Cleaning up the mess
A year ago this week the collapse of social housing contractor Connaught caused panic, leaving landlords struggling to maintain services. Here, Carl Brown asks whether landlords and contractors have learned their lesson
‘Before Connaught [went bust] no one really asked to see your balance sheet, now they want to know about your finances, how you are going to fund the work and how you manage your supply chain,’ says Jeff Adams, chief executive of building contractor United House.
Social landlords can be forgiven for asking more questions before appointing contractors these days. A year ago this week giant contractor Connaught went into administration after failing to service its estimated £220 million of debt.
The collapse caused chaos as dozens of landlords across the country who used Connaught scrabbled to keep vital repairs and maintenance services going. It was a process repeated, on a much smaller scale, when Rok went into administration just two months later - and once again, earlier this summer, when Kinetics also collapsed.
When asked how their housing clients have changed their approach to new contracts over the past year, the major contractors say the biggest single shift has been in the level of scrutiny with which landlords assess their balance sheets for evidence of profitability and cash holdings before they sign on the dotted line.
‘They are now a lot more sensible and are looking at the financial capabilities of the business and their ability to perform,’ explains Ian Lawson, managing director of Kier, which has a social housing division that turns over £158 million a year.
So, using the accounts of 10 major social housing contractors we try to judge what state the sector is in and what social housing providers and contractors are doing to minimise the risk of a ‘Connaught mark two’ (see box: Painting a clearer picture).
It is now accepted that the failed contractor, which held around 90 contracts in the housing sector, expanded too quickly by using debt to fund acquisitions. It was bidding too low for contracts - so-called suicide bidding - leading to concerns about quality, and failed to convert enough profit to cash, reducing the ability of the firm to wriggle out of financial trouble.
One rival contractor, which did not want to be named, said Connaught moved from capital works into the repairs and maintenance market without understanding that it requires different management skills and that repairs consume, rather than generate cash.
After scrutinising the accounts of 10 major contractors with large scale housing order books for Inside Housing, Gary Moreton, head of social housing at auditor Baker Tilly, says there is nothing to suggest any of them are in imminent danger of going bust. He points out that most of them have increased profit and turnover, and, crucially, have cash available - unlike Connaught.
Mr Moreton does, however, point out that Willmott Dixon, Kier and Morgan Sindall, which provides social housing repairs and maintenance services through subsidiary Lovell, all have profit margins of less than 2 per cent, which could give them less room to manoeuvre in a crisis.
So has the sector learned its lessons when it comes to bidding at unsustainably low prices?
One manager at a repairs and maintenance contractor thinks not. ‘I don’t think the industry has learned anything since Connaught and Rok went bust,’ he says. ‘Contractors are still doing exactly what they were before and haven’t changed anything about their approach.’
Several landlords, including 8,490-home association Poplar Harca have become so worried about low bids that they have introduced clauses to allow them to question contractors whose bids come in 10 per cent below the average bid received, and to ignore those bids if they are not convinced the work can be done for the price stated.
But Paul Dooley, director of estate regeneration at Poplar Harca, explains the clause has not been used yet as every contractor is bidding low. ‘They are still bidding very, very low. We are seeing in some instances contractors bidding 20 per cent lower across the board than what we wanted,’ he states.
In June, Apollo revealed it is considering a merger with Keepmoat which would create a social housing business with a turnover of more than £1 billion. This prompted speculation within the housing sector that Apollo is struggling and needs to merge in order to survive.
Dave Sheridan, chief executive of Apollo, vehemently denies this. He says the move will strengthen Apollo’s new build business in the south east of England. ‘The proposal will make us a stronger entity, we are certainly not in financial trouble, we have positive cash balances, a strong order book and we are not failing on any contracts. Apollo would continue if the deal fell through,’ he states.
Meanwhile, Morrison has also created suspicion among rivals by winning a large number of contracts in a highly competitive market. Its order book increased by £505 million to £1.43 billion last year, according to its most recent published accounts.
