2020 Construction Industry Outlook (So Cal Edition)

It’s been a good last few years in the construction industry, certainly here in southern California.  Most contractors have been reporting year over year revenue growth and strong profits.  Most contractors in the 10M to 25M revenue range have taken advantage of the recent law change allowing them to report taxable income on the cash basis method helping them boost cash reserves.  Larger contractors are generally ensuring their job budgets include contingencies resulting in conservative profit estimates.  Times are good.

Looking ahead, we see strong backlogs for most contractors.  We can already see a strong schedule through 2020, with many booking work in 2021 and some projects scheduled in 2022 as well.  Of course committed backlog isn’t a guarantee of precisely when that work will actually occur, however the backlogs we are seeing look good into the near future.  Many here in southern California point to some large scale events that will be visiting our region in the coming years as support for our market.  These include the following:

·         Super Bowl, being hosted in SoFi Stadium in Inglewood in 2022 (construction ongoing)

·         World Cup Soccer in 2026, Rose Bowl among the U.S. venues.  Canada and Mexico will each get 10 matches in this tournament as well.

·         2028 Summer Olympics, Los Angeles is the host city.  The events will use many venues already built or under construction, with a new arena in Inglewood proposed for construction for use by the LA Clippers.  There are many infrastructure projects on the boards for the LA area in anticipation of this event.

In addition to the work that will need to be done in anticipation of these events, there are many projects starting or proposed here in southern California.  Even if you aren’t associated with any of the big event projects cited above, construction resources will be utilized by those projects taking supply out of the market.  This should help with both opportunities to win new work as well as bolster pricing.

The rising tide doesn’t necessarily float all boats, although it does for most.  If a contractor isn’t making money in the last year or two, likely the issue is company specific.  Boats with holes don’t float in any tide.  We have seen a few cases where contractors in the market are having some challenges, however we can usually identify key areas they need to address.  Examples include not dealing directly with personnel issues (poor execution in their roles) including challenges with transitioning the business to new leaders.  If an owner is looking to pass the baton on to the next generation, s/he must make sure that the new leadership has a good grasp on that baton before letting go.  Labor is always the most difficult variable to manage, across all levels of the organization.  Be sure to address, in a direct and timely fashion, any issues your business may be encountering.  If one can’t make money in these times, it won’t be any easier when things slow down.

In summary, the outlook remains bright for at least the near term.  The hope is that the activity southern California will be enjoying over the next several years will continue to support the market.  As we know, it’s a cyclical industry and we are bound to see a slow-down at some point.  The last recession we saw 10 years ago was the “Great Recession” and was painful for many.  The next recession likely won’t be as deep or as long however it will still need to be managed.  For now, enjoy these good times and as always, have a plan ready for when things get slow.

Getting The Most Value When Selling Your Business

I was recently asked to speak about how business owners can maximize the value of their business as they prepare for an exit.  More and more business owners are starting to think about the next chapter in their lives and the demographics support this.  Note the following:

·         One quarter of business owners today are over age 60 (Source: Kiplinger Letter May '19)

·         Many of those intend to sell relatively soon, half of them within 5 years (Source: same)

·         Few of them have a solid exit strategy in place (Source: same)

Generally, it is best to have a 3 to 5 year runway of planning to execute a proper exit strategy.  The more time one gives to the process, the more options will be available.  The following are some bullet points I covered in my talk:

·         Valuation is key, depends on your sector, past performance, future outlook, composition/quality of customer base, management team, etc.

·         Re: management team, buyers just don’t buy businesses, of course they are also buying talent.  The more talent you have in management beyond the owner, the more valuable a business is.  If the business relies heavily on its owner, it’s more of an alter ego and lesser so a business.

·         During a potential sale, when going to market, stay focused.  Stay focused on business execution to maintain strong results (i.e. business value).  It’s easy to get distracted by the prospect of the exit, whether sale, ESOP, etc.  If business results start lagging, often so too will the value of the transaction.  Further, not all transactions are completed and if your business weakens as you lose focus, it's all your problem to solve when a deal falls through.

