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Housing's Underdogs Live On
Everyone loves the story of David and Goliath, save perhaps the likes of Donald Rumsfeld, George Steinbrenner, Shaquille O'Neal or last season's Miami Hurricanes football team
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Everyone loves the story of David and Goliath, save perhaps the likes of Donald Rumsfeld, George Steinbrenner, Shaquille O'Neal or last season's Miami Hurricanes football team. Something resonates in nearly all of us when the underdog dispatches the bigger, stronger, more highly rated foe. But lately there has been a lot of talk of how the top 20 U.S. home builders are making it more and more difficult for small and midsize builders to compete.
Last year a white paper titled "The Impending Consolidation of the Homebuilding Industry" by Paul DeCain of Andersen Corporate Finance generated quite a buzz. He projected that by 2011:
DeCain based these projections on an extrapolation of trend data. (He reminds me of my college physics professor, who demonstrated conclusively that every square inch of land in the continental United States would be covered by power plants in the year 2000, based on the assumption that power-plant construction would continue at the same rate from 1970 to 2000 that it had from 1960 to 1970.)
DeCain cited many advantages that the top 20 builders have over locals and regionals, but his analysis boiled down to their ability to buy bigger parcels of land for bigger dollars at a lower cost of capital.
I agree that the big-parcel issue is sometimes an advantage - but often not a huge one. And his cost-of-capital advantage by the top 20 was significantly overstated.
DeCain predicted in the same paper that 2002 would be the beginning of a downward trend, with the industry off at least 10%, doing no more than 875,000 units. So we have established that he is not so good at short-term prediction.
Further, he makes his predictions based on only financial considerations, demonstrating a profound lack of understanding about the many additional factors that contribute to home builder success in a market.
Recently, a Reuters news service story by Rachel Cohen said "the biggest builders could control virtually the entire U.S. market by the end of the decade." Wow! Now we are predicting 99% dominance by 2010! According to Cohens sources, smaller guys just can't compete.
DeCain and Cohen apparently spent all their time talking with Wall Street analysts and people from large national builders. And given that Andersen (now Accenture) is very big in the mergers and acquisitions business, it's not surprising that it brings a certain slant to this.
What I find more troubling is that at a recent builders' conference, I heard some very successful small and midsize builders express fears about competing against the top 20.
I readily agree that the top 20 have advantages, and having spent almost nine years with one of the biggest, I am well-acquainted with those factors. Yet there are many areas where strong local and regional builders not only compete, they are in a superior position.
It's important to note that I am not basing this on the business practices of your "average" local builder. My analysis is based on the strong, well-developed locals and regionals that stand out from the crowd. You can find examples from recent National Housing Quality Award winners such as History Maker Homes (Fort Worth, Texas), Grayson Homes (Ellicott City, Md.), Simonini Builders (Charlotte, N.C.) and Don Simon Homes (Madison, Wis.).
Thus my evaluation on who has the advantage is based on both structure and potential - that is, who should have the advantage, not necessarily who ends up with it.
For a parallel example, consider the 2002 Super Bowl. Any informed, rational analysis gave St. Louis a significant advantage. New England won. Obviously, having an advantage does not always produce results.
So let's look at some of the key determinants of home builder success and consider who has the best position.
It is widely assumed that the top 20 have an advantage here, yet traveling the country extensively and working with many local/regional builders, I just don't see it.
The top 20 have their stock and bond market sources as well as a host of big banks courting them. Yet the small and midsize builders have a huge number of local and regional sources for funds - from banks and private investors to firms such as Hearthstone. Many of them are self-funded to a significant degree. They have been successful. They have money. In these times, where better to invest it than in themselves? I simply never hear these builders complain about a shortage of funds. I also never hear them talk about a cost-of-capital inequity compared with the top 20.
Throw into this mix the short-term focus (read: impatience) of Wall Street, and the whole picture shifts. In publicly traded firms, this factor seriously affects fund allocation, often determining who gets how much and where. Again, the locals/regionals have no such concerns.
Now throw in the fact that locals can exist quite happily building 200-500 units a year instead of 800, 1,000 or more, and their needs aren't as great as the top 20's.
This area used to lean toward the top 20, with the lure of working for a big-name company and moving up the ladder appealing to many recruits. The potential rewards were, and still are, compelling.
Yet in the "corporate resizing" climate of the past 10 or 12 years, even though housing is largely untouched, people now tend to look at big firms with a considerably jaundiced eye. I see more and more managers migrating from large builders to smaller ones - and few moving the opposite way.
I also hear more young people going into our business expressing an interest in locals and regionals as opposed to the top 20. The reason is simple: trust.
I had a grandfather who worked for General Electric for 50 years. He started as a packing boy at age 15 and retired as plant superintendent at age 65.
Can you imagine? If I can't, imagine what my college-age sons think. They can't even conceive of it. The conventional wisdom now says there is no loyalty with big companies. Better to be a fish of any size in a smaller pond.
I'm continually amazed at the talent I find among local and regional builders. With a few noteworthy exceptions, the turnover rate among the top 20 is abysmal - much higher than the locals'. Many costs are associated with high turnover, but a commonly accepted conservative figure is 1.5 times salary and benefits.
Let's take two decent-size builders in the same market, one national and one local, each with 75 employees and each doing about 350 units per year at $200,000. The national has a typical turnover of 18%, the local 5% per year. That 13% difference per year translates into a headcount of 10. Take an average salary/benefit package of $65,000. Take that times 1.5 and then times 13 people, and we just spent a million bucks.
I submit to Mr. DeCain that the supposed 2% cost-of-capital advantage that the top 20 have over locals just got neutralized, and then some.
I hope by this point I have convinced you that David is still breathing. Goliath looms large, but he is not omnipotent. If you are a David, take heart. If you are Goliath, beware of small boys with slingshots.
Next month Scott Sedam will look into the factors of purchasing, supplier/trade relationships, market segmentation, land acquisition and performance culture.