Benefits of being an under-performing A/E firm

An A/E firm CEO is coming off its third consecutive year of record financial performance. It has multiple years of backlog in-house with A-list clientele. His managers are turning down work. Sustaining this performance is his #1 priority. His nights of fitful sleep are filled with nightmares of project failures because his firm cannot find the staff to do the work. Sound familiar?

Great industry? Or the greatest industry? Bank failures. Record inflation. Highest interest rates in decades. Tech industry layoffs. Big deal. The AE industry shrugs all of these off and continues its decade of crushing it. At last month’s Southeast Symposium in Miami, we reported on an industry registering universally positive vital signs.

Financial performance is humming (operating profits robust at 18%, staff utilization close to record highs at over 60%, overhead normalizing around 162%, and record net revenues per employee at close to $169,000). Balance sheets are stronger than ever with current ratios north of 4.0 and debt-to-equity ratios at a rock-bottom 0.46. Average backlog is close to a year’s worth of work. It’s no wonder that over 70% of the 200+ AE industry executives and investors attending the symposium were anticipating 2023 being an even better year for their firms than 2022.

However, not all indicators are “up.” And the direction of one in particular is downright confounding—the number of industry mergers. Traditionally, when the AE industry has experienced boom times, M&A has increased in line with the confidence of strategic acquirers and investors. But curiously, that’s not the case this year when the industry is arguably performing better than ever. The pace of consolidation in Q1 is actually down 25% over the same period last year, continuing a trend that we saw beginning in the middle of 2022. Indeed, M&A this year has fallen back to 2021 levels.

Knock-on effect: With this unexpected slowdown in M&A activity, it’s not surprising then that we’re seeing a corresponding softening in M&A multiples. The degree of value erosion varies depending on firm size and type. But to be sure (to be sure, for you Letterkenny fans) certain categories of firms are experiencing 10%+ declines from the highs of early 2022.

The (not so) curious case of under-performers: One category of firm that is bucking this valuation trend is that of the lower quartile of industry performers. These are the less-than-stellar firms. You know them. They are the ones whose websites look like they were created in 2012 and haven’t been updated in over a year. The firms that for whatever reason—mismanagement or bad luck—have flat-lining revenues or are seeing their profits erode and their backlogs dwindle. These firms—believe it or not—have seen their valuations increase by an average of 17% over the past year! Why?

Capacity—the most precious industry resource: This is what every successful industry firm is struggling to find in these boom times. And in 2023, that capacity still comes in the form of employees—be they in-office, hybrid, or remote. The 850,000 active professional engineers and 116,000 registered architects (thanks, ChatGPT) in the United States are just not enough to meet the current and anticipated demand for AE industry services. So, successful management teams continue to fine-tune their businesses to extract more performance from their existing staff, but this is a risky approach yielding diminishing returns while increasing the risk of burnout. They’re throwing money at internal and external recruiters only to pay top dollar to bring on board talent that they needed over a year ago. Too slow, too expensive.

And this is why under-performing firms have seen an uptick in their valuations. Under-performing firms represent a rich, untapped vein of capacity. Unlike their high-performing peers, these firms tend to have lower firmwide utilization rates, with a ton of excess capacity available. In most cases these under-utilized staff are more than eager to take on the career-reaffirming opportunities presented to them by being part of a high-performing firm. So, buyers are targeting these under-performing firms as a way to quickly bring on board talent that can add capacity. And while they are not paying the multiples that they would for targets that allow them to meet strategic growth goals, they are paying relatively more than they did in the past — 17% more — to quickly acquire the capacity that under-performers provide them that they cannot find elsewhere.

– Morrissey Goodale is a CFE Media and Technology content partner.

Original content can be found at Morrissey Goodale.

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