As chief financial officer of Atlanta-based PulteGroup, Bob O’Shaughnessy drew the short straw. His first-quarter 2020 commentary would include a note that would strike raw nerve. Just shy of 90 days from the decade’s rosiest outlook moment—when PulteGroup president and CEO Ryan Marshall, O’Shaughnessy, and the rest of the strategic team revealed they’d added Innovative Construction Group (ICG), a Jacksonville, Fla.-based off-site building enclosure producer—it fell to the CFO to flag material dollar variances to the business that speak to challenges ahead.
Public company accounting principles call for it. Full financial disclosure required the warning. “You will see a line for goodwill impairment in our first-quarter income statement,” O’Shaughnessy told analysts, investors, and other stakeholders in April as he reviewed the Q1 financial metrics of the nation’s third-largest home building enterprise, which reported 23,232 closings in 2019. “Given the significant decline in equity market valuations, we determined that an event-driven impairment test on a goodwill associated with our January 2020 acquisition of ICG was appropriate. This test resulted in an impairment totaling $20 million. This impairment was not the result of any factors specific to ICG’s operations but rather reflects the broad-based declines in the market capitalizations of publicly traded construction companies during the period.”
Never mind that accounting rules require a public company to “evaluate the recoverability of goodwill based on objectively verifiable market data” irrespective of how good, or bad, the deal for the asset winds up proving out. And, never mind that the moment still convulsed in aftershocks of COVID-19’s initial impact. Impairments equate, no matter how you look at it, to a loss of value. Involuntary muscle memory among home builders, especially ones who have weathered past boom-and-bust housing cycles, almost reflexively recoiled. “Déjà vu all over again,” ran the typical experienced builder analyst’s mental script. But is it?
Despite the goodwill write-down, PulteGroup’s Marshall is cautiously confident the Yogi Berra-ism does not apply for various reasons.
“We did an internal operations review with the ICG team yesterday,” Marshall said in May. “The optimism and excitement were palpable, and we’ve begun to move some of our Jacksonville operations through the ICG plant. The strategic elements we expected are there, and the talent that’s now part of our team goes beyond expectation. We believe we’ll have an opportunity to take a factory that’s open, profitable, highly productive, highly efficient today, and—in that environment—add incremental innovation, like preinstalling windows with flashing, evolving floor cassettes, integrating plumbing and electrical. We’re not going to let this crisis go to waste; it’s a moment to double down and push innovation even faster.”
COVID-19 cloaks one and all with a cloud of uncertainty as to what is next. As regards the future of fully integrated off-site manufacturing the shell of new homes, the industry’s ranks of 100,000 firms include believers, non-believers, and those who’ve suspended judgment for the moment. Believers’ bet is this: Whatever happens to new-home supply and demand in the wake and aftermath of the pandemic, they’re invested in and committed to a path of wresting market share from other builders at the expense of the weaker players and expanding that share to a growing universe in an eventual recovery.
Will History Repeat?
Smart money and plenty of housing observers—even among professed doubters—regarded 2019 as off-site construction’s breakthrough year. Startups got off on a solid footing, flush with venture capital and other forms of investment finance, none more dazzling than Katerra; Clayton Properties Group was investing in a model that fused its heft in prefabricated building with a blue-chip portfolio of site-build operators bent on bending their cost curves lower to reach the pocketbooks of more buyers; Japan-based companies like Sekisui House started demonstrating their systems in the U.S.; and even building materials supply companies took to the dance floor, like LP with a $45 million equity investment in fully integrated off-site solutions platform Entekra. By the outset of 2020, a growing consensus among home building operations leaders felt off-site might be ready for its pivot into breakout status. With volume momentum building, and labor capacity continuing its tight squeeze on new-home supply, a path from breakthrough to breakout seemed more than plausible.
Then, COVID-19’s collision with life as we knew it crushed all that was thought to be likely. And it happened in about the time it took to say the words “novel coronavirus.” Would the ruinous force of the event relegate off-site’s bright promise to being a quickly discarded memory, from breakthrough to breakout to broken?
It’s anybody’s guess as to what will be the fate of new-home housing demand in 2020 or 2021. Are all bets off for off-site’s growth to a major share of residential building enclosures, more becoming of the true future of home construction?
Veterans of housing cycles past feel instinctually that what’s playing out has happened, in a theme and variations, before. Again, and again.
Why? Costs. The moment COVID-19’s tornado funneled every form of economic activity into its vortex, builder business principals did what they do when doubt and danger obscure the horizon: They manage for present balance sheet peril, secure cash and its continued flow, and prepare to cut like hell if and when necessary.
The question for off-site investment and commitment is whether it can and will remain at the core of builders’ business and operational models after every other non-essential expense action has been taken. In eras past, it proved faster and simpler to retrench by reducing human labor costs—mothballing new communities, shutting down future sites, carrying fewer workers on the balance sheet. That’s not so easy when fixed operational costs flow directly into and out of a factory, which adds rigidity in both the reduction of expenses and ramping up once a downturn thaws and activity picks up.