Guy Wakeley, chief executive of Morrison, says the firm’s finances are healthy because it has no debt. He denies his organisation is winning contracts by bidding low - the accusation levelled at Connaught. ‘We have lost a number of contracts recently on price,’ he points out.
Finally, what of Lovell, the firm that wrong-footed the sector by negotiating the right to transfer Connaught’s contracts within days of the contractor’s collapse, thus ending up with 70 of them? It’s too early to say, but Lovell says the former Connaught contracts have strengthened its business.
Looking for signs of a Connaught-style demise in the accounts of other contractors is a futile exercise, hint some industry experts. ‘Most people would say [Connaught] was a failed business model to start with,’ sums up United House’s Mr Adams. ‘It would buy a plot of land [to build upon], reduce the overheads and then buy another one, borrowing money all the time to do this with the contracts getting bigger and bigger. How do you control that?’
Social landlords also seem to have come to the conclusion that it’s difficult to judge whether contractors are potentially risky by pouring over their accounts - so they’re taking defensive measures.
A tactic being employed by landlords is to charge contractors using a system based on the price of carrying out repairs per property, rather than a schedule of rates in which individual types of repairs are given a set price. A schedule of rates is difficult to administer as it can involve large numbers of invoices - the sheer amount of paperwork makes it easier for contractors
to bill for jobs which have not been carried out.
Chris Durkin, chief executive of Willmott Dixon Support Services, says that the proportion of landlords using a schedule of rates has fallen since Connaught collapsed from around 60 or 70 per cent to less than half. ‘People are starting to realise schedule of rates models have had their day,’ he states.
A third measure landlords have taken since Connaught’s demise is to break up work into smaller contracts. For example, Raglan Housing Association, which owns or manages 11,000 homes across the south of England and the midlands, is retendering work carried out previously by Connaught, and it’s looking to hire four smaller contractors.
Raglan was badly burned by the collapse of Connaught, which was one of only two contractors employed by the association and provided 80 per cent of its repairs and maintenance work, worth £60 million. Over the past 12 months it’s needed to rely on temporary arrangements to keep repairs going at extra cost. ‘We are looking to smaller contractors, which we have a good working relationship with and which we know can do the work for a realistic price,’ explains Martin Ward, director of asset and information management services at Raglan.
Splitting work up in this way means there will be less of an impact on Raglan’s finances if one contractor goes bust, he says.
Meanwhile, Midlands-based association Bromford Group has yet to decide how to cover its repairs and maintenance work going forward. Its contract with Connaught was worth £60 million over 10 years. The 26,000-home organisation drafted in Lovell on a temporary basis, but it is still considering a range of options, including splitting work between smaller contractors or taking some
of it in-house. ‘Associations are being much more circumspect about putting all their eggs in one basket,’ explains Mick Kent, chief executive of Bromford Group.
Other landlords are deciding to take their repairs and maintenance services in-house rather than risk another Connaught-style catastrophe. The increase in value added tax - from 17.5 per cent to 20 per cent - introduced by the government in January, has provided landlords with an additional incentive to do their own work, thus avoiding paying VAT on repairs services they buy in.
Wayne Hughes, managing director of consultancy Wayne Hughes Associates, is currently conducting research into how social housing contracts have changed since Connaught’s collapse. He knows of 14 landlords that have already taken services in-house, and a further 21 that are in the process of doing so.
However, the extent to which ‘insourcing’ has changed the face of repairs and maintenance in the housing sector is disputed among contractors. Whereas Alan Long, executive director of Mears, describes the move to insourcing as a ‘fundamental change’, Stewart Davenport, managing director of Lovell, says, ‘we have not seen as much of it as I thought we would’.
There’s no doubt that the scope for landlords with their own direct labour organisations is likely to increase though - if HM Revenue and Customs presses ahead with proposals to make not-for-profit organisations, including social landlords, exempt from paying VAT on shared services, it will make it more likely that one housing provider will be able to provide repairs and maintenance services for other landlords.
