Forestar Group Inc. (FOR) Earnings Call Transcript & Summary

Good afternoon. Welcome to the closing or the final presentation of our afternoon session today. We're at the JPMorgan -- 14th Annual JPMorgan Homebuilding and Building Products Conference virtually. And my name is Mike Rehaut, as it has been all day. I'm covering the -- I've been the lead analyst for the homebuilding and building products sector for JPMorgan for more years than I care to admit. But we're happy to have with us today. Closing out the day, I think, a really unique story within the space in Forestar Group. Really happy to have with us as CEO, Dan Bartok; and CFO, Jim Allen. Forestar, as many of you probably know, a lot developer and manufacturer as they like to call themselves. And I think it really is, I propose, given the kind of higher turnover nature of their business relative to what you might think of as a traditional land developer. Kind of a high-growth opportunity within the industry, not only growing with DHI, who owns currently on still about 65% of the company, which would go down over time. But also on a broader basis, we believe the -- serving a broader swath of the homebuilding industry over time. So with that, I'm going to turn it over to Dan and Jim for some prepared remarks and there are slides on the website that you can access to follow along. We also have -- there'll be time for Q&A. I'll lead several questions. But if you'd like to submit a question, we have an Ask a Question feature on the website that you can submit a question, and I'll be happy to pass it along to Dan and Jim. So with that, Dan, I'll turn it over to you.

Thanks, Mike. Really appreciate it, and good afternoon, everyone. As Mike said, Forestar is a kind of a differentiated lot manufacturing business. We do focus on turning our inventory over quickly. It is, I think, a unique story. So it all started really about 3 years ago when Forestar had been in the lot development business for many, many years. And D.R. Horton acquired a controlling interest in Forestar back in October of 2017. It really kind of set the wheels in motion. Horton saw a need in the industry for a kind of a well-capitalized national footprint, lot development business in order to really supply lots to the industry. And we've been happy to be a part of that. In the first year after their acquisition of their interest, we sold about 1,500 lots and have been building our platform from them. And this year, we're really projecting to get to about 15,000 lots. So 10x growth in 3 years and been profitable along the way. There -- and if you -- as far as the presentation, I'm going to start off on Page 3, which kind of gives a brief overview if you could try to follow along. Again, a highly differentiated developer. Horton's strategic investment in us has allowed us to really grow the platform quickly. Last year, we provided about 18% of their lot needs. I think our longer-term plan is to get to at least 1/3 of their lot needs, so which gives us quite a bit of continued runway there as well as expanding our platform to other builders as appropriate. The -- we're well positioned. We have -- we currently have operations in 54 markets across 22 states. And at the end of March, own and control about 84,500 lots. Going to Page 4. Again, a little bit of repeat, but differentiated business model, again, really we don't take any speculative risk. We only buy land that is entitled and ready to be put into production. We focus on projects that are shorter-term in nature and really look for that high inventory turn opportunity. Say the long-term growth opportunity is really for us to continue to build scale in the markets that we're in. And really expand both our ability to deliver more lots to D.R. Horton, the largest builder in the country as well as to expand our sales to other builders. This past year, I think year-to-date, we're selling about 5% of our lots to other builders. We expect that to get to about 30% of our overall production in the not-too-distant future. Again, we have an intense focus on risk mitigation. We get short duration projects. We phase our development and only bring on lots as best as we can on an as-needed basis. We're geographically diversified. And most importantly, we maintain strong liquidity and a conservative balance sheet. But with no project level debt. All of our financing is done at the corporate level. Which really, I think gives us a unique opportunity in the market to compete, especially when competing against other smaller and multiple developers that really have that project financing on every project. And their cost of funds is significantly higher than ours. Now turning to Page 5. Again, somewhat of a summary of what I've just said. We have a strategic relationship with Horton. Long term, I think, opportunity to continue the growth that we have been set out upon geographically diversified. We are focused primarily on the entry-level segment, so affordable price points. I think overall, the homebuilding industry has a preference to buy finished lots, which again gives us, I think, some tailwinds in our growth. We have a proven and seasoned management team and a strong balance sheet to really support the business model. So turning to Page 6. Again, somewhat of a repeat, but summary of what really differentiates us from what would be the typical land developer, short duration projects, returns focused, we're really -- inventory turn is extremely important to us. We really like the affordable price points, which gives us higher velocity in our subdivisions, base discretionary land spend, strong liquidity. Page 7 really provides an overview of really the process that we are involved in. And we source land opportunities that can be Forestar-sourced, they're sourced by the homebuilders themselves and bring those transactions that we would underwrite. And then if you like them, we could purchase that land, develop lots and sell lots back to that homebuilder. We place -- the important part to place the land under contract and complete our due diligence, which often includes some entitlement processes permitting. Really, everything it takes to put that land into production before we close on the land. And then closing on the land, which generally makes about 30% of our overall lot cost. And then we would do phase development over a period of time, again, simply meet that need of a homebuilder on somewhat of a basis that gives them the opportunity to take lots down as they need them, but trying to stay ahead of them for their production needs. And then ultimately, we sell those lots to the homebuilder. I think one of the things that is important to note is, for us, by the time we close on the land and really develop that first phase, on average, that's about a 1-year process to that first revenue event. Again, then taking land down over time and developing over time. And then eventually, average project is right now running about 36 to 42 months from start to finish. Jim, you want to take this part?

