FORESTAR GROUP INC FOR
May 04, 2015 - 12:02am EST by
hawaii21
2015 2016
Price: 14.95 EPS 0 0
Shares Out. (in M): 50 P/E 0 0
Market Cap (in $M): 742 P/FCF 0 0
Net Debt (in $M): 159 EBIT 0 0
TEV ($): 901 TEV/EBIT 0 0

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  • Sum Of The Parts (SOTP)
  • Real Estate
  • Real estate developer
  • Oil and Gas
  • Discount to NAV
  • Activism
  • Analyst Coverage

Description

Long Forestar Group (FOR)

Sum-of-the-parts real estate play at discount to NAV with activist on the board

Thesis

The Forestar Group (FOR) is a land developer and oil & gas company trading at a substantial discount to net asset value and only 80% of tangible book value. I conservatively value shares at $24 on a sum-of-the-parts basis vs. a recent price of ~$15 (~60% upside).

Forestar's discount is not new, and the stock has in fact been written up previously on VIC three times (in 2008, 2010, and most recently in 2012). However, value destructive capital allocation decisions have prevented this discount from closing. While "this time is different" are famous last words, the recent involvement of an activist consortium with newly won board representation should push the company to be more shareholder friendly and help catalyze share price convergence with asset value. Forestar is already instituting a number of corporate governance reforms and the company is currently in the midst of a strategic review that could result in the disposal of the company's non-core oil & gas business. Longer term, I believe Forestar could rerate as it transitions to a real estate operating company business model that is more reliant on recurring earnings as opposed to one-off gains from asset liquidation.

I value Forestar at $24/share for ~60% upside. Given the company's diverse array of hard assets, I use a sum-of-the-parts approach that focuses on net asset value instead of earnings power. Using more bullish yet still achievable assumptions, shares could be worth as much as $33/share (~120% upside). I believe risk-reward is asymmetrically skewed to the upside. I peg NAV at $13/share in a downside case (~13% downside), although a widening discount to intrinsic value in public markets could temporarily lead to a lower market price in a stressed scenario.

Forestar will report 1Q15 earnings on May 6. While this pitch is not meant to be a call on results specifically, I do believe that we could hear further updates on the company's strategic review.

I recommend consulting rii136's thorough write-up on 12/6/12 for further background and history.

Please see below for important disclosures.

(Note: Shares outstanding, market cap, net debt, and TEV in the data box have been adjusted to be fully diluted. Basic shares outstanding total 34.7m and unadjusted net debt is $263m, leading to undiluted market cap and TEV of $519m and $782m respectively.)

Business Model

Forestar's core business is land and real estate development, mostly in the Sunbelt region. The company owns 113,000 acres of land in various states of development in Texas, Georgia, Alabama, California, Tennessee, and several other states. Management adds value by moving land up the value chain to its highest and best use. Undeveloped land generating timber and recreational lease revenue is first entitled for development (i.e. permitted and zoned). Entitled land is then developed into a residential or mixed-use community with road, water, power, and sewer infrastructure. Lots are then sold to homebuilders. This multi-step entitlement and development process turns raw land worth ~$2,200/acre into construction-ready property worth ~$90k/acre for residential land and ~$200k/acre for commercial land.

Forestar also develops commercial buildings. The company owns a hotel, golf course, and multi-family building. There are a further five multi-family properties under construction and four more projects in the pipeline. Traditionally, the company has sold completed projects and then recycled the capital into new projects. However, they have retained some properties along the way that generate net operating income.

In addition to its extensive land holdings, Forestar owns and develops oil & gas reserves. The company owns 590k net acres of mineral interests primarily in Texas, Louisiana, Georgia, and Alabama. Traditionally, Forestar would lease these interests to E&P companies in exchange for a one-time lease bonus payment and ongoing production royalties. The company occasionally took a minority working interest in wells on its properties. In 2012, Forestar acquired Credo Petroleum, an independent oil & gas exploration and production company. With this transaction, the company entered the business of developing oil & gas reserves for its own account. Forestar holds 370k net acres of leasehold interests, including 9k acres in North Dakota's Bakken and Three Forks formations, 41k acres in Oklahoma's Anadarko Basin, and 285k acres targeting the Lansing-Kansas City formation. The company has working interests in 393 gross wells, including 153 operated in-house.

As is apparent from the above descriptions, Forestar's real estate business does not have a lot of recurring earnings in the traditional sense. Earnings instead consist of a series of one-off gains as the company liquidates its land and property holdings. The proceeds are then recycled into new real estate projects and the process is repeated. As I will discuss below, this business model makes valuing Forestar on current earnings difficult. The model is also dependent on prudent capital allocation, can be tax inefficient, and is perceived as riskier than an approach that entails recurring cash flows. A potential transition to a business model more reliant on building recurring cash flows from commercial real estate would support a rerating of the shares.

Why this Opportunity Exists?

Orphan Stock

Forestar is an orphan stock with its hands in many different industries. It was formerly part of a paper products company and still has timber assets. It develops land and real estate, but also owns mineral rights and operates an independent oil & gas exploration and production company. Forestar does not fit neatly into any one sector. Accordingly, it is often overlooked. Only five sell-side firms offer research coverage, and none of them are bulge bracket banks. When the company does get attention, the analyst is often only an expert on one part of the business.

Complex Conglomerate

As mentioned above, Forestar is a collection of diverse assets in different industries. There are a large number of distinct properties and asset types in numerous different locales, many of which are individually small but add up to a substantial value. The company also participates in both consolidated and unconsolidated JVs that make the balance sheet more complex. Some assets have little to no book value. As a result, getting to an estimate of intrinsic value requires investigating many small, separate line-items.

Value Not Based on Earnings

As mentioned above, a large proportion of Forestar's earnings are not truly recurring in nature, and therefore the company cannot be valued on a multiple of earnings. Net income includes gains from the liquidation of enhanced land. The appropriate way to value Forestar is via net asset value, which is more involved to calculate. On a P/E basis, Forestar appears to be trading at a full ~16x adjusted 2014 EPS, while a 20x trailing multiple would only yield an $18.80/share valuation.

Poor Capital Allocation to Date

In a business where capital recycling is crucial, Forestar has not been the best steward of capital. The company expanded beyond its core real estate competency and issued equity-linked securities to do so.

In 2012, Forestar acquired Credo Petroleum for $146m. In the subsequent two and a half years, the company invested an additional ~$219m into oil & gas exploration and production, for total gross invested capital of $365m or ~75% of the current market cap. Investment of this magnitude is hardly reflected in the current share price, and the oil & gas business generated only $10m in adjusted EBIT in 2014 (excluding $33m of impairment charges).

To fund all of this spending, Forestar issued equity-linked securities at prices below the stock's intrinsic value. In addition to convertible notes with a conversion price of $24.49/share, the company also issued Tangible Equity Units which consist of a debt component and a prepaid equity component worth as many as 7.9m shares if the share price is below $19.09 and 6.5m shares if the share price is above $22.91. These units become exercisable at the end of 2016, and will be more dilutive if Forestar's share price remains below ~$19.

Texas + Oil & Gas Exposure

As an oil & gas producer and Texas landowner, Forestar has gotten swept up into the recent oil price rout. Depressed oil prices negatively affect Forestar in two ways. First, lower oil prices mean lower reserve values. At $95/bbl WTI, Forestar's proved reserves had a PV-10 of $229m, but only $128m at $61/bbl. Second, lower oil prices negatively affect the Texas economy, which could reduce the value of Forestar's land, at the least in the near term. I believe fears about Texas exposure are overblown (see risks for further details).

What is Changing?

