2020 Vision: Construction and the New Financial Downturn

>> SPEAKER: Pre COVID the construction industries exhibited characteristics of one of robust markets ever in history. Our clients had record backlogs with increasing margins.

We were seeing all of the subcontract trades making more money than they ever had before. Labor was tight in the market, the unemployment rate in the construction industry was probably at an all time record low.

Fast forward to March of 2020 and the outset of the COVID environment and the market changed precipitously virtually overnight.

Projects were delayed or stopped, projects were canceled, projects were modified, shut down. We saw major supply chain disruptions.

Labor shortages and particularly in our sub trades where not only project safety was a concern, but also the fact that the unemployment benefits that were a part of the rescue package initially and had enhance unemployment benefits.

And so we actually had clients that were complaining about the inability to get workers to the job because of elevated pay levels for being on unemployment.

Finally, we really expected to see a cash crunch, similar to what had occurred in the downturn in the ‘08 – ‘09, the great recession, but that in fact did not materialize.

The government had done a good job of priming the pump with the financial system. And so we saw projects continue to pay out as expected. We didn't see any material delays and payment or owners having difficulty staying viable, at least during the course of construction. 

>>SPEAKER:

You see these three lines in here and I and I just wanted to touch on this from the standpoint of, okay, why is institutional above the other two.

And, and why is commercial the lowest of them all. Well, if you think about it, commercial for one instances like office buildings and retail

Probably two of the segments that were hurt the most optically by the coronavirus. I mean, nobody's working in their offices.

There's, there's a big conjecture is to, do many companies ever go back into the office or not.

And so that, that has to that will definitely impact the planning around future space, for office space and/or retail if we're not going to be able to shop in stores like we have that's going to be a whole different model.

Residential in in that space. You know there's there. There's a big thought that there will be an out migration from the big cities and then people will be moving back out in the suburbs.

And what does that mean for residential, i.e. condominiums and apartments that have been built in this in the center of the city.

Institutional is probably the highest because it had enough work in the pipeline and is funded in part not by tax revenues entirely but private sectors for like private universities and what have you. So that's why that numbers a little bit higher.

>>SPEAKER: This whole coronavirus thing has exposed the Achilles heel of the American economy is that we were highly dependent upon sources of supply that may in fact not be conducive to us doing things as we need to.

So I think we're going to bring back a lot of manufacturing from China and abroad.

And that's beginning to happen. Healthcare, obviously, we probably aren't if we built out enough to handle this kind of thing moving forward.

And the infrastructure bill. And I think there will will see something on this at some point in the not too distant future. But it's, that's a tall order.

Subcontractors are obviously better available now. However, there are some trades i.e. drywall in particular where, because of the labor concentration and as close as they work together, it's hard to get the kind of production that you need. So we're seeing some issues with that.

But overall, in Stan’s comment about the unemployment rate with a 14% unemployment rate, there are people available to work if in fact they choose to.

Again, the inhibitor is a little bit of the unemployment benefits that sits out there right now.

Risks moving forward. Funding. If it’s a tax based funding mechanism, that’s at risk. As far as the viability  and the amount of work to be had.

Jobs just getting started that were already previously funded, may be okay. If they were counting on future tax streams in order to pay for that, that might present a problem.

Supply Chain performance, I mean we'd had contractors that have been impacted greatly because they were waiting on materials from Europe and/or China that were from plants that were shut down during the virus.

Challenging contractual risk. That’s one of the issues that we we are exploring with our clients, almost every day today.

Owners are trying to put language in there to remove themselves from the responsibility loop for COVID related and/or pandemic or health related issues.

We could see a resurgence in the in the outbreak levels and we're starting to see that now as states have started to open up.

Worker health and safety continues to be an issue. But the biggest risk in here, biggest risk in here right now is the inability or concern about the inability to acquire new backlog and at what rate.

And what size will my company be in the future, given the constraints that I see in front of me.

>>SPEAKER: We've done an analysis of the losses that we've incurred over time and develop some characteristics that come out of those losses.

Down below in the box you'll see, difficult project + week internal controls = catastrophic situation. That's true. These get at percentages of the failed contractors in our portfolio as to the critical reason behind the failure.

Number one on this list, catastrophic project. One single, we're seeing way more losses today caused by one single project going bad than ever before.

Problem on a large poor estimate, new job type or location and bad owner.

The next most important is obviously internal controls and system failures.

And this manifests itself from the standpoint of we constantly stress with clients about the need to know where you are at all times in order to manage the business better.

And in losses, we're seeing many cases where the system that they had in place did not allow management information in a timely fashion to deal with a problem before it metastasized into something that was lethal.

Overextension. Stan’s point about overeating at the buffet line is the reason for failure more than starving to death and that is in fact the case.

And finally, excessive debt on the balance sheet is an is an additional risk from an outside creditor that can cause contractors to fail if in fact they end up starting to miss their payments.

So these are some four key elements of contractor failures and in this environment today because of the exposures that exists that aren't normal to the construction business, it's very critical to focus on these moving forward.

>>SPEAKER 1: Some of you baseball fans may recognize the little chart on the right.

And it's a chart that Ted Williams put together and Ted Williams was considered probably the greatest hitter all time in baseball. But what he figured out is it dependent where the pitches he swung at as to how successful of hitter he was.

So he divided the pelt plate that's home played into certain sectors and he he determine what his batting average would be if he hit pitches only from that sector.

So you can see if he had only low outside pitches, he would not have been a Hall of Fame hitter. He’d been a pretty pedestrian player there at 240 or 230, right?

But if he swung where the pitches were best for him, there in the middle of the plate, he was a 400 hitter.

So we want you to think about your job and your work, kind of in that regard. And this goes back to the graph before that, Dave.

David just talked about is, okay, what do I do. Well, we want you to do is, and we think about it, and I think about construction is really simple.

