Introduction

Forestar owns developed and undeveloped real estate, mineral rights, water rights, and operating properties. Asset complexity, small market capitalization, and low investor awareness have created an opportunity to buy this portfolio of assets at a very attractive valuation. We think FOR's core real estate assets alone support current trading levels even using very conservative pricing and volume assumptions. Meanwhile, several discrete value opportunities exist to provide the chance of significant upside, creating an asymmetric risk-reward profile. FOR is a low-risk vehicle for participating in a recovery in some of America's strongest real estate markets, and it provides free options on potentially massive appreciation in oil, gas, and water assets. As the market better appreciates these assets and management shows substantial improvements in cash generation, we believe that FOR could be worth over $40 per share, offering 130% upside.

Background

In early 2007, FOR emerged from the Carl Icahn-instigated split of Temple-Inland, a major forest products company. The other two successors were Guaranty Financial, holding the banking assets, and Temple-Inland, which retained the forest products operations. Most of the current management team is comprised of former Temple-Inland employees. The company is headquartered in Austin, TX, near many of its real estate and mineral holdings.  

Real estate development assets

FOR's developed real estate pipeline consists of 3,600 residential lots either developed or under development, 26,000 entitled but undeveloped lots, and 2,400 acres of developed and/or entitled commercial real estate. In addition, FOR owns 27,000 acres of residential land and 3,500 acres of commercial land that are currently in the entitlement process. Our base case ascribes no value to this un-entitled acreage, though it could prove to be a major asset: assuming 1.5 lots per acre suggests an incremental 40,000 possible lots.

About 60% of FOR's developed residential lots are in Texas, with the vast majority of those in the Dallas/Fort Worth and Austin metropolitan areas. The next largest real estate concentration is in Atlanta, but given the earlier stage nature of the Atlanta assets, time weighted value is further skewed towards Texas. It is reasonable to assume that at least 70% of FOR's present real estate development value lies in Texas.

Using conservative estimates for sales velocity and average pricing, FOR's real estate development holdings are worth at least $500 million, or $13.75 per share. Our estimates imply present value of $32,000 per developed residential lot; $8,800 per entitled but undeveloped residential lot; $84,000 per developed commercial acre; and $15,000 per entitled but undeveloped commercial acre. These values incorporate estimates of additional expenses that FOR will incur bringing these assets to market, as well as the taxes on their eventual sale. To support our assumptions for average selling prices, we contacted several real estate agents in FOR's key markets and examined current local listings for the large FOR developments. In addition, we analyzed real estate indicators in FOR's geographies, particularly Texas.

Our research suggests that FOR's geographies are unusually attractive. Texas is an attractive real estate market in general, with relatively low unemployment, high population growth, low housing inventory, and low property prices. Dallas/Fort Worth and Austin, where the majority of FOR's Texas properties are located, are particularly attractive markets. The housing affordability index, a ratio of median income to the required income to purchase a median priced house under prevailing financing conditions, stood at 2.3x for the Dallas/Fort Worth area, and 1.9x for Austin. In other words, a typical buyer in these markets has double the income necessary to purchase the typical house. These numbers are noticeably higher than the national housing affordability index, which stands at 1.6x. Inventory levels in these markets are also impressively low: roughly 6 months for both Dallas/Fort Worth and Austin, vs. national average of over 9 months. These inventory levels are close to long term averages. For perspective, the record low national inventory was 3.6 months at the peak of the recent boom, while the record high was 10.5 months in the recent crisis. Texas is also a high growth state, with expectations for 35% population growth between 2000 (date of the last census) and 2020. Dallas/Fort Worth and Austin are well above the state growth average at 42% and 52% respectively. Current unemployment levels in the counties around these metropolitan areas range from 7.5% to 8.5%, notably below the national average of nearly 10%. Furthermore, employment in these areas appears to be rebounding: unemployment declined by around 4% in February as compared to January, and by another 1-2% in March vs. February.

The housing market certainly remains difficult, but FOR's recent results suggest that these positive indicators are translating into the beginnings of a comeback. Volume levels are still historically low, but FOR's residential lot sales increased by over 80% in Q1 2010.

Raw land assets

FOR also owns roughly 200,000 acres of raw land, mostly in Georgia. Of this, FOR has identified 80,000 acres as low value, ready-for-sale timber land. FOR sold 60,000 acres of similar land last year at an average price of $1,700 per acre. We assume that FOR will sell down the rest of this land during 2010 at a similar price, realizing value of roughly $90 million, or $1,200 per acre (as with the development assets, we have made assumptions for margin and taxes). The remaining 120,000 acres we divide between lower value (75%) and higher value (25%). We assume that the lower value land is sold at the same $1,700 per acre price, and that FOR liquidates its holding fairly evenly between now and 2013, suggesting a present value of $100 million, or about $1,100 per acre. For the roughly 30,000 acres assumed to be higher value, we show FOR achieving sales of $4,000 per acre over a slightly longer timeframe - through 2016, yielding a present value of $70 million, or about $2,200 per acre. In addition, FOR owns a 58% interest in a JV holding 16,500 acres. This JV, known as Ironstob, recently sold land at $6,500 an acre. We have valued it at less than half of transacted values for a net value to FOR of $30mm. In total, FOR's raw land holdings come to roughly $290 million, or $8.00 per share. For raw land valuation, we use a low discount rate of 4%, which we believe is reasonable due to the low management and execution risk. In practice, we believe that most investors in raw land use low discount rates, as demonstrated by timber REIT valuations and by the low income yields implied by private land transactions, both current and historic. Additional upside exists if more of this acreage can be developed into high value residential or commercial property. This is a distinct possibility, given the historic and expected future population growth in the Atlanta metropolitan area.