Activist Involvement

In November 2014, Cove Street Capital (a value fund) and SpringOwl Asset Management (an activist fund) filed a joint 13D revealing a 6.1% stake in Forestar. The filing stated that they view Forestar as an "attractive investment opportunity" and disclosed interactions with management and the Board. Cove and SpringOwl singled out three specific issues on which they are focusing: 1) Strategic alternatives for the oil & gas business; 2) Enhanced capital allocation; and 3) Improved corporate governance practices. A letter filed on January 6 elaborates on their concerns (link below).

http://www.sec.gov/Archives/edgar/data/351262/000090266415000008/p15-0001exhibit3.htm

On February 9, Cove and SpringOwl came to an agreement with Forestar to add two new directors. Daniel Silvers of SpringOwl and David Weinstein, the former CEO of MPG Office Trust, will join the Board, while two existing directors will resign (one immediately and another in May 2016). The activist group will be subject to a standstill agreement until February 1, 2016. Having two new directors, including one from an activist manager, will introduce fresh perspectives to the Board and keep the company engaged with shareholders.

As of the latest amended 13D filing, Cove and SpringOwl own ~7.1% of share outstanding. NWQ Investment Management, an affiliate of Nuveen Asset Management that uses a bottom-up, research intensive strategy owns ~15% of shares, while Keeley Asset Management, a value manager, owns another ~7.6%. Together, these entities control ~30% of shares, meaning Forestar has a large contingent of value-oriented managers in its shareholder base.

Oil & Gas Strategic Review

Forestar has initiated a strategic review, including an evaluation of its oil & gas business. The company has already cut oil & gas opex by ~50% (~$9m/year) and capex by 70%+ (~$78m). The review could conclude with a sale of the oil & gas business, and Cove/SpringOwl had previously offered to connect Forestar with a potential private buyer. A spin-off appears less likely due to the business's small size. The review could also result in new strategies to monetize Forestar's extensive mineral rights, which have been largely ignored over the past several years due to the focus on the new Credo assets.                                                      

Improvements to Capital Allocation

Prior to activist involvement, Forestar's capital allocation appears to have been driven by its "Triple in FOR" initiative, which sought to triple segment EBITDA, triple oil and gas production, and triple residential lot sales. As the activists point out, these goals do not take into consideration capital requirements, return on capital, or the impact on NAV per share. The nature of Forestar's business also explains why "Triple in FOR" is not necessarily accretive. Forestar is not a traditional operating business with recurring earnings, but instead relies on asset liquidation and capital recycling to add value. Returns and impact on NAV/share, not accounting earnings, are the most important metrics.

Forestar's evaluation of its capital allocation could result in a new strategy focused on value maximization, with the real estate business at the core of a new Forestar. The company could accelerate land development and monetization where appropriate. With a more robust internal understanding of NAV, share buybacks remain another path given the substantial discount to intrinsic value at present.

Longer term, the real estate operating company (REOC) model presents a compelling opportunity. Forestar could reinvest the proceeds of land sales into income generating commercial properties and projects, thereby building a sustainable, recurring income base over time that commands a high multiple to earnings. The company already has a growing portfolio of existing and prospective commercial properties that could form a nucleus for a future portfolio. This model also promises increased tax efficiency through the use of 1031 exchanges where appropriate. The Consolidated Tomoka Land Co. has pursued a REOC strategy with great success so far. Consolidated Tomoka's ~50% share price appreciation over the past two years stands in marked contrast to Forestar's 30% share price decline over the same period.

Corporate Governance Reforms

Forestar is taking steps to improve its corporate governance practices. First, the company has terminated its Shareholder Rights Plan. The plan was previously scheduled to expire near the end of 2017 and would have been triggered if someone acquired more than 20% of shares. Second, the Board has recommended that shareholders approve a proxy proposal to declassify the board.

Although these are both modest changes and the Board de-staggering will not take full effect until 2018, they represent a favorable change in the company's approach to relations with shareholders. While more progress is needed, these are encouraging first steps.

Valuation

I value Forestar on net asset value using a sum-of-the-parts model. I assign a value of $24/share in my base case, with $33/share in a high yet achievable scenario and $13/share in a low scenario. A $24/share value implies a price/book of ~1.6x, in-line with or below other land company peers, as noted below.

Alexander & Baldwin (ALEX): 1.6x P/B

The St. Joe Company (JOE): 1.7x P/B

Consolidated Tomoka Land Co. (CTO): 2.3x P/B

The Howard Hughes Corporation (HHC): 2.6x P/B

Throughout this exercise, I have followed three guiding principles. 1) I have attempted to remain conservative in my base case valuation. In many instances I see achievable upside to the values I use. 2) I take present value into consideration when value realization may take time; 3) I allow for full dilution from dilutive securities and stock comp, although share buybacks at a discount to NAV could reduce the impact.

 

Asset Book Value Base Case Value Base Case Value Notes
Developed/In-Development Residential Lots 256 84 1,582 developed residential lots @ $53k/lot sale price
Entitled Residential Lots 204 13,546 entitled residential lots @ $20k/lot margin; discounted 3 yrs @ 10%
Entitled/Developed Commercial Acres 66 1,721 developed/entitled commercial acres @ $75k/acre margin; discounted 7 yrs @ 10%
Land in Entitlement 41 330 24,430 acres in entitlement; assumed 1.75 lots/acre; $20k/lot margin; discounted 10 yrs @ 10%
Undeveloped Land, including Timber 58 166 75,359 undeveloped acres @ $2,200/acre sale price
Total Land 355 849  
       
Cibolo Canyons Reimbursements 32 32 $32m undiscounted; accrues interest at 9.75%
Other Utility District Reimbursements 33 28 $33m undiscounted; assumes 5 yr payout @ 10% discount rate
Cibolo Canyons HOT/S&U Tax Receivables 0 19 $35m undiscounted with no growth 2015-2034; adj. for 2% growth/yr & 10% discount rate
Total Infrastructure Reimbursements 65 78  
       
Radisson Hotel, Austin 31 51 $3.6m in 2014 NOI @ 7% cap rate
Harbor Lakes Golf Course, Dallas 1 0 ($500k) NOI in 2014; assume no value
Eleven - Austin Multi-Family 53 68 $3.4 est NOI @ 5% cap rate
Midtown - Dallas Multi-Family 33 51 $2.8 est NOI @ 5% cap rate; discounted 1 yr @ 10%
360° - Denver Multi-Family, 20% Interest 4 8 $3.8 est NOI @ 5% cap rate; net of project debt; discounted 1 yr @ 10%
Acklen - Nashville Multi-Family, 30% Interest 6 12 $4.1 est NOI @ 5% cap rate; net of project debt; discounted 1 yr @ 10%
HiLine - Denver Multi-Family, 25% Interest 6 6 Book value
Elan 99 - Houston Multi-Family, 90% LP Interest 9 9 Book value
4 Planned Multi-Family Projects 44 44 Book value; includes Dilworth, Music Row, Downtown Edge, West Austin
Total Commercial Properties/Projects 185 249  
       
Oil & Gas, Mineral Rights 263 263 Book value; 10.1 MMBOE proved reserves; 590k net acres of owned mineral interests; 370k acres of leaseholds
Central Texas Leased Water Rights 0 12 2010 purchase price; 45k acre-feet/yr
East Texas & Other Water Royalty Interest 0 158 45% royalty interest in 1.4m acres of groundwater rights in TX, LA, AL, GA @ $250/acre
Other Owned Water Rights 0 31 50k acres of water rights in East Texas @ $250/acre; 188k acres of water rights in GA & AL @ $100/acre
Total Natural Resources 263 464  
       
Other JVs 41 41 Equity method joint ventures at book value; mostly land related
Cash 170 170  
Loans Secured by Real Estate 5 5  
Income Taxes Receivable 8 8  
Other Net Assets 7 0  
Total Other 231 224  
       
Debt, including Radisson, Eleven, & Midtown Debts (433) (330) Adj. for convertible notes
Corporate Overhead 0 (190) $21m in corporate G&A + $11m stock comp @ 6x EBITDA
Tax Asset/(Liability) 41 (223) Mkt value less book value times 35% tax rate
Proceeds from Option Exercises 0 44 Assumes all stock comp options vest and are exercised
Total Liabilities (392) (698)  
       
