Consolidation: Swift and Massive

This article is part of a Point-Counterpoint report on consolidation in the home building industry. To see the Counterpoint, click here.

When it comes to consolidation in the home building industry, there is a huge divergence of viewpoints. But there seems to be agreement on one point: The question is not if the industry will consolidate, but rather how much and how fast.

To the outside finance professionals who make their livings answering such questions, there is a growing consensus that home building consolidation has reached terminal velocity. The idea is that the top companies have gained critical mass and market advantages to such an extent that through acquisition and attrition, relatively few companies will soon dominate market share. The analysts say that during the coming decade, the industry will roll up swiftly and massively.

An analyst with Andersen Corporate Finance LLC, Paul F. DeCain, recently encapsulated this view in his report The Impending Consolidation of the Homebuilding Industry. DeCain concludes that by 2011 the top 20 U.S. home builders will account for 75% of new home sales.

“Certain large national builders have significant ad-vantages over their smaller regional competitors,” DeCain says. “These advantages include lower capital costs, operating and overhead efficiencies, significant land control, and powerful brands.”

DeCain’s logic goes something like this: Growth in demand for new homes will slow during the coming years because of lower employment levels that will offset any positive factors, including low interest rates, demographic demand and trends in wealth allocation. And if demand does not slow the home building industry, a lack of land will.

DeCain says two factors will make it impossible for land supply to support current home building levels. First, equity flows of $1 billion in annual investment from financial institutions representing the creation of 40,000 to 50,000 lots have dried up during the past three years. Second, no-growth sentiment and an increasingly prohibitive regulatory environment have formed a major barrier to further lot creation. Only those companies with control of tens of thousands of lots will be “protected,” he says, during the upcoming prolonged down cycle in home building.

In addition to a slowing economic outlook for home building, DeCain cites a rapidly increasing pace of consolidation by the top 100 home builders. Using figures from Credit Lyonnais Securities, he points out that from 1997 to 2000, the top 100 increased their market share from 24% to 37%. He predicts that a continuation of this pace will lead to 50% market share by the top 100 by 2004. More telling, he notes, are the gains by the industry’s top five. From 1995 to 2001, their share of new home sales increased from 4.5% to 10%.

DeCain is most persuasive in his argument that the industry is in the midst of swift, massive consolidation when he lays out the list of financial and market attributes the big companies have:

• Capital costs: Given the capital-intensive nature of the industry, companies with the lowest cost of capital — namely, large public builders — will have a huge market advantage. A public company with a BB+ bond rating will be able to achieve a 125-basis-point advantage on debt. For a $200 million company that’s 50% leveraged, that would equal an annual advantage of $1.25 million. On the equity side, the benefit is more like 1,000 basis points, DeCain contends, with an annual benefit to the same company of $5 million.

  “Lower capital costs enable large public home builders to capture more and more market share while still operating on a more profitable basis than regional competitors,” says DeCain.

• Operating and overhead costs: Through lower-cost supplier agreements (from roof trusses and central office professionals to insurance premiums) and the ability to draw on cash reserves to buy cheap land during a down cycle in home building, large public builders gain an estimated 200-basis-point monetary advantage. This amounts to an estimated $10 million advantage for a $200 million company, DeCain says.

• Revenue enhancements: “Large national builders enjoy significantly enhanced revenues through branding,” DeCain says. “Many home buyers and homeowners today associate specific architectural characteristics, designs and floor plans, quality levels, general locations and other factors with specific home building companies, and make decisions in accordance with these associations.” On this topic, the report concludes that companies unable to brand because of “inadequate scale” likely will face declining prospects.

• Land: Only the large national builders will be able to control substantial land positions, DeCain says, while small, even regional builders “don’t have the balance sheets to option significant land for long periods.”

  In addition to the effect these market advantages will have on big builders’ share of new home sales, DeCain argues that there are signs of conclusive activity on the mergers and acquisitions front. The industry will consolidate not only as a result of national builders’ buying regional and market players, but also through an emerging trend of the past few years: mega-mergers, or mergers of Giant equals. He cites the Pulte and Del Webb merger along with the U.S. Home and Lennar combination as proof that the big will be very big. DeCain says the total M&A value among builders in 2000 was $3 billion. Last year it jumped to $5 billion. He predicts the upward trend will continue.

  Home Builder Cost of Capital   WACC * Top 10 national home builders 10.0% Top 50 home builders 12.0% Regional home builders 15.0% * Weighted average cost of capital: 50% equity and 50% debt assumed Source: Andersen Corporate Finance LLC

  In the end, the report puts home building on a par with other capital-intensive industries that followed a similar path. As the industry matures, it consolidates until major players dominate. But DeCain is not predicting the demise of small regional home builders.

  “Regional home builders that recognize the forces of consolidation are likely to prosper,” he says. “Some will merge on their own terms, on their own timetable, with the best possible partner. And others will reposition themselves as niche players operating in sectors where speed to market and flexibility are more relevant than capital costs, efficiency, branding and land control.”

  This point of view was written by senior editor Patrick L. O’Toole based on the analysis of Paul F. DeCain, managing director for Andersen Corporate Finance LLC, Washington.