Like investing in the stock market, acquisition strategy requires constant analysis.
As it enters the end of 2011, the construction industry faces more than 14 straight quarters of contraction and decline. With this prolonged downturn, many firms have learned to deal creatively with and manage through uncertain environments. In short, a new reality has become clear: Firms with seasoned leadership, solid balance sheets, strong value propositions to their customers and a focus upon controlling operating costs are surviving the volatility and managing to earn profits in a down market.
Having stabilized their businesses, the question that many of these successful firms now face is how to proceed to grow in the future: continue to scramble in a hyper-competitive low-bid market and hope for a recovery? Or employ creative strategic thinking to gain lasting competitive advantage in a market facing a prolonged recovery?
In this article, we contend that acquisitions in today’s construction market offer the opportunity to deliver unprecedented value, provided that the acquiring firms utilize a disciplined strategic process to maximize returns.
THE MARKET FOR ACQUISITIONS
Economics demonstrates that the value of goods and services is driven inherently by supply and demand. Limited supply and high demand yields higher prices; oversupply and limited demand yields lower prices. The acquisitions market for construction firms is no different. In today’s construction market, demand for acquisitions is strong, given the large amounts of capital available to global corporations and the need for growth. Luckily, two principal forces are acting to increase the supply of companies available in the market. The first is overcapacity: While the weakest firms have exited the market during this downturn, many firms continue to limp along by procuring work at lower margins while hoping for economic recovery. The second principal factor adding to the supply of eligible acquisition targets is demographics. Many construction firm owners are reaching retirement age and desire to exit the industry but have been forced to continue to lead their firms through today’s economic environment.
In 2006 a University of Dallas/GW Equity survey of companies with $1 million to $150 million in revenues indicated that three out of four business owners intended to sell their business within three years, predominantly due to age concerns. Valuations since 2006 have declined significantly due to declines in earnings, which made many owners reluctant to sell. However, with a lack of strong fundamental catalysts for economic growth, many of these owners are questioning their decisions to continue in the market, in addition to the fact they are five years older than when they intended to sell originally.
For the strategic acquirer these trends present enormous opportunity. Surviving firms in today’s market have rightsized their balance sheets, lowered overhead and refocused on core competencies. Furthermore, employees who have survived the layoffs are talented and seasoned and searching for opportunity. Thus, if a firm can be found that fits an acquirer’s strategic objectives, a purchase can provide strong returns even prior to any potential synergies. In other words, the value proposition for creative, strategic acquirers is more compelling than ever.
A STRATEGIC FRAMEWORK FOR ACQUISITIONS
As our colleague Lee Smither pointed out in “Rethink Your Market Strategy and Grow”,1 growing any construction firm is a choice. And while not all growth is good, as explained in “Why Contractor’s Fail,”2 not growing can often be more dangerous than growing. This is not to be understated — by deciding to wait for better times, you place your firm’s competitive position, human capital and overall customer value proposition at risk.
Choosing to grow, especially through acquisition, must be approached strategically. To do this effectively, your firm must identify what it wants and why, well ahead of looking at specific opportunities. Many acquisitions are made simply because an opportunity came along, not necessarily because it represented the best alternative available. Given today’s environment, now is the time to actively pursue opportunities within a strategic framework, rather than sit back and wait for them to come to your doorstep.
To do this, the best acquirers in the construction industry utilize a top-down analytical process that flows directly from their strategic planning objectives. This type of process typically involves multilevel analyses designed to answer the following questions:
- Macro-level Analysis — What macro-level forces will affect our firm over the long term?
- Market-level Analysis — What market dynamics will provide the best opportunity for our firm to find margin and sustainable profitability?
- Micro (or Company-level) Analysis — What company type best fits our culture, operational structure and return requirements?
The purpose of these analyses is to identify major trends and get ahead of them; identify markets that will provide opportunities for sustainable, above average margins; and find companies in a strong position to leverage both the market dynamics and the macro-level trends while fitting within the acquirer’s culture.
THE MACRO-LEVEL ANALYSIS
Macroeconomic, social and political forces have a powerful effect on business. These forces are often intertwined but can dramatically affect certain sectors of the economy while leaving others unscathed. The purpose of the macro-level analysis is to first recognize high-level trends and secondly attempt to understand what their likely impact will be on the future.
Of the list of trends in Exhibit 1, how many of them have affected your business? How many of them will affect your business over the next five to 10 years? In all likelihood, your firm has been impacted dramatically by several of them, whether the decline in residential markets created new competitors in your core markets, new regulation increased employee costs, or social media altered the way you interact with potential customers.
As your firm kicks off its strategic acquisition process, you should develop a list of trends and discuss the following questions:
- Does this trend present an opportunity or a threat to my current business?
- Does the trend affect my competitors equally?
- What opportunities does this trend present?
- Does the trend provide risks to other segments of the economy, which may then influence ours?
For example, the technological development of horizontal drilling and fracturing of natural gas shale resources has had a major impact on U.S. energy markets and certain geographies like the Marcellus shale in New York and Pennsylvania and the Haynesville shale in Louisiana. This trend has also created strong demand for infrastructure in these areas and has boosted pipeline construction nationally. Has this brought new competitors to your markets? Does it present an opportunity or a threat? Could cheap natural gas resources alter the construction plans of utilities, which could then affect your ability to earn work?
