41-How the High End Company is Vulnerable

Highly cyclical industries can be very difficult places to compete. The US housing market is a cyclical industry. It is also growing slowly. How does a company thrive in that kind of industry? Well, it helps to have solid underlying demand. But the real secret is to increase your market share to create and exploit economies of scale that your smaller competitors simply don’t have. These economies of scale provide you with opportunities for both attractive products and pricing for customers and attractive returns for your shareholders. In this blog, you can see that secret in action.

Posted 8/11/08

The housing market is in a shambles, especially the new home construction market. In partial response to this horrible market, some of the home building industry’s largest competitors, including Toll Brothers and Hovnanian Enterprises, have entered the custom home market. Their entry illustrates the strengths of companies at the high end and exposes their vulnerability.

In the custom home market, small builders design and build homes for customers who own their own lots. These customers go to these high end builders because of Function. The builders will design and build exactly what the customer wants. The Features and Functions of the home are precisely built to the customer’s specifications. (See “How Customers Buy” in StrategyStreet.com/Tools/Perspectives.) We call companies at the high end of the product spectrum Performance Leaders. These companies usually offer Functions that the industry’s largest competitors, whom we call Standard Leaders, do not offer. (See “Success Under Fire: Policies to Prosper in Hostile Times” in StrategyStreet.com/Tools/Perspectives.)

There is not much of a market for the Standard Leaders in home building today. New home construction rates are near historic lows. In search of some market, then, these Standard Leader builders have begun offering custom-built homes. There are two types of these homes: semi-custom homes, which are developed from the builders’ pre-drawn plans; and custom homes, which are built to the buyer’s specific specifications. The Standard Leaders are entering the Performance Leader’s territory with both semi-custom and custom homes.

Why would a custom home customer buy a Performance Leader product, such as a custom home, from a Standard Leader company? There are three answers to this question. The first answer is that the customer wants Reliability. These customers want to be sure that the project will be finished as promised. These Standard Leader builders have more resources available to them and have a proven capability to complete a project, where sometimes Performance Leader builders might falter. Second, the customers for the custom home buy on Convenience. Some of these customers have found that the Standard Leader builders can produce a custom home in half the time it takes for the Performance Leader builder to complete the project. Finally, these custom home customers also buy on Price. The economies of scale that the Standard Leader builders can bring to the Performance Leader product category enable them to offer lower prices, per square foot of home. In fact, these prices can be as much as 25% below those of the Performance Leader custom home prices.

Performance Leaders are usually strong on Function. But Standard Leaders can attack their market, offering better Reliability, Convenience and Price. The Standard Leaders’ high-end product is “almost as good as” that of the Performance Leader company’s product, but it is much cheaper.

This Standard Leader attack from below pattern has recurred many times. Another example is the Lexus line of automobiles offered by Toyota. In the early years of Lexus’ debut, Toyota priced the Lexus at a breathtakingly low price compared to its competition from Mercedes and BMW, among others. This price advantage shot Lexus into the market. Today, the Lexus enjoys a much higher price level but it is still less expensive than BMW or Mercedes.

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Update 2022:

Both Toll Brothers and Hovnanian were successful in entering the Performance Leader product line. These 2 homebuilders are the middle of the pack among the larger national homebuilders in 2022. The industry leaders, DR Horton and Lennar, also offer a complete line of products, including Performance Leader products. These Standard Leader competitors use their superior economies of scale and national reputations to succeed in the Performance Leader category.

In 2020 DR Horton led the industry with $21.6 billion in sales, followed by Lennar at $20.8 billion.  There is a big drop off to number 3, Pulte group, at $9.9 billion in sales.  Toll Brothers is number 5 at $6.9 billion.  Hovnanian is not in the top 10.

Here is a bit more explanation on Performance Leaders.  The second type of Price Point, Performance Leader, sits at the high-end of the product price and performance range. These products offer more benefits for higher prices than do the Standard Leader products. Examples of Performance Leader products include first class airline travel, combination PDA phones, specialty beers, and laptop computers. The term Performance Leader can also refer to those companies that specialize in selling products at the higher end of the product marketplace. These companies would include BMW, Nordstrom, Restoration Hardware, and Bose. Each Performance Leader company would gather at least 50% of its revenues from Performance Leader products.

• Audio Tip #82: Performance Leader Products and Companies

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Update 10/25

The US home building industry in 2025 is slow growing and fragmented, though it is consolidating relatively quickly. Most management initiatives focus on pricing and cost control. The industry leaders operate in a relatively comfortable market with good price discipline and attractive returns on investment.

The US home building industry, while large at $167 billion, is still highly fragmented, with some regional concentrations and a plethora of small competitors. The largest competitor, DR Horton, has a market share below 15%. However, industry consolidation with the largest players is moving relatively quickly. Since 2015, the top five competitors’ market share has increased from 22.5 % to 36%, 13.5 share points over 10 years.

The market is relatively slow growing, 2.9% per annum since 2015. However, the Sunbelt and Mountain West regions are much better growth centers. The leaders who concentrate on those geographic markets are outpacing the industry’s growth rate. As a whole, the US is woefully short of housing, which sustains good pricing power for the industry. At the same time, the market is cyclical in demand and subject to wide commodity swings, requiring astute management of cost and risk exposures.

The industry leaders have introduced product and Price innovations that appeal to the entry level and the middle of the market. They offer “everything included” purchase packages to speed buyer decisions and comfort (Reliability and Convenience). Their products on offer use materials designed for long-term low-cost maintenance (Reliability). To ease the pain at the entry level portion of the market, the leaders offer mortgage buydowns and closing cost credits (Price discounts). These discounts are possible because the industry leaders have superior access to capital.

The industry leaders have been able to gain share over the last 10 years by developing their economies of scale. Better scale starts with their superior access to capital. Their wide geographic operations also allow for significant savings in materials purchases. Their cost management efforts focus on improving their companies’ productivity. For example, they have adopted new materials yielding faster installations and better quality, to reduce construction times and to avoid callbacks. They have expanded their online operations to reduce lead times by helping customers make decisions before the companies must spend money. Their size has also enabled them to employ technology and workforce locality to improve labor scheduling. The industry leaders produce attractive returns on equity, reflecting a comfortable market for the largest competitors. As the industry continues to consolidate and exploit economies of scale, industry leaders should continue to perform well in a market with strong underlying demand.

On a closing note, this is an industry where you must do strategy on a regional basis. Industry leadership is as fragmented as the industry. Leadership, and therefore strategic requirements for companies entering or expanding in the market, the varies by region. For example, NVR controls 3% of the national market but has more than 25% of the market in Washington DC and Pittsburgh. Lennar enjoys a low double digit leadership stake in the national industry, but it dominates the Miami – Fort Lauderdale market in Florida.

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