2023-06-07 23:17:48 ET
Summary
- Forestar Group's increase in book value per share and gross profit margin improvements are driven by a recent increase in the price of lots.
- FOR's diversified national presence and short-term project execution strategy offer multiple opportunities for profit margin maximization and FCF generation.
- Despite risks from debt outstanding, dependence on certain shareholders, and supply chain issues, the stock price could potentially trade at a higher mark.
Forestar Group Inc. ( FOR ) continues to deliver an increase in the book value per share and gross profit margin improvements driven by recent increase in the price of lots. In my view, further increase in the price of lots, diversification of the customer base, and further continuation of headcount growth will likely lead to FCF generation. I identified a number of risks coming from the debt outstanding, dependence on certain shareholders, supply chain issues, or lack of raw materials. With that, I believe that FOR stock price could trade at a higher mark.
Forestar Group: Short-term Projects, Diversified, And Recent Increase In The Book Value
Forestar Group is an American real estate company with its focus on the development of residential lots and investment in land for the construction and subsequent sale of finished houses for a single family.
Forestar executes short-term projects, which allow it to reach the objectives in phases, consequently maintaining a dialogue with the needs of the regional markets in which it serves and operates. I believe that this strategy is unique in the industry, and offers multiple opportunities to maximize the profit margins and FCF generation.
Most of the projects developed by the company aim at the sale of lots for the future construction of residential houses for a single family, except in some isolated cases that do not make up a statistic. The process commonly involves acquiring land or lots in the open market, providing the infrastructure for the construction of residences. In this sense, the company's clients are mainly local and regional independent builders or construction companies with a national reach.
The other beneficial feature of Forestar Group is its diversified national presence in close to 52 markets and 20 states. Considering the diversification of the portfolio, in my view, a potential economic crisis in the sector may cause less damage than that suffered by smaller and less diversified players.
The most recent quarterly release included an increase in the book value per share to $25.01 and an improvement in the gross profit margin of close to 25%. With the current stock price at close to $20-$21, I believe that Forestar Group could be trading at closer to $25 book value per share soon. At the same time, the net debt/total capital decreased from about 29% to around 25%. I believe that the numbers are beneficial.
With that about the past, I did not like at all that Forestar decided not to give annual guidance for the year 2023. In my view, no information or opinion about the future is sometimes perceived as a bearish indicator.
In any case, management did deliver some optimistic words including a beneficial commentary about future market share consolidation. Besides, Forestar believes that the state of the balance sheet will most likely allow further investments. I did form my own opinion about the financial figures reported by management, but let's say that I just do not disagree with the comments from management.
While we are not providing annual guidance at this time due to uncertainty in the market, we expect to continue consolidating market share in the fragmented and under-capitalized U.S. residential lot development industry. Our strong balance sheet and ample liquidity provide us with significant financial and operational flexibility, and we plan to maintain our disciplined approach when investing capital to enhance the long-term value of Forestar. Source: Forestar Reports Fiscal 2023 Second Quarter Results
The New Balance Sheet Includes A Decline In Total Liabilities
In the last quarterly report, Forestar Group reported a cash increase of 8.27% q/q. In the same time period, total assets did not decrease, and total liabilities decreased close to 4.9% q/q, which seems ideal. The decrease in liabilities was driven by a decrease in accrued liabilities of close to 31%, accrued development costs of about 18%, and accounts payable of 6% q/q.
More in particular, as of March 31, 2023, the company reported cash and cash equivalents worth $286.7 million, real estate of about $1988 million, investment in unconsolidated ventures close to $0.5 million, and property and equipment of about $5.6 million. Total assets were equal to $2336.3 million, so the asset/liability ratio stands at more than 2x.
The list of liabilities includes accounts payable worth $67.7 million, accrued development costs close to $99.1 million, and earnest money on sales contracts of about $130.1 million. Also, with accrued liabilities worth $48.1 million and long-term debt of about $706.8 million, total liabilities were equal to $1087.5 million.
I would really not be concerned about the total amount of debt because the debt maturity profile includes payments in 2026 and 2028. I believe that management will be able to negotiate new terms if necessary.
My DCF Valuation Included More Expensive Lots Sold And Operational Efficiencies Due To Scale Improvement
Under my cash flow model, I assumed that Forestar Group will successfully be able to increase its lot sales prices in the near future, which will lead to FCF generation. If the number of lots sold decreases, but the price of each lot sold increases, we may see FCF growth anyway. The company noted price increases in the last quarter, so I would be assuming that clients are not complaining that much.
We increase our land and lot sales prices when market conditions permit, and we attempt to offset cost increases in one component with savings in another. Source: 10-Q
Under the assumptions in my model, I included that Forestar will successfully diversify its customer base. In my view, as soon as the dependence on D.R. Horton ( DHI ) is smaller, many more investors will likely offer financing. As a result, I believe that we may see a decrease in the cost of equity and an improvement in the demand for the stock.
I would also expect certain operational efficiencies due to scale improvement, which would most likely have an impact on the FCF margin. Besides, I would expect margin expansion thanks to new technologies and its impact on the marketing efforts of Forestar.
