We are in strange times. The Federal Reserve Bank is increasing the effective fed rate in an effort to cool inflation, which is a response to a hot market. And yet demand persists. People keep spending money on houses (if they can find one), cars, COVID revenge travel, etc. Where is our pain threshold? How high do interests need to go before the market taps out? While one data point does not define a trend, the most recent report on Architectural Billings Index (ABI) published by the American Institute of Architects, delivered a 50 handle. The ABI is a nine-to-twelve-month leading indicator of building construction activity, with ABI measures above 50 indicating that billings are increasing and those below 50 signaling a decreasing billings. So July's reading is neither going up nor down. Is this the breaking point?
The details show a more mixed picture. The Midwest has increasing billings, while the other geographic areas are down. In terms of product, Commercial/Industrial and Institutional are up while Multi-family and Mixed Practice are cratering. Project inquiries, a measure of people planning projects for the future, is above solidly above 50, but it is way below the average for the past 11 years. Good news plus bad news equals break even.
The next few months will be very revealing. While the Fed indicated a week ago that they are done hiking rates for the near term, it is maintaining optionality to increase funds later this year. Which is Latin for they are waiting for more info before making a definitive call. Just like the rest of us. Until then, hold on tight.
The details follow:
For as long as I have been analyzing construction economic data, I have been fascinated by backlog. Backlog, expressed in dollars, is the amount of work companies are contracted to perform in the future. Backlog can also be expressed in time (typically months) as the amount of work that would keep a contractor busy if no other contracts were executed. Essentially, it is a measure of how busy contractors are. The Associated Builders and Contractors (ABC) tracks backlog and reports it monthly and their methodology can be found here.
Backlog is important, because it is a proxy for a contractor’s near-term economic health. If a company has a strong backlog, it can either be more selective about the additional work it pursues and/or increase its proposed fee on the work it pursues. If fees increase, profit, in theory, should also increase. On the flipside, a relatively small backlog indicates weakness, implying contractors must chase work more aggressively, typically eroding profitability.
Given that backlog is used to gauge an architecture/engineering/construction (AEC) company’s economic health, it would make sense that people with an economic interest in an AEC company would want to know the backlog to help determine if they should hold or sell their investment. Sure enough, for companies that must report financial performance, chiefly firms that are publicly traded on major U.S. stock exchanges, they do tend to highlight their backlog as an indicator of future performance. There are not that many publicly-traded AEC firms, but in the construction financial press, AECOM, Fluor Corporation, Granite Construction Inc., Jacobs, and Tutor Perini, prominently report their increasing backlogs. Whether the financial reports are good, bad or ugly, backlogs are typically featured prominently to magnify good news and deflect bad news. Think I am being cynical? Check out the press releases from this recent quarter:
My curiosity having been piqued, I wanted to use publicly-available financial data to see if there is a simple link between backlog and profitability. Hoping to avoid performing a linear regression to determine any causality, I will compare the financial performance of the five previously-mentioned firms from the most recent quarter to the corresponding quarter 10 years prior. (That sentence was not completely correct…I actually really want to perform a linear regression as it will scratch my nerd itch. But given a lack of time, I’m hoping to catch lightning in a bottle with an incredibly basic analysis.) Before diving into the results, keep in mind that total construction spending in the United States increased from $ 2,784,938 million in the third quarter of 2013 to $ 5,772,918 million in the second quarter of 2023 (10 years total), and increase of 107.3%. Over that same period, the United States Gross Domestic Product (GDP) increased from $ 16,911,000 million to $26,834,001 million, or 58.7% increase (yeah, those are really large numbers). We want to normalize the five AEC companies’ results against a raising U.S. economy over those 10 years, as revenues and backlog should catch a tailwind and grow as the U.S. economy grows.
The figure above is comically small, so I will summarize it in bullet points:
Based on connecting two reporting periods ten years apart, there does not seem to be a strong link between backlog growth and profitability. There are a lot of holes in the analysis, chiefly:
While not pure-play contracting entities, the companies analyzed above are AEC industry bellwethers. I would greatly like to add some publicly construction companies to the database, namely Skanska and Balfour Beatty, but they are listed on European exchanges and thus have different reporting requirements (different measure of profitability), so that will take some time. As for more in depth data analysis, it looks like my next move is a linear regression. Stay tuned for those results. Until then, there is no obvious correlation between increasing backlog and increasing profitability based on this basic analysis.
