Earnings Call Transcript - FOR Q1 2020

Operator, Operator

Greetings and welcome to Forestar's First Quarter 2020 Earnings Conference Call. All participants are in listen-only mode, and a question-and-answer session will follow the formal presentation. This conference is being recorded. It is now my pleasure to introduce your host, Jessica Hansen, Vice President of Investor Relations for D.R. Horton, the 65% majority owner of Forestar. Jessica, please go ahead.

Jessica Hansen, VP of Investor Relations

Thank you, Kevin. We welcome each of you to our call to discuss Forestar's financial results along with the company's expected growth and capital plans. Before we get started, today's call may include comments that constitute 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 Forestar does not undertake any obligation to publicly update or revise any forward-looking statements. Additional information about issues that could lead to material changes in performance is contained in Forestar's 2018 Annual Report on Form 10-K which is filed with the Securities and Exchange Commission. This afternoon's earnings release is on Forestar's website at investor.forestar.com and the 10-Q is planned to be filed early next week. After this call, we will post an updated investor presentation to Forestar's Investor Relations site under events and presentations for your reference. Now, I will turn the call over to Dan Bartok, CEO of Forestar.

Dan Bartok, CEO

Thank you, Jessica, and good afternoon, everyone. In addition to Jessica, I am pleased to be joined on this call by Colin, D.R. Horton's Vice President of Corporate Finance and Treasurer, who works closely with Jessica and me on Forestar's finance and Investor Relations efforts. Our team delivered a solid first quarter and made significant progress towards executing on our plans for fiscal 2020. We will discuss these results in detail, but first I'd like to remind everyone about Forestar's unique business model and how it differentiates our company in the marketplace. Unlike other land developers, we bring a production-oriented returns focus manufacturing mindset to the land development process. We are focused on short duration, fully entitled residential lot development. We develop our projects in a phased manner, and typically have a signed lot purchase agreement from a known buyer prior to making any significant new investments. Our approach to land development is lower risk than other public land developers and will produce more consistent cash flow and returns as we achieve scale. Forestar also has a unique and strategic relationship with D.R. Horton, the nation's largest builder. Our relationship with D.R. Horton de-risks the expansion of our operating platform and allows us to have a footprint that is more geographically diverse than most public homebuilders. D.R. Horton has an immense appetite for finished lots, and we are leveraging the strategic relationship to deliver topline revenue growth that is unmatched within the broader homebuilding and land development universe. I'll turn it over to Jessica now to discuss some of our financial highlights.

Jessica Hansen, VP of Investor Relations

Thank you, Dan. In the first quarter, net income attributable to Forestar increased 412% to $16.9 million or $0.35 per diluted share, compared to $3.3 million or $0.08 per diluted share in the prior year quarter. Forestar's first quarter revenues increased 542% to $247 million which included $30 million of residential track sales. Residential lots sold during the quarter totaled 2,422 lots, an increase of 368% from the prior year quarter. The average lot sales price for the quarter was $90,300. 58% of lots sold in the quarter were from development projects with the remainder from lot banking. Of Forestar's total lots sold, approximately 2,400 were sold to D.R. Horton during the quarter. Dan?

Dan Bartok, CEO

It's our goal to build a company that will produce consistent returns. During this period of rapid growth, we expect significant variability in our quarter-to-quarter results. However, at scale we are confident that our low-risk, high-turnover, production-oriented lot manufacturing model will produce consistent returns. Our pre-tax income for the quarter was $22.2 million with a pre-tax profit margin of 9%. Our gross profit margin was 12.4% in the first quarter, and SG&A expense as a percentage of revenues was 4.2%. We continue to expect our pre-tax profit margin in fiscal 2020 to be in the mid to high single-digit percentage range. For the remainder of the fiscal year, we expect significant quarterly fluctuations in our gross and pre-tax margins due to the quarterly mix of our lot deliveries, the timing of track sales, and the timing of incremental SG&A while building out our platform. We still anticipate approximately two-thirds of our lot deliveries in fiscal 2020 will be from lot development projects, which typically generate gross margins ranging from 14% to 22%. Our current development project portfolio is heavily weighted to shorter duration projects, not sourced by Forestar, which will produce margins at the lower end of this range. Additionally, short-term lot banking projects are expected to be roughly one-third of lot deliveries during fiscal 2020. Lot banking is expected to generate 12% to 16% annual returns with gross margins ranging from 3% to 9% due to the short duration of our current portfolio. Finally, the continued build-out of our platform infrastructure will require increased SG&A to support our ability to achieve scale. At scale, we believe we will manage our business at an SG&A percentage lower than a typical homebuilder. Jessica?

