Facing the challenge: After a recent difficult period, the sector may now be recovering

Looking at the skyline of any major South African city, you will see far fewer cranes than during the construction surge that occurred in the past decade, when the prospects of hosting the FIFA World Cup led to a huge building drive incorporating everything from stadia and hotels to large-scale transport infrastructure projects. More so than any other segment of the economy, the construction industry has felt the impact of the post-World Cup slowdown. The easy days of high margins and abundant contracts appear to be a thing of the past; however, ongoing urbanisation trends suggest the sector may pick up in the near future. South African construction companies have also experienced significant success in their efforts to expand into neighbouring countries. Despite the economic difficulties facing the country, the Construction Industry Development Board (CIDB) and the government are optimistic that the construction sector will witness a substantial improvement in 2013. Rodney Milford, the programme manager at CIDB, told OBG, “Our results are showing that the industry is under distress but that there are signs of improvement in some areas.” Indeed, confidence among industry players is beginning to move upwards in some segments. According to Milford, “Business confidence surveys at the moment show that the smaller contractors are more optimistic and that they are a little more protected.” This perhaps suggests an industry with fewer large contracts to sate the appetite of the country’s biggest construction firms, but sufficient projects to meet the needs and demands of medium-sized contractors. Across building contractors, business confidence increased in Grades 5, 6, 7 and 8 of the CIDB’s 9-grade system (with grade 9 being the largest contractors) in the fourth quarter of 2012.

Major Players

Nonetheless, the position of South Africa’s biggest construction firms looks relatively solid. The major construction players include Group Five, Aveng Group, Wilson Bayly Holmes-Ovcon (WBHO), Murray and Roberts, and Basil Read. Results for the latter half of 2012 have largely shown that the sector may very well be recovering. Group Five’s revenue from continuing operations was up 16% to R5.1bn ($621.7m), while operating profits rose by 23% to R270m ($32.9m). Aveng Group additionally reported strong growth in its interim results for the six months ending December 31, 2012, with revenues increasing by 30% to R25bn ($3bn) compared to the previous year and operating profits showing a 56% rise to reach R518m ($63.1m). In the same period, WBHO reported that its revenues grew by 42.8% to R12bn ($1.5bn) from R8.4bn ($1bn) and operating profits increased from R480.8m ($58.6) to R550.7m ($67.1m).

Murray and Roberts’ interim results showed that revenues grew over the same period from R15bn ($1.8bn) to R16.3bn ($2bn) and the company returned to profitability, from a recorded loss of R481m ($58.6m) in the previous year’s second half to a profit of R420m ($51.2m). Not all of the major players showed such positive results. Basil Read’s revenue grew in 2012 from R5.3bn ($646.1m) to R5.5bn ($670.5m), but the company’s profits dropped from a R205m ($25m) profit in 2011 to a R171m ($20.8m) loss in 2012.

Changing Direction

Despite the positive results posted by most of these companies, much of the gains are the result of a gradual reorientation away from South Africa. For example, cross-border work for Group Five grew as a share of the company’s construction revenue in the last six months of 2012. From a share of 29% in June 2012, it increased to 37% by the end of the year. The company has been focusing primarily on Africa, where concession opportunities for infrastructure projects remain promising. For example, the company has been pre-qualified in a consortium with Austrian company Strabag for the Road Decongestion Programme in Port Louis, Mauritius, a project that will be awarded on a public-private partnership (PPP) basis. Aveng Group was among one of the two pre-qualified consortia for the project.

Economic Indicators

It is unsurprising that the local construction sector has fallen upon hard times. The industry accounted for 3% of GDP in the third quarter of 2012, according to Statistics South Africa, but with the economy faltering, so too has construction activity. In the fourth quarter of 2012, GDP grew at an annualised rate of 2.1%, ending the year with a total growth rate of 2.5%, the lowest level since the 2009 recession. The National Treasury estimates that strikes at gold and platinum mines, which ended in November 2012, have cut output by more than R10bn ($1.22bn) and will snip approximately 0.5% off the economic growth rate. Indeed, in February 2013 Pravin Gordhan, the minister of finance, announced that there would be a R16.3bn ($3bn) shortfall in forecast revenues as a result of the economic turmoil in the second half of 2012. As such the budget deficit for 2012/13 was expected to reach 5.2% of GDP, up from the October estimate of 4.8%. In such circumstances, the potential for heavy spending to stimulate the construction industry is diminished.

