2018 State of the Construction and Surety Industries William J. - - PowerPoint PPT Presentation

William J. McConnell, PE, JD, MSCE, CDT Chief Executive Officer THE VERTEX COMPANIES, INC.

Forensic Consulting | Design Engineering | Construction | Environmental

2018

State of the Construction and Surety Industries

1

March-2018

Executive Summary – Page 1

The US economy continues its low growth / low inflation expansion cycle that started nearly 9 years ago, which makes it the third longest economic expansion on record. The Trump administration has implemented several stimulus measures and the headwinds that faced the energy industry have recently turned due to the robust global economy, which have both led to a recent spike in inflationary pressures and associated Fed rate hikes. In addition, the unemployment rate has been below the 5-percent “full employment” mark for the past 2.5

• years. Should inflationary pressures and low unemployment persist, the Fed will likely

implement three or four additional rate hikes in 2018. Accordingly, continued growth with higher prices and a lack of available workforce will be difficult. Hence, the US economy is poised for a recession in late 2019 or 2020. Overall put in place construction revenue is now in record territory, as it surpassed the $1.25 trillion mark in 2017. Construction growth has outpaced GDP growth for the past several years due to booming private sectors. In 2006, private construction was over-weighted with residential construction revenue this is no longer the case. Private construction is much more balanced but growth of late is starting to flatten due to a shortage of qualified construction workers and construction-related inflation. This will cool overall construction growth for the next several years. Contrary to the heated private construction marketplace, public construction has declined over the past decade. The Trump infrastructure proposal, if approved by Congress, will certainly help reverse this trend. However, despite low unemployment, federal deficits continue to rise, which leaves less money for infrastructure spending. The American Society of Civil Engineering recently gave America’s infrastructure a D+ grade, so demand for upgrades is pent up, to put it mildly. Because of the shortage of public funding, private funding through PPPs will likely be necessary to address many long-awaited improvements.

VERTEX

Executive Summary – Page 2

The surety industry continues its historic run of record-low loss ratios. In addition, direct premium is forecasted to eclipse the $6 billion mark in 2017 for the first time. Coupling above- average premium growth with low losses, particularly when the public construction marketplace is in a steady decline, evidences that the industry is properly diversifying more so into private and international construction sectors, which is a healthy signal. Also, the market share of the top ten surety providers is at its lowest level in approximately 20 years, which signifies a reversal in the industry’s consolidation trend. The industry will need to be cognizant

• f continued inflationary pressures that historically have a direct relationship with surety losses.

In addition, the soft market conditions might affect underwriting overall fundamentals. Lastly, the lack of construction labor exposes the industry to a variety of construction disputes that involve safety, quality, and schedule. In sum, the US economy has expanded, albeit slowly, for the past 8+ years. The construction industry, which overcorrected during the Great Recession, has rebounded with vengeance on the heels of record private construction spending. On the other hand, public construction spending was considerably less in 2017 than it was in 2006. Despite the compression of public construction spending, the surety industry has had a historic run due to strict underwriting fundamentals and low construction inflation. If either of these two factors change, the industry might experience a minor loss cycle in the next several years. Otherwise, the industry continues to be in great shape. Bill McConnell, CEO The Vertex Companies, Inc.

VERTEX

Table of Contents

Part 1. State of the US Economy Part 2. State of the US Construction Industry Part 3. State of the US Surety Industry

VERTEX

Part 1. State of the US Economy

The Good

• Booming but recently volatile equities market
• Historically low unemployment

The Bad

• Moderate economic growth
• Inflationary pressures are creeping back

The Ugly

• US debt/deficit issues continue despite low employment

Bottom Line: The US Economy is overdue for a minor correction, which will likely manifest in 2019 if not sooner.

VERTEX

The following are the longest periods of growth in US history:

1. 1991 to 2001: 10 years, 0 months 2. 1961 to 1969: 8 years, 10 months 3. 2009 to Feb ’18: 8 years, 8 months (and counting) 4. 1982 to 1990: 7 years, 8 months 5. 1938 to 1945: 6 years, 8 months 6. 2001 to 2007: 6 years, 1 month It is likely that the current expansion will continue through the summer of 2019, which will make it the longest economic expansion on record. It should also be noted that this expansion is the slowest expansion in terms of GDP growth since 1949.

VERTEX

Economic Growth

VERTEX

While long in duration, this economic recovery has not yielded high GDP growth; however, higher growth is projected for 2018.

VERTEX

Historical Expansion

[Trough to Peak in GDP]

Current Expansion: June ‘09 to Present

The trough of the current expansion took place in 2009; we have yet to record the peak of this expansion cycle.

