Forestar Group Inc.

Greetings and welcome to the Four Star Group's second quarter 2020 earnings call and webcast. At this time, all participants are in a listen-only mode. A brief 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 turn the call over to Jessica Hansen, Vice President of Investment Relations for D.R. Horton, the 65% majority owner of Four Star. Please go ahead, Jessica.

Thank you, Kevin. We welcome each of you to the call to discuss Four Star's financial results along with how the company is being managed during current market conditions. 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 Four Star 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 Four Star on the date of this conference call and Four Star 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 Four Star's annual report on Form 10-K and subsequent quarterly report on Form 10-Q, both of which are filed with the Securities and Exchange Commission. This afternoon's earnings release is on Four Star's website at investor.fourstar.com, and the 10-Q is planned to be filed mid-next week. After this call, we will post an updated InVetcher presentation to Four Star's InVetcher relations site under events and presentations for your reference. Now, I will turn the call over to Dan Bartok, CEO of Four Star.

Thank you, Jessica, and good afternoon, everyone. Our team delivered a solid second quarter during an unprecedented time for the nation. From the outset of the COVID-19 pandemic, our priority has been the health and safety of our people and the communities that we serve. We remain committed to all of our stakeholders as we continue to safely operate our business. In addition to Jessica, I am pleased to be joined on the call today by Jim Allen, our new Chief Financial Officer, who joined Four Star a few weeks ago. I'd like to take a brief moment to have Jim introduce himself before we get started. Jim?

Thank you, Dan, and hello, everyone. I'm excited to be part of the Four Star team. I look forward to helping the company build out its platform to achieve our goal of being the largest developer of residential lots in the United States. I'm working quickly to get up to speed on the business and look forward to getting to know our investors and analysts.

Thank you, Jim. Given that Jim just joined, he will not be an active participant today, but we are very glad to have him with us as a key member of the four-star team. We also have Colin Dawson, D.R. Horton's Vice President of Corporate Finance and Treasurer, with us again this quarter. To begin, we'd like to first express our gratitude to our country's dedicated field of healthcare workers and to all who are on the front lines caring for our communities. Our thoughts remain with those affected by this pandemic. Now we'll talk about the current environment before discussing our quarterly results. Economic fundamentals in the housing and residential lot development markets remain solid throughout most of the second quarter. However, During the second half of March and to date in April, the COVID-19 pandemic has impacted our business operations and the demand for our residential lots. Our HomeBuilder customers have informed us that they are slowing their purchases of lots during the current market uncertainty to adjust to decreasing home sales orders as a result of the pandemic. In almost all municipalities across the U.S. where social distancing and other restrictions have been issued, Residential construction has been designated an essential business as part of critical infrastructure. We have continued our lot development operations in those markets where allowed in order to supply home builders with finished lots. We are focused on maintaining the health and safety of our employees, customers, and trade partners and have made appropriate adjustments to comply with social distancing and other health and safety standards. We believe that we are well positioned to operate in this uncertain environment because of our low net leverage and strong liquidity position, our low overhead model, and our relationship with DR Horton. During this period of uncertainty, we are limiting land acquisition and carefully managing all lot development spending based on our current inventory and anticipated future sales pace. We are prepared to quickly respond to demand for residential lots both during and after the pandemic. Our team delivered a solid second quarter, and we opportunistically accessed the credit markets in February. We issued $300 million of 5% senior notes due in 2028, further enhancing our liquidity position. We'll discuss our quarterly results in detail, but first I'd like to remind everyone about Four Star's unique business model, which is designed to anticipate and adjust fluctuations in housing market and economic cycles, and how our business model differentiates our company in the marketplace. Unlike other land developers, we bring a production-oriented, returns-focused mindset to the land development process. We are focused on short duration, fully entitled residential lot development. We typically have a signed lot purchase agreement from a known buyer prior to making any significant new investments. We consider ourselves a lot manufacturer and follow a rigorous process to develop our projects in a phased manner. 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. We are in a strong liquidity position with low net leverage. Four Star also has a unique and strategic relationship with D.R. Horton, the nation's largest homebuilder. Our relationship with DR 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. DR Horton has a strong appetite for finished lots that will continue even during a market downturn. During the worst years of the last significant housing downturn, DR Horton still closed between 17,000 and 20,000 homes annually. the majority of which were built on finished lots purchased from third parties. We expect to leverage the strategic relationship and our strong capital position to significantly increase our share of the residential lot sales market both during and after the pandemic. I'll turn it over to Jessica now to discuss some of our financial highlights.

