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

Good afternoon, and welcome to the 2:45 session at Citi's 2022 Global Property CEO Conference. I'm Anthony Pettinari with Citi Research, and we're very pleased to have with us Daniel Bartok, CEO of Forestar. This session is for Citi clients only. So if media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. And for those joining us here today in person to ask management any questions, please just step up to one of the mics, or if you're joining us remotely, just type in your question to the box at the portal and that will come directly to us, and we'll do our best to ask the question during the session. So Dan, I'll turn it over to you to introduce Forestar and then maybe we can move into Q&A.

Thanks, Anthony. So Forestar is a -- we're in a business of manufacturing communities and building lots that are being sold to the homebuilders. So we really look at ourselves like a manufacturing company and providing that input to the homebuilder. We are national in scale. We are in 55 markets in 23 states. And I think at this point, we've now become the largest pure-play lot manufacturer in the country.

Great. Great. Dan, can you talk a little bit more about kind of scale and competitive advantage in lot development and a lot of your competitors are obviously smaller. Can you talk about the advantages of scale?

Yes. It is a very fragmented industry. It is mostly made up of small local developers. In some cases, there are some regional developers, but people that are really focused on creating that lot and selling that lot to the homebuilder, again, very fragmented industry. They use bank debt to finance their projects. So every project is separately underwritten. They are really looking at that homebuilder contract as an important part of that bank underwriting process. So they're contracting to sell those lots even before they bought the land and really fully contracted to build those lots. That's a different model than what we have and probably where one of our biggest competitive advantages is the fact that we use corporate debt. Our scale and our balance sheet gives us the opportunity to do that. And therefore, we don't have any project-level financing. We have over 200 active projects and the thought of having 200 different bank loans to finance those projects would be a nightmare, frankly. But it gives us the flexibility to underwrite projects, to close on land without having to get bank approvals and to deliver those lots in a way that lets us price the sale of those lots closer to the time of delivery of the lot so that we're not sitting there with all of the kind of cost risk of delivering those lots on both timing and cost at the time, again, going back to the point of when the lot was purchased, when it was purchased.

Great. Great. And you recently raised, I think, deliveries guidance for '22. Can you talk a little bit about your kind of full year '22 outlook and maybe what you're seeing in the market currently?

Yes, we did. We just increased our guidance to between 19,500 and 20,000 lots for the fiscal year. We are in a September fiscal year, so that was at the end of our first quarter. When we originally set our guidance, obviously, the supply chain issues are paramount and our thinking of how quickly we can deliver those lots. What we found after kind of the supply chain issues, first hit was that we were seeing elongated development times of maybe 60 to 90 days on average, depending on the market in the country. We learned from what was going on. We learned to adapt to order materials much sooner in the process than would be normal in a normal operating environment. We've actually been able to kind of pull those lot deliveries back to closer to normal. So today, we're probably on averaging about a 30-day delay -- over what would be a normal development time. So we took that into account. We looked at our first quarter deliveries and felt comfortable expanding that guidance. And I think we went up roughly 500. I think we went from 19,000 to 19,500 to 19,500 to 20,000.

Great. Great. And can you talk a little bit about what supply chain constraints look like for a lot developer versus maybe a homebuilder because a lot of the builders produced guidance last year and you guys were raising it throughout the year.

