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MEMORANDUM

To:

Supervisor of Southern California homebuilding firm

From:

TEAM #2- “UNCRUSTABLE CONSULTING” Diane Cabo, Zach Dostart, Steven Genson and Michael Kittle

Date:

October 18, 2005

Re:

Per your request, attached please find a report on the Southern California SINGLE FAMILY homebuilding industry. All cited sources are referenced in the endnotes in the report.

I.

A. Industry Definition and Overview

When analyzing the Southern California Single-Family Homebuilding Industry it is extremely important to analyze why this industry is so appealing. After all, the purchase of a home is typically the single biggest investment an individual makes in a lifetime, and Southern California provides an especially appealing locale to single-family homebuyers. New construction of single-family residences in Southern California’s Inland Empire is slated to remain the strongest of all the regions in California, making this a very appealing place for homebuilders to invest their resources.i The “booming” homebuilding market and increase in demand by homebuyers in that area makes Southern California the second largest place in the country besides Florida for homebuilding activity.ii Homebuilders are extremely concerned about location and that is what distinguishes DR Horton and KB Homes from other homebuilders of single-family residences in Southern California. These two homebuilding companies are poised to take advantage of this market plagued by high demand that exceeds supply with their significant presence in the Southern California market. Homebuilding is essentially a local business, but there can be common elements that can transfer over to homes in other regions, and every location is different and poses a different degree of risk to the homebuilder. iii Residential Single-Family Homebuilding Process When a homebuilder is identifying where to make new homes, there are many considerations, both physical and economic. First, the homebuilder must determine the geographic region that it wants to build, based on economic factors in that region. Then the builder acquires raw lots of land that are developable, and in most cases, will not buy land that accommodates more than 50 houses for a community. The land is either acquired directly from the landowner, through an auction which uses the bidding process, or most the time acquired by using option contracts, which provides financial flexibility to the homebuilder. Once land is obtained, it is necessary for the builder to acquire permits, land and site planning, procurement of environmental and regulatory approvals, and then construction of water, sewage, and electrical lines. The design of the homes is the next process and that is later followed by the construction process. The goal of every homebuilder is to erect durable and also highly attractive homes that will appeal to the market. The construction is done in phases with blocks of homes, so that there is more financial flexibility when dealing with inventory. Most builders like to get a certain number of contracts signed before starting a phase. The financial strength of a large homebuilder affords it the option to be more flexible with stages of building homes and also with its buyers. Economic Conditions of the Industry Homebuilding in general is a very cyclical industry, and for single-homebuilders it is greatly affected by economic trends and the industry’s outlook. Given the cyclical nature and also the length of years from land purchase to home sales in that industry, it is necessary to analyze long-term economic trends

that will affect demand for homes. There is a correlation among the three economic variables. These variables are long-term interest rates, job growth and consumer confidence that affects the demand for single-family homebuilding. Rising interest rates are correlated to periods of increased job growth and growth in consumer confidence and vice versa. In conjunction with these factors, there are other economic characteristics that affect the individual builder and their geographic area. The strength of the economy is a major factor in stimulating demand for single-family housing. The accommodating mortgage rates in the present are attractive to many buyers and it is predicted that the mortgage rates are only going to move moderately higher in the next few years. In the short-term this rush to buy into the market before mortgage rates increase will lead to some near-term growth, but overall the nation-wide industry of homebuilding is growing at an annual rate of 6.5%.iv In addition to mortgage rates, interest rates are the most significant factor affecting demand in the single-family housing market. In the past few years, interest rates have been low and a source of strength to homebuilder’s and also has pushed up home ownership in the US to 69%. Low interest rates make home purchases more attractive to buyers. It usually takes six to 12 months before a change in interest rates affect the homebuilder’s bottom line. Another major factor contributing to the sales of single-family homes is the revival of the labor markets and stronger incomes for homebuyers. Labor markets from August 2003 to June 2005 have rebounded with net payrolls increasing by 3.7 Million in the last 22 months.v Through 2008, there is supposed to be an increase in job creation leading to greater financial security for individuals so they can now afford a home. Lastly, another economic factor affecting the demand for single-family homes is the revival of consumer confidence. In conjunction with rising confidence, is the emergence of the baby boomer (born between 1946 and 1964) generation that is now purchasing first homes. Individuals buy more homes when they have a more positive consumer attitude. vi The baby boomer generation bought into the market in the 1970’s and 1980’s and purchased entry-level homes, and are now buying trade-up homes or second homes now that this generation is age 40 to 50 years old. This rapidly growing portion of the market is estimated to

Figure 1- Baby Boomer Population Growth 1995-2010

Source: U.S. Census Bureau

have the greatest population gains between 2005 and 2010 and will be served by the single-family homebuilder industry as shown in Figure 1.vii Single-family homes are being targeted at the baby boomer generation and other adults with active lifestyles or “empty nest” lifestyles. Another excellent indicator of housing growth and a leading economic indicator is the housing starts numbers. Housing starts indicate the number of residences on which construction has begun in a certain period. The housing starts in 2004 indicated a 7% upturn in the number of single-family starts, and that number indicated the highest number of housing starts since 1996.viii According to the President of the California Building Industry Association (CBIA), “While the housing starts data are good news for homebuilding industry and the state’s economy, it can not be overemphasized that we’re still not building enough housing to keep up with the population growth.”ix Industry Outlook The growth rate of homebuilding has been steady indicated by the compounded annual growth rate (CAGR) of new single-family homes in the US from 1995 to 2004 was approximately 6.5%.x However, the CAGR of the top 10 homebuilders has grown 15.5% in the same span. There is little evidence of oversupply in the homebuilding industry, but the economic outlook and the possibility of increasing interest rates in the future could slow the growth of this industry in the domestic market. xi Many times, builders, such as KB Homes have hedged the cyclicality of the domestic market by also operating subsidiaries in international countries, such as KB Homes’ operations in France. Homebuilding is one of the most fragmented industries in the United States. “In 2004, out of the top 100 homebuilders, approximately 449,000 new single family homes were sold, which is up 13% from 2003”, according to Builder Magazine home survey. Based on these numbers, DR Horton is the number one homebuilder in the nation, selling over 43,000 homes last year. Since DR Horton’s sales only accounted for less than 3.5% of the industry’s total, it is a strong indicator of a fragmented market. As indicated below in Figure 2, the ten largest homebuilders in the nation only make up 20% of the home sold in 2004. In the 1990’s that same group represented only 10% of the homebuilding market, so the market is becoming more concentrated, but not rapidly. It takes time for homebuilders to acquire new land and they also expand through acquisitions of other smaller builders over time.