Operating properties and other assets

FOR possesses several other real estate-related sources of value. As compensation for FOR's investment in the Cibolo Canyons development, the San Antonio municipal government owes cash reimbursements of $37 million, which will likely be paid to the company within the next two years. As further compensation, FOR is entitled to 9% of the room revenues at the new thousand-room JW Marriott resort, a fee stream that would normally represent the local hotel taxes. FOR will receive this royalty stream through 2034. Based on historical average occupancy levels and room rates comparable to local competition, we estimate that this will be worth $40 million. FOR is due to receive additional reimbursements of $20 million from various entities. FOR also owns several operating properties: a 25% interest in a 375,000 square foot office building in downtown Austin, a Radisson Hotel on two prime acres in downtown Austin, and a 144-unit luxury apartment building in San Antonio. We estimate that these assets together provide $125 million of value, or $3.50 per share.

Oil and gas assets

In addition to its surface real estate, FOR holds all of the mineral rights originally owned by Temple-Inland. The total holding is 619,000 acres in Texas, Louisiana, Georgia, Alabama, and California. 480,000 of these acres remain unleased, of which 259,000 are in Texas and Louisiana. Significant acreage is located near the popular Haynesville and Bossier shale plays in Louisiana and Texas.  These assets were largely neglected in the past: when FOR left the old Temple-Inland offices, all of the files relating to minerals were supposedly carried out in one cardboard box. It has only been in the past nine months that FOR has professionalized the effort to monetize these assets, hiring a team of former EOG employees to manage and stimulate leasing activity on the acreage. The results have shown in recent leasing performance, which is particularly impressive when considering the significant drop in natural gas prices since 2008.

In our base case valuation, we ascribe value only to the current royalty stream. We assume production levels similar to 2009, and pricing of $5/mcf for gas and $80/bbl for oil, which suggests cash flow to FOR of close to $10 million. This cash flow is of low quality for several reasons: it is subject to spot price and production volume fluctuation, and performance is contingent on the management skill of the operating partners. As such, we value this cash flow at a 17.5% yield, for a value of $55 million, or $1.25 per share.

In addition to this base value, there is potential for additional, perhaps significant, value in the un-leased acreage. We first frame the size of this opportunity by risking the acreage in Texas and Louisiana: we estimate that 5% - 15% will have commercial mineral value. To estimate future cash flows, we assume that leasing bonuses will average $500 - $750 per acre (vs. the average $1,000+ they have been collecting for the past few quarters). In terms of royalty value, we take the present value of royalties from a hypothetical well, which in flow rate and eventual size is at the lower end of wells in the region. We then discount that value further to imply that the drilling program on this acreage will be completed over a six year period. We predict a range for number of wells by assuming 100-acre spacing on the risked acreage, and use a natural gas price of $5 per mcf. Under this methodology, the potential upside ranges from $140 million to $425 million, or $3.75 to $11.75 per share.

Water assets

FOR also owns water rights on a massive acreage position: roughly 860,000 net acres. Unfortunately, to date management has not released many specific details on these assets. Based on low end sales of water rights between $500 to $1000 per acre foot, risking the acreage to only 10%, assuming an average reservoir depth of 5ft, and 12 years of discounting at 7.5%, these assets could be worth $135 million, or $3.75 per share. Given the paucity of facts and uncertain timing of any monetization, we consider this value only in our upside scenarios.  

Balance sheet

With $200 million of net debt, FOR has modest leverage in relation to its asset base and its ability to generate cash. Leverage had been higher at the time of the spin-out: the current level is the result of management's decision last year to accelerate raw land sales to shore up the balance sheet, reducing the debt balance by more than $100 million. This decision was spurred by an unsolicited takeover attempt from an Atlanta real estate developer. In January 2009, Holland Ware offered to buy the entire company for $15 per share, a price which management and the board considered to be far too low. Interestingly, the current enterprise value is now lower than Ware's offer: $835 million today vs. $870 million at the January 2009 offer price.

Why is FOR mis-valued?

There are several possible explanations for the existence of this opportunity. The enterprise value is sub-$1 billion, and there is minimal research coverage: two boutique firms provide the only commentary and estimates. Probably most importantly, the situation is complicated: the assets range across real estate development, raw timber land, operating properties, natural gas, and water. The high potential asset value relative to current earnings means that conviction requires more work and more assumptions.

What will trigger a re-valuation?

The crucial performance indicator will be further improvement in sales of residential lots, commercial acres, and undeveloped raw land. This will translate into substantial operating income, which will highlight the attractive pricing of the equity. Another potential catalyst would be announcements that heighten interest in FOR's mineral holdings. These could include new well data from operating partners, new well data from operators on nearby acreage, and data on regional lease bonuses. There is reason to think that this sort of news will come sooner rather than later, as much of FOR's acreage has been leased on a held-by-production basis under which many of the working interest holders will lose their leases if they fail to reach commercial production within three years. Large amounts of acreage will be hitting this deadline in the first half of 2011. On a more macro level, escalating inflation fears could drive investors towards hard assets such as those owned by FOR.  

Valuation summary

As shown in the table below, our low case valuation provides full support for the current share price. Significant upside potential comes from the following: the real estate development assets could be worth an additional $3.75 per share; the raw land could be worth an additional $2.75 per share; additional oil and gas upside could be as much as $11.75 per share; and the water assets could provide an additional $3.75 of value. The high case valuation stretches to over $40 per share, or ~130% higher than the current price of $17.50:   

Disclosure:  We and our affiliates are long FOR.  We may buy or sell shares in the future.  This is not a recommendation to buy or sell shares.