Where Are the GIANTS Headed?

The dizzy pace of growth among the public home builders atop PB's GIANTS rankings affects every builder within reach of their competitive grasp. As the Masters of the Universe dip into smaller, secondary housing markets, they'll touch just about everyone in the production building business. No wonder so many builders are asking how far consolidation will go and if it will ever stop.

A year after it first hit the pages of this magazine, the debate still rages over a white paper authored by Paul F. DeCain, managing director of Andersen Corporate Finance, that predicted by 2011 the top 20 builders would account for 75% of all new homes sold in this country. The entire GIANT 400 accounted for only 32.2% of housing completions in 2002, so reaching that level of consolidation would require the top 20 to acquire, in eight years, not only all the other Giants, but also many of the companies that now build fewer than 100 homes a year.

Few of the acquisitive GIANTS show any interest in companies that small. So DeCain's prediction now is given little credence by even the most enthusiastic Wall Street advocates of consolidation. But the question remains: What is a more likely prediction, and what might the consequences be for other builders?

Wall Street's Little Fishes
Start with Wall Street's perspective, which is where the imperative for growth begins. Pulte and D.R. Horton, each with more than $7 billion in annual housing revenue, boggle most builders' minds, but that doesn't come close to making them big fishes in the Wall Street pond.

Centex is the top builder in total revenue each year because it has so many other businesses in addition to home building. But the Dallas-based titan is only No. 241 in Fortune magazine's ranking of the 500 largest corporations. Pulte is No. 250. Wal-Mart is the top dog of the Fortune 500 with $246.5 billion in annual revenue. No wonder the public home builders feel that revenue growth is critical to getting noticed in New York.

That's why Pulte has a stated goal to get to $15 billion in annual revenue during this decade, and KB Home sets its target at $10 billion. That is not likely to happen except via many acquisitions.

"It's my belief that most of the growth of national builders comes through acquisitions in markets where they have no previous operations," Charlotte, N.C.-based consultant Chuck Graham says. "The nationals know very little about how to grow market share where they already operate. When they acquire a builder in a market where they already have operations, what usually happens is the direct opposite - they lose market share.

"Horton's acquisition of Torrey Homes here in Charlotte is a perfect example. They let Torrey operate for a while and then folded it into the existing Horton division. That probably made sense administratively but not competitively. Torrey and Horton are oil and water. Horton is margin-driven. Torrey is inventory-turn-driven. Combining the two resulted in a combined market-share loss. Beazer did the same thing when it folded Crossmann into Squires Homes in Charlotte."

For most of the past decade, the public Masters of the Universe - especially the big five at the top, all with more than 25,000 completions a year - have grown by acquiring smaller local or regional production builders that offered strong share positions in new markets, often hot markets with impressive annual housing starts. But a number of factors might limit the Masters' ability to continue growing this way:

1) Running out of new markets: The big five are already in most of the major markets. If they make acquisitions in markets where they already have operations, they risk doing what Graham says they always do, combining two companies and losing overall market share. The alternative is acquisitions in secondary markets, and we already see that happening - for example, Lennar's acquisition of Seppala Homes in South Carolina.

2) Running out of acquisition targets: The best targets are private builders with top-five market-share positions in strong markets. Most of the deals the big five have put together for such companies have come from the ranks of the Rich and Famous. These are not companies troubled in any way by competing with national firms. The big five picked off the easy targets during the first decade of the acquisition frenzy. Many of the remaining strong firms that would be good targets are owned by builders with no interest in selling.

3) The price is wrong: Wall Street loves acquisitions that increase revenue, geographic diversity and profitability. Many deals in the earlier stages of consolidation did that. But today, when the big five find a company that can do it, the price needed to make the deal happen is often too high. Most stock analysts who cover public home builders say Beazer paid too much for Crossmann, just as Centex did for The Jones Co. in St. Louis. They suspect the same in KB's $142 million deal for Colony Homes in Atlanta and North Carolina, but KB has yet to disclose the purchase price on a book basis. "Deals like this increase good will on the balance sheet but hinder return on capital," analyst Ivy Zelman says. "Good will now represents 30% of Beazer's shareholders' equity, while return on capital has declined from 15.2% before the acquisition to 13.3% at the end of 2002."