Sure. Thanks, Dan. Moving to Slide 8. The relationship between Forestar and D.R. Horton is a strong symbiotic relationship that provides strategic benefits to both. Relationship with D.R. Horton has enabled Forestar's operations to ramp quickly by supporting the build-out of a national platform, providing a significant built-in demand for lots, improved access to capital markets and shared services support. Forestar's alignment with the nation's largest builder also provides support and stability through changes in economic and housing cycles as DHI's strong appetite for finished lots continues even during potential market downturns. In return, Forestar has become a consistent long-term supplier of lots across a significant portion of DHI's national footprint and an integral component of DHI's operational strategy. Forestar's continued growth in development also provides an opportunity for DHI to participate in value creation at Forestar. As such, DHI's interests are fully aligned with other Forestar stockholders to ensure the profitable expansion of Forestar's platform. Several governing documents, namely the master supply agreement, stockholders agreement and shared services agreement, formalized the business relationship between Forestar and DHI and protect Forestar's interests. The relationship with D.R. Horton has and continues to strengthen Forestar's competitive advantages. Chart on Slide 9 shows DHI's significant market share growth over time to a current 9% of total U.S. single-family new home sales. It's impressive to note DHI's continued market share increase through and since the last big housing market downturn. The star symbol on the chart reflects Forestar's market share growth from almost 0 in 2018 to approximately 1.5% in 2020. Ultimately, we believe a 5% market share should be achievable for Forestar. DHI's market share growth provides a road map for Forestar with the potential for Forestar to gain market share even faster in the highly fragmented residential lot developed market, aided by the strategic relationship with D.R. Horton. Chart on Slide 10 shows lots sold by Forestar to DHI as a percentage of DHI's closings, which more than doubled from 7% in fiscal 2019 to 17% in fiscal 2020. We expect to grow this percentage further in fiscal '21 and beyond. The charts on Slide 11 reflect the significant ramp in lots sold in total revenue from fiscal 2018 to fiscal 2020, with lot deliveries increasing from 1,279 lots in fiscal '18 to our guidance of 14,500 to 15,000 lots in fiscal '21, and revenues increasing from $109 million in fiscal '18 to guidance of $1.2 billion to $1.25 billion in fiscal '21. The chart on Slide 12 reflects the increase in return on equity over the last several years, including a 360 basis point year-over-year improvement in ROE for the most recent quarter ended March 31, driven primarily by improved profitability and asset returns. Charts on Slide 13 reflect Forestar's investment in land acquisition and development for the last 3 fiscal years and by quarter for the most recent 6 quarters. We expect to invest more than $1.5 billion in land acquisition and development in fiscal '21, positioning us for further growth in lot deliveries. The chart on Slide 14 shows Forestar's total opposition by quarter for the last 5 quarters, split between owned and controlled plots. As of March 31, Forestar's lot position was 84,500 lots, representing a 62% increase from a year earlier. Consistent with Forestar to focus on capital efficiency, the portion of its land and lot supply that is controlled via purchase contracts has increased, supporting higher returns in the future. As of March 31, 20,400 or approximately 34% of Forestar's owned lots were under contract to DHI, representing over $1.5 billion in future revenue. An additional 16,700 owned lots were subject to a right of first offer with DHI. Slide 15 shows Forestar's owned lot position at each of the last 5 quarter ends, segmented by the number of lots sourced by Forestar and the number of lots sourced by DHI. As of March 31, Forestar source Lots comprised 48% of total owned lots compared to 31% a year earlier. The significant increase in Forestar sourced lots reflects the expansion of Forestar's operating platform and supports the potential for future increases in gross and pretax profit margins. Dan?