Thank you, Dan. In the second quarter, net income attributable to Four Star was $9.6 million, or 20 cents per diluted share, compared to $10.1 million or 24 cents per diluted share in the prior year quarter. Four Star's second quarter revenues increased 144% from the prior year quarter to $159 million. The prior quarter results included $14.8 million of revenues from 44 commercial acres sold compared to only $2.5 million of revenues from eight commercial acres sold in the current quarter. Residential lots sold during the quarter totaled 1,951 lots, an increase of 256% from the prior year quarter. The average lot sales price for the quarter was $79,700. 65% of lots sold in the quarter were from development projects, with the remainder from lot banking. Of Four Star's total lots sold, approximately 1,900 were sold to D.O. Horton during the quarter. Dan?

Our goal is to build a company that will produce consistent returns. Even prior to the current market uncertainty, we expected significant variability in our quarter-to-quarter results during our rapid growth period. As a result of COVID-19, we may experience even more variability in our near-term results. However, at scale, we continue to be confident that our low-risk, high-turnover, production-oriented lot manufacturing model will produce consistent returns. We also expect that we will manage our business at an SG&A percentage lower than a typical home builder. Our pre-tax income for the quarter was $13.7 million, with a pre-tax profit margin of 8.6%. Our gross profit margin was 14.1% in the second quarter, and SG&A expense as a percentage of revenues was 7%. Our gross and pre-tax margins are expected to fluctuate due to the quarterly mix of our lot deliveries and the timing of track sales. As the builders we work with have begun adjusting to the impacts of COVID-19, we have primarily been adjusting our lot sales contracts to delay the timing of takedowns as builders adjust to fewer home sales. Unless we see broad-based home price reductions, we would not expect significant changes to the contract pricing of our finished lots. But it is too early to predict the impact of this disruption on future market prices and terms. We are working closely with each D.R. Horton division and our other builder customers to determine the best course of action for each of our projects and will continue to adjust the market to market conditions as necessary. We are focused on controlling our SG&A while ensuring that our infrastructure adequately supports our business. We have made great progress building our local teams, but due to the current market uncertainty, we have instituted a hiring freeze. After we gain better visibility into our future revenue in each of our markets, we will then determine any expense adjustments needed to align with our revenue expectations. As we noted in our press release, due to the current uncertainty, In the U.S. economy and our business operations from COVID-19, we have withdrawn our guidance for fiscal 2020 and 2021. We expect to provide new annual guidance when we have clearer visibility into the business. Jessica?

In the second quarter, investments in lots, land, and development totaled $270 million, of which $160 million was for land and $110 million was for land development. During the current market conditions, Four Star has temporarily restricted its land purchase activity and continues to closely manage all lot development spending. Four Star's lot position increased 18% sequentially from December 31st to 52,300 lots at quarter end. Of Four Star's lot position at March 31st, 35,800 lots are owned and 16,500 lots are controlled through purchase contracts. 14,200, or 40%, of Four Star's owned lots are under contract to sell to D.R. Horton, representing approximately $1 billion of future revenue. Another 14,400 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 is targeting a three- to four-year owned inventory of land and lots. Colin?