Figure 2- Single-Family Homebuilders

Trends in the Industry The national homebuilding market is not homogeneous and trends vary from region to region. Housing cycles reflect changes in local conditions. As the focus is on Southern California, the trend mainly in the West is that housing has been strong because job growth and demographics support the increase in residential single-family construction. US homebuilders are very cognizant of the population growth in a region as well when picking where to build homes. Factors affecting population growth include age, demographics and the rate of immigration. In Southern California, you have an increasing amount of people immigrating to that area, because it is a desirable place to live and many people are emigrating from the Mexican border areas as well. Over the past 50 Years, the population in the West increased from 13% to 22% of the nation’s populations. According to the US Census Bureau in 2000, California has had the largest population growth increase in the 1990’s compared to anywhere else in the US, and has added a net population of 4.1 Million people.xii In the past four years, from 2000 to 2004, California has had a notable increase in population of 7%, approximately 2.5 Million people.xiii More industry-specific factors that affect homebuilders include the increase in regulation of the permitting process and the amount developable land. The California Association of Realtors predicted for 2005 that the California median home price would continue to increase, despite the fact that housing starts would remain low in comparison to what they were in the 1980’s. Housing starts can be defined as the number of permits issued for construction of homes, and
Figure 3-- Housing Starts Growth 1980-2005

of

therefore a number of housing starts in 2005 than in 1980 as illustrated in Figure 3, indicate more regulation with the permitting process and a potentially more competitive environment for homebuilders in California.xiv

II.

B. Porter’s Five Forces Analysis of Industryxv
The Southern California Single-Family Homebuilding Industry is a primary target for an

analysis using Michael Porter’s 5-Forces Model (“5-Forces”) (See Appendix 1). We have applied the 5Forces analysis into the respective divisions: Supplier Power, Barriers to Entry, Threat of Substitutes, Buyer Power and Degree of Rivalry. An in-depth analysis of each force within the Southern California SingleFamily Homebuilding Industry follows: Supplier Power Low. Supplier Power is analyzed though supplier concentration, importance of volume to supplier, differentiation of inputs, switching costs of firms in the industry, etcetera.xvi Suppliers are powerful if there are only a few suppliers, a large number of purchasers, and significant costs of switching suppliers. Supplier power is strongly buttressed when a supplier has control over prices. Suppliers in this industry are not concentrated. They act as separate groups competing for the same project through the bid system that is prevalent in homebuilding construction contract work.xvii Volume is a significant concern to these homebuilders. On one hand, the homebuilders require a specific amount of steel, concrete and wood for the homes. On the other hand, the subcontractors must build these variable costs into their homebuilding bids. Thus, large Southern California homebuilders are not affected in terms of supply volume giving suppliers any leverage. Moreover, the multi-million dollar nature of the bids for these large communities results in relatively few bidders/purchasers.xviii So, the subcontractors’ power is limited from the demand-side as well. Therefore, it initially seems that suppliers have very little power in the Southern California Single-Family Homebuilding industry. However, the Homebuilding industry is supplier intensive in a very industry-specific sense. First and foremost, land is required and is either owned privately or by government. According to Business Wire, Inc., a leading business publication, “[w]hile real estate industry revenues, profits, and unit closings continue to grow dramatically; the supply of land does not.”xix Although the supply of land is discrete, large homebuilders (such as KB Homes and DR Horton) do not spend a disproportionate amount of revenues on raw-land acquisitions.xx Supplier power is limited in that land prices fall within reasonably accepted ranges and buyers will typically not negotiable outside of those ranges. Every homebuilder, including KB Homes and DR Horton, requires a large number of inputs beyond land including wood, concrete, plastic, gravel, oil, gasoline, steel and other raw materials; all necessary components in homebuilding. Prices for some of these materials are non-negotiable, for instance,

the price of gasoline and oil, which affect all companies equally and do not lead to a strategic advantage for suppliers. However, the fragmented nature of the supplier market in all other construction supplies to homebuilding companies severely limits supplier power. For instance, DR Horton states in their 2004 Annual Report to Shareholders under the Cost Management section that:
We control construction costs by . . . obtaining competitive bids for construction materials and labor and by volume of services and construction costs negotiating favorable pricing from our primary subcontractors and suppliers based on the products we purchase from them on a local, regional and national basis. We monitor our on each house through our purchasing and construction budgeting systems . . . .xxi

