Bold Maneuvers

STEVE PETRUSKA HAS SEEN HIS SHARE OF CHALLENGES during the more than 20 years he's worked in the home building business. Before being named Pulte Homes' COO in January, he ran Pulte's high-velocity Las Vegas division. So he speaks from experience when he explains how “the most broken supply chain of any industry” bogs down the aspirations of high-flying builders.

Fixing that chain is at the core of Pulte's plan to nearly double its production capacity and significantly improve its profitability over the next three years and beyond. In the past several months, the Bloomfield Hills, Mich.-based builder has initiated a number of internal changes aimed at streamlining and simplifying operations that, at Pulte's current rate of growth, could be pumping out more than 100,000 homes a year before the end of the decade.

The most controversial component of Pulte's growth strategy—its fervent embrace of vertical integration to accelerate construction processes and lower materials and labor costs in larger markets—hasn't won many converts among analysts or competitors. But company officials believe vertical integration could provide the ballast Pulte needs to prevent its balance sheet from capsizing as it becomes a much larger builder.

Steve Petruska, COO, Pulte Homes Going into 2004, Pulte threw down the gauntlet to the rest of the industry. It set an ambitious goal for itself to be recognized within five years as the premier home builder in the United States among buyers, investors, and analysts. Pulte officials point to competitive advantages that they claim already put their company on a fast track to attaining that goal, including its estimable land assets, its product diversity, its high customer satisfaction rating, and its commitment to personnel development. “In many markets we already have the wind at our back,” proclaims Petruska.

A databank of 500,000 households provides Pulte with “excellent visibility” into its potential customer base, says president and CEO, Richard Dugas, and is informing virtually every strategic move the builder makes. Pulte's land bank, meanwhile, which includes more than a quarter million lots now under the builder's control, also gives Pulte extraordinary flexibility over its destiny.

But as the builder lays out its three-year growth plan, Pulte officials return time and again to supply chain management as the straw that is stirring the drink for a company that by 2006 expects to be delivering 60,000 units annually and generating more than $15 billion in domestic revenue. Pulte's entire business model is being retooled and coordinated to “drive value” to its bottom line, according to its CFO, Roger Cregg. Company officials spoke confidently about adding at least 50 basis points of gross margin each year through 2006—a year when earnings per share are expected to double to $11—from improvements in operational efficiencies.

That last proposition certainly got the attention of analysts and investors, some of whom have been underwhelmed by Pulte's return on investment and equity. Even Pulte's supporters await proof that this latest strategy is the elixir that transforms Pulte Homes into the nonpareil builder it envisions becoming.

Management Moves Pulte's confidence in the power of supply chain management to boost its productivity became clearer earlier this year when it turned to Wal-Mart—arguably the most proficient distribution company on the planet—to find and hire Reginald McCoy to the newly established position of vice president of supply chain. McCoy, who coordinates Pulte's vendor relationships from his base in Dallas, spent two and a half years as assistant general manager with the retail giant's distribution center in La Grange, Ga.

McCoy filled a vacancy that opened when Pulte reassigned Alan Laing, its former vice president of customer satisfaction and construction support, to Phoenix as president of Pratte Building Systems. The Pratte division was formed in January via a joint-venture partnership between Pulte and the framing and concrete foundation contractor Pratte Development. That venture now oversees all aspects of Pulte's construction in Arizona and Nevada, where the company expects to deliver 8,500 homes this year.

Manufacturers that distribute materials for the shell of a house—framing, foundations, or drywall—rarely offer installation. Those particular categories accounted for 35 percent, or $1.9 billion, of Pulte's home building costs last year. Consequently, the shell is where Pulte is focusing its efforts to vertically integrate its construction processes, and why its investment in Pratte can be seen as seminal to the company's long-range scheme.

