projects and smaller ones, such as micro hydro and biomass, which create opportunities for new market entrants. So far, 64 projects have been signed, representing foreign and domestic investment of over R100bn ($9.47bn), which will add 3916 MW of renewable energy to South Africa’s energy mix.

Sure And Steady

According to the State of the South African Civil Industry Report, both nominal (-5%) and real (-10%) turnover in the sector contracted in 2013 following increases of 6% in 2012 and 7.6% in 2011. Signs do, however, point to growth returning: in the fourth quarter of 2013 nominal turnover rose 6%, signifying a 13% improvement over the same quarter a year prior.

Business Monitor International’s South Africa Infrastructure report projects annual real growth for the sector to average 3.9% between 2014 and 2018. While this does not match the peak levels seen in the build up to the 2010 World Cup (sector expansion in 2009 was 7.8%), it represents more levelled growth driven by long-term, sustainable demand rather than a once-off event.

Indicators

Over the course of 2012, capital expenditure by the public sector was measured by Statistics South Africa (Stats SA) at R202bn ($19.13bn), a 21% gain on 2011. The South African Construction Survey cautions, however, that the figure can be misleading as most of the gains came from spending on plants, machinery and equipment, which increased by 55% to R38bn ($3.6bn), whereas new construction work in isolation rose by a more modest 3.5%. According to the South African Reserve Bank (SARB) spending by government departments grew 3.5% in 2013 against growth of 6.2% in 2012.

Total investments made by public enterprises in South Africa, meanwhile, increased by just 3.1%, from 4.9% in 2012. As a percentage of GDP, fixed capital spending fell to 19.4% in the final quarter of 2013. The target set out within the country’s National Development Plan (NDP) is 30%, with the public sector intended to contribute one-third (10%) of all fixed expenditure (see analysis).

Crucially, budget execution on the national level appears to be improving, with 80% spent in the 2012/13 financial year compared with 68% in 2011/12. There are still challenges associated with project spend and cash flow on the local level; however, which creates complications for smaller firms who rely on municipal and provincial contracts.

In the second half of 2012, Sanyatti Holdings, which employed around 2500 full and part-time staff at the time, went into liquidation. According to the firm’s departing CEO, the financial distress was caused by withheld and unpaid contracts totalling around R70m ($6.63m) from road departments in the Free State, KwaZulu-Natal and Limpopo Provinces.

However, private sector activity is also forecast to increase, which could result in a boost in industrial, residential and commercial construction. According to the SARB, the growth of overall private spending rose from 3.9% in 2012 to 5.5% in 2013, suggesting that investor appetite for spending on expansion and maintenance is on the up.

While the growth – particularly amidst a tighter macroeconomic environment – is fairly steady, if modest, margins are being impacted by rising costs. Input cost inflation, which is driven predominantly by plant, fuel, materials and labour costs, is predicted to rise by 5.7% in 2013 and 8.1% in 2014.

According to Stats SA, average profit margins for the industry fell to 5.9% in the third quarter of 2013 from 7% in the second quarter; levels that approximate the 6% inflation band the economy has been hovering at in recent quarters. Larger firms reported lower margins (2% to 3%) than their medium-sized counterparts (6%), a difference explained by larger firms being better equipped to operate with tighter margins as they work in larger volumes.

Competitive Tenders

Public spending on construction activity is expected to increase in the near term, although a tightly competitive procurement environment is prompting larger JSE-listed construction and engineering groups to shift away from government contracts. In turn, to varying degrees, South Africa’s “big five” construction firms – a grouping which includes Murray & Roberts (M&R), Aveng, Group Five, Basil Read and Wilson Bayly HolmesOvcon (WBHO), are considering more selectively bidding for public works projects.

This partly results in selection criteria that favour the lowest bid, which is difficult to contest since many smaller competitors tender at bids priced below cost. “South Africa’s Preferential Procurement Policy Framework Act (PPPFA) overly emphasises price over quality,” Lefadi Makibinyane, CEO of Consulting Engineers South Africa (CESA) told OBG.

Industry bodies and associations, such as CESA and SAFCEC are advocating for the tender evaluation methodology to be more focused on quality and functionality. “If a firm puts in a cheap bid, they will not put their best team in place to deliver and it is fait accompli that there will eventually be delays and unplanned-for cost over-runs,” said SAFCEC’s Milne.

