Forecast: Design and construction markets poised for recovery in 2012

WASHINGTON, D.C. — Management consultants Farkas Berkowitz & Company forecast that designers for transportation, power, water infrastructure, remediation, and facilities should see low single-digit growth this year and stronger growth next. Design markets related to environment, infrastructure, and facilities were unchanged in 2010 after declining 12 percent in 2009. Construction firms serving these same markets saw their revenues decline by 12 percent last year after a 9 percent decline in 2009, according to the U.S. Department of Commerce.

The firm presented its 23rd annual State-of-the-Industry Report to the 17th annual Farkas Berkowitz Forum, an invitation-only conference of CEOs from leading design and construction companies. During the opening dinner of the Forum, the firm’s managing director, Alan Farkas, noted that he would retire from management consulting at the end of this year and that this 23rd annual report would be the firm’s last.

The firm’s annual State-of-the-Industry Report was informed by 64 in-depth interviews with executives whose firms are leaders in the markets covered, a thorough analysis of all relevant primary data sources, and an analysis of the Engineering News-Record Design 500 survey results.

Farkas commented: “The fact that these design markets did not decline further is good news to many. As one CEO recently quipped, ‘Flat is the new up.’ But many CEOs expected stronger performance during the second half of 2010.” He cited a survey that Farkas Berkowitz conducted among CEOs during the first quarter of 2010. At that time, 90 percent of the CEOs surveyed expected an upturn in their principal markets to occur by now. “Unfortunately, most are still waiting,” he said.

Power engineering and construction
Farkas Berkowitz estimates that the U.S. power engineering market decreased 6 percent last year, after dropping 18 percent in 2009. The firm forecasts that the market will grow 4 percent this year and 15 percent next year.

Farkas pointed out that the current down cycle has affected large and small firms quite differently. The top five power engineering firms saw revenues from both domestic and foreign projects decline 14 percent last year and 31 percent in 2009. Conversely, those too small to be counted among the top 15 firms, enjoyed double-digit growth in both 2010 and 2009. Farkas explained: “The paucity of new starts in electric generating plants has hurt the large EPC firms, while the smaller firms enjoyed the continuing strong growth in transmission line and substation work and a more stable market in environmental permitting for renewable energy development.”

The power construction market dropped by 6 percent last year, according to the U.S. Department of Commerce, reflecting the drawdown of backlog associated with the coal-fired plant build-out. The firm forecasts that construction will continue to drop this year and most likely next. “Twelve coal-fired plants were still under construction when 2011 began,” observed Farkas, “but by the end of this year, most of those will have been completed. Although we expect to see some major natural gas-fired plants initiate construction next year, the lower capital costs associated with these plants is unlikely to offset the completion of coal-fired plants.”

Farkas observed: “The decline in the power market reflects, in part, the decline in demand for electricity in 2008 and 2009. Although the Energy Information Administration (EIA) estimates that demand increased by more than 4 percent in 2010, EIA is forecasting demand growth of just 0.2 percent this year. That means that by the end of 2011 demand for electricity will equal what it did four years ago.”

The report also attributes the down cycle to continuing uncertainty over the outlook for regulation of carbon and other greenhouse gas emissions and the confluence of so many compliance due dates associated with other environmental regulations.

The Farkas Berkowitz report noted that events during the last 12 months suggest that natural gas from shale deposits will revolutionize energy markets. Farkas commented: “Published reserves in North America are sufficient to meet current demand for over 100 years, and many industry insiders tell us that this estimate will double. Moreover, reserves in Europe are now thought to be as large as those in North America.” He went on to note, “The big oil companies clearly believe in its potential given the investments that Exxon-Mobil, Shell, and Chevron have made during the last year in shale gas deposits.”

Farkas Berkowitz found that the advance of green energy slowed last year. The firm forecasts that only two of the four nuclear power projects that were close to initiating construction will go forward in 2012, with the other two projects now in serious jeopardy. In addition, the firm forecasts that investment and production tax credits for renewable energy development will likely not be renewed at the end of this year and next due to Republican opposition in the House.

Transportation engineering and construction
Farkas Berkowitz reports that the transportation engineering market edged up 3 percent in 2010, after falling 2 percent in 2009. The firm is forecasting that transportation engineering will remain at about $11 billion per year for both this year and next. “We expect that continued weakness in the highway/bridge segment will offset growth in the other transportation segments,” observed Farkas.

Looking at the highway/bridge segment, the firm estimates that engineering billings were flat last year, while the U.S. Department of Commerce estimates that highway/bridge construction edged up 2 percent to $84 billion. Farkas commented: “We expected greater growth in highway construction, with stimulus spending on highways peaking at nearly $12 billion in 2010.” He went on to elaborate, “Unfortunately, the increase in federal spending was largely offset by a decrease of 6 to 8 percent in state and local funding.”

