Forestar Group Inc.

greetings and welcome to the four-star group first quarter 2020 earnings conference call. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It's now my pleasure to introduce your host, Jessica Hansen, Vice President, Investor Relations for D.R. Horton, the 65% majority owner of Four Star. Jessica, please go ahead.

Thank you, Kevin. We welcome each of you to our call to discuss Four Star's financial results along with the company's expected growth and capital plans. Before we get started, today's call may include comments that constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Although 4STAR believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different. All forward-looking statements are based upon information available to 4STAR on the date of this conference call, and 4STAR does not undertake any obligation to publicly update or revise any forward-looking statements. Additional information about issues that could lead to material changes in performance is contained in 4STAR's annual report on Form 10-K, which is filed with the Securities and Exchange Commission. This afternoon's earnings release is on 4STAR's website at investor.4star.com, and the 10-Q is planned to be filed early next week. After this call, we will post an updated investor presentation to 4STAR's investor relations site under Events and Presentations for your reference. Now I will turn the call over to Dan Bartok, CEO of 4STAR.

Thank you, Jessica. Good afternoon, everyone. In addition to Jessica, I am pleased to be joined on this call by Colin Dawson, D.R. Horton's Vice President of Corporate Finance and Treasurer, who works closely with Jessica and me on Four Star's finance and investor relations efforts. Our team delivered a solid first quarter and made significant progress towards executing on our plans for fiscal 2020. We will discuss these results in detail, but first I'd like to remind everyone about Four Star's unique business model and how it differentiates our company in the marketplace. Unlike other land developers, we bring a production-oriented, returns-focused manufacturing mindset to the land development process. We are focused on short-duration, fully entitled residential lot development. We develop our projects in a phased manner and typically have a signed lot purchase agreement from a known buyer prior to making any significant new investments. Our approach to land development is lower risk than other public land developers and will produce more consistent cash flow and returns as we achieve scale. Four Star also has a unique and strategic relationship with D.R. Horton, the nation's largest builder. Our relationship with D.R. Horton de-risks the expansion of our operating platform and allows us to have a footprint that is more geographically diverse than most public home builders. ER Horton has an immense appetite for finished lots, and we are leveraging this strategic relationship to deliver top-line revenue growth that is unmatched within the broader home building and land development universe. I'll turn it over to Jessica now to discuss some of our financial highlights.

Thank you, Dan. In the first quarter, net income attributable to Four Star increased 412% to $16.9 million, or 35 cents per diluted share, compared to $3.3 million, or $0.08 per diluted share, in the prior year quarter. Four Star's first quarter revenues increased 542% to $247 million, which included $30 million of residential track sales. Residential lots sold during the quarter totaled 2,422 lots, an increase of 368% from the prior year quarter. The average lot sales price for the quarter was $90,300. 58% of lots sold in the quarter were from development projects, with the remainder from lot banking. Of Four Star's total lots sold, approximately 2,400 were sold to DR Horton during the quarter. Dan?

It is our goal to build a company that will produce consistent returns. During this period of rapid growth, we expect significant variability in our quarter-to-quarter results. However, At scale, we are confident that our low-risk, high-turnover, production-oriented lot manufacturing model will produce consistent returns. Our pre-tax income for the quarter was $22.2 million, with a pre-tax profit margin of 9%. Our gross profit margin was 12.4% in the first quarter, and SG&A expense as a percentage of revenues was 4.2%. We continue to expect our pre-tax profit margin in fiscal 2020 to be in the mid to high single-digit percentage range. For the remainder of the fiscal year, we expect significant quarterly fluctuations in our gross and pre-tax margins due to the quarterly mix of our lot deliveries, the timing of track sales, and the timing of incremental SG&A while building out our platform. We still anticipate approximately two-thirds of our lot deliveries in fiscal 2020 will be from lot development projects, which typically generate gross margins ranging from 14 to 22 percent. Our current development project portfolio is heavily weighted to shorter-duration projects not sourced by Four Star, which will produce margins at the lower end of the range. Additionally, short-term lot banking projects are expected to be roughly one-third of lot deliveries during FISPA 2020. Lot banking is expected to generate 12 to 16 percent annual returns, with gross margins ranging from 3 to 9 percent due to the short duration of our current portfolio. Finally, the continued build-out of our platform infrastructure will require increased SG&A to support our ability to achieve scale. At scale, we believe we will manage our business at an SG&A percentage lower than a typical home builder. Jessica?