For CESA’s Makibinyane, inadequate skill sets and inexperience amongst staff at the government departments or agencies formalising the tenders can lead to unrealistic terms and conditions being set. For Milne, one example is the Medupi power station project. The 4800-MW, R170bn ($16.1bn) facility, which upon completion is expected to be the largest dry-coal fired power station in the world, has been plagued by a series of delays caused by labour unrest and technical glitches.

“It has been 20 years since the country built a power station and the technology and complexities have changed dramatically,” Milne told OBG. “The rule of thumb for power plants is it takes one year per boiler to construct. Yet Eskom (the state-run public utility) expected Medupi, with six boilers, to be completed in just four years.”

Changes in departmental strategies, policies and tenders – a challenge not unique to South Africa – also impact public sector work. Tenders are on occasion revoked, reissued or retracted once personnel spearheading the projects are replaced. A prominent example is the Department of Correctional Services, which had issued a tender for the construction of four new prisons dating back to 2003, but changed the requirements numerous times and eventually cancelled the project entirely eight years later, following a new minister being appointed.

However, the government is working to address some of the key weaknesses in public procurement, rolling out some key reforms to improve efficiency. In recognition of a need to improve administration in the tendering process, as well as reduce the potential for the involvement of corruption at various stages in the supply chain, in 2013 the government announced the appointment of a chief procurement officer, who could eventually work alongside a Central Tender Board, if one is established, to adjudicate tenders across all spheres of the government.

Sharing The Pie

One key change the sector is seeing in terms of public sector activity comes from the implementation of Broad-Based Black Economic Empowerment (BBBEE) policies, which seek to encourage more sub-contracting work and service procurement for black-owned and operated businesses, and has helped stoke an increase in terms of small contractor activity, albeit with mixed results.

The Construction Sector Charter had aimed for 27.5% black ownership (defined as shareholding of more than 50%) to be achieved in 2013 – a target that has not yet been met. While there is evidence that transformation is taking place, according to the Department of Trade and Industry – the ministry tasked with gazetting the charter – it is so far not happening at the level or pace anticipated or desired.

The Construction Industry Development Board (CIDB) grades registered contractors from one ( lowest) to nine (highest) according to their financial and organisational capacity, where a grade-one contractor is limited to bidding on government contracts valued below R200,000 ($18,940) and, at the opposite end of the spectrum, grade-nine contractors can execute on contracts of unlimited value.

As of January 2014, the majority (90%) of grade two to four general building and civil engineering contractors were owned by previously disadvantaged groups, a figure which drops to around 40% in grades seven to eight and 10% in grade nine. Of the 14 contractors in grades five to nine that have been upgraded by three or more rankings in the past five years, only six of them have been black-owned.

“There are high barriers to entry. The industry is capital-intensive and large firms need to set up their own plant and equipment. Financially, you need strong access to credit lines and the ability to absorb occasional losses,” said SAFCEC’s Milne.

In value terms, around 80% of public sector work is awarded to contractors in the seven to nine grade, pointing to the need for larger firms to subcontract work to lower-grade contractors as a means not only of sharing revenue, but providing the experience, knowledge transfer and capacity-building that smaller players need to improve in stature.

Under Scrutiny

The 2010 World Cup, which showcased a range of major infrastructural improvements, highlighted the capacity and efficiency of South Africa’s construction contractors. However, the push to meet deadlines before the kickoff of the first match has led to some unfortunate fallout.

Since 2011, the Department of Trade and Industry’s Competition Commission has been examining 140 projects involving 18 companies, including members of the big five, where there has been suspicion or evidence of collusion. The building and expansion of six World Cup venues lie at the core of the probe. In January 2014 the antitrust body struck a settlement with 15 of the companies under investigation for a combined R1.46bn ($138.26m).

Despite a settlement being reached, and subsequent measures being taken to strengthen transparency, several of the companies involved in the scandal still face the likely prospect of a drawn out process of civil claims being levied against them.

However, the competition scandal has the potential to enhance quality and performance in the construction industry, facilitating a cleaner and more transparent sector in the near future and ultimately improving the industry’s overall outlook.

