First Mega-Merger May Not Be Last

Consolidation of the housing industry has been going on for a decade, and there have been some big mergers during that span. Kaufman & Broad’s acquisition of California Giant Lewis Homes, and D.R. Horton’s deals for Torrey Homes in Atlanta and Phoenix-based Continental Homes come to mind. But nothing on the scale of the blockbuster just announced. Lennar’s purchase of U.S. Home unites the No. 5 and No. 8 builders on PB’s Giant 400 ranking to produce what may be a new No. 1 next year. (Those companies combined to deliver 21,658 homes in 1999, for $4.9 billion in revenues.) It’s a mind-boggling deal. Still, we should have seen it coming, and don’t be surprised if there are more like it in the works.

Wall Street’s institutional investors are so preoccupied with technology and Internet issues that publicly traded home builder stocks, and just about every other industrial group, have suffered through a year or more of falling stock price valuations, despite strong and growing revenues and profits. U.S. Home’s shares traded at $35 a share in February, 1999, and at $24 per share just before the Lennar merger was announced last month. Lennar’s shares traded at $25 and $16 per share at those same points. These are not isolated instances, but typical of the entire home building sector. In fact, many analysts contend that home builder stocks will only come back into favor when the firms prove they can weather a recession and still maintain strong earnings.

These depressed valuations make it nearly impossible for housing industry consolidation to continue in the form that dominated the 1990s. Big public builders now find it much harder to acquire small and mid-sized firms because their offer must include the devalued currency of their undervalued shares. But the large builders are pretty much all in the same boat. So if they merge with each other, it works, and may have a thunderclap impact on Wall Street - Lennar and U.S. Home obviously hope the merger will shake their combined company’s share price out of the doldrums. (After the merger was announced, U.S. Home’s share price rebounded to $34 a share to reflect the offer price.)

Lennar CFO Bruce Gross estimates that his firm’s earnings per share for 2000 will be 10% higher based purely on the pro forma performance of the two companies during 1999. He further estimates that per share earnings should rise another 5% as a result of a continuing Lennar program to repurchase 10 million shares from the public market.

A Synergistic Powerhouse

Lennar’s $476 million purchase of U.S. Home also creates a broadly synergistic new competitor at the top of the American housing industry. While Miami-based Lennar has operations in Florida, Texas, Arizona, Nevada, and California, Houston-based U.S. Home adds lucrative markets in Colorado, Minnesota, Ohio, New Jersey, and Maryland.

U.S. Home concentrates product at the midpoint of the pricing spectrum, but is also one of the top two firms (with Del Webb) in active adult communities aimed at aging baby boomers. Lennar, which now specializes in entry-level and first and second move-up homes, has vast land holdings in California, Florida, and elsewhere, that cry for active adult housing projects.

U.S. Home has 23 design centers scattered across the country, and is a leader in the consumer-driven and technology-impacted movement toward mass customization, while Lennar takes the direct opposite approach in marketing strategy, a value-focused "everything’s included" concept. This approach is based on extensive consumer research, but disdains design centers and customization.

As one Wall Street insider put it, "There’s a question about whether Lennar’s ‘everything’s included’ strategy is swimming against the stream of market pressure and new technology favoring more mass customization. Innovations in the supply chain may be moving against it. But this acquisition allows Lennar to hedge its bets in case that strategy proves to be faulty."

By buying U.S. Home, Lennar acquires over 60,000 building lots, many of them in new markets in the Midwest and Northeast, and perhaps even more important, a management team capable of using those lots to fill in the gaps in Lennar’s product offerings. Even in areas where the two firm’s operations overlap, they are still synergistic. For example, while U.S. Home is the largest builder in Southwest Florida, Lennar is far larger on Florida’s east coast. It’s not hard to foresee U.S. Home’s trademark active-adult golf communities popping up on Lennar land holdings in Southeast Florida. The combined company is now by far the largest builder in the nation’s No. 1 housing state.

While the synergy is real, executives from both companies are avoiding use of that word, which is perceived in merger situations as a code for impending layoffs, something Lennar president and CEO Stuart Miller says will not happen:

"If this industry has any real shortage, it is not drywall and lumber, it’s people." (U.S. Home has 2400 employees, Lennar has 4700.)

U.S. Home chairman Robert Strudler is equally careful to emphasize that the two organizations will continue to operate much as they have in the past:

"I’m not moving to Miami. I’m going to stay in Houston, as vice chairman of the new combined company. I’ll also serve as vice chairman of the board of directors of Lennar, and co-chief operating officer. I’ve committed to staying in place for a minimum of three years. I will continue to run the day-to-day operations of U.S. Home, which will still operate under that name in all its present marketing positions.