Type of work. Well, it's really easy to think I need to keep my revenue up and try a bunch of new things.

And that's didn't work out in the last recession. Really doing the type of work that you do is a really good predictor of whether the jobs gonna be successful or not.

Doing it in a familiar location. Working in a new geographic area greatly increases risk. So if you're doing work that you normally do in a place you'd normally do it, that has a higher probability of success.

 Then combine that with the will the team, the owner, the subs designer and the team that's actually doing the work.

Are those all familiar partners of yours from that, are you used to dealing with them. Again, the more familiar and success you've had in the past, the more likely you're probably gonna have a good job.

The same with procurement method.

This may not be the time to enter the design bill market if you've never done it. I'm not saying you can't learn it, but usually there's a learning curve with anything that's new, so trying something that you haven't done before.

And then finally contract language, again, a bad contract can negate a lot of good work because the terms don't go your way. Now your feedback to me and I know I can't really get it yet, but maybe Stan, but if things are tough now.

I'm not going to be able to just get work that I've always done. I'm gonna have to stretch a little bit

And we understand that a little bit, but kind of a good rule of thumb is the further you get away from each of these things, the more risky a job becomes.

So let's say I'm going to try a new type of work, but it's in a familiar location with a bunch of people that I've worked with, it's a procurement method I'm familiar. I've got a good contract. I've done work for this owner before. Well, maybe that's a risk you might want to think about taking and realize you have to be a little careful about it.

But now, let's say you're doing a new type of work for someone you've never worked for with a bad contract, that's a recipe probably to lose money.

So you really have to think about it and have your people and your estimators, your project, people kind of, Kind of keep it simple at some point in time. You can talk yourself into some I can hit that outside corner pitch down the line. I know I can slap it in the corner for a double. Maybe not.

And again it is a percentage game, and the more often you take these risk, the more often we see contractors have trouble so 

>>SPEAKER 2: It sounds like the downside of the risk could outweigh the benefit.

>>SPEAKER 3: Yeah, I really do. What, what, what was really clear in the last recession for us is those contractors that tried to grow during the recession, tended to do worse than those that were willing to get smaller and to stick to do what they were doing well at.

You just have a shrink your swings on a little bit and be willing to be a little smaller for a while.

>>SPEAKER: Yeah, I kind of go back to being there and I kind of said this another thing, work where you've been successful if you can, and it's going to be really important now to do what you know how to do.

Maybe you have to learn something a little bit, but if you're doing what you've done and doing what you know what you're doing for people, you know, with teams that have done it, under fair and reasonable contract terms, I think that's the best recipe for success.

I wish it was something mathematical or really, really good, but construction and most businesses really pretty simple as you gotta do what you know.

And and yes, you may have to take a little more risk here and there, but but try and do just one thing at a time. Try not to do three or four new things at a time.

I used to think sometimes the best job that you ever had is the one you didn't get. And I think a lot of contractors if you're listening probably can nod your head with that and

Another saying that one of my mentors taught me was in construction, you make money in shovels shovel falls, but you can lose it in dump truck loads.

And if you end up having one of those dump trucks on you, that's what we showed in that blue chart that can take you down. So what we're trying to do is avoid you from having that dump truck like event.

Maybe you can lose a few shovels for a while, but that's a lot easier to bounce back from I think.

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LOUISA DESSON: Well, hello again, and thank you, everyone, for joining us. Welcome to 2020 Vision, Construction, and the New Financial Downturn.

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Louisa Desson

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Today, we're going to look at real industry data from the Great Recession through today for insights into how some construction firms weathered past financial storms. We're going to take a look at factors shaping sales and profit trends through downturns, construction industry risks to look out for, and business fundamentals for a faster recovery.

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Our Presenters, Stan Halliday, David Hombach, Louisa Desson.

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I'm joined here today by Stan Halliday, our Chief Underwriting Officer in Construction Surety at Travelers who's based in Hartford, Connecticut. Stan has underwritten major infrastructure programs in building projects across North America. And then we're also joined by David Hombach, Chief Underwriting Officer Bond and Specialty in Travelers West territory. Based in Federal Way, Washington, which is between Tacoma and Seattle, Dave brings deep knowledge of the Texas and California markets. Together they have about 50 years of construction underwriting experience.

And I'm Louisa Desson. And I'll be your moderator today. I'm Director and Senior Editor in Enterprise Integrated Marketing at Travelers. We'll be talking through some points today. And then taking some questions from the audience. So please gather your questions. And we look forward to the conversation. Stan and Dave, thanks for joining us.

STAN HALLIDAY: Thanks. Thank you.

DAVID HOMBACH: Thank you, Louisa.

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David

(SPEECH)
Good morning, everyone. Thank you for joining us today. Today we're going to start off the presentation with a little economic overview and then get pretty specific about different elements of the construction marketplace.

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Economic Noise

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Really what our presentation today is really about the tale of two worlds. Pre-COVID, the construction industries exhibited characteristics of one of the most robust markets ever in history. Our clients had record backlogs with increasing margins. We were seeing all of the subcontract trades making more money than they ever had before. Labor was tight in the market. The unemployment rate in the construction industry was probably at an all time record low.

Fast forward to March of 2020 and the outset of the COVID environment and the market changed precipitously virtually overnight. Projects were delayed or stopped. Projects were canceled. Projects were modified, shut down. We saw major supply chain disruptions, labor shortages, and particularly in our sub-trades where not only project safety was a concern, but also the fact that the unemployment benefits that were a part of the rescue package initially and had enhanced unemployment benefits. And so we actually had clients that were complaining about the inability to get workers to the job because of elevated pay levels for being on unemployment.

