Earnings Call Transcript - FOR Q2 2022

Katie Smith, Director of Finance and Investor Relations

Thank you, John. Good afternoon, everyone, and welcome to the call to discuss Forestar's second 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 issues 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 Securities and Exchange Commission. This afternoon's earnings release is on our website at investor.forestar.com, and we plan to file the 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.

Dan Bartok, 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. The Forestar team delivered a strong second quarter, with net income increasing 68% from the prior year to $47.8 million, or $0.96 per diluted share. We also achieved a 68% increase in pretax income to $63.2 million. Our pretax profit margin expanded 190 basis points year-over-year to 15%. Revenue increased 47% to $421.6 million, primarily driven by a 61% increase in lot deliveries to 5,788 lots sold. We continue to make progress expanding our customer base. To that point, I'm excited to announce that during the quarter, Forestar sold a package of 787 undeveloped and partially developed lots from seven projects located across Texas for a total purchase price of $54.7 million. A lot for marketed to the purpose-built single-family rental segment of the market. As part of the sale, Forestar will complete development of those lots, with the buyers funding the remaining development costs. Despite the lot not being finished, we transacted at very favorable terms. Additionally, we will recognize the revenue and development profit over time without committing the additional capital required to complete the infrastructure. We refer to this as deferred development projects in our financial statements. This quarter, Forestar recognized all 787 lots in our delivery numbers and $12.5 million of the revenue. We significantly improved our capital efficiency in these communities with this type of structure. We are pleased with our ability to monetize a portion of each project earlier than if it had been sold when the lots were fully developed. Forestar has built an excellent land position in some of the most attractive areas in the country, and we will continue to pursue and capitalize on compelling opportunities. Our increasing profitability and focus on capital efficiency is translating into higher returns for our shareholders. Forestar achieved a 14.5% return on equity for the trailing 12-month ended March 31, 2022. This was a 490 basis point improvement from the same period a year ago and our eighth consecutive quarter of ROE improvement. This continued improvement further demonstrates that our high turnover, low-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 teams continue to capture market share in their respective markets, driving further improvements for returns on equity and inventory. People are key to our business, and our outstanding second quarter results are a direct result of the team's capabilities and commitment to Forestar. The operating environment was more challenging this quarter due to continued supply chain constraints combined with rising material costs. I want to thank everyone, especially our development teams and our contractor base for their strong execution over the last several months; they made these results possible. We’ll now discuss our second quarter financial results in more detail. Jim?

Jim Allen, CFO

Thank you, Dan. In the second quarter, Forestar’s net income increased 68% to $47.8 million, or $0.96 per diluted share, compared to $28.4 million or $0.59 per diluted share in the prior year quarter. Consolidated second quarter revenues increased 47% to $421.6 million. Lots sold increased 61% year-over-year to 5,788 lots with an average sales price of $81,900. Excluding lot sales from deferred development projects, lots sold increased 39% to 5,001 lots. Our average sales price this quarter was lower than the first quarter due to the mix of lot deliveries from communities and lower price point markets. We expect our average sales price will continue to fluctuate quarter to quarter based on the geographic location and lot size mix of our deliveries. We are pleased that we continue to make progress delivering more lots from projects sourced by Forestar. 39% of lots sold in the quarter were Forestar sourced compared to 23% in the second quarter of 2021. 82% of Forestar second quarter lot deliveries were sold to D.R. Horton, down from 94% in the second quarter of fiscal 2021. We grew our lots sold to D.R. Horton as a percentage of D.R. Horton’s closings both year-over-year and sequentially. We sold 1,017 lots to 12 customers other than D.R. Horton during the quarter, which was a 342% increase in lots sold to other customers compared to the prior year quarter.