Since each project is allocated to a subcontractor on a bid-by-bid basis, their profit margins make are small. A subcontractor must look over a project, determine the cost of raw materials and labor, and then bid on that particular project. The very nature of this closed-bidding process rewards the lowest bidder. Occasionally, a subcontractor will have neglected to include the costs for unforeseen circumstances and consequently, will have understated even their already tight profit margin, potentially to the point of negative profits. Thus, as the suppliers of raw materials, the subcontractors have very little supplier power. Labor is also a necessary input in homebuilding. Unlike subcontractors, skilled construction workers have supplier power. A recent study conducted by Scripps Howard New Service, revealed that “the construction industry . . . has issues with worker shortages.”xxii Additionally, “contractors’ associations say it’s particularly crucial during times like now when commercial and residential construction is in high demand.” This strong supplier power of construction workers leads to high costs of labor; up to $31 an hour.xxiii On the whole, suppliers exercise little control in this Industry. Raw materials, hence the amount paid to subcontractors for a winning bid, are very competitively priced. The shortage of skilled construction labor, although keeping labor costs high, does not represent a significant problem to the homebuilders directly; subcontractors bear this cost through reduced margins. Moreover, labor costs are only a fraction of material costs to both KB Homes and DR Horton. Buyer Power Low. U.S. citizens are buying homes in Southern California at relatively high rates, due to flexible financing terms and low down payments. Buyers have power over homebuilders when they are concentrated, purchase a significant portion of new homes, and pose a credible threat to purchases from competitors. Buyers have less power when they are fragmented, when suppliers produce a significant portion of homes, or if switching costs are high. In the Southern California Single-Family Homebuilding Industry, buyers of newly constructed single-family homes have very little power and are extremely fragmented. Each home purchaser competes individually for the best price. Homeowners rarely get together to negotiate a “good deal if we buy 50 homes at the same time.” Also, homebuyers usually do not have the ability to choose between suppliers

of new homes. Of course, homebuyers reserve the option of purchasing existing homes on the secondary market or renting. If a job or a family is located in a certain geographic area, then that individual must purchase property in that area, regardless of the specific homebuilder. Since homes are such a monumental investment (usually the largest purchase a person makes over his or her lifetime), the costs for a buyer to switch homes is normally prohibitive. Because there are many buyers competing for houses from few suppliers, new home prices are high and buyers have very little room for negotiation unless they choose to purchase existing homes. Various media reports indirectly reflect the weakness of buyers in the Southern California Single-Family Homebuilding Industry. The Copley News Service found that 21 of the nation’s 25 leastaffordable metro areas were in California and Alan Nevin, the California building association’s chief economist, said “the short supply of housing should keep prices strong for the remainder of 2005.”xxiv In addition, the “Campaign for California Homeownership,” a statewide campaign aimed to make it easier for developers to build new, affordable homes, believes buyers are paying too much for homes because the supply is limited by zoning restrictions, among other things.xxv These reports are evidence of the fact that buyers do not have much power buying new homes. Furthermore, demand for new homes is continually increasing. KB Homes’ 10-K Report states “[p]opulation growth, demographics, immigration, household formations and changes in home ownership rates were the primary long-term factors driving this housing demand, with particular strength in our Southeast, Southwest and West regions. Low mortgage rates were a positive influence on housing demand during 2004 and 2003, during a period of generally weak employment levels.” Despite this high demand for new housing, buyers have relatively low power. Barriers to Entry (Threat of Potential Entry) High. Identifying the possibility and probability of new entrants in an industry is critical because they can intrude on market share and profitability of existing competitors. Economies of scale, product differentiation, capital requirements, switching costs and government policy all affect Southern California Homebuilders. The economies of scale realized by large homebuilders make it almost impossible for new entrants. Homebuilding is a very capital intensive industry, especially when done on a large scale. Not only are the dollar costs high, but the knowledge it takes to build homes on a large scale is also difficult to acquire. Sourcing a parcel of land large enough for a development project requires a lot of capital and expertise. Only with the experience and the capital is it possible for a new entrant to seriously compete with the existing large homebuilders. Also, the governmental red tape that must be overcome in this industry is paramount to the success of a prospective homebuilding company. Possible zoning changes, building permits, traffic studies,

and the environmental impact reports mandate that a company has extensive experience in homebuilding. Moreover, Southern California homebuilders face strict environmental concerns.xxvi For instance, much of Southern California is considered “environmentally sensitive land.”xxvii Massive ecological and environment surveys must be done before companies can begin development.xxviii Additionally, homebuilders need the ability to negotiate and work with the zoning commissions and the other governmental commissions to be successful. The required capital and the ability to work with zoning commissions are the two primary barriers to entry that make large-scale homebuilding in the Southern California Single Family Homebuilding Industry very difficult. Threat of Substitutes Low. The threat of substitutes entails a consideration of such things as switching costs, buyer inclination to substitute and the price-performance trade-off of substitutes. Most individuals would like to make a permanent investment with the purchase of a home, and apartments and condos are considered plausible substitutes. Condos and apartments do not serve as a permanent substitute to a home, and resemble more of a temporary substitute. Many homebuilders do realize that apartments and other rentable units are substitutes to homes. When home prices become exorbitantly high, homebuilders mainly watch out for a decreased demand for homes in lieu of apartments. However, extremely low interests rates have enabled individuals to continue to purchase ever-more-expensive properties even with stagnant income levels. Variables such as interest rates, government programs encouraging first time homebuyers, and the required down payment on a home will continue to affect how viable substitutes seem in contrast to outright homeownership. Furthermore, another possible substitute to large single-family homebuilders is the individual homebuilder or smaller boutique homebuilders. An advantage for these companies is that they are not building large tract homes with similar, but uniform characteristics and styles. However, there is a striking disadvantage as well: when homes are differentiated from one another that increase costs. KB Home and DR Horton have been able to successfully expand in their markets because they are the low-cost provider (only two ways to make profits: be the low cost provider or differentiate your product). Thus, the actual threat of substitutes is weak given that it takes many things to build homes on this level of cost-savings: (1) access to the capital markets to raise money quickly and efficiently, (2) an established reputation for quality, (3) the ability to negotiate large dollar contracts quickly and, more importantly, advantageously, and (4) actually building good homes. These barriers to entry will keep the industry resembling an oligopoly, dominated by a few large homebuilders.