Four Star remains focused on maintaining a strong balance sheet with ample liquidity and modest leverage. At March 31st, Four Star had approximately $790 million of liquidity, including $440 million of unrestricted cash and approximately $350 million of available capacity on its revolving credit facility. During the quarter, Four Star issued $300 million of 5% senior notes due in 2028, and repaid $119 million of 3.75% convertible senior notes in cash at maturity. Debt at March 31st totaled $640 million with no senior note maturities until fiscal 2024. Four Star's net debt to capital ratio at quarter end was 19.5%. At March 31st, stockholders' equity was $836 million and book value per share was $17.41 of 6% 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. At scale, we continue to 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 profit margins of approximately 10%. Before we turn to questions, I'd like to briefly touch on Four Star's investment highlights, again from my perspective. We have a unique lot manufacturing business model, yet different than a typical land developer, we have no unentitled land. We have a strategic relationship with D.R. Horton, the nation's largest builder. We are geographically diversified. We are focused on developing lots for affordably priced housing. We have an experienced management team that knows how to navigate through market cycles. We have a strong balance sheet and liquidity position, and we are profitable at current operating levels. In closing, and as I've already mentioned, Four Star is extremely well positioned and prepared to operate through this uncertain environment because of our low net leverage, strong liquidity position, low overhead model, and our relationship with DR Horton. Kevin, at this time, we'd like to open the line for questions.

Absolutely. We'll now be conducting a question and answer session. If you'd like to be placed into 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 the star keys. Once again, that is star 1 to be placed into question queue. One moment, please, while we poll for questions. Our first question today is coming from Ryan Gilbert from BTIG. Your line is now live.

Hey, thanks, guys. I think it would be helpful if you just talked a little bit about how lot deliveries in April are currently tracking.

Well, You know, I'll just go back a little bit, and I'll give you a little bit of monthly information from January. So January, we closed on 567 lots. February, 678. And March, 706. And it was pretty heavily front-loaded to the first half of March. So you can kind of see we were on a pretty even trend leading up to that. Through yesterday, we closed on 146 lots in the month of April.

Okay, got it. And just in terms of land acquisition development spend in 2020, you know, I think the number that we had last quarter was a billion for the full year. Obviously, we're curtailing that. But maybe you can just talk about the cash requirements or cash out the door that you expect for the remaining two quarters of 2020.

You know, it's still pretty early to kind of provide that number. We're analyzing every deal on a development basis as to whether we can sub-phase those projects or whether we should actually stop development based on inventory of each of those deals and what the current sales pace is. Land acquisition, literally since March 12th, I don't think we've bought anything yet. But it doesn't mean we aren't still looking at opportunities. And if we can get concessions or find deals that really still make a lot of good sense to us, we'll continue some of that. So it's just hard to kind of predict that number. But I agree with you. Clearly, it will be less than, I think, the billion dollars that we previously gave guidance to.

Okay. Got it. Last question for me. Can you give us a sense of what you're seeing in the land market just in terms of changes in pricing for finished and unentitled lots? I know we're still pretty early stages here, but just if you're seeing any changes in pricing or if you're seeing any deals fall through that you could potentially take advantage of at some point in the near future.

We haven't really seen prices reduced yet. As you know, prices are pretty sticky and really tend to follow home prices. So we really haven't seen a fall off in home prices yet. I think the builders have probably been given a little bit of concessions, but nothing to really impact home and lot prices at this point. We are seeing almost in every case sellers willing to delay due diligence periods and closing periods. So at this point, kind of just being patient to kind of see how this all unravels. You know, we're definitely seeking price discounts on new acquisitions. But, again, at this point, I think it's been pretty easy to get delays. I have not really seen, you know, any distress in the sale prices yet.

Okay, got it. Thank you.

Thank you. Our next question today is coming from John Lovallo from Bank of America. Your line is now live.

Hey, guys. Thank you for taking my questions as well. First one is, you know, given the stress in the market right now, I mean, would you anticipate that maybe some of your smaller competitors may end up getting into some financial stress or trouble and, you know, have an inability to access capital, which could allow you guys to maybe come in and, you know, consolidate the industry a bit? I mean, is that something that you're hearing or seeing at this point?

