Forestar Group Inc. (FOR) Q3 2021 Earnings Call Transcript

Good afternoon. And welcome to Forestar’s Third Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now turn the call over to Katie Smith, Director of Finance and Investor Relations for Forestar.

Thank you, Paul. And welcome to our call to discuss our results for the third quarter of fiscal 2021. Before we get started, today’s call includes forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Although, Forestar believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different. All forward-looking statements are based upon information available to Forestar on the date of this conference call and we do not undertake any obligation to update or revise any forward-looking statements publicly. Additional information about factors that could lead to material changes in performance is contained in Forestar’s annual report on Form 10-K and its most recent quarterly report on Form 10-Q, both of which are filed with the SEC. This afternoon’s earnings release can be found on our website at investor.forestar.com and we plan to file our 10-Q early next week. After this call, we will post an updated investor presentation to our Investor Relations site under Events and Presentations for your reference. Now, I’ll turn the call over to Dan Bartok, our CEO.

Thank you, Katie. Good afternoon, everyone. In addition to Katie, I am pleased to be joined on the call today by Jim Allen, our Chief Financial Officer; and Jessica Hansen, D.R. Horton’s Vice President of Investor Relations. The Forestar team delivered an outstanding third quarter. We have built our team quickly and they have done an amazing job of executing on our development projects and identifying attractive investment opportunities. We accelerated our development activities last year and now that those lots are beginning to deliver, it has put us in a position to capitalize on significant market demand for finished lots. This resulted in significant revenue growth and margin expansion, creating meaningful value for our shareholders. Our development teams and contractors continue to execute solidly, positioning us for long-term profitable growth. We have delivered over 11,000 lots to homebuilders fiscal year-to-date, enabling us to increase our expected deliveries for fiscal 2021 to between 15,500 and 16,000 lots. Executing on our plan is delivering measurable results. Our third quarter gross profit margin increased 610 basis points year-over-year to 17.8%. Several factors contributed to this quarter’s gross margin improvement. The demand for developed lots remains incredibly strong as homebuilders bolster their inventory positions to meet sales demand. This, combined with our strategy of pricing lots closer to the time of delivery, enables Forestar to take advantage of favorable market conditions when setting finished lot prices in select markets. We also made further progress in delivering more lots from Forestar sourced projects and we continue to reduce our exposure to lot banking. We are committed to our returns-focused business model. Our high turnover, low-risk manufacturing strategy led us to achieve a 10% return on equity for the trailing 12 months ended June 30, 2021. This was a 390-basis-point improvement year-over-year and our fifth consecutive quarter of ROE improvement. We expect to continue to increase our returns on equity and inventory as our platform gains additional maturity and scale, and our team captures increased share in their respective markets. Jim will now discuss our third quarter results in more detail.

Thank you, Dan. In the third quarter, Forestar’s net income increased 56% to $15.8 million or $0.32 per diluted share, compared to $10.1 million or $0.21 per diluted share in the prior year quarter. For the quarter, revenues increased 76% from the prior year to $312.9 million. We sold 3,858 residential lots during the quarter, an increase of 91% year-over-year. The average lot sales price for the quarter was $80,700, with 86% of the lots sold in the quarter being from development projects, up from 77% in the same quarter in 2020. Lots sold to D.R. Horton during the quarter represented 96% of Forestar’s total lots sold, down from 98% in the third quarter of fiscal 2020. We sold lots to eight builders other than D.R. Horton during the third quarter of this year, up from four builders in the same quarter last year.