Degree of Competitive Rivalry High. The growth rate of the Southern California homebuilding market is tremendous; however, it is limited in many respects. The growth for the demand and the production of homes in Southern California is enormous. However, the growth of the actual number of homebuilders in Southern California is much smaller. We believe the limited growth in the actual number of competitors is merely a related effect of the costly barriers to entry. The large amount of initial capital required to build a home leaves the entire homebuilding industry to large companies that have sufficient capital or to individuals who have and are willing to risk the required amount of money. The market is both mature and developing at the same time. The maturity of the market can be illustrated by the complex legal system that has evolved to curtail any development of homes that are not in strict compliance with zoning code and other legal barriers to development. Moreover, the limited number of large builders (an oligopoly) leads to the conclusion that the market is mature and fairly saturated. However, homebuilders in Southern California will always have a market demand as they continue to develop and redevelop land and change the zoning of pieces of land. Michael Porter, the designer of Porter’s Five Forces, gave a speech at Harvard Business School on real estate development where he described the competitive rivalry perfectly: “There has always been lots of companies in the industry and so there has always been an active situation of rivalry. But again there was plenty of room. Yes, there would be seismic tremors and overbuilding in one city or one product type for a while, but the broad upsurge in demand over a long period of time allowed a lot of companies to prosper.”xxix And, Southern California homebuilders have not yet reached that “seismic tremor and overbuilding.” No, – even with the active, intense rivalry of the Southern California single-family market – these homebuilders are still making large profits. Michael Porter, however, said that the future real estate development market will only continue to yield above-average profits to firms that “operate with a strategic purpose.”xxx Whether large-scale Southern California homebuilders such as KB Home and DR Horton choose a competitive strategy will determine their future success and the future level of competitive rivalry in the Southern California Single Family Homebuilding Industry.

I.

C. Competitive Implications
A careful analysis of Porter’s Five Forces of the Southern California Single Family

Homebuilding Industry illustrates that the overall the industry is attractive, and fairly competitive. The stronger the competitive forces in an industry, the lower the profit potential for the firms. In order to be profitable, this industry needs to be competitive both regionally as well as nationwide. Most major homebuilders are building in different regions in order to increase their profitability and accessibility to resources. A major change in the last ten years that has emerged in the single-family homebuilding industry is the bifurcation of the market. There has been an emergence of the “superbuilders”, or the larger builders,

who will take market share away from small and mid-sized builders. While being a fragmented market, the large builders will maintain a dominant share of the market because of their ability to ride the wave of an economic downturn with their greater financial strength.xxxi The main trends increasing rivalry among firms are consolidation and the capital intensity of the industry. Firms are competing against each other with their availability of resources, which include land, raw materials, available capital, production efficiencies and product design, all of which lead to the highest profitability. The barriers to entry are high, giving the majority of power to the homebuilders and making the industry more competitive to potential entrants. The buyers in the Southern California possess very little power because they are at the mercy of the existing supply and demand, and currently the demand exceeds supply. Firms know that they need to control costs to increase their bottom line and that is affected by supplier power, which is relatively equal among all competitors. Economic factors tend to affect most competitors equally and therefore have a greater impact on the industry rather than individual homebuilders. Single-Family Homebuilders can be successful in this industry if they focus on accumulation of land in a good location and the consumer’s needs and changing preferences in a single family residence. A customer’s value is measured by how satisfied they are with the end product, their home, and that will never change. A customer expects a long-lasting, sturdy, and aesthetically pleasing home. Another major concern is the price of the home, but a homebuilder has the economies of scale to provide premium product design for lower prices than stand-alone residences not built by homebuilders. Many owners are also concerned with the potential long-term increase in value of their home. A trend among consumers is to purchase property when financial lending terms are favorable and mortgages can be obtained at good rates coupled with encouraging interest rates. A customer must analyze the economic outlook and the industry carefully in order to make a successful purchase.

II.

A. Competitor Analysis
Over the past five years, the homebuilding market in the Southern California region as well as

the nation has experienced explosive growth. The reasons stated in the Industry Analysis section of this report highlighted why this industry has consistently outperformed the market. Consequently, looking for a high performing firm and a low performing firm within an industry where there has been only positive growth proved to be more difficult than originally perceived. Instead of a truly low performing firm, our team chose a high performing firm and a higher performing firm from the homebuilding industry: KB Homes (KBH) and DR Horton, Inc. (DHI). Both companies have grown and profited during this current market cycle; however, compared to the Homebuilders’ Market Index, DHI has been the higher performing company, although this financial data is not specific to the Southern California region.

