Last year at this time we talked about how and why utility companies started entering the PHC contracting business in 1996, and why they began selling off those contracting businesses in 2000. This time around we tackle the demise or reorganization of roll-up corporations and other consolidators that entered our industry at the same time, companies such as American Plumbing and Mechanical, Encompass Services, Blue Dot and Group Maintenance America Corp.

Helping us to understand what went so wrong with so many companies is a recently released report by construction industry consultant and research firm FMI Corp. titled “Why Contractors Fail: A Causal Analysis of Large Contractor Bankruptcies.” In it, FMI examines large contractor firms (including mechanicals Encompass Services and JWP Group) and analyzes why so many of them didn’t make it.

“Recent history has shown that construction firms are not too big to fail even though they may have annual revenues ranging from hundreds of millions to several billions of dollars,” note the report authors Hugh Rice and Arthur Heimbach.

Of course, it takes more than one negative factor to bring down a company. The report’s objective was to go beyond the common causes cited for contractor failure, including unrealistic growth, bad contracts, poor financial management, poor leadership and economic weakness. Why did they grow unrealistically? Why did they have insufficient capital for their needs? Why did they have no financial management?

FMI’s research identified nearly 200 potential factors that can lead to contractor failure, which the report’s authors categorized into four major groups: general economic conditions; nature of the construction industry; culture and systems of the organization; and mind of the contractor.

The report notes that many of the unique characteristics of the construction contracting industry also contribute to contractor failures. These include conducting large amounts of business with very little equity; manpower shortages; the hard-bid process; project timing; low barriers to entry making the industry hyper-competitive; unique projects that may not be portable to the next job; the derived demand concept; and cyclical nature of construction.

FMI also found that the company culture played an important role in company failures. “Corporate culture issues have gained recognition in recent years as being more important than historically thought,” the report notes. “Ethical and moral issues are some of the more serious areas of corporate culture failures, but a company’s culture also affects decisions about the company’s strategy and hiring needs.”

When all these various factors combine to create poor company performance, the result is most likely loss of financial capacity. Failure is almost inevitable at this point.

“Loss of financial capacity is the ultimate trigger of the downward spiral that includes a decline in surety bonding, the calling of bank loans, and the inability to make payroll and pay suppliers,” the report says.

Root Causes Of Contractor Failures

Rice and Heimbach conducted in-depth interviews for their research with a wide range of senior executives involved in many of the recent and large failures in the construction industry. After analyzing the data, they identified five dominant root causes for failure:

1. Excessive ego — In 62 percent of company failures, ego-related issues were a crucial element in the actions that led to the companies’ demise. “There are many ways that excessive ago can distort reality, leading to misperceptions concerning the market, the company’s capabilities, and the leader’s personal needs, any of which can put the firm at much greater risk of failure,” the report states.

2. Poor strategic leadership — This was cited as a leading factor in the business failure in 76 percent of the cases studied. “We noted that many leaders, due to their excellent building and technical skills, ended up running large companies that far exceeded their business management capabilities,” the report notes. “Strategic mistakes resulted. … Indecision can lead to problems not getting resolved, which can … topple companies.”

3. Too much change — Ninety percent of the organizations had initiated excessive changes preceding their failures. “With each increment of change, there is an exponential increase in the risk of losing the systems of procedure and control that are so fundamentally critical to bringing projects in on time and on budget, and maintaining satisfied owners and employees,” the report says. “Changing too much, too fast leads to problems.”

4. Loss of discipline — This was cited in 45 percent of the cases. “The importance of maintaining discipline in the management and operations of the company is no different from the importance of discipline in the processes employed in constructing a building,” the report explains. “The analogies for management include … staying true to appropriate project selection and pricing policies, … avoiding bloated overhead and complex organizational structures, and not succumbing to the impulse of … [taking] the seldom-actualized ‘break-even’ project just to keep people busy.”

5. Inadequate capitalization — The inability to maintain a sufficient buffer for unexpected needs was cited in 58 percent of the cases studied. “The economics of the construction industry are rather unique, and many leaders fail to grasp the severity of risk that the company is exposed to by maintaining an inadequate amount of capital,” the report says.

External forces, such as economic conditions and the very nature of the construction industry, can quicken the pace of failure but are not root causes of failure, the report authors note. “It is a rather thin edge on which successful contractors live. A significant misstep can end the life of the company.”

(For another perspective of this report, see this month’s Editorial Opinion by Jim Olsztynski.)