Finally, we really expected to see a cash crunch similar to what had occurred in the downturn in '08 and '09, the Great Recession. But that in fact, did not materialize. The government had done a good job of priming the pump with the financial system. And so we saw projects continue to pay out as expected. We didn't see any material delays in payment or owners having difficulty staying viable, at least during the course of construction, so all right, Louisa.

LOUISA DESSON: So Stan, I mean, these are certainly some unprecedented times as we look at the impact of business. It seems like the story is evolving almost for the worse. What are you seeing?

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Market Conditions

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STAN HALLIDAY: Yeah, it's hard to know exactly where everything is going to end up. Certainly the last couple of weeks we've seen great changes in the numbers in certain states, especially in California and Texas. So what we thought and what we're known for a little bit in the surety department is we have some really good data from our robust contractor inventory that we've worked with over the years. And we've put together a couple of slides.

This one is California specific, or will be California specific. Go back one, I'm sorry. I got a little ahead of myself, Louisa. But this one has to do with the GDP.

So if you can look at the last recession, the green line is non-residential construction. And the red line is GDP. And you can see when the recession hit in 2007. The red line went down a little bit a couple of years and then slowly slid forward, right.

But in construction, there's a delay. There's always a lag. And then you saw really a 7-year pretty precipitous drop in non-residential construction, primarily the work that you guys will do. And it was growing pretty steadily since then.

So we're looking at that and thinking, OK, well, what can we take from that? What can we learn from the last recession? And that's where we get to the market conditions in California. And this slide is a little complicated. So we took data from a number of general contractors that are in California.

And if you'll notice the red lines are from the years 2011 to 2019. And the green lines are 2001 to 2010. So when you think about it, when you get to the end of the green line, really, the red line is a continuous move back. So these are for general contractors.

So overall on the revenue side, I'm over on that side, you can see that from 2001 to 2010 revenue kind of peaked in '08, '09. And then really fell down to 62 million. And it started to build back up a little bit in '11. And what a great run for the industry as it moved all the way up to 220 million, a really good growth. And this is a number of Travelers customers that have worked in the California area. And that's their averages.

And then you go to their backlog, which as you guys know is your predictor of future work. And the backlog had a similar trajectory. You know, it had moved up. And then it kind of leveled off for a long period.

But right there in about 2015, you see that. Look at that growth curve. And it's grown from the $80-$90 million range all the way to almost $300 million in average for a middle market book of business.

And so what we're thinking about that is, where are we today? Well, we're probably about year 7 on the green line when you think about it. We're at the beginning of this. Everyone's backlog, Dave just mentioned, is pretty good. Everyone's revenue heading into this thing was pretty good, though that was impacted by this.

But the real question is, what's going to happen going forward? Where am I going to be in 2021, 2022? And we're going to try and speak to that as we move forward.

Now, the next slide gets into a little more details. It gets into your profits and your overheads. And again, remember, the green lines are the first 10 years. And the red lines are the next 10 years.

And so when you go from the end of the green line back to the start of the red line, that's a continuous line. And you can see the growth and profit over that same time period, and then the drop.

You know, look at that drop from 9 to 10. And then it took about five years, five to six years to really see the earnings ramp back up. And we got back up there by the end of last year, really solid year. So really good revenue growth, really good operating profit growth.

And for those who aren't accounting experts, we define operating profit as revenue, less your direct costs, less your overhead. And that's your operating profit. It's what you make from construction. And if you look over at the overhead cost, you see a similar trend.

So if you look at the green slide, the overhead was really growing in the last three years before the recession. It really kind of peaked at almost 9%. And then the revenue drop, right? You see that revenue drop and you better drop your overhead pretty quick when that's happening.

And we saw it drop to 7 and then get back down into the 5's. And what a great job the industry has done this time at becoming more efficient and managing overhead. As you can see, overhead is not near as high heading into this particular recession that we think is happening.

LOUISA DESSON: It would appear California was pretty well positioned going into this, all things considered.

STAN HALLIDAY: Yeah, heading into it, I'm sure most of your customers, if you're an agent or if you are a contractor, the general consensus from general contractors was, I had really good record revenues and backlogs heading into this. I was making really good money. And I had my overhead under control. And then bang, March hit. And it was a whole new feeling.

And I think what our expectation is, most people are going to make it through 2020 OK. It's not going to be as good, jobs were impacted. Productivities were impacted. But they were in such a good spot they're probably going to make some money, and they're pretty busy.

The bigger concern is, I'm not replacing work at the same level that I was before. My backlog is starting to drop. And if my backlog starts to drop, my revenue is going to start to drop, Louisa. And that means I've got to get my overheads right. I've got to figure out how I can do.

The good thing it shows even in the last recession as long and nasty as that was, most of our customers were able to make money, just not as much as they were heading into the recession. So I think that's a good takeaway for them.

LOUISA DESSON: Dave, what can we take from the Texas numbers there?

DAVID HOMBACH: All right, thank you, Louisa. Well, to continue on with Stan's comments, as you see here-- well, first off, Texas benefits from probably the largest single DOT budget in the United States on an ongoing basis. And that plays out here in the graphs that you see.

We'll start with the revenue side. In 2001 to 2010 you saw a steady increase in the, and this is again, heavy highway in the operating revenues of our clients. Beginning in 2011, you see a rather significant increase in volume, again, reflecting the fact that the Texas Department of Transportation had significant increases in the lettings numbers each year.

Backlog parrots the same thing. You saw the backlogs had improved substantially during the 2001 to 2010. But yet, they almost tripled on average for our clients in the state of Texas during that 2011, 2019.

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Operating Profit

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Fast forward to the next slide and you'll see-- now, one of the things, these are going to look like there are two different graphs from two different places, right? So operating profit, you'll see in 2001 to 10, you saw a significant decrease in that period of 2008 to 2010 from the financial crisis. Yet backlogs were still relatively stable, right?

