Building the Next Canadian Shield
How Canada's construction companies can defend their market against foreign entrants
The Canadian construction industry is experiencing a major shakeup. Once relatively protected from foreign threats, domestic players have recently been subject to a wave of international com- petition. International players are aggressively entering the booing Canadian market, acquiring domestic firms and positioning themselves as full-service alternatives to domestic players. Canadian contractors have done little to counteract this new reality; they have either stood idle or allowed themselves to be acquired. Consequently, unless they are proactive in protecting their home turf, domestic firms will feel the pressure from foreign rivals.
The effects of replacing Canadian firms with international builders are far-reaching: management roles disappear, control shifts abroad, and financial gains are repatriated to the foreign country. The strategic flaws of Canadian contractors are highlighted by the fact that profits from vital Canadian infrastructure projects are flowing out of Canada. Barring a change in strategy from large domestic players, construction is poised to be next in Canada’s long list of industries where domestic players cannot compete with their international foes.
Particularly concerning is how Canadian contractors have al- most completely conceded revenues associated with acting as the long-term operator and maintenance provider of infrastructure projects. Earnings from the operation and maintenance of bridges, roads, and hospitals – known as concession revenue – has been a pillar in the strategy of international contractors’ at- tempts to learn more about Canada and entrench themselves in the market. Canadian firms have the capabilities to compete for concession contracts, but have chosen to instead focus their re- sources primarily on new construction as it offers higher mar- gins and immediate returns. Canadian firms have thus prioritized short-term gains at the expense of protecting their long-term position vis-à-vis foreign firms. If Canadian contractors do not re- vise their strategy, their long-term success will be in jeopardy.
Why Canada is a Target for Foreign Entrants
Canada is particularly attractive to foreign firms because of the country’s robust growth projections. The Great White North is predicted to be the fifth largest construction market in the world by 2020, largely driven by strong economic growth and a historical infrastructure deficit. Across the country, there is growth in both the complexity and scale of projects taking place: more condominiums are being built in Toronto than any other city in the world, Alberta’s oil sands require supporting infrastructure, and Canada’s aging roadways are becoming increasingly complex to redevelop.
Ongoing fiscal austerity in Europe and ballooning government debt in the United States have limited the growth potential of those markets. European and American firms have consequently chosen to look abroad for growth. Since 2010, the largest international contractors have experienced an 18.1% increase in revenue from projects outside their home countries. This trend shows no signs of slowing as firms are continuing to shift their corporate strategy to growth markets, of which Canada is one of the most lucrative. Yet, like any boom, the Canadian construction industry’s growth will not last indefinitely. Once this growth stops, the effects of foreign entrants will truly be felt.
Public Private Partnerships (P3s) vs. Traditional Development
The ability to help finance and obtain concession contracts has become increasingly important with the development of an alternative method of financing: Public Private Partnerships (P3). In a public private partnership, private partners finance, design, build, operate, and maintain public works projects.
Several companies, including general contractors, are responsible for providing upfront financing, often to the tune of hundreds of millions of dollars, and recoup this initial investment through operating revenues. P3s are different from the traditional public financing model in that P3s do not rely solely on government money to build infrastructure, and maintain and operate long-term projects. Another aspect of P3s is that the Canadian government has chosen to remove itself from the operation and maintenance of infrastructure projects, commonly known as the concession contract. Con- cessions are the final element of a P3 and can last upwards of 30 years. They generate revenue through a per usage charge, such as the 407 Electronic Toll Route fee, or regular public disbursement.
Canadian firms have been slow to react to clients’ changing need to share the risk of a project by providing upfront financing. In con- trast, European firms have years of experience with P3 contracts in their home countries and have used this as a competitive advantage when entering Canada. The C $1.4B Windsor-Essex Parkway, one
of the most expensive highway investments in Ontario’s history, highlights this trend. Spanish giant Actividades de Construcción y Servicios (ACS) and American’s Flour Corporation are responsi- ble for both construction and maintenance over the next 30 years.
In the traditional infrastructure model, government provides 100% of the funding. Yet the traditional model has lost favor as governments developed a greater desire to share risk and balance their budgets. P3s have become the de facto replacement; the Canadian government has already completed 180 P3 projects and signs point towards continued growth in the sector. With the introduction of P3s, responsibility for project delays and cost overruns has essentially been shifted from the government to all stakeholders, including financers, contractors, and sub-trades.