Four Star's underwriting criteria for new development projects include the minimum 15% annual pre-tax return on inventory and a return of the initial cash investment within 36 months. During the first quarter, investments in lots, land, and development totaled $230 million, of which $120 million was for land, and $110 million was for land development. In fiscal 2020, Four Star continues to expect to invest approximately $1 billion subject to market conditions. Four Star is currently operating in 51 markets and 20 states, which is an increase of 16 markets and four states from a year ago. Four Star is more diversified today and in more markets than most home builders. Four Star's recruiting efforts to date continue to be very successful, and the company has recently opened its 13th division office. There continues to be tremendous opportunity for growth through Four Star's existing markets and the relationship with D.R. Horton. Four Star's lot position increased 16% sequentially from September 30th to 44,500 lots at quarter end. Of Four Star's lot position at December 31st, 32,200 are owned and 12,300 are controlled through purchase contracts. 12,700 are or 39% of Four Star's owned lots are already under contract to sell to D.R. Horton, representing approximately $1 billion of future revenue. Another 12,900 of Four Star's owned lots are subject to a right of first offer to D.R. Horton under the master supply agreement. Four Star currently expects to own a three- to four-year inventory of land and lots. Colin?

While Four Star continues to grow its platform and scale rapidly, the company is focused on maintaining sufficient liquidity and modest leverage. At December 31st, Four Star had approximately $720 million of liquidity, including $370 million of unrestricted cash and approximately $350 million of available capacity on its revolving credit facility. Four Star's net debt-to-capital ratio at quarter end was 9.7%, and the company has $119 million of convertible senior notes maturing in March that are expected to be settled in cash at maturity. CoreStar is focused on maintaining a strong balance sheet that will utilize modest leverage. Subject to market conditions, the company expects to opportunistically access the public markets to provide additional capital for long-term growth while managing to a net leverage ratio of 40% or less. At December 31st, stockholders' equity was $826 million and book value per share was $17.19, up 7% from one year ago. Dan?

Four Star is uniquely positioned to consolidate market share in the highly fragmented lot development industry through housing market and economic cycles. We now expect to deliver 10,000 lots and generate $800 to $850 million of revenue in fiscal 2020 and continue to expect to deliver approximately 12,000 lots and generate $900 million to $1 billion of revenue in fiscal 2021. At scale, we expect our operating model to produce financial results and returns that are similar to or better than most mid-cap homebuilders, with long-term pre-tax margins of approximately 10 percent. As I indicated earlier, we still expect our pre-tax profit margin to be in a mid to high single-digit percentage range for fiscal 2020, and approximately 10 percent by fiscal 2021. Before we turn to questions, I'd like to remind everyone of Four Star's investment highlights from my perspective. We have a unique lot manufacturing business model, very different than a typical land developer. We have a strategic relationship with E.R. Horton, the nation's largest builder. We are in a significant growth trajectory. We are geographically diversified. We are focused on developing lots for affordably priced housing, the heart of the market. We have an experienced management team that is excited about our opportunities. We have a strong balance sheet and liquidity position. We are profitable at our current operating levels, and we will enhance our results as our portfolio matures and we continue to build scale. To put it simply, we are executing on our plan and our position for continued success. Kevin, at this time, will now open the line up for questions.

Thank you. We'll now be conducting a question and answer session. If you'd like to be placed in the question queue, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing star 1. One moment, please, while we poll for questions. Our first question today is coming from Truman Patterson from Wells Fargo. Your line is now live.

Hi, good evening, everybody. Nice results. Um, first, uh, just want to touch on lot count in 2020, you know, very strong balance sheet over 700 million in liquidity, only 10% net debt to total capital. Could you just walk us through how we should be thinking about your total lot count ending 2020? You know, I know this has a lot of moving parts. You're delivering 10,000 lots this year that will need to be replenished. You're purchasing lots outright, which could take up more capital than if you decide to option. But, you know, how should we think of, you know, total lot count ending 2020? Should it increase in a similar range? as 2019 where you all had lot count increase by about 18,000 year over year, or would that be too aggressive?