Government Spending

However, perhaps a more fundamental issue is that government spending, the key driver of the industry in tighter times, has been lagging behind the levels outlined in the budget. At the provincial and local levels, capacity issues are translating into significant underspending on the budget. In the fourth quarter of the municipal financial year 2011/12 (the second quarter of the calendar year 2012), approximately R13bn ($1.6bn) of capital expenditure was not spent, according to data compiled by the CIDB. In the first quarter of this financial year (third quarter 2012), total expenditure of metro and local municipalities had only reached 40% of the phased budget, while it reached 60% of the phased budget for district municipalities. For all provincial departments, the capital budget in 2011/12 was R49.6bn ($6bn), while the actual spend was R41.8bn ($5.1bn), or 84% of the total budgeted amount.

Given the underspending in the public sector and the lack of activity in the private sector, it is hardly shocking that the construction industry is suffering. Contractors that are struggling to secure work are beginning to retrench in a bid to cut costs. The Labour Force Survey of Statistics South Africa showed a net loss of 40,000 jobs in the construction sector in the year to the end of the third quarter of 2012. Given that the industry employs nearly 1.05m people, or 8% of South Africa’s labour force, this is a large blow.

This seems to be a symptom of a squeeze on the contracting industry. According to the CIDB, contractors’ profitability deteriorated in 2012, compared to 2010 and 2011. While only 4% of the projects assessed made a loss in 2012, the profit margins for the industry dropped. According to the board’s survey, only 25% of projects achieved profit margins above 10% in 2012. The largest share of projects (41%) achieved a profit margin between 5% and 10%.

Concerned Companies

The mood in the industry remains mixed. The CIDB survey paints an overall picture of industry still consumed by pessimism. Among building contractors, business confidence stood at a value of 36 in the fourth quarter of 2012 (on a CIDB scale of 1 to 100, with 50 showing a neutral outlook for the sector). This was up from 34 in the third quarter, but still indicates a depressed market: 75% of respondents said that demand for building work was a major constraint for the industry. The overall mood among civil contractors was hardly better. According to CIDB, business confidence here stood at 38 in the fourth quarter, with lack of demand for work ( reported by 72% of respondents) once again being the primary reason for pessimism.

In line with this, Milford at the CIDB told OBG, “Access to credit has become a little more difficult in the last quarter [of 2012], but the biggest constraint at the moment is access to work.”

The decision for a large number of the country’s top firms to expand into other African countries is likely influenced by the fraught domestic environment for concessions and PPPs. The opposition to tolling on freeways in Gauteng has raised questions about revenue generation and the funding of transport Compliant public sector tender awards per quarter, Q4 2011-Q3 2012 infrastructure projects in the country. The government has faced stiff opposition to the introduction of e-tolling for the province’s road network, following a R20bn ($2.4bn) upgrade to 185 km of roads carried out by the South African National Roads Agency aimed at reducing congestion on the M1 and N1 highways. The government reduced the proposed toll for the road to R0.30 ($0.04) per km in October 2012, but opposition to urban tolling still remains strong.

“The government is trying to introduce a system that has been rejected outright by society,” said Wayne Duvenage, chairperson of the Opposition to Urban Tolling Alliance (OUTA). “Why are they introducing such an expensive and cumbersome system? Questions remain about the whole cost of the project.” OUTA currently has a case before the Supreme Court of Appeal in Bloemfontein about the legality of the Gauteng e-tolling project. In such a scenario, with questions hanging over the funding mechanism for infrastructure projects, it remains a fragile time for construction firms in some segments.

Big Five

The big five construction firms in the country also face an uncertain period as a result of an investigation by the Competition Commission into bid rigging. The probe, which began in 2008, is focused on 65 incidents of bid rigging across 70 projects, with a value of at least R29bn ($3.5bn). Projects that were allegedly fixed include the National Stadium (FNB Stadium) in Soweto, the Nelson Mandela Bridge in Johannesburg and the Gautrain, Gauteng’s rapid rail and bus service. Still, large firms such as Group Five have been cooperating with the Competition Commission investigation for several years and largely remain sanguine about its potential impact on their medium-term outlook for the market.

