LAST FALL, AT A PRIVATE MEETING with investors, Centex Corp. offered a fresh perspective on the stock market's persistent undervaluation of home builders—that of Harvard Business School Professor Michael Porter. Porter's study, “The U.S. Homebuilding Industry and The Competitive Position of Large Builders,” presented compelling evidence that the profitability of large builders is not only sustainable, but greatly underappreciated by equity investors compared to other industries with similar structural characteristics.
Professor Porter is one of the world's leading authorities on competitive strategy and quite possibly the best-known academic in the field of business. His book, Competitive Strategy: Techniques for Analyzing Industries and Competitors, is in its 58th printing since its first publication in 1980 and has been translated into 17 languages. Porter has served as an adviser on competitive strategy to a number of leading companies, including DuPont, Procter & Gamble, and Royal Dutch Shell. He also has worked extensively with both U.S. and foreign governments on matters of competitiveness and economic policy.
With so many demands on his time, what intrigued Porter to accept a proposal by Centex to take an independent look at the U.S. home building industry?
Defining Value Starting with the premise that the goal of a company is to create economic value, measured by long-term return on invested capital (ROIC), Porter began by providing some context. First, the average ROIC for the home building industry over the period from 1985 to 2002 was 11.9 percent—slightly higher than the U.S. economy's average of 11.6 percent. Next, while ROIC has fluctuated over time, the trend over that period has clearly been upward. Finally, a deeper examination of industry structure using Porter's famous “Five Forces” model supports stable-to-upward trending returns over time. Many of the reasons Porter cited were the same that home builder executives have been highlighting for investors for some time—higher barriers to entry, notably improved capital market discipline, and increased consolidation of a still-fragmented industry.
Porter's discussion of the competitive advantage of large home builders focused primarily on procurement, access to capital, and land acquisition. Not surprisingly, the largest home builders were found to have significant cost advantages over their smaller competitors for both materials and labor. Although there was some evidence that large home builders get favorable pricing based on an ability to provide a steadier stream of work over the course of an entire cycle, that data wasn't definitive. While most labor and materials are currently procured locally, Porter says he believes that the large home builders are in the early stages of turning their national scope into a far greater competitive advantage in materials purchasing.
The ability of large home builders to access both bank debt and corporate bonds provides more reliable access to capital with a lower cost over the long term. However, Porter said he didn't see a definitive advantage in bank rates. Nevertheless, that capital access is critical to success in a land-acquisition process that has become increasingly lengthy and capital intensive.
In Porter's analysis, supply constraints are largely due to regulations that limit the amount of land that can be developed and increase its cost. According to Porter, one question that bears watching is whether builders can pass on the escalating cost of land to customers. In any case, the growing complexity of accessing usable land, “clearly raises the barriers to entry in the industry,” he said.
Relative Strengths Having established that the overall industry structure is becoming more attractive and the competitive advantage held by large home builders is significant and growing, Porter contrasted valuation with that of other industries sharing similar characteristics. Looking at price/earnings and price/book multiples relative to ROIC, the market consistently assigned home builders significantly lower valuations than their peers. Long-held investor perceptions of home builder cyclicality may be partly to blame. Porter's data sharply contradicted those views, illustrating that home builder ROIC since 1992 has actually been among the least volatile of the 65 industries measured.
In the week prior to the Centex conference, Lehman Brothers home building analyst Steven Fockens published his own analysis of the industry using Porter's Five Forces framework, drawing similar conclusions to those presented by Porter. Fockens contends that “As investors take more notice of the favorable application of Porter's model to the building industry, we believe that the stocks should benefit.”
Investors got their chance to take notice that very week when Porter's pronouncements were the subject of a CNBC Kudlow & Cramer television interview with Porter. Since then, however, Porter's position seems to have receded into the background. Still, Fockens maintains that “investors and analysts should pay more attention to the structural attractiveness of industries' sustainable competitive advantages versus just shorter term factors,” he wrote in a note recapping the presentation.
Even some who disagree with Porter's methodology support his broader conclusions. Paul Puryear, home building analyst for St. Petersburg, Fla.-based brokerage firm Raymond James suggested a slightly different approach. While Porter used EBIT (earnings before income taxes) in his analysis of ROIC, “We prefer to view interest as a real cost, particularly given the changes in capital structure undergone by the public builders over the last decade,” says Puryear in a report discussing the Centex conference. According to Puryear, though the competitive advantage public builders derive from lower-cost, fixed-rate capital has not been meaningful recently, that will change as rates rise. Even with that caveat, “We would recommend anyone with an interest in the industry to review [Porter's] study,” says Puryear.
The slides and Webcast are available on the investor relations section of Centex's Web site at http://ir.centex.com/nyconference/index.cfm.