Jessica Hansen, VP of Investor Relations

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 lots, land and development totaled $230 million, of which $120 million was for land, and $110 million was for land development. In fiscal 2020, Forestar continues to expect to invest approximately $1 billion subject to market conditions. Forestar is currently operating in 51 markets and 20 states, which is an increase of 16 markets and four states from a year ago. Forestar is more diversified today and in more markets than most homebuilders. Forestar's recruiting efforts to date continue to be very successful, and the company has recently opened its thirteenth division office. There continues to be tremendous opportunity for growth through Forestar's existing markets and our relationship with D.R. Horton. Forestar's lot position increased 16% sequentially from September 30th to 44,500 lots at quarter-end. Forestar's lot position at December 31st, 32,200 are owned and 12,300 are controlled through purchase contracts. 12,700 or 39% of Forestar's owned lots are already under contract to sell to D.R. Horton representing approximately $1 billion of future revenue. Another 12,900 of Forestar's owned lots are subject to a right of first offer with D.R. Horton under the Master Supply Agreement. Forestar currently expects to own a three to four-year inventory of land and lots. Colin?

Unidentified Company Representative, Representative

While Forestar continues to grow its platform and scale rapidly, the company is focused on maintaining sufficient liquidity, and modest leverage. At December 31st, Forestar had approximately $720 million of liquidity, including $370 million of unrestricted cash and approximately $350 million of available capacity on its revolving credit facility. Forestar's net debt to capital ratio at quarter-end was 9.7%, and the company has $119 million of convertible senior notes maturing in March that are expected to be settled in cash at maturity. Forestar is focused on maintaining a strong balance sheet that will utilize modest leverage. Subject to market conditions, the company expects to opportunistically access the public markets to provide additional capital for long-term growth while managing to a net leverage ratio of 40% or less. At December 31st, stockholders' equity was $826 million, and book value per share was $17.19, up 7% from one year ago. Dan?

Dan Bartok, CEO

Forestar is uniquely positioned to consolidate market share in a highly fragmented lot development industry through housing market and economic cycles. We now expect to deliver 10,000 lots and generate $800 million to $850 million of revenue in fiscal 2020, and continue to expect to deliver approximately 12,000 lots and generate $900 million to $1 billion of revenue in fiscal 2021. At scale, we expect our operating model to produce financial results and returns that are similar to or better than most mid-cap homebuilders, with long-term pre-tax margins of approximately 10%. As I indicated earlier, we still expect our pre-tax profit margin to be in the mid to high single-digit percentage range for fiscal 2020 and approximately 10% by fiscal 2021. Before we turn to questions, I'd like to remind everyone of Forestar's investment highlights from my perspective. We have a unique lot manufacturing business model, very different from a typical land developer. We have a strategic relationship with D.R. Horton, the nation's largest builder. We are in a significant growth trajectory; we are geographically diversified, we are focused on developing lots for affordably priced housing, the heart of the market. We have an experienced management team that is excited about our opportunities. With a strong balance sheet and liquidity position, we are profitable at our current operating levels and we will enhance our results as our portfolio matures and we continue to build staff. To put it simply, we are executing on our plans and are positioned for continued success. Kevin, at this time, we'll now open the lineup for questions.

Operator, Operator

Thank you. Our first question today is coming from Truman Patterson from Wells Fargo.

Truman Patterson, Analyst

Hi, good evening everybody, nice results. First, I just want to touch on lot count in 2020, very strong balance sheet over $700 million in liquidity, only 10% net debt to total capital; could you just walk us through how we should be thinking about your total lot count ending 2020? I know this has a lot of moving parts, you're delivering 10,000 lots this year that will need to be replenished; you're purchasing lots outright which could take up more capital, it will vanish, you have decided the option but you know, how should we think of total lot count in 2020, should it increase in a similar range as 2019 where you all had lot count increase by about 18,000 year-over-year or would that be too aggressive?