Our pretax income in the third quarter increased 105% to $21.1 million, with a pretax profit margin of 6.7%. As previously announced, during the quarter we refinanced our 8% senior notes due in 2024, with 3.85% senior notes that mature in 2026. As a result of the redemption, we recognized a loss on extinguishment of debt of $18.1 million. However, the refinancing transaction resulted in substantial interest savings. Excluding that $18.1 million charge, our pretax income increased 281% to $39.2 million and our pretax profit margin improved 670 basis points to 12.5%. In the third quarter, our gross profit margin increased 610 basis points to 17.8% from 11.7% in the prior year quarter. The improvement was primarily due to increased margins on lot sales from development projects, which was largely driven by capitalizing on the strong demand for finished lots. We continue to expect fluctuations in our gross and pretax margins, due to the quarterly mix of our lot deliveries and the timing of track sales. SG&A expense as a percentage of revenues in the third quarter was 5.4%, an improvement of 90 basis points from 6.3% in the prior year quarter. We remain focused on efficiently managing our SG&A expenses as we build out our platform to support our significant growth. We believe we will continue to manage our business in a mid single-digit SG&A percentage. Katie?

Forestar’s underwriting criteria for new development projects includes a minimum 15% annual pretax return on inventory and a return of the initial cash investment within 36 months. During the third quarter, our investments in lots, land, and development totaled $400 million, of which roughly 40% was for land and 60% was for land development. For the fiscal year-to-date, our investments in lots, land, and development totaled $1.25 billion. We now expect to invest at least $1.6 billion in lots, land, and development for the full year of fiscal 2021. Forestar’s lot position at June 30th increased 91% from a year ago to 96,600 lots, of which 64,200 lots are owned and 32,400 lots are controlled through purchase contracts. Of our 64,200 owned lots, 33% are under contract to sell to D.R. Horton, representing at least $1.6 billion of future revenue. Another 28% of our owned lots are subject to a right of first offer to D.R. Horton under the master supply agreements. Lots forced by Forestar continue to grow as a percentage of the company’s owned lot portfolio supporting long-term improvement in our gross margins. Of the company’s owned lot position at June 30th, 51% were forced by Forestar, up from 34% a year ago. We are continuing to target a three to four-year owned inventory of land and lots. Jim?

Forestar remains focused on maintaining a strong balance sheet with ample liquidity and modest leverage. We ended the quarter with $470 million of liquidity, including $120 million of unrestricted cash and $350 million of available capacity on our revolving credit facility. Total debt at June 30th was $704 million and our net debt to capital ratio at quarter end was 37.8%. As previously announced, during the quarter we amended our revolving credit facility to increase the facility size to $410 million and extended the maturity date from 2022 to 2025. At June 30th, stockholders' equity was $970 million and our book value per share increased to $19.58, up 11% from a year ago. Dan?

Looking ahead, we remain confident in the outlook for our business. Continued execution of our strategic and operational plan, supported by favorable market tailwinds across our diverse national footprint positions Forestar for further success. Forestar is uniquely positioned to gain market share through housing market and economic cycles in the highly fragmented lot development industry. Based on our results for the fiscal year-to-date and current market conditions, we now expect to deliver between 15,500 and 16,000 lots, generating approximately $1.3 billion of revenue in fiscal 2021. We are now expecting our pretax profit margin for the full year of fiscal 2021 to be in the range of 11.5% to 12%, excluding this year’s $18.1 million loss on extinguishment of debt. Additionally, we expect our tax rate for the full fiscal year to be approximately 25%, which does imply a tax rate of approximately 26% for the fourth quarter. Before we turn to questions, I’d like to remind everyone of Forestar’s investment highlights. We have a unique lot manufacturing business model that is very different from a typical land developer; we have no unentitled land. We are focused on developing lots for the affordably priced housing market. We have a seasoned management team that is experienced in consolidating market share and in navigating through market cycles. We have a strong balance sheet and liquidity position, with low net leverage. We have been increasingly profitable and are managing our business to be mid single-digit SG&A percentage. Most importantly, we have a unique competitive advantage due to our relationship with D.R. Horton, the nation’s largest builder. This highly strategic relationship allows us to expand our platform nationally while minimizing risk. To summarize, we are continuing to execute on our plan and are positioned for continued success. Paul, at this time, we will now open the line for questions.