·         Have a strong accounting/reporting function.  The owner may know what is transpiring in the business, but outside parties such as prospective buyers and their due diligence teams, valuation firms (including for ESOP), etc. do not.  They rely on strong financial reporting to understand the intrinsic value of the business.  Incidentally, strong reporting is also useful in running the business regardless of potential exit.

·         Have a written strategic plan.  While the reporting function tends to tell the story of the past, a strategic plan provides insight into the future.  At the end of the day, valuation of a business is a discounting mechanism of the future cash flows of the business.  The strategic direction outlining opportunities/threats and how to address them is a useful document for prospective buyers as well as management.

·         Get year end CPA audited or reviewed financial statements.  Having this outside attestation regarding the quality of the financial statements is another useful resource for outside interested parties.  This will lend credibility to the financial data used by prospective buyers and valuation firms.

·         Curtail discretionary spending and ensure normalization of earnings during due diligence.  There are certain types of expenditures that a strategic buyer would not incur and those should be added back to earnings for a proper measure of enterprise value.

·         Run lean.  Ensure efficiency with your labor force.  This is one of the most difficult areas to manage in a business and not having unnecessary slack capacity is helpful to force efficiency into your business and improve earnings results, a key driver in valuation methodologies.

·         To the extent possible, avoid customer concentrations.  This is often times the norm, however mitigating these concentrations when all other things are equal is good to avoid questions with the associated risks and a potential downward adjustment to value or worse, a deal not happening because of them.

·         Build quality backlog (as you would ordinarily do).  Backlog is a clear indication of future earnings and will be built into the measure of enterprise value.

·         Sell at a good time in the cycle.  This seems obvious, but is sometimes hard for business owners to do.  Similar to walking away from the blackjack table when you are ahead, selling at a time of strong earnings and future prospects will lead to a higher valuation.  Waiting until the next downturn when things are not looking quite as good and when others are also looking to get out will have downward pressure on value.

·         Understand your enterprise value.  If you don’t, there is a risk you will not get a fair price for what you’ve built.  Be sure to have professionals on your team that can help in this regard.  You need to know the right price to make an educated decision regarding offers.

·         Understand the tax implications of the proposed transaction.  Entity structure, transaction type (e.g. stock vs. asset deal), and a myriad of other factors can significantly affect the net amount of the transaction.  It’s not what you sell for, it’s what you keep after taxes that counts.  Again, be sure to have professionals on your team that can help.  Work with these professionals on deal structure to maximize the benefit for all involved, both seller and buyer.  It’s generally best for all parties to “win” in any transaction.

·         Do not be distracted by purchase price.  There are other considerations such as non-compete, cash vs. credit (or some combination), the deal vs. the “after-deal” for you and your employees.  What will professional life look like for you and/or your team after the deal consummates?  Will your key people be happy in the new environment?  Will your customers be happy?  Is this the right fit?

As you can see, there are many considerations when thinking about your off ramp from business ownership.  The longer that off ramp is, the more likely it is to be smoother.

Transitioning your Family-Owned Business to the Millennial Generation

Family-owned businesses are a strong part of the fabric comprising the American business landscape.  They create an environment full of dynamics, both wonderful and challenging.  One area we are advising in more and more lately is business transition from one generation to the next.  We have a number of companies we work with where the business is being transferred to the Millennial generation.  For the last several years we have heard of Millennials and their place in the workforce.  Now, we are seeing examples of businesses, both large and small, where individuals in their mid- to late-30s have controlling stakes in their old line, successful family businesses.

These individuals are bright and eager, and now have the daunting task of leading their family business forward to the next chapter.  It is exciting for us to be an integral part of their team of trusted advisors.  These young owners lean on us to help solve problems in both financial as well as the operations side of the business.