Turning to Slide 16. It really illustrates our diversification across the country. The numbers that represent the number of own and controlled lots by market. The stars designate the offices that we now have opened divisional offices and the other dots are markets that we're in, in addition to where we have divisional offices. As you can see, a focus on Texas and Florida, where over half of our own and control lots or control -- are located. Phoenix and the Arizona market coming up as a strong third place. And then Georgia and the Carolinas also a heavy emphasis. As you can see, our focus is really on the markets that have a significant number of housing permits each year. Slide 17, I think, illustrates somewhat of the tailwinds that we see in the industry. The chart on the right of the the percentage of own and controlled -- our controlled lots versus owned lots by the homebuilders. One on the left is D.R. Horton. As you can see, has expanded to 72% of its live position is controlled versus owned. And as an industry, it's grown to 45% overall. We see those percentages continuing increase, which gives additional market opportunities for Forestar to expand. And then the chart on the right is kind of the inverse, which is the number of years of owned land based on trailing 12 months. Again on the left is D.R. Horton, and the right is the industry as a whole. Page 18, quickly, our management team, again, very seasoned, lots of years of experience, have been through multiple market cycles. And I think is well suited to lead this company into its future growth. Jim?

Forestar's disciplined financial policies are core to its business model. Key elements included hearing district investment underwriting guidelines and maintaining strong liquidity and conservative net debt-to-capital with a target of 40% or less, which inherently implies the balanced financing plan that includes both equity and debt. Slide 19 reflects Forestar's financial position as of March 31, 2021, with net debt-to-capital of 34.1% and total liquidity of $500 million, including $167 million of unrestricted cash. Forestar is well positioned with low net leverage and strong liquidity. In April, we took actions to further strengthen our balance sheet and improve liquidity. We issued $400 million of 3.85% senior notes due 2026 and used a portion of the proceeds to redeem $350 million of 8% senior notes due 2024, resulting in substantial interest savings. Also in April, we amended our revolving credit facility, increasing the facility size to $410 million and extending the maturity date from October 2022 to April 2025. Slide 20 reflects operating and financial highlights for Forestar's second quarter and fiscal year-to-date periods ended March 31. With lot sales, revenues, profitability and lot position, all showing significant year-over-year improvement. Dan?

Slide 21, again, this is kind of a recap. Forestar is a unique returns-focused lot manufacturing business, so very unique in the industry. It has a strategic relationship with the nation's largest homebuilder, which -- and long-term market share gains, both in continuing to increase the number of lots we sell to D.R. Horton as well as expansion in the industry. I think we have a geographic diversification and a growing lot position. We're primarily focused on the entry-level housing segment. The homebuilding industry as a whole as it gives us additional tailwinds to grow our business model. We have a proven and seasoned management team with decades of experience and a strong balance sheet and liquidity position. And Forestar is really well positioned to continue the success that we have today. With that, Mike, that wraps up our prepared remarks, and we'll be happy to take any questions.