Yes. It's been -- every market is different, which is a little bit strange. When you think about what we do as a business, the first thing we do is you start with a piece of raw land and you start with moving dirt, like making the site balance, getting it ready to put improvements in the ground. So the whole first process is really guys running equipment, big equipment -- and there's really no supply chain issue in that aspect. We haven't had any problems finding the labor component. I know it gets asked a lot is what about labor, but we haven't had really any problems in the first portion of the development, which is moving dirt. The second phase is really putting in pipe in the ground. So whether that be sewer pipe or water lines. And we had a period there where they had that big freeze, if you remember, about a year ago, in Texas along the coast and it kind of hurt some of the petrochemical companies. And for PVC pipe that goes into the ground, it's again a petroleum-based product. So we did see some supply chain shortages in PVC pipe, particularly in the bigger sizes. And then things like valves, which are being made offshore, the water valves, that can turn water on and off at the -- like the fire hydrant type of valves. We're in short supply for a while. But both of those have seemed to correct themselves. Prices have gone up, but yet again, we just need to order those sooner in the process. The other big component of what we do is we put these big concrete structures in the ground where the sewer lines come in at different elevations and because when you think about a manhole that you see in the street, there's usually a big concrete structure below that manhole. And again, those are kind of custom-made for that exact location depending on the elevations of the incoming and outgoing holes at the bottom of that box. And that, again, there was a little bit of shortage with labor because they are custom made in local locations. And some of the COVID illnesses did affect the ability to get those on a timely basis. So -- but again, that all seems to have at least strained out in most markets, manhole for a while, we couldn't get manhole cover. They were being produced in India. And again, India had a big COVID outbreak. And so for a while, we couldn't get manhole covers. Today, the flavor of the day seems to be transformers and the ability of power companies that put transformers on your sites and get your lots hot. So again, it's kind of changed. And again, I might have an inability on one side of the Florida coast to not get pipe and on the other side, it was valves, and we started just shipping stuff back and forth and kind of taking care of some of our own shortages.

And you -- I think you indicated that maybe cycle times were getting pushed out 60 to 90 days, you've been able to kind of pull those back in a little bit. I'm wondering if you could just talk about kind of typical project length or typical cycle time. I guess it depends on the type of project. And then do you have an edge there versus smaller mom-and-pop developer?

Yes. The -- typically, from the time we close on a piece of land and start development, it takes about one year. And again, it varies in different markets, but on average, it's about a one-year process. so we can get that lot completed, signed off on by the municipality and be in a position where a homebuilder could buy that lot and start construction of a home. So that's the typical time frame. And again, there's certain markets we can do that in 9 months. Others, it might be 15 months, but on average, it's about a year. And that has stretched out to be roughly 14 to 15 months on average for us. And now we got it back into that roughly 13 months average time frame right now.

Got it.

And as far as smaller developers, one of the things that has been beneficial to us as we build scale in the markets that we're in is the ability to get the contractors on a site and then kind of keep them busy, whether it be on that side or another project we have in town, but really keeping those contractors working for on -- Forestar projects versus just having one project to do maybe once a year where the small guys may have a project here and there. So it's -- again, it's kind of being able to kind of have that continuity of work. And I think that's given us a good competitive advantage -- the other thing, frankly, is the ability to pay timely. Kind if I'm a small guy and I got to go to the bank to get a draw from the time I get that invoice and -- then get a draw put together, send it to the bank, get it funded and pay that guy, that might be 30 to 45 days. For us to get the invoice in and we cut checks every week. So if you get it in and properly approved, you can get paid within a week.

And can you talk just a little bit about what you're seeing in the land market currently in terms of lot prices, overall competitiveness in the land market? And how we should think about sort of lot price appreciation in an environment where home prices were up 20% last year nationally?

Yes. The finished lot product, I think, is in short supply, pretty much every market we are in right now, the demand for those lots is greater than the supply for those lots. So it has driven up prices. And I think some of that has -- obviously, after COVID, I think demand came back stronger, more people were looking to buy homes before COVID. I think you also had some demographic tailwinds behind us. But what happened is not only did the demand for houses to be sold improved, but kind of the build-to-rent market came alive in the last couple of years and something that wasn't really a customer for finished lots has now become a pretty hungry customer. They underwrite a little bit differently. They're underwriting based on cap rates rather than what I could sell that home for. And it's really kind of added another demand pressure to the lot delivery. But again, it varies from market to market. Some markets we're seeing lot prices go up 10% to 15%. I mean others were seeing 50% increases in Austin, Texas, right now, it's pretty much double, I can sell a lot from almost twice today what I could rate before COVID.

And can you talk a little bit about your regional exposure? I mean you're obviously in a number of states, but is...

