Mergers are headed the way of smaller homebuilders.  That is the take from Citi.  The firm is looking at several companies in the sector and it featured Beazer Homes USA Inc. (NYSE: BZH), Meritage Homes Corporation (NYSE: MTH), and Ryland Group Inc. (NYSE: RYL) as the possible target companies of M&A in the homebuilder sector.

Ryland Group Inc. (NYSE: RYL), Meritage Homes Corporation (NYSE: MTH) and Beazer Homes USA Inc. (NYSE: BZH) are believed to be the most likely targets under the Citi research.  The market caps of the potential targets are as follows: Beazer Homes is $285 million, Meritage Homes is $548 million, and Ryland is $725 million.

DR Horton Inc. (NYSE: DHI), KB Home (NYSE: KBH), MDC and PulteGroup, Inc. (NYSE: PHM) are believed to be the most likely acquirers per Citi.  The market caps are as follows: DR Horton is $3.3 billion, KB’s is $808 million, and Pulte is $3.17 billion.  Lennar Corp. (NYSE: LEN) was deemed as a wild card in the group.

The 5 reasons summarized were as follows:

• (1) new home sales have dropped to levels almost none of the management teams anticipated and have demonstrated
• no recovery so far
• (2) in sharp contrast to the 1Q10 earnings calls, on the 2Q10 calls managements sounded rather discouraged about the industry’s near-term growth prospects
• (3) most managements are now focusing more on gaining market share
• (4) the broader economic outlook, particularly the prospects for job creation, has deteriorated markedly
• (5) size confers an advantage.

What is interesting is that Citi does not believe there are really any public talks happening between firms at this time.  The belief is that there are likely some talks happening privately among management inside some of these companies.

Housing starts in July were released earlier this week as being up 1.7% on a seasonally adjusted annual rate of 546,000, while single-family housing starts fell by over 4% to 432,000 annualized.  This was after a deep revision downward for June and it appears that July’s drop in building permits for single-family housing was the lowest level in more than a year.

What is interesting about this speculation is that Citi just lowered its target on Beazer to $6 from $7 earlier this month and Wells Fargo also lowered its expectations and said Beazer will likely underperform peers after Beazer said its orders were down 33%.  Hedge fund manager John Paulson recently added to his stake in the company.

This call also builds o top of last week’s upgrade from Deutsche Bank on D.R. Horton, Ryland, and Meritage to Buy from Hold based upon the thesis that the housing market is nearing a natural bottom.

If consolidation does come, the hidden winner is likely to be the SPDR S&P Homebuilders (NYSE: XHB).  Its shares are up 0.35% at $14.54, but its 52-week trading range is $13.50 to $20.00.

As with any ‘reports of M&A activity,’ we treat these effectively as rumor until proven otherwise.

JON C. OGG

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