Great. Thanks, Dan and Jim, appreciate it. Let me start out with a few. And again, for those listening in, feel free to submit a question through the Ask a Question button on the dashboard. A lot of ground that you covered, obviously, in terms of the story and the positioning and the momentum that you have in your business. Yes. Maybe just to start off on the sourcing of the lots. The mix has come up nicely in terms over the last few quarters and couple of years in terms of Forestar sourced lots, which has been a nice driver recently of higher gross margins, now represents almost half of your owned lots as of the most recent quarter. How should we think about this ratio going forward over the next 1 to 2 years? And is this basically as this ratio continues to increase, should we see a similar ratable increase in your gross margin outlook?

Well, clearly, we spent the last few years building out our platform, getting it to the point that we do have a substantial number of folks on our team now sourcing and acquiring lots. I continue to expect the percentage of owned lots that are Forestar-sourced to increase. I don't really have a target number of what that's going to be. Obviously, both D.R. Horton and other builders will continue to bring those transactions as well. I think it makes a good blend. And controlling that transaction from the beginning does allow us, I think, to harvest better margins. The builder always has his choices on transactions that they source. They can self develop, they could bring them to other developers or they could bring them to us. So it's a little bit more competitive. And I'd say, controlling that transaction from start to finish, I think, will always give us better margins. I believe that it will be one of the drivers of continued returns in the future more Forestar-sourced transactions.

And look, I think, in general, you talked about both the growth of the Horton business and having increased penetration into -- getting to, as I think you said in your last call, maybe supplying up to 1/3, roughly 1/3 of the Horton business but then also wanting to try and get roughly 30% of our overall business from third-party builders. So how do you see those 2 goals playing out over the next 2 to 3 years as well? Is there any need to, let's say, prioritize one over the other? Do you just want to support both lines of growth as best you can. How do you see those trends playing out?

Yes. I mean, obviously, Horton is our biggest customer. We want to keep them happy. We want to continue to grow that relationship. But at the same time, it's important for us to diversify our customer base. So I think both things will bear out. We focus on both of them. I don't expect the third-party builder business to increase rapidly, at least on a real numbers basis, but I do see it continuing to trend upwards. I think over the next 3, 4, 5 years, I expect this to be about 1/3 of our business to be to other builders. Right now, only about 5% of our sales are to some builders other than Horton. So at the same time, I'm anticipating our Horton business to grow from 18% to 1/3 of there. I expect our overall sales to be about 1/3 to other builders and 2/3 to Horton.

Okay. Obviously, you also highlighted your growing share of the overall industry, getting up to maybe, I believe, you said 1.5% on that slide. Obviously, you can grow and continue to grow organically. I was wondering on the M&A front, how should we think about that over time, over the next few years as well? Is that something that you might be a little bit more active in, obviously, so far, you've been more focused on the organic part of the equation. And to the extent that you have transactions in front of you, would there be a need to access the capital markets as well and how do you kind of manage both of those levers to the extent that you do see opportunity for inorganic growth?