Go forward to 2011, 2019, and you see the operating profits start to really take off until you get to be about 2017, 2018. And then all of a sudden they start to fall off. Overhead on the other side appears to be under control, so that's really not the culprit.

The culprit was the fact that-- build it and they will come is what we used to say in Texas. Because of the massive amount of lettings, the amount of competition in that marketplace grew substantially. And you would think with growing backlogs, overhead under control, profits should be increasing, but they're not. Stan's group has a presentation they do. They call it the marginalist recovery.

And this is where this got over-competed. And so we call it the triangle between San Antonio, Dallas, and Houston, with Austin in the epicenter. There is a lot of road work being undertaken.

They are larger projects which we see in general, a reduced margin on that work because of duration risk among other things. But they had competed away a lot of the margin in that work. There's a big foreign influence, international contractors competing in that market. So that doesn't bear out with what you see in the previous two slides. But it is reality in that marketplace, OK, Louisa.

LOUISA DESSON: So what sort of things were we seeing in the market before COVID-19?

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Market Conditions Pre-Covid

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STAN HALLIDAY: Well, before COVID, I think Dave covered that kind of in his intro here. The biggest issue was almost being able to handle all the opportunities that were out there for a lot of our customers, Louisa. It was a big deal.

And things were very favorable. Upward pressure on pricing was good. That means contractors were getting more margins. There was a lot of work out there. And going back to simple economics, demand was exceeding supply.

There was more demand for contractors to do the work than there was number of contractors available to do the work. And that's a good situation to be in. Contractors love that. They typically make a lot of money in that environment.

Their big risk during that time was just being stretched too thin. Subs unable to show up, getting enough labor on the job, maybe over-extension. One of my mentors used to say, contractors don't starve to death, they tend to overeat. And you could see that maybe in the falling margins that you saw in Texas there.

But overall, it was a really good thing. Remember when all we were worried about was the US-China trade war. Or maybe did I get good contractual risk terms. But you know, when March hit, everything else kind of changed.

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Unemployment Rate

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LOUISA DESSON: We talk a lot about the shortage of skilled labor. And we can certainly see that changing now with COVID.

STAN HALLIDAY: Right, so this is the US unemployment rate. And you can see from 2009 to 2019, it was a great run. And that all changed in a month. So that arrow up at the end, and up is more if you look at the chart, that's March.

And I know it's tweaked out a little bit in April and in May. And I don't think we have June numbers yet. But it's still up in that 14%, 13% range. And that's just a huge hit.

And that's probably the biggest change that has happened out there. Some of that's been positive for construction I think. Some people that used to be in construction that left it may be coming back because construction was deemed essential. And you were able to get some more workers available for that.

But the flip side of that, Dave hit on, was like unemployment. With what the government has paid, some people are preferring to sit at home. And between unemployment and the $600 supplement, they're making more in wages than they perhaps they were working, or at least enough they don't feel like they have to work.

But if you look back to '09, at the peak of that recession, unemployment really struggled to get over 10%. And we blew through that in a month. And so this is a going to be a little bit of a different animal.

LOUISA DESSON: Yeah, so do you think that the slowdown we saw in March is similar to the beginnings of the Great Recession? Or is this pandemic different?

STAN HALLIDAY: Dave, why don't you take this one.

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Billings Index

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DAVID HOMBACH: Well, the answer to that is, that was really like falling off a cliff. And you'll see it here. What this graph shows is this is the AIA, the American Institute of Architects billings index. And it's a measurement of the aggregate amount of billings the architectural community is submitting to its owners to pay for the work that they've been engaged to do.

That line you see, the dotted line going across at 50% is an index line that historically economists have held out. Anything above that line portends growth in the amount of future activity, i.e. number of projects, magnitude of projects moving forward. You will see a rather precipitous decline of that in March and April of 2020, which obviously portends that the amount of work in the pipeline, getting again back to Stan's comment about the line of sight that our clients have about the future. Their backlogs today are good.

The margin they're going to realize on it is probably not as good because of some of the issues that they've had to face with the work underway. But what lies in the future? What line of sight do they have about future opportunities in their pipeline? That's different today.

So the next slide here, you can see is it's by different sign contracts, inquiries, and overall billings. And the level of inquiry is reaching out for pursuits to engage for future work. And you can see how low those numbers have gotten.

And you can see how significantly decreased the amount of billings are. And again, this pertains to the future that the amount of work that will be available in the marketplace will be down substantially.

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Map of US in four segments

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Louisa, you can go on to the next one. Stan, do you want to touch on this one?

STAN HALLIDAY: Yeah, this is just regionally from that. And I think you can look at the various regions there. The Northeast has been impacted the most, at least initially. Those were areas where work was shut down heavily, initially, New York, Massachusetts, Pennsylvania. And you can see the drop off was the greatest.

The Midwest and the South were comparable, but again, a significant drop off. And the West performed the best from that. But still the drop off was well over 20% in opportunities and well beyond anything that we saw in the last recession. It was almost twice as much of a drop. And much quicker.

And so I think that the thought process for everyone now is all right, I have a good, healthy backlog now. I've got to finish my work. But where am I going to be? What do I need to have in place to be successful and finish out 2020 well, but to survive 2021 and maybe 2022?

What is that going to look like? And what do I need to be to be successful in that? And we're going to talk about that in a minute.

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Institutional, Residential, Commercial

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So the next slide talks about some of the items. Louisa, can you pull this forward one?

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Market Conditions today.

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There we go. And Dave, why don't you talk about what folks are going through today.

DAVID HOMBACH: Well, can we go back to that slide just a bit there Louisa, that one right there. OK, you see these three lines in here. And I just wanted to touch on this from the standpoint of OK, why is institutional above the other two? And why is commercial the lowest of them all?

