Let's pick a number to start with; that number might be somewhere in the range of 500,000 and 600,000. When all is said and done, that's probably pretty close to the number of new homes builders will sell coast-to-coast in 2008.

Margaret Whelan, J.P. Morgan Photo: By Carol Seitz Although it won't be tallied up until early 2009, the figure assumes that things are going to get worse than they are right now. But then, after they get worse for several quarters more, they're going to stop doing that–finally. And when that happens, it's going to feel a whole lot better than it does now. For the home building industry, the plunge from 1.1 million sales or higher to half that number is a very hard landing. At a peak average sales price of close to $250,000, the "gross domestic new-home product" was north of $275 billion for a fluttering moment or two. Now, the new-home builder economy is probably going to snuggle in at around $135 billion for a bit before regaining some normalized momentum. This story, however, is less about home building, and more about home builders.

Home building is a nationally-afflicted industry sector, facing an enormous supply overhang, stunning lack of affordability in many markets, tightening mortgage money, and a psyche-challenged home buying public, many of whom can't sell their homes to buy new ones.

"The consequence of all this is that this housing correction is already the deepest, and it's likely to be the longest," says Tim Eller on a UBS Building Conference Webcast recorded in November. "This is going to be the most serious housing correction in modern times. How far into are we? I don't really know. I just know that the correction will still take years to work itself out."

Home builders, on the other hand, are enterprises that can radically change their heft and even some of their basic business practices to sync up with market condition cycles that–whenever they turn from peak toward trough–seem to trick most players at their own game. But, as much of a mess as home building is in right now, it is home building management teams who will find their way out of it.

Centex, says Eller, is still in a position to be a strong and dominant player in home building, both present and future. And so is The Ryland Group, according to its CEO Chad Dreier; and KB Home, per CEO Jeff Mezger; and K. Hovnanian, says its leader Ara Hovnanian; and Meritage, and M.D.C., and Lennar, and so on and so forth. There were a few home builders in UBS's coverage universe missing from the parade of those who stood up to predict their ultimate triumph over the current adversity–a couple of those conspicuously absent currently face financial problems many consider to be insurmountable.

"There's a growing disparity between the builders who will survive and those who are teetering," says Margaret Whelan, who, as a recently anointed managing director, oversees the J.P. Morgan Securities empire's investment banking, credit, and overall engagement in the world of home builders, public and private.

Whelan asserts one needs to look no further than the balance sheet for signs of long-term viability. "In some cases, the greatest asset for public builders is their debt–cheap debt on their balance sheet that won't mature for years."

J.P. Morgan may be committed to home building, but it's putting its money behind specific home builder management–not the industry sector. For more than 10 years, and a couple of fairly serious cyclical hiccups in the early and mid-1990s, Whelan analyzed public home builders' balance sheets and operational measures as an equities analyst at UBS.

A 12-year tenure on the sell-side primed a fortuitous blend of business intelligence and passion. "My research may begin in the boardroom with CEOs and senior executives, but it continues through building sites and into buyers' pockets," Whelan wrote in Big Builder magazine's September 2005 issue. "I make it a point to know the contractors, the salespeople, the suppliers, and the buyers–anyone and everyone who's involved in the process. ... I rate builders on numerous (and continually evolving) variables, such as their processes and projections, how they manage their business after a hurricane delays construction, and what their plans are to limit speculative buying. Investors look to me to give them a non-biased view as to which builders are doing it right, which are missing the mark, and which might just get bought outright."

The challenge for a sell-side research analyst is to work with the raw materials of what publicly traded companies say about themselves and use that as a starting point to relate the potential values of an industry and its respective companies to institutional and individual investors. Relationships with current and former executives, suppliers, competitors, and industry consultants become an analyst's way beyond the veneer of public affairs and investor relations channels. Still, it's an outsider's view of the business and its players.

In the Loop

In July of this year, the career tables turned, and Whelan took over a role within J.P. Morgan's investment bank that gives her a seat in the strategic inner circle among dozens of the nation's leading home builders. From her position, she leads the stewardship of the bank's areas that extend credit to home builders and is necessarily in the loop about the health and welfare of J.P. Morgan debt on home builders' books. More importantly, however–especially among companies that enjoy the greatest likelihood of coming out of the current downturn with a strengthened position–Whelan's place is as "trusted advisor," with both industry and specific operational knowledge.

Even from her prior perch at UBS, it was clear that as market conditions took a U-turn at the end of 2005, each company pursued its own path of action based on the signals it was picking up from its people on the ground in its respective markets, its access to capital, and its level of ambition.

Those signals were confusing at the least, very often contradictory, and sometimes outright false–phantom pulsations of activity that had ceased being meaningful months earlier. In any case, companies' ambition levels frequently eclipsed what the signals were saying, good or bad. Everybody behaved differently, and some got caught standing after the music went silent.