Pulte, in fact, has been gravitating in this direction since 1998, when it acquired DiVosta Homes in Florida. Last year, DiVosta closed 1,600 homes and its 55-day production cycle was 20 days faster than Pulte's as a corporation. “DiVosta is like an assembly line,” observes Rich Murray, a housing analyst with Raymond James. Pulte has exported best practices from DiVosta into its construction in Southern California, and its officials believe that Pratte could squeeze out similar results in markets such as Phoenix and Las Vegas—where Pulte derived 24 percent of its new orders in 2003—and possibly others.

NEW AGENDA: Pulte's Alan Laing (left) and Reggie McCoy at Pulte's Pratt Building Systems facilities in Phoenix. Greg Gieber, housing analyst at A.G. Edwards, says he thinks vertical integration is risky because of its fixed costs. “This is still a cyclical business, and the reason [builders] hire subs is so they can get rid of them during slower periods.” There is little doubt about Pulte's commitment to this, however, as vertical integration will cover one-fourth of the builder's closings this year. While he concedes that this process wouldn't work for every community, Laing confirms that Pulte is seeking more Pratte-like opportunities.

Installation Initiative When vertical integration isn't feasible, Pulte seeks suppliers that will install what they ship. “Given our increasing volumes, there's great opportunity in creating a supply chain that is much more about manufacturer-direct,” says Laing. He cited Pulte's arrangement with Masco's Merillat division, which delivers and installs kitchen cabinets into more than 70 percent of Pulte's homes, as “a fantastic model for what we want from other suppliers.”

Pulte is also moving toward greater market-to-market product consistency to make life easier for vendors and to further trim construction costs. This year, Pulte started using its customer databank, which it breaks down into 11 buyer lifestyle groups, to edit its product specifications by item with an eye toward simplifying purchasing and construction. Pulte already has pared its blueprints to 1,500 (from 1,750 in 2003), with the goal of reducing that number to between 1,000 and 1,250 by 2005.

The builder anticipates significant cost savings from “value engineering,” which reduces house design variations by eliminating product specifications that don't add value for customers. For example, its specs had called for 5/8-inch shelving in Nevada and 3/4-inch shelving in Arizona. “Why? No one knew,” says Laing. Petruska notes that value engineering is trimming Pulte's construction costs by $1,500 to $2,000 per house in the Southwest. As it standardizes its product lists, Pulte is rolling out an Internet-enabled program through which it will conduct and manage much of its procurement, home-plan selection, schedules, and post-construction service. Company officials aren't revealing much detail about this except to say that the rollout should be completed by mid-2005.

Puzzle Piece If fortifying its supply chain has the desired effect on its productivity, Pulte Homes, say its officials, will have found the final piece to the puzzle. It will catapult itself above that cluster of top-tier builders that is riding the same wave of high buyer demand as Pulte and has remarkably similar growth objectives and timetables (see “Competitive Forces,” page 44). In the process, Pulte may even assuage skeptics such as Ivy Zelman, housing analyst for Credit Suisse First Boston, who harbors some doubts about Pulte's grand design because “it's all supply driven,” she says. “How do they know the horse will come to drink their water?”

Pulte's CEO Dugas assured investors in February that interest rates would need to rise by “300 to 400 basis points” before demand would be seriously impacted. If that occurs and the housing market falters, he contends that Pulte could continue to expand by aggressively promoting its reputation for quality to take business from other builders, and by wielding the power of its sizable land assets.

Pulte places more stock than other builders in J.D. Power & Associates' customer satisfaction surveys to validate its standing with home buyers. The builder now mandates that each of its divisions must do whatever is necessary to be rated No. 1 in all 25 markets in which the surveys are conducted. Company officials contend that a high J.D. Power rating helps Pulte justify its pricing structure (from which it generates 60 percent to 70 percent of its gross margin growth). High ratings also help Pulte get land entitled faster in municipalities that—with greater frequency—are thwarting residential construction.

Large builders often covet the same real estate in many of those markets, which is why Dugas believes Pulte “is in the driver's seat” because it owns or controls more land—256,000 lots at the end of 2003—than any competitor. This year, Pulte will invest another $1.5 billion in land as it proceeds to add about 400 new communities by 2006.

