The robust pace of new-home construction continues to drive mergers and acquisitions (M&A) activity within the construction supply industry, yet many observers question the sustainability of this unprecedented run and remain skeptical about future growth. I think this conjecture is unnecessary because, even if residential housing decelerates (as some economists predict), the effect on the building products industry will prove manageable for two reasons:

1. Economic sentiment is improving and corporations have amassed significant capital and secured friendly financing. We expect an increase in non-residential construction, bolstered by pent-up demand, strong corporate balance sheets, and improving state budgets.

2. On the residential side, remodeling expenditures are strong. Just look at The Home Depot and Lowe's. Although it is difficult to quantify, the bulk of their retail sales is attributed to remodeling projects versus new construction, yet both companies continue to increase revenues year after year even as new construction has overshadowed the remodeling market. And we all know that as new construction slows, remodeling often picks up.

Lure of the Land In addition to these trends, builders have prospered since the last recession and are seeking to expand their market share through both organic growth and M&A. In the next five years, the nation's 10 largest public home builders will continue to look for acquisitions to solidify their market dominance. It is expected that eventually 50 percent of new homes could be constructed by the top-10 tier; medium-sized builders will become less relevant, and the small local builders will bid for the remains.

What is driving big-builder consolidation? Notwithstanding the age-old advantages (better purchasing, pricing flexibility, synergies, etc.), builders view M&A as an opportunity to build their land positions. In order to mitigate some of the risk of holding larger land positions, big builders have become more attuned to geographic and product diversification. Thus, builders seek to acquire: 1) smaller contractors that specialize in second homes or active-adult communities, 2) builders with access to desirable land, or 3) small corporations in previously untapped geographic markets—thereby mitigating risk across multiple regions.

Yet another catalyst for M&A activity among public builders: valuations. Public builders are currently valued at forward P/E multiples of eight to nine times. If valuations rise—as some analysts predict—public firms could afford to pay more for private firms without the risk of dilution to their earnings.

Between a Rock and a Hard Place At the same time, the customer base of pro dealers is gradually shifting to the large-volume home builder. With their massive purchasing power, the big builders have the ability to pressure pro dealers to lower margins, broaden scale/national scope, and supply specific product lines. To appropriately adapt, pro dealers are evolving from niche to full-service providers capable of handling builders' varied needs ranging from logistical support to component preassembly to product installation. Such a transition has required pro dealers to purchase competitors and service providers.

As if pro-sector rivalry wasn't enough, pro dealers also may now face increasing competition from The Home Depot, which is still pursuing the builder/contractor customer market. Witness the June 2005 acquisition of Williams Bros. Lumber Co., a Suwanee, Ga.–based lumber supplier that sells to professional residential and commercial builders and contractors, as well as last year's acquisition of White Cap Construction Supply of Costa Mesa, Calif.

Although difficult to gauge a time-frame, there is a strong likelihood that M&A transactions will heat up if The Home Depot becomes more of a factor in the sector. Smaller pro dealers may be forced out; those remaining in existence must offer multiple product lines and responsive customer service to remain viable in this hotly contested middle channel. Expect mergers ahead, with the possibility of the top pro dealers consolidating and/or the bottom tier using mergers as means to gain scale.

Nicholas V. Beare Managing Director, Stephens Inc. Little Rock, Ark.