"Some of them reacted very quickly to the downturn and were proactive in terms of trying to liquidate cash, sell land, and work defensively," explains Whelan.

"Others continued to build, invest, and buy land into the downturn. Now they're over-levered, have too much land, and not enough profits to service the debt."

For an investment bank whose corporate pedigree traces directly back to the post-industrial consolidation of energy, transportation, and financial companies in the first half of the last century, every parabolic swing of every real estate cycle represents opportunity. The anomaly of this cycle is that supply capacity crescendo-ed as affordability vanished, leaving artificial–speculator and unqualified buyer–demand as a critical data point that said to keep serving out product. A tide that lifted all boats had one final surge, thanks to a flurry of home buyers who scrambled across the chasm of their means with loans they never should have taken. And just as many homeowners face a moment of truth as their 2/28 and 3/27 loan payments reset to the tune of a $350 increase per month, home builders who borrowed, built, bought land, and didn't sell land and homes as fast as possible over the past couple of years face the same moment of truth.

"Home buyers are so focused on price point and the monthly payment, and everything influences that," says Whelan. In turn, she adds, "The [home builders] have got to get their overhead costs down." If you're going to knock home prices back to where they're inline with affordability measures, the land cost base needs to be reset, but before that will come a contraction in size of all the companies.

"If we assume 500,000 or 600,000 new-home sales next year, you only need to sell 10,000 or 15,000 homes to stay solvent," Whelan says. "Then it's a question of which markets you are in, which price points, which business decisions you are making to support that level of volume. We're focused on quality over quantity–there's no one-size-fits-all."

The challenge for investment and lending institutions with interests in and exposure to residential real estate is to separate particular home builders from the general ills of home building.

"In some cases, we're doing workouts and balance sheet restructuring," says Whelan, who seldom sits in J.P. Morgan's Manhattan offices, so often is she traveling. VP Sam Bakhshandehpour partners with Whelan as a West Coast-based alter ego. Increasingly, as the levers of financial pressure and market inertia click into play, strategic conversation tends toward scenarios unimaginable a couple of years ago.

"We are actively discussing consolidation and joint venture opportunities with many industry participants," Whelan notes. Within two years, "There'll be a flurry of M&A activity," she says (see "Less is More").

2008 Outlook

As risk has re-emerged as a bona fide matter of business, financial, and economic consequence after several years in apparent hiding, any organization whose management plans an extended stay in the home building arena, including J.P. Morgan, needs to be selective. Sales absorptions–or a lack of them–will naturally select some of the entities based on how much and whom they owe, as well as their means of paying that back if cash from selling homes isn't enough. Amid this Darwinian evolution, some players will gather strength, some will squeak by, and still others will verge on the brink. As for strategies for 2008, Whelan says hope is not one: "You can hope for the best, but you have to manage for the worst."

Whelan's view is that the environment will be worse next year than in 2007, mostly due to the sheer amount of inventory. There's going to be less pricing power overall, so margins and cash flow will be reduced as another batch of land charges plays out. What builders don't have now that they had at the end of last year was a backlog. Even with higher cancellation rates, the backlog meant cash generation.

"If you know that you're going to remain solvent, or if you're being proactive to remain solvent, the question is: 'How do you want to be positioned when the market turns?'" Whelan says. Even at half the "gross domestic new-home building product" of $135 billion, J.P. Morgan will align with builders positioned for a future now. In a patently simple but suggestive turn of phrase, Whelan observes, "2008 will look different for different people."

Less Is More

Will big builders get bigger? Yes. When? The timeline is difficult to plot, but J.P. Morgan Securities managing director Margaret Whelan believes that "there'll be a flurry of M&A activity in the next two years."

In a growth environment, when the strength of the tide lifts all ships, it's seldom that one sees market share consolidation occur because expansion is happening everywhere. "It's when things get tougher that it becomes clear that the better companies really have positioned themselves," says Whelan.

There are myriad reasons the CEOs of the largest home building companies downplay the likelihood of Top 10 to Top 10 mergers. Mostly, they say that from an operational and financial standpoint, it's difficult to imagine taking large enough costs out of overheads and yet retain scale and proficiency to compete in local markets. Also, the ownership of the largest–even publicly traded–companies is held closely enough that, until principals tire of the game, they don't plan to sell. Now, since many "national" builders have achieved the footprint most of them coveted based on the mathematics of new-home activity, geographical diversification is no longer the driver of M&A it used to be.

Still, there will be motivators, and frequently it's not so much a new market or more markets, but a product, price point, or market segment that one builder has that another builder wants. Says Whelan, "It's not just growth in geographical size that would be the reason, but it's also an opportunity to take supply out of the market–if you have a peer that's struggling or a peer that has a phenomenal brand, price point, or market position that you've envied and now it's available for sale for whatever reason, you go for it."