I have been working in the construction industry for past 4 years. Thus, I decided to dig deeper to understand how some of the contractors make money and what is their business model. Tutor Perini is a good case study for anyone who wants to understand few insights into construction industry specially in transportation and infrastructure sector in US.
TPC’s key ratios such as return on equity and return on capital are not impressive. This post although is not comprehensive, provides few key insights into general contractor’s business dynamics.
Business overview –
Tutor Perini currently ranks 12th in ENR Top 400 Contractors in US which is a very reputable position. They are one of the largest civil and building contractor in the nation. Ronald Tutor, CEO of Tutor-Saliba became chairman and CEO of Tutor Perini Corp after acquiring Perini Corp in 2008. The combined entity targets 2 key markets – Large building projects in leisure/gambling/health sectors in Nevada (Caesars palace and MGM) and large civil projects in California and North-East.
The business grew dramatically in its core building segment since Ron Tutor became CEO; TPC sales grew from little over $600 m in 1999 to $5b by 2009. Growth was fueled by large projects in Las Vegas where TPC had a strong hold. In 2005, Forbes named Perini Corp as ‘one of the best managed companies in America’ ranking No.1 in construction industry. By 2008, the building sector was alone contributing $152m in operating profits. TPC was established leader in building entertainment. Things started to fall apart after financial crisis in 2008 where large projects in Vegas were cancelled.
To compensate for losses in the Building segment, Ron Tutor, right after Perini merged with his own Tutor-Saliba company, embarked on an acquisition spree, focusing on the segment he was familiar with: Civil. Ron Tutor acquired several businesses in the Civil space, such as Lunda Construction, Becho and Frontier-Kempter in the Civil space and Fisk Electric and Five Star Electric in the Specialty Contractor space. These transactions helped the Civil segment and the Specialty Contractor segment grow sales between from $0.5bn in 2008 to $2.6bn by 2012. This is where TPC’s problems began.
The Civil segment has been the real driver of performance for TPC in the recent years, representing now ¾ of the operating profit generated by the company before central costs and over half of its backlog. Civil revenues went from less than $400m in 2009 to nearly $2bn in 2015. Ron Tutor was absolutely determined to have the business grow back to the heyday of the Las Vegas boom through aggressive growth in Civil. He nearly succeeded as TPC’s sales were back to $5bn by 2016 from little over $3bn in 2010.
It’s important to note that the Civil segment is a trickier one than building construction. Projects are typically longer and more complicated. Cost overruns are common and for this reason, typical contractors try to limit their exposure by having variable pricing or cost-plus type of contracts, rather than fixed price contracts. Furthermore, large Civil projects are often subject to many change orders during the construction period, leading to tricky contractual resolutions. Finally, while the building segment is predominantly dealing with private clients, the Civil segment is predominantly dealing with public entities, local municipalities, or the federal government. Competition is somewhat lower as bidders require scale and expertise. Because of this, margins could in theory be better than in Building, where a contractor earns low single digit margins. Other Civil competitors such as Fluor, KBR, Parsons, Granite, Skanska, Dragados, Kiewit Corporation etc. can earn mid-to-high single margins on larger projects if managed well. Tutor Perini is still a smaller competitor, ranked 12th in the US but 2nd overall in the transportation (roads, bridges, tunnels) segment. It is therefore extremely puzzling to see TPC generating double digit EBIT margins in its Civil segment when all peers make mid-to-low single digit margins. We will discuss more on accounting further below.
The growth in Civil segment though came at significant risks for TPC. Large construction projects are complicated enough where conservative players try to minimize risks structuring contracts where excess costs will be borne by the customer, or at least shared. Not so with Tutor Perini – the proportion of contracts under fixed prices increased dramatically over time and it represented 80% of sales in 2018. TPC has effectively been betting on lucrative contracts that could become huge liabilities if mismanaged. Think about a $4bn contract where TPC aims to make 10% margin. A 20% cost overrun will crush margins to negative 10%.
Tutor Perini does not have many attractive parameters for the investors to call it a good business. Sales haven’t grown in last 10 years; net profit margins are less than 2%. Interest coverage has been less than 3 at times and debt to equity is 0.58. Company has aggressive accounting policies and the cash flow from operations do not match net profits. At first, you might find that cumulative cash from operations is higher than net profit but when you deep dive into cash from operations and revenue recognition methods as explained below, you will realize that Tutor Perini is essentially signing up for loss making future liabilities. More or so, company has not generated positive free cash flow cumulative over last decade.
Aggressive Accounting –
The problem with construction companies is that revenue recognition is subject to management’s own estimates. This significant issue is compounded by the fact that larger Civil projects are naturally subject to order variations and changes to the original contract. The contractor continues to incur in costs and recognizes revenues and margins associated with these costs, not knowing though whether the client will ever pay for these.