Equity Value 707 1,166 1.6x Book Value
Shares 35 50 Fully diluted, including adj. for convertible notes, equity units, and equity compensation
Per Share Value $20 $24  

 

 Valuation

Base

Low

High

Developed Residential Lots

84

71

92

Entitled Residential Lots

204

153

254

Entitled/Developed Comm. Acres

66

53

88

Land in Entitlement

330

154

664

Undeveloped Land

166

113

188

Infrastructure Reimbursements

78

78

78

Commercial Properties/Projects

249

185

249

Oil & Gas, Mineral Rights

263

132

395

Water Rights

201

0

359

Other/Cash

224

224

224

Debt/Corporate

(475)

(519)

(475)

Tax Liability

(223)

0

(478)

Equity Value

1,166

644

1,639

Shares

50

48

50

Per Share Value

$24

$13

$33

 

 Assumptions

Base

Low

High

Developed Residential

     

# of Lots

1,582

1,582

1,582

Sales Price $/lot

$53,000

$45,000

$58,000

Entitled Residential

     

# of Lots

13,546

13,546

13,546

Margin $/lot

$20,000

$15,000

$25,000

Commercial Acres

     

# of Acres

1,721

1,721

1,721

Margin $/acre

$75,000

$60,000

$100,000

Land in Entitlement

     

# of Acres

24,430

24,430

24,430

Lots/Acre

1.75

1.75

1.75

Margin $/lot

$20,000

$15,000

$25,000

Years to Sale

10

15

5

Undeveloped Land

     

# of Acres

75,359

75,359

75,359

Sales Price $/acre

$2,200

$1,500

$2,500

Oil & Gas + Minerals

     

Price/Book

1.00x

0.50x

1.50x

 

Land Pipeline

I classify land into five buckets according to type and level of development. The below table contains some relevant historical metrics.

 

 

Residential Land

Commercial Land

Undeveloped Land

Includes Ventures

Lots Sold

Sales Price $/lot

Margin $/lot

Margin %

Acres Sold

Sales Price $/acre

Acres Sold

Sales Price $/lot

2008

1,060

$48,500

$15,300

32%

120

$232,400

6,063

$4,800

2009

642

$55,200

$17,400

32%

6

$263,800

18,200

$2,600

2010

804

$49,500

$16,600

34%

18

$90,100

5,800

$3,500

2011

1,117

$47,400

$17,500

37%

26

$193,700

17,150

$2,400

2012

1,365

$52,000

$19,500

38%

95

$130,800

9,325

$2,100

2013

1,883

$58,300

$25,000

43%

171

$197,100

6,811

$3,400

2014

2,343

$58,100

$25,600

44%

32

$258,600

22,137

$2,200

Avg

1,316

$52,714

$19,557

37%

67

$195,214

12,212

$3,000

 

1) Developed/In-Development Residential Lots: Forestar has ~1,600 residential lots that are either fully developed or in the development process. These lots are essentially finished product ready for sale to a homebuilder, and represent less than one year's worth of inventory. Management expects to sell ~1,900 lots in 2015, plus any bulk sales that may come up. While 73% of these lots are in Texas, only 9% are in Houston, with the balance in Dallas/Fort Worth, San Antonio, and Austin. The remaining lots are primarily near Atlanta, with others near Oakland, Denver, Nashville, and northern South Carolina. I assign a value of $53k/lot, which is in-line with the 2008-2014 average and below the realized price of ~$58k/lot in 2013-2014. I use sales price as opposed to margin because these lots are already entitled and completely or mostly developed, meaning the necessary cash investments have previously been made.

2) Entitled Residential Lots: Forestar owns ~13.5k already entitled and in-development residential lots, including the attributable share of consolidated JV properties. These lots have been permitted and approved for development, but still require some or all of the necessary community infrastructure. About 50% of these lots are located in Texas, but only 11% are in Houston. The remainder are spread across the same locales as the already developed lots, with a particular concentration near Atlanta. I value these lots at a $20k/lot margin to account for required development expenditures. This assumption is in-line with the 2008-2014 average margin and below the 2013-2014 average margin of ~$25k/lot. In fact, excluding bulk sales, lot margins would have averaged ~$30k/lot in 2014. I discount the entitled lot value back three years at 10% given that this land will be sold over time.

3) Entitled/Developed Commercial Acres: Some of Forestar's development communities are mixed use and include commercial acreage. This land can be used to provide retail and other services to nearby homeowners. The company has ~1,700 developed and/or entitled commercial acres, including the attributable portion held at consolidated JVs. Commercial land can be quite valuable, with selling prices averaging $195k/acre over the past seven years but reaching $259k/acre last year. However, some this land may still need to be developed, so I have taken a margin-based valuation approach like that used with the entitled residential lots. While commercial acre margin is not disclosed as is residential lot margin, I have looked back at the gains/acre booked on large commercial sales. These have ranged from $65k/acre to $298k/acre. I assume $75k/acre and discount back seven years at 10% given the slower pace of commercial land disposals.

 

Est. Commercial Land Margin $/acre

 
 

2006

$297,710

 

2007

$186,813

 

2012

$64,566

 

2013

$118,051

 

Avg

$166,785

 

 

4) Land in Entitlement: Forestar has ~24k acres of undeveloped land currently being entitled. These properties are primarily located in the Atlanta metro area, but 15% of them are near Houston and about 3% are near Los Angeles. I assume 1.75 lots/acre, in-line with the historical average. I apply the same $20k/lot residential margin used with already entitled land (ignoring any possible uplift from commercial acres sprinkled in) and discount 10 years at 10%.

5) Undeveloped Land: Forestar's remaining landholdings consists of ~75k acres of undeveloped land, 81% of which is located in Georgia and Alabama with the balance in Texas. Almost all of this land is leased for recreational purposes, but these leases can be terminated by the company with 30 days' notice. Forestar also sells wood fiber from portions of its land, largely that in Georgia. The company's Other Natural Resources segment, which includes undeveloped land, generates positive operating income. Forestar is gradually selling down this land, and sold 22k acres last year for an average of $2,200/acre. Management has indicated that this price is representative of the expected value of the remaining acres. Note that as urban development in Atlanta continues to sprawl, some of these undeveloped acres could become candidates for development and yield a higher value.

Cibolo Canyons & Infrastructure Reimbursements

When Forestar develops a new community by installing roads, power lines, water pipes, and sewers, it is sometimes able to recoup the cost of its infrastructure investment. The company conveys this infrastructure to a municipal authority in return for reimbursement from local tax proceeds. Forestar is due $32m from one such community, Cibolo Canyons, and the liability accrues interest at 9.75%. The company also has receivables of $33m from other utility districts, and I discount these to present over five years at 10%. Finally, Forestar has an arrangement related to its development of the JW Marriot Hill Country Resort & Spa at Cibolo Canyons under which the company receives payments from hotel occupancy and sales & use taxes through 2034. Management estimates the undiscounted value of this cash stream at $35m assuming no growth in collections. I assume modest growth with inflation and discount to present at 10%, yielding a value of $19m.

Commercial Properties

Forestar owns all or part of three operating commercial properties, five multi-family buildings under construction, and four planned multi-family projects. I value these using a cap rate approach, net of project debt, un-owned share, and present value discounts as appropriate. Cap rates are sourced from CBRE and are city specific. See the base case table above for property specific valuations.