Well, I think you just really have to go back to what we're saying as our target for lot sales, and remember that we're really targeting a three- to four-year lot supply. Yeah. You know, we're opportunistically buying transactions. You know, this last quarter was unique in our growth in owning controlled lots without a significant increase in our inventory. You know, we're just continuing to kind of execute deal by deal. But we clearly are going to grow that platform in order to support our continued growth.

Okay. Is there any limiting factor in ability to find land that isn't meeting your underwriting hurdles that would, you know, kind of limit or cap that, or is that just more of an internal decision?

Well, you know, it really goes back to people and capital. You know, that's really, I think, is our limiting factor. We're building a great team, you know, just You know, we're continuing to source more four-star source transactions in addition to the support we're getting from the Horton source transactions. You know, I think our pipeline is as strong as it's ever been, and I feel like we're really poised for good execution.

And we believe the three- to four-year owned lot supply gives them the ability, as they say is developed, to continue to grow into that and is sufficient for continued growth in coming years, that they don't need to own more than three to four years of land. And that's a big part of their returns improving over the coming years is delivering more revenue and profits on a three to four year owned lot supply.

Okay, okay. Could you all discuss how many fully developed lots do you have in your backlog currently?

Fully developed?

4,100.

It's about 4,000.

Yeah, 4,100 at the end of December.

Okay, okay, great. And then... you know, final one for me, and then I'll hop back into you. You know, just looking over the past 12 months, what kind of lot price appreciation have you all seen in some of your core markets, either what you've been able to pass through to the end user, IAD or Horton, or, you know, on the inflation side, what have you seen your costs kind of go up when you're out looking at the land?

Yeah, that's really a hard question to answer. You know, On an individual basis, most of the lots we're selling today were contracted for a year to 15 months ago. As I'm seeing new transactions, we're definitely seeing a lift in pricing on a market-by-market basis, but I don't know that I could really give you a percentage number on that. I'd probably want to do a little bit more homework before I answer that question.

Would a ballpark and maybe some of your core markets be kind of low to mid-single digits?

That's probably a good guess, yeah. And again, I think costs have gone up. Concrete has gone up a little bit on some of our concrete work, and I think a little bit of cost and grading. But it's really limited to certain markets where there's really a lot of development taking place in those sub-markets. But I think we've been able to easily achieve increased pricing as it relates to the increase in costs. Okay. Thank you all. Nice quarter.

Thanks, Truman. Thanks, Truman. Thank you. Our next question today is coming from Ryan Gilbert from BTIG. Your line is now live.

Hi. Thanks, guys. Just to piggyback on Truman's question, are you seeing an ability to price above the cost increases that you're seeing in the market, just given how demand has been here to date?

Yes, I would say that we're able to maintain margins in our projected returns in all of our underwriting and clearly pass on any increase in costs in lot pricing.

Okay, got it. And then, you know, as I said, it seems like demand's been pretty good so far in 2020, and we've had that 10,000 lot a goal out there for some time now. And I guess I'm wondering, in the event that we see the demand holding up throughout the year, can you talk about your ability to flex up a lot of production capacity to meet higher demand and potentially get above that 10,000 lot delivery range? I guess with the understanding that land development is a slow business, even lot manufacturing.

Yeah, you know, again, in most markets it takes me close to a year. Even on second phases it takes me close to a year to actually get lots on the ground. We're monitoring sales pretty closely at all of our subdivisions in order to try to get ahead of any increased demand. In a couple cases we are accelerating when we're getting lots on the ground. So, I mean, we're hopeful that we'll be able to exceed the 10,000, but we feel pretty comfortable that we'll get there. But, you know, you look at our first quarter and you think it should be pretty easy, but we've had a great quarter. And, you know, I think we've tried to steer you guys all along that it's going to be lumpy quarter to quarter.

Right. Understood. And then just last one for me. In terms of accessing the public markets in 2020, can you talk about your preference for debt versus equity capital?

Kyle, do you want to take a shot at that one?

