After seven years of robust expansion, 2019 will mark the first year of significant US construction growth deceleration. The decrease is attributable to a slowdown in residential and commercial spending growth. According to our research, there are two key reasons for it: an increase in labor costs and material price increases. These are expected to impact the financial performance of building materials players across all sub-groups over the next four years.
To address the headwinds, in this report Roland Berger has identified four characteristics that enable corporate success and support player performance. A better understanding of these, and a coherent long-term strategy, can equip players for success in the softening market.
Building materials industry performance in 2019
For most of the North American building materials industry, 2019 is projected to be the first year of decelerated growth. Construction activity has steadied, with value put in place of USD 1.30 trillion estimated in 2019, a 0.8% increase over 2018. Both residential and commercial construction is projected to flatten from 2018-2023 due to general unaffordability, demographic trends, high vacancy rates and a softening of segment-specific tailwinds such as e-commerce-related warehouse investment.
With revenues up 13% in 2018, revenue growth rates have largely matched their 2017 pace. This is a result of the recency of the construction slowdown which started in the second half of 2018 and has yet to fully manifest in building materials players' financials. Industry-wide operating margins are near flat at 10.9% and debt levels have also remained constant. Invested capital growth has decreased overall, driven mainly by a major decline in HPE (Heating, Plumbing and Electrical) systems and Exterior materials. Lighting systems and Basic metals were the two segments which showed an increase in invested capital growth since 2017. Working capital as a percent of sales has decreased by 2.4 percentage points to 15.6%, and asset turnover has increased across sub-groups.
The financial performance matrix (see infographic 'Building Materials financial performance') maps building materials companies according to key profit and growth metrics calculated over the full years 2016 to 2018. Here we see mixed performance among the industry sub-groups, although all but Lighting systems achieved positive economic profits and capital growth. HPE systems were the clear outlier in profitability with 10% average economic profit. These results align with expectations as downstream system players largely capture higher average economic profit, and lighting players are feeling the effects of the recent LED transformation and resulting technology commoditization. Overall, all segments displayed invested capital growth, with the Semi-finished materials segment growing fastest at 14.8%. Sector-wide invested capital growth is unsurprising given the strong S&P500 performance from 2016 to 2018.
Quadrant I companies, the Winners, had the highest average total shareholder returns, gaining 9.1% p.a. (unweighted). Although the Cash Generators in Quadrant II had the highest average ROIC at 11.9%, shareholder returns of 4.7% p.a. were lower than those of the Winners. The market punished shares of the Profitless Growers residing in Quadrant III; these firms displayed the lowest return on invested capital, culminating in negative shareholder returns of -6.6% p.a. on average. Quadrant IV's Underperformers managed to realize slightly greater total shareholder returns at -1.4% p.a., but on average were not able to raise their level of invested capital during the 2016-2018 period.
The building materials industry tracked the market from 2015 to mid-2018, until the North American construction market began to soften, and drove sector-wide underperformance. Since then there has been substantial divergence between sub-groups with five out of six lagging the S&P500 substantially. The outperformance of HPE systems is a result of the category having the lowest exposure to the North American construction market, and being able to benefit from robust construction activity in Emerging Markets. The recent performance of the building materials’ industry is expected to hold for the forecasted period, given the general reliance on domestic construction for most of the constituent players.
Average single family housing prices increased from USD 340,000 to USD 379,000 between 2015 and 2019.
The construction market consists of three major segments: residential buildings; commercial buildings; and infrastructure. Residential and commercial construction are predicted to drastically slow compared to their 2015-2018 rapid growth, while infrastructure is expected to accelerate its pace of growth in the next four years.
The residential segment has slowed dramatically, with construction growth predicted to decline from 8.4% in 2015-2018 to 0.2% in 2018-2023P. A substantial factor in this shift is the increase in average home prices resulting in widespread unaffordability. Average single-family housing prices increased from USD 340,000 to USD 379,000 between 2015 and 2019 and are showing no signs of slowing, with 5% year-on-year growth recorded in 2019 Q2.
The reliability of this trend is reinforced by its occurrence in spite of an increase in overall inventories, which would normally serve as a headwind to price increases. Price growth has been a consistent narrative across the country, with interior metropolitan areas, such as Boise, ID, leading the way, and high-income coastal cities, such as Seattle, growing at more modest rates.
The 99 to 100th percentile hold 30% of total assets in 2019.