 

Name

Type

Location

Ownership

% Complete

Radisson

Hotel

Austin, Texas

100%

100%

Harbor Lakes

Golf Club

Dallas, Texas

100%

100%

Eleven

Multi-Family

Austin, TX

100%

100%

Midtown

Multi-Family

Dallas/Fort Worth, TX

100%

95%

360°

Multi-Family

Denver, CO

20%

80%

Acklen

Multi-Family

Nashville, TN

30%

60%

HiLine

Multi-Family

Denver, CO

25%

10%

Elan 99

Multi-Family

Houston, TX

90%

3%

Dilworth

Multi-Family

Charlotte, NC

100%

Planning

Music Row

Multi-Family

Nashville, TN

100%

Planning

Downtown Edge

Multi-Family

Austin, TX

100%

Planning

West Austin

Multi-Family

Austin, TX

100%

Planning

 

Oil & Gas/Mineral Rights

Forestar owns extensive oil & gas reserves and mineral rights, including 10.1 mmboe of proved reserves (76% oil and liquids), 370k acres of leaseholds, and 590k net acres of owned mineral rights. The mineral leases are primarily in the Lansing-Kansas City formation, the Anadarko Basin, and the Bakken and Three Forks formations in North Dakota, and are associated with the company's exploration & production business. The owned mineral rights are primarily in Texas (252k acres), Louisiana (144k acres), Georgia (152k acres), and Alabama (40k acres), although many of the Louisiana acres may revert back to the surface owner if unused by 2017.

I value all of the oil & gas and mineral rights assets at book value of $263m (after a recent $33m write-down) despite the fact that the mineral rights have a near zero cost basis and this amount is well below invested capital related to the Credo acquisition. Forestar paid $146m for Credo in 2012 and has invested ~$219m into oil & gas exploration and production, for total gross invested capital of $365m.

Water Rights

Disclosure about the specifics of Forestar's water rights is limited. The company states that it has 1.5m acres of water interests, but it is not clear what proportion of these are attributable to the company vs. JV partners. I have attempted to determine location and attributable share, but in the process I may be underestimating the extent of the company's water rights.

Forestar holds a 45% non-participating royalty interest in 1.4m acres of groundwater rights in Texas, Louisiana, Alabama, and Georgia. The core of this stake is in East Texas in the Carrizo-Wilcox and Gulf Coast aquifers. The company also has 50k acres of wholly-owned water rights in East Texas as well as 188k acres of water rights in Georgia and Alabama.

I value the non-participating royalty interest and wholly-owned East Texas rights at $250/acre, and the Georgia/Alabama rights at $100/acre. Water rights in Central Texas have sold for as much as $500/acre, with less productive acres going for $400/acre. Given that East Texas is less arid, I haircut these figures. Academic studies have found that the value of land in Georgia with an associated water permit could be as much as $500/acre more valuable than similar unentitled land. I again haircut this value significantly. While it is difficult to pin down an exact valuation for water given the scarcity of comps and the importance of location and legal environment, water is becoming increasingly scarce and therefore valuable, giving me confidence that Forestar's water rights are indeed worth considering.

Forestar also purchased a Central Texas water company in 2010 for $12m in cash, including some contingent consideration. As a result, the company holds groundwater leases associated with the Simsboro aquifer on ~20k acres in Lee County. The company is already permitted for 12k acre-feet/year and eventually could sell as much as 45k acre-feet/year. There is an agreement in place with the Hays Caldwell Public Utility Agency that values the water at $100/acre-foot/year once needed, with a smaller retainer paid near-term. For now, I value this asset at the purchase price.

Other Assets & Liabilities

I include equity method JVs, which primarily hold land, at book value of $41m. I also add $5m in secured real estate loans and $8m in income taxes receivable to cash of $170m. I reduce total debt of $433m, which includes notes related to the Radisson, Eleven, and Midtown properties, to $330m to account for the conversion of the convertible notes. I capitalize $32m in corporate overhead ($21m in corporate expenses plus $11m in average stock comp expenses) at 6x EBITDA for a $190m valuation drag.

Based on my price target, I use a fully diluted share count of ~50m shares vs. ~35m basic shares. This includes ~3m shares of stock comp related dilution, ~5m shares from the convertible notes, and ~7m shares from the Tangible Equity Units. I also include $44m in estimated option exercise proceeds as an offset.

Finally, because my price target implies a valuation in excess of book cost, I attempt to estimate a tax liability. My methodology here is simple: I multiply 35% by the difference between my valuation and book value.

Low Scenario Overview

In the $13/share low valuation scenario, I assume: $45k/lot developed residential sales price, $15k/lot entitled residential margin, $60k/acre commercial margin, land in entitlement discounted by 15 years, and $1,500/acre undeveloped land sales price. I value the oil & gas and mineral rights assets at 0.5x book value, the commercial properties at book value, and the water rights at zero.

High Scenario Overview

In the $33/share high valuation scenario, I assume: $58k/lot developed residential sales price, $25k/lot entitled residential margin, $100k/acre commercial margin, land in entitlement discounted by 5 years, and $2,500/acre undeveloped land sales price. I value the oil & gas and mineral rights assets at 1.5x book value, the commercial properties at the base case value, and the water rights at $400/acre.

Risks

Texas Exposure Amidst Depressed Oil Prices

As a major oil producing state and the headquarters for many oil producers, small and large, Texas will likely see some economic impact from the collapse in oil prices since last summer. Forestar not only has direct oil & gas exposure, but also is a major landowner in Texas. Lower growth in Texas due to a prolonged energy bust (like in the 1980s) could reduce the value of Forestar's holdings, and there will indeed likely be some near-term economic hiccups. However, I view this risk as relatively minor and likely overblown. Forestar is not a Texas pure-play, its Texas exposure is not Houston or oil basin focused, and Texas has a much broader based economy than in past downcycles.

Only ~20% of Forestar's total acreage is in Texas, including ~45% of Forestar's developed acres (residential and commercial), ~15% of land in entitlement, and ~20% of undeveloped land. The balance is mostly in Georgia, with some in Alabama, California, Colorado, and Tennessee. While slightly less than half of the company's developed land is in the Lone Star State, only ~17% is near the energy hub of Houston. The remainder is in Dallas/Fort Worth, Austin, and San Antonio, which are much less exposed to energy and have more diversified economies. In other words, the Forestar thesis is not predicated on the value of land out in Midland or Odessa, but is instead tied to thriving diverse cities that do more than pump oil out of the ground.

The Texas economy, including that of Houston, is much more broad based than in the 1980s, when the state weathered an oil glut and experienced two recessions. The state's low touch, business-friendly regulatory policy has helped lead to 4.4% unemployment, below the national average, as businesses in a range of industries from manufacturing to information technology move to Texas. Mining, defined to include oil & gas extraction, makes up ~13% of Texas GDP and less than 3% of the labor force vs. 20% of the economy in the early 1980s. According to data from Texas A&M University, the government is actually the largest source of jobs while the education and health sector is third. Professional services and health care added more jobs than any other industries from 2009-2013. Even in Houston, ~4.3% of jobs are in the oil & gas industry vs. ~5.9% in 1985. On the other hand, 10.4% of jobs are health and social service related, including 106k at the Texas Medical Center, the world's largest medical center.

From a real estate perspective, the market remains healthy. Statewide housing inventory hit an all-time low of 3.1 months in 1Q15. Single-family homes sales rose by ~4.2% year-on-year during the quarter, while the median price rose ~7.8% year-on-year. The Texas Housing Affordability Index indicates that housing remains more affordable than the US average on an aggregate basis and in most localities.

Shareholder Unfriendly Actions Could Continue

While an activist presence has spurred the company to begin to move in the right direction, the current management team remains in place and only two of twelve (eleven by 2016) board seats are held by new individuals. As a result, shareholders are dependent in the near term on management's willingness to change the direction of the company. However, the presence of two engaged activist investors with more than 7% of shares collectively and a toehold on the board gives me confidence that change is coming to Forestar and any detours will not escape notice.

Important Disclaimer

The above text is the view of the author alone and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned, and does not have to provide updates for changes to his view. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

1) 1Q15 earnings release on May 6, 2015

2) Conclusion of strategic review

3) Monetization of oil & gas exploration and production business

4) Strategy shift towards growing recurring net operating income

5) Bottom/stability in oil price

    sort by    

    Description

    Long Forestar Group (FOR)

    Sum-of-the-parts real estate play at discount to NAV with activist on the board

    Thesis

    The Forestar Group (FOR) is a land developer and oil & gas company trading at a substantial discount to net asset value and only 80% of tangible book value. I conservatively value shares at $24 on a sum-of-the-parts basis vs. a recent price of ~$15 (~60% upside).