Sales Growth & Profitability Ratios On a national level, DHI has experienced greater sales growth (Figure 4) than KBH, primarily due to growth through acquisition. In 2000 DHI and KBH has sales revenue of $3.65 billion and $3.93 billion, respectively. By the close of 2004, DHI’s revenue had surged to $10.84 billion compared to $7.05 billion for KBH. This result can be in part attributed to differences in growth strategy. While KBH has focused on developing its existing markets (i.e. Southern California), DHI is continually expanding into new markets (i.e. Southern California). As a result, KBH has faced more competition, not only from DHI, in markets where it traditionally has been able to leverage its competitive advantage as the market leader. This effect can be seen in the fact that while sales revenue has increased for KBH in the Southern California region, the number of units sold has declined over that last couple years as well as California revenues representing a smaller percentage, 17%, of total revenues than in the past, 20% in 2002 and 21% in 2003.xxxii DHI is also more profitable than KBH, but not by as much as sales growth would have one to believe (Figure 5). Due to its expansionist strategy, DHI has incurred a large increase in general and administrative expenses, from $98.3 million in 2003 to $121.0 million in 2004.xxxiii With more sales and higher profitability, DHI has the edge in this performance metric. On the other hand, the “bottom line” ratio, Return on Equity, shows that both firms share high performing percentages, typically over 20% (Figure 6). Additionally, when comparing stock price, KBH has enjoyed larger growth, from $31.38 per share in 2000 to almost $88 at the end of 2004. DHI stock price has also climbed but not by as great of a percentage, from $17.19 in 2000 to $33.11 at the end of 2004. Recently, higher interest rates prompted by the FED, economic trends, rising energy costs and even investors’ self-fulfilling expectations of a housing market downturn (the bubble will burst) have resulted in both companies’ stock prices taking a dive. KBH has slipped to $64.58 down from over $80 just 3 months ago; DHI is down to $31.82 from over $40 in the same time period.xxxiv With such large swings, the market seems extremely volatile at this point in time and may not be a good judge of performance. Looking at assets is a better metric than stock price; DHI has nearly $9 billion in total assets, while KBH has a little under $6 billion.xxxv More specifically, Return on Assets, is a good indicator of homebuilding companies’ performance because the more money that is made per home sold can be captured in this metric. Both companies had relatively flat ROA from 2000 to 2002, but DHI began a period of growth with an increase of more than 50% on ROA in 3 years. KBH is more stagnant, growing from 2001 to 2003 but slipping a half percentage point the last year (Figure 8). Market Value Ratio The P/E Ratio indicates “how much investors are willing per dollar of reported profits.”xxxvi A higher ratio can mean that the firm in question is a risky investment and/or has high growth potential. A lower ratio alludes to the fact that there is little growth opportunity and/or the investment would be less risky.

When looking at DHI and KBH, both of their P/E Ratios are moderate; one can infer that the uncertainty in the homebuilding industry is causing the ratio to be high while secured future contracts help mitigate this risk. For the last five years both firms have been a wise investment. Summary Both KB Home and D.R. Horton, Inc. have outperformed the Homebuilders Market Index; D.R. Horton by a larger margin than KB Homes (Figure 9). Having been in a period of increased home prices (partly due to high demand) and low borrowing hurdles, the great majority of homebuilding firms reaped better than average profits. Now that the market has indicated that it will begin a cooling off period, competition may become even fiercer, resulting in smaller margins and fewer homes sold in general. Whichever company has braced itself better for this downturn in the market cycle will prove to be the higher performer even when profits may be slim.

II.

B.

Firm Capabilities and Competitive Advantages
(see also Appendices 2 & 3 for SWOT Summaries)

KBH Strengths KB Homes was founded in Los Angeles, California in 1957.xxxvii Having started its business in Southern California, KB Homes has been in a position to gain expertise over the Southern California homebuilding market. Moreover, the fact that KB Homes has been in the Southern California market for nearly 50 years has provided them the opportunity to observe, and live through, not only the short-term trends that impact the homebuilding market, but the long-term forces as well. KB Homes experience has resulted in the company being the leader in the Southern California homebuilding market.xxxviii One of the primary reasons that KB Homes has become the leader in Southern California is its growth strategy. Most of KB Homes’ growth comes from its existing markets and areas directly adjacent to existing markets.xxxix KB Homes is able to replicate its core business practices with ease in its current markets and those nearby. Growing into adjacent business space is one of the ways “successful companies” are able to “outperform their competitors.”xl More recently, KB Homes has begun to make acquisitions of smaller homebuilders in order to expand into new markets not directly adjacent to its current area: Today, KB operates in over a dozen states and in France.xli Overall, KB Homes prides itself on providing high quality homes with innovative architecture.xlii KB Homes also focuses on providing its customers excellent customer service and first-rate home warranties.xliii In running its business, KB Homes promotes trust: KB Homes has a corporate ethics policy that is fundamental to its management.xliv This trust is reinforced by the dedication to the business of the senior management, who average over 12 years with KB Homes.xlv

KB Homes has a stake in the mortgage writing business through its wholly owned subsidiary, KB Home Mortgage Company.xlvi This subsidiary allows KB Homes to take advantage of the next logical decision that faces one who purchases a newly constructed home; the decision of how to finance the purchase. Additionally, KB Homes has entered a strategic partnership between KB Home Mortgage Company and Countrywide Home Loans, one of the largest mortgage companies in the nation.xlvii This partnership allows KB Home Mortgage to provide a much larger portfolio of financing options to its customers, and in a more efficient manner, than they would otherwise be able. The alliance also allows each firm to “share the risks and the resources” involved in the business and allows KB Home to take advantage of Countrywide’s capabilities.xlviii DHI Strengths Similar to KB Homes, DR Horton is dedicated to quality crafted, distinctive homes designed by award-winning architects.xlix In fact, offers several amenities in its homes as standard features that other homebuilders consider options or upgrades.l Like KB Homes, DR Horton also has a wholly-owned mortgage subsidiary.li DR Horton has a very strong national reputation. As the number one homebuilder in the United States, DR Horton has experienced 27 consecutive years of revenue growth and profitability.lii Originally founded as a family business, the values of family business and the family business spirit continue to guide the company today.liii The family business’s policy of not buying land until all of the proposed construction has been approved also remains in effect.liv This policy alone saves the company from needless expenses caused by legal, environmental, and other regulatory issues. KBH Weaknesses KB Homes has recently changed one of its strategies in the Southern California homebuilding market: While historically KB Homes has invested in very large developments, greater than 250 homes, more recently they have focused on smaller-scale investments in the range of 50 to 150 homes.lv Much of KB Homes’ experience has been gained through building the very large developments; they are relatively inexperienced in building smaller tracts. Additionally, KB Homes purchases the tracts of land prior to building, largely through the use of options, but never purchases land with speculative intent.lvi Nonetheless, the purchase of the land or the purchase of the option, before planning is finalized, exposes KB Homes to regulatory risks. The corporate structure of KB Homes is very complex, involving dozens of subsidiary corporations and limited liability companies.lvii This complexity not only increases legal and accounting fees to the company, but also increases the learning curve employees and investors experience in attempting to understand the business.

