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Rod Oram: Fletcher’s problem with governance
Rod Oram goes under the covers of Fletcher Building's results and finds the source of its financial problems with project cost blowouts: corporate governance.
The table below from Fletcher Building’s results presentation on August 16 clearly shows the company’s incompetent corporate governance.
Five years into the biggest, longest construction boom this country has ever seen our largest construction company has lost almost $300m on its $2.65bn order book for commercial buildings.
Two big projects – the Justice Precinct in Christchurch and the Sky City convention centre in Auckland totalling $737m of work -- account for the bulk of the losses.
This, though, is not a simple story of two bad projects.
Fletcher has written down the value of the rest of the order book of Building + Interiors, the commercial building business in its construction division. Breakeven is the best it hopes for on this $1.49bn of business, it announced at its results briefing.
Nor is this bad news a bolt out of the blue. B+I eked out EBIT of only $16m a year over the 12 years to fiscal 2016. Add in the infrastructure business, the other main part of the construction division, and Fletcher’s EBIT on all construction averaged only $32m a year over the 12 years.
That insight is on slide 30 of Fletcher’s results’ presentation to analysts. Anyone wondering how Fletcher could achieve only a 6.76% total return to shareholders over the past six years of booming construction and stock markets will find the 1hour 24 minutes’ briefing revealing.
Chairman Ralph Norris, flanked by interim chief executive Francisco Irazusta and chief financial officer Bevan McKenzie, set the uncompromising tone with his opening remarks:
“Firstly, I would like to acknowledge the tough year we have had. This is not the result we wanted; it’s not the result our shareholders wanted; and we absolutely take responsibility for where we are today.”
But Norris and colleagues offered no apology or explanation to shareholders for the abysmal performance of the construction division over recent years, let alone the past 12 years.
Yet, the company has worked long and hard to dig this deep, dark hole.
Norris moved swiftly on. All that’s old news. We have in place new people and new processes in “project governance, project management and bid processes,” he assured analysts and shareholders.
Fine. That might work. But real change starts at the very top of every organisation. Yet, Fletcher is still governed by the board that failed to adequately manage Mark Adamson, the recently departed CEO; that failed to drill down into the dysfunctional culture and systems of the construction division; and that conspicuously lacks any construction expertise.
At an operating level, Fletcher is famous for its construction culture. It bids very aggressively; then it manages to make a slender profit by using its scale to squeeze every cent out of its sub-contractors, every cent out of its dominance of building materials manufacture and supply, and out of every add-on or change its clients make. The fact it usually delivers a good building or piece of infrastructure saves its reputation.
The TVNZ cost blow-out
Take, for example, the renovation of TVNZ’s Auckland headquarters. Fletcher completed the job last year for $60m, almost double the original price. Some unexpected complexities arose such as a leaking façade, is the only explanation TVNZ offered for the blow-out.
Joan Withers, TVNZ’s chair, added that Fletcher was on a guaranteed fixed price contract. Either that was literally true and Fletcher took a bath it hasn’t disclosed. Or, it kept ratcheting up the fixed price as the work expanded.
Such culture and practices served Fletcher well in quieter, simpler times. But they have proved disastrous during the current national construction boom.
First, our construction market has finally caught up with a trend abroad whereby more clients are getting construction companies involved during the design and development of projects. Done well, this leads to more efficient and faster construction.
But it also adds risk and complexity to the construction company’s contract negotiations, particularly when its clients demand fixed price, fixed term deals. The more sophisticated the client, such as Sky City and, yes, even the government with the Christchurch rebuild, the greater the risk and pressure on the construction company.
Second, the surge in construction brought overseas competitors into the market, and increased the scale and competence of many of Fletcher’s domestic competitors.
Bidding too aggressively
Third, Fletcher’s old hands were ill-equipped for these new challenges. Believing they were as dominant as ever, they bid far too aggressively on many contracts.
Then they quickly found their culture was letting them down. They lacked skills in dealing with design risk. They had less power over sub-contractors who now had longer term options with other companies thanks to the boom. Likewise, Fletcher’s building materials manufacture and supply businesses faced more competition from imports.
These failings were compounded by Fletcher construction’s lack of state of the art systems essential for managing these increased complexities, risks and competition. Its financial systems were a particular weakness.
Adamson, the group CEO, saw these chronic problems of culture, processes and systems. Given his strong manufacturing track-record, he knew what the best management systems entailed. But he knew little about how to apply them to complex construction projects.
Undaunted, he tried to force through change. But he failed twice over: he lost the old culture by driving out many deeply knowledgeable people; and he failed to adequately install the new culture.
Yet, if the board had exercised competent and timely governance, the problems would never have become so deep and damaging to shareholder value, the company’s reputation and its staff.
Norris' telling comments
Four comments by Norris at the results briefing on Wednesday were particularly telling about the culture of the board. He has been chairman since October 2014. He took it on knowing the company well, having been a non-executive director 2001-05, and again since April 2014.
First, he said “construction accounting is more of an art than a science.” Yet, as a former chief executive of ASB and then its parent, Commonwealth Bank of Australia, he would know that many of the most crucial decisions in finance are indeed an art not a science.
Moreover, the best way to make such decisions is to have superb financial systems. He started his banking career as an IT specialist and cites his IT revolution at CBA as one of his biggest achievements there. It seems, though, the inadequacies of Fletcher’s systems came to his attention too late.
Second, he said Adamson was rated "very highly" by his immediate reports and had done "a very good job improving the culture of the organisation". It seems, though, that the haemorrhaging of talent and experience from the construction division came to his attention too late.
Third, he said board changes would occur through the annual election process. This time around, someone with good quality construction experience “would be a valuable addition to the board.” Better late than never.
A 'fantastic year'
Fourth, he said “we had a fantastic year.” Without the B+I losses “it would have been a record year.”
Yes, but even excluding its B+I losses, Fletcher would have missed by a mile its key metric, which is a 15% return on average funds employed. In fact, it has averaged a return of only 11.3% over the past six years, as slide 38 of its presentation to analysts shows.
So, notwithstanding the results presentation featuring Norris’s dogged determination, Irazusta’s enthusiasm for Fletcher’s global prospects, and McKenzie’s dazzling dexterity with financial data, this is clearly a company and board that has a lot more renewal still to do.
Meanwhile, though, its clients are happy. They will get the buildings they contracted from Fletcher – late, but Fletcher will pay them for its shortcomings.
Its competitors are happy. Fletcher is once again a rational bidder, and even better for them it is more risk averse.
Even the country will benefit if the construction sector learns from Fletcher’s failings.
But, as ever, it is the shareholders who are paying the price.
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