“Because control transfers over time, revenue is recognized to the extent of progress towards completion of the performance obligations. The selection of the method to measure progress towards completion requires judgment and is based on the nature of the products or services provided… Due to the nature of the work required to be performed on many of the Company’s performance obligations, estimating total revenue and cost at completion is complex, subject to many variables and requires significant judgment”. Ref- Revenue Recognition, Annual report 2019.
TPC clearly highlights this problem amongst the risk factors in the annual report:
|Risks in Annual Report||Practical meaning|
|“If we are unable to accurately estimate contract risks, revenue or costs, the timing of new awards, or the pace of project execution, we may incur a loss or achieve lower than anticipated profit”||TPC may sign contracts that are loss making|
|“Our contracts require us to perform extra, or change order, work which can result in disputes or claims and adversely affect our working capital, profits and cash flows”||Because these contracts are loss making, TPC will end up burning cash|
|“Our actual results could differ from the assumptions and estimates used to prepare our financial statements.”||TPC may recognize profits on such contracts when they could be loss making|
This problem expresses itself at the balance sheet level under “Costs and estimated earnings in excess of billings”, otherwise known as Unbilled Receivables. These represent the receivables that the client owes the contractor for revenue recognized by TPC where costs have been incurred on a cash level, but the client could not be billed. The 2 larger categories of unbilled receivables are “claims” and “unapproved change orders”. Claims occur when there is a dispute regarding both a change in the scope of work and the price associated with that change. Unapproved change orders occur when a change in the scope of work results in additional work being performed before the parties have agreed on the corresponding change in the contract price. Over the last 9 years, since TPC focused its prospects on the Civil segment, unbilled receivables grew exponentially from little over $200m in 2010 to nearly $1.2bn in 2019. Particularly worrying was the growth in claims, growing 10 times from 75m in 2010 to over $700m in 2019:
Claims are the most troublesome item on balance sheet because it represents revenues (and margins) that have been recognized in the P&L that are highly uncertain in terms of collectability. The clients dispute both the change in the scope (“I never told you to add the extra ditch to the foundation of that bridge…”) and the price associated with that change (“you cannot possibly charge me $1m for that extra ditch”). Over the last 9 years, TPC recognized close to $1bn in revenue that not only was not paid for by the customer, it was not even billed.
The change in fortunes at TPC since the company decided to aggressively move into the Civil segment is remarkable. Between 2003 and 2010, when TPC was involved in Las Vegas type of construction projects, they generated close to $500m in free cash flow, which is over 50% of the EBIT generated in the period notwithstanding the negative FCF reported during the GFC in 2009. Vice versa, between 2011 and 2019, TPC generated close to $1.6bn in cumulative EBIT and negative cumulative free cash flow. Over the last decade, TPC did not generate a single dollar in cumulative free cash flow.
The above suggests that TPC continued to recognize P&L profits on contracts that were essentially unprofitable. The huge balance of claims will never be entirely paid off as some of these receivables are not going to be recognized by clients.
Goodwill Impairment – Several large impairments made in recent years suggest the above interpretation of financials is correct. Following the numerous acquisitions discussed above, TPC had nearly $900m of Goodwill on balance sheet by 2011. Over the years, the company was forced to take several impairments to these acquisitions, the latest in Q2-19 in the Civil sector. Following these impairments, Goodwill today is only $205m. There have been in the last years impairments totaling nearly $700m suggesting the true underlying value of the acquired business is significantly lower than previously expected. Still, TPC didn’t write off any receivable nor restated previously recognized revenue.
Stretched Balance Sheet –
The inability to generate cash discussed above, led the company to incur in substantial amounts of debt to fund operations. Large contractors should ideally be debt free or with very less debt due to nature of their business. Because TPC could not generate any cash, net debt went from $450m in 2011 to nearly $800m, bringing total leverage to very uncomfortable levels.
The company obviously reports only debt balance at quarter end. It seems that the company is continuously drawing on its revolver to fund day to day operations. This should not happen at a well-run, large scale contractor. The average cost of debt for TPC should be c. 6%, give or take:
However, if we calculate the actual interest cost on a quarterly basis, we notice that the implied interest rate paid by TPC on the average debt balance of the period is much higher than this:
The only way to explain this is to assume heavy intra-quarter revolver borrowings. Doing a simple back of the envelope calculations, we can imply from the above that on average, TPC carries at least $300m of debt on balance sheet more than it reports at quarter’s end. Average cost of debt is c. 200bps higher than it should be, or c. $15m a year. The revolver costs c. 4% a year. 4% of $300m is $12m. Tutor Perini is financially much more stressed than it would like you to believe.
