2006: A Reflection on the Top 25 U.S. Home Builders

Sidebars:
CEO Stuart Miller's Instant Response Leads Lennar to No. 1
Big and Bright
Hot Markets in Short Supply

The perception we have of 2006 as a bad year — especially for all those big production home builders now fighting excess inventories, cancelled sales and balky buyers in 2007 — doesn't stand up to close scrutiny of the actual year-end numbers reported by the Top 25 Housing Giants. For example, the average gross profit margin reported by the Top 25 in Professional Builder's Giant 400 survey was 23.32 percent for 2006. While that's down more than four full percentage points from the previous year, it's still a full point better than 2002, which was regarded — at the time — as a very good year for housing.

Of course, most of those margin points were racked up in the first half of 2006, when builders were still sucking the froth left over from 2005 pricing power. The trend line headed straight downhill in most markets during the second half of the year. Still, when the smoke clears at the end of this decade, we may see 2003 to 2006 as the anomaly and 2007 as a painful year of correction for the excesses of the Roaring 2000s in the middle. The trouble with those go-go years — when housing investors drove up prices to unsustainable levels in many markets — is that much of the home building industry believed they were looking at reality when what they really saw was a mirage.

If 2003-2005 turns out to be an aberration, future Top 25 home building might look a lot like 2002, which really wasn't a bad year for housing.

With prices retreating, investors gone and demand setting to a lower baseline, the largest home builders may have no choice but to shrink in size.

2006 seemed like a bad year for big builders mostly because the trend line tilted in the wrong direction -- but it might turn out to be just correction to sustainable levels of production.

Those prices weren't real, and neither were the growth rates and margins of the largest builders, both public and private. And it wasn't just builders who got hooked on that mirage. Trades, product manufacturers and land sellers all benefited from the housing price run-ups, and they will balk at giving back their gains every bit as much as builders and their shareholders. But that's what the market seems to be saying has to happen. Check out the charts and graphs on these pages, showing Top 25 closings, revenues, market share and gross margins. We're showing five years of data because we think the numbers from 2002 may be in the general vicinity of where we're heading. But builders will have to get their costs back down to find margins at lower prices.

Smaller Companies?

Wall Street housing stock analyst Ivy Zelman of Credit Suisse says No. 1 ranked giant Lennar Corp. and No. 7 NVR are doing the best jobs of managing their way through the current housing slowdown that began in 2006, but she believes all of the public companies will have to shrink to survive. "Lennar is slashing and burning inventories to keep utilizations up," Zelman says. "That's what they need to do: stay balance sheet focused. And NVR is set up to survive cycles. They don't have any land and their machine is the most efficient. They have the highest quality of operations. Land is not wine," says Zelman. "It does not get better with age."

She believes the majority of public builders will be losing money by the end of this year. "They have to shrink. If they did 40,000 closings last year, you can bet they'll be shooting for 20,000 to 25,000 this year. They will close some divisions, consolidate others and reduce head counts drastically. (Florida-based public Giant Technical Olympic USA just sold its Newmark Homes division in Dallas/Ft. Worth to Arlington, Texas-based private builder Steve Wall. See page 42.) They're going to have to be very aggressive on reducing their footprints. The top builder in the Giant 400 next year will have a lot fewer closings. It could be half.

"This is all about price," Zelman reasons. "If prices stabilize, we could see traffic pick up. But we think prices have to correct another 10 percent before that happens. There's still room for more correction before they get to the level of affordability that will move the market.

"The public builders are in more trouble than the private Giants," Zelman says, "because they have more land. At this point, I don't think any of the public builders will go down, but it depends on what they do now. If they shrink, they can survive."

In the 2002 Giant 400, Lennar was No. 1 with 23,899 closings for $5.47 billion in 2001 revenues, less than half of Lennar's size today in both closings and revenues. Is that where we're headed?

"There's no easy answer," says San Francisco-based housing stock analyst Carl Reichardt of Wachovia Securities. "What's the price needed to normalize the sales rate in the builder's communities? It's now clear that price is below cost, but a lot of builders have been slow to accept that fact. Prices are still too high relative to income levels.

"I'm not sure any of the public builders have managed their way through this slowdown very well," Reichardt says. "But at least Lennar was aggressive. [D.R.] Horton is great at fixed-cost control and field-cost control, but they gave away those advantages because they are so heavy on land. Most of the public builders reacted too much on the front end of the factory, cancelling land buys and stopping spec starts. The real problem is finished goods and near-finished goods inventories. Those have to be liquidated. They have to get out of the old communities with parabolic pricing curves. They need to open new stores that are not damaged by price falls, where the price and the product meet the demand that's out there in this new, emerging market."