DHI Weaknesses DR Horton is a relatively young company which started in the Dallas/Fort Worth area in 1978.lviii DR Horton is also relatively new to the Southern California homebuilding market and lacks the decades of experience of a domestic company such as KB Homes. It is this lack of experience of DR Horton and the experience of KB Homes that is the probable cause of DR Horton’s failure to lead the Southern California homebuilding market. The majority of DR Horton’s growth over the past decade results from the many acquisitions it made. From 1993 to 2002, DR Horton acquired 17 other homebuilding companies throughout the United States.lix Instead of concentrating on growing its current markets by replicating its current business practices, DR Horton grows through acquisitions both within and outside its market and adapts the acquired company to its own model.lx Opportunities in the Homebuilding Industry The Southern California market presents several opportunities to homebuilding companies. Over the past decade, but primarily in the past five years, most areas of the Southern California real estate market have experienced significant price appreciation as the result of increased demand for housing. Sparked primarily by 40-year low interest rates on mortgages, many communities in Southern California experienced value increases over 100% in the past five years.lxi Additionally, the demand for Southern California real estate has increased because of the normal population growth of approximately 2% per year and the general influx of population to Southern California from other portions of the country that has occurred since World War II.lxii Demand for housing is also strong because of favorable federal tax provisions that support and promote home ownership. The ability to exclude a portion of the capital gains on the sale of one’s primary residence and the ability to deduct mortgage interest and property taxes from income are key tax law provisions that support homeowners.lxiii Of course, as is the case with any tax regulation, the rules can change at any time. Both DR Horton and KB Homes, as large homebuilding companies competing in the Southern California market, are in positioned to take advantage of this high demand for housing. In fact, the homebuilding industry is projected to grow at an annual rate of 12% over the next five years.lxiv However, as the leading homebuilder in Southern California, KB Homes will experience a larger share of the benefits that result from the high demand for housing.lxv It is important that each company understands the opportunities presented by the external environment so that they can better align their internal capabilities to potentially build a competitive advantage.lxvi

Threats to the Homebuilding Industry While the Southern California market presents several opportunities to the homebuilders, there are also several threats that must be considered. These threats each have the potential to “hinder a company’s efforts to achieve value creation.”lxvii Foremost, housing demand is sensitive to changes in interest rates. With recent mortgage interest rates at 40-year lows, any significant rate increases are likely to result in less demand for new housing. Rate increases also cause declines in refinancing activity, surely impacting the mortgage subsidiaries of both KB Homes and DR Horton. Moreover, because of the planning involved, homebuilding generally lags housing demand; this means that if demand suddenly declines, homebuilders may be stuck with large inventories of new homes. In addition to the threat of interest rate increases is the threat of inflation. In periods of inflation, not only do interest rates rise, but prices on land, labor, and construction materials will also rise. While inflation has been relatively low over the past few years, prices have recently risen sharply for lumber and concrete because of the high demand for these materials. Any inflation pressures would amplify these price increases. Since the threat of interest rate increases and inflation impact the entire homebuilding industry, both KB Homes and DR Horton face this threat. To some extent, however, DR Horton has attempted to mitigate this threat by utilizing interest rate swap agreements and interest rate hedging, more so than KB Homes.lxviii Homebuilders face regulatory requirements in several ways including zoning, environmental regulations, building permits and construction inspections. The regulatory threat can cause significant project delays and cost increases if not taken seriously. DR Horton generally has less exposure to this threat than KB Homes because of DR Horton’s policy to not purchase land until the proposed construction has been approved by all regulatory bodies. Furthermore, KB Homes is currently under investigation by the EPA for violating Section 308 of the Clean Water Act.lxix Summary DR Horton has positioned themselves to take advantage of the industry opportunities while mitigating the threats, but its strategy of growth through acquisition does not match KB Homes’ core competency of growth by replication in the Southern California market. Homebuilding is a very local business; KB Homes has the local experience necessary to dominate the market.

II.

C. Sustainability and Outlook
Overall, KB Homes is expected to grow earnings at an annual rate of 18% over the next five

years, DR Horton is expected to grow at an annual rate of 15%.lxx However, KB Homes will likely find it difficult to keep growing by replicating its current business into other areas of the Southern California market. Rivalry intensity is likely to increase over the next several years due to several reasons. One of them

is that the Southern California market is simply running out of open real estate. As open space declines, competition and regulatory pressures will increase. In the long run, KB Homes will be forced to concentrate its efforts on areas adjacent to Southern California or on growth through acquisitions in a manner similar to DR Horton. Another reason for heightened intensity of rivalry between KB Home and DR Horton (plus other competitors) is the slowing of industry growth. Even though the Southern California market will continue to grow, it will not be at the same speed as the previous five years. Moreover, these two builders produce very similar products and offer the same mortgage services. The lack of differentiation and seemingly low switching costs (assuming before home purchase) makes for fiercer competition. Because of the above reasons and the fact that competition is taking place over a relatively small area of California, one can conclude that the strategic stakes are extremely high between these firms.lxxi DR Horton will continue to be able to grow through acquisitions. In fact, as previously mentioned, KB Homes will likely be forced to make strategic actions and move towards a similar strategy in the long-run. But, it is very unlikely that DR Horton will be able to overtake KB Homes as the homebuilding leader in Southern California. The Southern California market is very mature and little growth can be accomplished through acquisitions. In additions, KB Homes’ experience and current dominance of the Southern California market virtually precludes DR Horton from taking over the leading position. Nonetheless, on a national scale, the competitive rivalry between both firms is likely to redouble in the future. As both firms continue to grow, the number of geographic regions that they find themselves in direct competition with each other broadens market commonality and creates multi-market competition. Additionally, the same raw materials and expertise are needed by KB Home and DR Horton, meaning that resource similarity is markedly homogeneous. Figure 10 demonstrates the overlap (which implies a strong competitive rivalry) between KB Home and DR Horton. lxxii