You know, again, it's still pretty early in the cycle to really see anything pop up. Clearly, we've been anticipating these days pretty much for the last couple of years to try to be prepared for these opportunities as they may occur. But at this point, we haven't really seen anything materialize.

Okay. And then, you know, in terms of just the land that you own, I mean, How are you kind of thinking about the potential for impairments on any of that land?

At this point, we are not seeing any price discounts. We are seeing a little bit of slowing in deliveries, but again, a lot of that is just really focusing on trying to adjust to what do we think the market is going to be. I think the first reaction from the builders was, hold on, let's stop here and let's only take what I have to have. But as they're really adjusting on sales, I think we're going to end up with a little better sales pace than what we've shown here over the first part of the month. I think our land acquisitions were well thought out. I think that we have good positions. To be honest with you, I've been pretty surprised at a lot of the absorptions that we're seeing in the last four to six weeks are still staying pretty strong in some of our bigger positions. At this point, I really don't anticipate any kind of impairments until, in fact, you start to see land prices or house prices reduce substantially.

And, John, most importantly is four-star strong liquidity profile, because if you think back to the financial crisis and the last significant housing downturn, the biggest and most significant impairments were driven by the fact that builders had to sell land to pay off debt maturities. And if you can be patient and you do ultimately expect to sell that land down the road, or in this case, sell finished lots down the road at not significantly different prices, because you don't have to sell them to generate cash and pay off debt, that's where Forrester is in a very strong position that even if there were a correction in home prices, that strong liquidity profile is going to help insulate them from significant broad-based impairments.

That makes sense. Maybe just one more from me. Is there any reason to think that the mix of development lots versus, you know, banking lots or track sales will not continue to shift more towards development lots, you know, in helping the margin as we go through the year versus what we saw kind of in the first and second quarter?

You know, I don't, I don't really see the mix shifting again. It's on a, it's really on a project by project basis and where lots being sold and where our homes being constructed. I think you saw a little shift in, You know, our first quarter was obviously relatively heavy in lot banking sales, and it was, I think as you probably see from our average lot price, it was kind of West Coast oriented. So I think our exposure in the West Coast, California and Washington, went down a little bit. But again, I don't really see a big difference between the mix of lot banking to development deals as to what we would have normally expected for the year.

So we've expected variability from quarter to quarter, but roughly we had talked to two-thirds lot development, one-third lot banking. And so with some variability from quarter to quarter, that's still, you know, on a longer-term basis here, at least for the next year or so, what we would anticipate.

Thank you, guys. Thank you. Our next question is coming from Michael Reholt from J.P. Morgan. Your line is now live.

Hi, this is Elad on for Mike. I was wondering first if you could just talk a little bit about your cost structure in variable and fixed costs. In particular, like what percent of COGS would be fixed and what percent of SG&A would be fixed or just how to think about that.

I guess we'll start with SG&A. Most of our SG&A is really a fixed cost. It's really people and offices. I guess at some point you could always make adjustments to your headcount. But we feel actually pretty fortunate. We've been really building a solid team of people here. A lot of the most recent hires are really geared towards land acquisition. So I think we've got the right people out on the ground looking for opportunities right now and trying to find where those opportunities are at. So I actually feel really good about that part. From a cost standpoint, it's really more about development spend because the costs Our cost of goods sold is really, you know, based on that development spend. You know, one of the things we have seen almost immediately is a willingness by our contractors to adjust pricing. You know, so much that I know we talked about this before, so much of our cost is petroleum-based. You know, it's people running big equipments. You have big fuel bills. You see some, you know, plastics in pipes. But their costs have gone down, and we've basically seen an immediate reduction due to, I think, the softness in oil prices, as well as some of our competitors and other builders out there have really stopped developing. They've come to us and said, hey, we want to continue to work. We're willing to reduce our margins in order to keep working. And we haven't done that across the board, but it's really about looking at each project where we believe we're going to need lots. and trying to continue to develop where we can. But in many cases, we've already seen cost reductions.

