Forestar Group Inc. (FOR) is a subsidiary of D.R. Horton, Inc., which is the largest homebuilder in the United States by volume. We believe that this stock is a buy due to the company’s strong fundamentals and quarterly financial results. FOR has a PE ratio of 11x versus the US average of 18.2x. Earnings forecasts show an expected increase of 31.8% annually. Earnings increased by 83.9% from last year.

This residential lot development company operates in 55 markets across 22 states. Most of the company’s developments are lots for single-family residential communities. Forestar acquires undeveloped land and prepares it for residential lots, which they sell to homebuilders. Most of its investments are short-term, phased projects, which it expects to yield returns similar to homebuilder operations.

We recommend that investors consider buying shares of FOR before the company reports earnings results on November 4th.

Third Quarter Financial Performance

Forestar reported its third-quarter financial results on July 21, 2021, which showed improved revenue and earnings. Revenue was $312.9 million for an increase of 76% over the third quarter of 2020. Net income increased 56% for a total of $15.6 million. However, the profit margin decreased from 5.7% to 5% due to higher expenses.

Forestar’s land bank puts the company in a strong position for the fiscal year 2022. Lot deliveries for the third quarter increased 91% year-over-year, although the average selling price declined 8% year-over-year. Their land bank grew 91% year-over-year for a total of 96,600 with approximately 34,000 being optioned. Close to 40,000 lots are under a right-of-first-offer or contract to D.R. Horton. This represents an incredible increase of 171% year-over-year for a total of just over 57,000. Although national lot inventory is low or very low, Forestar’s own land bank and its relationship with D.R. Horton represent robust fundamentals.

In addition, Forestar Group reported a third-quarter EPS of $0.32 and an adjusted EPS of $0.59. With such positive financials, the company raised the midpoint of its lot delivery guidance for the entire fiscal year by 7%.

Demand for Residential Lots

We believe that demand for finished lots is still strong. At the same time, the National Association of Home Builders reported on October 22 that 76% of home builders in the U.S. said that the inventory of developed lots available in their regions was “low to very low.” That is the highest percentage recorded with the previous record being 65% in 2018. Strong demand and low inventory should ensure that Forestar Group will be able to turn over its own inventory quickly.

Forestar’s strategy last year was to accelerate lot development, and the company is reaping the results now. The demand for finished lots continues to be robust, which resulted in revenue growth and market expansion for the company. Year-to-date, the company has delivered more than 11,000 home builders. As such, Forestar adjusted its expected deliveries for the entire fiscal year to between 15,500 and 16,000, which will generate approximately $1.3 billion in annual revenue. And third-quarter gross profit margin grew by 610 basis points to 17.8%. The company attributed these results to several factors, including demand for finished lots and a strategy of pricing the developed lots near the time of delivery.

Forestar’s competitors remain focused on developing master-planned communities, and the industry remains primarily local, undercapitalized, and fragmented. This puts Forestar in a strong position with its backing by D.R. Horton and greater access to bank financing and capital markets. The company differentiates itself from competitors by its lot development business model, its efforts to decrease exposure to lot banking, and its returns-focused model. This business model produced a 10% return on equity (ROE) for the 12 previous months ending June 30, 2021. This represents an increase of 390 basis points and five consecutive quarters of increasing ROE.

Other results for the nine months ended June 30, 2021, include net income of $66.2 million for an increase of 81%, which is $1.36 per diluted share. This is versus $36.5 million, for $0.76 per diluted share for the same fiscal period in 2020. Pre-tax income was $87.9 million for an increase of 91%. Revenue was $907.1 million for an increase of 55% up from $584.3 million primarily due to the 72% increase in lots sold.

Overall Housing Markets

The housing market continues to experience a boom driven by the improving economy and millennials approaching their peak homebuying years. Housing supply remains low due to increasing costs of building homes and real estate investment companies outbidding families and individuals for starter homes. Other factors driving the low supply of homes include an increase in housing demands due to low mortgage rates and work-from-home opportunities fueled by the pandemic. Detached, single-family homes remain in very high demand. The Freddie Mac Housing Price Index (FMHPI) shows that home prices increased by 11.3 percent in 2020 due to demand and low mortgage rates. Growth is expected to slow down to approximately 4.4% in 2022. The FMHPI was at 248.1 in July 2021.

Concerns

Currently, Forestar has $704.1 million in debt, which is an increase of 9.9% from $640.6 million over the previous year. It holds $116.0 million in cash for a net debt of approximately $588.1 million. The company had short-term liabilities of $163.2 million and long-term liabilities of $881.4 million. Along with the cash, the previous reported balance sheet showed receivables of $2.0 million. Thus, liabilities outweigh cash and receivables by $926.6 million versus market capitalization of approximately $970.8 million.

Final Thoughts

Despite its debt load, Forestar is in a strong position to increase its profitability. Its PE ratio remains significantly below the market average. Its land lot inventory turns over quickly, and its relationship to D.R. Horton gives it a significant competitive edge from acquisition and capital perspective. Medium-term investors should consider buying shares of FOR ahead of the company's November 4th earnings report.