Thank you. Our first question comes from Ryan Gilbert with BTIG. Please proceed with your question.

Hi, everyone. Thanks for taking my questions. The first question is just on, I guess, the overall market, and Dan, I’d appreciate any color or detail you can add on the demand that you’re seeing from homebuilders. I think that there’s been some concern in the market that homebuyer demand is leveling off a bit and maybe that there’s a sense that that might be bleeding back into the land market, although from your results, that certainly doesn’t seem to be the case. So just any color that you could give us or details on demand from homebuilders would be helpful?

Yeah. As it relates to what the homebuilders are seeing, I don’t really have that strong visibility as to whether they’re really seeing a fall off in demand. What I know is that they have a hunger for lots that seems to be at this point, at least, insatiable. Our number of finished lots that we have in our inventory actually went down this quarter, even though we delivered really strong lot deliveries, which is as fast as we can deliver and they’re buying them, and obviously, based on our guidance for the rest of the year, we expect the fourth quarter to be a record breaker for us. So at this point, we’re not seeing any lack of demand from homebuilders that want to buy lots. I think one of their constraints is the ability to get lots to build houses off.

Okay. Great. Thank you. Second question is just on 2022, I think you’ve discussed, like, a 20% sustainable growth rate, with no additional capital needed on the balance sheet going forward and that’s kind of how I’ve been thinking about 2022. But your land bank is up 91% year-over-year. So it seems like you have a lot in place to do better than 20% growth. So do you think you can produce ahead of that growth rate in 2022 or just any color on 2022 would be helpful?

Yeah. At this point it is probably too early to give any real guidance for next year. Although we thought about it a lot preparing for this call and I’m not backing off that 20%. I feel very good that we will be able to hit that 20% growth rate based on a lot that we have under development today. Obviously, market conditions are strong right now and we hope that those continue. But at this point, I feel really good about that 20% guidance run. And I said, I think, next quarter what we’re going to try to tighten that up and give you some better color going forward.

Okay. Great. And then last one for me is just on pricing. It looks like your average selling price was pretty flat sequentially in the second quarter. I’m assuming that’s mostly mixed. But maybe you can just talk about what you’re seeing in the market in terms of finished lot price appreciation and how that compares to pricing of undeveloped lots?

Yeah. It is mix. We are definitely seeing some pricing power. I think that showed up in the margins. As you remember last quarter, we probably guided you down for the rest of the year, and we were able to overachieve on that. We are definitely seeing strength. But we really going to look at every project on a project-by-project basis and think about the returns that we’re trying to achieve. And really looking at velocities and making sure that, as we believe there’s pricing power there, we’re being very careful not to hamper that affordability of the house lot package. But, again, I felt really good about the quarter, again, obviously, better than we probably had anticipated for the quarter in pricing power. We really are looking forward to seeing what the future brings as we say we have a lot of lots under development right now.

Okay. Great. Thanks very much.

Thank you. Our next question comes from Anthony Pettinari with Citi. Please proceed with your question.

Good afternoon. Can you talk a little bit about what drove the change in lot delivery guidance, I guess, 1,000 units at the midpoint? How much of the raised guidance was 3Q deliveries above maybe your internal expectations versus sort of the outlook for the balance of the year?

Yeah. I don’t know that I have a specific number of what was delivered in the third quarter versus fourth quarter. I think it’s probably more driven by fourth quarter expectations. There’s been a lot of talk in the market, at least from our perspective, of delays in being able to get certain materials, there have been potentially delays in getting projects completed. We were very careful with making sure what guidance we give, we’re comfortable with. As this quarter has unfolded, and we see where we’re at on deliveries for next quarter, it made us comfortable in raising that guidance. So I feel really good about what we’re seeing for the next quarter.