Indeed, the main focus for the big five seems to be the prospects of an uptick in large-scale infrastructure projects from the government. From this perspective, there are certainly reasons to be more optimistic about the sector in the medium to long term. As with many developing countries, the demand drivers seem to be in place for a large pipeline of construction projects over the next decade and beyond. While South Africa’s basic population trend (with a growth rate of 1.2% in 2011) is not going to drive growth on its own, the dynamics of urbanisation, habitation patterns and building density trends could support significant demand for housing and infrastructure.

Urbanisation

South Africa has had a strong urbanisation trend in the post-apartheid period. According to World Bank data, the percentage of people living in urban areas rose from 52% in 1990 to 62% in 2011. Furthermore, in certain areas of the country, there is an even more pronounced trend. Gauteng province, which is the smallest by area, has the country’s largest population, at 12.2m people in 2011. It also has the most rapid demographic growth, with a population increase of 33.7% in the decade to 2011, a rate of growth more than double the national average.

Such trends have undoubtedly placed a burden on both the regional infrastructure network and housing stock and have led to significant demand in both areas. John Loos, household and property sector strategist at FNB told OBG, “South Africans have been used to living spaciously. There has been huge land availability in urban areas and previous governments up to the 1970s created a huge infrastructure network to suburban areas, allowing urban sprawl. But now, we’re moving into a process where urban land is scarce because infrastructure investment is scarce. The trend now will be to build smaller and smaller houses.”

Furthermore, there is demand for more effective transportation networks and nodes and development corridors built around transport arteries. According to the 2010/11 Income and Expenditure Survey by Statistics South Africa, South African households spend some 17.1% of their monthly income on transport, second only to housing expenditures.

As such, property development is likely to increasingly factor in infrastructure considerations in the coming years. To some extent this could be funded by private developers, given the potential premium around transport hubs. François Viruly, associate professor in the Department of Construction Economics and Management at the University of Cape Town, told OBG, “Studies have shown that housing around transport stations can push up prices by about 10%.”

Issues

Nonetheless, funding is likely to remain a major issue for a construction drive in the housing sector. Viruly estimates that there is a housing shortfall of between 600,000 and 1m units in the country, depending on the income groups that one is looking at, but this potential pipeline of future units will have difficulty being met by the commercial sector, as individuals in the affected income ranges have difficulty securing sufficient financing.

Furthermore, given the lack of large-scale housing projects, there has thus far been little potential for long-term investment to support development. Viruly said, “South Africa is one of the few countries where pension funds, whether private or public, are not significantly involved in the residential market. We’re not necessarily building at the scale that they require. There are very few billion-rand schemes that pension funds can get involved with. A function of the lack of density is that it has created an investment class that is not that attractive to larger investors.”

As such, a drive for mass housing that could provide a boon for the construction industry will most likely require some form of government support. Viruly argues that one option is the Chinese model of state-led high-rise, high-density residential building. However, as it stands, the recent trend is moving towards the informal renovation of shanty units, a pattern that excludes the construction industry from high-volume housing provision.

Government Support

The government has been taking measures to improve the environment for social and low-cost housing provision. For example, in 2011 the Department of Human Settlements altered the terms of the Finance Linked Individual Subsidy Programme, which provides deposits for home financing to eligible families. The alteration to the programme increased the threshold eligibility to a bracket of R7000 ($853) to R15,000 ($1829) per month and increased the maximum subsidy from R54,000 ($6583) to R83,000 ($10,117) on a maximum house price of R300,000 ($36,570). The Gauteng provincial government also allocated R8.5bn ($1bn) between 2012 and 2014 for formalising squatter camps in the region. This will see the completion of 1919 community residential and state-subsidised units. Such projects are complemented by the R9bn ($1.1bn) Housing Impact Fund of the Old Mutual Financial Investor Group. This fund will be used to construct affordable units for rental and sale, as well as providing housing loans and leasable accommodation for students and families. The fund and its partners have a target of establishing 120,000 affordable housing units.

As such, activity in the social housing segment offers some hope to the construction industry. According to Industry Insight, a firm providing sector analysis, as of March 2012 the number of social housing projects awarded had shown an annual increase of 15%. However, the number of tendered contracts in this segment had declined 11.3% compared to March 2011, while the postponements of low-cost housing contracts increased by 41.3% in the same month.