Equities Market Boom

The DJIA has increased by approximately 20,000 points over the last decade (~6k to ~26k).

VERTEX

Equities Market Boom

[Outpacing GDP]

VERTEX

The equities market is outpacing GDP growth over the past decade—it is likely that the next correction will return the DJIA trend line back to the GDP line.

P/E Ratio for S&P 500 Companies

February 16, 2018: 25.52 Historical Average: 15.69

Source Data: www.multpl.com

VERTEX

The P/E ratio for the S&P 500 is historically high, which is resultant from the exuberance of the equities market.

VERTEX

In Jan-2018, the FOMC noted that is it holding back the frequency of rate hikes until inflation tips the 2-percent mark. Because the CPI eclipsed 2- percent in early Mar-2018; further rate hikes are expected in the near future.

VERTEX

Inflation is important to the FOMC as it drives wage increases – without inflation, wages remain stagnant, as they have for the past decade. However, the Employment Cost Index has recently trended upwards, as shown on the following slide.

Employment Cost Index

Due to the booming equities markets, record corporate profits, and recent stimulus measures (tax cuts, etc.), the ECI is trending upwards, which will likely cause a continued spike in interest rates.

VERTEX

Inflation (CPI)

VERTEX

The CPI is trending upwards, and this will likely continue for the next year

• r two as the FOMC tries to prevent the economy from getting
• verheated. An overheated economy swiftly leads to a recessionary

cycle.

VERTEX

Between January-2018 and February-2018, the FOMC, under the new direction of Jerome Powell, is alerting the public of looming rate hikes to prevent the economy from

• verheating.

Unemployment Rate

Over the past two economic cycles, the unemployment rate bottomed

• ut around 4 to 5-percent. Once unemployment bottoms out, a

recessionary cycle typically follows approximately one year thereafter.

VERTEX

Energy Inflation

VERTEX

After years of deflation due to a glut of supply, the global economy is heated and increased demand has caused a spike in energy prices.

Interest Rates

To prevent a sharp spike in inflation, the FOMC has been ticking up the Federal Funds Rate for the past year, after approximately 8 years of a near-zero interest rate.

VERTEX

Recent Federal Funds Rate Changes:

06/20/06 5.25 09/18/07 4.75 10/31/07 4.50 12/11/07 4.25 01/22/08 3.50 11 changes in ~2 years 01/30/08 3.00 03/18/08 2.25 04/30/08 2.00 10/08/08 1.50 10/29/08 1.00 12/16/08 0 - 0.25 12/16/15 0.5 12/14/16 0.75 4 changes in ~9 years 03/15/17 1.00 06/14/17 1.25

VERTEX

Federal Deficit

The federal deficit typically shrinks during periods of low unemployment because

• f the associated rise in tax revenue; however, this is not the case in 2018 due to

the tax cuts and additional federal spending. VERTEX

Federal Debt

VERTEX

Federal Debt is now over 100% of the US GDP. The rising debt level has caused a decrease in federal infrastructure spending.

Part 2. State of the US Construction Industry

The Good

• Booming private sectors

The Bad

• Flat public sectors

The Ugly

• Lack of skilled workers
• Construction cost escalation / thin margins

Bottom Line: Private sectors continue to boom while public construction remains flat. This trend will likely reverse within the next 24 months.

VERTEX

Overall Construction Spending

VERTEX

Put in place construction hit a record (~$1.25T) in 2017. The industry has recovered all lost ground (and then some) since the Great Recession.

Construction is Outpacing the U.S. Economy by a Wide Margin

US Construction Industry Growth Rate Since 2011: 9% US Nominal GDP Growth Rate Since 2011: 3.5%

VERTEX

GDP v. Put-In-Place Construction

VERTEX

The construction industry outpaced the overall US economy in the early 2000s before the industry overcorrected and put in place construction trended well below GDP growth in the early 2010s. The construction industry is now trending with GDP, which is a good sign—the construction industry is right-sized for the first time since 1996.

VERTEX

The Dodge Index is flattening out in large part due to construction inflation, slowing demand, and a lack of skilled craftsman.

Private Construction

VERTEX

Private construction is back to $950B in revenue, its pre-recession high. However, it is more balanced now, and not over-weighted with residential work, as was the case in 2006.

Residential Construction

VERTEX

Residential construction peaked in 2006 at nearly $700B. At the end of the Great Recession, residential revenue was down to approximately $200B. This sector has rebounded since 2012 and it now hovers around $500B, which is a reasonable figure.

