Buyers and sellers who spent 2013 participating in and closing various mergers and acquisitions may be asking Santa for a smooth integration, a rising stock price, or perhaps just some extra help hitting that earnout milestone. And if you’re gearing up for 2014, start making that list as old Kris Kringle is always watching. So for those who have been both naughty and nice, we thought we would reflect on some of the key themes and trends on A/E M&A activity this past year.
|Year||% of Deals <50 Staff||Median Target Staff Size|
At Rusk O’Brien Gido + Partners, we possess strong relationships and years of experience navigating A/E and environmental buyers and sellers through the M&A process and towards winning combinations. Whether you are seeking to grow through acquisitions or by evaluating your firm’s strategic and ownership alternatives, please contact us as to how we can help your organization.
On a final note, Season’s Greetings and a Happy, Healthy and Prosperous New Year from all of us here at ROG+ Partners!
Yes I’m stuck in the middle with you,
And I’m wondering what it is I should do,
It’s so hard to keep this smile from my face,
Losing control, yeah, I’m all over the place,
Clowns to the left of me, Jokers to the right,
Here I am, stuck in the middle with you.
“Stuck in the Middle with You” – Stealers Wheel (1972)
This fall will mark five years since the collapse of Lehman Brothers, AIG, and global stock markets, events which unofficially kicked off the “Great Recession.” For many A/E executives, it’s been an exhausting, unrelenting stretch, and a large number of organizations have still not fully recovered from the halcyon days of the mid-2000s.
Let’s stroll down memory lane. Broadly speaking, the early years of this tumultuous period, 2009 and 2010, were generally characterized by pure survivability. Design firms shrunk dramatically as they desperately reduced staff counts, slashed salaries and benefits, and shuttered offices and divisions. Once considered “automatic,” backlogs started to slowly evaporate and timely cash flow and collections became more elusive. Hunker down. Live to fight another day.
Years 2011 and 2012 saw incremental improvements for many as executives learned to do “more with less,” adjust expectations to a fickle client and a tougher fee climate, and get aggressive on business development in a 1% growth world. Hiring picked up for those “right people” with the golden mix of technical and sales capabilities. Organizations focused on energy, power, industrial, mining or other niche markets came away unscathed as did others not directly tied to building or land development busts. We made it but where’s the recovery?
Alas, here we are in 2013. As the dust has settled, A/E owners have adjusted to this new, nebulous climate. Many will privately admit the last few years have made their organizations tougher and more resilient to future challenges as staffs hung together despite tough headwinds. Time for a victory lap.
Unfortunately, for many leaders who put off, but are now contemplating options to internally transferring shares, these rudderless five years have made that endeavor much more challenging. As a result, leaders are awakening to rudely discover it’s a much different ownership transition climate than it was a mere 6 or 7 years ago. Most common lament we hear – “We’re stuck!”
Based on dozens of executive discussions and client engagements, here are a few of the internal transition challenges and trends we are observing:
More leaders are incorporating ownership transition elements in their strategic planning engagements.
This time of year typically kicks off annual strategic planning and budget/forecast activities. A/E organizations spend a significant amount of time and resources developing strategic plans to help guide them and as yardsticks for performance. These plans typically address items such as which geographic markets or service lines to penetrate, expected client needs, and competitor moves and maneuvers. Traditionally, the strategic and ownership transition planning orbits rarely intersected as leaders compartmentalized them into discrete exercises. Not today. Clients are sharing with us that with more retirements on the horizon, there is a pressing need to address the strategy execution from a leadership void perspective. That means making sure their “bench” is growing with younger, motivated talent and effectively moving blocks of stock to that next generation so they’re not a flight risk. In addition, more strategic planning exercises are also incorporating detailed financial forecasts. This is to ensure that not only do A/E firms have the cash flow and capitalization to meet their overarching strategic objectives but also are prepared for looming stock redemption obligations in a coordinated manner.
Slow growth rates and low profit margins equate to less cash flow to fund ownership transitions. Today’s owners may have to prepare for a future environment of lower value and greater liquidity risk.
For a majority of A/E firms, dampened profitability and tepid growth remain realities. Shareholder returns haven’t reached similar levels to that of the mid-2000s, and this lack of buoyancy has been a double whammy for many owners. On one hand, both dividends (distributions) and capital appreciation have been stymied, and with profit levels down, firms have less ability to pay large bonuses to fund stock transactions. And on the other, liquidity risk has increased rapidly, with younger employees either incapable, or downright skittish, to buy-in due to their own challenged personal financial picture.
Demographic trends today mean more sellers, less buyers.
To no one’s surprise, the 65-year-old+ demographic is expected to grow by nearly 50% by 2030, with broad societal and financial ramifications for our country. For many professional service businesses there are simply fewer individuals in Generation X ready and willing to buy out the larger pool of Baby Boomer shareholders ahead of them. You just can’t make the math work. And in some cases apathetic and disinterested younger staff members are compounding the problem. Unfortunately, the lack of organizational clarity can become downright paralyzing, and “kicking the can down the road” can seem more convenient and less threatening than tackling the problem early on.
Some A/E owners are attempting to address this by inviting certain “rising stars” from younger Generation Y to increase the buyer pool. Others realize they may receive less in value/proceeds from their organization than they planned or have to extend their note payment over additional years in order to be fully redeemed. For countless owners, they are simply delaying retirement.
Many firms are already burdened with obligations to separated shareholders.
Call this the A/E “sandwich generation.” There are many multi-generational firms in between buyouts that have significant former shareholder debts on the books that ultimately have to be met. For some of these retired owners, their timing was sublime in that they sold out right before the industry (and their firm’s stock price) took a turn for the worse. In fact, the recession caused a number of distressed firms to go back to their retirees to significantly alter their payout terms (value and/or payment duration) for pure survivability!
Unfortunately, in a plodding industry environment, burdensome debt levels result in less cash available for raises, benefits, and bonuses; equipment and software investments; hiring, training and development; and funding future shareholders and ownership programs.
Many firms that were staunchly opposed to ESOPs in the past are now giving them a second look.
The popularity of Employee Stock Ownership Plans (ESOPs) waxes and wanes with economic cycles and tax laws, and we have found that some leaders love them and others don’t. Readers of our perspectives know we have addressed the pros and cons of ESOPs in the past. Basically, the plan needs to be melded with the right leadership team, firm size, growth prospects, and open book management philosophy to gain full benefits.
However, recent interactions with A/E executives, as well as industry tax and legal advisors, have indicated a renewed interest in this tool. Primarily because ESOPs create a much larger (and easier to manage) pool of potential owners than does a traditional direct buy-sell arrangement, thus enhancing liquidity for current owners. Others have observed that mid-sized firms which have been unable to sell to strategic buyers have reconsidered the ESOP. That being said, ESOPs can be cost prohibitive, and don’t fit with every firm culture, but we’ve noticed a marked increase for ESOP-related assessments and consulting.
