Mapping the future – Learning from recent industry turmoil
In recent years, major industry players have suffered large losses and have even collapsed. Uneconomical payment terms, poor balance sheet management and low margin contracts have resulted in difficulty converting operating profits into operating cash flow with many, including Carillion, Kier and Interserve suffering.
A key criticism is that some players have taken on too many contracts that make relatively poor returns and which they struggle to deliver. Through vast ‘empire building’ companies accepted contracts that they would be unable to complete profitably and also acquired businesses aggressively. This resulted in a domino effect on their finances as payment cycles became stretched thus damaging relationships with sub-contractors and suppliers. As a result, many amassed huge debts which began to snowball as costs continued to rise resulting in administrations, parts of businesses being sold off and thousands of job losses.
Sector operators now have these failures as examples – so are increasingly looking to maintain and enhance strong relationship with their suppliers, while properly investigating contracts before accepting. Those businesses that take heed of recent failures will remain profitable and attractive to investors and acquirers alike.
Through vast ‘empire building’ large companies accepted contracts that they would be unable to complete profitably and have also acquired businesses aggressively.
Shaping up with technology
Operators have an opportunity to serve emerging 21st century infrastructure trends such as ‘smart cities’, connected transport, the Internet of Things and utility control automation by leveraging 5G to meet specific performance, bandwidth requirements or improve margins and job allocation efficiencies.
Utilities and infrastructure operators, alongside service providers, are planning to capitalise on 5G by providing locations for small cells and base stations which can be used in traffic signals, street-based CCTV, passenger information devices at bus stops, and other roadside information devices.
Customer demand is also driving the need to build connected infrastructure with UK data consumption having grown c.7.5 times since 2014. Unfortunately, the current infrastructure is struggling to keep up with this demand with only c.60% of the UK having appropriate 4G coverage. Described as a ‘digital desert’ the UK has less 4G coverage than Albania, Romania and Peru ranking 54th in the world – creating significant opportunity for providers and investors in a growing market. Those who are unable to adapt or acquire the relevant technology or skill-sets, will surely be left behind as the global race to adapt to an increasingly connected world continues.
Although there are clear avenues for growth, future government legislation is far from clear cut. A change in government has the potential to reverse the current governments’s commitment to infrastructure upgrades and expansion, with c.£188bn promised by 2021 and an extra c.£225bn beyond this. Currently, no-one is able to predict what impact political uncertainty – regulatory, economical or otherwise – could have on the UK, resulting in hesitancy to invest in the sector.
The historic need for private ownership has been clear as upgrades and maintenance work have been facilitated this way. Similarly, deregulation has created opportunities and outsourcing has improved efficiencies through specialist skills and best practice initiatives. Since privatisation in 1989, around £160bn has been invested in the water industry and customer bills are roughly the same in real terms as they were 20 years ago.
The threat of nationalisation has meant that many foreign pension and investment funds have opted to shift their stakes in UK utilities to jurisdictions such as Hong Kong, where bilateral treaties protect against asset expropriation. Increasingly, lawyers are seeing clauses added to bonds to ensure holders are repaid immediately if an asset should be nationalised, as investors grow anxious around British utilities.
If we are to continue to take major strides forward, we need to see politicians, regulators and companies able to work together – this should come in the form of effective legislation. The UK needs inward long-term investment from institutional investors to help fund the pipeline of critical infrastructure improvements, particularly to meet ambitious carbon reduction targets, upgrade the UK’s ageing infrastructure and meet timetables for large capital expenditure projects.
If we are to continue to take major strides forward, we need to see politicians, regulators and companies able to work together to continue to progress – this should come in the form of effective legislation.
Bifurcation of operating models
In recent years, infrastructure and rental services providers have moved towards two types of operating models:
- Traditional – that operates a pure-play service model
- Modern – owns either ‘last-mile’ assets or rental hardware
The traditional operating model’s focus is on public facing professional service delivery, while the latter is a more recent development where service companies have started to venture into asset ownership. This has normally taken the form of owning ‘last-mile’ assets such as, water and/or gas pipes, electricity cables, utility meters, or telecommunications towers, and through acquiring specialist rental companies.
The benefits of a combined model include:
- capturing an increased share of client spend;
- an ability to capture margin from other operators;
- attractive annuity style cash flow dynamics from owning the asset; and
- barriers to entry through economies of scale.
The differing operating models often lead to differing valuation levels both on public markets and in transactions. Owning ‘last-mile’ assets is seen as a strong value driver and differentiator through its differentiated annuity enhanced revenue model and underlying asset value. Traditional operating models can also achieve strong valuation levels if they have a strong track record, are multi-disciplined and of scale.
The different operating models have also widened the investor universe looking at the sector which now includes (alongside traditional private equity) debt funds, pension funds, sovereign wealth funds, patient capital and infrastructure funds.
As questions around the future of the industry continue to be raised, in order to ensure business longevity and future profits, operators in the space should look to exhibit, or investors looking at assets should focus on, the following characteristics:
• Strong revenue visibility – contracted or repeat revenues typically with 3-5 year contracts
• Scale and multidisciplinary offering
• A track record of financial stability – minimal margin volatility, strong balance sheet and cash flow management, demonstrable track record of accretive M&A
As long as market conditions remain benign investment into the sector and consolidation by large market players should continue.