Dan Bartok, CEO

Our pretax income for the second quarter was $63.2 million, with a pretax profit margin of 15%. This was an improvement of 190 basis points over the prior year quarter. Our gross profit margin expanded 220 basis points to 20.8% compared to 18.6% a year ago. We recorded a non-cash real estate impairment charge of $3.8 million this quarter, which reduced our gross profit margin by 90 basis points. The impairment charge was an isolated issue related to cost overruns in one project in Colorado. Excluding the impairment, our gross profit margin expanded 310 basis points to 21.7%. Several factors contributed to this quarter's gross margin improvement. In addition to the lot sales from deferred development projects, this improvement was primarily due to increased margins and lot sales from Forestar-sourced development projects. Additionally, interest charged to cost of sales decreased by approximately 40 basis points compared to the prior year quarter, partially attributed to our senior notes refinancing last year. Finally, the market has remained strong, with significant demand for lots from home builders. Our SG&A expense, as a percentage of revenues in the first quarter was 5.8% compared to 5.7% 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 efficiently managing our SG&A while investing in our teams to support our continued growth. We believe we will continue to manage our business at a mid-single digit SG&A percentage.

Katie Smith, Director of Finance and Investor Relations

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 second quarter, investments in land and land development totaled $336 million, of which $86 million was for land and $250 million was for land development. Forestar’s lot position at March 31 was 96,500 lots, of which 64,200 lots were owned and 32,300 lots were controlled through purchase contracts. At quarter end, we had 5,001 finished lots on hand. Finished lots have accounted for less than 10% of Forestar’s owned portfolio for six consecutive quarters, demonstrating continued strength in demand. At March 31, 55% of our owned lots were sourced by Forestar, up from 48% a year ago. As Jim said, 39% of lots sold in the quarter were from projects sourced by Forestar, up from 23% 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 margins. And we expect that percentage of our portfolio to continue to increase over time. We also have good visibility into future revenues. Of our 64,200 owned lots, 30% are under contract to sell to D.R. Horton, representing approximately $1.5 billion of future revenue. Another 27% of our owned lots are subject to a right of first offer to D.R. Horton based on executed purchase and sale agreements. Our acquisition teams are finding ample opportunities that meet our underwriting criteria. However, we remain very disciplined when investing in new projects. We plan to invest approximately $1.75 billion in land and land development during fiscal 2022, subject to market conditions, and are continuing to target a three to four year owned inventory of land and lots.

Jim Allen, CFO

Forestar remains focused on maintaining a strong balance sheet with ample liquidity and modest leverage. At quarter end, we had approximately $580 million of liquidity, including $230 million of unrestricted cash and $350 million of available capacity on our revolving credit facility. Total debt at March 31 was $705 million, with no senior note maturities until 2026. Our net debt to capital ratio at quarter end was 29.9%. In recognition of our improving financial profile, Moody's recently upgraded Forestar’s corporate credit rating and senior unsecured notes rating to Ba3. Standard and Poor's also upgraded Forestar’s corporate credit rating and senior unsecured notes rating during the quarter to B plus and BB minus, respectively. Forestar’s access to capital is one of our key competitive advantages and allows us the ability to price lots later in the development process. With our access to institutional corporate level financing, Forestar has unparalleled flexibility in the lot development industry. 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 makes it more difficult to react to changing market conditions, while adding complexity and administrative costs. At quarter end, stockholders’ equity was $1.1 billion, and our book value per share increased to $22.24, up 16% from a year ago.

Dan Bartok, CEO

As I said in my opening remarks, the environment has become more challenging since the earnings call in late January. We believe supply chain disruptions will continue to impact us throughout fiscal 2022 and potentially into 2023. However, our teams are relentless problem solvers, and they continue to navigate the environment exceptionally well. In addition to ordering materials earlier in the development cycle, we are substituting materials if there is an available alternative and are modifying development plans as needed. We expect to see further increases in development costs as a result of the supply, demand imbalance and rising fuel prices. Consistent with prior quarters, we plan to pass through any cost increases into our future lot pricing. Despite the inflationary environment and rising interest rates, we have not seen any softening in demand. We remain positive on the demand outlook for finished lots, which is supported by our strong backlog. We affirm our guidance for fiscal 2022 lot deliveries of between 19,500 to 20,000 lots this year, generating approximately $1.7 billion of revenue. However, we now expect our pretax profit margin to be between 14% and 14.5% for the year, up from our prior guidance of 13.5% to 14%. We expect our revenue and pretax profit margins to be higher in the fourth quarter compared to the third quarter, due to the quarterly mix of expected lot deliveries and to a lesser extent, operating leverage. Finally, we still expect our effective tax rate in fiscal 2022 to be approximately 24.5%. Our teams and contractors continue to outperform our expectations. The accomplishments of the Forestar team, combined with our growth plan and proven business model, give me confidence in our ability to execute throughout the remainder of our fiscal year and beyond. We are extremely excited about the opportunities ahead of us. Forestar is uniquely positioned to continue gaining market share, increasing our annual profitability, and generating meaningful value for our shareholders. John, at this time, we will now open up the line for questions.