Well, I'd say right now, we're at about 1.5% of overall market share in delivering lots to the housing industry. We think that we can easily grow that to 5%. So we think there's quite a bit of upside there. We have been successful with organic growth. We -- we're having, again, the support of Horton in these various markets allows us to enter new markets relatively easy compared to going to a market blind. And we've been able to staff up those teams and think there's a lot of upside within the markets that we're in. As far as M&A, I think there is going to be opportunities out there. We have discussions with folks all the time about that opportunity. We're looking for the right fit. It's got to be both a people and culture fit. As I say, we look at the business a little differently with that manufacturing mindset. So it's got to be -- it's got to have the right fit. It's got to have good assets and be in markets that are either additive to our current physicians or bring us into new markets. I don't think we -- I don't have to have M&A growth to hit our growth goals, but I think it would be -- it would get us there faster. And again, hopefully pick up some good teams at the same time with people. As far as the capital markets, we like where our capital positioning is. So we've got strong liquidity. We believe that we can probably grow at a 20% annualized rate with our current capital structure. And just by reinvesting our earnings. However, we think that there's an opportunity to grow faster than that. We've been pretty strategic in the use of our -- the capital markets up to this point. We tend to continue to be strategic. And we did a capital raise a little over a year ago. In the capital markets, we raised a little over $105 million. Last quarter, we kind of started tapping the ATM facility that we have in place, which has allowed us to bring capital in pretty efficiently, put to work pretty efficiently. And right now, as far as managing to that 40% net debt-to-cap. Again, I think we have some room in there to grow. As the capital markets are cooperative, we will continue to be strategic and access that as appropriate. It's all about trying to be really accretive to the existing shareholders. It's about being strategic but it's also -- we don't want to have too much capital that we can't put the work. So it's just -- we really like the timing and the way that ATM facility played out last quarter and have looked at continue to try to leverage that when appropriate.

That's helpful. Thank you for that. I mean, another way to grow or at least homebuilders look at it in a way that pros and cons is through land banking. That's maybe a year ago or so it was more about 70% of your mix -- I'm sorry, 30% of your mix, development, 70%. That development has increased in share closer to 85% or in the high 80s. How do you see that playing out? Obviously, land banking, similar type of dynamic for yourselves, I think, relative to other builders, higher ROE, but lower gross margins. Do you want to see that portion of your business remain where it is or even lower? Or how do you think about that as a future contributor?

Yes. For us, lot banking, buying finished lots from other developers and then rolling those out to the builders. It's a good use of funds when we had more capital then we could put the work in the development side of the business. It is a little bit lower returns. It clearly is lower margins because it's a very short-cycle of the time that, that money is outstanding. But for us, it was pretty strategic. It gave us ability to gain market knowledge in markets that we hadn't operated in before, help us build relationships with the Horton divisions. And I think it was really an important part of our growth story to this point. However, with the amount of opportunities we have on the land development side, and again, being able to bring in capital on an efficient basis. I don't really see us utilizing lot banking to the same extent in the future. However, again, if we have a large amount of cash available, it was a good way to put that money to work and gain market knowledge at that point in time.

Okay. So as you scale the business, you highlighted on your geographic footprint slide. The still vast majority of your business focused in Florida and Texas. Still a lot of markets across the country where you're doing maybe 200, 300, 400 lots or that's your lot positions on that scale. When you think about growth over the next 2 or 3 years, should we see a higher rate of growth in some of those smaller markets where you just have toeholds? Or would you expect -- or should we expect the predominant lot positions to remain where they are?

I think in real numbers basis, I think it's going to continue to stay pretty balanced. We really look at where are the housing permits at when we think about where we want to grow our footprint. On a percentage basis, I think that you'll probably see a bigger percentage growth in some of those smaller markets, only going from 100 lots a year to 200 lots a year is a huge increase, even though not a big real number increase. But I like being balanced. I like having a little bit of risk diversification in various markets. And frankly, I think in some of these smaller markets, there's even less competition. And some of the markets we've gone into, there is no land development industry because there's nobody out there doing it. But the only option builder has bought and owned lots. So it really kind of gives us some opportunity to have some outsized returns in some of those smaller markets. But again, I just really like to be balanced and being in the markets that have the most number of permits gives us quite a bit of room.

Okay. We are maybe 5 minutes away to the end of the session. Again, I'll remind people who'd like to ask a question to hit the Ask a Question button. Just a couple more from me, I guess, just kind of talking about the increased scale over time. And the impact on the income statement as you continue to build your business, again, I think with more Forestar-sourced lots, better scale. Your gross margins were certainly a bit more elevated most recently at 18.5% versus more 14% in the first quarter. So there's definitely, I think, maybe on top of the natural shift of your business, just some timing issues with the most recent quarter. Over the next 2 or 3 years, I mean, maybe you could talk to a little bit about the directionality of gross margins, how to think about that? Should it be more of a moderate increase, but still improving and how much of that may be coming from scale versus your own sourced program?

