On the back of a recovering housing market, the US building products industry has seen a spurt of M&A activity and increased investor returns. Since the bottom of the recession in April 2009—when US housing starts fell to the lowest level in decades at 478,000 new starts per year—double-digit growth has led to a seasonally adjusted annual rate of 1.28 million unit starts as of December 2017. Though still shy of its historical rate of 1.5 million starts per year, this rapid recovery has reignited investors’ confidence in the industry. An average of more than 43 transactions per quarter since 2011, combined with higher purchasing multiples, shows strong investor confidence.
Housing starts are, in fact, still below long-term averages. Even so, there appears to be pent up demand in addition to several bellwethers—including the outlook on both mortgage rates and macroeconomic trends—pointing to a continuation of the current bull market. At the same time, however, an accelerating labor shortage, lack of productivity growth despite technological advances, and increased consolidation across the value chain will likely put pressure on growth and margins for players across the value chain.
To continue creating value, industry leaders—whether public or private equity owned—will need to expand their value-creation playbook beyond consolidation and operational improvement. To maintain sustained momentum in total return to shareholders (TRS), leaders across the value chain will need to grow more strategically. This aim can be achieved through a granular approach to identify enduring pockets of growth and by relentlessly pursuing commercial and operational excellence through the adoption of digital and advanced analytics capabilities. Throughout each of these efforts, companies should be prepared to solve systemic issues, such as the labor shortage, facing the industry.
The first act since the Great Recession
In 2017, residential building products and services was an approximately $660 billion industry. This total included about $345 billion in new construction (excluding the cost of land and marketing) and about $315 billion in residential repair and remodel (R&R) costs including materials and labor. From 2012 to 2017, the compound annual growth rate (CAGR) of new residential housing construction increased by 16 percent. On the back of this growth, leaders in the industry have reaped exceptional returns for investors: between 2012 and 2017, TRS was 11.9 percent per annum for publicly traded building product manufacturers, 25.5 percent for publicly traded building product distributors, and 12.4 percent for home builders. In contrast, in the same time period TRS for the S&P 500 companies was 6.5 percent per annum. Multiple factors played a part in this outsized performance.
Strong recovery from the Great Recession. The financial crisis resulted in a significant reduction in housing activity. Recovery was slow from 2009 through 2011, but since then the housing market has grown at an impressive 13.5 percent CAGR through the end of 2017, more than doubling the number of starts (Exhibit 1). This growth significantly increased total shareholder value for the industry.
Rapid consolidation in the sector and resulting synergies have bolstered profitability. Propelled by continued optimism in strong economic fundamentals and significant headroom for construction growth, rapid, increased consolidation in the sector is occurring across the value chain, from manufacturers to distributors, and more recently among home builders. This activity contributed to completed transactions reaching a peak in 2017 (Exhibit 2).
A robust outlook for housing recovery and the consolidation of this relatively fragmented industry explain this sustained level of M&A. Indeed, industry players have been consolidating to achieve operational synergies, accelerate scale and increase national footprint, broaden product portfolios, and improve margins through better buying power. Given these trends, along with an expected increase in valuation multiples, execution risks will go up and potential buyers will find it even harder to sustain high returns.
Key trends shaping the next five years
In addition to ongoing, significant M&A activity and market consolidation in the sector, two key trends are continuing to affect economics and returns for players across the building-product value chain and will change the outlook relative to recent performance.
Trend 1: Near-term growth rates will be more muted
Analyst companies, including Moody’s and Dodge Data & Analytics, show wide variability for projected housing starts from 2017 through 2022, from zero to 8 percent. If housing starts reach their long-term historical average of 1.5 million by 2022 that would imply a modest CAGR of 4 percent from 2017 through 2022. Several financial considerations—such as economic indicators in unemployment GDP, lending levels, interest rates, and the uncertainty created by the recent tax law—affect consumers’ decisions and their ability to buy houses and could influence the outlook on new home construction. In addition, most millennials have postponed their first home purchases, as they are plagued by high student loan payments. As a result, it remains to be seen to what extent millennials, the largest living generation, will fuel housing-start growth over the next few years.
Trend 2: Construction labor shortages and stagnant productivity are expected to propel innovation and technological adoption
The construction industry has yet to recover from the mass exodus of skilled workers when work dried up during the recession. More than 50 percent of construction companies surveyed by the National Association of Home Builders (NAHB) reported labor shortages in 2015 and 2016, and NAHB data show shortages have worsened since July 2017. Furthermore, uncertainty regarding current immigration policies creates more pressure on the already dwindling labor pool. In a letter to Congress, the NAHB emphasized the significant contribution of an estimated 50,000 immigrant workers in the construction industry nationwide. Finally, increased demand for reconstruction after natural disasters, such as hurricanes Harvey and Irma, exacerbated the scarcity of construction workers for housing starts.
Builders are reacting to this scarcity by seeking more labor-efficient options, including the use of drones for inspections, modular construction methods, increased use of prefabricated components, and improved workflow tools. Yet, to date, productivity growth has eluded the construction sector. According to the McKinsey Global Institute, over the past 20 years productivity growth has averaged just 1 percent annually compared with 2.8 percent and 3.6 percent for the world economy and the manufacturing sector, respectively.