Yes. We think about allocating our capital in our business really based on single-family housing permits. So we kind of start with MSAs and the permit base as our beginning number. When you really look at where houses are being built and where there's the most in migration, Texas and Florida rises to the top of that list. And a little over half of our dollars and half of our lot count of owned and controlled lots is in Texas and in Florida. Florida actually were a little bit ahead of Texas right now. But those 2 states make up over 50% of our inventory investment today. Behind that, we have Arizona. It's probably #3, and then I really move over to kind of Georgia and the Carolinas being right behind that. So again, the states that have the most amount of homes being built is where we have our highest concentrations. But we're also -- we've also moved into markets in the Midwest. We're now in Desmoines, Iowa, we're in Columbus, Ohio, Indianapolis, where you'll never have the same depth in that market. But what we found was that there's really no competition. There's nobody there doing what we're doing or maybe one player. Land prices are very reasonable still. And the regulatory environment for getting projects approved is much more lenient than in some of these higher-growth states. So we found we can have a pretty small presence. It doesn't take a lot of people on our team to run an operation. So I can go into a market and do 300 lots a year and have really great returns as compared to other markets where we might be doing 2,000 lots a year.

Right. A couple of questions on rates. I guess, first, how has the business historically performed in periods of rising rates? And then just maybe more near term, have you seen any change in activity or maybe just calmer customer…

As of right now, we have not seen any fall off in demand for finished lots. The builders are still hungry for those lots. And again, I think the build-for-rent component adding on to that demand side. We -- what's interesting for us is we've grown -- 3 years ago, we sold 4,000 lots. Today, we're going to sell almost 20,000 lots. The number of finished lots we carry stayed about static. We're right about 5,000 lots, whether we did 4,000 lots a year or whether we're doing 20,000 lots in a year. So what that shows me is as fast as I can get those lots completed, there's a buyer for those lots. So that little bit of overhang is really just some timing. And in some cases, we're doing some stage takedowns of those lots. But -- so it shows me the demand is strong. We're able to sell those lots as soon as they're completed.

And is there a way to think about your pricing power in terms of maybe the lag that you would see versus like a builder ASP price increase? And then if we look at your bank of owned and controlled lots or lots under development, can you just talk about how your ability to price or negotiate price.

Okay. Well, the -- generally speaking, lots do follow ASP increases. So if you think about it historically, and kind of on a national basis because again, every market is a little bit different. But you think about the value of the finished lot being in the 20% to 25% of the value of that sold home, right? So the home sales for $300,000. You can think of that lot being $75,000 kind of ballpark. I think it has a rule of thumb, every market is a little bit different. Like in California, that number might be 50%, right? Vegas is probably in the mid-to-high 40s today. Texas, it's probably 20%, right? So it does vary from place to place. But on average, it's at 20% to 25%. So as that pricing power for the house goes up, again, the pricing power for that lot goes up. And again, that added component of the build for rent who's using a different pricing model, we're finding that we can sell a lot to a build-for-rent community, maybe 20% to 25%, 30% greater on a per lot basis than a typical build-for-sale situation. As far as our land inventory, interesting is kind of going through the meetings earlier today, about 70% of the lots that we own today, the purchase of that land was contracted for before 2021. So before any of the run-up in kind of land values, which really been over the last 9 to 12 months, we've really seen land inflation. So good portion of our land was contracted long before that. And then -- and if I go to my control lots, that number moves about 80% of what we have under contract today that we haven't closed on yet was contracted before 2021.

Got it. Got it. And can you talk a little bit about land spend for '22, where your guidance is? And what kind of growth that implies maybe year-over-year versus what guidance growth?

I'm sorry, I missed the first part of that.

The land spend?

