Forestar Group Inc. Q1 FY2022 Earnings Call

Good afternoon and welcome to Forestar's First Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode, and the floor will be open for your question and comments following the presentation. I will now turn the call over to Katie Smith, Director of Finance and Investor Relations for Forestar.

Thank you, Catherine. Good afternoon, everyone, and welcome to the call to discuss Forestar's first quarter results. Thank you for joining us. 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 filed with the SEC. This afternoon's earnings release is on our website at investor.forestar.com and we plan to file our 10-Q tomorrow. After this call, we will post an updated investor presentation to our Investor Relations site under Events & Presentations for your reference. Now I will turn the call over to Dan Bartok, our CEO.

Thank you, Katie, and good afternoon everyone. In addition to Katie, I am pleased to be joined on the call today by Jim Allen, our Chief Financial Officer. As reflected in our results, we had a strong start to our fiscal year. So I'd like to start the call by thanking the Forestar team. People are the key to our business and I continue to be extremely proud of our excellent performance. Our team's ability to execute and the operational platform that we have built. Our outstanding first quarter is a direct result of the team's capabilities and commitment to Forestar. During the quarter, we maintained our momentum by achieving significant revenue growth and margin expansion. The highlight of the first quarter is an 84% increase in our net income to $40.5 million or $0.81 of earnings per diluted share. Forestar achieved an 83% increase in pre-tax income to $53.5 million and our pre-tax profit margin expanded 360 basis points year-over-year to 13.1%. Revenue increased 33% to $407.6 million, primarily driven by a 27% increase in lot deliveries to 4,516 lots. We continue to make progress delivering more lots from Forestar sourced projects. 22% of our lots sold in the quarter were Forestar sourced compared to 13% in the first quarter of 2021. This combined with our strategy of pricing lots closer to the time of completion enabled Forestar to take advantage of favorable market conditions when setting finished lot prices. We are maintaining our focus on development projects and are doing less lot banking than a year ago. As a result, our gross profit margin expanded 360 basis points to 18% compared to 14.4% in the first quarter of 2021. We continue to increase our market share in a highly fragmented lot development industry. Forestar made further progress selling lots to third-party customers while growing our lots sold to D.R. Horton as a percentage of D.R. Horton's closings both year-over-year and sequentially. We estimate our national market share is now 2.2%, up from 1.4% a year ago based on Forestar's trailing 12-month lot deliveries and new single-family homes sold in calendar year 2021. Our intermediate-term goal is to achieve 5% national market share, representing one out of every 20 new homes sold in the US being built on a Forestar developed lot. Our increasing profitability is translating into higher returns for our shareholders. Forestar achieved a 13.2% return on equity for the trailing 12 months ended December 31, 2021. This was a 550 basis point improvement from the same period a year ago and our seventh consecutive quarter of ROE improvement. This continued improvement further demonstrates that our high turnover, lower risk manufacturing strategy is fundamentally stronger than that of a traditional land developer. We expect our platform will gain additional maturity and scale as our team continues to capture market share in their respective markets. This will drive further improvements to our returns on equity and inventory. We will now discuss our first quarter financial results in more detail. Jim?

Thank you, Dan. In the first quarter, Forestar's net income increased 84% to $40.5 million or $0.81 per diluted share compared to $22 million or $0.46 per diluted share in the prior year quarter. Consolidated first quarter revenues increased 33% to $407.6 million which included $3.5 million of track sales and other revenue. Lots sold increased 27% year-over-year to 4,516 lots with an average sales price of $89,000. Our ASP was higher this quarter due to the mix of lot deliveries from communities and higher price point markets. We expect our ASP will continue to fluctuate quarter-to-quarter based on the geographic location and lot size mix of our deliveries. 97% of lots sold were from development projects, up from 87% in the same quarter of 2021. 89% of Forestar's first quarter lot deliveries were sold to D.R. Horton, down from 95% in the first quarter of fiscal 2021. We sold 502 lots to eight customers other than D.R. Horton during the quarter, which was a 182% increase in lots sold to other customers compared to the prior year quarter.