Operator, Operator

And the first question is coming from Truman Patterson with Wolfe Research.

Paul Sadowski, Analyst

Good afternoon. Actually, it’s Paul Sadowski. I guess first of all, I was wondering if you could provide any additional color on the SFR transaction. How do those economics compare to FOR sale lots given the operator is going to fund that development? And how scalable do you think that business is moving forward? And are you seeing interest from multiple operators or just this one?

Dan Bartok, CEO

Paul, it was somewhat of an experiment for us. We identified several opportunities that we thought would be well suited for the build for rent markets while observing what others were doing. They're obviously all Forestar-sourced transactions where we had the opportunity to take these to market; they had different characteristics. To some extent, we were trying to understand where and how the demand for these lots, or just the land parcels, was really going to develop. From our perspective, it was a really successful transaction. One, we learned a bunch; we learned a lot about how people were looking at values and land and opportunities in different types of geographies. I think it really set us up well to look at these things in the future and identify opportunities that we think will continue to drive value for us. A big part of the transaction was the capital efficiency of it, getting really to monetize the land upfront, as well as not putting our equity into finishing developing lots, which drives a lot of value for us. And our margins were higher. I mean, we're not going to fully disclose specific margin needed, but I can tell you they were more favorable than at least from our perspective of what we've done in the past to sell them as FOR sale builder.

Paul Sadowski, Analyst

Great, good. And then, I guess, given the higher rate environment, have you seen from your competitors or the home builders themselves any inflection in the land market? Has there been any deceleration in land price inflation here over the past four to six weeks? Or have you seen any deals maybe get kicked back that were underwritten more aggressively in the lower rate environment?

Dan Bartok, CEO

At this point, we have not really seen any fall off in demand for lots from our perspective. Although you obviously need to be cautious, right? We're all seeing interest rates go up. At this point, the builders are still giving us thumbs up; demand is strong for housing, and they still want more lots. So from that perspective, I feel really good as far as land parcels and land pricing have not really seen any fall off at this point. We're starting to hear a little rumblings of builders maybe not closing on deals, but nothing that I can put my finger on yet; there is some scuttlebutt going around that some deals are starting to fall out.

Operator, Operator

The next question is coming from Carl Reichardt from BTIG.

Carl Reichardt, Analyst

Thanks very much. Hey, Dan, Jim, and Katie. I was going to ask Paul's question, but let me see if I can turn it into a nuanced one. He asked about scalability. So I guess what I'd say is if you look at what you learned from this transaction and look at your current lot position, how well do you feel that jives with what you learned from this singular transaction? And I guess is this a new channel you feel you could develop and build over time? Or, if you had to bet, would you say this is kind of a one-off, and this is an occasional type of business we might do and not a long-term business line.

Dan Bartok, CEO

Well, again, we learned a lot. And I think that when I looked at our land portfolio across the country, there are definitely other opportunities that we look to try to capitalize on. I think it will modify somewhat our acquisition targets. So I think that it's a process that, whether it's going to be a trend or a scale, at this point, I think it's too early to tell. I remember some time when somebody told me, one time is a number, two times is a coincidence, and three times is a trend. So when I get to my third portfolio sale, I'll tell you the trend.

Carl Reichardt, Analyst

Thank you for your question. We've noticed that many public builders are shifting to land banking, which seems to be a strategy influenced by decreasing costs. I'm interested to know if this shift has provided you with the chance to capture more market share from finished lot developers, and whether you are experiencing builders hesitant to purchase your product due to lower margins. They may prefer to collaborate with land bankers for self-development. I'm trying to understand how land bankers are competing with you and other finished lot developers for builder business, especially since builders seem to be favoring land banking over finished lots due to challenges in volume acquisition.