More A/E firms are using advisors with ownership planning skills to act as a mediator, help diffuse emotions, and provide a range of alternatives and options to various constituencies.
The hands-on, solutions-focused mentality of A/E firms leads many executives to adopt a “do it yourself” approach to activities such as strategic planning, recruiting, marketing, and, even business valuation (much to our chagrin). The internal transition process however, is often a delicate negotiation exercise, with design professionals who work cohesively together all week, finding themselves thrust into separate, antagonistic corners over terms and conditions. And as is true in cases of buyer vs. seller, these teams have similar, but essentially incompatible goals and objectives.
As a result, increasingly, A/E firms are relying on outside, expert advisors to either represent the interests of the firm as a whole with impartiality or advocate the goals and positions of respective buyer or seller groups. Advisors can often assist with creative solutions to entrenched positions, model and run future “what if” scenarios, and simply serve as a communication conduit while reducing the stress and tension that goes along with the process.
Developing the right plan for your firm can be a daunting task. The team at ROG+ Partners has more than four decades of combined experience working with companies in the A/E and environmental consulting industry to develop comprehensive ownership plans. Our approach to transition planning takes into consideration the needs of all the key constituents – current (selling) shareholders, future (buying) shareholders, and most importantly, the company itself. We consider all available tools and options with the goal of ensuring the long-term success of your company.
Register now! Join the leading industry experts and also leverage the experience of other A/E Leaders from all over the United States and Canada – and learn how they are handling these challenges.
Sportscaster Vin Scully once said about statistics that they should be used like a drunk uses a lamppost, “for support rather than illumination.” But even leaning on statistical data for support can be dangerous if the data is flawed. In the huge and highly fragmented architecture, engineering and environmental consulting industries, owners and managers hunger to know how they are performing relative to their peers, and what their firms are worth. But sturdy and reliable data on peer financial performance and stock valuation can be particularly difficult to find. What’s worse, trying to draw conclusions from imperfect or irrelevant statistical data can be problematic, particularly when trying to place a value on your firm. We hope to remedy this situation soon (read on to learn how), but first a few words of caution on the data sources currently available.
Publicly traded company data
There are a number of publicly traded firms in the industry — AECOM, Stantec, URS and Tetra Tech to name just a few. Because the Securities and Exchange Commission (SEC) requires publicly traded companies to submit regular filings on their financial performance, and because their stocks are traded on open exchanges, a wealth of information can be gleaned with the click of a mouse. There are two major problems with this information however.
The first problem is that these firms are enormous compared to the typical firm in the industry. While the modal firm size in the industry is probably between 10 and 100 employees, publicly traded firms employ thousands of people and generate revenue in the billions of dollars. Because of the vast size difference, using these firms for peer comparison is tricky.
The other major problem relates specifically to stock valuation data. On the one hand, stock pricing data for public firms truly reflects fair market value, as it is based on daily arms-length transactions between willing buyers and willing sellers. However, the stock prices of public firms also reflect their very large size, which capital markets associate with lower risk, and the stock’s liquidity (i.e. the ability to sell the stock almost instantly). These two factors substantially enhance the value of publicly traded firms, all other things being equal.
In other words, just because the average publicly traded firm’s stock is trading at 15x earnings does NOT mean that a much smaller privately held company should also be valued at 15x earnings. Major adjustments must be made to account for size/risk and for the difference in liquidity.
Private merger & acquisition data
Data on actual sales of whole companies is much harder to come by than data on publicly traded stocks. This is because there is no requirement for a privately held firm to disclose the details of a merger or acquisition. Some transaction data can be found if one knows where to look, but that data is often limited and imperfect. Transactions can be structured in a wide variety of ways (asset purchases, stock purchases, statutory mergers) and payment can take many forms (cash, stock of the buyer, notes, earnouts, etc.). It’s often difficult to find information about a private transaction that includes all these details.
Assuming sufficient information can be gathered on private merger & acquisition transactions, it’s very important to understand what this data represents in order to avoid drawing the wrong conclusions. A frequent mistake we see is firm owners using anecdotal data from mergers & acquisitions of peer firms as an indication of how they should price their shares for an internal ownership transition.
The fact that firm XYZ, Inc. was sold to a publicly traded firm last month at a price equal to 80% of its annual net service revenue does NOT mean that you should be pricing your own stock at the same level for internal transactions. The fundamental flaw in this calculus is that the sale of XYZ Inc. represents a controlling interest transaction, while internal ownership transactions typically involve the sale of minority interest ownership stakes. On a per share basis, a block of stock that gives the buyer control over the company is significantly more value than a non-controlling ownership interest.
Surveys of “theoretical” valuations
Industry surveys can be helpful in that they often provide data from samples that are much more representative of the majority of firms in the industry. They also have their weaknesses, however. Such surveys often base valuation data on how the respondents value their stock, rather than on actual arms-length transactions. Therefore they reflect “theoretical” valuations rather than fair market values. Imagine a real estate appraiser estimating the value of a house by walking around and asking neighbors with comparable homes what they think their houses are worth, rather than looking for comparable homes that have actually sold recently.
Surveys that do not distinguish between controlling and non-controlling interests, or other factors such as a respondent firm’s capital structure, or whether or not it holds any non-operating assets such as real estate, can also lead to skewed and unreliable data.
So what’s an owner (or appraiser) to do?
As appraisers, we always look to multiple sources of data and “triangulate” in order to develop a reliable estimate of value. We also make sure to understand what the data we are using represents, and make adjustments accordingly.
Still, it would be great to have a reliable source of appropriately detailed, transaction-based data on the stock values of privately held companies. To this end, we are happy to announce the creation of the A/E Business Valuation and M&A Transaction Study. Over the coming months we will be compiling this study using a confidential on-line survey. The compiled data will include financial performance benchmarking data, valuation multiples for internal (minority interest) stock transactions, ESOP transactions, and merger/acquisition transactions. M&A data will include pricing data as well as data on transaction structures.
As professional business appraisers, we’ve worked carefully to construct a survey that is brief and easy to complete, yet captures enough data to compile a meaningful study.
We plan to supplement the data gathered through this questionnaire with data compiled from public sources. The results of the study will be presented in a form that will allow the user to benchmark their firm’s financial performance and condition, as well as the value of their firm (or an acquisition target) under a variety of circumstances.
If you’re interested in learning more and would like to participate in this new survey, please follow the link below.
When you have completed the survey you will be provided with a coupon code for a $200 discount on the study and a link to a separate and secure web page where you may pre-order your copy. We anticipate completion of the study by the end of the year and will be presenting selected highlights and findings at the annual Growth & Ownership Strategies Conference in Naples, Florida November 6-8.