“For the sake of delivering these projects, which are so crucial for job creation and community upliftment, industry and government has to find a way to repair relationships,” said SAFCEC’s Milne.

Personnel

The construction sector is a key component of South Africa’s economic development strategy, in large part due to the labour-intensive nature of the industry. As of the end of 2013, total construction employment amounted to 1.2m formal and informal jobs, representing around 8% of total national employment.

Industrial action has impacted the construction sector, although to a lesser extent than some other industries such as mining. On July 1, 2014, for example, the National Union of Metalworkers of South Africa (NUMSA) organised a walkout for 220,000 of its metal and engineering members, demanding a wage increase of 12%.

The strike impacts firms including steel plants and equipment manufacturers that supply the construction sector, and the stoppage led to disruptions in the construction of some major projects, including the Kusile power plant, which is tapped to be the country’s largest electric facility when completed.

Improving training and skill sets in the labour force is also a key component of efforts to improve BBBEE targets. On the one hand, this is an issue that should resolve itself over time, as slowly and surely new entrants into the profession are rising through the ranks, while on the other, it can be attributed to inequalities in the education system that is not producing sufficient amounts of black graduates with solid foundations in maths and sciences.

Shifting Geographies

While the construction sector’s domestic outlook is brightening, a combination of factors is prompting the big five to look further afield. “We would prefer to play at home. It is just that the pie has not grown in the past five years,” Milne, who also serves as the Commercial Director for Basil Read, told OBG.

For Group Five, transportation investments and concession projects in Eastern Europe and Africa have grown to exceed 25% of core group operating profit. According to PwC’s annual sector review, Aveng’s Australasia and Asia segment is delivering four times the value of its home market, with the company stating that it has seen "no material improvement" in local construction spending as order books have declined 20% due to a softening in both the local mining and infrastructure markets.

The diversified company, which also has large units in the areas of power, mining and materials, saw labour disruptions negatively impact group earnings by R96m ($9.09m) in 2013.

Henry Laas, CEO of M&R, told local press in May 2014 that the company would no longer be making significant investments in South Africa, and would instead be pursuing opportunities in the US energy and Australasian mining sectors that it deems as being more lucrative. In its latest financial year, M&R’s South African revenue, which currently comprises 25% of group earnings, fell to R7bn ($662.9m) from R12bn ($1.14bn) two years earlier. Laas cited policy uncertainty, a complex operating environment and the failure of the government to get its R847bn ($80.21bn) in infrastructure projects up and running as reasons behind South Africa’s declining position within the group’s portfolio.

On The Doorstep

While Asia, Australia and the US represent new opportunities for the country’s larger firms, so do nearby markets. Driven by consumption and infrastructure spending, GDP growth for sub-Saharan Africa is averaging around 6% – triple that of South Africa’s, and newfound wealth and urbanisation is sparking demand for housing, shopping centres, transportation and power – all of which are areas in which South African contractors have a proven track record of success.

Competition in the construction industry is fierce, particularly with Chinese contractors often bidding on major infrastructure projects in West and Central Africa. According to Milne, as it is difficult to compete with the Chinese on costs, it is important to demonstrate a focus on quality, skills transfer, and the employment of local labour.

“Certainly, the African story is exciting. But it is important to remember that for all the success stories a number of our companies have been burned on projects in the past,” Rodney Milford, the CIDB’s programme manager, cautions. “South Africa’s leading players are true multinationals, working and competing on projects in the Middle East, Australia and South America, with Africa still a small proportion of their international turnover.”

Outlook

Although South Africa’s construction sector has come out of the worst part of the economic slowdown relatively unscathed, an aura of uncertainty still looms. Indeed, “wait and see” remains the order of the day as the government’s funding shortage and account deficit – combined with tough trading conditions for the mining and manufacturing sectors – persist in 2014.

With the ruling African National Congress winning another five-year term in office, the hope is that the current administration can turn its full attention to fast-tracking vital infrastructure projects and that vital institutional reform and newly established infrastructure bodies, such as the country’s Presidential Infrastructure Coordinating Commission and Central Tendering Board, will be able to both improve transparency and expedite delivery going forward.