Our pre-tax income for the first quarter was $53.5 million with a pre-tax profit margin of 13.1%. This was an improvement of 360 basis points over the prior year quarter. Our gross profit margin was 18%, also a 360 basis point increase from 14.4% a year ago. As I mentioned earlier, this 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. SG&A expense as a percentage of revenue in the first quarter was 5.3%, compared to 5% in the prior year quarter. We are extremely pleased with the progress we have made building our team and we continue to attract high-quality talent. We remain focused on managing our SG&A efficiently while building out our infrastructure to support our significant growth. We believe we will continue to manage our business at a mid-single-digit SG&A percentage. Katie?

Forestar's underwriting criteria for new development projects includes a minimum 15% annual pre-tax return on inventory and a return of the initial cash investment within 36 months. During the first quarter, investments in land and land development totaled $380 million, of which $135 million was for land and $245 million was for land development. Forestar's lot position at December 31 was 103,300 lots, of which 65,700 lots were owned and 37,600 lots were controlled through purchase contracts. At quarter end, we had 4,900 finished lots on hand. Finished lots have accounted for less than 10% of Forestar's owned portfolio for five consecutive quarters demonstrating continued strength in demand. At December 31, 54% of our owned lots were sourced by Forestar, up from 46% a year ago. As Dan said in his opening remarks, 22% of lots sold in the quarter were from Forestar-sourced projects, up from 13% a year ago. That percentage will continue to trend higher as more Forestar-sourced projects start to deliver lots. Growth in Forestar-sourced projects supports further improvement in our gross margin and we expect that percentage of our portfolio to continue to increase over time. We also have good visibility into future revenues. Of our 65,700 owned lots, 30% are under contract to sell to D.R. Horton, representing approximately $1.5 billion of future revenue. Another 28% of our owned lots are subject to a right of first offer to D.R. Horton based on executed purchase and sale agreements. We remain very disciplined when investing in new projects and our acquisition teams are finding ample opportunities that meet our underwriting criteria. We reiterate our plan to invest at least $1.75 billion in land and land development during fiscal 2022 subject to market conditions and are continuing to target a three-year 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. At December 31, we had approximately $500 million of liquidity, including $160 million of unrestricted cash and $340 million of available capacity on our revolving credit facility. Total debt at December 31 was $705 million with no senior note maturities until 2026. Our net debt-to-capital ratio at quarter end was 33.9%. Forestar's capital structure is one of our key competitive advantages and allows us the ability to price lots later in the development process. Most traditional land developers are encumbered by project level financing which inhibits them from pricing lots closer to completion after development costs are finalized. Additionally, project level financing can make accelerating or slowing development to match market conditions more difficult. With our access to institutional corporate level financing, Forestar has unparalleled flexibility. At December 31, stockholders' equity was $1.1 billion and our book value per share increased to $21.29, up 15% from a year ago. Dan?

Given the strength of our first quarter results and the current market conditions, we are increasing our fiscal 2022 guidance. We now expect to deliver between 19,500 and 20,000 lots this year and to generate approximately $1.7 billion of revenue. We expect our pre-tax profit margin to be between 13.5% and 14% for the fiscal year. Consistent with our last earnings call, we expect revenue to be higher in the second half of the year than the first half and we expect lower pre-tax profit margins in the first half of the year compared to the second half due to the quarterly mix of expected lot deliveries and to a lesser extent operating leverage. Finally, we expect our effective tax rate in fiscal 2022 to be approximately 24.5%. The core drivers of our business remain healthy and strong and our teams and contractors continue to outperform our expectations. The accomplishments of our teams combined with our growth plan and proven business model give us confidence in Forestar's ability to execute through the remainder of our fiscal year and beyond. We're extremely excited about the opportunities ahead of us. Forestar is uniquely positioned to gain market share, increase profitability and generate meaningful value for our shareholders. Catherine, at this time we'll open up the line for questions.

Ladies and gentlemen, the floor is now open for questions. Your first question is coming from Carl Reichardt. Your line is live.

Hi, everyone. How are you doing? Thanks for taking the time today. I have a couple of questions for you. First, the market share story is obviously very important for the long-term growth of the company. I'm curious, Jim or Dan, about the private peers' project level financing. What kind of basis point capital advantage do you have? What do their debt structures look like? Additionally, if the market begins to slow down due to interest rates or other factors, what is your expectation regarding how financing sources will view those private peers and what actions they might take? What kind of advantage would that provide you given the stability of your capital sources?