Summer is here and that means barbecues, beaches, and of course – our annual Mid-Year CEO Outlook. Sensing that the A/E industry and overall economy is gaining some momentum, we thought that we would check in with six leading CEOs across the country to gauge their thoughts on their company’s performance, where they are seeing promising opportunities for growth, and how they are unwinding this summer!
Carl Davis, President & CEO, Array Architects, King of Prussia, PA
How has Array’s performance fared so far in 2013?
It will be very difficult for us to match our 2012 performance, so a great year for us in 2013 would be to have a flat year in 2013. In 2012 Array performed very well on a number of fronts. Our financial performance was very good, but just as important, we gained significant ground on leadership and ownership transition, brand awareness, digital footprint, and knowledge sharing both internally and externally, to name a few.
Given the firm’s focus on healthcare, in what services, building types, or models are you seeing promising opportunities for growth?
In the very recent past, expenditures on healthcare care broke down as follows: 31% on Hospital, 20% on Clinical Services, 5% on Nursing Home, and 3% on Home health care. However, this is rapidly changing. Soon, Clinical Services is going to surpass Hospital Care (if it hasn’t already). Nursing home and Home Health Care will continue to rise as Hospital Care expenditures will drop. The change for Hospital Care will continue to serve patients with higher acuity – specialty critical care suites will be required. Renovation of facilities will require fewer, but more critical beds.
When talking in terms of the types of services money is being spent on, 75% of the $2.7 Trillion (2012 numbers) is spent on people with chronic diseases (Heart Disease, Cancer, Diabetes, Obesity, Respiratory Diseases). This is one of the reasons why the shift in location is happening: the treatment for these chronic diseases is best when it’s convenient, integrated, and well-managed. These factors also contributed to the need for the Patient Protection and Affordable Care Act – before it, there was no real incentive/catalyst for change. These three factors for successful care delivery are best provided by ACOs, ambulatory care buildings organized around a Medical Home Model, or – at the greatest degree- at the patient’s home itself. A reorganization of the care delivery model is occurring now; health systems are retooling what they have and building new outpatient facilities to support other functions.
Broadly speaking, how is the design of healthcare facilities evolving due to industry regulation and reform initiatives?
I’d say the biggest evolution right now is the tension between the need for facilities that contribute to exemplary patient satisfaction scores (since these scores will be used to determine reimbursements in our “reformed” industry) and the need to be fiscally conservative until reform impacts are more settled/obvious.
Right now I think we’re seeing a lot of extremes (high cost and high value) and I expect the typical model to evolve more toward the middle as more market certainty is known. As far as a design technology goes, modular construction has the potential to become a real game changer – speeding both design (by having a predetermined set of templates to work from) and construction (which is where the most potential savings are from schedule reductions).
From your perspective, what’s the biggest challenge facing the architecture industry right now?
The U.S. economy is rapidly moving from a service-based to a knowledge-based economy. One of the key characteristics of the knowledge-based economy is separation of the production and consumption of the services. The use of technology is advancing that separation in the A/E industry.
Why is this is important to our practice? In a knowledge-based market design, practices will most likely thrive or fail by demonstrating mastery of sought-after services or an expertise. If you are not practicing in knowledge-based markets you will be left to compete in fee-based markets which we all know is a race to the bottom, and a fast race at that. Fee-based markets result in scarcity of resources limiting our ability to attract and retain talent, and to innovate at levels that create value for both us and our clients. But they also permit easy commoditization of our services by our clients. All of this will be a death blow to many A/E firms. Firms that create, capture, and share their organization’s knowledge and expertise as part of their overall business strategy should be successful in transitioning to the new knowledge-based economy. While this link between knowledge management and business strategy is often talked about, it is widely ignored in practice.
Have you had to change your leadership style over the last few years due to the soft economy?
No, not really. Array has a fairly transparent culture so we share the good, the bad, and the ugly with staff frequently. Transparency is a powerful unifier. So when we share with our team and acknowledge to them our strengths we need to leverage and the weaknesses that we need to work on, we begin to build trust. And in the worst of times it is this trust that staff has in their leaders that will facilitate and drive higher levels of performance.
What’s on your summer reading list?
Blue Ocean Strategy by W. Chan Kim and Renee Mauborgne and How Successful People Lead by John Maxwell.
Jim Lee, P.E., LEED AP BD+C, President, Shive-Hattery, Cedar Rapids, IA
How has Shive-Hattery’s performance fared so far in 2013?
After having record results for 6 of the last 7 years, I wondered whether we could sustain that performance and whether 2013 would yield yet another record for us. We saw our backlog fall off during the 4th quarter of 2012. It has rebounded nicely in 2013, however, it also created some pockets of under-utilized staff in some of our offices in the first quarter. As a result, 2013 has started off a little slower than last year, but still producing profitable results above our goals in many areas. The rest of the year looks promising, but whether we have another record or not, only time will tell.
In what market or service areas are you seeing promising opportunities for growth?
One of our quickest growing markets lately has been a rebound of the commercial work. This market sector includes projects in the retail and interior workplace as well. Of course it’s rebounding out of the cellar of the last recession, but rebounding nonetheless. As far as opportunities for growth, I believe our energy-related services have the greatest potential. There are a lot of opportunities out there in most of our major markets to do more in the energy arena. Most of our other markets (education, healthcare, industry, government, and telecom) are steady and so far have been tracking fairly close to our forecasted revenue projections.
Last year you acquired another architecture firm, Design Organization. What was the rationale behind that and how has it worked out?
We’re not overly aggressive when it comes to acquisitions, but have been looking for opportunities for growth when they make sense. We had not been targeting a specific region or type of firm particularly. The most important aspect we try to look for is a solid cultural fit.
When we started having conversations with Design Organization, it became very apparent to us that their firm shared the same business and people values as Shive-Hattery. The other attractive features that Design Organization brought to the table were a new geographic area that we could potentially expand our engineering services to, a deeper level of experience in higher education design, a new service area in Workplace Interiors, and just a bunch of “good folks.” I have to say that it has worked out very well so far and both S-H and DO are excited about the possibilities that could unfold. But our initial impressions about a good cultural fit, I believe, have been the key to the success of the transition.
You assumed the role of President in 2012. Did you have to adapt your leadership style to this new position?
Well, it’s certainly a different job than being a team leader in a design office. Instead of selling work and delivering projects, my focus tends to be on the bigger picture, what the future holds for S-H, and positioning ourselves well in the marketplace. But, I don’t think my leadership style has had to adapt any new aspects. I continue to reach out to others to gather input when making decisions. I strongly believe in our coaching/mentoring approach, our leadership development program, and successful succession planning. My leadership style has worked well in the past, and I hope it will serve me well moving forward.
Broadly speaking, the country and A/E industry is still suffering from a jobless recovery. Is Shive-Hattery hiring?
