A private home building company operating in the Mid-Atlantic region that had suddenly seized up toward the end of 2005 had a CEO with a dilemma. He owned a personal jet and he was thick into the process of buying a spiffy new pleasure boat–a power boy toy ideally appointed to cruise the waters of the Chesapeake Bay and beyond with his family, friends, and maybe a business partner or nine. A pang of guilt arose as his $150 million company's numbers rolled in during the latter end of that year, signaling that his first company layoff in many years couldn't be that far off. The question is, "Should he keep both the private jet and the yacht?"
Just about the same time, the president of this same 300-a-year or so home builder began to wrestle with his conscience over whether to take delivery on a new six-figure luxury automobile–he was already driving a top-of-the-line Mercedes–as pricing power in the market went flaccid and absorption paces in their neighborhoods throughout the Washington, D.C., region slowed from a torrent to a trickle.
"We'd worked our butts off for four years running just to try to keep up with the demand and felt we deserved the rewards," says the CEO. "At the same time, we're about to have layoffs and times are tough out there. How would having a brand new boat and a plane look to the staff? I'm selling the plane."
The onset of housing's proverbial rainy day would transform the year 2006 into home building's equivalent of someone suffering from a peculiar strain of bi-polar disorder–a manic first six months meeting 2005 orders, followed by a depressive back-half, where cancellations conspired to gang up against harder-and-harder-to-get sales.
The rainy day lingers and may do so throughout 2007 and into next year, drawing into stark contrast the strategies and tactics of companies modeled on access to public equity and debt versus those with private capital structures and investors. For public companies, the risk of such times amount to performance warnings and lowered guidance. For privates, it's different. It's personal–a matter of pride and pocketbook.
Long-ignored warnings of housing bubbles aside, public companies would spend 2006 devoting a lot of their executive ranks' bandwidth managing EPS, shareholder perceptions and looking to "comp" favorably 2006 versus 2005. Busy dancing the other people's-money dance, the publics mostly hurried their operations into a defensive, downsizing mode, looked to slash costs and reduce excess inventory, and took solemn vows up and down the streets of Manhattan, swearing that their balance sheets could and would withstand all the fury the markets could hurl at them.
Private companies of many stripes and structures acted differently, and why not? First of all, virtually any combination of two or three of the top 10 public builders exceeds or matches the total units and revenues of the top 20 private builders. So, while publics got drawn into the vortex of dealing with Wall Street's analysts, investors, and debt holders, big and little private powers countered with decisive action closer to home in the field of battle. Quickly, they cut back on both vertical and horizontal construction expense and exposure and toiled to bring their "floated" costs and project loans for materials and labor in line with hard cash coming in from new sales, even as they slowed. Meanwhile, as most of the public companies inclined toward fire-selling their homes with enormous concessions, private companies held their ground for as long as they could on their home prices.
Prudence Not Optional
For private companies, financial discipline (i.e., selling the jet) has never been an option. Cash flow and cash reserves for a rainy day are the difference between life and obsolescence for private companies. Many of them are led by veterans of two to three cycles who not only know when to sell the jet, but also when to shift over from bottled sparkling water to water coolers in the office. They motivated their talent, redesigned products, and pulled out every trick in the book to make a buck, assuming absorption rates that more closely matched historical trends than the past five-year pace.
"We believe the larger private builders are as, if not more, prudent than their larger public counterparts and are often nimble, niche-oriented, and opportunistic participants within the larger market," writes Michael Rehaut, vice president and senior analyst at JPMorgan Securities, parent of Big Builder majority owner CCMP. Rehaut invited leaders of several of the top 25 private companies to New York this past February to discuss their preparedness for current and future market challenges. Attention naturally gravitates to the 10 or 15 public players that account for one out of four new-home closings, simply because that group serves as a proxy for the sector. Still, 70 or 80 private builders' collective share is almost as large as the publics', and their wins, losses, and capitulations to the national market tell an equally compelling story about home building's current and future outlook.
But public and private behavior share more kinship during good times–partly because, historically, oodles of privates have cashed out and sold to publics during a run-up when they can get the highest price–than they do in bad.
Why? Well, publics are bent on gaining market share during downturns, and that's largely what they did in 2006 and are likely to do more of by the end of 2007. During the same leg of the cycle, most privates tend to fixate on paying the bills, making a little money, picking up some coveted parcels on the cheap, and being around for the next uptick, which is what many of them did. Monitoring the market actually meant more than reading lurid headlines in the newspapers and checking internally generated weekly and monthly sales reports.
"What it feels like at the community level is a reduction in start pace [and] a reduction in the quantity of starts. And that pace of activity is spread over a greater gap of starts than it would have been [when things were at peak levels of demand]," says longtime Shea Homes vice president of operations Robb Pigg, describing Shea's response to the turn and its downward trajectory. "There is a similar scrutiny to horizontal construction, the development pace for horizontal improvement. The artfulness in all this is trying to align the pace to what makes sense, with regard to grading and local improvements that produce streets and sewers and water systems–aligning those with a start pace that is adjusted to reflect the downturn in sales. There is a lot of planning and re-planning in the effort to align those things."
In other words, the big difference between public company and private company behavior in 2006 lay largely in the swiftness and scope of the privates' readiness to respond to the explosion of a widely held industry myth that demand would hold up after the removal of investor buyers from the marketplace, thanks to the fundamentals of a good economy and income and household growth.
For public, especially national, companies, 2006 became the moment to throw their growth plans wholesale into a sort of reverse mode, especially as regards to their erstwhile hyper-acquisitive land position and pipeline. Whereas, for the private firms, strategy became quite tactical, a series of fluid and course corrections highly sensitized to submarket give and take, opportunism, and risk. Most of the public home builder senior managers took pride in operationalizing their financial strategies in 2006, while most of the private builders preferred to concentrate on their operations themselves.
"We have better operating disciplines [today than we did in previous downturns] because of the data and systems that we have," says Pigg. Real-time, retrievable, and decipherable data "allows us to make better judgments about what we have to do, and that reflects itself in the management decisions we make, rightsizing the employees and the company at the division level. It also speaks to how we approach our business relationships with our trades–we have to be very clear with them about our start flows and about how they can help us achieve our cost reduction goals through better specification or simpler product design."