I wouldn't really describe it as a basis point advantage but rather a structural and operational advantage. When times get tough, banks usually tighten their financing. If a project encounters issues, banks must address that loan by either adding more equity or finding another solution, and often these projects are cross-collateralized for developers which creates administrative challenges. A significant advantage for us is our capacity to pay contractors quickly. This allows us to negotiate better pricing compared to those who have to wait through the monthly bank loan draw process. We have the capability to build and make weekly payments, so once our team receives an invoice, it gets approved and paid rapidly. This suggests that our advantage is more operational rather than related to debt pricing. That said, we do utilize fixed-rate financing, allowing us to manage our costs conservatively. When projects are funded based on a loan-to-cost basis and expenses rise, it complicates how the loans align with the new cost structures. Often, banks require sales contracts before funding land acquisitions, which means they secure their sale price without fully understanding their final development costs. So, there are various advantages, but I wouldn't say they are solely based on debt pricing.

Yes, that makes a lot of sense. Thanks again. Are you seeing an increase in demand for communities with larger lot positions, whether from Horton or some of your other customers? We’ve heard from some who are self-developing that this seems to be the direction they are headed. If this is indeed an overall trend, what implications does it have for your margins, growth, or absorption?

I don't think we really look at it that way. The demand for lots is strong, whether it's a 99-lot community or a 300-lot community. We price based on what we believe is a phase or roughly a year's worth of demand. As we develop the next phase, we will put more lots on the ground. We can speed up or slow down based on demand, but we focus on the phase-by-phase aspect of the larger communities. In some cases, we are delivering multiple product types, allowing room for a builder to offer different products or even bring in multiple builders into the same projects. Overall, I see more builders competing for land acquisitions for larger projects than I did in the past. Regarding the lot side, they can acquire lots easily; we recently completed a 28-lot deal that made a lot of sense. So, the size of the project is not crucial for those wanting to buy finished lots.

Thank you. I have another question regarding the horizontal side. We've previously discussed the extra time involved in preparing lots. Do you believe this delay is due to the cities and their approval processes, a lack of graders, or difficulties in sourcing materials like pipe? Could you elaborate on the significant supply chain challenges you're currently facing and when you expect these issues to improve? Thank you.

It's funny. On an overall basis, from where I sit today than where I sat maybe six months ago, I don't feel like the supply chain is getting worse for us. If anything I think we've learned how to adapt a little better order material sooner in the development process, and really be able to deliver lots really hasn't extended as much as maybe I had anticipated. You kind of see that in our first-quarter results. I think we probably guided everybody even though we didn't give direct numbers that we did better than we thought we would this quarter, and I think that shows. But the areas that I'd say make me most nervous is frankly the utility companies. It's getting projects hot, getting transformers on site and getting the utility companies to get electricity to the lots is probably where I see the biggest issue. And it's sporadic, it's not nationwide, but it is clearly in different parts of the country, we're seeing that similar theme. And then the others a little bit in getting acceptance from the cities where they don't have the same staffing to really manage that final acceptance process like because of the volume.

Dan, thank you so much. Take care, guys. Thanks a lot.

Hey, Carl, thank you.

Your next question is coming from Deepa Raghavan. Your line is live.

Hi, good afternoon, everyone. Thanks for taking the call. First question obviously topical interest rates. Dan, does any of the upward pressure in rates that upcoming does that change your capital raising strategy or any of your balance sheet dynamics?

Well, we've always been pretty strategic in our capital raising strategies both in debt and equity. I think we're going to continue to be strategic. And when the opportunities make sense for us, we will continue to grow our capital stack. I think the thing that I feel may be better about almost daily, one day to the next is that we can really continue to maintain a pretty strong growth rate without expanding that capital base. I mean just being able to reinvest our earnings look the earnings we had in this quarter alone is really helps fuel that future growth. We just continue operating. We're not really that dependent on adding to our debt or equity stack to really fuel the growth that path that we're on.