In one case a father is selling majority ownership to his son.  The challenge is the method used to value the business was based primarily on the father’s monthly personal cash flow desires versus the true value of the business.  The valuation used was approximately double the true value.  That company is now in the process of bringing the valuation in line with reality and restructuring the debt.  In addition to constraining working capital for operations and growth, sufficient capital would not have been available to properly reward the efforts of the management group and employees.  Difficult conversations are being had; however, ultimately it is critical that fairness prevails - to all those who rely on the business. 

Other examples of Millennial owners being consultative include two late-30s owners taking over from one of their fathers.  Their management and financial reporting systems lack the quality needed to properly reflect the results of their operations and manage key performance metrics on a regular basis.  Our team is working with them to put the appropriate systems in place and train them on how to maintain and use the data.  In addition, we identified a number of areas in their tax returns that resulted in their business paying too much in taxes.  Lost tax deductions had cost them tens of thousands of dollars annually.  We were able to amend their prior tax returns within the statute and recapture those monies.  Another set of young owners who broke off from their former employer to start their own engineering firm is relying on us for similar consultative and tax services. 

We are working with young owners, helping them become high-level business operators by providing an education in business ownership and management.  It's great when we can help that next generation of young and eager new business owners looking to take their businesses to the next level!

4 Reasons Contractors Fail

As things continue to go well in our market for the building economy and contractors are generally doing well, it's always good to avoid complacency and stay true to sound business practices.  This month we'll take a look at four key areas of running the business of a construction company.  I say it this way because, regardless of sector, owners and CEOs need to manage the overall business of whatever it is their company actually does to generate revenue.

In times where revenues are strong and margins are decent, inefficiencies throughout one's business can be "covered up".  Strong revenue is, to some extent, a "cure" for less than optimal business practices.  Even though your business may not be feeling the effects of not performing well in these areas today, when the market gets tougher you certainly will.  Now is the time to ensure you have these areas covered before you get into crisis mode.  The piece below puts a focus on the following four key business areas:

1. Insufficient cash flow/working capital

2. Poor estimating/job costing

3. Expanding too quickly

4. Lack of Succession Planning

Construction Industry Financial Update and ABI Check

As we get to mid February many of our contractors 2018 numbers are rolling in, with results showing it was a good year for most.  Net profit margins are above average, with the majority reporting solid financial results for the year.  The challenge isn’t so much finding new work, it’s more finding qualified labor to execute on the abundance of work that is out there.

In construction, we get to see what is ahead in the short/intermediate term by virtue of the backlog as well as bid log, new contracts right around the corner.  Backlogs in our market today are strong, with work being scheduled filling out the balance of 2019 for many contractors with some work being slated for 2020 and even 2021 in some cases in our portfolio.  Prices used to bid new work today are generally designed to yield above average margins with the capacity being limited by already booked backlog.  Times are good for most right now and we should see positive results yet again for the whole of 2019.

The commercial construction market tends to lag the overall economy, which remains strong across the nation by most measures today.  A widely followed leading indicator for the industry is the Architecture Billing Index (ABI).  For more on that index click here… On a national level, the index for December 2018 was 50.4.  For the West region, the score was 49.2, trending up since October 2018.  In a nutshell, billings are reasonably steady, but not growing in the West in Q4 2018.  However activity, especially for those contractors with solid reputations and relationships, has been good in recent times so steady from that vantage point is not a bad thing.  It is interesting to note, however, that the trend line relating to architectural billings from the beginning of 2018 to the end in the West is down.

For 2019 it seems steady as we go with the relative strength we've been enjoying, with an always cautious eye for when the outlook doesn’t seem as rosy.  Always have that “what if the stuff hits the fan” budget ready for sharp revenue declines so you aren’t reactionary when things get tough.

Tax Depreciation Limits

I wanted to share this handy summary for any interested parties, I hope you find it useful…

Changes to Depreciation (2018 and Beyond)

Bonus Depreciation

Under new tax law, tangible personal property placed in service after 9/27/17 is eligible for 100% bonus depreciation.  Also, the property can be used.  Bonus depreciation drops to 50% in 2023.

Used property eligible for bonus does not include property received as a gift or inherited, or acquired from a related party or common control taxpayer.