Yes, we are! We’ve been very fortunate through the recession and the slow recovery. Our need to continue to identify and recruit top talent in our key positions never seems to end. There truly is a war on talent out there. We consistently have had 10 to 20 positions open over the last couple years. Our number of full-time staff has never been higher and we looking to add some more.
What’s on your summer reading list?
I’m currently reading The Advantage by Patrick Lencioni as part of our Leadership Development Program. I just completed Biomimicry by Janine Benyus and for fun I just completed D-Day by Stephen Ambrose.
Michael Schwerin, CEO, HELIX Environmental Planning, La Mesa, CA
How has HELIX’s performance fared so far in 2013?
HELIX’s financial performance in 2013 has been good, albeit a little shy of our goals. Our year-to-date profits are in the double digits as a percent of net service revenues, but that six-month average masks significant month-to-month volatility, with profits at or above 20% in some months and in the single digits for others. With regard to our internal goals, such as recruiting to fill key positions and improving the development of our next tier of company leaders, we are seeing more steady progress.
In what market or service areas are you seeing promising opportunities for growth?
Renewable energy continues to provide significant opportunities for environmental consulting, even if the initial rush of desert solar projects is wrapping up. HELIX is seeing substantially more activity in the private development market, including residential and commercial developments. A lot of properties that went through the entitlement process prior to the recession are resurfacing with different development plans. What worked in 2008 won’t sell in 2014. This creates opportunities for environmental consultants who can minimize the work necessary to guide the proposed new development plans back through the entitlement process.
What are the biggest concerns your clients face today?
Uncertainty tops the list. I think that everyone, from clients to competitors to subconsultants, remains concerned about the strength and pace of the economic recovery. Within the markets we serve, our clients are concerned about cost and the time required to complete the environmental compliance process. Local governments have tighter budgets; our water district clients have lower water sales and less revenue (as a result of water conservation efforts); and our private clients are facing a much different cost environment than they were pre-recession. And despite calls for streamlining the environmental compliance process to help boost economic activity, we haven’t seen that happen.
What advice would you offer aspiring environmental professionals today?
Learn to manage and sell. While there will always be career opportunities for environmental technical experts, far greater career opportunities exist for technical experts who also can generate work and manage people and projects. Business development is especially key, and it is important to start building your network now. Attend local professional events such as luncheons, and position yourself to attend industry conferences. Many companies will sponsor conference attendance if you will be presenting a paper. If you’re terrified of public speaking and loathe the idea of making a presentation or leading an interview for a new project, start going to Toastmasters now.
Have you had to change your leadership style over the last few years due to the soft economy?
I was promoted to CEO of HELIX in June 2008, when the economic wheels were just coming off. One way in which this affected my leadership style was that there was a much stronger focus on business development as CEO than I had realized before taking the job. When you’re laying off employees, as we had to in 2008 and early 2009, succeeding in business development correlates directly with being able to retain your employees.
One other way in which the soft economy affected my leadership style was that it forced me, and the rest of HELIX’s executive team, to improve communications about the financial performance of the company. We started holding quarterly all-hands company meetings, in large part so that our executive team could convey on a regular basis what we were doing to ensure the fiscal health of the firm. Even though those dark days seem to be behind us, our practice of frequent and open communication remains an important element of HELIX’s leadership.
What are your plans this summer for rest and relaxation?
We took a two-week family trip to New York and New Jersey in June, with time split between Mohonk Mountain House (located overlooking its private lake in the Hudson River Valley), New York City, and Cape May on the Jersey Shore. This trip provided a great combination of beautiful natural scenery, intense urban activities, and fun at the beach. As a bonus, our nine-year-old son and aspiring inventor got to see the laboratories of Thomas Edison in West Orange, New Jersey.
Jim Soltesz, P.E., President & CEO, Soltesz, Rockville, MD
How has Soltesz’s performance fared so far in 2013?
To date, 2013 has followed a similar pattern as 2010, 2011, and 2012. We started the year extremely strong, saw a soft patch in the spring, and it appears to be picking up once again through the summer. In 2012, we had our strongest year since 2006 in terms of revenue growth and profitability.
In what market or service areas are you seeing promising opportunities for growth?
We are seeing tremendous demand in the residential market, similar to 2003 right before the major ramp-up. The for-rent market has been strong and we are seeing that substituted by extreme demand in residential for-sale products, including condominiums.
Your company recently launched a new name and brand campaign. What was the rationale behind that?
Our company launch of our new brand has been extremely successful. Four years ago, we initiated an ambitious diversification program – expanding into new market sectors and geographic regions. With our continued success with repeat clients and our expanded market reach, the firm is stronger than ever. The time was optimal for rebranding.
Your company’s strengths have traditionally been in land development activities. How has that market changed since the 2000s?
We have traditionally had tremendous success and experience in residential land development. We have, however, tried to expand our site civil expertise to a wider variety of clients. These include healthcare, educational facilities (both K-12 and higher education), and municipal facilities. In addition, we have also been fortunate to have had great success in stormwater management water quality initiatives, which have been initiated through the Chesapeake Bay Act and the MS4 permit program.
What advice would you give aspiring engineering professionals today?
Constant training and a never ending desire to improve one’s skill sets is my advice. Here at our company, we have extensive training programs in both professional development and technical training. We believe that well-rounded professionals in the engineering field should possess both types of skill sets and that is why we have invested considerable time, effort, and capital into these training programs.
What’s on your summer reading list?
My reading list over the summer will include my traditional year-round extensive reading of Bloomberg and CNBC articles on the economy. This summer I will also be reading It’s Different This Time, written by two local University of Maryland professors. In addition, my close high school friend, former Congressman Robert Ney, finished a book called Sideswiped regarding his career on Capitol Hill and the scandals in which he was caught up.
Brad Thomas, P.E., President & CEO, Progressive AE, Grand Rapids, MI
How has Progressive AE’s performance fared so far in 2013?
Before the “Great Recession,” we experienced several consecutive years of firm record financial performance. We now fondly refer to 2009, 2010, and 2011 as a holiday (in growth and earnings), but no vacation! In 2012 we celebrated our 50th year in business and a return to record financial performance, and at period 7 of fiscal 2013 we are ahead of plan and expecting to close another record year.
In what market or service areas are you seeing promising opportunities for growth?
We have seen a strong rebound in most all of our markets, with what appears to be significant pent-up demand. Regionally, the Midwest seems to be doing well with a manufacturing rebound, driven in-part by a strengthened domestic auto market and related businesses (manufacturing, suppliers, retail dealerships), and in-part by what may be a growing trend to “on-shoring” of supply chains. Healthcare reforms are driving consolidation in the healthcare industry resulting in projects to create operational efficiency and care integration. Multi-family housing and corporate commercial office have been strong and continue to show promise.