"We’ve created a fantastic new playing field for our employees and managers," says Strudler. "It’s going to be fun."

Still, it’s clear that enhancing shareholder value and trying to change Wall Street’s perception of this home builder are the keys to the deal.

"It’s a great deal when you look at the way home builder stocks have come down over the past year," says one Wall Street analyst who asked to remain anonymous. "Lennar has taken out U.S. Home on the cheap, paying 80% of book value, which is probably 60% of net asset value. There’s no other way they could have acquired these land assets, let alone the management talent to handle the building, for anything close to this price."

E-commerce is also a major focus of the deal. Isaac Heimbinder, former U.S. Home president, will become a Lennar board member and executive vice president of e-commerce. In addition to developing the combined company’s new Internet strategy, he will also assume responsibility for developing businesses that deliver high-tech services to home buyers. Such services are lumped into a category often called "the last mile," referring to the telecommunications infrastructure that connects the world to the home owner’s lot.

Many industry insiders believe builders and developers are in the best position to control the last mile, to bring in such services as cable TV, telephone, security and Internet access. Lennar already owns security monitoring and cable television businesses in Arizona and California, respectively, which Heimbinder will now run. Heimbinder’s position on the Lennar board suggests these initiatives will be treated as high priority areas for investment.

Even though Lennar acquires U.S. Home at a bargain price from its perspective, to U.S. Home shareholders, the shoe is on the other foot.

"When you look at what’s happening in e-commerce and the capital requirements of the business today, in light of what’s happening to companies labeled as ‘small cap,’ it’s easy to see why this deal makes so much sense to our shareholders," says Strudler. "They get a significant premium on what our shares have been trading for. It takes our stock from the $24 to $25 range, where it has been trading, to the $36 a share Lennar is offering."

Perhaps the most surprising aspect of this deal is the decision of Strudler, a veteran of 30 years in the top echelon of the industry and widely acknowledged as a giant among public home building executives, to sublimate his ego to join a much younger management team, led by Stuart Miller, 42, and CFO Bruce Gross, 41.

"I’m a lot closer to the end of my career than the beginning, but I’m not ready to ride off into the sunset yet," says Strudler. "The opportunity to spend the balance of my career on a playing field like the one we’ve put together is very exciting...The chemistry works very well. Stuart is a young, aggressive leader coming into his own in this business. He’s very, very bright.

"I bring three decades of experience, with a proven management development system that’s the best in the residential construction industry."

Asked what role Lennar Corp. founder Leonard Miller played in the deal, Strudler says, "Lenny is the guiding father. He and I go back 30 years. Lenny calls me up to convince me this is the right thing to do. I think we’ve created the best possible playing field for everyone concerned, on both sides of this deal."

Trouble for U.S. Home

The transaction may have been hastened by several factors that make sooner better than later for U.S. Home. One is an on-going, nine-month-old investigation by Florida’s Attorney General’s Office into U.S. Home’s marketing and building practices in that state.

Assistant Attorney General Victoria Butler was quoted by Florida newspapers saying the Office’s economic crimes unit is looking at how U.S. Home presents itself at the time of sale, its inspection process, and warranties.

U.S. Home was involved last year in bitter disputes with several home owners in a Sarasota subdivision where 17 houses had to be repaired after water penetration led to discovery of building code violations in several houses. "They’ve put themselves out as a high-quality builder," Butler told South Florida’s Sun-Sentinel newspaper. "We’re looking at that." However, she also reported U.S. Home is cooperating completely with the investigation.

It’s likely that neither party in this merger wanted to wait for that investigation to rear its head again, which might further dampen U.S. Home share values.

The other factor favoring quick resolution is the knowledge that other large builders may be working on similar blockbuster deals. There’s a lot to be gained by being first. "I didn’t want to wait," says Strudler. "I wanted to make this move at a time when it would create a company infinitely better than any other in the business."

Lennar now looks to be the largest and most powerful force in the housing industry, but its hold on the top spot may be as tenuous as college basketball’s No.1 the week before the NCAA tournament begins. There are eight other companies in Professional Builder’s Top 10. Play with some of those names and numbers and it’s not hard to foresee an even larger No. 1 in the days ahead.

Will we see another blockbuster?

"It wouldn’t totally surprise me," says Strudler. "The same factors that influenced this decision could influence others."