Section 179 Depreciation

For tax years beginning after 12/31/17 maximum Section 179 depreciation increases from $500,000 to $1,000,000.  The maximum asset placed in service phase out increases from $2,000,000 to $2,500,000.  For assets placed in service after 12/31/17 Sec 179 is mostly redundant since Bonus Depreciation offers the same 100% depreciation without various limitations (exceptions for QIP and QRP).

Luxury Auto Limitations

These limits have been increased for passenger autos placed in service after 12/31/17 for tax years beginning after 12/31/17.  The depreciation has been increased from $3,160 to $10,000 in the 1^st year, $5,100 to $16,000 in the 2^nd year, $3,050 to $9,600 in the 3^rd year, and $1,875 to $5,760 in the 4^th and subsequent year.  For passenger autos eligible for bonus depreciation, the increase in 1^st year depreciation remains at $8,000.

Heavy SUVs (Gross Vehicle Weight over 6,000 pounds)

The $25,000 Section 179 limit remains but is inflation indexed.

However, bonus depreciation for these vehicles acquired and placed in service after 9/27/17, new or used is 100%.

Pick-Up Trucks qualify as a Heavy SUV if they weigh 6,100 to 7,050 pounds and the truck bed interior length is under six feet.

Qualified Real Property – 4 Categories

Due to the PATH Act of 2015, there are four categories of qualified real property, each with its own set of requirements and limitations, effective 1/1/16.  Note that none of these apply to residential real estate. The four categories are discontinued after 12/31/17.

Leasehold Improvements, retail improvement, and restaurant improvement property are 39 years for California (for all years).

  

Qualified Improvement Property – (After 12/31/17) This is a new category of property This property is not subject to the limitations in #1, 2, and 3 below.  Instead, the improvement must be placed in service after the date the building was first placed in service (even the very next day is fine).

Conference Report changed life to 15 year property and allowed bonus.  

However actual new law states 39 years and does not allow bonus (but does include Section 179.) Technical correction is required to allow Bonus and change to 15 year property. 

Not to be confused with 15 year land improvements in which Bonus depreciation is allowed.

Qualified Leasehold Improvement Property – (No longer exists for property placed in service after 12/31/17) This property is eligible for Sec 179 expensing, bonus depreciation, and 15-year depreciation.  This is an improvement to an interior portion of a building:

1.    Pursuant to a lease that is not between related parties, and used by either lessee or lessor.

2.    The improvement is placed in service more than three years after the building is first placed in service.

3.    Does not include common area of the building.

4.    Cannot include enlargement of the building, escalator or elevator, or internal structure of the building.

QRP (Qualified Real Property) also qualifies as QIP (after 12/31/17) and includes roofs, HVAC property, fire protection and alarm systems, and security systems.

After 1/1/18 a restaurant building does have a special 25 year life but is no longer eligible for Section 179.

Changes in Depreciation if electing out of Business Interest Deduction Limitations 163(j)

A real property trade or business electing out of the business interest limitation must depreciate

any nonresidential real property, residential real property and qualified improvement property in accordance with ADS (Alternative Depreciation System).

Nonresidential real property has an ADS class life of 40 years.  QIP property in this class is not eligible for bonus depreciation under ADS (this would be applicable if there is a technical correction in the law).  Residential real estate under ADS is 40 years if placed in service 2017 and earlier and 30 years if placed in service 2018 and later.

Existing residential real property that is required to be depreciated under ADS will have their depreciation lengthened from 27.5 to 30 years if originally placed in service 1/1/18 or later.  If originally placed in service 2017 or earlier the depreciation is lengthened from 27.5 to 40 years.  Nonresidential real property depreciation increases from 39 to 40 years.  This change to ADS depreciation will likely be the case for most of our real property trades or businesses that have interest expense.

An electing business must depreciate both existing property and new property under ADS in the election year and in subsequent years.  If this is properly done then a form 3115 for change in accounting method is not required because a change in computing depreciation for the election year for existing property is not a change in accounting method.