Stopping the invasion of the fleshmongers
Published August 3rd, 2017
So CH2M is not going to do anything interesting with the money it raised from Apollo Capital Management in 2015-16. Instead, it is going the way of MWH Global, Atkins, and Amec Foster Wheeler to become another redundant brand left on the roadside by the juggernaut of engineering industry consolidation. It is difficult not to feel disappointed. CH2M is one of the best. It has a unique culture (in part due to the fact that it is employee-owned, while Jacobs is publicly traded). It has a brilliant position in the water sector, both internationally and in terms of its portfolio of interests, which include operations and maintenance as well as more traditional design and design-build work.
Apollo’s $300 million might have taken CH2M into project development and ownership or the digital water space. A bad year in 2016 – which saw a $121 million pre-tax profit in 2015 become a $256 million loss – put paid to that. Instead, a merger became almost inevitable. Fortunately, CEO Jacqueline Hinman found a buyer in Jacobs who was prepared to pay a good price for the business. The Dallas-based engineer was over-exposed to difficult markets such as oil & gas and mining, and views CH2M’s key markets – water, environment, transport and nuclear – as “high growth sectors”. Furthermore, Jacobs also liked the idea that only 10% of CH2M’s backlog comes from higher-risk fixed-price contracts. The remaining 90% of the order book is lower risk “reimbursable” business based on hours worked. At Jacobs the split is 18-82.
So much for the industrial logic of the merger, but what does it say about the water industry? Here are my thoughts:
- Despite what Jacobs said about water being a high-growth market, the deal probably wouldn’t be happening if it actually were growing quickly. It is a steady market, and one which is not prone to the kind of falls that we have seen in a number of industrial sectors. If it really were delivering high growth, CH2M – the global market leader in water and wastewater design work – would not be looking for a way out for its employee shareholders. The logic of this deal is two firms facing tough growth conditions looking to combine to cut costs. You could say the same of the GE Water/Suez deal.
- As engineering firms grow, their appetite for risk seems to get smaller. CH2M pulled out of design-build work in the power and transportation sectors after losing its shirt on some fixed-price projects. Jacobs, meanwhile, seems to pride itself on maintaining its “industry-leading low-risk profile” despite now being the largest design firm in the world. This is in part because the market is flat, and aiming to grow by increasing market share via fixed-price contracts is suicidal. It is also because as firms get bigger, the need to maintain tight financial control and revenue stability becomes greater, so reimbursable projects become more attractive. This is particularly true of publicly traded engineers whose shareholders prefer lower but predictable profit streams to higher but unpredictable ones.
- Customer appetite for risk is not growing. The reason why the market is flat (at least on the water side of the business) is because public sector client finances are under pressure. These clients are unlikely to welcome a world in which their engineering partners are continually looking to avoid risk and squeeze more margin out of the hours they bill. This pursuit of margin generally involves spreading true expertise very thinly while bulking out the billings with an offshore army of low-cost draftspeople, and spinning out engagements for as long as possible. It reduces the scope for the kind of true innovation that really delivers value to the client, and increases the probability that projects will come in late and over budget. This approach very much goes against the way clients are increasingly looking at large capital projects. Utilities are increasingly interested in new approaches that share the risks and the rewards. In a perfect world, the pie charts in the Jacobs presentation should have a third category beyond “fixed price” and “reimbursable” contracts. It should be for contracts where Jacobs has skin in the game.
- The worst outcome of the consolidation of the engineering sector would be a cartel of fleshmongers. If your business is based on the margin you can make from renting out flesh by the hour, it is always important to buy cheap and sell expensive. At the moment, the only thing that stops engineering firms selling rotting horsemeat as prime American beef is competition, and there is a real risk that this consolidation will slowly stifle that. Alternatively, this consolidation could in fact be a stimulus for competition, enabling firms to rethink their business models, and develop new risk-sharing propositions which provide a win-win for both client and engineer.
- The shadow of President Trump falls across all of this. On the day that Donald Trump was elected, the Jacobs share price rose 9.8% to $54.91. It subsequently rose to a peak of $62.27 by the end of November last year, and has been gently drifting down ever since. At the time of going to press today, the shares were trading at $52.55. It is a reflection of the way hopes for Trump’s $1 trillion infrastructure package have risen and fallen over the past eight months. It also introduces a new urgency to the discussion of how the model for delivering infrastructure in the US needs to evolve. It is clear to most people now that an infrastructure stimulus which has a real impact on the water sector is pretty low down on the priorities of the White House. The best we can hope for is some loosening of the rules on private finance. Otherwise, we are pretty much on our own in terms of developing a solution, or to be more precise a set of solutions, because without magic money from Washington, every city will be looking for new ways of addressing the challenges they face.
In summary, the CH2M acquisition suggests that there is a real danger of the US water sector reaching a sub-optimal Nash equilibrium where nobody can improve their outcomes unless the others change their strategy. Flat or falling capital expenditure leads to consolidation, loss of competition, and predatory allocation of risks, which in turn make capital expenditure less effective. The way to break this equilibrium is to explore new models for working together – ideally ones which are not zero-sum games in which the only way the contractor can gain is if the client loses. My contribution to the solution is to get all the people who matter in the US water industry together in November for the American Water Summit: the engineers, the financiers, the utility leaders, the technology innovators and even the politicians to explore new ways of working together. The theme is Proactive Partnerships. Let’s hope it makes water great again.