While a number of programmes have been established to support the development and construction of social housing units, activity is still not at a level to meet the demand and backlog in the market. According to estimates by Industry Insight, the Department of Human Settlements currently builds approximately 200,000 subsidised houses each year, using an annual budget of R22bn ($2.7bn) in 2011. Each house costs approximately R55,000 ($6705). Other departments also receive R100bn ($12.2bn) to construct bulk infrastructure for these social settlements.

While the construction sector is currently reliant on government intervention to create volume in the residential market, in the longer term this may begin to change. As incomes grow in the country, the viable market for commercial development across the real estate sector should begin to expand.

Incomes have been moving in the right direction. According to the South Africa Reserve Bank, gross national income per capita has grown in the postapartheid period from R27,521 ($3355) per person to R38,734 ($4722) per person in 2011. In 2011 the highest growth in household income was observed in the income bracket between R3832 ($467) and R10,824 ($1319), according to information derived from the Living Standards Measure of the South African Advertising Research Foundation.

These income levels are defined as middle class and point to the development of upward mobility within the country. If this trend continues and incomes continue to climb, there should be further demand for residential and commercial real estate.

Green Growth

Furthermore, the wider industry may begin to see activity in niche areas, particularly the design and construction of energy-efficient and green buildings. The country now has 30 certified Net gains/losses in construction employment, Q4 2011-Q3 2012 green buildings, just five years after the inauguration of the official body for the industry, the Green Building Council of South Africa. The council is targeting 500 certified buildings by its 10th anniversary. This suggests a minor impact for architects, consultants, contractors and developers at this stage. However, this could begin to change, particularly given the heavy toll that utilities rates are having on property management and the sector as a whole.

Added Benefits

There could also be substantial commercial benefits for developers to go green. While there has not been enough transactional history in South Africa to establish firm rental and sales price trends yet, in other countries green buildings have commanded significant premiums. In Australia, for example, the price premium for green buildings is between 4% and 8%, according to Brian Wilkinson, CEO of the Green Building Council of South Africa. He told OBG that for larger buildings in particular, the additional cost of construction is more than offset by this price premium. The additional overhead associated with green buildings is largely fixed, as a result of consultancy fees around modelling, and as such, becomes more competitive the more spacious the building. There is little history of costs yet, although the ABSA Towers in Johannesburg, which were built to the standards of the Green Building Council, were constructed at an additional premium of 1.2%, according to the Green Building Council.

The opportunities for growth in this segment look strong given the heavy burden of energy costs in the country. “Energy pricing is going to start influencing energy decisions,” said Wilkinson. Growthpoint, the largest South-African-listed property company, has begun tracking electricity costs as a component of tenant occupancy costs. In the office segment, gross occupancy costs usually range from R80 ($9.75) to R140 ($17.07) per sq metre, but Growthpoint’s study has shown that electricity costs can add as much as R30 ($3.66) per sq metre to occupancy costs. The company is now looking to do an energy audit with its tenants and introduce energy savings through building adjustments. The company will then take 50% of the measured savings. Such moves are likely to become increasingly common as both owners and tenants look for cost savings and the ability to build occupancy through differentiation.

As such, the construction industry, from architects and consultants to contractors, are likely to begin operating more extensively in this space. Wilkinson told OBG, “We haven’t seen yet any construction companies differentiating themselves as green building specialists, but we’ve seen a tremendous interest amongst the contractors industry and we have seen fairly specialised consultancy on this. I do not believe that there are any new projects of any significance that are not seeking a green building rating.”

Infrastructure Spending

In the shorter term, any potential optimism in the construction sector is more likely to come from infrastructure projects than from real estate development. Milford told OBG, “We will certainly start seeing the impact of the government infrastructure programme in 2013 and beyond.” The infrastructure plan of the Presidential Infrastructure Coordinating Commission (PICC), released in summary in April 2012, highlights 17 strategic areas for infrastructure development. The strategic integrated projects (SIPs) include investing in infrastructure for the northern mineral belt; developing a Durban-Free State-Gauteng logistics and industrial corridor; improving the infrastructure for electricity generation, transmission and distribution; public transport improvements; a national school building programme; and rural and municipal infrastructure. The commission, chaired by the president, was established in July 2011 to oversee infrastructure projects in the country and ensure their timely execution.