Dan Bartok, CEO

Frankly, I don't think I compete with a land banker. One of the things that I think when you look at our results and what we've been able to do, I think we're just really good at delivering lots. Maybe it's the lot structure, but again, kind of the one-time number, two times, and we are starting to see a trend that we are able to deliver lots more efficiently and effectively than a builder and probably other developers in the same bucket. Land bankers are providing that service; it's really a financing transaction. If they want to bring in a land banker to buy my finished lots and hold them for a longer period of time, I'm fine with that because that helps me monetize faster. So I don't really see that I'm competing with those guys for opportunities. We're providing a different product.

Carl Reichardt, Analyst

Okay, great. Thank you, Dan. And then if you will indulge me one more. In talking to a couple of other folks, I had been hearing that there were some land developers out there, long-term project guys, who are now asking builders not only for heftier deposits but also to share in potential development cost overruns. So the contracted lot price could change two years from now if the developer incurs more significant cost overruns. There wouldn't be a fixed price here; the builder would have to share those costs. I'm curious if that's something that you've seen or doing at all right now.

Dan Bartok, CEO

We can't say that we have ever asked a builder or our customer to help us if there's been something wrong in the budget, but we are not contracting for that upfront. I think one of our benefits in the way that we're capitalized is our ability to price lots a little later in the process when most of those costs are identified. So that we are able to set the prices correctly upfront. The problem is when you go back to that builder, and again you can try to get them to agree upfront, and in some cases, you'll probably get that. But the best thing is to be able to do what you say when you say it. And that's really what we've been focused on: trying to ensure we're delivering what we know. Obviously, our costs have gone up, but we've been able to, again, mostly through a little bit later pricing, passed through all those costs plus a little bit through the pricing model.

Operator, Operator

Up next, we have Deepa Raghavan with Wells Fargo Securities.

Deepa Raghavan, Analyst

Hi. Good afternoon, everyone. Thanks for taking my call. Dan, it appears things are pretty good at this time. But are you starting to slow sourcing land or thinking about purchases much more cautiously? And relatedly, is this SFR experiment a defensive move on your part?

Dan Bartok, CEO

I'm going to take the second part of that question first. No, I don't think it's defensive at all. I think that we always look for opportunities to improve our capital efficiency, and look for ways that offer new products and markets into the marketplace. I think it was the opposite of defensive; I think it was maybe a little bit more proactive. Again, we'll see when we do the third one. But no, I think we were very thoughtful in how we put the package together; we really looked at how we could learn the most to make it something that we can hopefully capitalize even more on into the future because clearly, there's a lot of money out there looking to invest in the built-for-rent space, and we'd like to get our fair share of it. As far as slowing our land and being more cautious, I think we've always been cautious. We're very carefully underwriting. I will say that our land acquisition in this past quarter was less than in prior quarters. Some of that is maybe deals not underwriting, and we did drop a few deals that you've probably noticed. Our total lots and controlled lots went down a little bit, and there were some deals we had under contract that when we got into due diligence, it just didn't make sense to us. So we didn’t try to force them through the process; we just moved on. But I think we've always been cautious. The other thing that I've seen is it is a little bit of things that I was hearing before, and now we're actually starting to see it; it is taking a little bit longer to get entitlements and permitting completed on projects. As you know, we don't like to buy until those, all those permits are in hand. So we have deferred the purchase of those properties until we get them. So probably another one of the things that leads up to us having less owned and controlled lots at the end of the quarter compared to the prior quarter.

Deepa Raghavan, Analyst

That's fair. Just staying on the defense, the defensive thing, what are some of the moves you could take to protect margins and ROE, should we go into a slowdown?

Dan Bartok, CEO

Well, I think what protects margin, again, I guess I look at our strategy in a way we price lots to be a good way to do that. I think our core strategy of trying to make sure we really know our costs before we set that pricing. If you want to call that defensive, then we've been defensive all along. Because we don't want that margin erosion; we're trying to protect it as much as possible. It is challenging. I mean these rising costs, it's challenging, and not knowing when you're going to get material definitely changes the landscape of how you're pricing these things, and we're seeing more and more differences. But, again, I think having good land positions, having good customers, and being in affordable price points, and having a product that we believe we can deliver on time and on budget is going to keep us well-positioned.