    Forestar's discount is not new, and the stock has in fact been written up previously on VIC three times (in 2008, 2010, and most recently in 2012). However, value destructive capital allocation decisions have prevented this discount from closing. While "this time is different" are famous last words, the recent involvement of an activist consortium with newly won board representation should push the company to be more shareholder friendly and help catalyze share price convergence with asset value. Forestar is already instituting a number of corporate governance reforms and the company is currently in the midst of a strategic review that could result in the disposal of the company's non-core oil & gas business. Longer term, I believe Forestar could rerate as it transitions to a real estate operating company business model that is more reliant on recurring earnings as opposed to one-off gains from asset liquidation.

    I value Forestar at $24/share for ~60% upside. Given the company's diverse array of hard assets, I use a sum-of-the-parts approach that focuses on net asset value instead of earnings power. Using more bullish yet still achievable assumptions, shares could be worth as much as $33/share (~120% upside). I believe risk-reward is asymmetrically skewed to the upside. I peg NAV at $13/share in a downside case (~13% downside), although a widening discount to intrinsic value in public markets could temporarily lead to a lower market price in a stressed scenario.

    Forestar will report 1Q15 earnings on May 6. While this pitch is not meant to be a call on results specifically, I do believe that we could hear further updates on the company's strategic review.

    I recommend consulting rii136's thorough write-up on 12/6/12 for further background and history.

    Please see below for important disclosures.

    (Note: Shares outstanding, market cap, net debt, and TEV in the data box have been adjusted to be fully diluted. Basic shares outstanding total 34.7m and unadjusted net debt is $263m, leading to undiluted market cap and TEV of $519m and $782m respectively.)

    Business Model

    Forestar's core business is land and real estate development, mostly in the Sunbelt region. The company owns 113,000 acres of land in various states of development in Texas, Georgia, Alabama, California, Tennessee, and several other states. Management adds value by moving land up the value chain to its highest and best use. Undeveloped land generating timber and recreational lease revenue is first entitled for development (i.e. permitted and zoned). Entitled land is then developed into a residential or mixed-use community with road, water, power, and sewer infrastructure. Lots are then sold to homebuilders. This multi-step entitlement and development process turns raw land worth ~$2,200/acre into construction-ready property worth ~$90k/acre for residential land and ~$200k/acre for commercial land.

    Forestar also develops commercial buildings. The company owns a hotel, golf course, and multi-family building. There are a further five multi-family properties under construction and four more projects in the pipeline. Traditionally, the company has sold completed projects and then recycled the capital into new projects. However, they have retained some properties along the way that generate net operating income.

    In addition to its extensive land holdings, Forestar owns and develops oil & gas reserves. The company owns 590k net acres of mineral interests primarily in Texas, Louisiana, Georgia, and Alabama. Traditionally, Forestar would lease these interests to E&P companies in exchange for a one-time lease bonus payment and ongoing production royalties. The company occasionally took a minority working interest in wells on its properties. In 2012, Forestar acquired Credo Petroleum, an independent oil & gas exploration and production company. With this transaction, the company entered the business of developing oil & gas reserves for its own account. Forestar holds 370k net acres of leasehold interests, including 9k acres in North Dakota's Bakken and Three Forks formations, 41k acres in Oklahoma's Anadarko Basin, and 285k acres targeting the Lansing-Kansas City formation. The company has working interests in 393 gross wells, including 153 operated in-house.

    As is apparent from the above descriptions, Forestar's real estate business does not have a lot of recurring earnings in the traditional sense. Earnings instead consist of a series of one-off gains as the company liquidates its land and property holdings. The proceeds are then recycled into new real estate projects and the process is repeated. As I will discuss below, this business model makes valuing Forestar on current earnings difficult. The model is also dependent on prudent capital allocation, can be tax inefficient, and is perceived as riskier than an approach that entails recurring cash flows. A potential transition to a business model more reliant on building recurring cash flows from commercial real estate would support a rerating of the shares.

    Why this Opportunity Exists?

    Orphan Stock

    Forestar is an orphan stock with its hands in many different industries. It was formerly part of a paper products company and still has timber assets. It develops land and real estate, but also owns mineral rights and operates an independent oil & gas exploration and production company. Forestar does not fit neatly into any one sector. Accordingly, it is often overlooked. Only five sell-side firms offer research coverage, and none of them are bulge bracket banks. When the company does get attention, the analyst is often only an expert on one part of the business.

    Complex Conglomerate

    As mentioned above, Forestar is a collection of diverse assets in different industries. There are a large number of distinct properties and asset types in numerous different locales, many of which are individually small but add up to a substantial value. The company also participates in both consolidated and unconsolidated JVs that make the balance sheet more complex. Some assets have little to no book value. As a result, getting to an estimate of intrinsic value requires investigating many small, separate line-items.

    Value Not Based on Earnings

    As mentioned above, a large proportion of Forestar's earnings are not truly recurring in nature, and therefore the company cannot be valued on a multiple of earnings. Net income includes gains from the liquidation of enhanced land. The appropriate way to value Forestar is via net asset value, which is more involved to calculate. On a P/E basis, Forestar appears to be trading at a full ~16x adjusted 2014 EPS, while a 20x trailing multiple would only yield an $18.80/share valuation.

    Poor Capital Allocation to Date

    In a business where capital recycling is crucial, Forestar has not been the best steward of capital. The company expanded beyond its core real estate competency and issued equity-linked securities to do so.

    In 2012, Forestar acquired Credo Petroleum for $146m. In the subsequent two and a half years, the company invested an additional ~$219m into oil & gas exploration and production, for total gross invested capital of $365m or ~75% of the current market cap. Investment of this magnitude is hardly reflected in the current share price, and the oil & gas business generated only $10m in adjusted EBIT in 2014 (excluding $33m of impairment charges).

    To fund all of this spending, Forestar issued equity-linked securities at prices below the stock's intrinsic value. In addition to convertible notes with a conversion price of $24.49/share, the company also issued Tangible Equity Units which consist of a debt component and a prepaid equity component worth as many as 7.9m shares if the share price is below $19.09 and 6.5m shares if the share price is above $22.91. These units become exercisable at the end of 2016, and will be more dilutive if Forestar's share price remains below ~$19.

    Texas + Oil & Gas Exposure

    As an oil & gas producer and Texas landowner, Forestar has gotten swept up into the recent oil price rout. Depressed oil prices negatively affect Forestar in two ways. First, lower oil prices mean lower reserve values. At $95/bbl WTI, Forestar's proved reserves had a PV-10 of $229m, but only $128m at $61/bbl. Second, lower oil prices negatively affect the Texas economy, which could reduce the value of Forestar's land, at the least in the near term. I believe fears about Texas exposure are overblown (see risks for further details).

    What is Changing?

    Activist Involvement

    In November 2014, Cove Street Capital (a value fund) and SpringOwl Asset Management (an activist fund) filed a joint 13D revealing a 6.1% stake in Forestar. The filing stated that they view Forestar as an "attractive investment opportunity" and disclosed interactions with management and the Board. Cove and SpringOwl singled out three specific issues on which they are focusing: 1) Strategic alternatives for the oil & gas business; 2) Enhanced capital allocation; and 3) Improved corporate governance practices. A letter filed on January 6 elaborates on their concerns (link below).

    http://www.sec.gov/Archives/edgar/data/351262/000090266415000008/p15-0001exhibit3.htm

    On February 9, Cove and SpringOwl came to an agreement with Forestar to add two new directors. Daniel Silvers of SpringOwl and David Weinstein, the former CEO of MPG Office Trust, will join the Board, while two existing directors will resign (one immediately and another in May 2016). The activist group will be subject to a standstill agreement until February 1, 2016. Having two new directors, including one from an activist manager, will introduce fresh perspectives to the Board and keep the company engaged with shareholders.