In October 2012 the deputy president, Kgalema Motlanthe, said at an event held to mark 60 years since the establishment of the Southern African German Chamber of Commerce and Industry in Pretoria that the PICC will expedite infrastructure development in the country. The mandate of the committee is to develop a 20-year pipeline of projects, removing the uncertainty and inconsistency in project development in the country. Motlanthe said the commission “will allow us to ensure better financial mobilisation, provide greater certainty to the construction industry, give educational institutions a framework around which to plan their skills development strategies, and provide a roadmap for investors and communities”.

Unclear Future

However, despite the PICC, the problem for the construction industry continues to be uncertainty over the details of the infrastructure plan and the funding mechanisms to implement it. Still, certain state-owned companies have already begun to detail capital expenditure programmes that could benefit the construction industry. Eskom, the stateowned electricity company, is continuing with its capacity expansion programme that began in 2005. The budget for the programme is R385bn ($46.9bn) up to 2013, with more than an additional R1trn ($121.9bn) to be spent by 2026. This plan is likely to whet the appetite and sustain the workbooks of engineering contractors. Furthermore, Transnet, a stateowned rail, port and pipeline company, has also announced an expansive investment programme. In his State of the Nation Address to Parliament in February 2012, President Jacob Zuma announced that Transnet would spend R300bn ($36.6bn) over the next seven years in capital expenditure programmes. While some of this expenditure will be invested in rolling stock, it should also provide plenty of tendering opportunities for contractors in the country.

While these programmes may offer some solace to the industry, it remains an uncertain time for many South African contractors. Margins have been squeezed and operating conditions remain challenging. This is the result of a number of factors including input costs, access to credit and cash flow issues. Industry Insight estimates construction costs increased 6-7% in 2012. Coface South Africa, an international credit insurer, estimates that input costs for construction will rise a further 7% in 2013. This is a consequence of price pressure and inflation on fuel, logistics, cement, steel, electricity and labour. Given the continued industrial action and worker disquiet in the country, labour costs are likely to persist as a key issue for construction. Milford has estimated that labour can now constitute between 30% and 50% of total building costs for contractors.

Contractors are also feeling the constraints of payment schedules and access to credit. According to the CIDB, in the fourth quarter of 2012, 32% of building contractors reported access to credit as a constraint to their success. Among civil contractors, the figure was 30%. While these were a slight improvement for the industry on the third quarter, it still is indicative of a tough financial environment for contractors. Cash flow challenges are not simply confined to financing. Payment schedules also make the operating environment tough for the contracting industry. Saijil Singh, lead analyst at Coface, told the trade magazine Engineering News, “While there are jobs within the industry, delayed payment from government, as a result of poor administration, has strained the cash flows of construction companies.” Singh suggests that government bodies need to improve their tendering processes and internal accounting procedures.

While late payments are perceived to be a challenge, South Africa performs better in this regard than many developing countries. The 2012 CIDB survey found that 48% of payments to contractors were made within 30 days of invoicing, while 45% were made within 90 days and only approximately 8% were over 90 days. Perhaps a bigger concern for contractors is tendering competition, a trend that is driving down prices and squeezing margins further. Indeed, the current classification system for public sector tenders (which grades contractors from 1 to 9) only takes account of financial capabilities, and many contracts, the vast majority of which are lump sum, are awarded purely on cost. The government is looking at the current regime to see where it can improve transparency and efficiency in the award of government contracts, according to Milford. While this is still under consideration, it could include a greater emphasis on assets and equipment and the introduction of systems to assess the historical performance of contractors. Such a move could help arrest the trend towards pricing closer to cost, as clients begin to factor in quality and experience to tender awards.

Outlook

Nonetheless, in the short term, the environment is likely to remain difficult for contractors. The overriding concern remains the lack of contract awards from both the public and private sectors. With volumes down and margins being squeezed, most contractors are trying to ride out the current downturn. The optimistic view is that the sector has already reached the bottom and that the industry will begin to pick up in 2013. Whether this comes to pass will largely rest on the state’s ability to implement its infrastructure plan and for the public sector to improve its allocation of funds in the infrastructure segment.