Roughly, the plot goes like this: During boom times in housing, volumes go up, labor costs accelerate, and the appeal and cost efficiencies of factory-based modular, component, and panel kit fabrication spike upward. When the cycle turns down, unit demand craters, the volume at these plants is insufficient to justify their operation, and they close and fall out of favor as a cuttable expense. When the housing cycle picks back up, builders tend to tap human skilled labor to reboot their building efforts because they can wean costs upward more manageable as market demand increases. Labor tends to run cheaper because people have been out of work, and they’re happy to come back at competitive day and per-project wages. This can make cost-per-square-foot math work out better using human crews that can scale with volume.
After several of these cycles, builders hesitate to adapt factory construction practices—widely used in Europe, Japan, and South America—because they feel they’ve been to this rodeo before. They’re into pieces of the factory-produced approach, buying roof trusses here, wall panels there, and other parts of the pre-cut framing kit of parts. As for a systems-thinking approach, it’s been big talk of innovation and change, a few bright spot advances in technology and operations that look promising, and then—just as their moment to shine occurs—the bottom falls out of the market, crushing the economics, and pushing the industry back to square one.
This time, it’s different. That’s what some claim, and several factors make this claim a strong possibility.
“We’re past the tipping point,” says Margaret Whelan, founder and CEO of boutique investment bank Whelan Advisory, which has served as one of residential construction’s most active matchmakers of strategic innovation and capital over the past five years. She’s in the “this time it’s different” camp, viewing off-site as a core, no-going-back business and operations model change.
“Up until the outbreak, builders were intrigued by off-site and what it promised to do for predictability, to offset a crisis in skilled labor shortages, in waste reduction, and speed,” she explains. “Now, from what I’m seeing and hearing, the pandemic makes them look at off-site as a necessity. It allows for a meaningful reduction in on-site labor, while factory schedules can be staggered to allow for social distancing. The installation of a kit that’s produced in a factory setting and then installed via crane at the jobsite ... reduces the amount of rework as each house is built, ensuring that subs and inspectors can work more effectively and in less time to get the house finished.”
Through the prism of PulteGroup’s ICG purchase, and its staunch belief that its vertical integration of off-site manufacturing is a long-term business model essential, we’ll look at how the industry may have crossed a no-going-back point in its embrace of off-site building.
PulteGroup's Pivot to Off-Site
Jan. 28 dawned less than seven months, but a lifetime, ago. Still, when PulteGroup’s gangbusters fourth-quarter and full-year 2019 earnings commentary came with the ICG acquisition announcement, analysts, observers, and longtime gadflies of home building did a double take.
In response to PulteGroup’s ICG acquisition, JPMorgan equity research analyst Michael Rehaut noted on the Q4 2019 earnings call that he was curious about the rationale of buying ICG “outright versus being a customer as is and reaping the benefits of the efficiencies of the business or the business relationship simply as a customer. Or, perhaps making an equity investment to allow the company to grow further without fully consolidating it.”
PulteGroup did not, as may have been expected on the call, unveil the purchase of a strategic land asset portfolio, a customer segmentation exposure, or a home builder M&A deal. Instead, it shared it had agreed to buy ICG, an 11-year-old outfit with an inventive pedigree and a well-oiled proof-of-business model concept, for $104 million.
The ICG acquisition leans into the role of factories to solve an almost wholly different set of challenges. Whelan believes ICG’s design and engineering expertise is a large source of value, as the company builds each house twice, the first time in BIM 3D, to rationalize the plans and remove waste.
While PulteGroup chose in this case to vertically integrate the Jacksonville ICG plant because of dynamics, opportunities, and specifics of the North Florida market, at least two other variations on the off-site factory cut-over may play out in the coming years for Pulte. It may, in some markets, avail as a customer of already available off-site construction manufacturing plants, such as Entekra in Northern California. Too, it may use the ICG plant and its operational and business models as a template to start up its own vertically integrated plants where it has community count concentration in other parts of the country.
In a dramatically lower-unit volume environment—should that be what prevails when the COVID-19 dust clears—PulteGroup can pause on some of those future steps, awaiting the arrival of a new recovery cycle. The good news in the near term is that ICG’s business backlog is hedged for both residential and commercial jobs in the pipeline. “Accelerated project work on commercial structures—apartments—has offset some of the slowdown on the single-family side,” Marshall says.
Off-Site's Faster Forward Future
Labor. It’s the reason the shift to factory-based pre-engineering, design, and fabrication of building envelopes—which a majority of builders expected would take another five years to gain real traction—has rocketed from nice-to-have to must-have, practically overnight.
