Volume 8, Issue 11 - December 2007
Capitulation Occurs in Building Industry
A number of people have asked me lately for my prediction as to when the housing market will turn, which has brought to mind the concept of capitulation. Capitulation was a much-discussed topic during my time in the wealth management group at Morgan Stanley. We were in the bottoming process following the dot-com blow-up. The question on everyone’s mind was, “When will the market turn back up?” It was believed that the recovery would only begin after capitulation—a series of related, very ugly events indicative of investors throwing in the towel—had occurred.
Clearly, the forces of the stock market move much more quickly than the forces at work in the building products industry. They also send signals, in the form of stock prices, which allow for an easy three-minute assessment of the direction of the market during the evening news. However, the concept of capitulation is no less valid in our industry than in others and it can be used to confirm that we are in a bottoming process.
In looking at recent events, a gradual process of capitulation appears to be underway, which will allow recovery to begin. Signs may be seen in the suffering of homebuilders, whether it is the national builder that announced in the fall that it will build no more homes in a certain troubled Midwestern state or the major builder in Chicago that recently filed for bankruptcy. These activities may be viewed as part of a process of capitulation, because they are motivated by a lack of belief that conditions will improve. Thus, they are the equivalent in the building products industry of panic selling.
Even the acquisition of EFCO by Pella can be viewed as a form of capitulation regarding the residential market. When you see a major residential door and window company seek to diversify its revenue stream by permanently adding a commercial business that is at least a mild form of capitulation. Economic self-interest dictates that a company like Pella will always invest the excess cash generated by its business in the available project with the highest return on invested capital. Bear in mind that the cash flow to be generated by a successful “project” like EFCO also must be discounted by a factor that accounts for the execution risk that comes when a company that historically has served the residential market starts serving the commercial market.
This fact serves to underscore the significance of that transaction to the capitulation process.
Another important aspect of the capitulation that will occur before the market will recover is the exit of the weak players in any particular segment of the market. Companies that have failed to find a successful niche or that have to compete over much on price will find themselves squeezed out of the market by the currently low volumes. A handful of companies that have not weathered the current downturn as well as their competitors will likely seek a sale or a merger in order to regain the momentum they will need to capitalize on the upturn that, for them, will not come soon enough.
This brings us back to the requests for a prediction of when the market will turn. Perhaps the better question to ask is what would the owner of a door and window company do differently if they knew the exact date and time at which the market will recover? Would they lay off workers until the month before? Would they close a plant? Would they hold off on making an acquisition or taking their company to market in anticipation of that day? The fact is that the recovery will occur and there is little any company could or should be doing differently in the uncertainty of the timing of recovery than they would do if the timing were known. Now is the time that opportunistic companies will improve operations, eliminate excess, rationalize facilities, keep in touch with the needs of their customers and generally prepare for the recovery that eventually will come.
Michael Collins is with Jordan, Knauff & Company, an investment banking firm that specializes in the door and window industry. He may be reached at firstname.lastname@example.org. Mr. Collins’ opinions are solely his own and do not necessarily reflect the views of this magazine.