Last year you acquired another Michigan firm, Design Plus. What was the rationale behind that and how has it worked out?
The strategic rational was to deepen expertise in a couple of specific markets (multi-family and student housing & student dining), add senior client leadership capacity necessary to support growth, cross-sell engineering and non-traditional services into acquired clients and markets, and accelerate Revit and BIM deployment. The integration has gone very well, with high morale, good cultural fit, 100% retention of clients and staff, and continued growth.
From your perspective, what’s the biggest challenge facing the A/E industry right now?
Fees – the industry continues to be too quick to drop fees in an effort to win the work. Perhaps fueled by the past recession, perhaps by the growth in the number of new sole proprietors – but we need to be very clear about the value we deliver and be confident and firm in what appropriate compensation is. I find in some cases we are too quick to want to please, perhaps even negotiating against ourselves.
Broadly speaking, the country and A/E industry is still suffering from a jobless recovery. Is Progressive AE hiring?
Yes – in addition to the acquisition we organically grew by over 20% last year. Currently there are nine full-time positions posted on our website.
What are your plans this summer for rest and relaxation?
My 19-year-old son and I both received our pilots’ license last fall and bought a light sport aircraft. I enjoy flying because it provides a very different perspective of our world while demanding my full attention and presence-of-mind – which is a nice vacation from the business.
Keith Sampson, President & CEO, SRP Environmental LLC, Shreveport, LA
How has SRP’s performance fared so far in 2013?
SRP Environmental’s revenue growth is ahead of last year on a YTD comparison. We have continued to expand our geographic footprint and are successfully expanding our operations both organically and through acquisition. Our team is committed to providing superior services to our current client base and expanding our service offerings in strategic markets. Additionally, we anticipate that our business plan will provide a solid platform for future growth as demand for Environmental, Health, and Safety services continues to grow in all of our market segments.
In what market or service areas are you seeing promising opportunities for growth?
We continue to see very strong growth opportunities in Oil & Gas, Agriculture, Manufacturing, Health Care and Private/Public property development and/or renovation. Our Environmental Compliance and Assessment/Remediation group has been experiencing steady demand for Air Permits, Environmental Audits, Site assessment & Remediation as well NPDES and SPCC compliance. Furthermore, we have experienced rapid growth within our Industrial Hygiene, Safety Training & Safety Consulting sectors. Our Catastrophe Response group has continued to expand its client and geographic base and is currently making preparations to prevent or limit the impact of the upcoming storm season as it relates to client business interruption from hurricanes, floods etc.
You acquired a safety consulting and training firm in Colorado last year. What did that transaction accomplish for SRP?
Our Colorado acquisition accomplished several key objectives critical to future growth and expansion. First, we inherited an incredibly talented and motivated team as Tara and Ivan Steinke had built a very strong client base within the mountain region. The acquisition allowed us to add to our client base and take advantage of cross selling opportunities within the Industrial Hygiene and Environmental Services sector. Secondly, we were able to obtain a strong degree of synergy as our Colorado office is now able to serve all of our existing clients in that area. Having a physical presence in the Rocky Mountain region has enabled us to be more responsive to our clients, increased our resource allocation flexibility and allowed us to capitalize on economic trends across several unique markets.
SRP has made the Inc 5000 and has been growing rapidly while adding new managerial talent, systems, and processes. What’s the key to managing all of that growth effectively?
I believe the most important key to sustaining rapid growth, while maintaining superior quality service is a leader’s ability to surround themselves with talented people that are passionate about what they do. A company can’t grow and adjust to client demands that are fluid and constantly changing without a dynamic team of visionaries. Additionally, leveraging a firm’s strengths and knowing its weakness is also vital to the sustained success of a rapidly growing firm. The most successful firms will be those that disrupt not only the strategic markets they serve but also those that are willing to disrupt their own culture and change in response to client and economic demands.
What are the biggest concerns your clients face today?
Many of our clients are concerned with a rapidly changing regulatory environment that tends to overburden the ability of a business to thrive within its industry. Clients are frustrated with a growing and complex array of regulations that put them at an economic disadvantage and divert their attention away from the primary business focus. That is why SRP Environmental strives to navigate our clients through the regulatory process with effective expediency so that they can focus on growing their business while maintaining compliance with applicable federal, state, and local regulations.
What’s on your summer reading list?
I tend to read a lot of financial magazines including Fortune Small Business and Inc. Magazine. I am also reading June Jewell’s Find The Lost Dollars and look forward to the release of John Grisham’s next novel.
After several years of uneven growth, the signs of a sustainable recovery are finally emerging for A/E organizations, however, there are numerous long-term structural issues that remain. Drawing on our engagements and interactions with hundreds of executives across the country, this year’s Growth & Ownership Strategies Conference, scheduled for November 6-8 at the Ritz-Carlton Golf Resort in Naples, Florida will focus on the three biggest challenges facing A/E leaders today:
“Reinvigorating Our Growth” – If your organization has been chalking up double-digit growth rates the last few years, consider yourselves in select company! However, for the vast majority of firms, it’s been a continued “mixed-bag” of industry performance. Leaders are managing their way through up and down spurts while waiting for the broader economic recovery to arrive. Given a relentless competitive environment, many leaders are simply resolved to “ride it out” while others joke that “flat is the new growth” in terms of top-line expectations.
Our Conference tackles this challenge head-on by offering insights and strategies to renewing growth in a slow economy. Attendees will learn how to: instill a culture that drives firm wide performance; understand what drives client’s expectations and perceptions; pursue “win-win” mergers and acquisitions; interpret the macroeconomic outlook for the U.S. economy and A/E industry; and revamp business development programs that are more proactive and results-oriented.
“Assessing Our Ownership Transition Alternatives” – For many A/E firms, a short-term survivability focus has pushed longer-term ownership transition and retirement planning further and further off. The reality today is that a large percentage of firms of all shapes and sizes have ownership profiles that defy logic. Many are “top-heavy” with principals in their 50s and 60s who own a large majority of the stock. There simply aren’t enough 30- and 40-year-olds ready, willing, and able to buy these senior owners out in a coordinated process that won’t result in a decade-long (or longer) sell-down. Given the demographic shifts impacting the industry’s workforce, it’s becoming evident that effective ownership transition planning, from monetizing assets and unlocking wealth to perpetuating the organization and creating opportunities for a new generation, are critical to the overall health of the design industry.
Attendees will discover, through panel discussions and interactive breakout sessions, various ownership transition models that align with their culture and shareholder objectives. This includes maximizing current performance through a critical assessment of existing ownership models, incentive compensation practices, and tax ramifications. And if this is your sole focus, plan on attending the pre-conference Ownership Transition Workshop on Wednesday afternoon.
