It's good to be the king. The thing is, since the mid-1990s, home builders have operated in a sort of business utopia where you can have a lot of kings. “It's been a great decade to be a home builder,” says David Hill, CEO of Kimball Hill Homes.
“A tailwind of prosperity and good times for housing,” says Credit Suisse First Boston's Ivy Zelman, a relative bear among Wall Street analysts who make a name for themselves covering public home builders.
It wasn't always so. “In the first half of the last 10 years, there was a profound, inexorable decline in the amount of interest, intellectual curiosity, and good old fashioned fundamental equity research being done on home building,” says Stephen Kim, managing director at Smith Barney. Translation: Wall Street just wasn't paying attention.
Then came April 2000, when the NAS-DAQ crashed. Suddenly old economy businesses looked more appealing. Fast forward to 2006, and now a whole bevy of analysts follow the every move of what have become corporations in all senses of the word.
Along the way, Big Builder, which this year celebrates its 10th anniversary, has been there, tracking and bringing insight to this evolution. Propelling the advances and changes, of course, has been a housing market that has broken records year after year. Thus, questions linger as to whether builder stocks are trading at appropriate multiples, just how cyclical the industry is nowadays, and whether builder processes are efficient enough to defy a soft market.
Stay tuned. Meantime, take a step back to assess the big changes, watershed moments, and strategies that brought builders to where they are now—which sets the stage for what's to come in the next 10 years. Needless to say, BIG BUILDER will be there all the way.
Lennar's $1.2 billion purchase of U.S. Home in 2000 ranks among the smartest, not only because it doubled the company in heft, but because of the timing—just before Wall Street took notice of the home builders. “That really sparked an era of consolidation in the industry,” says Tony Avila, managing director at JMP securities.
Other big deals were noteworthy not only because they signified consolidation in the industry but because they marked new business strategies (Pulte's purchase of Del Webb) and business processes (Kauffman and Broad's acquisition of Rayco Homes).
Ara Hovnanian, CEO of Hovnanian Enterprises, believes that consolidation movement will forge on regardless of market conditions. Hill's vision of 10 years hence: “There will be no super regional builders,” he says, with the possible exception of Shea Homes. “There are going to be fewer [privates], but the ones that are left are going to be pretty darn competitive.”
And then there is the question of whether a top 20 will buy another top 20. Answers vary dramatically, and they might depend on self-interest. Toll Brothers CEO Bob Toll says he'd be surprised if it didn't happen in the next two years. But D.R. Horton CEO Don Tomnitz believes that to buy a top 20 builder, “you'd have to put an awful lot of goodwill on your books. I think there will be consolidation, but with the pricing out there, it just doesn't make a lot of sense.”
SUPPLY AND CYCLE One of the most tangible effects of consolidation is the trend toward national purchasing. When Tomnitz talks about any dimension of business strategy, scale inevitably comes up. It's all about “profitable aggregation of the fragmented home building industry.” National purchasing is one thing he's referring to.
As a result, “[Consolidation] also has had a tremendous impact on the building supply companies,” says Michael Kahn of Michael P. Kahn and Associates. In the past, suppliers had to deal directly with local builder; now many material accounts are done at the national level.
On the building cycle side, the big story was even flow. The seachange moment for that process came in 1996, when KB Home, then doing business as Kaufman and Broad, bought Rayco, one of the pioneers in the discipline. (That acquisition is symbolic for other reasons: a big builder was buying a builder for its expertise.) Ten years later, even flow is a builder household term. “We took the lead in converting the industry from being spec builders to pre-selling,” says KB Home COO Jeff Mezger.
And as the decade progressed, builders turned their attention to supply chain efficiencies, even trying to jump on the dot-com bandwagon with a group of big builders launching USBuild.com. “It was the first attempt at a digital supply chain,” says Luis Solis, president of Symbius. Solis, who was involved in the bold endeavor, says that it ended up not working because, while it was started by a group of builders, it was truly independent, unlike, for example, Builder Homesite, a consortium of builders that has produced the Envision options system.
As for digitizing the supply chain in the future, Solis expresses concern that big builders will work on such initiatives individually as opposed to in a consortium.
Still, he says, in coming years look for builders to start slicing out a couple of links in the supply chain. “Direct purchasing is going to be a huge issue,” agrees Tim Costello, CEO of Builder Homesite. And count on technology leading the way, with more real-time information passing between suppliers and builders.
Even flow, meanwhile, might have a long way to go. “All builders are doing it right now, because all builders are pretty much sold out,” says Toll bluntly. And Tomnitz guesses most builders close 55 percent to 65 percent of their homes in the third and fourth quarter regardless of fiscal year end, with 45 percent or 50 percent of the quarterly closings coming in the quarter's last month. “If you call that even flow, I would say it has a long way to go.”
There are other efficiencies to conquer. “I think the next production life changing event that the industry will flirt with is vertical integration,” says Hovnanian, whose company is experimenting with the concept of bringing trades in-house. “The jury is still out, but it's definitely a possibility.”
GEOGRAPHIC DIVERSIFICATION Back in 1992, when Tomnitz was just getting started with Horton, there was no such thing as a national builder. “We were all regional builders,” he says—Centex and D.R. Horton basically in Texas, Pulte in the Midwest, and KB in California.
A couple of landmark moments in this area, naturally, involve the No. 1 builder on the Builder 100. Tomnitz cites Horton's merger with Arizona builder Continental Homes, which joined two companies that built 7,000 homes a piece, as a watershed moment. Then in 2002, Horton bought Schuler Homes, capping a run of 17 deals in eight years.
