Description

Summary
On the surface, Forestar (FOR) is a sleepy, small capitalization land development company with an overweight position in Texas and smaller holdings in in Denver, Atlanta, Charlotte, Raleigh and Nashville. What makes this opportunity so exciting, however, is D.R. Horton’s (DHI) recent purchase of 75% of the company.

This sleepy company is about to be supercharged and we believe that FOR is worth $45/sh+ over the next couple years, or more than a double from here. We also believe that at today’s prices, we are paying below the liquidation value of FOR’s existing portfolio and receiving all of that supercharged growth for free.

The Don
On June 5, 2017, DHI (the largest homebuilder in the country) announced its intent to purchase a majority stake in FOR. Upon announcement, there was one element to this transaction that stood out to us beyond all else:  the former CEO of DHI from 1998-2014 (15+ years), Don Tomnitz, was coming out of semi-retirement to lead FOR.

Don wrapped up his successful career at DHI at a time when the company’s enterprise value was $10b and generating $8b in revenue – the largest homebuilder in the country. We thought, why would he now want to run a sub-$500m (less than one-twentieth the size of his predecessor) EV company with $150m in revenue that DHI is going to gradually expand over time?

Well, we do not think Don is coming back to run a small company that has limited plans for shareholder value creation. We think he’s coming back for quite the opposite and expect that FOR’s expansion could be much more rapid and with stronger return economics than DHI initially laid out in June. DHI’s historical tendency to be conservative is likely to prove true here once again.

DHI / FOR Transaction Details
DHI purchased 75% of FOR, in cash, for $17.75/sh on October 5, 2017. There were roughly 42m shares outstanding and $280m of net cash at the time of close, for an enterprise value of $470m. About 10.5m shares remain tradable today at a total market cap of just over $900m.

DHI stayed out of the bidding process throughout late 2016 and early 2017 and only emerged on June 5, 2017 after Starwood Capital officially came out the victor of the competitive process. The best and final bid from Starwood Capital was $16.00 for the entire company. From our understanding, Starwood was simply looking to liquidate the assets and generate a respectable IRR.

For some background prior to the competitive bidding process that DHI removed itself from, DHI initially approached FOR in 2016, but could not come to an agreement on terms. We do not know what those terms were and whether FOR had too high of aspirations. Since the original approach, FOR sold off much of its remaining non-core assets, including oil & gas, hotel, multifamily and timberland properties and what DHI ended up purchasing was $6.50/sh of net cash and $15.50/sh-plus of real estate value, or $22/sh of undiscounted market value, for $17.75/sh.

Why DHI is Buying FOR
DHI is well on its path to emulating the unique NVR model of high returns on capital, high free cash flow conversion, low leverage and significant share repurchases. For some quick background, NVR does not own the majority of its land, but rather puts a deposit down on a tract of land that is owned by a land developer and purchases the remainder on an as needed basis. This results in high free cash flow (a rarity for a builder as much of the cash generation is reinvested right back into land when times are good), which in NVR’s case, is used to grow the business and for significant share repurchases. The market rewards them for these returns on capital, low leverage and high free cash flow generation with high-teens forward earnings multiples versus the land heavy, higher-levered builders that trade in the low double-digits.

DHI has already increased returns on capital, increased its optioned lot vs owned percentage, and reduced leverage over the last few years, but FOR is DHI’s vehicle to rapidly accelerate the progression to an asset-light model from the path it is already on. Going forward, FOR will develop more and more of DHI’s land needs and DHI will eventually deconsolidate FOR’s land holdings from its own balance sheet once its ownership dips below ~40%.

We very much like DHI as well for this reason and feel that there is a long runway of shareholder appreciation in DHI as well.

Why FOR is Special
FOR is unique for a few reasons in this construct.

First, while FOR has an existing operating team in place, DHI has experienced local land development teams in 78 markets coast-to-coast. FOR’s entire corporate employee count is less than 60. FOR can simply leverage the DHI infrastructure and plug-and-play. In the several weeks after closing the FOR transaction, FOR had already sourced 15 deals from DHI and closed on 2 of them.

Second, FOR has a natural outlet in DHI that can purchase its finished lots. This is a luxury most land developers could only dream of. In this sense, FOR becomes more of a manufacturer than a land bank. We also note that FOR still intends on selling to non-DHI builders as well.

