Construction Bonds: Heavy Civil Contractor Edition
Author: Andrew Cartwright
2021 remains a very interesting time for construction firms in Canada. We have all seen the various budget announcements and are hopeful that the billions of dollars in ‘shovel ready’ projects are actually ‘shovel ready’ this year.
So far, our experience has been a fairly slow roll out of tender opportunities towards the end of 2020 and to start the new year. However, we remain optimistic that the tenders will begin coming out over the next couple of months and are hopeful that infrastructure projects will be seen as a major driver in leading Canada out of the economic challenges COVID has created.
The long-term impact of COVID 19 on the construction industry is still fairly unknown but for the most part it seems that the construction industry has not experienced widespread failures, especially in comparison with other industries like retail, restaurants and tourism. This is in part due to construction being deemed an essential service very early on in the pandemic. The surety industry only saw modest performance bond claims in 2020.
The government wage subsidies also seem to have played a significant role as we are seeing that many companies are actually in better financial shape today than they were a year ago. We would be remiss to also not mention the robust nature of our industry and how so many contractors have been able to adjust strategies and scale back overheads as needed over the past year.
The one construction class that seems to have performed quite well is the heavy civil space. This is likely due to a few different factors. Many of these firms operate in the transit space which is clearly essential. In addition, the fact that most of this work is done outside also means that the risks of COVID outbreaks have been less. In addition, there are also significant barriers to entry in this space when compared to some other classes of contracting.
As such, we have not seen the bid lists grow and margins shrink as quickly in this space. To be competitive, a contractor usually needs to own multiple pieces of heavy equipment and these costs can add up significantly for new operations. As it has been harder to access credit this past year, even with the historically low interest rates, these initial costs tend to limit how many businesses entering this sector each year. This provides a great historical advantage to longer standing heavy civil contractors.
Due to the equipment heavy nature of this class of construction, the balance sheets of heavy civil contractors tend to be vastly different from their counterparts in general contracting or even most sub trade classes as well. Generally speaking, these companies tend to be much more heavily weighted towards capital assets (equipment).
The average heavy civil contractor will generally hold about 40% of their assets in equipment, while this is typically less than 10% of the asset base for most general contractors and sub trades. Most often there is a substantial debt portion that is tied into these equipment holdings as well. This debt generally requires monthly payments to service the debt which tend to erode the overall working capital of civil contractors especially as they grow and build up their fleet.
Despite the limited working capital, the bond companies are typically quite comfortable with the make-up of these balance sheets as they tend to understand that rather than ‘working capital being king’ for this class of construction, the saying should actually be ‘equity and cash flow are king’. The equity the contractors build up in their equipment over time, and the strong margins and cash flows it allows them to generate are where the bonding company will gain comfort in providing surety bonds for civil contracting firms.
As Michael Lanzillotta, Director of Surety at Economical Insurance explains, ‘At Economical we understand that heavy civil contractors normally carry a substantial amount of equipment, and generate revenue and profit from that equipment, rather than strictly employing labor and materials to get a job done. We also understand that this equipment may be financed by the manufacturer or the bank. If you are partnered with a sophisticated broker and surety, they will keep an eye on how successfully profits and cashflow are being generated from your equipment. Sureties require tangible working capital and tangible equity to leverage support, therefore, a good balanced approach regarding equipment holdings is a characteristic that we look for. Economical understands that the heavy civil realm poses its own unique challenges and opportunities and are positioned to help protect and grow your company with you.’
Of course, equipment holdings is just one factor and there are other considerations the surety companies will look to understand on a contractors financial statements prior to issuing a construction bond. The ownership structure and management team is a major consideration with a specific focus on past experiences and projects completed to date.
A surety may hesitate to support a sewer and water contractor on a bid to build a new bridge for example due to a lack of experience in this space unless the contractor can present a compelling business case. With the average gross profit margin in heavy civil work typically between 18-22%, the makeup and profitability of the contractor’s current backlog of work is also something the sureties will look to understand.
Regardless of the type of construction you are in, it is important that your broker and surety bond company understand your business and the industry you operate in. If they don’t, you risk being painted with a broad bush and in challenging times that is the last thing you want for your firm.