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.

Land Pipeline

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

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.

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.

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.

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