High Market Commonality Low II III I IV

D.R. Horton KB Home

Low

High Resource Similarity

Figure 10: A Framework for Competitor Analysis

Appendix 1 Summary of Porter’s 5-Forces Analysis: Threat of New Entrants: Low Bargaining Power of Suppliers: Low Bargaining Power of Buyers: Low Treat of Substitutes: Low Degree of Competitive Rivalry: High

Appendix 2: KB Homes (KBH) SWOT Summary
Strengths Long History in Southern California High Quality, Innovative Architecture Strategic Partnership with Countrywide Strong and Dedicated Senior Management Leader in Southern California Focus on Trust and Corporate Ethics Growth From Within Existing Business National Branding 18% Growth Projected Over Next 5 Years Weaknesses Not the National Leader Only Recently Expanded Out of California French Subsidiary Seems Disconnected Relatively New to Acquisitions Purchases Land Before Approved Plans National Branding Strategy in Local Business New to Small Scale Developments Complex Corporate Structure Involving Dozens of Subsidiary Companies Threats Exposure to Differing Economic Markets Because of Diversification Large Percentage of Shares Held by Large Institutions or Insiders Homebuilding is a Historically Local Business Interest Rate and Inflation Variability Building Restrictions/Regulations Housing Alternatives Such as Existing Homes and Rentals Materials Price Fluctuation Competition for Subcontractors in Competitive Southern California Homebuilding Market Environmental Concerns

Opportunities Diversification in Many National Markets Growing Southern California Homebuilding Market 12% Industry Growth Projected Annually for Next 5 Years Federal Income Tax Provisions That Promote Home Ownership Current Low Interest Rate Environment

Appendix 3: DR Horton (DHI) SWOT Summary
Strengths Dedicated to Quality Crafted Distinctive Homes Offers High End Amenities as Standard Offering Award Winning Architecture Founded as Family Business – Family Business Values Remain 27 Consecutive Years of Revenue Growth and Profitability Doesn’t Buy Land Until Entire Plan Approved DHI Mortgage Subsidiary Uses Interest Rate Swap Agreements to Fix Variable Portion of Debt 15% Growth Projected Annually Over Next 5 Years Opportunities Diversification in Many National Markets Growing Southern California Homebuilding Market 12% Industry Growth Projected Annually for Next 5 Years Federal Income Tax Provisions That Promote Home Ownership Current Low Interest Rate Environment Weaknesses Relatively New in Southern California Large Debt Position Growth Primarily as a Result of Acquisitions Not a Leader in Southern California Homebuilding Market

Threats Exposure to Differing Economic Markets Because of Diversification Large Percentage of Shares Held by Large Institutions or Insiders Homebuilding is a Historically Local Business Interest Rate and Inflation Variability Building Restrictions/Regulations Housing Alternatives Such as Existing Homes and Rentals Materials Price Fluctuation Competition for Subcontractors in Competitive Southern California Homebuilding Market Environmental Concerns

Appendix 4_: Financial Ratio Analysis
Figure 4 Sales Growth
60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 2000 2001 2002 2003 2004 KBH Sales Grow th DHI Sales Grow th

Figure 5

Profit Margin
10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2000 2001 2002 2003 2004 KBH Profit Margin DHI Profit Margin

Figure 6

Return on Equity
35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 2000 2001 2002 2003 KBH ROE DHI ROE 2004

Appendix 4_(Cont’d): Financial Ratio Analysis
Figure 7 Return on Assets
12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 2000 2001 2002 2003 KBH ROA DHI ROA 2004

Figure 8
P/E Ratio
25 20 15 10 5 0 KBH P/E DHI P/E 2000 2001 2002 2003 2004

Figure 9 Performance During Past: 3 Months 6 Months Year-to-Date 12 Months 2 Years 5 Years D.R. Horton, Inc. -16.97% 12.47% 9.48% 50.56% 79.63% 518.74% Kb Home -15.50% 11.83% 28.26% 70.27% 106.92% 385.80% Home Construction -14.97% 5.39% 10.53% 47.18% 72.68% 365.00% DJ U.S. Total Market Index -1.24% 1.46% -0.20% 7.83% 17.75% -12.39%

Performance data reflects previous day's closing price, updated by 12 a.m. ET. Data is based on price appreciation only. Calculations do not include returns from dividend reinvestment. Historical data is displayed for the selected stock and its specified DJ U.S. Industry Index. The DJ U.S. Total Market Index measures the performance of the broad U.S. equity market and includes over 1800 component stocks. Copyright © 1998-2005 BigCharts.com Inc. User agreement applies. Source: http://online.wsj.com/quotes/industry_comparison.html?symbol=kbh&type=usstock

i

“California Homebuilding Remains Strong”.Reeves Journal (2003), available at http://80web2.epnet.com.lib.pepperdine.edu/externalframe.
ii

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80-umi.compustat.com.lib.pepperdine.edu

iii

Dunlop, John T. “The US Homebuilding Industry: A Half-Century of Building the American Dream”, Harvard University (2000). available at http://www.jchs.harvard.edu/publications/markets/balexander_M00-1.pdf
iv

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu/
v

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu
vi

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu
vii

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu
viii

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu
ix

“California Homebuilding Remains Strong”. Reeves Journal (2003), available at http://80web2.epnet.com.lib.pepperdine.edu/externalframe.
x

William, Mack. S&P Industry Survey: Homebuilding, (Aug. 11, 2005) available at http://80umi.compustat.com.lib.pepperdine.edu/cgi-mi-auth/mihome.cgi?tree=25201030&tab=industry&go=Go%21
xi