Public builder executives like to say how geographic diversity has made them less vulnerable to cyclical downturns. But even for the mid-sized builders, heading for new territories was a big story. “Had I not diversified, and stayed strictly in Michigan, we would have had to downsize our business by 50 percent,” says Cross-winds Communities CEO Bernie Glieberman. Now, “80 percent of our revenue comes from outside Michigan.”
Meantime, the biggest builders need to figure out how they're going to continue to grow at the same clip. The number of 1,000-unit home builders out there to be bought up is dwindling; thus, builders will be eying the ones doing 200, 300, and 400 units, says Kahn.
Hill calls himself a skeptic that D.R. Horton or another builder can hit the goal of 100,000 homes by 2010, although he acknowledges it's possible. “There aren't any new markets to go into, so they're going to have to double their penetration in order to double their size,” he says.
PRODUCT DIVERSIFICATION With urban infill and active adult leading the way, this was the decade that builders diversified their product. Active adult came of age with the acquisition of Del Webb by Pulte in 2001. Even before that, though, Del Webb was leading the way in the market. In the early part of the decade, active adult communities were mostly confined to the Sun Belt. Then, in 1998, Del Webb opened Sun City Huntley in the Chicago area, suggesting that at least part of the 55-plus crowd might like to stay close to home. Now, roughly two-thirds of the top 20 builders have active adult divisions and initiatives.
On the infill side, builders started getting hungry for the know-how. In 2003, for example, Toll Brothers bought the Manhattan Building Co. and christened the new division City Living.
“In the next 10 years, urban infill could probably double,” says Glieberman.
“We think from the supply side there's a push toward that area [because of slow-growth policies], and from the demand side there's a pull, with the population desiring this kind of housing,” says Hovnanian.
As for the 10 years after 2016, Hill says, a movement toward customization will play perfectly into the hands of the non-behemoths.
MARKETING AND SALES As real corporations, big builders changed drastically in the area of marketing and sales, with such corporate mainstays as the Internet, branding, and customer satisfaction becoming ubiquitous.
Most home builders will tell you that the vast majority of buyers today will poke around the builder's Web site before they ever set foot in one of the homes. “A builder with great communities and great product with a bad Web site may get eliminated from consideration by a home buyer,” says M/I's Schottenstein, adding that M/I has sold homes to buyers who have not even walked into their models.
“For the last decade, there has been a non-stop focus on customer satisfaction,” says Larry Webb, CEO of John Laing Homes. If you're looking for concrete indicators of such a change, look no further than JD Power and Associates' move into the industry. It conducted its first study in 1997 and has been adding on markets every year since. (It's up to 30.) Some builders have bristled at being rated by a firm outside the industry, but like it or not, JD Power is a force. “They would be a great example of how the home building business recognizes the great improvement and impact of satisfied customers,” says Webb.
As for what's to come, look for an even greater exploitation of Internet capabilities. What will become ubiquitous in the next year, says Webb, is the offering of individual Web sites for every customer to watch and track the entire home building process, from the beginning phases of construction all the way to final move-in.
LAND APPEAL In early 2005, Lennar bid $649 million, plus $400 million in fees, for the 3,700-acre former El Toro Marine base in coveted Orange County, Calif.
Thus, land deals got bigger and more complex—a phenomenon that plays to the consolidation story and into the hands of the biggest builders, who say they are best equipped to handle the size and scope of such deals. “The size and maginitude is becoming more and more the domain of the big builders,” says Hovnanian. “It's not uncommon to see $20, $50, $100 million transactions. That's a change from 10 years ago.”
In fact, the deals have gotten so big that even the biggest publics are going the joint venture route—a trend that has emerged, allowing builders to manage risk.
Still another change: In this era of limited supply and lengthy entitlement, builders have been buying five, six, and seven year supplies of land. But, notes Tomnitz, builders typically option 50 percent of their land—something that wasn't done 10 years ago.
Toll notes that one reason to hold more land is that whereas 10 years ago the approval process used to take six months, now it can take two to five years.
Still, says CSFB's Zelman, “the soup du jour” may change in coming years. “Builders might realize it's not good to own seven to eight years worth of land, and so they might pull back and become more prudent because land has become so expensive and they've offset it with home price inflation, but that's flattening.”
SHARE THE WEALTH On Wall Street, builders still complain that they're not getting their due. Hovnanian thinks P/E ratios “will be dramatically higher” once the industry successfully tackles a downturn. While acknowledging improvement in this area, Schotttenstein is more skeptical, saying that Main Street's view of the industry is more important than Wall Street's anyway.
Naturally, the publics got shrewder in dealing with the Street. “We had the industry understand what return on capital was,” says Zelman. Builders started doing more off-balance-sheet financing in the mid- to late 1990s, she says, pointing out that NVR Corp. led the way in this approach. “To me, that was a huge leap of growth for them.”
In the past 10 years, smaller bank facilities have been replaced by large revolving credit facilities, notes Horton's Tomnitz. Builders have access to five to 10 year debt, “which puts us in a lot stronger position if there is a down cycle because the bank can't force us to pay off the loans.”
Once again, it's always about lobbying Wall Street. As Smith Barney's Kim is quick to point out, at least the Street is paying attention.
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Learn more about markets featured in this article: Los Angeles, CA.