Just to follow up on Carl's question but from a slightly different angle, does the upward pressure influence the competitive dynamics of the land development industry? Does this suggest that some of your competitors may struggle to operate effectively in this environment, potentially giving you a competitive edge? Could this be a possibility considering the direction interest rates are likely headed?

Yes, I think

Well, we're still very low enough that it may not make impact in the next couple of years. I don't know. Just any color there?

Yes. I mean at this point I can't say that we're seeing any change in the demand for lots. I think the demand for lots still outstrips the supply which obviously has given us some pricing power. I think if the market does soften, I know I've alluded to this in past calls, but if the market does soften, I think there's going to be some things that actually will help, I believe will help our business model and gain market share. One is that land or homebuilders historically will stop buying land and want to focus more on buying developed lots and stop developing their own lots sooner in the cycle. And I think that the banks will be more hesitant to do project level financing for the smaller and local developers. I think just those two things alone, I think really helped our business so that even though overall market demand might slow, I believe we still have an ability to continue to grow market share.

Okay. That's fair. Last one. It's pretty strong raise to margins. Can you talk to some of the drivers behind that? And specifically, address is that all coming mainly because of your mix, your self-sourced lots? Or is there a leverage benefit or any other dynamic that's helping you raise your margin guide pretty substantially?

Deepa, this is Jim. The increases are mainly due to a higher number of development project lots sold, especially more lots sourced from Forestar. We've discussed this during the call, particularly the advantages that Forestar-sourced projects provide compared to builder-sourced projects, which enable us to price lots closer to the time we are ready to sell them. This is likely the main reason for the margin increase.

All right. Thanks very much. Appreciate it, Dan and Jim. Take care. Bye.

Thank you.

Your next question is coming from Truman Patterson. Your line is live.

Good afternoon, everyone. I appreciate the opportunity to ask my questions. Investors seem to be concerned about a prolonged downturn in the housing market, which is not necessarily our perspective. Can you clarify how much of your finished lot cost is related to discretionary development? In the case of a downturn, do you reduce your development activities to conserve liquidity and capitalize on the land market, or do you continue to develop in order to gain market share using the structural advantage you mentioned earlier?

To answer your first question, about 30% of the cost of a finished lot for us is in the land itself, while about 70% is in development costs, including grading, utilities, and streets. This ratio varies by market, but overall, it remains consistent with what we observed a couple of years ago. I haven't seen any significant changes in that. Going forward, builders may start by reducing land purchases. However, we will evaluate each project individually rather than applying a blanket approach. We will assess where our sales and traffic are still strong and make decisions based on that regarding the timing of future phases. It's crucial to have finished lots available since we can't sell them otherwise. Maintaining a strong balance sheet is essential, and we aim to take advantage when land prices reset to gain market share. Our focus will be on a project-by-project basis, identifying strengths and weaknesses.

Okay. Okay. And then you mentioned in the event of a downturn possibly pulling back in the weaker markets right? But currently in the current environment, are there any areas in the country where you're intentionally curbing land acquisition markets you might perceive as a bit frothy?

I believe the investor presentation isn't live yet, but it includes a map showing that our owned and controlled lot totals are lower in the western states like Washington, Oregon, and Utah. In contrast, the rest of the country continues to grow. This is partly due to high and accelerating land prices, as well as a tougher regulatory environment, making it harder to develop those lots. Regarding the second question about rapid land inflation, my answer remains the same as last quarter: Austin, Texas, and Phoenix are experiencing significant increases in land prices. However, demand has been exceptionally strong, allowing these markets to handle the rising land costs for now.

Yes, it's definitely encouraging that you haven't experienced any slowdown in lot demand despite the increase in rates. However, I'm noticing that your SG&A has increased slightly year-over-year. I’m trying to understand the reason for that and whether we should anticipate some efficiency in this area in 2022 or if more expenses are expected as you continue to expand your infrastructure nationwide.

Yes. We are still aiming for mid-single digits, around 5% to 6%. The recent increase is mainly due to timing. We are expanding our teams in our key markets. For the year, we estimate our SG&A will be quite similar to last year's percentage. I don't anticipate significant leverage in a positive direction, nor do I expect this to indicate a trend. The figures from last quarter were 5% and 4.8%, and now it's 5.3%, so there's not much of a notable increase. The timing of office openings and personnel additions mainly influences these numbers, as well as when lots are delivered.