The firm reports that many Capitol Hill observers expect to see the reauthorization of the federal surface transportation act later this year. “The outlook for the highway market over the next four to five years will greatly depend on the outcome of the funding debate in Congress,” observed Farkas. “The Republican chairman of the cognizant House Committee has said he is committed to holding federal grants to those funds generated by the Highway Trust Fund, and transportation economists estimate that, under this scenario, federal grants would decline from approximately $41 billion last year to less than $35 billion in federal FY2012.” In contrast, Farkas noted that President Obama’s proposed $556 billion, six-year bill, with a special boost in funding for FY2012, would see grants rise to $70 billion in FY2012 and then average $47 to $50 billion per year over the remaining five years. “Over time, with lower federal funding, we would expect to see state and local governments increase spending on highways,” commented Farkas. “But,” he said, “in the meantime, highway engineers and contractors can expect to see a stalled highway market.”

Farkas Berkowitz believes that the future of the transit market also depends on the funding levels written into the federal surface transportation bill. Unlike the highway segment, the firm estimates that the transit engineering market was growing at better than 5 percent last year, while the U.S. Commerce Department reports an increase of nearly 30 percent in transit-related construction. “Strong local support for transit funding should enable this market to grow even if federal funding is cut,” Farkas observed. But the firm’s report states that the declining prospects for high-speed rail will adversely affect the growth rate of the transit market over the next several years. The firm noted that the continuing resolution for the remainder of FY2011 removed all of the $2.5 billion the president was going to provide for high-speed rail. “In the current political climate, we are unlikely to see additional federal funding for high-speed rail,” Farkas predicted.

Farkas Berkowitz estimates the airport engineering market increased modestly in 2010 but reports that this market is unlikely to take off in the near term. The firm cited the latest report from the Airports Council International, North America, which estimates that annualized capital spending over the next five years is just slightly greater than current spending levels. The Council reports that large hubs had reduced their capital spending estimates by 28 percent in 2010 over those estimates provided in 2009.

Farkas reported: “Congress finally seems ready to reauthorize the airports bill that expired three and-a-half years ago, but in the bills that have passed the House and Senate, there is no provision for raising the cap on passenger facility charges and there is little likelihood that we will see a more generous airports grant program. The bills that passed during the last session by both houses, but never reconciled, would have increased the cap, at least at some major airports, and would have increased the level of grant funding.”

Reporting on the small ports and harbors engineering market, the firm saw only a very modest recovery in 2010. The firm had reported a market growing by double digits from 2003 to 2007, but in 2008 and 2009 this market contracted. The firm did report major projects under way along the East Coast to accommodate the larger ships that are expected to pass a widened Panama Canal after 2014.

Facilities design and construction
The market for facility-related architectural and engineering design leveled off last year after plunging some 21 percent in 2009, according to Farkas Berkowitz. The firm also reported that the top five companies in this market saw their design revenues from both domestic and foreign projects increase 23 percent over 2009, while all other firms saw declines averaging 3 to 5 percent. “This difference cannot be explained by increased revenue from foreign projects,” explained Farkas, “suggesting that the top five took market share in the U.S. market in 2010.”

The Farkas Berkowitz report provides forecasts for individual facilities segments but not for the market as a whole.

The report cites U.S. Commerce Department statistics showing that facilities construction declined 21 percent last year after dropping 17 percent in 2009. In 2009 public facilities spending increased thanks to federal spending on base realignment and closure (BRAC) and other DOD initiatives, plus stimulus funding. Commerce reported that while federal spending grew 4 percent in 2010, the decline in state and local spending drove the overall public facilities market down 12 percent last year. Spending on private facilities construction plummeted 29 percent last year, bringing the total decline in over two years to 48 percent.

Turning to the commercial facilities market, the firm cited U.S. Commerce Department statistics showing a 33 percent decline in construction, but designers report that one component of that market, the build-to-suit office market, has begun to show signs of life. Farkas said, “During the fourth quarter of last year, firms started to see expressions of interest in build-to-suit offices, and contractors expect to see potential projects begin later this year.” He went on to observe that although office vacancy rates continued to climb last year, the rate of increase has begun to slow. “With steady hiring in the private sector, we expect to see the vacancy rate drop in 2011, and that could lead to speculative office development beginning a comeback in 2012,” said Farkas.

Farkas Berkowitz reports that the data center facilities market, which it believes began to rebound in mid-2009, continued strong throughout 2010. Farkas observed, “The data center market is driven by expansion of e-commerce, greater use of the cloud, and social networking.”

Citing U.S. Commerce Department statistics, the firm reported that construction spending fell 26 percent in retail and 57 percent in lodging in 2010. However, for retail, the firm reports that year- over-year monthly retail sales have increased for 17 straight months. The company expects to see the retail facilities market begin to grow later this year. The firm also believes that the lodging market will reach bottom this year and begin to show growth in 2012.