Dan Bartok, CEO

One thing I think is, we have to go back to what we're saying as our target for lot sales; remember that we're only targeting a three to four-year lot supply. You know, we're opportunistically buying transactions; this last quarter was unique in our growth in all the controlled lots without a significant increase in our inventory. We're just continuing to kind of execute deal by deal and we're clearly going to grow that platform in order to support our continued growth.

Truman Patterson, Analyst

Okay. Is there any limiting factor and ability to find land that is in meeting your underwriting hurdles that would kind of limit or cap that or is that just more of an internal decision?

Dan Bartok, CEO

Well, it really goes back to people and capital. That really, I think is our limiting factor, we're building a great team; we're continuing to source more Forestar-source transactions in addition to the support we're getting from Horton-source transactions. I think our pipeline is as strong as it's ever been and I feel like we're really poised for execution.

Jessica Hansen, VP of Investor Relations

And we believe the three to four-year lot supply gives them the ability as the phase develops to continue to grow into that and is sufficient for continued growth in coming years; so they don't need to own more than three to four years of land, and that's a big part of their returns improving over the coming years is delivering more revenue and profits on a three to four-year owned lot supply.

Truman Patterson, Analyst

Okay. Could you all discuss how many fully developed lots do you have in your backlog currently?

Jessica Hansen, VP of Investor Relations

4,100.

Dan Bartok, CEO

Yes, about 4,000.

Jessica Hansen, VP of Investor Relations

Yes. 4,100 at the end of December.

Truman Patterson, Analyst

Okay, great. And then, final one for me and then I'll hop back in queue. Just looking over the past 12 months, what kind of lot price appreciation have you all seen in some of your core markets; either what you've been able to pass-through to the end-user, i.e. D.R. Horton or on the inflation side, what have you seen your costs kind of go up when you're out working at the land?

Dan Bartok, CEO

That's really a hard question to answer. On an individual basis, most of the lots we're selling today were contracted for a year to 15 months ago but I'm seeing new transactions, we're definitely seeing a rise in pricing on a market-by-market basis but I don't know if I could really give you a percentage number on that, I probably want to do a little bit more homework before I answer that question.

Truman Patterson, Analyst

Would a ballpark in maybe some of your core markets be kind of low to mid-single digits; just so…

Dan Bartok, CEO

It's probably a good guess, yes. And again, I think costs have gone up, concrete has gone up a little bit on some of our concrete work - I think a little bit cost in grading, I think there is - but it's really limited to certain markets where there is really a lot of development taking place in those sub-markets. But I think we've been able to easily achieve an increased pricing as it relates to the increase in costs.

Truman Patterson, Analyst

Okay. Thank you, all. Nice quarter.

Operator, Operator

Thank you. Our next question today is coming from Ryan Gilbert from BTIG.

Ryan Gilbert, Analyst

Hi, thanks guys. Just to take you back on Truman's question; are you seeing an ability to price above the cost increases that you're seeing in the market, just given how demand has been year-to-date?

Dan Bartok, CEO

Yes. I would say that we're able to maintain margins in our projected returns in all of our underwriting and clearly pass on any increasing cost in lot pricing.

Ryan Gilbert, Analyst

Okay, got it. And then, as I said, it seems like demand has been pretty good so far in 2020 and we've had that 10,000 lot goal out there for some time now. And I guess I'm wondering in the event that we see the demand holding up throughout the year. Can you talk about your ability to flex out a lot production capacity to meet higher demand and potentially get above that 10,000 lot delivery range? I guess, with the understanding that this land development is a slow business, even lot manufacturing.

Dan Bartok, CEO

Yes. Again, in most markets it takes me closer to a year, even on second phases, it takes me close to a year to actually get lots on the ground. We're monitoring sales pretty closely at all of our subdivisions in order to try to get ahead of any increased demand; in a couple of cases, we are accelerating when we're getting lots on the ground. So - I mean, we're hopeful that we'll be able to exceed the 10,000 but we feel pretty comfortable that we'll get there. But if you look at what our first quarter and you think it's simply pretty easy but we've had a great quarter and I think we tried to assure you guys all along that it's going to be lumpy quarter-to-quarter.

Ryan Gilbert, Analyst

Great, understood. And then just last one for me; in terms of accessing the public markets in 2020 can you talk about your preference for debt versus equity capital?

Dan Bartok, CEO

Colin, do you want to take a shot at that one?