Okay. That’s very helpful. And then in terms of just sort of hitting the higher or lower end of guidance, do you think it’s mostly a function of demand materializing on the part of the builders or maybe just timing or is it sort of those maybe labor permitting material-related bottlenecks that, in terms of the kind of driving the greatest risk to the upside and the downside?

Yeah. I think the risk of upside versus downside is really in the delivery side. We have not seen any fall off in demand for lots. If anything, I think the demand has increased, once again, has given us a little bit of pricing power. So I think it’s pretty good predominantly based on the ability to complete those projects that we see hitting substantial completion this quarter and being able to deliver those lots.

Okay. That’s very helpful. Maybe just one quick follow-up. In terms of cycle times, it seemed like you were able to sort of accelerate cycle times in the wake of the pandemic because of some looseness in the labor markets, obviously, that’s probably tightened quite a bit. In terms of cycle times and where they stand now, are they stable, improving, maybe deteriorating, just any color you can give there?

I think as compared to where they were six months ago, we are definitely seeing cycle times expand. Again, you’re right, we were able to kind of accelerate cycle times when we really stepped on the gas earlier last year when a lot of people were not. And it really into lots of things, there is delivery of certain materials, there is the ability to get inspections, it’s the ability, and a little bit of it’s been weather. I always hate to use weather. But it’s been a pretty rainy season in certain parts of the country. So we’re definitely seeing an extension, but probably back to more what was normal for us a year ago or a year and a half ago, first that extended definitely from earlier this year.

Okay. That’s helpful. I’ll turn it over.

Thank you. Our next question comes from Deepa Raghavan with Wells Fargo Securities. Please proceed with your question.

Good evening, Dan, Jim, and Katie. Thank you for taking my question. I'm looking for more clarity on the type of growth you're experiencing and how you’re managing operations to support that growth. Have there been any new challenges that emerged this quarter? You mentioned some issues with cycle time, but it seems like labor could be a bigger challenge considering your growth. I'm curious if any new challenges arose this quarter, and if you could share how you're managing this level of growth, particularly regarding operations, it would be very helpful.

I’ll start with the second part of your question first. We have been planning for our growth for quite a while and have significantly increased our staffing. Our headcount has nearly doubled over the past year as we prepared for our current volumes. From a labor standpoint, we are well positioned to continue executing our business plan. As we progress on our growth path, we will need to add more staff. Regarding our operators and project completion, I feel fortunate that we’re not experiencing delays due to contractors being unable to supply workers. While we have heard about some turnover, with operators moving to other opportunities for slightly higher pay, they have managed to replace those workers. We feel positive about this situation. I mentioned last quarter that we were hearing about material shortages, and we are starting to see some delays in obtaining fittings for PVC piping and concrete allocation, which has affected our ability to conduct full day pours on specific projects. We are experiencing some of the impacts we anticipated from last quarter, but nothing dramatic at this point. We are taking proactive measures to ensure materials are ordered earlier than usual. We are relying on reliable contractors; our customer base is strong, and we have partnered with some of the best people in various markets, which has been beneficial for us.

Okay. That's helpful. My second question is about the lot price increases. It appears relatively flat, but the trend isn't downward and it's already at 80K. Are you seeing some stabilization at this point, or do you believe that strong demand and supply imbalance will lead lot prices to continue increasing? From your perspective, are you taking any steps to maintain the average lot pricing within a certain affordability threshold? How are you approaching this?

Well, we think about it on a project-by-project basis. We really look at sales velocity that the builders are experiencing in those projects or in the case of a new project, I mean, what we think is a comparable project. And we try to make sure that we’re balancing price versus velocity. At this point, even with an average sale price of a little over $80,000, we still think it keeps us in that affordable price points. But an interesting fact is that even our average is $80,000 or median price is closer to $70,000. So over half of our lots that we sell are under $70,000, which again, I think really sets us up well for that affordable price house today. But yeah, as far as just trying to manage it, it’s probably where we spend a significant amount of time is on a project-by-project basis as we’re setting prices and trying to negotiate appropriate pricing is making sure that we’re keeping velocity to keep our returns high.