Chronic Inability to collect –
Since 2010, when Ron Tutor embarked on an aggressive growth strategy in the Civil segment, TPC failed to collect unbilled receivables. Put it differently, TPC continued to generate positive EBIT on paper but negative free cash flow. Over the years, this became an important focus for management for 2 reasons:
- Notwithstanding record backlog and good growth in earnings, the stock wasn’t going anywhere as investors realized that TPC was unable to collect on its unbilled receivables
- TPC was starved for cash and needed cash quickly. Collection of old receivables would be an obvious place to start in order to generate cash
Illustrated below is management’s chronic inability to collect receivables notwithstanding their bombastic claims to the contrary. Ron Tutor promised time and time again he’ll tackle the issue, but his track record should really make investors very skeptic. Unbilled receivables increased from $139m in Q4-10 to $905m in Q4-15. At Q4-15 results, in February 2016, Mr.Tutor finally had to concede to the market that the company had an issue with collections and that the unbilled receivable balance needed to be resolved. As far as I can tell, it’s the first time he tackled the issue publicly. This is what he said:
“The increase in the cost in excess account has certainly gotten our attention and we are working hard to drive it down. Note that just three years ago the cost in excess balance was about half of what it currently is. We expect to reach that level by no later than the fourth quarter of 2017”.
Quarter by quarter, management kept repeating this mantra. Just 3 months later, at Q1-16 results, the CFO said “in late February, we communicated our plan to reduce unbilled costs, that’s the cost and estimated earnings in excess of billings reflected on our balance sheet from $905 million at the end of 2015, to about half that amount by the end of 2017, so over a two-year period. To accomplish this, we have been intensely focused on resolving numerous claims and unapproved change orders, as well as billing and collecting other unbilled amounts…We’re starting to see considerable traction in our efforts as we have made very good progress in the first quarter of 2016″.
A quarter later (Q2-16), same promises were reiterated: “We expect to make further progress in reducing our debt level as we collect substantial cash that we are owed throughout the balance of this year and beyond in accordance with our previously stated goal”.
Even as the company was clearly not delivering on its stated plan, it continued to boast confidence in these targets. A quarter later (Q3-16) the CEO stated on the call” …this is Ron Tutor. I’m more confident today than the last time we spoke that we will collect the dollars, and we are currently making great strides…”. I won’t bore you with comments from every single quarter, suffice to say that the company missed its targets miserably.
Unbilled receivables balance was $905m in 2015. The CEO vowed to bring it back to 2012 levels ($465m) by Q4-2017. Instead, unbilled receivables increased a further $28m by Q4-17 to $933m, missing management target by nearly half a billion dollars.
Having missed its 2017 targets, management then focused on 2018 and 2019. On its Q4-17 call, the CFO stated the following: “we remain dedicated to significantly reducing our unbilled costs. Based on how negotiations are developing and expected to further progress, we anticipate more progress in resolving and reducing certain of our larger unbilled cost issues in 2018 and beyond…our operating cash flow in 2018 is expected to exceed net income…Deleveraging, in other words, debt reduction, remains a top priority in terms of capital allocation. We plan to utilize as much operating cash we generate in 2018 as possible for this purpose”. The annual guidance given at Q4-17 results implied net income at the mid-point of c. $100m. Operating cash flow should have been higher. It ended being $21m, some 80% lower. Furthermore, TPC was supposed to pay down debt during 2018. Instead, net debt increased from $543m to $645m. Once again, management failed to deliver on its promises.
The above illustration gives some background to Q3-19 results, where management showed positive cash generation in the quarter and made new promises about cash collections in 2020. Given management track record, it was quite a surprise.
Enter Q3-19 results
Expectations were high going into the quarter. During TPC’s Q2-19 call, the CFO promised strong cash generation in H2: “We expect more substantial reductions in unbilled during the second half of this year and into 2020, as we continue to focus our efforts on negotiating, litigating and settling the various claims”. The stock rallied over 50% from Q2 ahead of Q3, in expectation of a cash flow relief. Q3 results involved a reduction in EPS guidance from $1.60-1.80 to $1.40-1.55 but also the best quarter ever in the company’s history in terms of cash flow. TPC generated $200m in FCF in the quarter. The surprise sent the shares 18% higher on the day and nearly 100% up from Q2.
The CEO was quick to tout the strong cash flow generation as a victory for him on the collection front, vindicating his earlier claims. The CEO said “The Company generated a new quarterly record $222.9 million of operating cash for the third quarter…The strong operating cash flow was driven by collections associated with certain dispute resolutions, as well as from the Company’s continued focus on improved working capital management… Our strong cash flow was driven by significant collections associated with several settlements”.
The perception that TPC got a handle on collections sent the shares higher. Furthermore, the CEO indicated that 9 individual disputes (claims) totaling $257m will be resolved (either settled or via legal means) in Q1-2020. This further positive development reinforced the perception that collections are a problem of the past and significant cash flow will be generated in the near term.