    As of the latest amended 13D filing, Cove and SpringOwl own ~7.1% of share outstanding. NWQ Investment Management, an affiliate of Nuveen Asset Management that uses a bottom-up, research intensive strategy owns ~15% of shares, while Keeley Asset Management, a value manager, owns another ~7.6%. Together, these entities control ~30% of shares, meaning Forestar has a large contingent of value-oriented managers in its shareholder base.

    Oil & Gas Strategic Review

    Forestar has initiated a strategic review, including an evaluation of its oil & gas business. The company has already cut oil & gas opex by ~50% (~$9m/year) and capex by 70%+ (~$78m). The review could conclude with a sale of the oil & gas business, and Cove/SpringOwl had previously offered to connect Forestar with a potential private buyer. A spin-off appears less likely due to the business's small size. The review could also result in new strategies to monetize Forestar's extensive mineral rights, which have been largely ignored over the past several years due to the focus on the new Credo assets.                                                      

    Improvements to Capital Allocation

    Prior to activist involvement, Forestar's capital allocation appears to have been driven by its "Triple in FOR" initiative, which sought to triple segment EBITDA, triple oil and gas production, and triple residential lot sales. As the activists point out, these goals do not take into consideration capital requirements, return on capital, or the impact on NAV per share. The nature of Forestar's business also explains why "Triple in FOR" is not necessarily accretive. Forestar is not a traditional operating business with recurring earnings, but instead relies on asset liquidation and capital recycling to add value. Returns and impact on NAV/share, not accounting earnings, are the most important metrics.

    Forestar's evaluation of its capital allocation could result in a new strategy focused on value maximization, with the real estate business at the core of a new Forestar. The company could accelerate land development and monetization where appropriate. With a more robust internal understanding of NAV, share buybacks remain another path given the substantial discount to intrinsic value at present.

    Longer term, the real estate operating company (REOC) model presents a compelling opportunity. Forestar could reinvest the proceeds of land sales into income generating commercial properties and projects, thereby building a sustainable, recurring income base over time that commands a high multiple to earnings. The company already has a growing portfolio of existing and prospective commercial properties that could form a nucleus for a future portfolio. This model also promises increased tax efficiency through the use of 1031 exchanges where appropriate. The Consolidated Tomoka Land Co. has pursued a REOC strategy with great success so far. Consolidated Tomoka's ~50% share price appreciation over the past two years stands in marked contrast to Forestar's 30% share price decline over the same period.

    Corporate Governance Reforms

    Forestar is taking steps to improve its corporate governance practices. First, the company has terminated its Shareholder Rights Plan. The plan was previously scheduled to expire near the end of 2017 and would have been triggered if someone acquired more than 20% of shares. Second, the Board has recommended that shareholders approve a proxy proposal to declassify the board.

    Although these are both modest changes and the Board de-staggering will not take full effect until 2018, they represent a favorable change in the company's approach to relations with shareholders. While more progress is needed, these are encouraging first steps.

    Valuation

    I value Forestar on net asset value using a sum-of-the-parts model. I assign a value of $24/share in my base case, with $33/share in a high yet achievable scenario and $13/share in a low scenario. A $24/share value implies a price/book of ~1.6x, in-line with or below other land company peers, as noted below.

    Alexander & Baldwin (ALEX): 1.6x P/B

    The St. Joe Company (JOE): 1.7x P/B

    Consolidated Tomoka Land Co. (CTO): 2.3x P/B

    The Howard Hughes Corporation (HHC): 2.6x P/B

    Throughout this exercise, I have followed three guiding principles. 1) I have attempted to remain conservative in my base case valuation. In many instances I see achievable upside to the values I use. 2) I take present value into consideration when value realization may take time; 3) I allow for full dilution from dilutive securities and stock comp, although share buybacks at a discount to NAV could reduce the impact.

     

    Asset Book Value Base Case Value Base Case Value Notes
    Developed/In-Development Residential Lots 256 84 1,582 developed residential lots @ $53k/lot sale price
    Entitled Residential Lots 204 13,546 entitled residential lots @ $20k/lot margin; discounted 3 yrs @ 10%
    Entitled/Developed Commercial Acres 66 1,721 developed/entitled commercial acres @ $75k/acre margin; discounted 7 yrs @ 10%
    Land in Entitlement 41 330 24,430 acres in entitlement; assumed 1.75 lots/acre; $20k/lot margin; discounted 10 yrs @ 10%
    Undeveloped Land, including Timber 58 166 75,359 undeveloped acres @ $2,200/acre sale price
    Total Land 355 849  
           
    Cibolo Canyons Reimbursements 32 32 $32m undiscounted; accrues interest at 9.75%
    Other Utility District Reimbursements 33 28 $33m undiscounted; assumes 5 yr payout @ 10% discount rate
    Cibolo Canyons HOT/S&U Tax Receivables 0 19 $35m undiscounted with no growth 2015-2034; adj. for 2% growth/yr & 10% discount rate
    Total Infrastructure Reimbursements 65 78  
           
    Radisson Hotel, Austin 31 51 $3.6m in 2014 NOI @ 7% cap rate
    Harbor Lakes Golf Course, Dallas 1 0 ($500k) NOI in 2014; assume no value
    Eleven - Austin Multi-Family 53 68 $3.4 est NOI @ 5% cap rate
    Midtown - Dallas Multi-Family 33 51 $2.8 est NOI @ 5% cap rate; discounted 1 yr @ 10%
    360° - Denver Multi-Family, 20% Interest 4 8 $3.8 est NOI @ 5% cap rate; net of project debt; discounted 1 yr @ 10%
    Acklen - Nashville Multi-Family, 30% Interest 6 12 $4.1 est NOI @ 5% cap rate; net of project debt; discounted 1 yr @ 10%
    HiLine - Denver Multi-Family, 25% Interest 6 6 Book value
    Elan 99 - Houston Multi-Family, 90% LP Interest 9 9 Book value
    4 Planned Multi-Family Projects 44 44 Book value; includes Dilworth, Music Row, Downtown Edge, West Austin
    Total Commercial Properties/Projects 185 249  
           
    Oil & Gas, Mineral Rights 263 263 Book value; 10.1 MMBOE proved reserves; 590k net acres of owned mineral interests; 370k acres of leaseholds
    Central Texas Leased Water Rights 0 12 2010 purchase price; 45k acre-feet/yr
    East Texas & Other Water Royalty Interest 0 158 45% royalty interest in 1.4m acres of groundwater rights in TX, LA, AL, GA @ $250/acre
    Other Owned Water Rights 0 31 50k acres of water rights in East Texas @ $250/acre; 188k acres of water rights in GA & AL @ $100/acre
    Total Natural Resources 263 464  
           
    Other JVs 41 41 Equity method joint ventures at book value; mostly land related
    Cash 170 170  
    Loans Secured by Real Estate 5 5  
    Income Taxes Receivable 8 8  
    Other Net Assets 7 0  
    Total Other 231 224  
           
    Debt, including Radisson, Eleven, & Midtown Debts (433) (330) Adj. for convertible notes
    Corporate Overhead 0 (190) $21m in corporate G&A + $11m stock comp @ 6x EBITDA
    Tax Asset/(Liability) 41 (223) Mkt value less book value times 35% tax rate
    Proceeds from Option Exercises 0 44 Assumes all stock comp options vest and are exercised
    Total Liabilities (392) (698)  
           
    Equity Value 707 1,166 1.6x Book Value
    Shares 35 50 Fully diluted, including adj. for convertible notes, equity units, and equity compensation
    Per Share Value $20 $24  

     

     Valuation

    Base

    Low

    High

    Developed Residential Lots

    84

    71

    92

    Entitled Residential Lots

    204

    153

    254

    Entitled/Developed Comm. Acres

    66

    53

    88

    Land in Entitlement

    330

    154

    664

    Undeveloped Land

    166

    113

    188

    Infrastructure Reimbursements

    78

    78

    78

    Commercial Properties/Projects

    249

    185

    249

    Oil & Gas, Mineral Rights

    263

    132

    395

    Water Rights

    201

    0

    359

    Other/Cash

    224

    224

    224

    Debt/Corporate

    (475)

