MergerTalk: Homebuilders may hammer deals together

By Julie MacIntosh

NEW YORK, May 20 (Reuters) - Merger activity in the fragmented U.S. home building business could pick up this year as higher stock prices, strong balance sheets and an expected drop in housing starts prompt an upswing in new deals.
Sky-high housing demand has spurred such robust growth in the past year that builders have had little need for M&A to add scale.

But a handful of them have tossed merger scenarios back and forth in recent months, although those talks have quieted somewhat because of the stock market's volatility, said one investment banking source who requested anonymity.

Residential construction has enjoyed massive growth in recent years on the back of the low interest rates that have helped make mortgages more affordable.

Pulte Homes Inc. (PHM) , D.R. Horton Inc. (DHI) , Lennar Corp. (LEN) and Centex Corp. (CTX) -- some of the largest builders -- have boosted their financial outlooks and posted record- or near-record backlogs of home orders in recent quarters.

But interest rates are edging upward, and national housing starts are expected to dip in 2004 after falling in three of the first four months of the year.

Much of the construction industry's low-hanging fruit -- the higher-quality, privately run companies -- has already been snagged by rivals prowling for market share.

That leaves the publicly traded companies to combine with each other. Their stocks have enjoyed heavy gains, but some analysts still consider them undervalued.

TWO KINDS OF SCALE

UBS investment bankers Bob Crowley and Adam Reeder said they expect a significant increase in acquisition activity over the next 12 to 18 months as the larger homebuilders look to expand their geographies and product lines, strengthen their existing market positions, and build the scale they need to generate cost savings.

A handful of top-tier homebuilders could end up with as much as 40 percent to 50 percent of the U.S. market over the next decade, up from 20 percent currently, Crowley and Reeder estimated.

The growing dominance of the biggest players has sparked a rally in their share prices and boosted their financial positions to the point where they can be aggressive with acquisitions if they choose, industry sources said.

Companies are likely to make acquisitions for one of two reasons -- to enter new markets or to add more types of customers in existing ones.

For example, a builder like Toll Brothers Inc. (TOL) or Hovnanian Enterprises Inc. (HOV) , with a solid presence in the luxury market, might acquire a company that specializes in lower-cost housing.

And a company like Los Angeles-based KB Home (KBH) , which has a strong presence in the western United States, could make a move to buy builders in other regions.

MEASURED BENEFITS

Building national scale isn't as lucrative in the construction market as it is in some other industries because homebuilders are heavily exposed to regional suppliers and economies.

Too much size can be a curse. During an expansion a decade ago, some of the top builders squandered their local connections and antagonized consumers who saw their operations as increasingly unwieldy.

Quite often, a builder with a big share of even a small geographic area generates higher margins and returns than one with small market share spread over a large area, the UBS bankers said.

But large national builders also can perform on a more consistent basis.

"You have land positions all around the country that you can draw upon," another investment banker said, "and you have different market conditions in different parts of the country at different points in time" to help spread risk.

U.S. homebuilders have largely taken a "wait-and-see" attitude in recent years. But competition among the leaders is cutthroat, and their attitudes could shift quickly if even one major deal comes to market and is well-received, several investment bankers said.

Economists expect the Federal Reserve to raise interest rates this summer. This could depress homebuilding stocks and dampen growth in the cyclical home construction market, prompting companies to seek strength by joining forces.

Legg Mason analyst David Weaver said in a recent research note that while he is confident that the housing market is not facing a collapse in units or prices, the wind at the backs of builders in the form of low interest rates might subside.

A.G. Edwards analyst Greg Gieber recently forecast that new home sales would slide 3 percent this year and drop another 4 percent next year.

"To create growth going forward in this less favorable environment," Gieber said, "builders will have to have a strategy that will win them better market penetration and market share gains."

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