Well, if you think about it, commercial instances like office buildings and retail, probably two of the segments that were hurt the most optically by the coronavirus, I mean, nobody's working in their offices. There's big conjecture as to, do many companies ever go back into the office or not? And so that will definitely impact the planning around future space for office space and/or retail, if we're not going to be able to shop in stores like we have, that's going to be a whole different model.

Residential, in that space, there's a big thought that there will be an out-migration from the big cities and then people will be moving back out in the suburbs. And what does that mean for residential i.e. condominiums and apartments that have been built in the center of the city? Institutional is probably the highest because it had enough work in the pipeline and is funded in part not by tax revenues entirely, but private sectors for like private universities and what have you. So that's why that number is a little bit higher. OK, you can go to the next one now, Louisa.

So the market conditions today, like I said, Stan touched on it perfectly. Our contractors have great backlogs in their work. Backlog and their work has some good margin in it. Its ultimate realization coming out the other end will be a little bit diminished because of delays and what have you. And many of our contractors are beginning to be in discussions with their owners about how they get paid for some of those impacts.

We're seeing our road contractors, when there was nobody on the road got a lot of road work put in place because the cars weren't there. Now, people have always asked us, where do you see the opportunities in the future? And I think we're going to touch on that in the future. But one of the items here, bullet number 3, manufacturing and health care along with infrastructure.

Manufacturing from the standpoint of this whole coronavirus thing has exposed the Achilles heel of the American economy is that we were highly dependent upon sources of supply that may in fact not be conducive to us doing things as we need to. So I think we're going to bring back a lot of manufacturing from China and abroad. And that's beginning to happen.

Health care, obviously, we built out enough to handle this kind of thing moving forward. And the infrastructure bill, and I think we'll see something on this at some point in the not too distant future. But that's a tall order.

Subcontractors are obviously better available now, however. There are some trades i.e. drywall in particular, where because of the labor concentration and as close as they work together, it's hard to get the kind of production that you need. So we're seeing some issues with that.

But overall like in Stan's comment about the unemployment rate with a 14% unemployment rate, there are people available to work if in fact they choose to. Again, the inhibitor is a little bit of the unemployment benefit that sits out there right now.

Risks moving forward, funding, if it's a tax-based funding mechanism, that's at risk, as far as the viability and amount of work to be had. Jobs just getting started that were already previously funded maybe OK. If they were counting on future tax streams in order to pay for that, that might present a problem.

Supply chain performance, I mean, we've had contractors that have been impacted greatly because they were waiting on materials from Europe and/or China that were from plants that were shut down during the virus. Challenging contractual risk, that's one of the issues that we are exploring with our clients almost every day today. Owners are trying to put language in there to remove themselves from the responsibility for COVID related and/or pandemic or health related issues.

We can see a resurgence in the outbreak levels. And we're starting to see that now as states have started to open up. Worker health and safety continues to be an issue. But the biggest risk in here, the biggest risk in here right now is the inability or concern about the inability to acquire new backlog and at what rate. And what size will my company be in the future given the constraints that I see in front of me?

LOUISA DESSON: Stan and Dave, it really seems like the biggest risk is really uncertainty. And so contractors may be wondering, given all of this and something that does really seem to be unprecedented, what can they do to put themselves in a good position in the future?

DAVID HOMBACH: Right.

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Failure has many different causes.

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STAN HALLIDAY: Dave, do you want to do this and I'll do the next couple.

DAVID HOMBACH: OK, so what this is, is something that we share with our clients. So in the surety business, we strive to never write bonds for a contractor that fails. Well, we don't always do that perfectly well. But what we also want to do is, if in fact, we do have a contractor failure, we want to learn from it to try to avoid the mistakes of the past so that the tuition that we spent wasn't spent for nothing.

So what you see here in front of you are-- we've done an analysis of the losses that we've incurred over time and developed some characteristics that come out of those losses. Down below in the box, you'll see difficult project plus weak internal controls equals catastrophic situation. That's true. These get at percentages of the failed contractors in our portfolio as to the critical reason behind the failure.

Number one on this list, catastrophic project.

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57%

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We're seeing way more losses today caused by one single project going bad than ever before. Problem one at large, poor estimate, new job type or location, and bad owner. The next most important is obviously internal controls and system failures. And this manifests itself from the standpoint of we constantly stress with clients about the need to know where you are at all times in order to manage the business better.

And in losses we're seeing many cases where the system that they had in place did not allow management information in a timely fashion to deal with the problem before it metastasized into something that was lethal. Over-extension, Stan's point about overeating at the buffet line is the reason for failure more than starving to death. And that is in fact the case.

And finally, excessive debt on the balance sheet is an additional risk from an outside creditor that can cause contractors to fail if in fact they end up starting to miss their payments. So these are some four key elements of contractor failures. And in this environment today, because of the exposures that exist that aren't normal to the construction business, it's very critical to focus on these moving forward. OK, Louisa.

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What to do?

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LOUISA DESSON: So what can contractors do to avoid that?

STAN HALLIDAY: Well, this is probably an interesting little graph. Some of you baseball fans may recognize the little chart on the right. And that's a chart that Ted Williams put together. And Ted Williams was considered probably the greatest hitter all time in baseball.

But what he figured out is, it depended where the pitches he swung at as to how successful of hitter he was. So he divided the plate, that's home plate into certain sectors. And he determined what his batting average would be if he hit pitches only from that sector.

So you can see if he hit only low outside pitches, he would not have been a Hall of Fame hitter. He would have been a pretty pedestrian player there at 240 or 230, right? But if he swung where the pitches were best for him there in the middle of the plate, he was a 400 hitter.

So we want you to think about your job and your work kind of in that regard. And this goes back to the graph before that Dave had just talked about is, OK, what do I do? And I think about construction as really simple.

Type of work, well, it's really easy to think I need to keep my revenue up and try a bunch of new things. And that didn't work out in the last recession. Really, doing the type of work that you do is a really good predictor of whether the job is going to be successful or not.

