Description

Forestar Group – (FOR)

Forestar owns a hodge-podge of hard assets that are worth $35 on an after-tax break-up basis and as much as $45 in a change of control  vs. $15 as ascribed by the market today. At today’s prices, Forestar is an opportunity to buy a mix of commercial real estate, residential lots, raw land, royalty revenue, water rights, and energy assets at book value, with much of the cost basis dating as far back as the 1950s.  The stock historically has been owned by real estate investors who own it for its real estate assets.  It has traded down recently primarily over investor dismay at a recent acquisition in the energy space, which we think confused the story for real estate focused investors and has led to underperformance despite substantially increased optimism over a housing recovery.

We believe an upcoming investor day Dec 11^th (its first in 2 years) and increased disclosure in the upcoming 10-K will provide further clarity on the company’s plan and also give a better lens into the reserves underlying their legacy energy holdings, which we estimate are worth more than double the energy assets Forestar recently acquired.   Currently, we value Forestar’s real estate assets at $22.50 a share net debt & corporate expense, consistent with how the market has valued Forestar in the past.  We believe investors are currently placing a negative value on the energy assets due to the lack of disclosure and fear that Forestar will pursue value destroying activities.  Our diligence has led us to believe that management’s recent energy acquisition was at a reasonable price and that they will be disciplined on future investments in energy.   Although the stock may never trade at it sum-of-parts value, we think it should re-rate substantially higher over the next 12-24 months as investors give the company more credit for its substantial assets outside of real estate.

 Overview of Owned Assets & Value:

Forestar consists of the legacy land assets of Temple Inland, which spun off Forestar at the end of 2007.  Temple Inland’s land business originates from the 1955 incorporation of Lumbermen’s Investment Corporation, and its mineral assets date all the way back to the 1940s.  The majority of Forestar’s real estate assets are in Texas (Dalls Ft Worth / Austin), markets with very healthy population growth, inventory levels, and affordability characteristics.  Below is an overview of the assets and our base case sum of parts valuation:

 Developed / Entitled Land

Forestar owns nearly 20,000 residential lots and 2,000 lots of commercial land.  It also receives a 9% royalty on occupancy revenues from Marriott’s Cibolo hotel, as well as a 1.5% royalty on sales tax from the resort.  Further, Forestar is owed a $35M reimbursement from the local municipality which should be paid within the next 12 months.  We value the Cibolo royalty at 67M and the SPID reimbursement at 35, yielding $131 for Cibolo. Approximately 75% of the value of this land is based in Texas, in areas with healthy demographics and low levels of inventory (Austin, Dallas Ft Worth, Houston, etc.)

Forestar expects to sell its residential and commercial land lots within the next 5 years.  The company on average has earned $25k margins on residential lot sales and $100k on commercial lot sales over the last several years and is currently earning ~15-20k margins on residential lot sales.  We value developed land at the below valuations:

 Commercial Operating Properties

Forestar owns several commercial properties in Texas, including 3 multifamily, one hotel, and one office.  Forestar is in the process of selling the majority of these properties and already has offers on several for numbers at or in excess of our valuations, which we include below:

 Undeveloped Land

Forestar has 122k acres of undeveloped land in Texas and Georgia, 27.5k of which are currently in the entitlement process.  We value Forestar’s undeveloped land at different valuations based on our estimations of use (note the company thinks that a majority of their undeveloped land can be entitled for higher use).  We value the higher use undeveloped land in the entitlement process at $10,000/acre, and the likely to be entitled land at $7,000/acre, at the low end of market comps.  The remainder of the land we value as recreational land (selling in markets for $2,000-$3,000/acre) and timberland (selling for $1,500-$2,000/acre).

 Mineral Rights

Forestar owns all the mineral rights originally owned by Temple-Inland, which consists of approximately 595,000 acres of land in Texas, Louisiana, Georgia, Alabama, and California.  48,000 are currently leased, 32,000 are producing, and the other 515,000 are unleased today.  The majority of these assets are Oil / NGLs / NG plays.  One of the big reasons the stock has traded off is that Forestar increasingly seems to be shifting their focus to putting modest amounts of capital into this piece of the business with limited track record.  While we acknowledge this as a risk, we would point out that the company to date has appeared to be disciplined with capital allocation, paying a reasonable multiple for the Credo business and also favors relatively capital light ways to prove out and develop their assets, mostly through leases or development partnerships.

We have done extensive bottoms-up work on valuing Forestar’s mineral holdings.  Using very conservative DCF assumptions, we arrive at a value of $350M.  Going asset by asset on a comparable transaction basis, we arrive at somewhere between $350-500m+.  We use 350M in our valuation, which implies $575/acre for this land.

Water Rights

Forestar owns approximately 800,000 acres of Central Texas land with water rights.  The majority of municipalities located near Forestar’s acerage face substantial water shortages over the next 20-30 years and will likely have to address this issue sometime in the next several years.  Water rights can either be sold outright, or sold on a per/acre foot-basis.  Value can vary based on proximity to cities that need water and the degree to which the water sources self-replenish.  The best, recent transaction was 200,000 acres of water rights which sold for $500/acre to the Canadian River Municipal Water authority by Boone Pickens.  Boone Pickens paid $300-$350 for most of the water rights he purchased in the Texas area since 2002, so we feel very comfortable valuing this around $350 an acre.  We have also heard that from people in industry that, relative to the land Boone Pickens sold, Forestar’s land is likely worth more because it is self-replenishing and generally located closer to municipalities with water needs.  This land receives minimal value today and any transactions in this area could better highlight the value here.

Credo & JV interests

We value the remaining assets at book value, including the recent acquired Credo assets, which we value at cost.

Comps

There are several public traded companies with assets similar to Forestar, many of which trade at some discount to their NAV, but much closer to their NAV than does Forestar.  Although many of these companies have a history of being value traps (and FOR to date has been no exception), we would point out that FOR trades at a substantial discount to most accepted NAVs for other publicly traded comparables.

Management Plan

Management plans to transform the entity over time from an asset rich run-off to a sustainable operating entity with real earnings and free cash flow.  The company targets tripling land lot sales, tripling oil & gas production, and tripling total segment earnings, all of which we think are reasonable expectations over the intermediate term.  Although we would prefer for the company to monetize the assets and distribute cash to shareholders, or sell the entirety of the business to a third party, we think management is unlikely to erode substantial value through its planned investments, which are modest.

Risks:

The biggest risk is that Forestar invests sale proceeds from its valuable assets and reinvests that money into money losing ventures (e.g. development of its energy assets).  We are cognizant of this risk, which is one of the main reasons we thinks it’s likely the total delta between the sum of parts value and where the stock trades today is unlikely to be realized immediately.  That said, we take comfort from the fact that the company has been cautious with its investments in energy.  Our conversations suggest they paid a fair multiple for Credo and their go forward capex plans in energy are very modest.  They have also generally expressed an interest in lower risk, less capex intensive deals, such as royalty deals or working interest deals with a partner.  The other risk is, with lack of clear catalysts or plan to realize value, the things that make this cheap today may very well persist, making this dead money. 

Catalyst