4) Iffy economy: Many of the Rich and Famous that sold to public builders during the past five years did so because they saw an opportunity to sell at the peak of an expanding market. With interest rates declining for most of the past decade, housing has been on a roll. No one yet is willing to say the long expansion might be ending. But Wall Street seems to think so. "The valuation for this group [builders] peaked on May 2, 2002," analyst Barbara Allen says. "They were selling then at 197% of stated book value and 9.9 times trailing EPS. That's almost exactly what this group has gotten at the end of every cycle since they've been public. They're now at six times trailing EPS and 125% of book. This isn't a one-month phenomenon. It's been going on since May. All the big margin expansions go away when you can't raise prices anymore. They really go away when you're forced into incentives to keep sales."

The New Growth Model
If the big five can't generate enough growth to please Wall Street by using the acquisition model of the past decade, what will they do? Find a new one.

Here's what it might look like: Instead of targeting local and regional private builders who always want more for their firms than Wall Street thinks the publics should pay, the big five might target smaller, less capitalized public builders, using Pulte's deal for Del Webb and Lennar's for U.S. Home as models for how to make such an integration work. Lennar and U.S. Home meshed geographically. In Del Webb, Pulte found the perfect vehicle to not just enter but dominate the active-adult market.

Public builders often gripe about Wall Street's inclination to treat them as a unified sector rather than as individual firms. The share prices move up and down together. But this weakness could become a strength in a strategy that targets smaller public companies for acquisition. Zelman explains it simply: "Since public builders trade in parity, a deal between two public companies would be an exchange of equity at similar levels."

When we look at possible combinations of companies among public firms, it's obvious that the universe of candidates for acquisition is small. If this is a field upon which the big five compete, it won't be long before they become, perhaps, the big two. Companies such as M/I Schottenstein and Meritage jump out as targets, but it wouldn't take long for eyes to move in the direction of Weyerhaeuser, Standard Pacific and even Ryland.

If public builders merge, one or two could reach $15 billion by the end of the decade, but probably not five. The top five have total annual revenue of about $31.5 billion, the next five only $13.5 billion.

Worst-Case Scenario
Some Wall Street analysts say it's more likely that none of the big five will make it to $15 billion, for the same reason that none has before - an economic downturn that cuts big public builders off at the knees. "Size doesn't protect public builders from the cycle," Allen says.

Good private builders have no trouble competing with publics, especially when sales are tough to come by, Allen says. "It would not take much in the way of a sales downturn to create chaos among the public builders."

How much more the industry consolidates probably depends more on the economy than any other factor. Builders across the country are uneasy about the softness in some markets.

Pulte president/CEO Mark O'Brien says such situations show the strength of size. "Geographic and product diversity is a sound defensive strategy as well as a platform for growth. If you're a single-market builder and a malaise hits that market, you are in trouble - like Northern California when the dot-coms exploded. We dealt with that problem effectively because we're in so many other markets [44 U.S. markets in all]."

That confidence is based on power, but smaller builders, even in depressed markets, often show resilience that big public builders don't understand. "The Midwest is depressed compared to California and Florida," Indianapolis builder Paul Estridge says. "It will be hard for us to grow volume. We'll concentrate on operational excellence and the bottom line."

The Estridge Companies is No. 144 with $126 million in revenue. It typifies the midsize local production builders that Denver consultant Chuck Shinn says thrive by being nimbler than the publics. "The publics sometimes make things tough with cash land buys and lower cost of capital," he says. "But their advantages don't offset the negatives associated with bureaucratic organizations."

Shinn says builders such as Estridge will survive no matter how concentrated the top of the Giants' list becomes. "Smart local builders can compete with the nationals," he says. "Market share matters, but only local market share. How big the number one builder is nationally doesn't matter."