The Farkas Berkowitz report also evaluated the institutional facilities market, which includes education, health care, public safety, religious, and amusement and recreation. The U.S. Department of Commerce reported that construction of institutional facilities declined by 13 percent in 2010, after sliding just 4 percent in 2009. “All of the major segments of the institutional facilities market showed greater weakness last year than in 2009,” commented Farkas. The report went on to note that education was especially hard hit with construction spending down 15 percent last year. “Over 30 states have cut school funding,” reported Farkas. He went on to note that although state tax collections were up in 2010, local taxes declined 1 percent as property taxes catch up with declining house prices. Statistics on tax revenues were reported by the Rockefeller Institute of Government. The firm predicts that health care will lead the recovery of the institutional sector, with design billings rising later this year and construction values increasing next.

Reporting separately on the federal facilities market, Farkas noted, “The FY2011 budget for design and construction at the U.S. Department of Defense (DOD) is off 37 percent from the peak it reached in FY2009. In 2009 the federal market benefited from the confluence of BRAC, other DOD initiatives, and stimulus spending.” Nevertheless, he reported that the $17 billion slated for expenditures during this fiscal year is still quite robust by historic standards.

Designers and contractors will see strong bidding opportunities throughout this year from the Army, Navy, Government Services Administration, and the Veterans Administration,” said Farkas. He noted the Army is about to launch a seven-year program to replace or renovate two- thirds of its on-base schools with a budget of $4.5 billion.

The firm observed that the cutthroat competition reported during 2009 got even worse in 2010, as contractors were apparently willing to cut prices to utilize idle equipment. The firm reported that DOD spending for design and construction will continue to fall, with the President’s proposed FY2012 budget down some 32 percent from that of 2011.

Remediation consulting and engineering
Farkas Berkowitz estimates that the remediation consulting market remained level last year after declining some 13 percent in 2009. “We are forecasting a 5 percent growth in the market this year and another 5 percent next year thanks to a very strong industrial market,” observed Farkas. The firm estimates that strong industrial growth will offset any softness in the DOD and Department of Energy (DOE) markets.

The management consulting firm reported that the industrial market grew by 5 percent after contracting at least 10 percent in 2009. “Some of the major players in this market saw growth as high as 10 percent last year,” reported Farkas. As the firm predicted last year, oil and gas and mining have led the remediation market recovery. Farkas observed, “Virtually all industrial categories saw increased remediation spending with the exception of the automotive sector.”

“Over the years, we have suggested that the industrial remediation market was favoring large international firms,” commented Farkas. He went on to note, “Five years ago the top five firms in this market represented 33 percent of the market, and today they represent 47 percent.” Farkas Berkowitz forecasts accelerating growth in 2011 and 2012 thanks to strong corporate profits, particularly in the oil and gas industry, and to the increasing pace of mergers and acquisitions, which generates due diligence environmental consulting often followed by remediation.

The firm estimates that the DOD remediation market probably declined by about 5 percent last year, even though some DOD contractors reported double-digit growth over 2009. “The DOD remediation market is showing the characteristics of a seasonal market,” observed Farkas. “In 2010, we saw a lull in the issuance of new contracts and new task orders during the first two calendar quarters, and then a surge of activity in the third quarter, in advance of the end of the federal fiscal year,” said Farkas. He went on to say, “This year we are seeing that same lull, ostensibly due to the uncertainty surrounding the FY2011 budget, and like last year, we look for a surge in the third quarter.”

In its report last year, Farkas Berkowitz observed that “best value,” the official standard for selection, was beginning to look a lot like low price. In this year’s report, the firm found a basis for concluding that the market is showing promising signs of rewarding quality performance, as well.

“Increasing use of performance-based contracting places a great premium on both technical innovation and strong relationships with state regulators. In addition, this year DOD has vastly improved its approach to tracking a contractor’s past performance and making that information readily accessible to those awarding new contracts and task orders,” said Farkas.

The firm forecasts a relatively stable DOD remediation market this year and next. The report noted that the continuing resolution enacted last April for FY2011 spared the DOD any cuts in its environmental and remediation budget.

Farkas Berkowitz reported that the DOE Environmental Management program was the hottest
2010 market, having received a 50 percent increase in its budget over FY2010 and FY2011 thanks to stimulus funding. The report also notes that this very strong market attracted greater competition last year with four competitors in pursuit of the Oak Ridge cleanup contract and six competitors going after the West Valley cleanup job. The report noted that two or three bidders per opportunity had been the norm.

“Those in hot pursuit of the DOE gravy train need to recognize that the train may have left the station,” forecasted Farkas. He went on to note, “Not only will the DOE Environmental Management program no longer have the benefit of stimulus funding in 2012, but the congressional action to cut its remaining FY2011 funding by over 10 percent could suggest further cuts for its FY2012 budget.”