    (519)

    (475)

    Tax Liability

    (223)

    0

    (478)

    Equity Value

    1,166

    644

    1,639

    Shares

    50

    48

    50

    Per Share Value

    $24

    $13

    $33

     

     Assumptions

    Base

    Low

    High

    Developed Residential

         

    # of Lots

    1,582

    1,582

    1,582

    Sales Price $/lot

    $53,000

    $45,000

    $58,000

    Entitled Residential

         

    # of Lots

    13,546

    13,546

    13,546

    Margin $/lot

    $20,000

    $15,000

    $25,000

    Commercial Acres

         

    # of Acres

    1,721

    1,721

    1,721

    Margin $/acre

    $75,000

    $60,000

    $100,000

    Land in Entitlement

         

    # of Acres

    24,430

    24,430

    24,430

    Lots/Acre

    1.75

    1.75

    1.75

    Margin $/lot

    $20,000

    $15,000

    $25,000

    Years to Sale

    10

    15

    5

    Undeveloped Land

         

    # of Acres

    75,359

    75,359

    75,359

    Sales Price $/acre

    $2,200

    $1,500

    $2,500

    Oil & Gas + Minerals

         

    Price/Book

    1.00x

    0.50x

    1.50x

     

    Land Pipeline

    I classify land into five buckets according to type and level of development. The below table contains some relevant historical metrics.

     

     

    Residential Land

    Commercial Land

    Undeveloped Land

    Includes Ventures

    Lots Sold

    Sales Price $/lot

    Margin $/lot

    Margin %

    Acres Sold

    Sales Price $/acre

    Acres Sold

    Sales Price $/lot

    2008

    1,060

    $48,500

    $15,300

    32%

    120

    $232,400

    6,063

    $4,800

    2009

    642

    $55,200

    $17,400

    32%

    6

    $263,800

    18,200

    $2,600

    2010

    804

    $49,500

    $16,600

    34%

    18

    $90,100

    5,800

    $3,500

    2011

    1,117

    $47,400

    $17,500

    37%

    26

    $193,700

    17,150

    $2,400

    2012

    1,365

    $52,000

    $19,500

    38%

    95

    $130,800

    9,325

    $2,100

    2013

    1,883

    $58,300

    $25,000

    43%

    171

    $197,100

    6,811

    $3,400

    2014

    2,343

    $58,100

    $25,600

    44%

    32

    $258,600

    22,137

    $2,200

    Avg

    1,316

    $52,714

    $19,557

    37%

    67

    $195,214

    12,212

    $3,000

     

    1) Developed/In-Development Residential Lots: Forestar has ~1,600 residential lots that are either fully developed or in the development process. These lots are essentially finished product ready for sale to a homebuilder, and represent less than one year's worth of inventory. Management expects to sell ~1,900 lots in 2015, plus any bulk sales that may come up. While 73% of these lots are in Texas, only 9% are in Houston, with the balance in Dallas/Fort Worth, San Antonio, and Austin. The remaining lots are primarily near Atlanta, with others near Oakland, Denver, Nashville, and northern South Carolina. I assign a value of $53k/lot, which is in-line with the 2008-2014 average and below the realized price of ~$58k/lot in 2013-2014. I use sales price as opposed to margin because these lots are already entitled and completely or mostly developed, meaning the necessary cash investments have previously been made.

    2) Entitled Residential Lots: Forestar owns ~13.5k already entitled and in-development residential lots, including the attributable share of consolidated JV properties. These lots have been permitted and approved for development, but still require some or all of the necessary community infrastructure. About 50% of these lots are located in Texas, but only 11% are in Houston. The remainder are spread across the same locales as the already developed lots, with a particular concentration near Atlanta. I value these lots at a $20k/lot margin to account for required development expenditures. This assumption is in-line with the 2008-2014 average margin and below the 2013-2014 average margin of ~$25k/lot. In fact, excluding bulk sales, lot margins would have averaged ~$30k/lot in 2014. I discount the entitled lot value back three years at 10% given that this land will be sold over time.

    3) Entitled/Developed Commercial Acres: Some of Forestar's development communities are mixed use and include commercial acreage. This land can be used to provide retail and other services to nearby homeowners. The company has ~1,700 developed and/or entitled commercial acres, including the attributable portion held at consolidated JVs. Commercial land can be quite valuable, with selling prices averaging $195k/acre over the past seven years but reaching $259k/acre last year. However, some this land may still need to be developed, so I have taken a margin-based valuation approach like that used with the entitled residential lots. While commercial acre margin is not disclosed as is residential lot margin, I have looked back at the gains/acre booked on large commercial sales. These have ranged from $65k/acre to $298k/acre. I assume $75k/acre and discount back seven years at 10% given the slower pace of commercial land disposals.

     

    Est. Commercial Land Margin $/acre

     
     

    2006

    $297,710

     

    2007

    $186,813

     

    2012

    $64,566

     

    2013

    $118,051

     

    Avg

    $166,785

     

     

    4) Land in Entitlement: Forestar has ~24k acres of undeveloped land currently being entitled. These properties are primarily located in the Atlanta metro area, but 15% of them are near Houston and about 3% are near Los Angeles. I assume 1.75 lots/acre, in-line with the historical average. I apply the same $20k/lot residential margin used with already entitled land (ignoring any possible uplift from commercial acres sprinkled in) and discount 10 years at 10%.

    5) Undeveloped Land: Forestar's remaining landholdings consists of ~75k acres of undeveloped land, 81% of which is located in Georgia and Alabama with the balance in Texas. Almost all of this land is leased for recreational purposes, but these leases can be terminated by the company with 30 days' notice. Forestar also sells wood fiber from portions of its land, largely that in Georgia. The company's Other Natural Resources segment, which includes undeveloped land, generates positive operating income. Forestar is gradually selling down this land, and sold 22k acres last year for an average of $2,200/acre. Management has indicated that this price is representative of the expected value of the remaining acres. Note that as urban development in Atlanta continues to sprawl, some of these undeveloped acres could become candidates for development and yield a higher value.

    Cibolo Canyons & Infrastructure Reimbursements

    When Forestar develops a new community by installing roads, power lines, water pipes, and sewers, it is sometimes able to recoup the cost of its infrastructure investment. The company conveys this infrastructure to a municipal authority in return for reimbursement from local tax proceeds. Forestar is due $32m from one such community, Cibolo Canyons, and the liability accrues interest at 9.75%. The company also has receivables of $33m from other utility districts, and I discount these to present over five years at 10%. Finally, Forestar has an arrangement related to its development of the JW Marriot Hill Country Resort & Spa at Cibolo Canyons under which the company receives payments from hotel occupancy and sales & use taxes through 2034. Management estimates the undiscounted value of this cash stream at $35m assuming no growth in collections. I assume modest growth with inflation and discount to present at 10%, yielding a value of $19m.

    Commercial Properties

    Forestar owns all or part of three operating commercial properties, five multi-family buildings under construction, and four planned multi-family projects. I value these using a cap rate approach, net of project debt, un-owned share, and present value discounts as appropriate. Cap rates are sourced from CBRE and are city specific. See the base case table above for property specific valuations.