All right. My final one, any updates on how July is trending so far? Just curious and I’ll leave it there. Thank you.

As for July, we are providing our guidance today for the full year, which suggests a record-breaking quarter for us in lot deliveries. At this point, as I sit here on July 20th, I feel very optimistic about July and the upcoming months ahead.

Thank you. Our next question comes from Truman Patterson with Wolfe Research. Please proceed with your question.

Hey. Good afternoon, everyone, and thanks for taking my questions. First, just wanted to touch on your balance sheet and kind of spin going forward, you’re approaching that 40% net debt to total capital threshold, your own lots over 64,000 four years own if you look at kind of 2021 closings. I guess going forward, assuming that development work takes up a decent amount of networking capital right? Are you all comfortable going above that 40% threshold or should we just expect that your lot acquisition to start to moderate a little bit over the next, we’ll call it, six months to 12 months?

Our sales velocity should continue to increase, ensuring the necessity to replace existing lots. Regarding the 40% threshold, we are focused on managing that number. It may slightly exceed 40% temporarily, but our aim is to bring it back down. We are concentrating on identifying projects that align with our operational model and underwriting criteria. However, it has become more challenging to find suitable projects due to increased competition driving up land prices, particularly for smaller shovel-ready projects that may not meet our requirements. I have confidence in our pipeline and we are committed to carefully selecting only strong projects. Nevertheless, we will aim for that 40% threshold, and we do not plan to exceed it for an extended period or by much, if at all.

Okay. Okay. And then, you all are finding lots that are hitting your underwriting. There’s clearly some lot pricing power in the market right now, very strong builder demand in your markets. When I look back at the past couple quarters gross margin in that 18% range, same thing just looking at your guidance, it seems like it’ll be at least in that range. Is it safe to assume just given kind of the tailwinds in the market that this is kind of a new normal that we should see at least maintain out into 2022 or are there any big items that we need to think about?

We’re still developing our portfolio, and you can expect some fluctuations from quarter to quarter. I wouldn’t consider that 18% as a standard rate. What I’ve shown, at least to myself and possibly to you, is that we can achieve 80% more than just once, which is a positive sign. However, if I were in your position, I wouldn’t wager on consistently doing that every quarter for an extended period. Hopefully, that will occur, and while I can’t say it's impossible, the market is still the market, and I have to align our pricing with it. Looking back to a year ago, we were fortunate during a time when we acquired a lot of land. Those purchases were significant for us before prices escalated. Whether due to sheer luck or smart decisions, we bought a lot of land at an excellent time in the market, and we feel confident about our inventory.

And Truman, as you’ve heard, Dan and the team say over and over. I mean the focus is more on returns than it is gross margins. They’ve reported a fifth consecutive quarter of improvement in ROE and the gross margin will be what it will be based on market conditions, but they’re going to maximize their portfolio to drive the best possible return.

Okay. Okay. Fair enough. And then just final one for me, there’s been a lot of talk already on the call about very strong demand and builders are basically short lots right now. Just hoping you can give a little bit more color, are there any markets that you’re scaling back investment? Just any metros, where you perceive as a bit of a frothy land environment or are there any markets where you’re starting to see or hear builders push back a little bit or their appetite for a lot soften a little bit?

I don’t think there’s really, I think, where we’re seeing a slow up in demand. When our investor presentations decks get published, you compare our map against the map last quarter, you’ll probably see we have less exposure up in the Pacific Northwest than we did before, and again, further increased exposure in Florida and in Texas. Again, so our focus has been in the markets that we know we can get velocity and are hopefully not as governmental regulated as other markets where we can have a more fashionable and deliverable lot timeframe. So, again, I it’s not from lack of demand, it’s more from looking at opportunities and making sure that the projects that we’re underwriting we can deliver on and so, as I say, you will see a less allocation of our dollars on lots into the Pacific Northwest right now.