Many of those communities will target active adults, a customer segment that's about to explode. Pulte expects to have an active-adult community in all 44 of its markets by next year. Through subtle shifts in pricing, product mix, and overhead control, the builder is increasing the sales pace and profitability in existing communities. “Don't underestimate the Del Webb part of Pulte's business,” says Margaret Whelan, UBS Investment Bank's housing analyst. Whelan recently visited Sun City Hilton Head in South Carolina, which closed 3,200 units in its first decade and now expects to reach 7,500 total closings in five to seven years. That community closed 601 units in 2003, compared to 274 in 2001.

As the industry's second-largest builder last year, based on homes delivered, Pulte roared through the first three months of 2004 with a 52.8 percent increase (to $131.6 million) in net income from continuing operations. Its sales that quarter grew 31.3 percent to $2.01 billion. And its closings jumped 21.6 percent to 7,039 units, while new orders increased 31 percent.

Analysts and investors, however, have remained uncomfortable with Pulte's game plan, primarily because the company's track record for return on investment has trailed—or at least, has run in the middle of the pack with—some of its competitors' records in recent years. With interest rates set to increase, there's the usual concern over Pulte's ability to improve margins and boost volume.

Petruska, for his part, can't spend a lot of time worrying about naysayers. He and his operations team are focusing instead on executing Pulte's game plan as swiftly as possible, and making sure this builder can tackle—and not be tackled by—the big challenges that lie ahead.

Competitive Forces Pulte's bid to nearly double its capacity over the next three years may be a reach, but Pulte is not the only builder gunning for such an aggressive goal. Nor is it the only builder claiming to be in a distinct position of strength: Lennar is banking on its rock-solid balance sheet to maintain its competitive advantage. Neighborhood growth will be the key to doubling Centex's market share to 6 percent by 2008. KB Home is “the best geographic position in our 45-year history,” says chairman and CEO, Bruce Karatz. And D.R. Horton is homing in on “internal growth” after a furious decade of acquisitions.

Each of the industry's largest builders, including Pulte, has its own approach to expanding its business. But all of them believe two things: that demand for housing will stay strong for years; and that their respective companies will be the chief beneficiaries of this growth.

As the industry consolidates, it's certainly conceivable that the industry's leaders may all be right. “There's certainly room for all builders to grow,” says Rich Murray, housing analyst for Raymond James, pointing to the relatively low market shares the largest builders currently have in such major markets as Atlanta.

And they have the financial might to fuel that growth. Several large builders have recently negotiated larger lines of revolving credit to be ready for any opportunity.

Lennar's $1 billion joint acquisition of Newhall Land and Farming last year gave the Miami-based builder access to about 34,000 acres north of Los Angeles. Lennar's CEO, Stuart Miller, recently told investors he's ready to pull that trigger again, but not at the expense of depleting his company's cash reserves. “We're a balance sheet company first,” he said. Lennar is projecting a 15 percent increase (to 37,000 units) in closings this year and is reducing costs by exploiting its size, according to Miller.

At a March conference in London, Centex told investors that it would deliver 36,000 homes in 2005, versus 26,477 in 2003, and increase its operating income that year by 21 percent. Centex expects to expand its neighborhoods in development—519 in 2003—at an average annual rate of 8 percent to 12 percent through 2005. It is also working to coordinate its diverse portfolio of business units to bring construction costs down.

After acquiring 17 companies during the past 10 fiscal years, Horton says it's taking a breather to expand its existing operations. But as Horton's 2003 annual report made clear, the hunt goes on: “We are continuing our historical approach of evaluating opportunities for strategic acquisitions in the future.”

One factor that is likely to throttle how quickly big builders are able to achieve their near-term expansion goals is their internal cash flow. UBS Investment Bank's 2004 cash-flow estimates for larger public builders project a 1,000 basis-point gap separating the top from the bottom. Its housing analyst, Margaret Whelan, expresses concern that the “obsession” some companies manifest in their drive to close more units could jeopardize future earnings if they are forced to make concessions in their choice of markets and real estate simply to meet their unit-count objectives. “I prefer quality over quantity myself,” she says.self,” she says.