Yes. I think obviously, last quarter, frankly, our performance even surprised ourselves. There was a lot of stars aligned for us. The margins vary based on project size because we're so focused on returns. The shorter in and out projects are going to have a lower margin to get to the same return as a larger project where you're carrying that inventory over an extended period of time. So it was really kind of the stars aligned on the delivery of some short-cycle projects that were actually delivered ahead of schedule, and we're able to be sold, which worked out really well for it. But it also shows what we can achieve when the model is working properly. I don't -- I think it's repeatable. I think it can become a consistent pattern, although I don't expect it to be repeated this quarter or the next quarter, I do believe that it shows what we can really achieve. And again, the reason for, I think, the margin expansion is several places. One is the fact that we're doing less lot banking as a percentage of our total sales. So that overall, our development projects are going to have better margins. I think you can see improvement in our ability to source transactions and have Forestar-sourced transactions, which I think will prove out to have higher gross margins than builder-sourced transactions. The third is the market strength. I mean the ability and some of the pricing power that seems to be out there today, where demand is clearly outstripping supply. It's given some additional tailwinds in margins. How long does that continue? I don't -- my crystal ball is not quite that clear yet, but I believe that over the next few years, you will definitely see some market expansion and margin expansion for us. From a SG&A standpoint, it's still a little bit lumpy. We're building out our platform. We've doubled our headcount in the past year. We seem to be right now in that 5% to 6% range. That feels about right. I think it's a little more efficient than most of the mid-cap homebuilders if not all of them mid-cap homebuilders. We don't really have a sales force. We're really more of a wholesale company. We don't have that retail, wholesales and marketing effort, the same as the home builder does. So we should be able to run in that 5% to 6% range pretty smoothly, which I think gives us some pretty good room for profits in the future. We're really focused on returns and that return on equity number is really what we're zeroing in.

And the -- when you talk about margins and some of the strong pricing power that's out there, I mean, are you able to capture any of that on the fly? In other words, if most of your contracts are structured as options where you're setting an exercise price 1 or 2 years in advance. Is there any optionality to the upside as the market heats up? Or is it more of just as you strike new deals that you're able to build in a little bit better margin for the out years.

Yes. Well, we generally only really price a phase at a time. So as that phase burns off and we move in those subsequent phases, there is some pricing power. We're always very careful. What we don't want to do is overprice our lots to the extent it slows up velocity since that velocity is really important to our returns. But there are opportunities to take advantage of currently the strong market right now today. We're really not pricing 2 years out. We're pricing more like a year out. And then on Forestar-sourced transactions, we aren't pricing those lots until we're actually into the development process. So the time between pricing and delivery is shorter. When a builder brings us a transaction, whether it be Horton or another builder, they want to know what that first phase pricing is when they're assigning us that contract. So we're pricing a little bit longer out on a builder-sourced transaction than we are on a Forestar-sourced transaction. So again, I think that's one of the reasons you'll see Forestar-sourced deals having higher margins over time. We're able to be a little more flexible and take advantage of market movement at the right time.

Right. Well, that actually does it for the time allotted. We're at the -- a little bit past the 35 minute mark. So I want to thank you, Dan and Jim, for participating at the conference. I always learn something and appreciate your time. That actually does it for today. The end of our first day of our JPMorgan conference. Tomorrow, we have a full -- another set, a full agenda for you, starting off with Fortune Brands CEO, Nick Fink. Also have JELD-WEN, D.R. Horton, Taylor Morrison, Masco, TopBuild, Installed Building Products and Green Brick. So another full day tomorrow. Thanks again, Dan and Jim. Appreciate the time, and have a good evening, everyone.

Great. Thank you, Mike. Thanks for having us as part of this. Appreciate it.

Thank you.