Land spend. So right now, I think our guidance is about $1.75 billion for this fiscal year in land and land development costs. What you've seen is the company has grown is in those first couple of years, the -- it was very heavily skewed towards land as we were building up that base land portfolio. And now we've skewed the other way, now a predominant amount of our dollars is really in developing the land that we own as we get into multiple phase projects. So to the end it probably is about 60% this year roughly, give or take or go towards developing land and about 40% for actually buying new land parcels. We can grow based on our current capital -- equity capital and debt structure, we can grow at about a 20% rate year-over-year without any additional equity capital coming in. So what you'll probably see is that our land portfolio, again, it was growing much more rapidly, but our own and control lots will probably start to skew towards that 20% growth rate rather than the 30s and 35 that you've seen last year and 40%and 15% the year before that.

And is there a -- do you have a target in terms of sort of years of supply? Or where are you in that versus that target?

It's -- again, we're a little bit evolving with the manufacturing mentality that we have because we really are focusing on turning our inventory as quickly as possible. Again, I focus more on my return on equity than I do my gross margin. So how can I balance the 2 out to maximize my return on the equity investment? We set off thinking that we would probably need to carry about 3 to 4 years of owned inventory. What we're finding is we're able to operate a little leaner than that, more towards the 3-year number. And I think that's probably a good run rate. As we continue to build scale in the different markets that we're in, we might be able to get that down a little bit lower. But right now, we're skewing right between 3 and 3.5 years is where we're skewing today.

You talked about the focus on return and gross margin. Just on margin, you are guiding to, I think, 300 bps roughly of margin -- pretax margin improvement. What are kind of the key drivers there?

Well, I mean, for us, it's the gross margin on the lot and then our SG&A leverage, right? And we're able to operate in that mid-single digits in SG&A. Again, the thing I like about the business is we're a wholesale company. I don't have a big sales force. I don't have salespeople on our teams get all the actual construction work is done by contractors. So it's a pretty people-efficient business for us. I'd say being able to operate in that 5% to 6% range feels about right. Even though we've been growing the teams pretty significantly, it still seems like we're holding in that range. I think for the foreseeable future, that feels about right. So I think our guidance right now for PTI is in the 13.5% range somewhere out in there. I am scaping, but I think it's right, maybe even up the 14%, again driven by continuing to improve our pricing power in today's market. The fact that we've been able to price our lots a little later is given us that margin expansion at a time when probably all the smaller and smaller developers are probably getting the margins beat up because they price so early in the process, and we've been able to run an efficient operation.

Great. A couple of questions from investors here, I am going to read the first one. How much of your lots are contracted via options so that your buyers/homebuilders can walk away? And what are the potential risks with those options?

Yes. So today, about 30% of our owned lots are under contract to be sold. The typical contract is about 10% in earnest money -- for that contract. So if they were to not close or default on that contract, we would keep that 10% earnest money. Again, for us, our model is different than that. I'm not contracting for those lots 2 years ahead of time or 1.5 years ahead of time. I'm contracting them more like 90 days before closing or 120 days before closing. So I think there's a much shorter window for the market to change and get either retraded or have them walk from those lots. And again, with our kind of approach at the way we're capitalized, we have some lots at one builder walks on good chance somebody else will walk them today. I guess in an Armageddon situation that might change. But -- what really happens if the market turns down, I think we saw that when COVID hit, and then we clearly saw that in '09 and '10, was that the first thing a builder will do when they see falling demand as they stop buying land and they stop developing lots and focus on buying developed lots. And it's really kind of -- I think part of our strategy is to be in a strong position in a downturn and actually gain market share.

Great. Can you talk a little bit about your relationship with D.R. Horton? And maybe just first off, the ownership stake and maybe potential thoughts around deconsolidation to...

Yes. So D.R. Horton initially purchased a controlling interest in Forestar, 75% interest back in 2017. Their strategy was that for them to continue growing the company, they needed a national, well-capitalized supplier of lots. So they looked at Forestar as being someone they could kind of guide into that position. Today, they own about 62%. So they've gone from 75% to 62%, primarily by -- we did equity offering a couple of years ago, which added to our equity base, and then we've used the ATM facility a little bit in order to kind of add some additional capital -- so that's been -- they've been diluted to this point. I think where our share prices are today, I don't see us issuing any additional shares. I think shares are on sales. I'm not necessarily looking to sell more at this price. And I don't think I see Horton diluting any further by doing any direct sales today. They do have a stated goal, though, which is to get down to between 25% and 35% ownership. For them, that would allow them to deconsolidate Forestar from their financial statements, which I think has always been an ultimate goal of theirs. So I think over time, they've proven to be patient. I think the operating model is working well. And I think when the time is right, that they'll probably get to that ownership. But that I think that's going to be dependent upon our share price.