“Preparing Our Next Generation of Leaders” – Many executives readily admit that recruiting, retaining, and motivating the next generation of leaders is their biggest worry. Leadership succession is becoming a huge structural challenge for our industry, and many firms simply do not have younger principals with the skills and business acumen ready and available to lead in the future. And despite the large number of A/E professionals seeking new opportunities, firms are still busier than ever trying to find those elusive “right people” for their organizations short on emerging leaders.
The event will explore new methods A/E firms are adopting to attract and retain talent. Participants will also hear from distinguished speakers and CEOs on transformational leadership tactics, including fostering team loyalty, employee engagement, project effectiveness, market differentiation, and becoming an employer of choice.
So, on behalf of all of us at ROG + Partners, we cordially invite you to join us to be part of the only annual conference which gathers together leaders of successful architecture, engineering, and environmental consulting firms throughout the country with the goal of showcasing the most effective strategies for achieving growth, improving profitability, and building real and sustainable value.
We’ve brought together an unparalleled faculty of leading speakers, sponsors, and panelists in order to provide attendees with unique insight, new ideas, and tactical information to help their organizations work smarter. The spouse-friendly program also includes a wide variety of opportunities for unwinding and networking, including a golf outing at the Greg Norman designed Tiburón Golf Club and a group fishing charter out of the Port-O-Call Marina.
90% of past attendees rated this Conference as excellent! Register by June 14th and receive the best conference pricing available. If you have questions, or would prefer to be invoiced, contact Ashley Cristman – email@example.com.
As a leading provider of business valuation services to companies operating in the architecture, engineering, and environmental consulting industries, we have the unique advantage of witnessing many of the leading indicators affecting valuations. For the past 15 years we have collectively conducted approximately 750 business valuations in this niche market. In addition to the many valuations that we conduct annually for ERISA requirements or in accordance with shareholders’ agreements, we are increasingly seeing more firms take a holistic approach to their strategic planning, an approach that often includes a more probing look at managing shareholder redemption obligations.
Since 2004, we’ve sounded the warning bells about what the impact of an ever-growing number of retiring employees would have on a company’s ability to redeem shares. The “Great Recession” has further increased this risk, because as many firms experienced severe depressions in value, they’ve been left with little other choice than to delay leadership and ownership transition planning.
Over the next two decades, the rate of change in population demographics will have a significant effect on value, liquidity, and leadership succession. The following graph shows that the population of those between 65 and 84 years of age will increase by nearly 30 million people. During the same period, the population of those between 25 and 64 years of age will only increase by 11.1 million individuals, or nearly one-third of those individuals reaching retirement age.
So why is ownership planning more important now than it’s ever been? We’ve recently begun to see improvements in the overall economy, including long-term growth rates that are gradually beginning to edge upwards. As companies begin to grow again, their need to invest in working capital will also grow. However, if a company’s future cash flows are needed to fund stock redemption obligations, its ability to invest in growth will be impaired. Or even worse, it might not have sufficient cash flow to provide the required incentive compensation to its employees to mitigate employee turnover.
To ensure that your firm will be positioned to thrive when growth begins to commence in earnest, incorporating a shareholder redemption liability study in your annual strategic planning should be of chief importance. A mere awareness of imminent redemptions is a sign of inadequate planning – you also must know how those redemptions will influence your company’s ability to fund future growth while continuing to reward employees.
To learn more about how you can minimize your redemption risk and how your peers are addressing this issue, give me a call or plan to join us at our Growth & Ownership Strategies Conference November 6-8, in Naples, Florida.
Most small businesses destroy shareholder value, rather than create it. This was the conclusion of a study by a well-respected business professor I recently heard lecture on the subject of small to mid-size business capital markets. The premise is simple. If your business cannot provide a return on investment equal to or greater than its cost of capital, it is destroying shareholder value. This theory raises many interesting questions for the small business owner/manager.
To answer the first question, we need to define the cost of capital, specifically the cost of equity capital that would apply to the typical small businesses in the A/E and environmental consulting industry. Without going into the gory details of capital asset pricing models, let’s just say that under current market conditions a typical cost of equity for a small, privately held A/E firm is around 18% (this rate could be significantly higher or lower for any given firm depending on its unique risk profile).
Now the test… If a company has a fair market equity value of $10 million, it would need to generate a return of over $1.8 million each year to theoretically “create shareholder value.” That return can consist of any combination of cash flow to shareholders and stock price appreciation.
The table below illustrates three examples. In the first row, the combined return exceeds the cost of capital, creating shareholder value. In the second row, the combined return falls short of the cost of capital, destroying value. In the third row, the return equals the cost of capital, neither creating nor destroying value.
|Starting Equity Value ($)||Cash Distribution ($) [A]||Increase in Equity Value ($) [B]||Total Return ($) [A+B]||Total Return (%)|
Depending on which industry surveys you believe, the median EBITDA margin in the overall A/E and environmental consulting industry runs somewhere between 10% and 12% of net service revenue. Furthermore, some of those earnings will NOT be available for distribution to shareholders. After staff bonuses, working capital investment and fixed asset investment, available cash flow might be whittled down to as little as 5% of NSR. Let’s assume that our hypothetical firm generates $25 million in net service revenue (NSR) and $3.75 million in earnings before interest, taxes, depreciation and amortization (EBITDA). That equates to a 15% EBITDA margin—a pretty healthy profit by most standards. Such a firm should have no difficulty providing a return that exceeds its cost of capital. But what about the typical A/E firm?
Now we can start to see how the theory of value destruction could very well be true for many firms. The following chart illustrates the total return on investment for a “typical” firm in the A/E industry, starting with an assumed EBITDA margin of 12%. We’ve used a number of other assumptions regarding staff bonuses, capital expenditures, working capital investment and taxes, all of which are footnoted below.
|Return on Investment Analysis|
|Net Service Revenue||$25,000,000|
|Pre-bonus EBITDA (12%)||$3,000,000|
|Capital Expenditures ||-$500,000|
|Working Capital Investment ||-$80,000|
|Income Taxes ||-$880,000|
|Cash Flow for Shareholders||$1,240,000|
|Growth in Value ||5%|
 Staff bonuses estimated at approximately 2% of total labor cost or 10% of EBITDA
 Capital expenditure estimated at 2% of net service revenue
 Working capital investment based on 5% revenue growth and a working capital turnover rate of 6x/year
 Income taxes estimated at 40% of taxable income, assuming depreciation expense equal to capital expenditures
 Growth in stock value is based on 5% growth in revenue and earnings.
If we assume a cost of capital for the hypothetical firm above of 18%, this firm comes close, but does not quite clear the hurdle rate for creating shareholder value. This suggests that there may in fact be more firms in the industry that theoretically destroy shareholder value rather than create it.