Deepa Raghavan, Analyst

Got it. One final housekeeping question. The deferred purchases, the deferred lots, sorry, 787. Is that accounted for in the guide?

Dan Bartok, CEO

Yes. So the 787 lots were counted as sales in quarter two, even though all the revenue and gain from those lots. The lot count is in this quarter sales. The future revenues and margins will be included in future quarters because some of these are seven separate projects, but it'll probably be over a 12-month period or so that all of that revenue and profit will be recognized. So yes, it is accounted for in our guide.

Operator, Operator

Okay. Up next, we have Nate Pettinari with Citi.

Anthony Pettinari, Analyst

Good afternoon. It's Anthony. Dan, you talked about supply chain challenges during the quarter and you talked about permits and entitlements maybe taking a little bit longer in some cases. I'm just wondering, were there any sort of incremental constraints in the quarter from a supply chain perspective that weren't expected? Do you see supply chain conditions worsening? And when you think about what could potentially get you to the higher or lower end of the guide? Are you maybe more concerned about just kind of demand materializing from your builder customers, or is it the cost, labor, permitting bottlenecks maybe more of a swing factor?

Dan Bartok, CEO

Let's see how I attack that one. As far as the supply chain constraints, it's a bit spotty from market to market. In some markets, one market, you might not be able to get big pipe, another one concrete structures might be tough to get; another one it might be concrete. Some markets we were having a hard time getting concrete when we wanted and we had to schedule differently. Probably the one thing that I would say over the last quarter that has materialized to be on a broader scale is electrical transformers and the ability for the utility companies to get out there and get power to the lots. I'm seeing that in more of the markets across the country. So I'd say that is the one challenging thing, and that is, again, was hard to control that one here; it's just kind of in the hands of the utility companies. So we're doing our best to try to stay ahead of it; we're trying to convince them to order transformers sooner or whatever. But I think, again, it depends on the power company, and some of them have transformers no problem, and others are just they didn’t do a good job of ordering ahead. And so that's the one as far as the product goes, and I think is more widespread than anything else. And the other one, we've learned a lot of lessons in ordering earlier and trying to substitute some things; like using concrete pipe instead of a plastic pipe in certain instances or steel instead of plastic or vice versa, depending on what's more readily available for that particular situation. As far as costs, I mean, I'm always worried about rising costs, and obviously, at this point, we've been able to continue to pass through our higher costs into higher prices. I'm not a rocket scientist to say interest rates are going up, and there's a fear that housing prices are going up, and at what point does that maybe lead to lower housing demand? At this point, I haven't seen it. What we're hearing on the ground is there's still demand for those houses. As they're releasing houses for sale, there's still people bidding on houses. So we're cautious. We're thinking about it; we've got our ear to the ground, but I'm not really seeing any of those impacts on us yet.

Anthony Pettinari, Analyst

Okay, that's very helpful. And apologies if I missed this, but is there a specific percentage of sales to third parties that is baked into your guidance? Or maybe realistic for ‘22? Are there kind of one or two key things that you need to do to drive penetration among third-party builders? Is it just sort of more of a matter of time and relationship building? Or can you just maybe talk a little bit more about that?

Dan Bartok, CEO

Yes, we haven't provided specific guidance on those numbers. In the long term, we aim for around 30% of our customers to be non-Horton. By the time we reach that target, we may consider increasing it. We believe 30% is a reasonable goal for us. The primary limitation is related to Forestar-source deals, where I manage lots that aren't offered to Horton first. This allows us to take on larger projects and work with multiple builders. I think we are doing well in executing our strategy, and you will see that reflected in future trends. While this past quarter saw an uptick in third-party sales due to the BFR sale, I wouldn’t characterize it as a consistent trend. It was likely higher than what we will observe in the upcoming quarters, but we continue to focus on expanding our customer base to enhance sales in communities by providing various product types. We value our partnership with Horton; they are an excellent customer, and we are looking to attract more significant clients.

Operator, Operator

I'd now like to turn the call back over to Dan Bartok for closing remarks.

Dan Bartok, CEO

Thank you, John. 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 we look forward to speaking with you again in July to share our third quarter results. Thanks, everybody.

Operator, Operator

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