In a previous post I showed how architectural billings, a leading indicator of construction activity, has been very up-and-down since early 2021 after rocketing upwards from a pandemic-induced crater. In theory, contractor activity should similarly move similarly lagging by nine to 12 months. But that has not happened. Backlogs have steadily moved upwards since the tail end of 2021. Given that increasing backlogs are a proxy for how busy contractors are (and by extension, if backlogs increase, so should contractor pricing power, leading to higher fees), this is positive news that outperforms the AIA ABI expectations.
The above curve plots the average backlog by quarter, so the curve is smoothed. If we drill down into the month-over-month data, it reveals more, albeit mild, volatility. Overall backlogs are unchanged from May, but drilling into the industry breakdown shows some randomness, with Heavy Industrial down big but Infrastructure up even bigger (Federal infrastructure bills perhaps? Infrastructure is up over 40% year-over-year). The story is similar for regional and company size breakdowns.
The reductive hot take is that it is a good time to be a $50-100 million per year contractor performing infrastructure work in the northeast and midwest markets.
More detailed information is below:
The Architecture Billings Index (ABI) as reported by the American Institute of Architects (AIA), is clinging to the increasing billings side of the ledger with a 50.1 handle for June. The ABI is a nine-to-twelve-month leading indicator of building construction activity, with ABI measures above 50 indicating that billings are increasing and those below 50 signaling a decreasing billings. While June's reading was down from May's 51, this is the first two-month positive streak since August/September of last year.
The data was largely mixed, with half of the sub measures above 50 and four of ten increasing month-over-month. Seven of ten measures are down year-over-year, with the West falling by almost 16%.
While the architecture/engineering/construction market clearly ripped up from the COVID chasm, the ABI performance has whipsawed since 2021. While the industry seems really busy, the capacity to deliver projects has been hampered by supply chain issues, lack of labor and, more recently, increasing interest rates. As long as those headwinds persist yet demand remains high, we will likely continue to experiencing seesawing ABI figures.
Detailed data can be seen below:
I read an interesting article last week that discusses how current market uncertainty has created a divide between winners and losers in the construction industry. That article was great foreshadowing for the March results of the Architecture Billings Index (ABI) as reported by the American Institute of Architects (AIA). The good news is that overall billings increased month-over-month, clocking a 50.4 handle in March, up from 48 in February. The bad news was widespread declining billings in the sub categories. Adding insult to injury, the numbers are way down on a year-over-year basis. A quick reminder that the ABI is a nine-to-twelve-month leading indicator of building construction activity, with ABI measures above 50 indicating that billings are increasing and those below 50 signaling a decreasing billings. The overall billings tend is displayed below, with March's figure peeking just above the 50 line:
A dive into the details shows the extent of the carnage. While there were month-over-month improvements in the ABI in all geographic regions save the West and there were big sectoral gains in Commercial/Industrial and Institutional projects, only the Midwest and Mixed Practice have an increasing rate of design billings; all other sectors are decreasing. So the positive overall ABI of 50.4 is being propped up by projects in the Midwest and Mixed Practice projects. Everything else is a drag. If we zoom out and look at ABI performance over the past year, we see darker clouds. The overall ABI, as well as many sub-ABI measures, are down by double digit percentages. Multi-family, once the darling of the AEC industry and the sector that managed the COVID pandemic the best, is falling like a stone with a drop of almost 23%.
It's not time to panic. With the construction market starved for labor and still finding it difficult to procure materials, having some sectors cool while others heat up will keep many contractors busy for a while. Furthermore, many of the sub ABI figures are flirting with the 50 level, meaning a few good months of future performance could turn the tide. Chances are we will just have to become comfortable with this "on the one hand, on the other hand" type of fluctuating good/bad news cycles. A lot of people watching the banking industry are wondering if lenders with a lot of commercial real estate loans on their books are the next shoes to drop in the Silicon Valley Bank/First Republic Bank failure melodrama. If weakness is revealed, I suspect the breaks will lock up on the design and construction industry. Let's hope not.
Detailed regional, sectoral and contracts information is as follows:
It has been a while since I wrote about contractor backlogs and I picked a lousy month to restart. Backlogs declined across most categories, deeply in some cases. Backlog can be represented two ways. It can be measured in dollars as the amount of future work under contract. Conversely, it can be represented as the duration of time that a contractor will be busy without adding any additional work. In either case, it is a representation of how busy contractors are, and when contractors are busy, it is a sign of a robust market and increased pricing power for contractors. Backlog will be represented below in months, and the overall industry backlog decreased from 9.2 months to 8.7 months. On a quarterly basis, backlog has moved sideways since Q2 2022. Keep in mind that backlogs have been increasing in fits and starts since bottoming out in Q4 2020 due to the COVID-19 pandemic.
