Big Builders Prepare for an Acquisition ‘Feeding Frenzy’
The current housing slump has brought consolidation in the residential construction industry to a screeching halt, but the top 10 public builders in the nation are preparing themselves now for the next round of mergers and acquisitions, maybe even a “feeding frenzy,” when the markets return to normal over the next couple of years, according to housing analysts at the recent International Builders’ Show in Orlando, Fla.
“The buyers are looking at candidates this year,” said Jody Kahn Klein of Michael Kahn & Associates in Pointe Vedra Beach, Fla. At the present time, however, they are “putting out fires and liquidating so that they will be in a good position to get those companies and better-priced land.”
Buyers are going back to a popular paradigm of the mid-1990s to structure their deals, said Michael Kahn, recapitalizing the company and allowing the seller to grow the business over a typical five-year period.
The seller receives a share of the profits that drops each year, starting out at perhaps 20% to 25% in the first year and declining to 5% in the final year of the deal, he said, but the actual dollar amount of the compensation can be the highest towards the end if the business has grown substantially.
Companies that have been building in the range of 800 to 1,000 homes a year “will see a lot of suitors,” said Klein. And big builders will be “paying attention to markets that are somewhat hurting” in an attempt to find opportunities for “contrarian moves.” For example, “Lennar uses down cycles to buy up lots,” she said. “That’s how they entered Texas and California.”
Buyers don’t have much interest in builders below the 200 to 300 unit annual production range, she said, and are looking for companies with a three-year inventory of lots and land.
Klein suggested that there are a number of things builders can do to make themselves attractive candidates for acquisition:
- “Do benchmarking,” she said, to determine how your company stacks up with other builders, especially in the area of profitability. Pre-tax profits of 10% to 12% represent a solid return on home building, although buyers will consider a range of performance, starting as low as 4%. “A company earning 15% to 16” is doing everything a little better,” she said.
- Builders should be able to provide a description of their management systems and procedures on a few sheets of paper.
- Candidates should benchmark their scheduling for homes that are similar to those they are building.
- A business plan should provide a narrative of where the company has been, where it is now and where it is going, including information on capitalization, growth opportunities, the competition, strengths and weaknesses, market research, an evaluation of the business team and a five-year financial projection.
- "Prepare for due diligence.” Use an annual operating budget, organize files, take a look to see if land contracts are assignable and look at signed contracts with subcontractors and suppliers.
- Prepare complete files on any litigation the company is involved with.
Although the nation’s overall housing market will continue to be composed of a large number of small companies, “the market share of the top 10 builders will continue to grow,” said Gopal Ahluwalia, NAHB’s senior vice president for research.
In 2005, three big builders had at least a 3% share of the market in terms of closings, he said: D.R. Horton, Pulte Homes and Lennar Corporation. In 1992, the nation’s top builder produced only 1% of the nation’s homes.
Here Comes the Mega-Builder?
The combined market share of the top 10 builders exceeded 20% in 2005, and the share of the top 100 builders was about 40%. From 1995 to 2005, the top 10 builders increased their closings by more than 333%.
A merger or two among the top five builders could even create a mega-builder with the capacity to build 100,000 units a year, he said.
However, growth prospects don’t look that favorable for the next tier of builders who are ranked from 21 to 100, he said. Their market share has not been growing.
Ahluwalila noted that the big builders are diversifying geographically to insulate themselves from regional industry declines and also diversifying their product, which originally was concentrated on the market for first-time buyers.
California Is Where the Profits Are
California has been the most profitable state for the big builders, said Ahluwalia, based on numbers from Credit Suisse showing a comparison of the percentage of units they delivered in that state with the state’s contribution to their after-tax profits. For example, D.R. Horton in 2005 delivered 16% of its homes in California, but sales on those homes accounted for 37% of the company’s profits. Texas, by comparison, accounted for only 9% of profits even though one-fourth of the company’s homes were built there.
With the exception of NVR Inc., which didn’t build in California and counted on Virginia for more than half of its profits on 30% of its deliveries, the ratio of units delivered to profits in the Golden State was similar for the rest of the top 10 builders: 13% vs. 26% for Pulte; 23% vs. 43% for Lennar; 14% vs. 35% at Centex; 21% vs. 48% for KB Home; 14% vs. 28% for Beazer Homes; 25% vs. 38% for Hovnanian; 10% vs. 22% for Ryland; and 14% vs. 22% for MDC Holdings.
The big builders are having an impact on the distribution of building materials, Ahluwalia added, as they increasingly buy directly from producers. Some are storing these materials in regional warehouses so that they can be supplied quickly, cutting their cycle time. Some are also assembling framing and components. “Their long-run objective is to buy in volume and warehouse it,” he said.