Right. And do you still leverage Horton kind of back-office infrastructure? And can you talk about sort of G&A buildout within Forestar?

Yes. When we first -- when the first transaction first happened, Forestar had about 30 employees. And we relied there's a shared service agreement in place, and we relied on Horton for a lot of things to kind of help set the platform in place and grow the company. Every year, we peel some of those shared services out. Today, it's primarily their technology group and their IT. So for a company in 300, I still have a 24-hour help desk, and we have all the things that go with being a big company. It's something we would probably outsource anyway. But I think we get some extra efficiencies of utilizing our technology group. And the other is really in the human resources area where we're getting the benefits of offering benefit packages of a much bigger company, again, even with the size that we're at. So I think things that -- those are really what's left. There's still a couple of little things here and there that we leverage them on. Back in the beginning, we were even really relying on them even to develop lots in some markets and paying them a fee for that. But the platform has grown pretty significantly in the last 4 years.

Can you talk a little bit about the right of first offer to Horton and how that protects Forestar from the rest?

Yes. The right of first offer -- I said there were 3 things that were put in place at the time that Horton bought the controlling interest. One was the shareholder agreement, which gave them certain control features, which until they get down below 35%, they retain some of that. The other was the master supply agreement and the third was the shared services agreement. The master supply agreement basically, I think, is really for them, the key, which if for all deals that Forestar sources, there's a right -- they have a right of first offer in at least half of those lots. And what that means is that Forestar still gets to control the pricing and what the market terms -- what we believe are the market turns. It just means we have to offer them to Horton before we offer them to somebody else. So they get the first look at the opportunity to buy those lots at what we believe is the right market pricing. And on a transaction that if the builder sources an important source of the deal and brings they have rights on 100% of the lots again on that right of first offer basis. And if a third-party builder brings us a deal, they don't have any rights to those lots. But the real key for us is really the Forestar source transactions. That's where we control the deal from the beginning. I think we have the most flexibility on those projects and have the best returns on those projects as well. So again, so we set the price, we offer it to them. If they don't like it, and we can't negotiate something that is good, then they would pass, then we're free to market those lots to other builders. And I'd say today, we've done that a couple of times. But generally speaking, we're coming to terms with Horton at this point.

And do you have a target of the share of Horton lots that Forestar could supply and sort of where are you versus that target? And is there sort of a theoretical maximum in terms of the size of...

Yes. I think kind of the step function. My next goal, right now, we're at 2% market share in the country, so about 1 out of every 50 lots built in the home and building these countries on a lot that Forestar develops. I want to get that to 1 out of 20. I'd like to get the 5% market share, which is in the 45,000 to 50,000 lot range based on where we think single-family permits are going to be. We look to get there in a couple of ways. One is increasing our share of lots that we sell to Horton. Right now, we, I think, supply about 19% of their lot needs. We'd like to get that up to about 1/3, and Horton shares that go with us. And then the other is by selling more lots to other builders as well. And we'd like to see that number get to at least 30% at that kind of that step goal. So 70% of the lots going to Horton, 30% to others. Today, we're at about 10% today that are going to others, other than Horton. I see significant growth there, significant growth within Horton, which I think gets us roughly up to that 5% market share.

Can you talk about the progress in selling to third-party developers and building those relationships? And is the Horton relationship at all viewed as an impediment by some of -- or is there any hesitation by some of these third-party builders? And then I guess, to the extent that you can, are these really local builders? Are they maybe larger publicly traded guys like...

