Globally, mergers and acquisition activity is on a tear. Deals valued at over $3.2 trillion have been announced already this year; over the last 20 years only 2007 recorded more activity than this year (Dealogic). According to Dealogic, Healthcare, Telecom and Real Estate have been the most active industries. We’ve seen significant activity in the home building industry with twelve major deals announced so far in 2014.
So what is driving this wave of acquisitions? What is motivating buyers to buy? And in home building, how are deals being valued and why?
Acquisition Wave Drivers
Two major drivers account for acquisitions in today’s global and home building markets. The first is slow industry growth and the second is very cheap credit.
Annual shareholder return is a major concern for public companies; public home builders are no exception. As a public company, if earnings don’t grow organically to support the returns investors demand, earnings derived from acquisition can make a great deal of sense.
Given that new single-family home sales in 2014 are growing at a dismal rate (NAHB forecasts 443,000 new single family sales in 2014, annual growth of just 3%), public home builders are motivated to supplement anemic organic growth with growth through acquisition.
Cheap credit fuels M&A activity as well. Here’s how classic finance theory looks at it: If the future cash flows to be acquired---discounted by the weighted average cost of capital--is greater than the acquisition price, the transaction will be accretive, creating value for the purchaser’s shareholders. Given the low cost of credit and its impact on return expectations of equity investors, a firm’s weighted average cost of capital is very low in today’s environment. Therefore, the values of the discounted cash flow are being driven higher. This fuels acquisition activity. Keep in mind that if and when interest rates increase, the value of a firm will be reduced as the weighted cost of capital increases.
In the home building industry, a number of small public home builders recently completed initial public offerings; there were eight home builder IPOs over the last two years. Newly public companies are under tremendous pressure to grow shareholder value quickly or they risk losing the interest of investors. Therefore, it is no surprise that out of the 12 acquisitions completed by public builders in 2014, four of these newly-public companies (UCP, Century Communities, William Lyon and LGI) accounted for six of the deals. Of these four companies, Century Communities stock price is down 28% from its IPO price, UCP is down 24% from its IPO price, and William Lyons is down 20% from its IPO price; only LGI is up, with an increase of 35% over its IPO price (based on December 2, 2014 closing prices).
Clearly, the three companies suffering negative shareholder returns are under great pressure to grow earnings. While acquisitions are an alternative, there are risks associated with undertaking an acquisition (please see previous blog posts). Investors don’t always reward purchasers. Investors may view the acquisition as risky with respect to the buyer successfully integrating the acquisition, or risky as to legal and anti-trust issues, or simply that the purchaser overpaid.
For instance, Halliburton stock fell 11% after it announced its acquisition of Baker Hughes in November and Century Communities stock fell 11% within the first five days after it announced its acquisition of Peachtree Communities.
Home Builder Valuations
While classic finance theory values a company based on its expected future cash flows, today home builders are being valued on the fair-market-value of the assets being acquired. Home builders don’t get valued on the discounted value of the future cash flow they are capable of generating.
When a home builder is acquired, the major assets acquired include homes under construction, land owned, and lot option agreements. If the current value of 100 finished lots owned are $10,000 more than their cost basis, a buyer would be willing to pay a premium to book value of $1 million. If there are 250 lots under option and the current market value of each lot exceeds the option price by $10,000, then a buyer would be willing to pay a premium to book value of $2.5 million.
When a home builder looks to acquire another home builder, the purchaser views the acquisition as a method to acquire land positions, as land position are usually the most significant asset owned by the seller.
We can see this by the fact that Goodwill (the excess of the purchase price over current asset value) is not commonly recorded as part of an acquisition; all of the premium is attributed to assets being acquired.
So why are builders not being valued on a discounted cash flow basis? Since the common view is that only assets are being purchased, there is no value being attributed to people, intellectual property, innovation capabilities, brand, and the future cash flows that these can generate. The view of purchasers is one of depletion of the assets acquired rather than acquiring a going concern capable of generating cash flows on a long-term basis. This is akin to the purchase of a mining company or oil and gas companies.
If and when private builders can demonstrate value other than the current value of their real estate assets, the prevailing model may change. Until that time, purchasers will continue to value an acquisition target based on the current value of the assets.
If you have any thoughts or experiences, I would invite you to comment below so that together we can generate a discussion on this topic.