Quiet GIANTS

Sometimes, it's hard to see anything beyond the Big Five at the top of the GIANT 400 rankings unveiled each spring. (Of course, drawing attention to themselves is an important part of the public builders' growth strategies.) But this year, note the progress the top four private home builders are making. Quietly, these companies are growing to proportions never before achieved without Wall Street's help. And that growth has important implications for all production builders aspiring to greatness.

The numbers the Big Five publicly traded behemoths rack up seem to defy reason: Pulte Homes and D.R. Horton exceeded $7 billion in housing revenue and 30,000 homes closed in 2002 to top the 2003 list, and Lennar Corp., Centex Corp. and KB Home were close behind. All of them now operate nationally, and the race is certainly on to hit 50,000 closings and double-digit billions of dollars in home building revenue.

But if you think you need to be public to join the billion-dollar club, think again. Shea Homes, the largest private home builder in history, broke that barrier in 1998 and topped $2.3 billion in housing revenue last year, on more than 5,800 closings. Where that will land Shea in the rankings this April is still anybody's guess, but last year the firm checked in at No. 13, ahead of public companies including Weyerhaeuser Real Estate Co., Technical Olympic USA Inc. and Meritage Corp.

Shea Homes doubles the size of the other private builders in last year's top 25: No. 20 David Weekley Homes, No. 21 The Drees Co. and No. 25 Kimball Hill Homes. But this year or next, all of those firms likely will top $1 billion in housing revenue, which might force us to re-evaluate whether there's a limit to how big a private builder can grow.

Five years ago, Weekley was No. 22 with $608 million in home building revenue, Kimball Hill was No. 30 with $408.4 million, and Drees was No. 38 with $347.9 million. So the growth of these firms is better characterized as steady rather than flashy.

It's important to note that Drees operates on a fiscal year ending March 31, so when the GIANT 400 appears each April, Drees always is ranked on year-old data. For instance, the 2004 rankings will not reflect the acquisition of Ausherman Homes, the Frederick, Md., builder that ranked No. 261 last year on $63.5 million in revenue. The deal closed in June, and Ausherman had added $80 million to Drees' coffers by mid-January 2004 that won't show up in the GIANTS rankings until April 2005.

To ask them the many questions these prodigious private companies bring to mind, we tracked down the leaders of these four titans at the recent International Builders' Show in Las Vegas. We found Shea CEO Bert Selva, Weekley chairman David Weekley, Kimball Hill chairman David K. Hill and Drees president David Drees in the company of many public builders at a meeting of the NAHB's high-production home builders council. Here's some of what they had to say:

Bert Selva: There are so many, but one of the most important is that we can take much longer land positions in markets where land is appreciating rapidly. In some of our markets, we're seeing 20% to 25% annual appreciation of land values. The public builders have to limit the land they carry on their balance sheets. They are also much more concerned about top-line unit growth, while we focus on revenue growth, profit and returns, which makes a lot more sense. This past year, we're up 8% in units, 25% in revenue and 65% in profit. A lot of that is location-driven growth in prices. We made some great land buys.

If you're public, long-term land plays are viewed negatively, and analysts don't like spec building. In hot markets, buyers want inventory right now. If we don't have it, we miss out on the price appreciation that occurs between the sale and the closing, while the house is being built. A lot of money is left on the table when you sell way out in front of delivery.

David Hill: All of the big home builders are major landholders. But we have a lot more flexibility in how we put deals together. The publics have an extra cost of carry to keep land off their books. And right now, we're actually operating at a lower cost of capital than the public companies. We've had that for about 15 months. It's abnormal, but in a low-inflation environment, we can be at push or even a little better than them.

We are becoming increasingly less dependent on developers to roll lots to us. We're extending our development capabilities and entering joint-venture relationships with other large private builders and with strategic alliance partners to take advantage of opportunities we might otherwise miss.

David Weekley: I want to control my own destiny. Most builders who go public or sell to a public company do it to create a liquidity event - for themselves and their families. We've found ways, through our partnership structure, to address liquidity without creating a special event. We have regular distributions while continuing to grow the company.

And we can make long-term decisions without worrying about the impact on quarterly earnings. I can make a decision that may not pay off for five years without worrying about a thousand shareholders threatening me. But there's a downside to the freedom we have: That swim-or-die pressure the publics are under creates a sense of urgency in those companies to drive earnings right now. There's an energy that goes with that, and we don't get it.

David Drees: The public builders are able to grow faster than us, but I don't think there's any limit to the size we can eventually become. We have the capital structure to meet our needs. And how fast is too fast? The reason large private builders sell to publics has a lot more to do with exit strategies for the owners than it does with any inability to compete with the publics. The efficiencies the public builders achieve come from being big more than from being public. And there's a hefty cost associated with operating as a public company.

Selva: I've seen that estimated at $5 million a year when you add up all the filings and additional audits that are required. There's a whole level of administration that they have.

Drees: The bigger you are, the more muscle you have in purchasing. We have some national contracts, but let's face it, we're nowhere near the size of Pulte, Horton or Lennar, so they've got an advantage. But does it offset what we gain by being more flexible on land? I don't think so.

Hill: You can quantify this. We're getting about $550 a house in cost savings from our national purchasing contracts, and we've only been at it for a year and a half. Shame on Pulte if they're not getting $2,200 a house. We figure we can get to $1,000 to $1,200 a house easily when we get to annual production of 5,000 houses a year.

Weekley: We've had a national purchasing program for five years now. We made some serious gains in the first few years, to maybe $1,200 a house. Then we thought we might be at the end of the curve, until we brought in a real purchasing professional from another industry. He's been able to double that savings.