Sure, Brian. So, you know, our approach to the capital structure is really centered on being, you know, conservative, flexible, and disciplined. Through our capital raising efforts last year, together with the performance of the business, Four Stars, we're in a unique and great position where we can be opportunistic as it relates to the timing and sequencing of debt versus equity. And certainly, so our approach to tapping the capital markets will parallel our philosophy on capital structure. We're going to be opportunistic but disciplined as we evaluate the capital markets, but certainly any decisions we make would be centered on maintaining a conservative capital structure and certainly leverage less than 40% net.

Okay, great. Thank you.

Thank you. Our next question today is coming from Michael Reho from J.P. Morgan. Your line is now live.

Hi. This is Alad on for Mike. Nice job this quarter. First, ASPs are elevated again, and I was curious, what were the drivers of the higher ASP? Was it mixed issues again, maybe land banking or West Coast lots? And do you expect an elevated ASP to recur again in 2Q?

You hit it right on. It's definitely a mix of lots, and there was somewhat of a concentration of lot banking in the West that came through this quarter. Kind of the same as last quarter. If you see our quarter-to-quarter, we see 90,000 ASP in both quarters. I don't expect that to continue. You know, if you look at the amount of lot banking that we did in this quarter and I think where we're steering you for the rest of the year, I think you'll see a fall off in lot banking sales for the rest of the year.

Okay, thank you. And also, just in terms of 2Q continuing, any other color that you could provide in terms of closings, gross margin, or SG&A?

No, we're really sticking with annual guidance. As Dan already indicated, it's going to be lumpy from quarter to quarter. Although on an annual basis, it's a very significant growth trajectory. Just with the timing of lot deliveries and impact of mix, it's going to be lumpy quarter to quarter. So we're not planning to provide any quarterly guidance.

Okay. So just turning to the full year, I was wondering what's baked into the revised fiscal year 20 total revenue guide in terms of residential track sales, given you had another big track sale this quarter?

Yeah, that's really what it was. We actually had three track sales in this quarter, two small multifamily pieces and one larger residential track. That won't be repeated, so we feel pretty good about raising the bottom of our revenue bags.

Okay, thank you.

Thank you. As a reminder, that's star one to be placed in the question queue. Our next question is coming from Alex Barron from Housing Research Center. Your line is now live.

Yeah, thanks. Yeah, I guess you kind of answered a few of my questions because I was just trying to figure out, given your guidance for this year, and I guess we shouldn't take this quarter's revenue as a run rate then. What would cause it to kind of fluctuate? What would be the biggest driver there?

Yeah, Alex, you're right. So to be specific on what we did this quarter, since we didn't spell it out in the conference call, our previous guidance was for $750 million to $850 million of revenue. And then with what we delivered this quarter, which included $30 million of residential track sales, which are what we've talked about being somewhat lumpy, and those aren't recurring every single quarter, we felt comfortable that we could move the low end of the guidance to $800 million from 750. So that really was just driven by, you know, solid lot deliveries this quarter, coupled with the $30 million of track sales.

Okay. And obviously, you're only kind of giving us an idea of this year and next year, not beyond that. But, you know, it would seem to me growing the top line 20%, where there's obviously a lot of demand for land and everybody's growing even faster than that, it seems, in orders this quarter, what would be the constraint? Why would the constraint be around 20%? Is it really capital or is it more people, you know?

Well, you know, it's back to it takes us about a year from the day we buy land and before we get to that first revenue event. So it's kind of that leading indicator. We just raised some additional capital at the end of last year. That money is now being put to work. So I think you'll see some impact in 2021, but you'll see the bulk of it really in 2022.

It's definitely going to be a growth story for years to come. We're just not in a position today to feel comfortable giving guidance past 21, but we do expect this to be a growth story for a multitude of years.

It would seem that way. Well, thanks and best of luck. Thank you.

Thank you. We've reached the end of our question and answer session. I'd like to turn the floor back over to Dan for any further or closing comments.

Thank you, Kevin. And thank you to everyone on the four-star team for your focus and hard work. We look forward to working together to continue growing and improving our operations over the coming years. We appreciate everyone's time on the call today and look forward to speaking with you again in April to share our second quarter results. Thank you.

Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.