Doing it in a familiar location, working in a new geographic area greatly increases risk. So if you're doing work that you normally do in a place you normally do it, that has a higher probability of success. Then combine that with, the team, the owner, the subs, the designer, and the team that's actually doing the work.

Are those all familiar partners of yours from that? Are you used to dealing with them? Again, the more familiar and success you've had in the past, the more likely you're probably going to have a good job, the same with procurement method.

This may not be the time to enter the design build market if you've never done it. I'm not saying you can't learn it. But usually there's a learning curve with anything that's new, so trying something that you haven't done before. And then finally contract language, again, a bad contract can negate a lot of good work because the terms don't go your way.

Now, your feedback to me-- and I know I can't really get it yet. But maybe Stan, but things are tough now. I'm not going to be able to just get work that I've always done. I'm going to have to stretch a little bit.

And we understand that a little bit. But kind of a good rule of thumb is, the further you get away from each of these things, the more risky a job becomes. So let's say, I'm going to try a new type of work, but it's in a familiar location with a bunch of people that I've worked with. It's a procurement method I'm familiar. I've got a good contract. I've done work for this owner before.

Well, maybe that's a risk you might want to think about taking and realize you have to be a little careful about it. But now, let's say you're doing a new type of work for someone you've never worked for with a bad contract. That's a recipe probably to lose money.

So you really have to think about it and have your people and you're estimators, your project people kind of keep it simple at some point in time. You can talk yourself into some, I can hit that outside corner pitch down the line. I know I can slap it in the corner for a double. Maybe not. And again, it is a percentage game. And the more often you take these risks, the more often we see contractors have trouble.

LOUISA DESSON: It sounds like the downside of the risk could outweigh the benefit.

STAN HALLIDAY: Yeah, I really do. What was really clear in the last recession for us is those contractors that tried to grow during the recession tended to do worse than those that were willing to get smaller and to stick to do what they were doing well at. You just had to shrink your swing zone a little bit and be willing to be a little smaller for a while from that.

And then the next slide, so this kind of is a good way to think about it, OK? And this is a little fancy there on the right. But it's really a pretty simple slide. So the blue line is the market price. And we'll take it for anything. But we'll take it for construction.

There's not much you can do about the market price. It kind of is what it is when you bid, correct? Everyone kind of knows that's where the market is, OK? What you're trying to do, though, is look at that green line. You want to find work where your risk price is below the market price. And that may differ for different accounts.

But where you're going to make money is when you bid low and left here in this chart, OK? And as long as your risk-based price is below your market price, that's where you make money. But if you look over to the right there in the upper outside contract, that's where your risk gets above the market price. And no matter what you do at that point, you're not going to be able to make money, even if it's good work for you.

If the work gets so cheap, the market price gets down so low that it can't justify the risk you're taking, you got to be disciplined enough to take a pass. So how do you do that? Man, it's really important now more than ever that you and your employees or your customers-- can you go back one-- know your cost. And I can't say that enough. Really know your cost, and that will help.

And the market doesn't know how to price risk. It just prices what's out there. And the same job today that you were bidding a year ago at a 12% margin, may be a 7% margin today. Nothing changed in the risk equation there, nothing. The market price changed. And you have to figure out, is your risk price below the market price? If it is, you can continue to bid. If it's not, you shouldn't.

And just remember that last principle and your employees should understand that. Don't fall in love with the job. There's no single job that any business has to have, OK? There's still going to be work out there so don't fall in love with a single job. Now, you can go on, Louisa.

LOUISA DESSON: And that risk is really individual to each company, right?

STAN HALLIDAY: It's going to vary, yes. Everyone's got their strengths and weaknesses. And there's some that you'll share more commonality with than others. But yeah, you will have to assess that yourself as a business owner. Or if you're an insurance agent or broker, help your customer assess that.

LOUISA DESSON: So how do companies know what where these fat pitches are, to use your analogy.

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Keep it Simple

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STAN HALLIDAY: Yeah, I kind of go back to being there. And I kind of said, this is another thing. Work where you've been successful if you can. And it's going to be really important now to do what you know what to do. Maybe you have to learn something a little bit. But if you're doing what you've done and doing what you're doing for people you know with teams that have done it under fair and reasonable contract terms, I think that's the best recipe for success.

I wish it was something mathematical or really good. But construction, and most business is really pretty simple. It's, you have got to do what you know. And yes, you may have to take a little more risk here and there. But try and do just one thing at a time. Try not to do three or four new things at a time.

LOUISA DESSON: It sounds like companies may also be need to be willing not to swing if they don't see something. And that might be difficult.

STAN HALLIDAY: Yeah, and I used to think, sometimes the best job that you ever had is the one you didn't get. And I think a lot of contractors if you're listening probably can nod your head with that. And another saying that one of my mentors taught me was, in construction, you make money in shovelfuls. But you can lose it in dump truck loads.

And if you end up having one of those dump trucks on you, that's what we showed in that blue chart, that can take you down. So what we're trying to do is avoid you from having that dump truck like a bit. Made you can lose a few shovels for a while, but that's a lot easier to bounce back from.

And I think a good way to think about it is what this next slide will say. And a very successful businessman you'll recognize said it. But we'll close out with this slide here.

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Warren Buffett

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He said, "I don't look to jump over 7-foot bars. I look around for 1-foot bars that I can step over."

And I think that's a good way, a good thought, for your team to lead right now is, when you're in a tough time, don't take the hero shot. You know, let's look for something we can do that's pretty easy. And yeah, you may have to look a little harder and work a little harder on that.

And yeah, you might have to get a little smaller. And you hate doing that but don't confuse being busy with being successful. You can be busy and lose a lot of money from that. You're heading into a recession, things are a little different. And you have to prepare for it that way. Dave, is there anything you want to add?

