Blog

Case: Why “Constricted Construction”​ and Its Lenders Needed To Invest 90 Days Each To Better Understand The Business

Over the years, I’ve worked with several of our colleagues at Qorval Partners on about 60 situations in about 30 industries.

In addition to every industry imaginable, from firearms to pharmaceuticals, we have done quite a bit of work for specialty contractors, and there are quite a few examples where lenders had their blinders on, and management, despite prior experience, industry accolades, and in many cases, heavily credentialed people, negligently missed some basic “blocking and tackling” fundamentals.

As is often the case with getting external counsel, whether it be turnaround or advisory, or any other kind of counsel, the borrowers often wait too long and the lenders often don’t bother. It’s fascinating to us that when we look back, we find that lenders invested into a company that they weren’t aware was insolvent, or plagued with weak controls.

For the sake of simplicity and anonymity, we’ll refer to the example company as Constricted Construction.

THE CASE OF CONSTRICTED

Following is an amalgamation of just some of what we discovered at Constricted Construction and a few of their peer companies, during our engagements.

We always say that struggling companies, particularly field service companies (construction, civil, telecom, utility, water, solar, energy infrastructure, bridge and highway, e.g.), usually wait about 90 days too long, on average, before pulling in resources to help them turn their business around.

In addition, we find that lenders and creditors do little, if any, due diligence on the in-depth operations of businesses, and should be more concerned with preempting problem credits (borrowers) than scrambling to run them through workout or special assets/special situations or forbearance at a later date.

Usually, the same 90 days applies to lenders/creditors – if they’d taken more time to understand the business before they threw money at it, they’d wind up with fewer insolvencies and winddown risks.

Some of what we’ve found:

CASH FORECASTING

·       The 13-week cash flow projection was set up in a satisfactory format and provided valuable information to navigate an extremely tight cash flow situation, tracking inflows, outflows, and net cash.  We advised that collections were difficult to predict in the construction industry, so the company needed a more conservative projection with continued input from field personnel.

·       CFO didn’t have bandwidth to properly manage cash and was consumed with daily oversight and fending off vendor pressures.

·       Concerns that forecast was regularly missed – mainly on the revenue side – due to a breakdown in communication through the COO and project managers.  They didn’t understand the difference between backlog and pipeline (do the projects actually have a purchase order or are they just “hearsay?”), and at their client level, their relationships were with lower organizational level market people giving out the work.

·       Suggested and implemented a variance analysis by week to track progress.  We didn’t see any sense of reality in the project management calls in which the discussion centered around longshot predictions and irate vendors with historical issues related to broken payment plans.

·       Recommended the Company add a worksheet showing an accounts payable aging ranking and on what projected pay date.

·       Established vendor priority schedule and classification of vendors by criticality, lien risk, e.g. which gave us visibility into some of the many downstream vendor problems.

TRACKING PPP LOAN FUNDS

·       Provided tight fisted control and classification of outflows by allowed SBA/PPP expenditure categories – payroll, insurance, utilities, taxes, e.g.

·       Prioritized payments to go-forward vendors to get profitable work begun and completed, and prioritized payments to critical services.

·       It is noteworthy that even with a substantial $2.0 MM PPP “subsidy,” Constricted Construction couldn’t run the business profitably, further illustrating the reality of it’s poor margins due to poor estimating of all direct and indirect costs and job management and loose job costing, materials and labor leakage, excessive cost structure, e.g.

WORKFORCE

·       Constricted Construction was overstaffed.  It had a fragmented approach to getting administrative support done and should have self-integrated admin support for the two operations it was running with duplicative overhead and excess staffing.

·       Headcount was too high on both sides and the office staff and operating divisions’ leadership were often in conflict.

·       Compensation levels too high for many roles.

·       “Part time, show up when we feel like it” administrative office culture.

·       Organization needed to be flatter.

·       IT didn’t need an in-house director.

·       HR poorly managed. Several mistakes identified with improper payroll taxes within certain states, loose payroll and overtime controls.

·       Conflicts across departments (IT with HR, IT with first operating division, HR with second operating division, e.g.)

