Managing Director & Senior Partner
With a market capitalization of $7 billion, PulteGroup is one of the largest builders of new homes in the U.S.—the company sold more than 17,000 homes in 2014. During the five-year period from 2010 through 2014 covered by this year's Value Creator's Report, the company delivered an average annual TSR of 16.9 percent—above the median for the companies in this year’s Value Creation database.
At first glance, it’s tempting to interpret Pulte’s above-average performance as a consequence of the recovery of the U.S. new-home market after the recent global recession. But the foundation for Pulte’s success really derives from changes that the company made at the nadir of the housing downturn—in particular, how the organization used a focus on value creation to fundamentally change its business model. The story also illustrates how emphasizing absolute, as opposed to relative, value creation can obscure what is really going on at a particular company or in a specific industry or sector.
Throughout the 1990s and into the early years of the subsequent decade, housing starts were growing rapidly, and U.S. home-builder stocks were routinely among Wall Street’s top performers: the home-building sector consistently outperformed the S&P 500. Pulte, along with other companies in the industry, delivered TSR that, in an absolute sense, made the company look like a strong value creator.
It was during this period of unprecedented industry growth that Richard J. Dugas, Jr., became CEO of Pulte, in 2003, making him the youngest CEO of a Fortune 500 company at the time. Dugas had risen rapidly through the organization since joining the company in 1994. More than a decade’s worth of experience, however, was not enough to prepare him—or anyone else in the industry—for the one-two punch that hit U.S. housing. In 2006, housing starts began to decline rapidly; then, in 2008, the financial crisis hit, causing mortgages to dry up and the U.S. housing market to collapse.
Although the entire industry was hit hard, Pulte’s aggressive growth strategy leading into the downturn made the impact on the company especially dramatic and damaging. “Our stock price went into free fall, losing 95 percent of its value from its peak in 2005 to its bottom in 2011,” says Dugas. “We had to let go of 80 percent of our employees. And the need to significantly write down our land assets put our balance sheet in a highly levered position, severely limiting our options during very challenging market conditions.”
It was around this time, in 2010, that Pulte called on BCG to help the company understand why it had underperformed its peers during the housing collapse. A detailed analysis of the company’s value-creation performance over the 20-year period from 1990 to 2010 concluded that Pulte’s problem wasn’t that it had underperformed during the downturn. Rather, the company had consistently underperformed its peers—in both good times and bad. Throughout the entire 20-year period, the company was in the second quartile of its peer group in revenue growth, but it was in the third quartile for asset turns and the bottom quartile for gross margin, returns on capital employed, and revenue per employee. And the majority of its divisions were delivering returns below Pulte’s cost of capital. Little wonder, then, that the company was in the bottom third of its peer group when it came to TSR.
“BCG’s findings were eye opening and difficult to accept at first,” remembers Dugas. “But the underlying data and related analysis made it impossible for us to ignore. Our success in driving strong topline and EPS growth disguised weaknesses and risks in our underlying business model. We needed to change fundamentally how we ran the business.”
Perhaps paradoxically for a company in the home-building business, PulteGroup had not focused on making money by building homes. Rather, the company had relied on capturing value through intelligently acquiring land assets, preferably at the bottom of the cycle, and then selling them at retail by dividing the land into home lots and monetizing it through the sale of individual houses. The implied assumption was that building the houses was necessary to realize value on the land but was not a meaningful source of profitability.
BCG’s analysis, however, showed that there were opportunities to generate significantly greater profitability and returns by optimizing the home-building process. By developing more of a “manufacturing mind-set” toward its construction operations, Pulte could develop capabilities in value engineering (such as economizing on the inputs) and manufacturing efficiency that would allow the company to make money not only on land but also on houses. The BCG team defined a three-part strategy that would allow Pulte to derive greater efficiencies, profits, and returns from both its land and its construction operations.
Manufacturing Excellence. Through a program that ultimately became known as common plan management, the company initiated a series of fundamental changes in its construction operations. PulteGroup began by reengineering its manufacturing process to feature fewer and more-standard home designs. The new process emphasized rigorous value engineering of the floor plans to ensure that each was optimized for material content and ease of constructability. The company then reorganized its operations into geographic zones, across which a series of highly efficient floor plans would be shared. The result: more-efficient floor plans that were used more frequently under a system that enabled future cost savings through ongoing analysis of purchasing and construction data. The company ultimately took the process one step further by overlaying a strategic pricing model that enabled the company to optimize each component of the price—base house, options, land premiums, and incentives—to better maximize total price realization.
Active Portfolio Management. BCG’s analysis showed that the key driver of valuations in home building was a company’s return on invested capital (ROIC) over the housing cycle. But Pulte had historically focused on revenue and pretax growth, not ROIC, as its key performance metrics. As a result, the company tended to allocate its capital inefficiently: one manager called it “spreading it around like peanut butter.” Even worse, because managers were rewarded on growth in pretax dollars, regional managers had a strong incentive to invest heavily, even late in the housing cycle, to maximize their growth (and their bonuses), whether they were actually generating returns on their investments or not.
The company’s ROIC was largely a function of having high market share in the geographic markets that were the most attractive because they had not been overbuilt. By developing metrics that tracked the relative appeal of different markets and the company’s share in those markets, Pulte could start actively managing its portfolio of market positions and allocate capital disproportionately to the most promising markets.
Customer Intimacy. Another unintended consequence of Pulte’s traditional focus on growth was that its homes often included features and options that raised the cost of construction even though consumers might not be willing to pay for those upgrades. Since managers were rewarded based on growing pretax income without regard to margins or balance sheet demands, superficially it made sense to spare no cost in order to ensure a sale. Even worse, when the pressure was on to meet the numbers, managers would often find themselves cutting the price on these overengineered homes to ensure that they would sell—even though the value realized on a particular sale suffered as a result.
The new model required the company to work harder at understanding exactly what customers valued and were willing to pay for. That meant investing in new capabilities for market research and customer discovery and changing the Pulte culture to make it more “consumer inspired.”
These three pillars—manufacturing excellence, active portfolio management, and customer intimacy—together represented a fundamentally new way for Pulte to do business. Building these new capabilities would put the company on a path to triple its stock price by 2016. (See Exhibit 1.)
In late 2010, Pulte announced that it would begin focusing its metrics on long-term value, and the company began implementing its new strategy and operating model in early 2011. Although the company is still on its journey, the impact on its business has already been dramatic. (See Exhibit 2.) From the end of 2010 to the end of 2014, Pulte took its operating margin and gross margins from sixth place to second place—and its ROIC from seventh to second—among its peers. The company’s TSR has followed suit. In 2012, Pulte’s stock was the second highest performer in the S&P 500. The company had the highest TSR in its peer group in the four-year period from 2011 through 2014. By the end of the first quarter of 2015, Pulte was well on its way toward tripling its stock price.
“It was one thing to understand the implications of BCG’s findings,” says Dugas. “Truly internalizing the message and changing the culture in order to execute the program has taken time. Reorienting the organization’s focus to return on invested capital, and keeping it there even during challenging periods, has been critical to our success.”
Now that Pulte has substantially improved its ability to create value, and the housing market appears to be strengthening, it’s time for the company to start thinking about growth again. “We worked hard to improve our operations and to earn the balance sheet strength and flexibility necessary to support our future success,” says Dugas. “We are now in a position to begin growing the business but following the disciplines established at the outset of this work and with an unwavering commitment to realizing better returns on our investments and improved TSR for our investors. We think we have a lot of runway left.”