Third, the company is starting with a large net cash position and can grow quickly off a small base as a result. Capital markets reliance is minimal up front to grow aggressively, but we expect FOR to operate with some leverage and to issue some debt in the near term. Equity offerings should be expected in the future as leverage is kept in check and DHI looks to reduce its ownership (while still retaining control).

Economics and Upside / Downside
In short, FOR will be more of a land manufacturer than the traditional land developer. We expect relatively fast inventory turns and high-teens returns on inventory, driving nearer term earnings towards $3/sh annually without raising external capital. However, we believe that FOR will expand in a manner that will require raising equity and debt capital (which will be well bid). As FOR ramps up to represent 25%-30% of DHI’s home closings (and another 25% of FOR’s closings to come from non-DHI builders), $4/sh+ in annual EPS is very reasonable.

Leverage will likely trend up to the 30% debt / gross asset value level, resulting in ROEs in the mid-teens. High ROEs and considerable earnings growth is a recipe for at least low-teens earnings multiples.

Taking $4.25/sh in CY 2020 run-rate earnings at a 13x earnings multiple gets us to $55/sh. We discount back 2 years at 9% to get a YE2018 value of $47/sh.

For downside, we calculate that one can buy FOR at 5x run-rate earnings in 2020 and right around today’s liquidation value of $22/sh. We are valuing FOR’s current land holdings at an average $72k/lot or an implied home price of $287k (25% of home sale price is land on average). DHI is significantly accelerating the monetization of FOR’s existing assets and two-thirds of FOR’s land is either in negotiation or under contract with DHI and outside builders. We value the remaining one-third of the lots at a 60% discount to the lots that are in negotiation or under contract.

We should also mention that while this is not a main component of the investment thesis, FOR is a clear beneficiary of tax reform: domestic focus, low leverage, and soon-to-be full taxpayer (much the same way DHI is).

Catalysts
FOR has been relatively ignored versus DHI as an investment case and understandably so. DHI has a market capitalization of close to $20b with 23 sell-side analysts covering versus FOR at a $900m market capitalization with 3 sell-side analysts covering. We believe FOR has a scarcity value and expect FOR to receive more and more attention in the future.

DHI management’s initial pitch in early June on the merits of the FOR deal were positive, but were likely drastically understated given that they did not want to pay any more than they had to. Coincident with DHI’s 1Q18 earnings report on January 31, 2018, greater clarity will be provided on the plan for FOR. This will be the first real update since the deal was announced in June. We do not know how granular management will be, as they also plan to make an incremental update in April 2018 coincident with DHI’s 2Q18 report, but we expect this initial update to further the discussion on the investment case towards something like the one above.

FOR’s first equity offering should also be a catalyst. While there is no urgent need (net cash today), growing the size of the company and increasing free float will allow for incremental investors that are prohibited from currently participating.

Finally, analyst coverage should ramp in correlation with the company’s size.

Quick Company and Industry Overview
FOR is a rather simple company at this stage after disposing of its timberlands, oil and gas interests, and the majority of its commercial assets in the last couple years. As it sits today, there is roughly $400m of cash, $115m of debt and 9,000 residential lots with 60% in Texas and 5%+ concentrations in Denver, Charlotte/Raleigh and Atlanta. FOR will be focused on the development of land for single-family home development going forward.

We are bullish on the housing outlook for the foreseeable future. Housing stock is tight, particularly in the first-time buyer and first move-up buyer segment that DHI specializes in.

Overall housing completions have been below the rate suggested by household formation, replacements, second homes and vacancies for over a decade now. We currently sit ~30% below that natural steady state, according to The Harvard Joint Center for Housing Studies. Recent completions have been just shy of 1.2m vs Harvard suggesting the natural rate should be closer to 1.7m. We believe that the slow and steady ramp in housing demand should continue towards this rate.

Risks
The primary risk is the economy and housing in general. We like where DHI is focused at the lower end of the home price spectrum for first-time buyers and first move-up buyers, an area of the housing market that is expected to outperform over the next few years driven by relative affordability and millennial demand. We also like DHI’s under-indexed exposure to high SALT states vs public peers.

Catalyst

• More attention in the future on this scarce asset
• DHI / FOR earnings on January 31, 2018 - first real update since deal originally announced June 5, 2017
• DHI / FOR earnings in April 2018
• Equity offerings
• Analyst coverage