In reality, the market was blinded by the strong cash generation in the quarter, ignoring the real sources of cash. Contrary to what management would like you to believe, settlements of claims had very little to do with cash generation this past quarter. As per table below, the claims balance continued to climb higher each quarter last year:
Rather, what is driving cash flow, is the increase in “Billings in excess of costs and estimated earnings”, otherwise known as Deferred Revenues
Understanding movements in Deferred Revenues
Billings in excess of costs and estimated earnings, or deferred revenues, is defined as the excess of contract billings to date over the amount of contract costs and profits (or contract revenue) recognized to date. In other words, it represents the cash amount clients advanced to TPC for large project that wasn’t spent yet. It’s a sort of advance payment, typically 5-10% of the contract value, that clients pay contractors to help them managing their working capital. In a normally managed business, one would expect this balance to remain stable over time, at least as a proportion of revenues. There is no logical reason to explain why clients would decide to prepay larger proportion of projects over time. However, this is exactly what happened to TPC clients in recent years:
Until 2017, deferred revenue balance was in the $300-400m range, or 6-8% of sales. Over the last 2-3 years, the balance jumped to over $800m, or 18% of sales, nearly 3x larger than the “normal” level. This was a huge source of cash flow for TPC in recent periods. Since Q1-17, TPC raised nearly $500m in cash from changes in deferred revenue: $126m in 2017, $116m in 2018 and $246m in 2019. It’s fair to say that without this huge increase in deferred, TPC would probably be busted by now.
What is driving this huge increase in Deferred? This is probably the most interesting and misunderstood element of TPC business. I would like to believe that TPC is desperate for cash, they cannot collect receivables and the only way to fund themselves is to ask clients to do it for them. TPC might be signing as many projects as they can because every time a new project is signed, the client will have to put down some 5-10% of the total project cost up front, thereby advancing working capital to an otherwise stressed balance sheet. TPC is effectively committing themselves to a huge amount of liabilities (remember – at least 80% of contracts are fixed price, if there is a cost overrun or the contract was bid overly aggressively, TPC is on the hook for the losses) in order to get some cash in the door. This is also very clear just by looking at the backlog. Backlog ballooned to $11bn from $6bn 3 years ago while sales are still lower than they were then.
TPC would justify this by saying that a large backlog means higher revenues in the future. While this may well still happen in the future, the huge increase in backlog didn’t bring any revenue growth over the last 4 years:
Let’s think about this for a second. Over the last 4 years, revenues went nowhere but backlog went up by over $4bn. We also know that over the same period, deferred revenues increased by c. $0.5bn. A typical contract has c. 10% down payment / advance payment. Signing incremental $4-5bn of backlog should lead to $400-500m of cash inflow from deferred. This is exactly what TPC did – they signed as many contracts as they could in order to get hold of the cash.
Key findings –
Construction is highly dependent on the overall economy of the country. While growth varies in different sectors such as healthcare, commercial construction, residential, technology, infrastructure. Contractors can find themselves a niche in certain markets that are expected to grow in the long run and make their business model more sustainable.
Contractors with large scale and healthy balance sheet can enjoy repeat contracts for large projects due to their sheer size and execution capacity. However, this does not necessary mean they would profit from it. Margins in the construction industry are very less in general.
General contractors build projects with contracts that can be cost plus fee, guaranteed maximum price and lump sum or fixed price. Contractors prefer to pass on the risk by not having lump sum contracts for complex projects.
Construction companies cannot accurately estimate their revenue and margins as the contract amount for a project keeps on varying depending on approved/unapproved pending change orders which remains uncertain given the nature of the project.
There could be large gap between actual profit vs cash coming out of operations. This occurs because of varying revenue recognition policies that apply to construction project. The revenue and costs are recognized as the work is put in place. However, actual cash may not be equal to profits due to claims, unapproved change orders that contractor has proceeded on at risk.
Contractors have to deal with resolving these claims and unpaid change orders which incur drag on cash flow management especially for companies with debt, interest has to be paid whereas claims take years to be resolves and may not necessarily be in company’s favors.
Tutor Perini certainly enjoys advantages due to its large scale which can be seen in their ever-growing backlog of $11b however, 80% of fixed price contracts pose a huge risk on profitably of these projects. This risk is evident from growing unbilled receivables and claims up to $1b. The cash crunch has caused company to incur more debt every year. The interest expenses put even more pressure on the profitability of the company as a whole. I wasn’t very impressed with management’s claims through their concalls as they are not able to walk the talk. It was interesting to understand how TPC was using deferred revenue as a source of cash to breathe in for the time being.
References – TPC Annual Reports, Morning star data, value investors club and motly fool reports. The original report was written on value investors club, the above report presents my opinions after double checking the financial data and conference call transcripts.