Homebuilders Hammered. Time for M&A?

(page 2 of 2)

Land Glut

Whether homebuilders start making substantial deals now may well depend on whether they believe that the housing market has finally stabilized. One reason builders buy other builders is to expand into new markets and acquire land for construction. Some experts say that given the outlook for housing, many homebuilders have all the land they want and acquisitions won't begin for a while. "In the near term, the consolidation phase is on hold," says Morningstar (MORN) senior analyst Eric Landry. "[Homebuilders'] big motivation is land, and right now they've all got too much, in spades."

Some top players say they're not ready to start buying. During the D. R. Horton conference call with investors on Jan. 23, analyst Stephen Kim of Citigroup (C) asked whether the company was thinking about stepping up its acquisitions, as it has done in past downturns. "The only reason we would want to do that is if we felt like we needed to add to our current land and lot inventor, which at this stage of the game we absolutely do not," said Dan Tomnitz, chief executive at the company. "Our land and lot position is more than adequate today, and that would take away any reason for us to do an acquisition on that front."

Builder inventory, though down from its October, 2006, peak, is still at historic highs. UBS Investment Research (UBS) analyst Margaret Whelan estimates that an inventory overhang of approximately 900,000 homes remains, with relative land positions of 8.8 years, calculated in terms of years of supply.

"This is driving builders to scrutinize their land assets, and many are walking away from optioned lots with the assumption that returns on land purchased later in the cycle will be higher," Whelan wrote in a January research report. The analyst expects average earnings-per-share in the homebuilder sector to decline 51% in 2007 after a 31% decrease in 2006.

When the housing market perks up, and builders become comfortable with their land positions, acquisitions could become common again. But don't bet on this happening until at least the second half of this year, Landry says. "People want to see stabilization first."

Alternative Incentives

What kinds of deals are likely to make sense? Homebuilders may look to build market share, increase their scale, or diversify geographically. Builders may also want to acquire a company with a distinctive business model, as Bloomfield Hills (Mich.)-based Pulte Homes did when it bought retirement-community specialist Del Webb in 2001. Toll Brothers, based in Horsham, Pa., may be a likely candidate in the near future because of its focus on luxury home building, says one research analyst.

It may also make sense for two second-tier players to join forces. By combining companies with revenues in the $5 billion to $9 billion range, they could move up into the top tier. "A pair of second-tier companies might want to join together to be able to borrow at more reasonable interest rates and have more purchasing power," says Todd Smith, an analyst at Standard & Poor's, which, like BusinessWeek, is a unit of the McGraw-Hill Cos. (MHP).

While private equity firms have been eyeing downtrodden homebuilders, a successful leveraged buyout may be difficult to pull off. Because land doesn't produce steady income the way a retailer or steel producer does, it's tough to take on debt that requires regular interest payments. "You are going to see some private equity buying, but to leverage land up to the point of an LBO is an extremely dangerous proposition," says Stevenson of Morgan Stanley.

In addition, private equity usually looks out for beat-up companies with fixable problems. But builders' current troubles seem to stem from the business cycle—not the business models. "There's nothing really broken, it's an efficient industry," Stevenson says.

Power Shift

Some signs of a brighter future for homebuilders have begun to materialize. The National Association of Home Builders/Wells Fargo housing market index increased to 35 in January from 33 in December, its highest level since July, 2006. On Jan. 23, Goldman Sachs (GS) upgraded its opinion on the homebuilder sector to neutral from sell, citing a possible deceleration in the housing market's rate of decline (see BusinessWeek.com, 1/23/06, "A Fresh Boost for Homebuilders").

The housing sector, already reeling from the downturn, may be headed for more change. Traditionally, the homebuilder industry was dominated by small, private, family-owned companies. During the past 15 years, it has been gradually shifting to a market of publicly owned firms. Now, the industry may be headed into a new phase of consolidation, where the fragmented sector sees a wave of consolidation that puts power into the hands of relatively few. "Even in good times there always were acquisitions," says Gopal Ahluwalia, head of research at NAHB. "In the long run, there will always be more."

Roney is Real Estate writer for BusinessWeek.com.