DAVID HOMBACH: I would just second what Stan said about it's OK to get smaller, to reduce your own risk profile, your exposure to the enhanced risks that you see in the marketplace today, doing work for owners that you've worked with before in places where you've worked with before with team members you've worked with before.

It sounds overly simple. But it's a key to success even in this marketplace where the world's getting a little bit smaller in front of you. It's OK to get smaller. Stan was absolutely right.

We've seen contractors try to grow in a recession. And they don't look very good coming out the other end. If you want to look strong and good coming out the other end, I'd take a hard look at the advice called out here today.

LOUISA DESSON: I mean, we've looked at the overhead was pretty lean going into COVID-19. So there might be some difficult decisions that these companies have to make. But I think Dave, you've made the point before that making those tough decisions today can help you be around in the future.

DAVID HOMBACH: Yep.

STAN HALLIDAY: Absolutely.

LOUISA DESSON: So at this point, we would love to open it up and take some questions. I can answer them in the Q&A field in your chat window. And we have a couple coming in right now. So this one, outside of the private sector, do you think we'll see any federal or state projects ramping up as a sort of stimulus to the economy?

STAN HALLIDAY: I'll take a first crack at that. So I'll start at the state and municipal level. That's where this recession is very different. The tax impact on the state and city budgets that you guys all live in and work in have never been hit like they were hit in the last two to three months. And this is a hole that they cannot fill back.

So most state or fiscal budgets run 7 ones. So people are going to feel that hole. And they're going to have to make some tough decisions going forward. And it's very hard, I think, for a city or state to stimulate, especially depending on the economic condition they were in heading into this.

But I think it's going to be tough to do that. And it's going to be tough for a city to say, OK, I'm going to lay off 300 people in our certain departments or whatnot, or I can build this new $60 million courthouse or something. I think you're going to find the building start getting delayed. I think it's going to be hard for that to do that.

So that has us a little more worried than anything in the past. Federally, I would love to say we have a very functional government that always looks out for the best people and doesn't care about partisan politics, but that has not been our experience for the last 10 or so years. And I don't expect that to change in the short run.

I would love to say that there would be a stimulus coming forward before the election. I'm not so sure that our government will get this act together and do that. But I do think we will see ultimately fiscal stimulus from the federal side. I think you'll probably see it may be more targeted than in the past. I think they're going to have to help our hospitals and health care, folks with the financial situations that they've been hit on.

And I think that yes, they're going to look at infrastructure as they've done in the past because that's easy. But I think this one's a little more broad-based. So I'm optimistic that something will come together there. But that may have a 18 to 24-month lag before it really gets to you. So I think you have to prepare for that.

LOUISA DESSON: Is it fair to assume that contractors should stick to that fat pitches rule of thumb when looking at stimulus projects?

STAN HALLIDAY: I hope I'm wrong with that there is a lot of work that's out there. Because then things will keep going. But I just don't see how the budgets in most city governments don't run with excess. No one had built in rainy day funds to cover this. So yeah, we've got some real deep holes to dig out of. And the taxpayers can't take it all on either. So this is going to be some shared pain by everyone.

DAVID HOMBACH: And many state and local governments are prevented from borrowing large sums of money under a stimulus program that the federal government seems to be able to do pretty easily if they have the will to do it. So to Stan's point, many of them are locked out from ever even being able to consider such a thing because they're structurally incapable of being able to borrow like that.

LOUISA DESSON: Interesting. So as construction firms begin to recover after the Great Recession, what sectors did we see improvement in first. And are there any lessons we can take from that?

DAVID HOMBACH: The last one or this one?

LOUISA DESSON: The Great Recession, 2009, 2010.

DAVID HOMBACH: Oh, I thought you saw a pretty big residential component both for sale condominium type and in apartments. I mean the residential side boomed after that. That's one that I can say really took off, that and manufacturing.

STAN HALLIDAY: In this time though, Louise, I'm thinking, Dave kind of hit on it a little bit. We think manufacturing probably is going to see a bit little uptake as they bring back supply chain to here. I think everyone realized just-in-time maybe wasn't as good as everyone thought it was. We had nothing in reserve. And it works fine long as there isn't a big disruption. But we got that disruption.

I think technology data center, think about virtual bandwidth and things like that. That will be a growth area. Health care, though the hospitals themselves are greatly impacted financially and not in a good way, we are going to have to think about delivering health care differently and how we want people to enter hospitals and things of that nature. So I think you're going to see investment there, and probably those areas first.

You know, I still think residential will come back in some form because people need a place to live. But I'm not sure you'll see a hotel or an office building or anything like that as a high priority on any developers bid list here in the short run. And we're just going to have to figure out what the world is going to look like till we get a vaccine.

And I don't have answers as to whether people are going to rush back to the city or we're going to become more suburban again. Does anyone want to get onto a train? And we're investing in light rail and transit. But it's going to be a while before I think people are comfortable getting on things like that. So opportunity to do some work if you believe there's going to be a vaccine, those are great unknowns.

LOUISA DESSON: And what do you think that the turnaround timelines might be in seeing some of these projects with the engineering and the manufacturing before these projects are ready to get started?

STAN HALLIDAY: That's a great question. I wish I had a perfect crystal ball. I think companies that financially did well during this situation will probably be able to do it more quickly than others. I think a thoughtful government program on key needs for our country probably can help stimulate that as well.

So those are all very good questions. But I think it's real clear that there's certain things we need, medical equipment, things like that, that need to be in reserve. I think warehouses will be a growth area that online sales and things like that will probably have a lot more warehouses than retail stores.

And then at some point you hope our restaurants come back. But things like that, the other retail developments that we were seeing we hope will continue to go. Student housing, Dave mentioned that. We thought that would be a great booming area. But right now that's a little shaky. It's just a lot of uncertainty that's out there.