VERTEX

Average home prices are soaring much faster than GDP growth. When this happens for an extended period, it generally leads to flat growth followed by compression.

Home value growth is most notable in the south and northwest. Certain areas

• f the northeast have seen significant growth as well (Boston/New York).

VERTEX

Apartment Vacancy Rates

VERTEX

Apartment vacancy rates have flattened out for the past two years, which signals that ample supply exists.

Office Construction

VERTEX

Office construction dipped after the presidential election, and the sector reheated approximately six months thereafter. Overall this sector has doubled in size over the past four years (~$36B to ~$72B).

VERTEX

Like apartment vacancies, office vacancies are flattening out, which will likely cause office construction spending to slow over the next several years.

VERTEX

Lodging Construction

Hotel construction has grown from ~$8B in 2011 to ~$28B in 2017; however, construction revenue is flattening out as occupancy rates are no longer on the rise.

VERTEX

Hotel occupancy has remained at approximately 65% for the past four years, which has led to flat growth in this sector of late.

Retail Construction

VERTEX

Despite fears that Amazon will eliminate the need for retail centers, retail construction has grown from ~$40B in 2011 to over ~$80B in 2017. However, like many other sectors, occupancy rates have flattened out and, consequently, the demand for new retail product has slowed.

Manufacturing Construction

VERTEX

Between 2011 and 2015, the US dollar strengthened against most other

• currencies. As a result, exports started to slow, which led to a notable

decrease in this sector. Now that the US dollar is on the decline, the manufacturing sector should rebound significantly over the next several years, particularly when coupled with the stimulus measures by the federal government (tax cuts, tax incentives, etc.).

US Dollar Index

source: www.macrotrends.net

VERTEX

Health Care Construction

VERTEX

Spending in the Health Care sector has remained flat for the past decade despite the aging population. Experts attribute this to a lack of demand for hospital beds, and extreme consolidation in this industry. In addition, technological advances are likely going to lead to less demand as doctors will be able to evaluate vitals signs remotely, etc.

VERTEX

Power Construction

The flat demand for electricity has led to flat construction spending in the Power sector. This trend will likely continue for some time.

VERTEX

Public Construction Spending

[21% of overall construction spending] Public construction spending has steadily declined for the past decade even though demand is pent up (to put it mildly). The decline is due to the increase in deficits and federal debt level. In the near future this will become an emergency situation and the federal government and states will have no

• ther choice than to prioritize infrastructure spending. Due to the shortage
• f governmental funds, PPPs will likely become a large part of the solution.

VERTEX

In 2017 the American Society of Civil Engineering graded the US infrastructure at D+, which evidences the pent up demand for spending.

VERTEX

Takeaways from the Trump Infrastructure Plan:

• Federal Government would

commit up to $200B over the next decade so long as…

• State/Localities/PPPs put up

approximately 85% of the funds for individual projects, or $1.3T

• Total plan is for $1.5T in

infrastructure spending ($200B + $1.3T = $1.5T)

• Congress will address this plan
• ver the next couple of months
• The 53 page plan includes

permit streamlining elements VERTEX

VERTEX

Public Construction as a Percent of GDP

Public construction as a percent of the GDP has been on a steep decline for the past decade.

Sewage & Waste Disposal Construction VERTEX Water Supply Construction Public Safety Construction Educational Construction

Most public sectors have seen a steady decline in spending since the Great Recession.

Highway & Street Construction Transportation Construction

The two sectors that have bucked this trend is Highway & Street and Transportation, likely because these demands are patently evident (traffic, dilapidation, etc.).

VERTEX

Construction Workforce

The construction workforce peaked in 2006 at ~7.6M; the workforce dropped to ~5.6M in 2010—thus, the workforce lost ~2M people. Over the past 8 years, however, the workforce has increased by ~1.5M but it remains 500k workers short of its peak, even though the same amount of work is being installed (~$1.2T in 2006; ~$1.2T in 2017).

VERTEX

Average Hours Per Week

VERTEX

Due to the shortage of workers, the workforce is working longer hours. This trend causes safety issues, quality issues, and schedule issues.

Unemployment Rate - Construction

VERTEX

Construction unemployment historically never gets far below 5%, which it has been at for the past three years. Hence, if the workforce does not grow, it will be difficult if not impossible for the construction industry to grow, save for increases due to inflation.

Construction Establishments

Source: Bureau of Labor Statistics

Reduction

• f 120k

companies

Over the past decade the number of construction establishments has reduced by 120k. Therefore, less companies and less workers exist to perform the same amount of work. Again, this trend will likely restrain industry growth.

