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2021.10.29 Long Forestar (Ticker: FOR) $19.57

Forestar (ticker: FOR) is a land developer majority owned by D.R. Horton (ticker: DHI).  Teton0321 published an excellent writeup nearly 4 years ago which I would highly encourage reading:

https://valueinvestorsclub.com/idea/FORESTAR_GROUP_INC/1121096511

Back then, DHI had recently (on 10/5/2017) acquired 75% of FOR for $17.75 / share and FOR’s new business model was all still on the come.

A lot has transpired since, much of it positive.  Yet the stock has done virtually nothing – it’s up only 10% from DHI’s purchase price in October 2017 and actually down ~11% in the almost 4 years since Teton0321’s writeup.  It has also lagged the homebuilders by a wide margin.

Interestingly, this period coincides with what has generally been a strong upmarket in housing overall (especially measuring from that starting point until today).  More importantly, broad US home price index measures of year-over-year % home price appreciation have actually outpaced even the highest yoy measures achieved during the prior US housing bubble.  This makes FOR’s languishing share price even more surprising at first glance because land is generally viewed as a leveraged exposure to home price appreciation.

In fact, most of the roadmap laid out by FOR at the time DHI took over has been accomplished – actually most targets have actually been exceeded.  The multi-year trajectory initially set forth by FOR was surprisingly accurate so far.  Despite COVID, the initial targets for fy20 of $700-800mm of revenues and 10,000 lot deliveries at high single digit pretax margin were surpassed.  The fy21 targets of pretax margin ~10% with >20% rev growth will be beat.  As will the targets for fy21 revenues of $900-1,000mm and 12,000 lot deliveries. 

FOR has demonstrated better than targeted access to debt capital, with multiple successful bond raises.  Today, FOR has a mix of unsecured bonds maturing in 2026 and 2028 and yielding ~4% YTW.  This is a significant difference relative to private developers.  FOR not only has lower cost debt capital, but it is far more flexible, especially during a period of stress given the relative lack of covenants and unsecured nature.

FOR also demonstrated access to the equity markets with a modest follow on equity offering in 2019.  Prior expectations for a second follow on equity offering sometime in 2020 did not materialize for a number of reasons – ample capital given the successful unsecured bond raises and unsecured revolver and the weaker than expected valuation at which FOR shares have traded.

For now, FOR trades at a single digit multiple of earnings and at a very slight discount to TBV, despite revenue growth above 20% and even higher profit growth.  As FOR’s inventory investment matures over time (i.e. as % growth decelerates from the larger denominator) returns metrics should naturally improve.  Even with a steady pretax return on inventory hurdle of ~15%, as the portfolio on average transitions over time from mostly early stage projects to more of a steady state mix of projects, FOR’s inventory turnover and asset turns should continue to increase.  Likewise, its pretax margins should continue to increase.  This should all drive continued improvement in ROIC and ROE.

I don’t think the current valuation requires it or prices it in, but there is at least the potential for FOR to continue growing rapidly for years to come, driven by its better access to longer term and more flexible capital.  That would seem to be particularly the case in the next housing bear market.  After all, the public homebuilders similarly grew market share in a massive fashion over time, with particular share gain acceleration during housing downturns or broader periods of capital scarcity.

A combination of supply chain disruptions and increased demand for single family housing during and after the onset of Covid has driven significant home price appreciation.  Yet that impact on FOR’s results has been muted to date.  I believe the primary reason is the natural lag time.  Specifically, land price changes tend to lag home prices.  More importantly, land revenues at FOR don’t hit the P&L until the finished lots are delivered to the homebuilder – typically a year or two after the pricing on that land had been agreed upon.  I believe the most significant land price increases in FOR’s P&L are still several quarters away.

I also think this means that when home price gains slow down, FOR will still be putting up accelerating price improvements due to the natural lag effect.  In the meantime, I believe this means that FOR’s TBV is particularly understated relative to the current market value of its land inventory.  Trading at a hair under TBV which is already understated relative to liquidation value, I believe that the fundamental downside to FOR is limited.

As for the upside, I think that it is pretty straightforward to sketch out a double over 3 years as EPS grows to ~$4.50 and TBV grows to ~$31.  If FOR trades to 1.25x TBV in 3 years, that would imply a $39 share price, double the current quote.

In fact, I think there is potential for greater upside to the extent that strong home price appreciation drives FOR margins above my expectations and sets in motion a positive flywheel of sorts.  As is often the case with illiquid stocks, beating expectations can drive the share price higher alongside higher trading liquidity which can attract more interest and further improved valuation. 

As an upside case, trading to 1.9x TBV in 3 years implies the share price triples.  That sounds hard to believe today given the stock’s recent performance.  But a low double digit PE multiple on a mid teens ROE company with a track record of strong growth and a similar outlook for growth doesn’t seem out of the realm of possibility.

The biggest fundamental risk for FOR is that land prices decline significantly and trigger major impairments.  But while this happened in the wake of the housing bubble bursting, I would note that was an anomaly (aside from the Great Depression and the housing bubble), especially on a broadly diversified national level.

In conclusion, my thesis is a simple one.  While FOR has largely met and exceeded the longer term path laid out at inception 4 years ago, that was not enough to satisfy some of the most bullish investor hopes and assumptions.  Investor fatigue and a lack of trading liquidity has caused the stock to do basically nothing for years as the valuation significantly derated.  But I think that sets it up well going forward from here – with significant upside potential and limited fundamental downside.

Catalysts

Patience

Positive revisions as margins beat expectations

As stock starts to work, it attracts trading liquidity, which drives further valuation improvement

Risks

Housing crash drives major impairments

Catalyst

Patience

Positive revisions as margins beat expectations

As stock starts to work, it attracts trading liquidity, which drives further valuation improvement