Digging into the detailed data shows widespread drops in backlog. As with most economic data, there are some pockets of good news.
First the good news: the South remains a hot region for construction. Also, and I find this very interesting, backlogs increased for all size categories except small contractors (<$30 million in annual volume). Unfortunately, that's where the good news ends. Backlog for smaller contractors was down sharply, and the news was worse in the all regions except the South. The real pain was saved for the heavy industrial and infrastructure categories.
If we zoom out to the year-over-year data, the picture is a bit better, with eight of 12 categories increasing. But the infrastructure numbers are confounding. Given all the government funding being rotated into infrastructure, I would expect backlogs to be growing. However, it may just be a while before we see infrastructure construction to increase as many projects may still be in design. We will just have to see how that category evolves over the next few years.
For more details on how the data has evolved since 2009, keep scrolling.
For those of you following the financial press, much of the discussion is about what moves Jay Powell his and his fellow voting board members of the Federal Reserve of the United States will do with the Federal Funds Rate. Simply stated, the Fed Funds Rate is the interest rate that depository institutions, such as banks and credit unions, lend their reserve balances to other depository institutions. The Federal Reserve is currently increasing the Fed Rate in an effort to make it more expensive to borrow money, and hence, more costly to finance goods (both personal and business). The Fed is doing this to purposefully cool the economy to tame inflation.
The construction industry is highly dependent on credit. (In the simplest terms that deserve their own post, most construction companies need to borrow money to complete projects due to cash flow challenges created by the mismatch between project expenditures and progress payments received. Also, the construction industry is equipment dependent, much of which is financed.) So if the Fed is increasing the Fed Rate, and by association the cost of borrowing, what is happening to the cost of capital for players in the construction industry? Does the construction industry cost of capital increase similarly as the Fed Rate?
The answer is yes.
Before revealing the data, some background. The cost of capital being used is the weighted cost of capital (WACC) based on a company's blend capital sources, chiefly common stock equity, preferred stock equity and bonds. Equity is most often associated with public companies and the data represented is for publicly-traded companies (as provided by Prof. Aswath Damodaran of the NYU Stern School of Business). The overwhelming majority of construction companies are not publicly-traded. Most are privately-owned small businesses, so that is a weakness of the data below in terms of applying it to the entire construction industry. But publicly-traded companies must report their finances, so that is the available data. All that being stated, below are the WACC for engineering-construction companies and building materials companies compared to the Fed Rate.
The Fed Rate was effectively zero for an entire year (2021 to 2022) and then increased sharply to 4.33% in January 2023. It is currently 4.75% and was predicted to go higher at the next Fed board meeting until Silicon Valley Bank went sideways (due in part to its inability to manage the increasing Fed Rate unlike every other bank save one, Signature Bank in New York, which also recently failed).
The WACC were 5.1% and 5.2% for engineering-construction companies and building material suppliers, respectively, in January 2021. The both moved sharply upwards, in lock step with the Fed Rate to 9.34% for engineering-construction and 9.82% for materials in January 2023.
So what does this mean? Aside from a higher WACC cooling the economy (higher WACC means a higher cost of construction), there are other knock-on effects. In recent years, many large construction companies have been engaging in mergers and acquisitions. M&A takes many forms in the construction industry, from one firm buying another or a division of another (e.g. Pearce Renewables buying Mortenson Renewables), specialty contractors buying companies to broaden scope (e.g. an electrical contractor buying a mechanical contracting company to become a "super sub"), a general contractor forward integrating by purchasing or investing in a self-perform division (a GC buying a company or the equipment to self-perform concrete) or a contractor backwards-integrating into the supply chain to buy a material provider (a company that self-performs framing buying or investing in a company that provides cross-laminated timber). In order to make these types of company (or division) acquisitions or investments in new lines of business takes capital. The more expensive the WACC is, the harder it is to finance acquisitions. And the increasing cost of capital for engineering-construction and building supply companies is correlated with reduced M&A transactions, both in number and in aggregate value (data from Refinitiv).
Correlation is not causation, but it is tough to ignore the connection between increasing WACC and reduced M&A activity. These trends are consistent across other industries as well.
I suspect we will see less expansion of companies (opening additional offices in new geographic locations), contractors focusing deeper on their true strengths rather than diversifying into adjacent business lines, and focusing on supplies or installation but less of doing both. As the economy contracts, builders will stick to what they do best to maintain their highest profit potential.