The residential construction slowdown is exacerbated by increasing economic headwinds for key homebuying demographics. This has been driven both by student debt levels increasing from USD 1 trillion to USD 1.6 trillion since 2014, and wealth gains being highly skewed to a small share of wealthy households. The 99 to 100th percentile hold 30% of total assets in 2019. Mixed views exist on whether millennials and Generation Z will revert to previous generational preferences around home-ownership and location preference when they overcome these early life economic headwinds, or stay truly distinct.
Commercial construction put in place is also forecasted to rapidly decelerate from a compound annual growth rate of 4.6% between 2015 and 2018 to 1.4% in 2018-2023P. The hardest-hit segments are projected to be hospitality (from growing at 13.3% to shrinking by -1.5%) and retail (from growing at 10.7% to shrinking by -0.4%). Hospitality experienced a peak in hotel and casino construction in recent years and now has a limited mega-project pipeline, with a segment-wide trend toward renovation/capacity addition over new hotel construction further dampening growth. Retail has suffered from the rise of e-commerce which has negatively impacted traditional brick-and-mortar retail construction and led to retail vacancy rates rapidly rising to 10.2% in 2019. Furthermore, e-commerce-driven construction is unable to compensate, as warehouse construction costs are dramatically lower than typical mall construction.
Unlike the overall commercial market, manufacturing is expected to improve from -6.6% p.a. growth from 2015-2018 to 2.0% growth in 2018-2023P. Growth in the sector is driven by a sustained increase in US industrial output since 2016, with manufacturing production rising 0.5% in August 2019 and capacity utilization continuing to grow.
Infrastructure is set to grow at an accelerated rate of 3.8% p.a. through 2023, driven by overall increased federal and local funding and a trend towards transit-oriented megaprojects. A substantial federal funding increase from a job-driven infrastructure package is possible, and would support much higher growth. However, negotiations between the current administration and the House for a USD 2 trillion package stalled in early 2019 with no progress made over the past half year. Regardless of whether such a package is approved, supply-driven dynamics must also be considered, particularly the current labor shortage, which could render such a dramatic investment increase infeasible.
Despite the relative uncertainty of overall federal infrastructure funding, focused infrastructure funding in areas such as transit and utilities has been, and is expected to continue to be, successfully passed. In total, additional federal funding of ~USD 12 billion per year is projected to be allocated under various programs including the America's Transportation Infrastructure (ATIA) Act, which has been proposed to replace the existing Fixing America's Surface Transportation (FAST) Act. At USD 287 billion over 5 years, ATIA would constitute a dramatic increase in federal highway funding.
Labor and key material costs trends in North America
A nationwide deficit of skilled trade professionals has resulted in sub-contractor costs growing at a 2-4% compound annual growth rate from 2014-2019 Q3 across all types of construction labor. The purchasing price index for concrete contractors (nonresidential building work) has risen at the highest rate – 4.1% over the last 5 years, while roofing, electrical and plumbing commercial sub-contractor costs have grown at rates between 1.9% and 3.1% over the same period.
The overall driver of the sub-contractor cost increase has been an ongoing industry labor shortage.
The overall driver of the sub-contractor cost increase has been an ongoing industry labor shortage. Of the ~1.5 million workers who exited the industry during the Great Recession, an estimated 600,000 have not returned to construction since the market recovered. In addition to the general labor shortage, the industry is struggling to attract younger workers, and the share of workers aged 24 years or younger in the industry has declined almost 30% since 2005. An increased cultural emphasis on the importance of higher education is a key factor depressing the pool of younger workers entering the construction industry. An industry-wide consensus exists that as the average age of the construction workforce continues to increase without a subsequent influx of younger workers entering the labor pool, construction firms will be forced to rapidly adopt labor-saving technologies.
Compared with labor costs, aggregate material cost movement has been less dramatic, growing at 1.8% from 2014-2019 Q3. Despite measured material cost growth, volatility of individual material prices has been substantial with energy, lumber and key metal scrap experiencing the most dramatic swings. This is the result of the global nature of these commodity markets and the corresponding impact of international trade policy. Both developers and contractors are being adversely affected by this volatility as they are forced to introduce contingencies into their bids in a move to protect profits in the face of unexpected cost increases.
Key success factors and how Acuity Brands demonstrates business excellence
Among the Building Materials winners identified, four Winner's Characteristics emerged that drive performance of individual players: Business leadership; strategic coherence; financial scale; and proven ability to execute. Each of these characteristics provides a substantial advantage in challenging market environments.
The case study of Acuity Brands offers an instructive example of how best-in-class business leadership can enhance a business' ability to maintain margin through pricing and to limit business disruption.