So if it IS true that many firms in the industry fail to create shareholder value, then why do they continue to exist? The nature of the professional services industry is one reason. Unlike other industries (e.g. manufacturing, retail, or high-tech) architecture, engineering and environmental firms are predominantly owned by practicing professionals. For these professionals, the business is not purely a financial investment, but is also their source of employment, and a vehicle for practicing their craft.
Furthermore, in privately held businesses it’s often difficult to segregate the owners’ compensation from their return on their investment, particularly in privately held C-corporations, where there is a strong aversion to declaring and paying dividends due to the double taxation of such distributions.
While I wouldn’t jump to the conclusion that traditional capital models are flawed as applied to small business, particularly professional service businesses, I do believe they fail to capture the less tangible returns—returns not easily measured in dollars and cents. Autonomy, job security, control over one’s own destiny, and pride of ownership are all factors that drive professionals to establish new firms, or buy into existing ones.
If an architect, engineer or scientist is able to create a business that fulfills such personal goals, while simultaneously serving a market need and creating jobs and livelihoods for other individuals, I would argue that he or she has “created value” in doing so, irrespective of the level of financial return.
That said, the ideal firm would create value in all of the above ways, while also achieving a level of financial return on investment that creates shareholder value. This would in turn attract additional financial investment in the firm, allowing the cycle to continue. As small business owners and managers, this is what we should all strive for.
Third Annual Growth & Ownership Strategies Conference Set for November 6th – 8th
If you‘re interested in learning from experts and peers about ways to create real and sustainable value in your architecture, engineering or environmental consulting firm, we hope you’ll join us at the third annual Growth & Ownership Strategies Conference in Naples, Florida on November 6th, 7th and 8th. The program will feature expert speakers and panelists from inside and outside the industry, offering their insights into ways to spur growth, build value and positively transform your business. They’ll also be plenty of opportunities for peer-to-peer networking.
This year’s program will include an all new and complimentary pre-conference workshop focused on ownership transition strategies including internal transitions, ESOPs and mergers/acquisitions. Registration is open now at www.rog-partners.com/conference.
“As for me, I am tormented with an everlasting itch for things remote. I love to sail forbidden seas, and land on barbarous coasts.”
– Herman Melville, Moby-Dick
Last year I had a lengthy telephone chat with a friend of mine who happens to be the President of a mid-sized environmental consulting firm. Throughout the course of our discussion, he listed various anxieties and opportunities and wondered aloud if his business challenges were unique to his organization. At the end, he mentioned several competitors he thought he could outmaneuver that year.
When he uttered the name of his last opponent, I brought to his attention that the firm was acquired a month earlier by a sizable multi-disciplined organization from Australia.
He responded, “Who are they?”
When I shared with him their name and background he paused for bit and then replied, “Why in the world would they buy them?”
* * *
Indeed. 15 years ago it was a rarity if an international A/E firm courted, much less even acquired, a company here in the United States. Historically, wide cultural differences, disparate business practices, limited technology and telecommunication infrastructures, litigation stigma, a strong dollar, and simple risk vs. return alone kept buyers from aggressively “coming ashore.”
However, with each passing year since, slowly but steadily they have come. The Canadians. The Europeans. The Australians. The U.S. real estate and construction boom of the 2000s helped accelerate it. Big deals and small deals have taken place across every discipline – architecture, engineering, environmental, and construction. Company names that many had never heard of in the 1990s are now firmly part of the U.S. competitive landscape and industry lexicon. In fact, with many of our firm sale engagements, we prepare clients that it’s increasingly likely they could end up selling to an unknown, although growth-oriented, international A/E buyer. Ten years ago that possibility was barely a consideration. The table below highlights some of the more prominent cross border industry deals the last five years, but these are the tip of the iceberg:
|Buyer||U.S. Seller||Price||Number of Employees|
|Balfour Beatty (U.K.)||Parsons Brinckerhoff||$626MM||13,000|
|Arcadis (NL)||Malcolm Pirnie||$222MM||1,700|
|Cardno (AUS)||ATC Associates||$106MM||1,600|
|GENIVAR (CAN)||WSP*||$442MM||9,000 (950 in U.S.)|
|Stantec (CAN)||Burt Hill||N/A||600|
|exp (CAN)||Teng & Associates||N/A||500|
|GHD (AUS)||Winzler & Kelly||N/A||300|
*WSP is U.K.-based with significant U.S. operations
These international firms are here for much the same reason 16th century explorers sought out the “New World” – new opportunities (although back then they called it “riches”). With many overseas design and infrastructure domestic markets mature or slowing, these global entities have come to view the United States, with its 300 million+ inhabitants, voracious building and risk taking appetite, and perennial D-grade infrastructure ratings, as fertile ground to plant the flag. As much as we think of our own A/E or environmental markets as local, regional or even multi-regional, it’s increasingly global. And the trend shows no signs of slowing down.
As such, a number of A/E owners have been wined and dined by global executives with different accents, business references (to some, turnover is revenue and not architect churn), and industry best practices and philosophies. For global suitors, they understand the time and coordination needed to build a U.S operation from scratch is not an option, or rather a limited one.
For sellers, some have realized they are either not on the radar screens of the large U.S. publicly traded or privately-held buyers anymore (as those organizations have gone searching for targets overseas themselves – a tale for another time) or simply would prefer not to sell to those groups for cultural or competitive reasons. Global buyers have often promised (with elements of both truth and wishful thinking) that sellers would be able to operate and integrate on a relatively “stand-alone” basis with the support of their new foreign parent some five time zones away. Add to the equation that global firms have often arrived paying higher multiples than U.S. suitors or private equity firms as well as offering large, up-front cash deals. As a result, it’s made for a number of eager marriages!
Some opined that when the recession hit, the international firms might reduce their U.S. exposure and begin to curb their appetites here. In fact, the opposite has happened. Global A/E CEOs we speak with say they still view the U.S. as “high market potential” with “enormous needs” and having “world class schools and talent.” Despite the lingering recession here, they want access to U.S. multi-national companies and federal and state agencies for growth and diversity. Our discussions with U.S. leaders who recently sold to their European or Canadian counterparts have shared a more patient, longer-term approach these organizations often take in building out their worldwide franchises.
That’s not to say that all these transactions have turned out rosy. A/E cross border deals are just as ripe to executive and staff turnover, poor due diligence, cultural and communication challenges, turf battles and egos, and bad strategic intent. There’s still one universal mantra all buyers can understand – caveat emptor!
* * *
As we reported in December, 2012 M&A activity ended on a high note, aided by a healthy amount of year-end tax driven selling. By our tracking, the number of transactions was up 15% over 2011 levels. Although the number of U.S. sellers only ticked up by 4%, international targets surged over 50%. Many global and domestic A/E firms continue to seek international targets in emerging economies (China, Middle East, India) and/or mining and energy rich regions (South America, Canada, Australia, etc.).