Reichardt does not think any of the public builders will go down because they all entered this downturn with such strong balance sheets. "And if they all emerge wounded, but not dead — they will all be bidding for land against each other when the market comes back. No wonder land sellers are not dropping prices. The classic opportunity for buying land at the bottom of the cycle may not show up."

He thinks the current downturn may last another two years. "In the mid-1960s, we had a housing downturn without a recession. We had a couple of down years where the market compressed by 30 percent, then it flattened out for four years. That may be where we're headed."

On shrinking companies, Reichardt says it's certainly an option: "That's what MDC did in 1987. MDC might fold its tent today and go into a cave somewhere. Many shareholders would not be upset with that strategy. Liquidate as many assets as possible, accumulate a lot of cash and sit on it until the time is right to invest again. You don't keep your people, but who's hiring now? It is an option."

Another Wall Street insider who asked for anonymity said, "A lot of these companies are now selling a half a house a week at many of their subdivisions, when they need two or three a week to sustain the project. These guys need to keep their sales strong to burn through all this inventory. A 10 percent gross margin on a house sold today is better than a 5 percent gross next month. They should be cutting prices to whatever level is necessary to sell houses. At least that way, they'd find the right price and be able to work on costs to find some margin points."

Texas-based builder David Weekley's firm made the biggest jump in this year's Top 25, from No. 27 to No. 21: "The public builders went on a growth binge the last five years because they could, and Wall Street rewarded them for it," Weekley says. "This is the first time in 13 years that it's OK for the public builders to not grow. Their emphasis now is on profitability, but the pricing power is gone from virtually all their markets, even the ones where houses are still selling. As profits sink on the coasts, I think you'll see margins increase in Texas. The public builders now need to make money there; they won't be selling Texas houses at break-even anymore just to build up their volume."

Of course, that assumes the Texas market will stay strong, and even that's no sure thing.

CEO Stuart Miller's Instant Response Leads Lennar to No. 1

Stuart Miller admits now that Lennar's move in 2005 to even-flow production provided an early warning of an emerging crisis in inventory levels early in 2006. "The decision to restructure to an even-flow production model was intended to help us hit our scheduled closing dates," Miller says now, "but it did give us something of an early warning system. We saw the market expectation for pricing coming down and inventories beginning to build up as a result." Miller's quick response to those early signals led Miami-based Lennar to No. 1 in our Top 25 rankings.

Lennar advanced to just shy of $14.86 billion in 2006 revenues, up 16.9 percent from the previous year. Closings were up 17 percent, to 49,568. As a result, Lennar leapfrogged from No. 3, over previous No. 1 Pulte and No. 2 D.R. Horton, to claim the top spot for the first time since 2002. Horton had $14.52 billion in revenue to stay at No. 2. But Pulte slid to No .3 after dropping 2.6 percent in revenue, to $13.98 billion.

Our take on this remarkable shuffling of the deck at the top (where moving up even one position is big news) is that Lennar saw excess inventories sooner than competitors last year and moved faster with incentives and price cuts. That allowed the Miami firm to hold orders and closings at higher levels longer than any other Top 25 builder. It was an impressive performance in the most trying market conditions in 13 years. But Miller claims no triumph.

"I'm not anxious to be No. 1," he says. "It's not a focus for us. There was no strategy to go from No. 3 to No. 1. As the year went along, and no rebound appeared, the whole industry began to focus on strength of balance sheets, which is always our focus. We managed to the current condition, which we saw as deteriorated. From very early in the year, we focused on tightly managing our inventory and keeping our balance sheet in good shape for whatever way the market moved."

The strength of the Texas market helped, Miller says, and shows the wisdom of geographic diversity. "Texas and the Carolinas softened the blow," he asserts, "and the lower margins in Texas that we used to complain about are now higher than our margins in both California and Florida."

He won't play the game of blaming investors for the price run-ups that triggered trouble in California and Florida. "As demand strengthens and land supplies tighten, it's a natural thing in a free market for investors to find their way in," Miller says. "We'll see it again. I don't think we have the ability to keep them out. And remember, new homes are only one-seventh of the residential marketplace. It's really existing homes that drive pricing."

Lennar managers in every division meet each morning to discuss sales, starts, closings, inventory levels and asset base. "Those meetings are mirrored every evening at 5 p.m. Eastern time when the executive leadership of the company gets together on a conference call to go over the same things," Miller says.

Miller's dedication to managing in the moment stems from a belief that it's impossible to time stages in the housing cycle. "I'm an agnostic toward thinking about where things are going short-term. When does market psychology move from fence-sitting to buying? When do people move from saving psychology to spending? Nobody ever gets that right, so we'll just stay tied to the present and try to react fast."