·       Recommended a workforce reduction to get to 60-65 FTE.  Our frame of reference was XYZ, a company which ran in the same industry, with higher revenue, in the same town, with 30 fewer people, and two FTE’s principally providing the same project administration and billing support as the large staff funded by a $30K a month payment to an outsourced overseas IT group.

·       The overseas operation was something we were never allowed to gain any transparency into.

JOB COST REPORTING

Job cost reporting in QuickBooks was weak because:

·       estimates were not recorded

·       payroll was not recorded by job, some COGS expenses are not charged to a job

·       job cost reports were not reconciled to the Profit and Loss Statement to uncover and investigate errors

·       a report to show expenses not assigned to jobs was not investigated and used as a tool to make adjustments and implement tighter internal control over recording expenses.

Work in Process (WIP) schedules were not prepared and no journal entries were recorded for cost in excess of billings (CIEB) or billings in excess of cost (BIEC). There were some journal entries that book unbilled accounts receivable.  Given the lack of tie-out of CIEB and BIEC to the balance sheet, we were suspect on the integrity of the balance sheet accuracy.

WIP schedules are only as valuable as the time spent with project management and accounting and finance together reviewing the schedule of jobs, and ensuring that the change orders were captured, all costs are correctly assigned to the appropriate jobs, that cost to complete was accurate, and that the stated and forecast gross- and net- margin for each job were correct.

We furnished a WIP format report (based on active jobs) for future reference, showing President/GM, Controller and COO how QuickBooks produces WIP reports as well, once the source data for the report is trusted to be accurate.

The lack of WIP, CIEB, BIEC, made it is impossible for the companies to forecast an accurate “cost to complete” (“CTC”) to define what remaining labor, material and other expenses were anticipated in order to complete and close out jobs so billing can be entered, and receivables generated and collected.

We cautioned that given Constricted Construction’s desire to engage a commercial banking relationship, line of credit, invoice and receivables factoring, e.g., accurate portrayal of WIP and CTC was essential.

Potential acquirers struggled to get a comfort level with understanding the relationship of CIEB/BIEC to the balance sheet.

FACTORING RECEIVABLES

·       Recommended (names of lenders and factoring companies) for a quote and potential cost savings for consolidation lending opportunities to bundle (incumbent lenders) positions; no follow up was done here and both companies got frustrated waiting on unfilled diligence requests for loan prequalification.

FLEET LIQUIDATION TO GENERATE CASH/IMPROVE BALANCE SHEET

·       Recommended early fleet review and liquidation of surplus assets to generate liquidity, reduce maintenance expense, e.g.  COO and project manager did not follow through.  Brought in (names of auctioneers) and others.

INTEGRATION

·       Recommended COO take over oversight and reporting of second division personnel, consolidate operations of two overlapped entities into one (Constricted Construction and second division). This was not done.

GROSS JOURNAL ENTRIES

·       The company’s books and records were marked with en masse journal entries with little or no backup.

INSURANCE

·       Recommended insurance broker to quote all current insurance coverage plus D&O to reduce premium costs and improve coverage; again, lack of follow up by Constricted Construction.  Constricted Construction overpaid for insurance coverage and likely had coverage gaps/insufficient coverages.

·       Plan was to have a new workers comp policy and tracking premiums by adjusting payroll for overtime and allocating workers to proper work codes at a lower premium rate. Admin support in Finance and HR had no understanding or desire to work on this.

Field Workforce Software

·       “FWS” was implemented over a two-year period at a substantial 5K a month cost without any due diligence and little comparison to other software options.

·       “FWS”  was improperly classified as a fixed asset, further skewing balance sheet and income statement.

·       Project Managers entered subcontractor and material estimates and actual invoices, representing poor internal control; this was but one of many “fox in charge of the henhouse” problems with project management.

·       Revenue numbers were a calculated number as opposed to actual revenue, which made job profitability a meaningless and inaccurate number.

·       QuickBooks was not fully mapped and integrated to “FWS”  so job cost data integrity was weak, and there was zero data on Second Division in “FWS”.

·       “FWS”  reports were needed to categorize in a worker’s comp report showing overtime and job work code, so company could realize significant cost savings in insurance premiums; requested of HR, never completed.

·       Second division managers resisted rollout of “FWS”  because they didn’t want accountability (we know why now).

