Graeme Davies looks at how FM service providers that are part of construction firms compare to their pure-play FM service competitors.
2 July 2018 | Graeme Davies
Carillion's fall from grace earlier this year brought into focus questions about the viability of a business model that combines construction activities and services such as facilities management under one umbrella.
Considering that a significant number of major UK operators in the FM sector have construction operations - or have evolved from primarily construction-focused businesses - this is a key question for the sector.
But why has the UK market evolved in such a way? And are there parallels in other countries or lessons to be learnt for those whose FM sectors are not as mature as the UK's?
The roots of the UK's current market make-up were set in traction more three decades ago when the UK government began seriously to explore the potential for outsourcing both services and the construction of public buildings in an effort to shift more public costs and liabilities off the public balance sheet. With the advent of the financial crisis 10 years ago, and the need to pare back the public balance sheet even further, outsourcing was embraced even more fervently.
Borne out of construction
In many ways the combination of construction and services such as FM makes sense on paper, especially when many of the contracts being handed out are from the same customer - as is the case with the UK government. Construction companies pitching to win project work are uniquely well placed to also bid for the continuing management and service contracts once such projects are complete. That's why many construction companies either acquired or organically developed FM divisions that would allow them to offer a holistic solution at the bidding stage of project contracts.
Today, many of the companies who occupy the UK's FM sector were born from a construction background including the likes of Kier, Interserve, Atkins, Balfour Beatty, Morgan Sindall and Galliford Try. Indeed, in many cases the considerable size of these businesses is down to the fact that they were established construction players before they began building or buying services capabilities.
The same effect is less pronounced overseas, especially where FM markets are less mature. Consider Europe, where major FM players including the likes of ISS, Sodexo and Atalian have evolved as pure service companies - and companies such as Vinci - which began life in construction, are in the minority.
In the US, companies such as Cushman & Wakefield and CBRE evolved from property services while others such as Brookfield Multiplex have been built through acquisitions that have melded construction and services into one larger operation.
For construction companies that have to carry a lot of working capital on their books through the lifetime of construction projects, having other business streams that bring in regular income makes sense. Construction is a capital-intensive business and often requires companies to carry significant debt during the construction phase of projects even if there may be staged payments as construction progresses. To have a pipeline of work under the same corporate umbrella, which in some cases can run to billions of pounds spread over many years and often with index-linked increases in payments, can give lenders comfort when it comes to negotiating the debt required to see construction projects through.
The Carillion effect
Understandably, the downfall of Carillion, together with high-profile problems suffered by peers such as Serco and Interserve, has sent shudders through the sector and raised questions about the viability of such a model among customers.
A lot of these concerns can be dismissed by pointing to problems unique to Carillion, including aggressive accounting and questionable management practices. But it does raise the wider issue of whether combining two relatively low-margin businesses, which in some cases can come to rely on the same set of customers, is a sound model.
The strategy can mean that any particular pressure on those customers - such as the budget cuts seen across the board for public services over the past eight years - can hurt a company twice over. And in recent years several support services companies have run into financial trouble and had to reset strategy and raise extra funds from investors to cover overstretched balance sheets that have come under pressure from rising costs pitted against low-margin contracts.
Unfortunately, as in the case of Carillion, it is not always easy to spot when a company is getting into financial trouble. On the face of it, Carillion was maintaining dividend payments to investors and generally appeared in reasonable shape considering the whole sector was under pressure. But under the surface it was burning its cash and not generating enough free cash flow - cash available after all costs - to actually pay those dividends.
Aggressive accounting techniques can often hide such issues for some time, in some cases buying the company time to turn things around but more often than not just delaying the inevitable.
It is instructive to look at the profit margins of major players to understand how companies in the sector typically operate.
For example, construction-heavy Kier's net profit margin in 2008 was 2.7 per cent; this dipped to 0.1 per cent following the financial crisis as work across the business gummed up before recovering to top 3 per cent in 2012. Thin margins are a way of life in a sector where companies can turn over billions but only produce profits in the tens of millions.