Selva: I'd rather buy the land right and make 3% to 5% better margins on the land than have the advantages the publics realize in national purchasing.

Hill: Companies that are at $500 million in annual revenue and above can bring into play a host of modern management and information technology methods. They have good capital structures and a good reputation that helps attract management talent. We lose a little to the largest publics on national purchasing contracts but not enough to offset the flexibility we have [on land issues] and the time we save to work on our businesses, while the publics have to fly to New York all the time to meet with stock analysts. This is now an industry of big builders and small builders, not public and private.

Selva: We've done acquisitions. [The deal for Mission Viejo in the late 1990s nearly doubled Shea's size.] But we like organic growth better. Internal growth provides better returns. If you're public, it makes more sense to do acquisitions, but integrating an acquisition into a company is never easy.

Drees: We've been growing primarily by acquisition, usually cash deals. We've found we can achieve profitability much faster with a good acquisition. Our deals have been of two types: one, established companies in the move-up sector of our existing markets, where we are looking for good cultural matches to move people right into our organization. The Ausherman deal last year in the Washington, D.C., market was one of those. And two, deals where the sole reason is to create an entry vehicle into a new market, where we get land, trade relationships and cash flow to use as a platform to entry. Both the Austin and Raleigh entries were like that.

Weekley: We're doing acquisitions, but they are small and opportunistic, not a central part of our growth strategy, which is much more tied to expansion of our product lines. We've added Imagination Homes by David Weekley, which has an average sale price of $140,000 compared to $300,000 in our existing David Weekley move-up product.

This is a whole new operating methodology for us, limiting choice to deliver value. We've always allowed buyers to customize in our move-up product. In Imagination, we don't. Where our move-up product emphasizes high design, choice and service, Imagination emphasizes design, value and service. Imagination will pick up a portion of the market we never touched before, with entry buyers dominating. We think it will allow us to double our business in the next several years.

Hill: We have always been a developer in Chicago, but we're now building up our capacity to do development everywhere we build. We're developing major planned communities - not master-planned communities, which I categorize as those over 1,500 acres. We now have 29 large land deals on our books, ranging from 300 lots to 2,500 lots. Our strategy is based on selling a good portion of the lots we develop to other builders.

In one deal in Dallas, we're building on a third of the lots and selling a third each to Drees and Weekley. We are building up our development teams all across the country. Within four years, we want to be selling about a quarter of the lots we produce. Land is in such short supply, we want to be able to buy raw land and entitle it, then serve our fellow builders with developed lots, the publics as well as the privates.

The biggest story today is not what's good or bad between public and private, but how can private and public builders work together to overcome the limits of each. We're already selling lots to Ryland, Hovnanian and Horton as well as Weekley and Drees. You'll see more of those collaborations in the future. We can go after larger projects knowing that if we need more velocity, the public builders can give it to us.

Weekley: Land is a big challenge for us. Historically, we've always been an option lot buyer. But now we've had to go into developing land. There's no other way for us to get what we need. We founded a separate land development company, Priority Development, capitalized separately, so our mother ship is not at risk. We have 5,000 lots under development.

It's operating in half our markets now and will be in all of them once we find the right land positions. What we came to realize is that we were already in the land development business since we owned so many lots that we had to take down to meet our contract obligations, but we owned them at retail rather than wholesale, which makes no sense at all.

Since it's our money on the line, not the public's, we may not be as aggressive as a public company would be with many of these land deals. We may be a little too focused on risk.

Selva: We are very much focusing on master-planned community development. As part of the Mission Viejo acquisition, we now have Highlands Ranch in Denver, which is 15,000 lots. In 1999, we purchased a property in Gilbert, Arizona, where we are now developing Seville, which is 3,000 lots. We also have Vistancia, in Peoria, Arizona, which will have 13,000 lots. These are long-term land plays, which is what makes us different from most private builders as well as the publics. We have another MPC in Denver called Reunion, near Denver International Airport, where we'll have 12,000 home sites.

We'll develop these properties as both a builder and as a land seller. We'll feed lots to the public builders, fitting the velocity of lot sales to local demand and to our own needs as a builder. We never want to build on all the lots ourselves. Remember, a lot of this land we control without owning. We carry it where it makes sense or control it with options if that makes better sense. Developing and building are two different businesses. We know both.

Drees: We don't have a land development division in Texas. If we can buy lots from developers, with minimal risk, that's our preference. But we develop everywhere else that we build. In Cincinnati and Washington, D.C., we develop land to get the positions we need. In Cincinnati, we have a 3.8-year supply of lots in front of us. In D.C., it's 6.4 years. But that's deceiving because we have one project, Glenkirk, that's 250 acres and 700 lots, and we only build 215 homes a year in that market. That's the only project where we're selling lots to other builders. We anticipate selling half of those lots to other builders.

In Dallas, the market has been strong enough that we've had to form some joint ventures with other builders and developers where we invest equity and participate in the profits but don't do any actual development work ourselves. We've not yet decided if we need our own land development division there. The way we do land is as a separate division, within The Drees Company, but organized as an individual profit center.

When we look at these companies, individually and collectively, we see Shea as a clear-cut leader, with the others changing their operations to evolve along the lines Shea is pioneering. The full Shea model is a multidisciplined land developer and builder capable of forming strategic alliances with many types of companies - including public home builders.

Shea is something of an alter ego to the publics, gladly performing for them those functions that Wall Street dictates the public builders should not perform themselves. Kimball Hill embraces the Shea model enthusiastically, Drees reluctantly, and Weekley is being dragged toward it by the cruel forces of economic necessity.

What all of these large private builders are beginning to see is that everywhere the big public builders go, there's a niche for a big private. And there's more money to be made as an alter ego to the publics than by going it alone.