October, 2006

A Well-Oiled Machine

How the Middle East crisis may determine the fate of the channel.

By Greg Brooks

You may have heard the joke about two statisicians who went deer hunting. They spotted a 12-point buck and both fired. One missed six ft. to the right and the other six ft. to the left, and the deer bounded off into the woods.

“Hooray!” they shouted. “On average, we got him!”

That’s the housing market in 2006. An analysis of June single-family permits by Chicago-based LBM Research (www.lbmresearch.com) showed that 31 of the top 75 housing markets were down more than 10% versus 2005, while 13 posted double-digit gains. Austin, Texas (+24.1%), Charlotte, N.C. (+18.8%), and Ocala, Fla. (+31.6%) are asking, “What downturn?” Detroit (-42.9%), Sacramento, Calif. (-39.3%), and Louisville, Ky. (-38.8%) are literally in free fall.

So much for a soft landing.

Will it get worse? In The State of the Nation’s Housing 2006, the Harvard Joint Center for Housing Studies (www.jchs.harvard.edu) notes that “the greatest threat to housing markets is a precipitous drop in house prices,” and “sharp price declines... seldom occur in the absence of severe overbuilding, dramatic employment losses, or a combination of the two.” Neither condition exists right now, and according to the National Association of Realtors, home prices rose 9.4% in 2005.

That’s the good news. The bad news is $3-per-gallon gasoline.

Housing is cyclical, but there have actually been only three severe downturns since World War II. The slide of 1956 lasted fewer than two years, while the late-’60s slowdown was relatively mild. The first big bust came with the recession of 1974-75; single-family starts in 1975 were down 32% from their peak in 1972. Next came the recession of 1980-82, when mortgage rates hit 15%. At the low point in 1982, single-family starts were 54% off their 1977 peak. Then came the 1990-91 downturn, when starts slid nearly 29%.

Is 2006 the Next Big One?

The common thread in all three recessions was a sharp spike in oil prices—the OPEC embargo in 1973, the Iranian revolution in 1979 and Iraq’s invasion of Kuwait in 1990. No one knows whether 2006 represents a pothole or a cliff, but if the answer depends on the Middle East, there isn’t much to do except “stay tuned to CNN,” as they say. So the more relevant question is what happens in the supply channel if this is the next big one.

It’s common knowledge that we’re in a period of unprecedented consolidation, and many believe it’ll continue until only megaplayers remain. Historically, that’s not true: In past downturns, big builders and top-50 dealers disappeared at a far greater rate than independents. But the dynamics are different.

Builder consolidation is the byproduct of a boom. As one builder noted recently in Professional Builder, “suburban subdivisions are...where (megabuilders) have their biggest competitive advantage. That’s what their machines are set up to produce.” If subdivisions go away, some megabuilders may, too.

Because production housing is just one of many markets available to dealers, downturns cause them to change direction. Which direction depends on demographics. The cash-and-carry model pioneered by Wickes in 1950 targeted builders and DIYers with price; it dominated for a generation, then gave way to home centers in the early ’70s. Likewise, home centers dominated for 20 years before they were replaced by big boxes.

In both cases, the catalyst for change was a recession: 1974-75 dealt a knockout blow to cash-and-carry while 1990-91 launched the big box era. Today, big boxes are approaching their 20-year benchmark and all signs are that warehouse retailing has passed its peak in all segments of retailing. If a severe downturn is coming, independents know how to survive. The real challenge will be to identify and capitalize on emerging opportunities.