Looking at Kier's latest results illustrates the difference between construction, where profit margins were just 1.8 per cent, and services, where margins were a healthier 4.9 per cent. An even more extreme example is Galliford Try, whose margins on its construction business, which is dealing with legacy issues on some contracts, were a wafer thin 0.9 per cent at its last results. Compare this with pure services businesses that have entered the UK market such as ISS and Sodexo, whose most recent trading period saw margins of 5.4 per cent and 5.7 per cent, respectively.
"A lot of questions can be dismissed by pointing to problems unique to Carillion, including aggressive accounting and questionable management practices"
We often see companies in areas with low margins looking to add higher-margin business streams to their operations, as historically construction companies have done with FM services. Many FM operators in recent years have tried to bolster their offering, and margins, through additional business streams such as environmental services and technology additions like building information management and those that have succeeded have tended to perform better overall.
As Satvir Bungar, national head of facilities management at advisory specialist BDO, says: "Carillion's recent liquidation should be used as an opportunity to change wider industry behaviours, and to promote value-added initiatives on contracts as opposed to decisions driven solely by cost.
"The pressure to innovate has never been more acute as FM providers focus on addressing escalating employment costs, increased regulatory scrutiny over flexible labour models, government spending cuts, delayed spending on projects following the UK's vote to leave the EU, and ever-more rigorous workplace health and safety regimes."
The evolution of the UK market
British FM service provision is now dominated by larger multidisciplinary service companies offering a range of services with increasing levels of sophistication and automation, allowing for efficiency to be maximised, alongside a large number of smaller and medium companies who are increasingly relying on their specialist niche skills to survive and compete.
The UK market has matured: it has seen the entry of a number of overseas companies but very few have tried to replicate the construction/services hybrid model. The likes of ISS, Sodexo, Atalian and property companies such as Cushman & Wakefield have stuck to their knitting and concentrated on offering services and have, in the main, been successful in establishing decent market positions in the UK in the process.
One of the few European companies of scale that has grown from a construction background to a full service FM provider is French business Vinci. In recent years it has gained a foothold in the UK market, where it offers both construction and facilities management services, replicating the success it has enjoyed in continental Europe.
"It does raise the wider issue of whether combining two relatively low-margin businesses, which in some cases can come to rely on the same set of customers, is a sound model"
So how does a company focused solely on FM thrive? Either through scale or concentrating on higher margin specialist business. If we take the example of ISS, it is through scale. This allows a business to enjoy economies of scale as their costs are spread over a wider base and key business operations such as finance and back office can be run as efficiently as possible with the sunk cost spread more widely. This explains how a company such as ISS or Sodexo has been able to come in and compete effectively in a low-margin UK market and win business.
For the public sector awarding contracts it appears that over recent years there have been a dwindling number of companies of sufficient scale to provide all the services they require. With increasingly large and complex requirements coming through the tendering process, the reaction from suppliers has been to grow and develop into multidisciplinary 'one-stop shop' operations capable of winning and servicing such contracts. Whether this has been healthy for the sector as a whole or for customers is debatable. Nor is it clear that it has turned out to be any more cost-effective for those holding the purse strings.
Certainly, the collapse of Carillion has shone a new focus on the FM sector and the construction-led model at a time when there is a general feeling that the consensus may be turning against outsourcing in general both politically and on a practical level. Questions have been raised about whether end customers, in particular the government and local authorities (and by proxy the taxpayer), are getting proper value from money from the outsourcing of services and construction. On the other side of the coin, investors and shareholders in companies who specialise in outsourcing are increasingly asking whether the low margin, high profile and potential for significant aggravation from taking on such contracts is worth it. The 'old-fashioned' construction/services hybrid is beginning to look somewhat outdated.
Those companies that have moved with the times and added on more sophisticated services are likely to continue to thrive. And those who have sensibly drawn in their horns a little to concentrate on areas of expertise are also following a wise strategy.