I also expect that further hiring of employees and their training will most likely bring more opportunities in new regions in the United States. The headcount increase in 2022 and 2023 is quite impressive. Even considering that the market conditions are difficult right now, I think that management may be expecting a beneficial period once the storm is over. Managers usually do not hire that much when they expect a declining business environment.
Our business operations employed 271 and 309 employees at March 31, 2023 and 2022, respectively. Source: 10-Q
Our business operations employed 291 and 250 employees at September 30, 2022 and 2021, respectively. Source: 10-K
Finally, I would be expecting net sales growth and FCF expansion mainly because Forestar Group is targeting a massive market size. In Q2 FY 2023, the number of lots sold was close to 12K, but we are talking about an estimated target market of close to 70K. Considering the remaining market share, I think that further investments in marketing could lead to further market share gains.
All of the company's operations are covered by its single real estate segment, divided in turn into dependencies that enjoy a certain autonomy to be able to act with the knowledge and needs of each of the regional markets. The fact that Forestar reports only one segment makes the life of DCF modelers a bit easier.
My financial model included 2033 net income of $178 million, 2033 depreciation and amortization of about $13 million, and 2033 deferred income taxes of about -$49 million.
I also included a stock-based compensation expense worth $10 million, real estate impairment and land option charges close to $83 million, increase in real estate of -$79 million, changes in increase in accounts payable and other accrued liabilities worth $183 million, and increase in earnest money deposits on sales contracts of -$197 million.
Finally, net cash provided by operating activities would be about $151 million, and with expenditures for property, equipment, software, and other of -$21 million, 2033 FCF would be close to $132 million.
My assumptions also included a WACC of 7.1%, EV/FCF close to 19x, and 2033 terminal FCF of close to $2.501 billion, which implied a total enterprise value of close to $1.714 billion.
Also, assuming cash and cash equivalents worth $286.7 million and long-term debt of $706.8 million would imply an equity value of $1.293 billion. In sum, the implied fair price would be close to $25.9 per share.
For the calculation of the EV/FCF, I believe that my numbers are conservative. Some of the competitors of Forestar Group trade at 22x, 25x, and even 41.5x 3 years median FCF. In this regard, investors may want to have a look at the following image from YCharts.
There Are Many Competitors, Large And Small, And The Market Is Quite Competitive
The real estate market, specifically the real estate sector, is highly competitive and highly fragmented according to regional conditions and the needs present in each one of them. In this sense, competition comes from companies with similar services, whether regional or national in scope, and some construction companies that have their own means for land acquisition and development.
There are also competitors dedicated to the development of projects that point to other facilities that are the construction of houses for a single family. This market is marked by the variation in its participants, since there are companies with great scope and historical participation, but many small companies or developers that do not have margins to face times of crisis.
Risks
I see a myriad of factors that stem from D.R Horton's ownership of Forestar Group and the limitations to operating level that the company has for this condition.
D.R. Horton beneficially owns approximately 63% of our common stock. As a result, until such time as D.R. Horton and its controlled affiliates hold shares representing less than a majority of the votes entitled to be cast by our stockholders at a stockholder meeting, D.R. Horton generally has the ability to control the outcome of any matter submitted for the vote of our stockholders, except in certain circumstances set forth in our certificate of incorporation or bylaws. Source: 10-kThe interests of D.R. Horton may not coincide with the interests of our current or potential stockholders. Source: 10-K
To this we must add the conditions of the real estate market, the lack of future projection in some cases, possible complications in the fulfillment of the supply chains, and the variation in fuel prices and raw materials. Any of these issues may bring lower operating margins or FCF margins lower than expected, which would most likely have an impact on the valuation of the company. If a sufficient number of equity researchers remark on a decline in FCF margins, I believe that the stock price could fall.
I would also be concerned about a decline in the number of lots sold. In the last quarter, the decrease in lots was quite significant. If investors continue to see declining figures, they may decide to sell their stakes, which may lead to lower stock price marks.
Lots sold during the second quarter decreased 49% to 2,979 lots compared to 5,788 lots in the same quarter of fiscal 2022. Source: Forestar Reports Fiscal 2023 Second Quarter Results
I also cannot ensure the success of operations since this highly depends on the population's access to housing and general economic conditions. If families fail to have sufficient access to the credit markets, or there is a significant change in the market trends, the demand for the product offered by Forestar may decline.
Finally, I believe that risks will come from the total amount of debt and the possible incursion into new loans or debts, which may cause financial complications in the future. If debt owners decide to limit the number of operations that Forestar can run, I believe that management may take fewer risks, which may lead to lower FCF expectations.
Conclusion
Even considering the recent decrease in the number of lots sold by Forestar Group, I believe that management is reacting well by increasing the price per lot sold. In my view, further price increases, diversification of the customer base, lower dependence on DHI, and economies of scale could bring the attention of new investors. I also assumed that headcount growth will likely continue, which may bring even more opportunities for FCF generation. Yes, there are a number of risks coming from concentration of clients and the total amount of debt, however I believe that the stock price could be higher.
For further details see:
Forestar: Headcount Growth And Lot Price Increase Could Imply Undervaluation