By early 2009, light-emitting diodes became commercially viable for use in general lighting applications, marking a tipping point in an industry that had still been, in some cases, using technology that had existed for over a century (e.g. incandescent bulbs). LED lighting was a dramatic improvement over previous lighting technologies, even more recently developed compact fluorescent lighting. This major shift was felt globally from 2009 to 2014-15 during a period of rapid efficiency and LED manufacturing cost decreases. These ended with commoditization of the technology in key application segments such as consumer and retrofit. This cost improvement was not only a result of improvements to the underlying semiconductor technology, but also due to the perceived strategic nature of LED lighting from the Chinese government and corresponding major subsidies included in the 12th five year plan. At the turn of the decade, Chinese policy had created a highly competitive global lighting market, supported by over 10,000 domestic firms, some of which sold below materials costs and relied on subsidies. This was quickly felt by the big three light source manufacturers (GE Lighting, OSRAM, Philips), who had asset heavy technology positions, and were impacted by the volume and speed of competition from China. LED was not only superior in terms of efficiency, but also had substantial secondary benefits including light quality, ease of dimmability, product lifetime and increased design freedom. While most of these features are widely recognized and enjoyed by the market, increased design freedom is a benefit that is still in the process of being realized. The traditional fixture format, which has been dictated by the need to have a separate and replaceable bulb, no longer bounds design, as LEDs can provide even lighting in any shape that can house semiconductor chips small enough to fit on one's fingertips. In conclusion, LED has radically disrupted the global lighting market, shifted required core competencies and provided substantial benefit for end-users. Furthermore, LED is expected to become the dominating light source technology for the foreseeable future. OLED, which was widely hailed as the next disruptive lighting technology and heavily invested in by LG, has not yet reached the cost improvements, performance/light output and lifetime required to unseat LED in the general lighting market. The key advantage of OLED is greater form factor flexibility, which only outweighs increased cost in select applications such as automotive headlights, where any weight is treated as a constraint on performance.
In addition to mastering a shift in technology competence, downstream channel and brand strength became the primary source of differentiation. This is particularly challenging to implement, given the local nature of the lighting business, which ranges from a highly traditional relationship-based selling approach to state-level building code requirements that require customized products. Acuity Brands, while already relatively well positioned, recognized this shift and demonstrated business leadership by executing consistently on building a robust portfolio of brands – expanding globally in a regionalized market. This was largely driven by M&A with Acuity building a broad portfolio and #1 position in NA through 1-3 lighting and adjacency acquisitions per year. Major global competitors were less intentional in their direction and either back-integrated into commoditized technology or overinvested in technology areas such as the IoT (Internet of Things) and BMS (Building Management Systems) which are largely beyond the core competence of lighting players. IoT leadership is a challenging transition because lighting sits at the edge of the ecosystem and standards have yet to form. Meanwhile, BMS is a specialized offering that requires truly deep software investment and the ability to compete against entrenched global conglomerates such as Honeywell and Johnson Controls. The cost to play in BMS is also dramatically different from lighting as a USD 100 m lighting factory can produce for 15-20 years while a similar investment will finance a programming team for only a few years.
Acuity has outperformed global players for the past decade while maintaining ~40% gross margins.
As a result of this intentional approach, Acuity has outperformed global players for the past decade while maintaining ~40% gross margins. Select players have also successfully deployed Acuity's strategy in other markets, such as Opple Lighting, the most recognized Chinese lighting brand with domestic distribution in over 30,000 locations, a leading position in e-commerce and a broad product portfolio that is tailored to the needs of domestic cities within multiple development tiers. Furthermore, select global players are still enjoying the price premium of having household brands along with the financial uplift from their high-margin, but rapidly decreasing, traditional lighting business. However, given the dramatic industry headwinds, average lighting player economic profit has dropped below 0% in 2018 with limited reason to expect a rebound in the future.
While Acuity's success provides insight on the importance of business leadership in a challenging environment, all four characteristics are critical in the current market environment. Business leadership allows for margin maintenance limiting business disruption, strategic coherence provides unique levels of cost control, financial scale enables investment in key operational improvement and acquisitions and ability to execute allows for the necessary degree of adaptability.
Download the full PDF to find out more about the right metrics to measure growth, profitability and risk in our North American building materials winners and industry outlook publication.
North American building materials winners and industry outlook: Falling residential and commercial spendings have caused a growth deceleration of the US-construction market, significant in the year of 2019.