Lennar certainly did it in 2006.

Big and Bright

Last year, we led off our Top 25 Giants Report by noting that Texas-based David Weekley Homes dropped out of that elite group despite closing over 600 more homes in 2005 than the previous year. We opined Weekley's biggest problem was that it built mostly in Texas, rather than California or Florida, where runaway prices produced gargantuan revenue gains for others. What a difference a year makes: Weekley made the biggest jump in the Top 25 this year, from No. 27 to 21, because it builds mostly in Texas.

The Lone Star State was a rare exception to the contraction that took hold of most U.S. housing markets in 2006, particularly in Florida and California, as consumers rebelled against double-digit price increases the previous three years (driven at least in part by speculative investor buyers).

"We look good this year mostly because 72 percent of our closings were in Texas," Chairman David Weekley acknowledges. The firm boosted 2006 closings 16.2 percent to 5,360, while revenues increased 21.3 percent to $1.54 billion. Still, Weekley points out, Texas' always-skinny margins got even thinner in 2006 as private builders had to match price cuts with public companies trying to maintain velocity in Texas to offset declines on both coasts.

Weekley builds in Florida, Colorado, Georgia and North Carolina and has just entered Arizona and South Carolina, but the bulk of its growth in 2006 came from product (rather than geographic) diversification. Several years ago, Weekley began selling Imagination Collection homes priced well below the firm's usual move-up product. "Those homes are now more than 30 percent of our sales," Weekley says, "and building Imagination helped us lower our costs on our move-up homes as well."

The firm uses a project manager form of organization by breaking up a big company into many very small profit centers where all sales, construction and warranty personnel report to a project manager. That person has full profit-and-loss responsibility for four to six communities, several of which may be Imagination Collection product.

Culture Advantage?

Weekley believes PM organization and his unusual corporate culture help him attract and retain people, especially when times are tough. "Because sales, construction and warranty all report to the same manager, they work as teams," Weekley says. "There's no finger-pointing when things go wrong, and the buck stops much closer to the customer. Team members all know the P&L impact if we have to discount houses to sell them. They all either make profit-sharing — or don't — together.

"Our corporate culture, which emphasizes career path development and maintaining a good place to work — no matter what the market is like — helps us more in tough times than good," Weekley asserts. "We don't shoot managers for market-related issues out of their control. It's a tough time out there right now, lots of layoffs and fear. And our business is dominated by tough, belligerent, top-down management styles. Our people are under stress, too — but we don't beat them up. We pick up a lot of good people in times like these — not the ones other builders let go, but the ones they try to keep. But the mass layoffs scare them, and they think there has to be a better way to run a company."

Weekley says his firm may drop 15 percent in revenue in 2007, but he expects to climb again in the rankings next year — perhaps as high as No. 17.

Hot Markets in Short Supply

Geographic diversity works as an antidote to isolated bad markets, and it even helped mitigate the widespread doldrums of 2006 for some builders, as long as Texas, North Carolina and a few other markets stayed toasty. But today, even the largest, multi-market public builders are running out of hot spots.

The largest builders are heavily concentrated in the Sun Belt's big three housing states: Florida, California and Texas. The Top 25 builders had 56.6 percent of their 2006 closings in those three states. Add Arizona and the concentration reaches nearly 70 percent of Top 25 closings. You can bet that the 17 Top 25 builders with operations in Texas were mighty glad they had those divisions up and running in 2006.

No wonder Houston-based Giant David Weekley Homes made the largest upward move among the Top 25 (six positions to No. 21). Weekley is heavily concentrated in its home state, with 72 percent of its closings from Texas — and also has operations in North Carolina. Eleven of the Top 25 build in North Carolina, and 10 of those are in Texas as well.

Still, no other states match Florida and California for concentrations of Top 25 builders: 20 of them are operating in Florida, 19 in California. No surprise, then, that when those two states catch a market malady, almost everybody gets sick. "Our goal in Florida this year is to break even," says David Weekley. "We've got a shot at it after taking some write-downs last year in Fort Myers and Palm Coast. That market may be a little different when it comes back. Florida's growth was based on being a low-cost retirement destination for more than 20 years. That changed about five years ago, but nobody noticed because of all the investors. I think markets like Tampa and Orlando that are job-driven may come back before those that depend on second home and retiree buyers."

Orlando-based economist Hank Fishkind seemed to see it the same way when he spoke at a recent meeting of Sarasota and Manatee County HBAs. He said the bottom of Florida's housing cycle passed in late 2006, but recovery will be slow, drawn out and variable — with Orlando strongest and Fort Myers and Miami markets the weakest. "The single-family market is finally stabilizing," Fishkind said, "but the condo market is in serious trouble in many areas."

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