Pulte-Centex: A House Built on Sand?

soldPulte’s agreement to buy Centex for $1.4 billion means, in the words of the Wall Street Journal, that Pulte “succeeded in its quest to become the largest home builder in the U.S.,” but Pulte’s may be a Pyrrhic victory. The acquisition shows many of the characteristics of the classic mistake we identified in our book as “Doubling Down on a Bad Hand.”

While the decline in the U.S. housing market is slowing, and a rebound may even be beginning, the problems in the sector are so profound that it will take many years to work through them. Any company that decides it wants a much bigger presence in the housing market needs to have a very strong rationale.

So, what does Pulte offer?

Mainly, it says the additional size will let it build a national brand. But building a brand is a tricky thing, and housing doesn’t seem to lend itself to brand development. Brands are often built by advertising, but the depths of the housing downturn will put such pressure on margins that little money will be available for years. In addition, the market will be hard to target. People considering building a home tend to rely on word of mouth; there’s no trade publication that they consult, and trying to reach them through mass media would mean paying high rates to reach an awful lot of people who aren’t in the market for a home builder. Brands can also be built through repeated experiences, but home-building tends to be a one-off for people; at most, someone might build two or three homes in a lifetime. Pulte may have more luck with big developers, whom it could reach through marketing, but developers tend to have long-established relationships with builders that will be hard to change.

It’s worth looking at the experience of Macy’s, whose industry lends itself to brand building and which decided to buy a series of retailers as a way of increasing its presence and developing a national brand. After struggling for years, Macy’s has now decided it can’t build a truly national brand. It’s going to leave many more decisions about merchandising to local managers.

Pulte also says its newfound size will let it save on costs, but such attempts often fail. While there may be some back-office efficiencies, Pulte already has enough size that it gets big volume discounts from suppliers. How much can it really drive down the price of lumber? The market is so fragmented that Pulte’s newfound size just means it will be “one of the leading builders in half of the nation’s top 50 markets”–“one of” and “half of the. . . markets” not being phrases often associated with Walmart-like pricing power. While we’re having trouble finding figures at the moment on what Pulte’s share of the total home building market will be, let’s say they’ll be going from 5% to 8%. How much extra pricing power does that really give the company?

The potential problem shows up in the experience of Oshkosh Truck, which bought JLG, another heavy-equipment maker, three years ago for $3 billion. Much of the rationale was that Oshkosh would double the amount of steel it purchased each year and would drive down prices. But, even doubled in size, Oshkosh had so little share of the steel market that no material savings occurred. Oshkosh’s total market cap is less than $2 billion at the moment, even though the stock price has tripled in recent months because of businesses that have nothing to do with the JLG acquisition.

Pulte likely was driven by the thought that it could get Centex for a bargain price. At its peak, Centex was generating more than $8 billion a year in revenue and was a major force in the industry. Isn’t it worth $1.4 billion to buy a business with that kind of potential? Isn’t there enough margin of safety built into such a low price?

Maybe not. Centex’s revenue fell by half to less than $4 billion in fiscal 2009, which ended March 31, and revenue fell 50% again in the first quarter of fiscal 2010. Centex’s recent losses have more than wiped out its earnings during the boom years. Where does it end?

Like many companies, Bank of America¬†focused on long-coveted assets when it agreed to buy Merrill Lynch last fall and assumed that Merrill’s businesses wouldn’t deteriorate too much further.In the process, BofA grossly underestimated the problems it was¬†acquiring along with those assets. Pulte seems to be making the same mistake.

Looking at Pulte’s market cap of some $3.3 billion might suggest that investors are optimistic about the company’s prospect. But realize that, following the acquisition, Pulte has $3.4 billion of cash on hand. Investors are saying they’d pay you $100 million if you’ll take the company off their hands.