As for 2013, we believe industry M&A activity will be flat to slightly down for the year. The combination of the strong transaction year in 2012 means that many A/E management teams are spending the first part of 2013 digesting and integrating these recent purchases. And while many favorable deal making elements remain in place (stronger balance sheets, cheap acquisition financing, lackluster organic prospects, dire need for exit strategies, etc.), our recent conversations with industry executives and M&A participants suggest the need to perhaps “take a breather.” Others want to see sustained traction on the industry and overall economic recovery fronts before committing time and resources to deals.
At ROG+ Partners, we possess strong relationships and years of experience navigating A/E and environmental buyers and sellers through the M&A process and towards winning combinations. Whether you are seeking to grow through acquisitions or by evaluating your firm’s strategic and ownership alternatives, please contact us as to how we can help your organization.
With a nation nearly evenly divided on politics and economic prospects, expectations for 2012 were anything but certain. And while the outcome of the presidential election may not have quelled the political divisiveness, investors are expressing moderately more confidence in the A/E industry than the overall economy.
That said, uncertainty is still prevalent in the industry as projected long-term growth rates are at historic lows. Of the A/E firms that are expected to exceed the industry long-term growth expectations, (CBI, EME, FLR, JEC, and TTEK) the common denominator appears to be their presence in the energy, water, and environmental market sectors. On the other hand, firms relying heavily on transportation, municipal services, and facilities engineering market sectors face slower growth prospects.
We conducted an analysis of a select group of publicly traded companies doing business in the architecture, engineering, and environmental consulting industry to gauge the investors’ outlook for 2013 and beyond. This analysis is based on the fundamental fact the stock price of a publicly traded company is a function of three key factors: 1.) The company’s current earnings per share (“EPS”), 2.) The projected long-term growth rates of the current EPS, and 3.) The risk of not achieving the current EPS along with its projected growth rate.
In our analyses of these companies, we’ve made adjustments to reported earnings for extraordinary or non-recurring income or expense items because investors will typically discount one-time events that may impact the reported earnings results. Interestingly, the most common extraordinary expenses we found were write-downs of goodwill. Goodwill write-downs occur when a firm recognizes that the goodwill value of a recent acquisition has been “impaired.” In other words, it would appear that some of public firms have had to acknowledge that they paid too much for recent acquisitions, and/or that those acquisitions have not performed as hoped.
Using the capital asset pricing model (“CAPM”), a theoretical financial tool, to determine a company’s cost of capital we can determine investors’ sentiment for a company. The following table shows a summary of companies and their respective cost of capital, current price to earnings ratio (“P/E”), next fiscal year (“NFY”) P/E multiples, and our calculation of the implied growth rates.
|Guideline Company||Ticker Symbol||LTM P/E||NFY P/E||Cost of Capital||Implied 1 Year Growth||Implied Long -Term Growth|
|AECOM Technology Corp.||ACM||10.3x||9.7x||9.0%||6.0%||-0.6%|
|Chicago Bridge & Iron Co NV||CBI||16.1x||12.9x||16.6%||24.8%||9.8%|
|EMCOR Group, Inc.||EME||17.4x||14.2x||12.5%||22.6%||6.4%|
|Jacobs Engineering Group, Inc.||JEC||14.5x||14.1x||11.2%||2.6%||4.0%|
|TRC Companies, Inc.||TRR||8.9x||8.6x||11.0%||3.7%||-0.2%|
|Tetra Tech, Inc.||TTEK||18.5x||16.4x||8.6%||12.2%||3.1%|
|Standard & Poor’s 500||14.4x||12.7x||8.5%||13.8%||1.5%|
The cost of capital is the required rate of the return expected by investors – most of which are institutional – based on their understanding of the underlying risk of each of these companies’ current EPS and their respective projected growth rates. A higher cost of capital (or greater required rate of return) reflects the higher level of risk that investors are placing on a company’s ability to achieve the projected near-term and long-term growth rates. The P/E multiple is the price at which the stock is trading relative to the companies’ earnings per share, and NFY P/E is the price at which the stock is trading relative to the companies’ NFY earnings per share. The implied one year growth is calculated by taking the current P/E multiple and dividing by NFY P/E and subtracting 1. The implied terminal growth rate is the derivative of the LTM P/E and the companies’ cost of capital.
A cautionary note; when trying to infer an entire industry’s outlook based on public firm stock performance it’s very important to look at a basket of companies instead of any one firm in particular. There could be unique facts and circumstances driving investors’ assessments of any particular firm. For example, Michael Baker is priced at the highest P/E multiple for the industry. But this could well be due to the recent departure of the firm’s CEO and inquiries from private equity firms looking to take the company private. And in the case of Chicago Bridge and Iron, investors have already begun to price in the benefits of the CBI’s impending acquisition of the Shaw Group. For this reason, we examined a group of 12 firms and compared their stock performance to that of the S&P 500.
The S&P 500, consisting of the largest publicly traded companies, is considered the barometer of the overall market in the United States. According to the table above, investors are expecting both near term and long term growth rates of the A/E sector to outperform that of the overall market. Historically, the A/E sector has grown at a slower pace than the S&P 500, so this is somewhat unusual. At the same time investors are currently placing a higher investment risk on companies in the A/E sector compared to the S&P 500. This higher risk is also unusual. Historically investors have viewed firms in the A/E sector as less of an investment risk when compared to the overall market because much of the business of these firms is generated directly or indirectly from federal, state, and local governments. This may indicate that investors do not view the public sector markets as positively as they once did.
The market appears to be particularly skeptical about the A/E industry’s near term growth. This is evidenced by the fact that the difference in the 2013 growth rates between A/E firms (14.0%) and the S&P 500 (13.8%) is virtually non-existent, yet the risk rate differential between the A/E industry and the S&P 500 is 1.9%–a spread that is quite large in the finance world. In the long-term, however, investors are expressing more optimism for the A/E industry when compared to the overall market. A/E firms are expected to grow 2.3% in the long run compared to the overall market growth projection of 1.5%. While this spread is 0.8%, the risk spread is still 1.9%. Therefore it appears that investors are more confident in the A/E industry in the long-run. This is good news for the industry, as long-term growth prospects trump short-term growth anytime.
But before we get too excited, let’s not lose sight of the fact that these growth expectations are still relatively low. An overall broad market long-term growth rate of 1.5% is well below the level needed to significantly reduce unemployment and improve fiscal conditions at the federal, state, and local levels. By some estimates a GDP growth rate of 3% or higher is needed.
We suspect that the relatively low growth expectations reflect the continued uncertainty stemming from Washington’s inability to come to a resolution on the fiscal cliff and other legislative matters. On a positive note, of the many different market sectors, the A/E sector is perhaps best poised to benefit from almost any fiscal resolution coming out of Washington. So let’s all keep our fingers crossed.