The universe of skilled labor participants in the building trades has shrunk for two reasons. A large exodus of skilled workers occurred at the time of the Great Recession years, as many people returned to their lands of origin, south of the U.S. border. Compounding that loss of skilled and experienced hands, age demographics have taken a further toll. Estimates of as many as six skilled building trades workers “age out” for every young recruit into the early stages of a building career.
“In states and regions like Northern California where COVID lockdowns went into effect and shut down construction activity on 80% of our sites, many subcontractors, having lost their jobs temporarily, didn’t even wait around for things to open back up here,” says Entekra founder and CEO Gerry McCaughey. “They left immediately. The problem is, these are among the most experienced and highest skill-level carpenters, framers, and other trades, and that leaves more junior, less skilled people who don’t have an example to follow now.”
Craig Collin, chief operating officer at Tavistock Development Co. and former PulteGroup executive, suggests construction labor may see a surge of new entrants as layoffs in other industries create an army of otherwise unemployed workers. But, he adds, there’s a key caveat.
“We may be able to draw on more labor during and after the worst of the crisis,” says Collin, whose design for Tavistock’s 24,000-acre Sunbridge master plan south of Orlando, Fla., includes 7,000 new homes, offices, and hotels starting in the next 24 months or so. A fully integrated factory, stood up on–site specifically for the job, would churn out building envelopes for many of the community’s builders. “The thing is, will you be able to get qualified, experienced people with the skills we need?”
Continuum Advisory Group co-founder and principal Clark Ellis agrees with Collin that, in broad strokes, “We may have gone from a labor-negative to a labor-positive, and, from some perspectives, we could end up with excess labor. But, when you’re looking at productivity, you get that from the people who are more skilled ... and better able to achieve a quality on the first time, than more junior people. That’s what you’re going to be missing.”
Another reason for a shift toward off-site construction is the need for faster building cycle times. Pre-COVID-19 building start-to-completion cycle times, ranging anywhere from six weeks to six months, were considered to be a hazard of new-home development. For home buyers, unless you wanted a pre-built spec home, getting the semi-personalized home of your dreams meant having to wait. Post-COVID, delays mean taking on more risks.
Many of these risks plagued builders plenty prior to the virus outbreak. However, since its onset, the time value of money issues, the disruption of household wherewithal due to economic convulsions, and the ongoing menace of broken and stressed links in housing finance’s byzantine circulatory system give the lack of precision and predictability in the production cycle an extra squeeze of peril in a time of doubt and volatility.
“There’s no stick-framing system in the country that can give us this kind of timing predictability,” a senior-level executive of a top 15 Builder 100 company client of Entekra told McCaughey. “What this does for our scheduling—of people hours, of materials management, of deliveries—we’ve never been able to do before.”
The Plan: Less, But Better
The enterprise rigor that led to the ICG acquisition traces back to PulteGroup’s “commonly managed plan platform.” This initiative reduced floor plan variability and looked to establish standards for floor plan design and engineering to both simplify construction and improve the ability to buy building products and materials at greater scale for more efficiency.
“The commonly managed plan platform gave us discipline and systems-thinking approaches in three areas of innovation,” said Chuck Chippero, national vice president of strategic sourcing and innovation at PulteGroup. “By paring back and simplifying we achieved prediction in build times, we saw the connectivity of floor-plan design disciplines with a number of other internal processes, and we used the time back for even greater focus on customer experience and satisfaction.”
Pulte’s learning curve on the commonly managed plan platform allowed it to see its off-site investment as an integral part of how the firm can subtract expenses that do not redound to value in customers’ minds and hearts.
“We want to change the way homes are built,” Chippero says. “Better, faster, more cost effectively, and totally for customers. That meant we had to change ourselves.”
Labor, precision, waste-reduction, all-weather reliability, safety—each of these factors has taken on a heightened intensity with the onset of COVID-19.
Temperature-controlled, indoor manufacturing environments eliminate the errors climate and site conditions produce, which contributes to consistency, accuracy, and reliability. And BIM pre-construction and coded-CNC cutting reduces the need for excess building materials. As ICG founder Ryan Melin notes, “There’s waste everywhere in the process, and we eliminate it.”
Melin feels the ICG fit with PulteGroup can take his already-established efficiency and process improvement track record and unleash new, quantum-leap gains from the added scale and resource focus.
“We’re not looking to save dollars on buying studs or 2x4s or buying labor better than builders do,” he says. “We are looking to fuse the design, engineering, and construction process into a better way for people to get their home.”
A move toward off-site takes on a different meaning at a time when workplace health and safety have reared up in life-or-death clarity. Catching COVID-19, or not, may depend on new social-distancing protocols that force old-school construction processes into new light as unnecessarily risky. Factories, while not all conducive to safe distancing for staff, stand a better chance of being controlled environments than many construction jobsites.
“In eight weeks [since COVID struck], we have seen more digitization in our industry and in customer interactions than we saw in eight years before that,” Whelan says. “Off-site is a way for builders to remove costs that don’t add value customers appreciate, and to add meaningful value they do want and insist on.”