Profiling Canada’s Incumbents and Foreign Entrants
The Canadian construction industry is fragmented by geography and level of expertise, leaving only four firms with over $2.5B in revenue. PCL is Canada’s largest construction firm and the only one capable of matching the financial strength of international players. The benefits of size are clear when considering that PCL’s balance sheet has provided it with the ability to win 52% of the P3 projects it has bid upon. That being said, neither PCL nor other Canadian contractors have sought to expand beyond the typical construction scope over fear that it will lead to undue financial risk and divert them from their core business of building. Mean- while, international giants coming to Canada have used their size to allow them to manage risk, take on multiple large-scale projects and perform numerous acquisitions. They have extensive construction knowledge, as well as specialized expertise in many sectors in which Canadian firms do not. Their financial capabilities, large concession entities, and P3 experience have made them a valuable but hazardous partner for Canadian contractors.
Method of Entry
In the past, when specialized services like tunneling expertise were required for a project, domestic companies would enter a joint venture with foreign partners, who participated ad hoc but did not re- main in Canada to pursue continued operations. Foreign companies attempting to enter Canada alone struggled due to a lack of local market knowledge and inability to control sub-trades. How- ever, foreign companies are now able to secure a long-term position following the conclusion of joint ventures by aggressively pursuing opportunities to take on the concession role of a P3 project.
British multinational Carillion has used this joint venture-concession approach to enter Canada and establish its presence. Through partnering with leading Canadian contractor EllisDon on various projects, Carillion has built relationships with owners and sub- trades while gaining local knowledge. Carillion then purchased Vanbots Construction, giving it the construction capabilities that EllisDon had previously provided in the joint venture. Carillion is now a single integrated entity, conducting work in both the P3 and traditional markets. The firm has grown to be the ninth largest contractor in Canada, competing directly against its former joint venture partners. The Carillion example is a stark warning of what may happen to the Canadian construction landscape in ten years if domestic firms don’t confirm their positions in advance.
On the Defensive
The current behavior of domestic firms demonstrates a belief that capital is better invested pursuing new building opportunities over developing a concession division. While this belief holds true during a construction boom, this strategy will prove disastrous when the market inevitably slows down. Though it is impractical to avoid all strategic partnerships with foreign firms given their diverse set of expertise, a greater emphasis must be placed on capturing concession contracts as a defensive measure by domestic firms.
To prevent foreign firms from becoming entrenched in their home market, domestic firms must play defense today in order to secure market share tomorrow. Focusing more heavily on concessions will also allow domestic firms to offer greater value when bidding on P3 projects. This is necessary to prevent foreign firms from acquiring the strategic knowledge of local sub-trades, developers, and market conditions that is required to act as full service general contractors.
Canadian contractors will also benefit from more stable and long- term cash flows generated by concession contracts. Revenue from concessions will help hedge the risk a general contractor faces from the sporadic short-term inflows they typically experience when working on traditionally financed projects. In effect, con- cessions will help change the risk profile of a general contractor and reduce their exposure to the revenue fluctuation that occurs when the traditional construction business faces a slowdown.
Although a transition to concessions will require a transfer of cap- ital away from high yield construction contracts, Canadian firms should first pursue concession contracts in industries in which they have significant experience performing contracting work. Contractors already have the resources and capabilities to maintain the physical infrastructure – if they can build the road, they can fix the cracks – but what is now needed is a change in perspective to recognize the imperative nature of concession projects. In cases where operation requires additional organizational and human resources, contractors should look at their target projects and either make acquisitions or grow organically to fill capabilities gaps. Fortunately for Canadian contractors, there are few barriers preventing them from increasing the number of low skilled laborers they employ to handle concession contracts.
From a strategic perspective, an increased focus on concessions will eliminate Canadian contractors’ dependence on foreign competitors for the operation and maintenance components of P3 project bids. The progression to concession management allows contractors to further utilize market specific construction expertise during the construction and operation phases. Although foreign companies have been able to establish themselves in certain areas already, limiting their growth options will protect other sectors within the construction industry. The consequences of having established international contractors in Canada will be fully felt when growth in the Canadian construction industry slows and projects are no longer abundant. Canadian builders must refocus their strategy away from short-term revenue gains towards long-term profit maximization, and this requires aggressive defensive action with respect to concessions.