Interest rates are another example. With bond rates at record lows, companies are currently earning little to no interest on cash balances while also paying higher prices for key materials, like fuel and metals, as the value of the dollar declines. This squeezes the margins of companies of all types. If this dynamic accelerates, does it provide your firm an opportunity or a threat versus your competitors? Are there relationships or strategies you have used to combat this dynamic that may provide an opportunity to gain market share?
Once you have answered these questions, you will likely have a better understanding of potential future risks and opportunities. More importantly, you will likely have an idea of what markets might represent strong opportunities for further consideration.
THE MARKET-LEVEL ANALYSIS
The macro-level analysis will likely spur thought about the attractiveness of several markets. However, market-specific factors will play a large role in whether businesses in that market will be successful. When analyzing markets, specifically consider the following factors:
- Procurement Environment — Is the market primarily hard-bid, negotiated or T&M-type work?
- Barriers to Entry — Is there a barrier to new competitors? Typically, barriers in contractor markets are limited, but those that exist are driven by expertise, capabilities and bonding requirements.
- Customer Profiles — How many owners are seeking work? What is their level of sophistication? Do they see “value added” as important, or do they look for contractors primarily based on price?
- Purchasing Advantages — Do any competitors have purchasing advantages or self-perform capabilities that provide cost structure advantage?
Each of these factors has a strong impact on the sustainability of margins for the contractor. For example, in a hard-bid environment with no barriers to entry and little customer concentration, opportunities are abundant for new market entrants to compete on price. Thus, if you are considering entry to that particular market, you must be able and willing to compete effectively on price, likely driven by either self-performance capabilities, purchasing advantages or another form of competitive advantage such as bonding capacity. This may be one of your firm’s competitive advantages currently, in which case further analysis may be warranted. Typically, however, these types of markets are hypercompetitive and not likely to produce sustainable margins over time.
On the other hand, a market that typically consists of negotiated work, requires a higher degree of expertise and serves larger, more sophisticated customers is going to have more sustainable margins, as entering the market requires both knowledge and the development of relationships with key customers that likely are already being served effectively.
The key to this analysis is understanding what significant competitive dynamics drive profitability in each market, and whether or not you believe competitive advantages can be maintained given the macro forces that are driving your firm’s view of the market. Once you have determined that a sustainable advantage can be found in a market, company-specific search criteria can be examined in the micro-level analysis.
THE MICRO-LEVEL ANALYSIS
Once you have identified markets that are attractive, the next step is not to identify candidates, but rather identify the characteristics of companies that fit with your firm on an operational level. This analysis often includes consideration of the following:
- Cultural — If you are a firm working primarily in hard-bid markets, can you acquire a smaller, high-margin “value-added” company and have it fit in culturally? What cultural factors lead to employee success at your firm?
- Operational — What are the operational characteristics that provide competitive advantage in the marketplace? Self-performance? Specific capabilities? Government clearances?
- People — Do you require a leadership pipeline to enter this market, or is it an opportunity for internal candidates?
- Return requirements — What types of returns are required to make an investment in another firm worthwhile? How much capital is available?
As anyone who has been close to acquisitions knows, the micro-level drivers can present tremendous complications when it comes to integration. The lean, hard-bid general contractor acquiring the marketing-driven, LEED-certified, negotiated general contractor will undoubtedly have some cultural issues. Thus, a leadership pipeline within the target company is going to be essential and your employees are unlikely to move between the merged organizations effectively. Evaluate these concerns and develop a list of company-specific criteria that are going to be important once individual candidates are identified.
PUTTING IT ALL TOGETHER
In this process, a firm will identify macro-level forces that are both threats and opportunities, recognize the markets that are most likely to provide sustainable margins and develop the specific, company-level criteria that the firm needs to acquire to be successful financially, culturally and operationally. A summary output might look like something in Exhibit 2.
The last step in the process is an active, iterative undertaking. Senior managers must constantly be questioning assumptions, analyzing new macro forces and considering whether the conclusions reached remain relevant and accurate. If a Republican president and Senate are elected in 2012, the example “green job trend analysis” above may be dramatically altered. If health care legislation increases funding for those living in retirement communities, it might increase the attractiveness of the above example of “aging population analysis”.
Like investing in the stock market, acquisition strategy requires constant analysis. Having an established framework in place will provide structure to your firm’s thought process and improve the likelihood of finding an acquisition that facilitates the long-term growth of your company.
Today’s economic environment presents unprecedented challenges to the construction industry. However, great acquisition opportunities are sometimes identified in the most uncertain conditions. The question for acquirers is how to separate the winners from the losers, through a strategic framework that provides insight on the ultimate drivers of business success.
The analytical frameworks outlined in this article provide construction firms with an introduction to some of the basic tools that can be used to consider acquisitions. Proactive pursuit of acquisitions in today’s market offers an opportunity for favorable valuations, buyer-advantaged deal structures and the opportunity to recharge employee morale. Competitive advantage is truly on sale— will you be a buyer?
Timothy R. Sznewajs is a managing director with FMI Capital Advisors, Inc. He may be reached at 303.398.7214 or via email at firstname.lastname@example.org. Scott Duncan is an associate with FMI Capital advisors. He may be reached at 303.398.7250 or via email at email@example.com.
1 Smither, L. (2011) Rethink Your Market Strategy and Grow. FMI Quarterly (2011 #1).
2 Rice, H. & Heimbach, A. (2007). Why Contractors Fail. FMI Quarterly (2007 #2).