Harmon, Jennifer, “Builder’s Don’t See Disaster. National Mortgage News (Dec. 2004), available at http://80web2.epnet.com.lib.pepperdine.edu
xii

US Census Bureau, 2005, available at http://www.census.gov Meyer’s US Housing Market, 2005, available at http://www.meyersgroup.com Kim, Stephen. “California’s Forecast: Heavy Clouds, but No Rain” Smith Barney Research Report (Jan.31, 2005) EPSCO Quick MBA/Strategy/Porter’s Five Forces, available at http://www.quickmba.com/strategy/porter.shtml/ Quick MBA/Strategy/Porter’s Five Forces, available at http://www.quickmba.com/strategy/porter.shtml/ Los Angeles Times, “Bidding Wars: The Ballooning LA Home Market.” January (2004).

xiii

xiv

xv

xvi

xvii

xviii

KB Home’s and DR Horton’s 10-K report ‘multi-million’ dollar accumulated costs for a project. There 10-K’s also report figures such as $80,000,000 for a southern California home community.
xix

Business Wire, Inc., “Land Shortages Inspire Developers to Use Mapping Technologies to Acquire Best Locations; Digital Map Products Web GIS Software Helps Developers Secure Most Desirable Land.”
xx

DR Horton, 2003 10-K. available at http://www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200310-K DR. Horton, 2004 10-K, available at http://www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K. Scripps Howard New Service, “Construction industry grapples with skilled labor shortages” (2005). Scripps Howard New Service, “Construction industry grapples with skilled labor shortages” (2005).

xxi

xxii

xxiii

xxiv

Copley News Service, “State urged to shift policy to meet housing demand” (2005). The Press Enterprise Co., “Developers mount effort to build more homes” (2005). The California Real Estate Journal, “Southern California Building Permits Pose Problems for Developers” (January 22-29 2005). The California Real Estate Journal, “Southern California Building Permits Pose Problems for Developers” (January 22-29 2005). The California Real Estate Journal, “Southern California Building Permits Pose Problems for Developers” (January 22-29 2005).

xxv

xxvi

xxvii

xxviii

xxix

Professor Michael E. Porter, Harvard Business School, “Competitive Strategy and Real Estate Development, Remarks to the 1989 Harvard Business School Real Estate Symposium.”
xxx

Professor Michael E. Porter, Harvard Business School, “Competitive Strategy and Real Estate Development, Remarks to the 1989 Harvard Business School Real Estate Symposium.”
xxxi

Dunlop, John T. “The US Homebuilding Industry: A Half-Century of Building the American Dream”, Harvard University (2000). available at http://www.jchs.harvard.edu/publications/markets/balexander_M00-1.pdf
xxxii

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
xxxiii

D.R. Horton, 10-K, available at http://www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K Wall Street Journal Online, available at http://online..wsj.com/companyresearch-quote-cgi. Wall Street Journal Online, available at http://online.wsj.com/companyresearch-quote-cgi Brigham & Ehrhardt, Financial Management: Theory & Practice: 11th Ed., 2005 Yahoo! Finance Company Profile, available at http://finance.yahoo.com/q/pr?s=KBH

xxxiv

xxxv

xxxvi

xxxvii

xxxviii

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
xxxix

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
xl

Zook, Chris and James Allen. “Growth Outside the Core.” Harvard Business Review. December 2003. p. 3.

xli

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
xlii

KB Homes Homepage available at http://www.kbhome.com/ KB Homes Homepage available at http://www.kbhome.com/ KB Homes Homepage available at http://www.kbhome.com/

xliii

xliv

xlv

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
xlvi

Yahoo! Finance Company Profile, available at http://finance.yahoo.com/q/pr?s=KBH KB Homes Homepage available at http://www.kbhome.com/ Hoskissin, Robert E. et. al. Competing for Advantage. Thompson South-Western. 2004. p. 288.

xlvii

xlviii

xlix

DR Horton Homepage available at http://www.drhorton.com/

l

DR Horton Homepage available at http://www.drhorton.com/ D.R. Horton 200410-K, available at www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K D.R. Horton 2004 10-K, available at www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K DR Horton Homepage available at http://www.drhorton.com/ D.R. Horton, 10-K, available at www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K

li

lii

liii

liv

lv

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lvi

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lvii

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lviii

DR Horton Homepage available at http://www.drhorton.com/

lix

D.R. Horton, 2004 10-K, available at www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K D.R. Horton, 10-K, available at www.sec.gov/Archives/edgar/data/8882184/D.R.Horton200410-K Los Angeles Times, Real Estate Section, October 10, 2005. United States Bureau of Labor Statistics available at http://www.bls.gov/ Referring to advantages provided by several provisions of the Internal Revenue Code available at http://www.irs.gov Yahoo! Finance Company Profile, available at http://finance.yahoo.com/q/pr?s=KBH

lx

lxi

lxii

lxiii

lxiv

lxv

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lxvi

Hoskissin, Robert E. et. al. Competing for Advantage. Thompson South-Western. 2004. p. 67-68. Hoskissin, Robert E. et. al. Competing for Advantage. Thompson South-Western. 2004. p. 71.

lxvii

lxviii

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lxix

KB Homes, Form 10-K Annual Report, available at http://media.corporateir.net/media_files/irol/11/111266/reports/KBHome_AR2004.pdf
lxx

Yahoo! Finance Company Profile, available at http://finance.yahoo.com/q/pr?s=KBH Hoskissin, Robert E. et. al. Competing for Advantage. Thompson South-Western. 2004. p. 89-91. Hoskissin, Robert E. et. al. Competing for Advantage. Thompson South-Western. 2004. p. 176-178.

lxxi

.
lxxii

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