     

    Name

    Type

    Location

    Ownership

    % Complete

    Radisson

    Hotel

    Austin, Texas

    100%

    100%

    Harbor Lakes

    Golf Club

    Dallas, Texas

    100%

    100%

    Eleven

    Multi-Family

    Austin, TX

    100%

    100%

    Midtown

    Multi-Family

    Dallas/Fort Worth, TX

    100%

    95%

    360°

    Multi-Family

    Denver, CO

    20%

    80%

    Acklen

    Multi-Family

    Nashville, TN

    30%

    60%

    HiLine

    Multi-Family

    Denver, CO

    25%

    10%

    Elan 99

    Multi-Family

    Houston, TX

    90%

    3%

    Dilworth

    Multi-Family

    Charlotte, NC

    100%

    Planning

    Music Row

    Multi-Family

    Nashville, TN

    100%

    Planning

    Downtown Edge

    Multi-Family

    Austin, TX

    100%

    Planning

    West Austin

    Multi-Family

    Austin, TX

    100%

    Planning

     

    Oil & Gas/Mineral Rights

    Forestar owns extensive oil & gas reserves and mineral rights, including 10.1 mmboe of proved reserves (76% oil and liquids), 370k acres of leaseholds, and 590k net acres of owned mineral rights. The mineral leases are primarily in the Lansing-Kansas City formation, the Anadarko Basin, and the Bakken and Three Forks formations in North Dakota, and are associated with the company's exploration & production business. The owned mineral rights are primarily in Texas (252k acres), Louisiana (144k acres), Georgia (152k acres), and Alabama (40k acres), although many of the Louisiana acres may revert back to the surface owner if unused by 2017.

    I value all of the oil & gas and mineral rights assets at book value of $263m (after a recent $33m write-down) despite the fact that the mineral rights have a near zero cost basis and this amount is well below invested capital related to the Credo acquisition. Forestar paid $146m for Credo in 2012 and has invested ~$219m into oil & gas exploration and production, for total gross invested capital of $365m.

    Water Rights

    Disclosure about the specifics of Forestar's water rights is limited. The company states that it has 1.5m acres of water interests, but it is not clear what proportion of these are attributable to the company vs. JV partners. I have attempted to determine location and attributable share, but in the process I may be underestimating the extent of the company's water rights.

    Forestar holds a 45% non-participating royalty interest in 1.4m acres of groundwater rights in Texas, Louisiana, Alabama, and Georgia. The core of this stake is in East Texas in the Carrizo-Wilcox and Gulf Coast aquifers. The company also has 50k acres of wholly-owned water rights in East Texas as well as 188k acres of water rights in Georgia and Alabama.

    I value the non-participating royalty interest and wholly-owned East Texas rights at $250/acre, and the Georgia/Alabama rights at $100/acre. Water rights in Central Texas have sold for as much as $500/acre, with less productive acres going for $400/acre. Given that East Texas is less arid, I haircut these figures. Academic studies have found that the value of land in Georgia with an associated water permit could be as much as $500/acre more valuable than similar unentitled land. I again haircut this value significantly. While it is difficult to pin down an exact valuation for water given the scarcity of comps and the importance of location and legal environment, water is becoming increasingly scarce and therefore valuable, giving me confidence that Forestar's water rights are indeed worth considering.

    Forestar also purchased a Central Texas water company in 2010 for $12m in cash, including some contingent consideration. As a result, the company holds groundwater leases associated with the Simsboro aquifer on ~20k acres in Lee County. The company is already permitted for 12k acre-feet/year and eventually could sell as much as 45k acre-feet/year. There is an agreement in place with the Hays Caldwell Public Utility Agency that values the water at $100/acre-foot/year once needed, with a smaller retainer paid near-term. For now, I value this asset at the purchase price.

    Other Assets & Liabilities

    I include equity method JVs, which primarily hold land, at book value of $41m. I also add $5m in secured real estate loans and $8m in income taxes receivable to cash of $170m. I reduce total debt of $433m, which includes notes related to the Radisson, Eleven, and Midtown properties, to $330m to account for the conversion of the convertible notes. I capitalize $32m in corporate overhead ($21m in corporate expenses plus $11m in average stock comp expenses) at 6x EBITDA for a $190m valuation drag.

    Based on my price target, I use a fully diluted share count of ~50m shares vs. ~35m basic shares. This includes ~3m shares of stock comp related dilution, ~5m shares from the convertible notes, and ~7m shares from the Tangible Equity Units. I also include $44m in estimated option exercise proceeds as an offset.

    Finally, because my price target implies a valuation in excess of book cost, I attempt to estimate a tax liability. My methodology here is simple: I multiply 35% by the difference between my valuation and book value.

    Low Scenario Overview

    In the $13/share low valuation scenario, I assume: $45k/lot developed residential sales price, $15k/lot entitled residential margin, $60k/acre commercial margin, land in entitlement discounted by 15 years, and $1,500/acre undeveloped land sales price. I value the oil & gas and mineral rights assets at 0.5x book value, the commercial properties at book value, and the water rights at zero.

    High Scenario Overview

    In the $33/share high valuation scenario, I assume: $58k/lot developed residential sales price, $25k/lot entitled residential margin, $100k/acre commercial margin, land in entitlement discounted by 5 years, and $2,500/acre undeveloped land sales price. I value the oil & gas and mineral rights assets at 1.5x book value, the commercial properties at the base case value, and the water rights at $400/acre.

    Risks

    Texas Exposure Amidst Depressed Oil Prices

    As a major oil producing state and the headquarters for many oil producers, small and large, Texas will likely see some economic impact from the collapse in oil prices since last summer. Forestar not only has direct oil & gas exposure, but also is a major landowner in Texas. Lower growth in Texas due to a prolonged energy bust (like in the 1980s) could reduce the value of Forestar's holdings, and there will indeed likely be some near-term economic hiccups. However, I view this risk as relatively minor and likely overblown. Forestar is not a Texas pure-play, its Texas exposure is not Houston or oil basin focused, and Texas has a much broader based economy than in past downcycles.

    Only ~20% of Forestar's total acreage is in Texas, including ~45% of Forestar's developed acres (residential and commercial), ~15% of land in entitlement, and ~20% of undeveloped land. The balance is mostly in Georgia, with some in Alabama, California, Colorado, and Tennessee. While slightly less than half of the company's developed land is in the Lone Star State, only ~17% is near the energy hub of Houston. The remainder is in Dallas/Fort Worth, Austin, and San Antonio, which are much less exposed to energy and have more diversified economies. In other words, the Forestar thesis is not predicated on the value of land out in Midland or Odessa, but is instead tied to thriving diverse cities that do more than pump oil out of the ground.

    The Texas economy, including that of Houston, is much more broad based than in the 1980s, when the state weathered an oil glut and experienced two recessions. The state's low touch, business-friendly regulatory policy has helped lead to 4.4% unemployment, below the national average, as businesses in a range of industries from manufacturing to information technology move to Texas. Mining, defined to include oil & gas extraction, makes up ~13% of Texas GDP and less than 3% of the labor force vs. 20% of the economy in the early 1980s. According to data from Texas A&M University, the government is actually the largest source of jobs while the education and health sector is third. Professional services and health care added more jobs than any other industries from 2009-2013. Even in Houston, ~4.3% of jobs are in the oil & gas industry vs. ~5.9% in 1985. On the other hand, 10.4% of jobs are health and social service related, including 106k at the Texas Medical Center, the world's largest medical center.

    From a real estate perspective, the market remains healthy. Statewide housing inventory hit an all-time low of 3.1 months in 1Q15. Single-family homes sales rose by ~4.2% year-on-year during the quarter, while the median price rose ~7.8% year-on-year. The Texas Housing Affordability Index indicates that housing remains more affordable than the US average on an aggregate basis and in most localities.

    Shareholder Unfriendly Actions Could Continue

    While an activist presence has spurred the company to begin to move in the right direction, the current management team remains in place and only two of twelve (eleven by 2016) board seats are held by new individuals. As a result, shareholders are dependent in the near term on management's willingness to change the direction of the company. However, the presence of two engaged activist investors with more than 7% of shares collectively and a toehold on the board gives me confidence that change is coming to Forestar and any detours will not escape notice.

    Important Disclaimer

    The above text is the view of the author alone and is for informational and educational purposes only. It should not be construed as investment advice or a solicitation to buy or sell securities. The author may hold a position in the securities mentioned, and does not have to provide updates for changes to his view. The author does not warrant his work for correctness or accuracy. Perform your own due diligence before making investment decisions.

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    1) 1Q15 earnings release on May 6, 2015

    2) Conclusion of strategic review

    3) Monetization of oil & gas exploration and production business

    4) Strategy shift towards growing recurring net operating income

    5) Bottom/stability in oil price

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