Yes. It's a little bit of both. We sell a lot -- I think we sold less of 13 or 14 builders other than Horton in the last couple of quarters. It is some publicly held builders, it's some regional builders, it's some small custom builders -- it's really about -- for us, it's most of those transactions are finding the right balance. It depends on the community, how many product types we can get in there and finding the right builder that complements having Horton there. Horton is fabulous at building homes and delivering a great value. They don't give their customers much choice, right? So it's like this is the house going to buy it, great. You want to change it after you buy it. It's up to you, right? But they do that at a really good value. Not every homebuyer wants that type of home. Some of them want to make selections. They want to pick their tile, their colors, their countertops or cabinets, whatever. And there's builders that do that and do that really well. So it's finding the balance that helps us absorb as many homes as we can. Again, we're focused on the velocity of the next year. So it's finding the right balance. To date, I haven't really seen any pushback. I got builders of all types that would like to buy lots, and they understand, in some cases, they're getting in the subdivision at Horton might also have a community in. There's been a couple of cases, they're builders and Hortons in that community because it was one that they passed on.

And you talked about the self-funded model. Can you talk about capital allocation priorities, maybe optimal leverage range?

Well, from a leverage standpoint, we've been targeting kind of a maximum 40% net debt to cap. So that's been one of our things we said early. There's no reason to change that. We like the way that's working. We just got 2 upgrades both from Moody and S&P on our credit rating. So that's actually 2 years in a row, we got upgrades. So they seem to like our allocation from a debt and capital standpoint. And we look to continue to run a pretty conservative balance sheet.

Great. Can you talk about ESG in land development and what that means for Forestar?

I'm sorry, I didn't…

ESG?

ESG. It's interesting. For us, probably the number one impact we have is storm water and the storm water runoff, especially when you're developing a site -- there's a lot of controls that are put in place, a lot of regulatory things. And we've built up an internal team of people that help make sure that our teams are educated, that we're complying with all the ordinances and really focusing on that. The other thing that we're doing now is we're really focusing on kind of energy conservation and how we can maybe incorporate solar energy into whether it be amenity projects and how do we supplement kind of the energy uses. So those are the things that I think we're focused on right now.

And then just in terms of the performance of the stock, I mean, you've recently traded below book. And this is despite very strong financial and operational performance. You're beating and raising every quarter while some of the builders are not. What do you think it is that investors are maybe missing about the story? Or is most of this misunderstood?

Yes. It's -- that's a head-scratcher. Yes, I think if I had to guess, I think our story just isn't fully understood yet. I think there's a thought that we're controlled by Horton by some people that they dictate what's happening. And in fact, it's not. We're the ones who are setting pricing, we do operate independent of them. So I think that story is a little misunderstood. I think our float, we hear from investors, there's some people who would love to take positions in the stock. But since our float is still probably below what their requirements are. They're waiting for us to get more average daily trading. So I think that's part of the issue. And the third is really our approach to the business is that manufacturing company. I really think of myself as a building products company, more than a land development company and some people I think still put us in that risk bucket of a land development company. And I think that as we continue to prove out our model, they'll come around. It was interesting. We did a sort on the Russell 2000, did a filter on that and said how many companies in the Russell 2000 have grown 40% or more each of the last 3 years in revenues are profitable and had a return on equity greater than 10%. We're 1 of 2 -- so it's kind of an amazing thought and yet we're trading at 80% of book value today or wherever we ended up -- it's kind of incredible.

Great. Great. We just have a couple of other questions from the portal. What is the internal target threshold for lot inventory level or unsold lots?

Yes. I think we talked about that a little bit earlier in that I'm really looking to own and control -- or own about 3 years and maybe have another year of control lots of what we expect our next 12 months sales to be.

Got it. Got it. Great, great. And I guess you gave the return on equity kind of through cycle return targets for the company. I mean you said 10% plus, but...

Yes. I think our trailing 12 at the end of the last quarter was like 13% return on equity somewhere in that ballpark. And every quarter, it's gone up over the last, whatever, 3 or 4 years.

Dan, thank you very much.

Thank you, Anthony. We appreciate it.