CPA REVIEW FINANCIAL STATEMENTS

·       Recommended the first CPA review financial statements with going concern language as appropriate by a reputable, experienced CPA firm (management chose to stick with (incumbent CPA firm), which worked very hard and produced solid reporting); previous financials were essentially internally prepared and none of the numbers tied out to the balance sheet, or fixed assets.

·       Created year end workpapers to provide to CPA firm as part of audit process, identifying missing and incorrect information and record keeping, large journal entries with limited or no backup, e.g.

·       Provided numerous general ledger reports to facilitate the process.

·       Assisted auditors and provided information to substantiate figures, wherever possible.

·       Created internal control questionnaires to uncover issues and recommend solutions.

·       Reviewed CPA review report and suggested changes.

·       Instructed how to properly book year end journal entries, run financial reports, tie into CPA review report and lock QuickBooks by establishing closing date with password protection.

INCOME TAX RETURNS

·       Reviewed 2018 tax returns and advised that journal entries were not booked to adjust books accordingly.

·       Discovered that prior owner bounced $97K check to IRS and there was no follow up or clawback tied to pre-acquisition due diligence.

·       Recommended IRS Enrolled Agent to get tax lien removed so sale of real estate can be completed (in process).

·       Enrolled agent identified additional problems with 2016 and 2017 filings.

·       2019 tax returns are in process.

·       At this juncture, many tax related issues across multiple filing years remain unresolved but enrolled agent was able to clear a few tax liens and get corrected transcripts.

CONSOLIDATION OF CONSTRICTED CONSTRUCTION AND SECOND DIVISION FINANCIALS

·       Second Division format for cost of goods sold was not properly set up, so Controller was wasting time making reclassification entries and issued statements that do not tie to QuickBooks.

·       Recommended changing to correct format and correcting YTD figures, so reports tied into QuickBooks; Book activity to correct G/L account to avoid reclassifications.

SECOND DIVISION

·       Advised there was no oversight, (and a complete absence of COO involvement), lack of internal controls and the situation was extremely vulnerable to fraud.

·       Suggested employee contracts with non-compete clause; as it would turn out the lack of noncompete language exacerbated the diversion of business opportunities to XYZ Newco, owned by principals working for Second Division. This would have been a noncompete violation, had management bothered to have all employees sign offer letters/NDA/NC/NS agreements when it bought the business.

·       Suggested support from overseas was grossly overpriced and had no transparency on cost, also created cyber- and data loss risk.

·       Recommended that 30K monthly invoices from overseas include backup like employee task and hours, client to be charged, job and was based on authorized work.

·       Suggested hiring of two internal admin people in the US and elimination of the overseas support, saving $240,000 per year.

·       Require 1099 and employees to provide hours worked and task by client.

·       Implement billing controls and proof to ensure hours worked were billed according to contract terms.

·       Advised using “FWS” or some other method to:

o   Prepare estimate and compare to billing

o   Establish a framework for a job cost system to track profitability by client and job and monitor that billing and expenses were processed properly

o   Compare job cost reports to actual cost of goods sold in QuickBooks to test data integrity

o   Establish estimating procedures to make sure all GAAP cost of goods accounts were reflected in bid along with proper overhead allocation, so estimate was priced properly to yield a reasonable profit margin

BALANCE SHEET CONCERNS

Overvaluation of Assets

·       Fleet assets were overvalued and in poor condition.  Fixed assets didn’t tie out to balance sheet and fleet maintenance recordkeeping was poor. Inventory controls were substandard.  Creditor’s desktop appraisal far overvalued rolling stock given their condition. Notably, the outside CPA firm recorded an impairment to fixed assets charge of $2,297,000 to SG&A expenses on the 2019 Income statement.

Quick Ratio

·       Constricted Construction was unable to meet short-term obligations with its most liquid assets. This metric is a more conservative look at liquidity than the current ratio, because it only takes cash and accounts receivable into account, not inventory. In general, quick ratios between .5 and 1 are satisfactory; in the case of Constricted Construction, the Quick Ratio was as follows:

•    Quick Ratio = (Current assets -Inventory) / Current liabilities
•   1,456K – 558K/3,491K = .26
• This suggested the company was unable to pay its current liabilities from its near cash or quick assets.