VERTEX

VERTEX

VERTEX

VERTEX

VERTEX

$127/SF

One example of construction inflation is on multi-family projects, where the average cost per square foot has increased from $127/SF in 2010 to $187/SF in 2018, or growth of 8%/year.

VERTEX

Construction Escalation

8%/year since 2010 VERTEX

Even though the construction market is booming and there are less companies and workers to complete the work, net profit margins remain

• low. In fact, over the past five years, the net profit margin of publicly

traded general contractors has gone down. The same holds true for heavy contractors, which is not surprising due to the lack of public construction spending. Net profit margins for engineering companies have increased, but not to 2006 levels. The most profitable sector remains residential construction, but most public residential contractors also serve as developers, so the higher margins make sense.

VERTEX

One interesting trend in the construction industry is the addition of AE firms that recently acquired construction companies to ENR’s Top Contractor list, such as AECOM and Jacobs. This trend will likely continue as publicly traded AE firms will need to find ways to promote revenue growth.

VERTEX

VERTEX

Market Share of the Top 100 Contractors:

2004: 18% 2009: 26% 2016: 30% The market share of the Top 100 contractors in the US has nearly doubled in the past two decades. This trend will likely continue as AE firms enter the construction space.

VERTEX

VERTEX

Inflation in the construction industry is trending well above the CPI.

Construction is one of the few industries that has seen little to no efficiency gains over the past 100 years. In fact, McKinsey recently reported that construction workers are actually less efficient now than they were 50 years ago. However, recent trends indicate that this is about to change over the next decade.

VERTEX

VERTEX

VERTEX

Several large heavy contractors are now using drones (UAVs) to complete aerial surveying and geo-mapping on a daily or weekly basis. In addition, many large heavy contractors are using self-driving earth moving equipment on grading projects (most equipment continues to have

• perating engineers on them for safety purposes). These advances will

greatly improve the efficiency of earthwork construction in years to come.

Large building contractors are now leveraging 4D technology to improve the efficiency of construction as 3D models are plotted against CPM schedules so the workforce can understand the proper sequence of work, and the proper integration of various divisions of work. This trend is in large part attributable to design subconsultants embracing Revit software, so each subconsultant can work on the same software platform.

VERTEX

The trend towards smart cities will create massive demand for the installation of new smart technologies, a sample of which is shown

• above. This is referred to as the “Internet of Things.”

VERTEX

Part 3. State of the Surety Industry

The Good

• A Decade of Low Loss Ratios
• Expansion into international markets

The Bad

• Soft Market Conditions
• Additional risk due to labor shortage

The Ugly

• Is a Loss Cycle nearing?

Bottom Line: The industry remains in remarkably good shape and is defying historical trends.

VERTEX

The Surety Industry Continues to be Profitable for the 12th Consecutive Year, Despite Modest Premium Growth. 2008 Premium: $5.6 billion 2016 Premium: $5.8 billion 2017 Premium: $6.2 billion (forecast)

Even though public construction is flat, the surety industry is poised to realize significant premium growth in 2017, which confirms that the industry is gaining greater market share in private and international markets.

VERTEX

2006 - 2017

VERTEX

Surety loss ratios continue to run at historic lows. The surety industry has not had a loss ratio north of 20% since 2005.

VERTEX

A positive trend is emerging from recent surety data—the surety industry is realizing notable premium gains despite flat public construction spending, which evidences that the surety industry is diversifying away from the public sectors and into the private and international sectors.

VERTEX

M&A Activity in the Surety Industry:

• Berkshire Hathaway (#29) enters surety market (Jun 12, 2014)
• ACE acquires Chubb (#5) (Jan. 14, 2016)
• XL exits surety marketplace (Mar 7, 2016)
• Markel acquires SureTec (#19) (May 1, 2017)
• Intact acquires OneBeacon (#21) (May 2, 2017)

Surety consolidation has slowed and several insurance companies have entered the surety marketplace due to remarkable industry performance over the past decade.

VERTEX

Market Share of the Top 10 Surety Providers:

1980: 21% 1990: 42% 2004: 67% 2008: 68% 2014: 63% 2016: 62% 2017: 61% (through Q3) The market share of the Top 10 surety providers has not been this low for approximately 20 years.

VERTEX

Top Risks that Face Contract Surety Providers in 2018:

1. Labor Shortage = Safety/Quality/Schedule Issues 2. Lack of Growth in Public Construction = Low Margins for Heavy Contractors 3. Inflationary Pressures lead to Surety Losses Over Time 4. Soft Market Conditions = Potential Reduction in Underwriting Standards

VERTEX

End

VERTEX