LOUISA DESSON: A question from an underwriting perspective, how will you view enhanced balance sheets as a result of the PPP funds that companies may have received?

DAVID HOMBACH: Well, that's an interesting question. Well, the need for liquidity at the time was very important. And our clients, many of whom did get it, got it for all the right reasons. The way we look at it has a lot to do with the way-- there's two options in the end, you either repay it or it gets forgiven.

And the process by which the loan is analyzed for its use and is forgiven, there's there some risk in that. And I think that's a moving target. So we have decided to treat it as if it is a long-term liability and we leave the liquidity up top. I don't think we've had any of our clients-- Stan, have we had any of our clients yet have their loan adjudicated to say that it's forgiven yet?

STAN HALLIDAY: Not completely yet. So yeah, I think our initial thought with it is consistently say, it's dead until it's not. But if it does, if it is forgiven it's going to be done fairly quickly in an interim cycle. For most people if they are a 12/31 year end.

So most of the forgiveness will come here in these next few months. And then we'll see if they extend it further from that. But we think it was a really smart thing to do for those that need that.

Certainly the last recession was a liquidity crisis, right? The money capital markets froze up. And for all the things you can say good or bad, the federal government did a good job of turning up the printing press and keeping liquidity in the marketplace.

And that did not happen as quickly here. And I'll give credit to construction owners and general contractors and subs, everyone paid each other and was very good about that. Everyone was very concerned about that at the beginning. And so we didn't see that initial credit freeze we saw at the last time.

But long run, this is going to be a long-term recession. And hopefully those that use that Triple P funds kept some people off the unemployment rolls, built themselves some cushion. And over time we'll see if it's forgiven or not. If it is forgiven, it will become an earnings. I think it will come in the other income. It will come in as earnings.

And the debt will just disappear. So we're kind of taking, I guess, a middle position on that. But one we think is pretty prudent. Great question though.

LOUISA DESSON: We have a question about your fat pitches baseball analogy. So if you're supposed to swing at the fat pitches, what happens if the only pitches are being thrown are low and outside. So if none of the projects really fit into that category, that are familiar and the corner that you know and some of the other metric documents.

STAN HALLIDAY: That's a great question. I think you have to think long and hard about it if you're a business owner, OK? It depends also on how much have you built in your business, and what do you want to do with that?

During the last recession, there were some pretty successful contractors that decided there wasn't a pitch out there that they could swing at that they wanted to swing at. And so they took their money and went home. And that's a hard decision. I'm not saying that's the right one for every business. And some businesses can't do that.

But if you're constantly going to bat 180 in construction, that's not going to be a great thing. So I think you have to really be disciplined and have the courage to say no and say no and to get smaller. And at some point, it may be the right decision to pay all your bills and take your hard earned money and net worth you've earned during these two times. And what Dave likes to say, keep your powder dry for another day. That totally worked better last time.

DAVID HOMBACH: Yep, I agree with Stan. Having coached for a long time, we used to tell the girls, leave it down there. And so after four of them, you walk to first base. And if they're not giving you anything to hit, you have the choice to swing at something outside the strike zone or take it and live to see another day, right?

So that's pretty much what Stan's point was. You can take the pitches and don't have to swing at everything that's thrown up there. Being disciplined, again, it comes back to being disciplined.

STAN HALLIDAY: I'm not saying it's easy because people like to work. People like to do things. But you also as a business owner or as a business advisor have to take into account is, can you generate the type of return that you're looking to return. And is there a chance that I'm going to lose money.

So I get a couple of jobs. And I have built up a war chest of net worth in my company. And I give 40% back in a year. Well, maybe I would have been better off not playing. You know, those are things you have to think about over time and make some hard decisions.

LOUISA DESSON: We have time for one more question. And I think we can answer this one because it gives us the chance to end on a positive note. What are the early indicators that a recovery is beginning to occur?

DAVID HOMBACH: Well, I'll take one of those. From your graph we had before about the AIA building cycle, you'll start to see that come back up above 50. Unemployment will drop. You'll start to hear about, there's nobody sitting on the bench in the union halls because they're being called out to work.

Those are a couple of the easy ones that are very clear to see. It just the general overall level of activity. I mean, we see it by the virtue of the number of bid requests we get from contractors for bid bonds. Or requests for RFPs and different instruments that we write around those. So as that volume starts to increase, that will be a good bellwether of improved construction activity levels.

STAN HALLIDAY: And I think the shape of this recovery is still uncertain. Everyone hoped quickly it was going to be a V. It's clearly not going to be a V. And where it bounces right back to where it was before, and this was just like a three month hole or something. That hasn't happened.

So will it be a U where it's a longer hole, but it gets back up there pretty quick? I think a lot of people are thinking probably not now. So now we're either looking a W where it swings up a little bit, back down and maybe back up, or possibly even an L that eventually heads back up. But the L is kind of the worst. For an extended period of time, we're just going to have a lower level of economic output and opportunity.

And it's still a little bit too early to tell for that. But I think how well our government functions and is able to stimulate. Its role is to provide stimulus in times like this. And it has been able to do that in the past. And hopefully, it will be able to do that here again in this cycle. But certainly we need to see a little better partisanship in Congress to help make some of that happen for all of us. I think it's really critical.

LOUISA DESSON: That's great. Well, we're almost out of time here. We've had a great conversation and we appreciate, Stan and Dave of your time today. Just a few housekeeping announcements. There's plenty more that you can check out at travelers.com.

You can also enter your email into the Zoom chat and contact a Travelers rep for more information or to get information on this recording if you'd like to share it with others on your team. So thank you all for your time. Thank you for coming today. And good luck to everyone in the future.

STAN HALLIDAY: Thank you.

DAVID HOMBACH: Thank you. Thanks for having us.

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