The average length of contracts has changed over the past 12 months, states Mr Hughes. ‘They are definitely getting shorter,’ he says. ‘Before, contracts were for 10 years, with an option to extend to 21 years, while these days most are for five years. Landlords are much more risk-averse now.’
Mears’ Mr Long, however, disputes this claim. He says he has not seen a noticeable change in contracts’ length.
It’s not just social landlords that are changing the way they work in order to minimise risks - contractors are also making alterations. Some including United House and Kier are looking to set up joint ventures with councils, where the local authority contributes land for development, and in return shares the profit with them, the developer. For example, Kier is building 80 affordable homes as part of a joint venture with Birmingham Council.
The coalition government has halved the budget for the development of new affordable homes, and this type of partnership is a means for authorities to contribute land which, in effect, makes up for the loss of capital grant.
‘It reduces the risk as we don’t have to spend money on the land,’ explains Mr Lawson. Several contractors point out that because of their lack of scale, smaller building contractors are unlikely to be able to work with local authorities in this way.
‘The market will be interesting, some of the smaller businesses might be under threat because there is a limited amount of capital works out there,’ Mr Lawson adds.
Maybe so, but whether they are successful in securing land in this way or not, contractors are still working in difficult circumstances - ‘All the contractors are suffering from the [government] cuts and savings that are going on,’ states Mr Hughes.
These swingeing public spending cuts mean the temptation for contractors to cut their prices to unsustainable levels to win work is still very much there. Likewise, while the picture of social housing contracting in 2011 is one of nervous landlords asking more questions of contractors before tendering or spreading risk through insourcing, splitting contracts or taking work in-house, in an era of substantial grant cuts the draw of low-price tenders must be strong.
As Baker Tilly’s Mr Moreton says, perhaps the biggest deciding factor in whether contractors go under is the wider economy. As public sector work gets scarcer, many of these businesses are expecting the private sector to come to their rescue by offering them more business, he says. If it doesn’t, there’s a risk that we could have further collapses.
Painting a clearer picture: 10 major social housing contractors’ accounts
Operating profit 2011
Operating profit 2010
Operating profit 2009
Net assets 2011
Net assets 2010
Opinion: Gary Moreton
The financial health of most contractors is improving but pressures remain
Last year saw the collapse of Connaught and Rok, two of the leading contractors to the social housing sector. Twelve months on, have lessons been learned?
Many housing associations claim to be paying more attention to quality and service delivery when retendering, but with cuts in funding and pressure to reduce costs, the temptation to go with the lowest price remains. Be wary of contractors that are significantly under-cutting competitors.
In general terms, the latest accounts of the major contracting companies operating in the sector are favourable. Most report increased turnover and profitability. There is recognition by the major contractors that the sector represents continued growth opportunity, particularly in responsive maintenance and energy efficiency projects. Most are reporting increased order books.
But there are no signs that competition for work is easing, with contractors highlighting that it remains fierce. There are still several contractors operating at slim profit returns of less than 2 per cent (profit after tax to turnover).
While low profit margins give less room to manoeuvre, when assessing the viability of contractors, the key issue is the availability of cash. On the positive side, the accounts of the major contractors show high emphasis on cashflow. Some are proud they have no bank borrowings, while where there are net borrowings, those contractors highlight prominently their unused banking facilities. Going concern - the assumption that a business can function without the threat of liquidation - and cashflow are, rightly, high on their agenda.
Many contractors are large, diverse property companies operating in many areas, within both the public and private sector. Over the past two years, the public sector has underpinned many contractors’ performance, and as government spending cuts start to bite, many expect the private sector to come to the rescue. But in the current economic climate there could well be a time lag. Inflationary pressures will place further financial strains especially with fixed-price contracts. These and other general economic pressures will, undoubtedly, continue to stretch the financially weaker contractors. Social landlords, therefore, must still take care when choosing their contracting partner.
Gary Moreton is head of social housing at auditor Baker Tilly