Water infrastructure engineering and construction
Farkas Berkowitz estimates that the water and wastewater design market receded by 3 percent last year after declining 2 percent in 2009. The firm forecasts that the market will remain at this plateau this year and then grow modestly in 2012.

According to the U.S. Department of Commerce, the construction market for water and wastewater edged up slightly in 2010, but it has essentially been on a plateau since 2007 at about $41 billion.

The firm reported that market participants generally expect their revenue to be flat in 2011 after many saw declining revenue in 2010. Farkas commented, “The municipal market for design and construction has three principal drivers: regulation, water scarcity, and migration to the Sunbelt states. The first two drivers are still in place, but the housing crisis has paralyzed continued migration to the South and West, and not surprisingly, these states represent the most depressed markets for designers and contractors.” The firm reports that markets in the Northeast, Mid-Atlantic, and Midwest are better than those in the Sunbelt states, but the best markets were reported to be in Texas, Colorado, and Wyoming.

“We are encouraged by the latest American Water Works Association survey that shows annual utility rate increases averaging 6 to 7 percent from mid-2008 through mid-2010,” said Farkas. The firm noted that these rate increases exceeded the 4 percent annual average increases during the prior decade.

“We have found that multi-jurisdictional authorities have been more willing to raise rates than city utilities, and these authorities have thus represented relatively stronger opportunities for designers and contractors,” observed Farkas. He went on to comment, “But unfortunately, the housing market shows no signs of recovery. We are also concerned over the very weak municipal bond market during the first quarter of this year. The issuance of new bonds fell to an 11-year low, and some predict that the value of total sales could be half of last year’s total.” Citing pent-up demand, the firm believes that the market will show recovery next year with a 5 percent growth rate.

Farkas Berkowitz reported that the design-build municipal water market contracted further in 2010 from the peak it reached in 2007. But here, the firm finds good support for a strong recovery. Citing a survey of its members conducted by the Water Design-Build Council, Farkas Berkowitz estimates the design-build project pipeline has grown to over $10 billion, representing over 100 projects in 25 states. The firm looks for accelerating growth in water design-build beginning later this year.

Water public-private partnerships
Based on a survey recently conducted in Public Works Financing magazine, Farkas Berkowitz finds that the water public-private partnership market has remained essentially constant since 2005 at just under $1.4 billion. However, the firm reports that private operators have reported a surge in interest. Firms estimate they have received about 200 inquiries last year, many of which were unsolicited. “For the first time in a long time, some large cities are expressing interest in partnerships,” said Farkas. “New York City is in the process of preparing RFPs for entering into partnerships for two of its new big water treatment plants.”

The firm reports that some significant competitors in this market are not waiting for the financial crisis to generate new projects; instead, firms are experimenting with different business models. Farkas said, “Veolia Water North America, the market share leader in the U.S., is trying out a program management approach. Instead of putting city employees on their payroll, Veolia will assign only a handful of its top management talent to work with the city’s executives in achieving specific savings in operation.” He commented further, “Veolia then proposes to share the savings with their public partner.” The Farkas Berkowitz report also cites the renewed emphasis by CH2M Hill on providing operational consulting services.

Farkas concluded his assessment of this market by saying, “Although we do not expect to see growth this year, we do believe that this long dormant market will show some signs of life next year and the following as a result of the financial crisis and the willingness of major providers to strengthen their value propositions to prospective public partners.”

Concluding remarks
The State-of-the-Industry report concluded with a discussion of forces shaping the rise of the mega-firm. The report displays the diagram below to show the linkage among trends that are giving rise to both consolidation of engineering firms and to the integration of design and construction within those firms.

The report explains that clients’ pursuit of greater efficiency in procurement and management of design and construction projects has led over the past five to ten years to greater outsourcing of program management, larger projects including the aggregation of smaller projects into a single contract, and alternative delivery. Farkas commented, “All of these trends favor the larger firm and thus favor continued consolidation.” He went on to note, “In addition, the growth of alternative delivery in public-sector markets is leading to the creation of a new set of engineer- constructors. Historically, engineer-constructors have served the petroleum and industrial process markets and later the power market. Over the past 10 to 15 years, we have seen firms in environmental and infrastructure markets develop these integrated capabilities.”

He cited AECOM’s acquisition of Tishman Construction and Balfour Beatty’s acquisition of Parsons Brinckerhoff as the two most visible examples during the last year of firms that have developed a platform for vertical integration. Farkas also observed, “The pursuit of stable revenues has led to increased diversification, and the pursuit of markets growing more rapidly than those in the U.S. has led to globalization.” He further commented, “Both diversification and globalization will drive even greater consolidation in the future.”