Okay. Thank you.

Your next question is coming from Mike Rehaut. Your line is live.

Hi. Doug Wardlaw on for Mike Rehaut. You guys updated your annual guidance this quarter. And I was wondering if you guys could give a further breakdown on how you think that's going to shake out throughout the year. And if there are some changes or you guys feel there could be potential changes, what could be some drivers of that?

Yes. So we did increase our lot guidance by 500 lots. And like we said in our scripted remarks, Dan alluded to it that we expect for the higher revenue to come in the back half of the year relative to the first half of the year. So that's where we're going to see probably the greatest pickup. Does that answer your question? Or do you have anything else?

I was wondering if the uptick in rates has already been factored into the lot guidance, especially considering it's only 500 lots.

Yes. We definitely considered that when we were updating our guidance. We've just really continued to see strength in demand and a lot of demand for our lots. And we've been able to develop them a little bit quicker than we had originally anticipated. We were thinking that the supply chain might deteriorate further and we really haven't seen that happen. And so we just felt more comfortable saying that we were going to deliver more lots this year than we did last quarter.

Your next question is coming from Anthony Pettinari. Your line is live.

Hi, this is Asher Sohnen filling in for Anthony. I wanted to check on your previous guidance of around $1.75 billion for land and development spending in 2022. Is that still the case? It seems to imply a high single-digit growth over 2021, which contrasts with your approximately 24% growth forecast for lots delivered. I understand that you might be at the upper end of your target supply range for lots, but I'm curious about future land spending. Should I expect high single-digit growth in this area for the next couple of years, or is a decrease likely in 2023? How should I consider that moving forward?

Yes. This is Katie. I'll take that too. We expect to spend at least $1.75 billion in land development this year. And so that's really our baseline. If we see good opportunities or need to accelerate development that number could obviously fluctuate higher. But we feel really good about being able to put down and to invest that amount of capital in land and land development this year. Going forward, yes, I would say that that sounds about right. But what we've really always said is we have a very good lot position that we've built up so far. And now we really want to develop all of that land and start to generate earnings from those dollars that we had already invested. So you'll see a greater proportion of our land development spend go into development versus just acquiring new positions.

Thanks for that information. I'm curious about how pricing negotiations are progressing for uncontracted lots. While it seems home price appreciation might be slowing down at a national level, I wonder if this trend is reflected in your discussions with builders regarding price growth on your deliveries.

No. Builders typically do not want to see an increase in lot prices. Therefore, every time we initiate a pricing discussion, we encounter pushback. Our goal is to strike a balance between achieving the best possible price and ensuring there is activity in those subdivisions. With our return-focused model, maintaining velocity is just as crucial as the profit margins we obtain, and we are very focused on asset turnaround. In every discussion, builders often express that the pricing is too high or that they cannot meet it. However, we always manage to reach a resolution. There is substantial demand, which is advantageous due to the way the master supply agreement functions, allowing us to determine what we believe is the appropriate market price while factoring in velocity. We continue to experience effective pricing discovery with builders. However, each project is unique, and it’s always about finding that delicate balance between price and velocity.

Yes. And this is Katie. I would also add, if rates do rise really quickly and we do see some sort of a slowdown in housing, we might see a pause while they digest those new rates. But we're really focused on developing lots for affordably priced homes and we still believe that there will be demand for new affordably priced homes. And so we feel confident in our business model.

Understood. Thanks for taking my questions. I’ll turn it over.

We have no further questions from the lines at this time. I would now like to turn the floor back to Dan Bartok for closing remarks.

Thank you, Catherine and thank you to everyone on the Forestar team for your focus and hard work. We look forward to working together as we strive for increased efficiencies while continuing our growth. We appreciate everyone's time on the call today and look forward to speaking with you again in April to share our second quarter results. Thank you.

Thank you, ladies and gentlemen. This concludes today's conference call. You may disconnect at this time and have a wonderful day. Thank you for your participation.