I read an article today stating that construction employment is up in 45 states last month. Given how busy the construction market is, and should in theory continue to be with government investments in infrastructure, this makes complete sense. Then I went down the rabbit hole: many of the projects we have put out to bid or proposal recently have been coming in at costs higher than expected. Is this due to increasing labor and/or material pricing? The short answer is both, but one in particular.
The supply chain issues since the onset of the COVID-19 pandemic have been well articulated and continue to present times. The lack of labor, due to double whammy of fewer people entering the trades and a mass retirement of people on the tail end of their careers, is also a well know problem. So going further down the rabbit hole, which one is more acutely leading the the increasing cost of construction? It turns out materials pricing has the bigger lever.
While declining 5% since the first quarter of 2022, construction material prices, as measured by the Producer Price Index for Construction Materials, are up over 40% since starting a skyward upward trend in the second quarter of 2020. Keep in mind, the y-axis is relative, with 1982 being pegged at 100.
Labor costs are also up recently, but the increase is much more subtle.
The y-axis on this chart is in dollars. Since 2011, total compensation has increased on an annualized rate of 0.7% per year. Since Q3 of 2021, the annualized growth rate doubled to 1.5%. This is a big jump, but the increase pales to the increases in construction materials.
For the time being, the extraordinary cost in construction can be blamed on material prices. If demand for construction stays at current levels and 1) supply chains get ironed out, and 2) we do not increase the number of people entering careers in the skilled trades, this dynamic could flip and labor costs will be the cause of accelerating construction costs.
The slide in architectural billings continued this month with the American Institute of Architects (AIA) reporting an Architecture Billings Index (ABI) handle of 48 for February, down from 49.3 in January. This is the fifth straight month of sub 50 results indicating a secular decline. The ABI is a nine-to-twelve-month leading indicator of vertical construction activity, with ABI measures above 50 indicate that billings are increasing and those below 50 signal a decrease. After a few weeks of discussing potential bank failures, this result in ABI is an unwanted coda to a period of bad economic news.
There were some slivers of good news in the granular data breakout, but the trends are not great. Billings in the West are above 50, but they are down month-over-month. The South, once the behemoth in activity, continues its slide. The only true bright spot is Mixed Practice, clocking in at 57, up from a robust 56 the month prior. Design Contracts remain above 50, but are way off from a year ago. Only the Northeast, West and Mixed Practice are up over the past year.
The best spin to put on this is that construction activity remains strong (for now...) and the recession that has been discussed for three years has yet to truly materialize. Given stubbornly high construction material prices and increasing interest rates, it is not surprising that design activity has softened. The big question is how long before we pull out of the tailspin. Up or down next month is a coin flip given the headwinds the economy is facing. The detailed data breakouts are below.
There was a lot of news on the employment front. On Thursday March 9, the Associated Builders and Contractors (ABC) reported that the number of construction job openings was almost halved from December 2022 to January 2023 (a decrease from 488,000 to 248,000). This was a shocking development until a few days later when construction employment was reports by the Bureau of Labor Statistics as reaching 7,918,000, the highest level ever. The construction industry has been steadily increasing in employment since May 2021.
Current employment levels are well above the previous peak of 7.7 million in May 2007. This is amazing given the Fortune article published on March 10 (sorry, paywall protected) recounting an anecdote in the latest version of the Fed's Beige Book about a Montana-based contractor that flies its employees around in a private jet to fill operational need. As wild as that sounds, the article cited ABC data that shows we need to hire a lot more people even if the need for construction slows.
According to ABC, if the economy slows, an additional 342,000 construction workers will be needed, or 4.3% more than current levels. Should the need for construction stay at its current rate, an additional 546,000 workers will be needed, or 6.9% more than current levels. Given almost two years of employment gains, including adding 24,000 from the previous month, one might think that we will eventually add enough jobs, even it it takes a long time. But the Fortune article drops another statistical nugget that is terrifying for those trying to hire construction workers: a quarter of all construction workers are over the age of 55, revealing a demographic headwind that will make it incredibly difficult to to ever hire enough workers to meet foreseeable demand.
Increasing wages and a concerted effort to invest in infrastructure by local, state and the federal government, making construction jobs viable for the long term, might help attract people to the industry, but we will need more than that. Immigration reform and automation can also help, but both of those have policy implications. The future is bright for those in the industry, yet we have a lot to do to make the construction industry more appealing to a new generation of employees.