Unidentified Company Representative, Representative

Sure, Dan. So our approach to the capital structure is really centered on being conservative, flexible, and disciplined through our capital raising efforts last year together with the performance of our business; Forestar is in a unique and great position where we can be opportunistic as it relates to the timing and sequencing of debt versus equity. And certainly, our approach to tapping the capital markets will parallel our philosophy on capital structure. We're going to be opportunistic but disciplined as we evaluate the capital markets, but certainly any decisions we make would be centered on maintaining a conservative capital structure, and certainly leverage less than 40% net.

Ryan Gilbert, Analyst

Okay, great. Thank you.

Operator, Operator

Thank you. Our next question today is coming from Michael from JP Morgan.

Unidentified Analyst, Analyst

Hi, this is Lauda on behalf of Mike. Great job this quarter. First, average selling prices are elevated again, which creates some challenges, possibly due to a mix of issues, like land being on the West Coast. Do you expect to speed things up in the second quarter?

Dan Bartok, CEO

You've nailed it. It's clear that there was a mix of factors, and there was a notable concentration of lot banking in the West this quarter, similar to the last quarter where we saw a $90,000 ASP in both quarters. I don't foresee this trend continuing; the unusual level of lot banking we experienced this quarter is not expected to persist. However, I believe you will see a continuation of lot banking sales for the remainder of the year.

Unidentified Analyst, Analyst

Okay, thank you. And also, just in terms of 2Q continuing, any other color that you could provide in terms of closings, gross margin or SG&A?

Jessica Hansen, VP of Investor Relations

No, we're really sticking with annual guidance. As Dan already indicated, it's going to be lumpy from quarter-to-quarter, although on an annual basis, it's a very significant growth trajectory. Just with the timing of lot deliveries and the impact of mix, it's going to be lumpy quarter-to-quarter, so we're not planning to provide any quarterly guidance.

Unidentified Analyst, Analyst

Okay. So just turning to the full year, I was wondering what's baked into the revised fiscal year '20 total revenue guide in terms of residential track sales given you had another big track sale this quarter?

Dan Bartok, CEO

Yes, that's really what it was. We actually had three track sales in this quarter, two small multi-family pieces and one larger residential track. That won't be repeated, so that's why we feel pretty good about raising the bottom of our revenue guidance.

Unidentified Analyst, Analyst

Okay. Thank you.

Operator, Operator

Thank you. Our next question is coming from Alex from Housing Research.

Unidentified Analyst, Analyst

Thanks. Yes, I guess you kind of answered few of my questions because I was just trying to figure out given your guidance for this year; and I guess we shouldn't take this quarter's revenue as a run rate then. What would cause it to kind of fluctuate or what will be the biggest driver?

Jessica Hansen, VP of Investor Relations

Alex, you're right. So to be specific on what we did this quarter since we didn't sell it out in a previous guidance was for $750 million to $850 million of revenue, and then we delivered this quarter which included $30 million of residential track sales which we've talked about meaning somewhat, one, being those aren't recurring every single quarter, and we felt comfortable that we could move the low end of the guidance to $800 million from $750 million. So that really was driven by solid lot deliveries this quarter coupled with the $30 million of track sales.

Unidentified Analyst, Analyst

Okay. And obviously, you're only kind of giving us an idea of this year and next year, not beyond that but it would seem to me growing the pipeline 20% where there is obviously a lot of demand for land and everybody is growing even faster than that, it seems in order to this quarter what would be the constraint - why would the constraint be around 20%? Is it really the capital or is it more people?

Dan Bartok, CEO

Well, it's back to - it takes us about a year from the day we buy land before we get to that first revenue event; so it's kind of that leading indicator. We just raised additional capital at the end of last year, that money is now being put to work; so I think you will see some impact in 2021 but you can see the bulk of that really in 2022.

Jessica Hansen, VP of Investor Relations

It's definitely going to be a growth story for years to come, we're just not in a position today to feel comfortable giving guidance past '21 but we do expect this should be a growth story for a multitude of years.

Unidentified Analyst, Analyst

It would seem that way. Well, thanks and best of luck.

Dan Bartok, CEO

Thank you.

Operator, Operator

We have reached the end of our question-and-answer session. I'd like to turn the floor back over to Dan for any further or closing comments.

Dan Bartok, CEO

Thank you, Kevin. And thank you to everyone on the Forestar team for your focus and hard work. 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 and look forward to speaking with you again in April to share our second quarter results. Thank you.

Operator, Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.