Debt to Equity Ratio

·       It indicated the funds supplied by creditors versus stockholders. The company showed negative net equity of $2-$3MM, so funding was essentially provided 100% by creditors.

ACCOUNTS PAYABLE

·       The days payable outstanding (DPO) is a financial ratio that calculates the average time it takes to pay its vendors and suppliers. The company tracked a DPO of 188-200 days, very high.

·       The accounts payable balances indicated nearly 80% of the A/P was over 90 days past due, with high exposure to general threats of contract defaults, lien risks and other potential risks.

CONCENTRATION RISK ISSUES

·       Advised that 2019 Sales for (Customer 1), (Customer 2) and (Customer 3) represented 41%, 21% and 11%, respectively, indicating concentration risk with 73% of revenues coming from just three customers.

·       In 2020, (Customer 1) and (Customer 4) represented 64% and 13% of the current active job business.

·       (State #4) accounted for 55% of active jobs and (State #11) represented 20%, totaling 75% of expected jobs in progress; despite (Core location 1) being the core of work, the COO, based in (Location 2), seldom visited the (Location 1) operation.

SALES FORECASTING

We recommended Constricted Construction prepare a realistic backlog and pipeline forecast, categorizing these numbers using a breakdown as follows:

·       Signed purchase order (backlog)

·       Verbal approval waiting for signed PO (pending)

·       Pipeline of potential new business without any commitment (pipeline)

There was a lack of confidence-level based forecasting scenarios such as: best case, base case (mid case), worst case.   (It has been our experience across other infrastructure companies that this is an industry where customers frequently give projections that don’t materialize and staffing up for larger run rates on work has had serious consequences.)

The company lacked strategic relationships/MSA’s in place with other active companies such as (Big Client).  Constricted Construction was poorly positioned to take advantage of work created as a result of the (industry consolidation and other market dynamics). This projection in varying scenarios would have improved gross and net margins.

Furthermore, Constricted Construction and it’s Second Division were getting the “crumbs” of project assignments given their problematic reputation with subcontractors and vendors that were starting to circumvent the company and complain directly about not being paid timely.

We advised that the company develop higher level relationships at the prime contractors and even introduced our network connections at (Corporate in City, State) to help speed up payments.

MARKETING AND BUSINESS DEVELOPMENT

We recommended rehiring of the former Business Development Manager John Doe or a suitable replacement; this, like most every other recommendation and initiative, fell on deaf ears, with the rationale that the COO and project managers could develop a sustainable backlog and pipeline.  Both were ineffective at generating bidding opportunities and winning business, further plagued by vendor chatter, diversion of opportunities.

Visitors to the (State 1) headquarters were met with an unkempt front lobby, nonworking doorbell and messy office. Web site was poor and there was a competing web page, left up by prior owners to interfere with the company’s own page, causing confusion. The condition of Constricted Construction’s offices in (State 2) did not say pride in any way.  The (State 3) operations were much better organized and maintained. Calling this to the attention of the COO fell on deaf ears.

The company did little or no marketing and promotion, no customer news, no safety news, industry leadership, e.g. and much of the industry didn’t realize it wasn’t still owned by the prior owners.

RECAP

These are just excerpted examples from the analyses we conduct. These kinds of situations are often too far gone to source new lenders or acquirers, despite valiant efforts to find potential suitors. There’s just too much hair on the deal. Investors often ask, as do we as turnaround professionals, if there’s this much bad news, what is it I don’t know? What other landmines are buried out there?

As you can see, there are numerous “misses” on the part of management, the company, and it’s lenders. One of the major failure points for a contractor is the job costing, because without granular visibility into the profitability of individual jobs, how can they know if the company overall can be profitable, especially in such a razor thin margin business.

CONCLUSION

Lenders/creditors need to do a better job with their due diligence before throwing money at a borrower; borrowers need to better manage their businesses with a clear mastery of revenues and the cost side of the businesses, and it both cases, it’s best to start earlier with getting another set of eyes on the business – there’s no substitute for “objective perspective” – especially another 90 days worth.

Many more businesses could be saved, if the stakeholders just didn’t wait too long to get outside help.

Copyright 2021, Paul Fioravanti, MBA, MPA, CTP and/or Qorval Partners LLC