S&P sees softening in construction markets

By Ronda Fears

Nashville, Tenn., July 8 - The U.S. construction markets are sending mixed signals since building demand remains on the rise, but profitability is still lagging, said S&P credit analyst Joel Levington. Moreover, the agency expects nonresidential building to be soft for the remainder of 2002 and into 2003.

Recently, the U.S. Commerce Department reported that construction put in place in May was estimated at a seasonally adjusted annual rate of $852 billion, a 1% increase over May 2001, and a 1% decrease compared with April. In the nonresidential sector of the construction market, construction put in place in the industrial, office and hotel and motel end markets declined year-over-year by 42%, 28% and 23%, respectively.

"Although the aggregate change in demand is modest, a more thorough review indicates that demand for construction services ranged widely, particularly in the nonresidential building market," Levington said in a report Monday

"From a credit perspective, specialty contractors, which provide mechanical, electrical and telecom infrastructure services, are most heavily exposed to these market sectors. Because projects in the specialty contractor sector generally last no more than three to four months, many industry participants are generally experiencing declining profitability and cash flow generation."

For some time, he said, S&P has been concerned that nonresidential building construction would have a negative impact on credit quality in the specialty contractor market.

S&P believes that the nonresidential markets will remain weak throughout 2002 and into 2003.

"In particular, the office market, which is the largest single end market in the nonresidential building sector, declined at a much faster rate in May [down 6% sequentially] than the previous few months," Levington said.

"Discussions with several experts in the field indicate that while market deceleration is expected to moderate, there are no meaningful signs of improvement, and price competition remains fierce." Although the office market is not in such an onerous condition as in previous recessions, it has significant overcapacity in many key segments, the analyst said.

As such, even as the U.S. economy recovers, new construction in the office sector will likely lag as unabsorbed capacity is utilized and contractors will mainly focus on lower-margin retrofit and efficiency projects during the next several quarters, he added.

Partially mitigating the weakness in the industrial, office, and hotel and motel markets has been strength in the educational and medical markets, Levington said. Through May 2002, public construction for education facilities is up 18% sequentially, while hospital construction is up 30% year-over-year.

However, he noted, F.W. Dodge recently said their expectations is for the education market to peak in 2002 with reduced demand in the next 12 months, which may further weaken specialty contractor's credit profiles.

In contrast, the analyst said, key end markets for general contractors have remained solid during the past 12 months to 18 months.

"Profitability of general contractors tends to lag the overall economy, along with profitability of specialty contractors, as longer-term backlogs are worked off," Levington said.

"As a result, declining economic conditions, the rapid deterioration of the natural-gas power plant market, and deceleration of public spending projects are now only starting to flatten out backlogs and potential earnings growth. S&P believes that because market conditions are starting to soften, general contractors may pursue niche and strategic transactions to broaden their service capabilities, and provide new growth opportunities."

In addition to service expansions, several general contractors have expressed interest in further developing their positions in the operations and maintenance area, which generally has more stable revenue and earnings patterns, albeit at modest margins.

Recent examples of these trends include Shaw Group Inc.'s proposed, but later terminated, acquisition of Turner Industries Group.

S&P continues to expect further industry consolidation in the near term.

However, S&P takes a cautious approach to acquisitions because they can be quite challenging. Some of the key risks include valuation of projects, melding corporate cultures, integrating management and financial computer systems, retaining critical personnel and understanding accounting and internal control systems.

"In addition, most of the recent industry transactions have included at least some debt financing, which adds a layer of financial risk onto the acquisition risks taken," Levington said.

"Nonetheless, recently completed transactions for rated companies have been financed in a manner such that financial risk did not meaningfully impact credit quality. However, should internal growth prospects temper and stock price valuations decline, the potential for more debt-financed acquisitions in the sector may increase, pressuring the ratings on general contractors."

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