Implications and the next act in building products
Investors continue to pour capital into this industry with the goal of achieving high returns. But challenges such as high acquisition multiples, increased competition for quality assets, and possibly a more muted growth outlook make it harder for industry leaders and investors to continue creating value at recent historical rates. As a result, players will need to go beyond traditional ways to create value—such as consolidating manufacturing plants and distribution centers to capture operational synergies—to maximize returns.
Industry leaders across the value chain and top private equity firms have recognized the changing tides and the need to develop incremental value-creation strategies that hedge against the future risks of large upfront purchases. These strategies are to aggressively pursue pockets of growth, improve commercial and operational execution, and use technology to boost productivity and quality.
Aggressively pursue pockets of growth at a granular level
There are indeed potential tailwinds in the housing industry, but the rising tide may not lift all boats. Continued growth momentum, population redistribution, consumer buying behavior, and industry innovation will continue to create pockets of growth in certain regions and product categories and provide attractive growth opportunities for well-positioned players.
Southern states are projected to see high population growth. In 2017, Texas grew at 1.4 percent, while Georgia grew at 1.12 percent per annum, which is double the US national average of 0.7 percent. However, growth is highly variable even within regions, and a deep understanding of micromarkets is required to know where to play. For example, in the Midwest, construction spending in Minnesota is expected to shrink by about 1 percent over the next four years, while spending in Iowa is expected to increase by nearly 6 percent. These projections are affected both by population changes and demographic trends. Company leaders must pay attention to macrotrends outside of their immediate industry (such as fracking in North Dakota) or isolated incidents that could have an outsized impact on the construction market (such as a large e-commerce player announcing the location of its new headquarters). Furthermore, recent hurricanes and wildfires have resulted in widespread demand for reconstruction in California, Florida, and Texas.
Categories aligned with trends
While some categories are fully penetrated and unlikely to grow above the total housing market, others are underpenetrated and show ample opportunity for growth.
Energy-efficient products. Increased regulations and economic necessity are pushing more homeowners and builders toward energy-saving options. Experts agree that underlying market trends, such as green building and increased fire regulations, point to the fact that categories such as insulation, HVAC, and fire suppression should grow at a healthy clip of more than 7 percent over the next few years. Many exterior components are now designed to provide higher insulation factors, which provide homeowners with lower HVAC and energy costs. Interior blinds, solar shades, and thermochromic films are also becoming popular.
Limited maintenance products. Demand is shifting toward maintenance-free products that reduce the total cost of ownership and propel composite use. For example, hardwood cross-laminated timber is replacing wood, and fiber cement products, vinyl sidings, and accents are replacing cedar and traditional sidings.
User-friendly and labor-reducing products. The labor shortage is pushing manufacturers to make accessible products that require less labor, such as new vinyl and laminate floorings and precut trims and moldings, or to invest in prefabrication capabilities to limit onsite construction and labor needs, or to pursue modular or industrial construction.
Stronger and lighter products. New materials are continually being developed to provide more structural strength or differentiated design. Additives such as microfibers, for instance, create stronger and longer lasting concrete, helping prevent damage such as plastic shrinkage cracking.
A step change in commercial and operational excellence
Industry leaders have traditionally fueled growth and margin expansion by building scale and capturing synergies in a highly fragmented market. The consolidation focus was mainly on reducing redundancies and improving purchasing power through increased scale. Our analysis suggests that significant margin improvement can be unlocked. To do so, building products companies must pursue step changes in commercial and operational processes that, in the past, were avoided because leaders feared a lack of internal capabilities to make the required changes. As a result, building product manufacturers and distributors lag behind other industries in areas such as manufacturing capabilities, procurement excellence, pricing discipline, and sales efficiency, among others.
Many commercial and operational levers can provide a significant boost to bottom-line margins. For example, through smart, data-driven product purchasing and sourcing, leading building products manufacturers and distributors can shape categories and conduct fact-based and analytics-driven negotiations with suppliers for better pricing. Similarly, leading players in pricing and revenue management can develop a tailored pricing strategy and structure that are specific to customer segments and end markets. They can also use advanced analytics and the treasure trove of available data to arm sales reps with pricing intelligence and benchmarks to limit margin erosion and increase pricing discipline.
In general, the building products industry has lagged behind others in applying the latest technologies to business problems and processes. Like the construction industry where in 2016, 70 percent of construction firms dedicated 1 percent or less of their revenue to technology, the building products industry is a laggard in technology adoption. Opportunities abound, including taking a digital approach to designing and building a home rather than a traditional, on-site approach. Players can also optimize their manufacturing footprint and supply chain with advanced geospatial analytics and use predictive maintenance to reduce the cost of assets such as fleets and warehouses. Moreover, they can strive to better understand and segment customers according to their needs and work to enhance the customer experience—which should serve to increase stickiness—through machine learning and advanced analytics.
We expect industry leaders to accelerate the adoption of digital tools and advanced analytics to optimize workflows and propel productivity growth. This optimization will happen through a digital supply chain that includes, for example, equipment monitoring, inventory management and ordering, quality assessment, field productivity improvement and safety, and e-commerce capabilities to better serve customers.
Continued investments in granular growth segments—including strategic acquisitions that fill voids in leaders’ product portfolios and geographic coverage, operational and commercial value levers, and digital and analytics enablement—will help promote profitable growth in the sector. A combination of these initiatives could position building products distributors and manufacturers to lead the market as growth eventually slows, the labor shortage continues, and consolidation across the value chain increases margin pressure.