EMCOR — A Large Mechanical Success Story

Tony Guzzi, President and Chief Operating Officer of EMCOR

EMCOR Group has been PM’s No. 1 Pipe Trades Giant for many years. It was forged from the ashes of JWP Inc.’s Chapter 11 reorganization, keeping the best of the bunch and weeding out the weaker companies.

But what sets EMCOR apart from the roll-ups that began pushing their way into this industry in the late 1990s? Tony Guzzi, president and chief operating officer of EMCOR, gave PM five reasons why EMCOR works.

1. Management personnel are operators, not just financial managers. “We just don’t buy companies and try to put things together at a low multiple and trade it at a higher multiple, which is what consolidators do. We know construction and services. We know what to get involved with and what to avoid, yet at the same time we don’t overreach. We know what the capital structure should be for this company, and we make decisions accordingly. We’re very astute financial managers from this standpoint.”

2. The company is driven by a core set of strategic initiatives, objectives and values. “In the long-term, this operating philosophy creates shareowner value, but has nothing to do with just creating mass or financing. The strategic initiatives and objectives are things like developing a balanced earning base, building a brand, keeping a cash focus on the running of our company, focusing on return on assets, increasing the things we can do for our customers, and broadening our reach on the number of owners we touch.”

3. EMCOR only acquires market leaders. “Consolidators will buy just about anything that moves. And they’re out there buying [small] companies. Most of the time we buy companies that have mass and that are market leaders in their own right in their local markets. We focus on leadership development, and we focus on making sure the right people are in the right jobs. We have a philosophy of balance, and that extends to balancing the local entrepreneurship with central risk management.”

4. The company creates scale where it makes sense. “We look for scale opportunities where they exist; e.g., purchasing, bonding, risk, marketing, facilitating the attraction of talent and people development. However, in creating this scale, we also build on the strength that exists. For example, in the case of branding, we build on the local brand by using it together with the EMCOR brand, vs. trying to kill the local brand (as some failed consolidators have previously done).”

5. The management team has extensive industry and/or functional knowledge. “We’re not teaching people the business all the time. Everybody at the top of this company has either been around this company for a long time or been around the industry for a long time.”

Guzzi also notes that EMCOR has a certain corporate culture that facilitates its success. For one thing, its corporate management team is lean, with no more than 65 people overseeing the $5 billion firm. And everyone respects and understands that everybody has a job to do.

“Quite frankly, rank doesn’t mean a whole lot,” he says. “You have to earn your stripes every day. We’re all player-coaches at the senior level, including our CEO. Everyone gets involved, everyone knows the business. So it’s a culture that is very low on pomp and circumstance, very low on management by PowerPoint, but very high on content, and very high on the management of risk. And it’s a culture that likes to win consistently.”

Companies that become part of the EMCOR family are not dismantled or stripped of senior management. EMCOR realizes the importance of local relationships and the spirit of entrepreneurship of local owners. It doesn’t sweat the small stuff, like decisions made at the local level to sponsor Little League teams or throw the annual Christmas party.

“We want the management of our EMCOR operating companies focused on jobs, productivity and margins, not spending time seeking permission for things that are smart and make good business sense, such as activities that are local and important to their employees and communities,” Guzzi explains. “We treat them like senior executives — peers — which is what they are in our world. That is something that other people and companies don’t always do.”

At the corporate level, EMCOR provides access to the best, Fortune-500-caliber people to handle problems or situations that the entrepreneurs may not be proficient at and/or do not need to recreate within their individual operating companies — contract lawyers, project accounting specialists, marketing professionals, financial specialists, safety professionals, insurance help, etc. The idea is to give them the tools they need to give their companies a competitive edge in their marketplaces.

Guzzi attributes this culture and philosophy to Chairman and CEO Frank MacInnis, who joined the company 14 years ago and has kept that winning formula even during tough times.

Although this industry is dominated by small shops, Guzzi acknowledges that there are certain advantages to being a large company — financial capacity to get bonding, marketing capacity to get brand recognition and visibility, sharing information and techniques between companies, better product sourcing, etc.

But being a large company doesn’t guarantee a prosperous future, as the failure of many consolidator companies illustrates. There must be processes in place to effectively manage the individual businesses, yet not over-manage. Remnants of the consolidator culture of the late 1990s in the industry exist today — Service Experts, American Residential Services, Comfort Systems USA, Residential Services Group. But they are different entities now, forced to evolve in order to survive.

“If you get the mix right — local decision-making, entrepreneurship and flexibility; having great people in local markets; backed by a very strong financial company with a significant marketing machine and great knowledge transfer — you can make a lot of things happen. And that’s really the story of EMCOR,” Guzzi says.

For a look at the history of these roll-ups and consolidators, visit our Web site archives at www.pmmag.com.