Thanks. And then also, how are you positioning for potential recovery in the market and thinking about the process of opening up again fairly quickly? Or is it just a function of land development? Is there going to be some part of hiring more people again? just how you're thinking about that process in the event of the recovery.

You know, the process really is, I know I've said it before, but it really is deal by deal. I mean, I've spent the last two weeks probably going through each deal twice with the teams on the ground to understand what our inventories are, where we were in the development process, where we might be able to get cost concessions, where we should stop, you know, because there's a sufficient inventory in front of us, where, you know, and really looking at each deal and trying to make sure that our inventory is matching where we believe that the demand for lots is going to be. A lot of what we've done is if I've had a phase that maybe is 120 lots, how do we stop part of that phase and only maybe deliver 60 lots instead of 120? But still keeping an eye on how do I turn it back on if the recovery happens quick. So I think from a development standpoint, we are in business. Other than in the state of Washington, we have been impacted because everything has been stopped there. I think pretty much every one of our other development projects has continued. From a people standpoint, again, we're just going to sit back and see how this unfolds. We've done a really good job building a team. And my guess is when our growth re-accelerates, we'll be hiring to meet those needs.

Great.

Thank you. Thank you. Our next question is coming from Truman Patterson from Wells Fargo. Your line is now live.

Thanks. This is actually Paul Chbilsky. I guess, you know, as we emerge from, you know, the recession, however long it worked out to be, Do you foresee any changes in the consumer segmentation of your lock pipeline?

Well, again, I kind of look to the builders. Maybe, Jessica, you want to answer that from a home builder standpoint more than for myself.

Sure. Paul, I know you and I have talked about it a lot, and there's always conversation about, you know, does entry level get harder hit by certain things? But we continue to like that as a big piece of our business today and after we get through the current pandemic because an entry-level buyer is buying out of need. They're not a discretionary buyer who's as heavily impacted by the stock market or changes in oil prices, and they already have a home to live in today. So we continue to really like that entry-level focus, and I think it's a core piece of our business, 50%-ish of our homebuyers are first-time homebuyers, and Four Star's investments have been concentrated to those types of projects, and they've been very focused on putting finished lots on the ground for homes at affordable price points, which is where the shortage of lots is. So the great thing about going into whatever this looks like from a downturn perspective is there is no oversupply of finished lots for homes at affordable prices. that's going to continue to be a market need both during and after the pandemic. So I would expect, you know, four-star will continue to focus on that, and they'll have, you know, a little bit else in their portfolio to deliver to builders that want houses at different price points, but the majority still to be focused for homes at affordable prices.

Okay. Do you have a number of lots that are actively being developed today versus maybe what were developed in the second quarter?

Well, the number of lots that we have that are finished on the ground at the end of the quarter, I believe, was 4,400, which is pretty consistent with what we've been running. I think it might have been 4,100 the quarter before and maybe 4,400 a quarter before that. So it's That number has stayed pretty consistent of finished lots. Again, generally as we're finishing them, we're selling them. As far as underdevelopment, I don't have that number handy or even off the top of my head, so I'd hate to guess that.

We can get back to you on that, Paul.

Yeah, I can get back to you on that. Okay, and just one final one. Does the slowdown in any way accelerate your desire to... have sales to third-party builders?

Well, we always have had the desire to do that. I think the flip side, I think the other builders may increase their desire to want to buy finished lots. So I think it's, you know, again, I almost think this is going to be a good opportunity for us, you know, as we come out of this to really expand our footprint and our customer base.

If you think about the last downturn, Deer Horton, along with the rest of the industry, generally shut off their internal lot development and continued to buy finished lots. So I do think that provides an additional opportunity for four-star here. Great. Thank you. Thanks, Paul.

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 closing comments.

Thank you, Kevin, and thank you to everyone on the four-star team for your focus and hard work during this uncertain time. 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 July to share our third 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.