Okay. Thank you and good luck on the upcoming quarter.

Great. Thanks, Truman.

Thank you. Our next question comes from Michael Rehaut with J.P. Morgan. Please proceed with your question.

Hi. This is Maggie on for Mike. Thanks for taking my questions. First, I was hoping to zero in a little bit on the gross margins this quarter. You listed several factors driving the upside, demand, pricing lots, closer delivery, delivering more Forestar sourced lots. But I was wondering if you could maybe rank order the different drivers of that upside, maybe give a little bit more color there?

It's a challenging task to rank the order of factors. However, if I had to identify the top two, they would be transactions sourced from Forestar, where we didn't set prices earlier in the process, and strong market demand. Last quarter, we found ourselves in a favorable position, delivering many lots that had recently been priced into the market constraints. A significant portion of this success is attributable to Forestar sourced transactions rather than those from builders. Additionally, we are expanding our portfolio in this area, with now over 51% of the lots we own coming from Forestar sourced transactions.

Got it. Thanks. And second, just on SG&A. I know you spoke to kind of a mid single-digit range. I know in the past you had talked about maybe being comfortable in the kind of 5% to 6% range, so mid single-digit. But as we look forward into 2022 and kind of the next few years, can you talk about the ability to continue to see some leverage on that line and how we should be thinking about SG&A over kind of the more medium to longer term?

I believe a 5% rate is quite good, and it's manageable based on my upbringing. The mid-range could fluctuate between 4% and 6%, with some variability each quarter depending on volumes. As our platform matures and scales, you may see some leverage, but I'm unable to provide a specific quantification on that at this moment.

Got it. Thank you.

Thank you. Our next question comes from Alex Barron with Housing Research Center. Please proceed with your question.

Thank you for taking my question. I would like to understand how sensitive your lot prices are compared to home prices. Specifically, if home prices start to rise as they have in the past couple of quarters, how quickly could you adjust your lot prices? Additionally, are the lot prices linked to home prices, or are you using a different metric? Thank you.

I believe our ability to continue increasing lot prices is more dependent on the builders' margins than on the home prices themselves. Builders are trying to manage their own margins, and if I can extract some of that increased margin, I will. As for metrics, we don’t have any true-up based on a percentage of the home price; that’s not how we price our lots. We aim to gauge the market pricing within an area, but our focus is really on each project to find the right balance between velocity and pricing, maximizing our returns on invested dollars.

Got it. If I can ask another one on materials, as you mentioned, builders have been facing various material supply chain issues, and I think I heard you mention concrete. So I was curious, if you could give us a sense whether you guys are experiencing shortages of concrete? And if so, is it just in one market or is it pretty widespread across the country?

We are experiencing delays in certain isolated markets. In some locations, there are concrete allocations limiting the amount of concrete available per day for various projects. However, this situation is not widespread and is limited to specific areas. Another issue is with pipe fittings; while we can obtain the pipe itself, there is a shortage of the fittings needed to connect the PVC sections. Much of this shortage is due to manufacturing issues in India, where factories have faced shutdowns or limited operations because of COVID. Although we've been proactive in ordering these fittings earlier in the process, there have still been delays in getting them to job sites. These delays are somewhat isolated; different contractors manage their inventory levels differently, with some purchasing only what is necessary for immediate jobs, so the situation is not uniformly problematic.

Thank you very much.

Thank you. There are no further questions at this time. I would like to turn the floor back over to Dan Bartok for any closing comments.

Thank you, Paul. Thanks to everyone on the Forestar team for your focus and hard work. It was a great quarter. We look forward to working together to continue growing and improving our operations over the coming years. We appreciate everyone’s time on the call today. We look forward to speaking with you again in November to share our fourth quarter results and our full year results. Thank you.

This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful evening.