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Forestar Real Estate Group Inc. (NYSE:FOR)

Q1 2008 Earnings Call

May 7, 2008 10:00 am ET

Executives

James D. DeCosmos – President, Chief Executive Officer & Director

Christopher L. Nines – Chief Financial Officer

Analysts

Mark Weintraub - Buckingham Research

David Woodyatt - Keeley Asset Management

Robert Holt - Holt Capital Partners

Operator

Welcome to the first quarter 2008 Forestar Real Estate Group Inc. earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host for today’s call Chris Nines, Chief Financial Officer.

Christopher L. Nines

This is Chris Nines, Chief Financial Officer of Forestar Real Estate Group and I’d like to welcome each of you who have joined us by conference call or webcast this morning to discuss the results for first quarter 2008. Joining me this morning is Jim DeCosmos, President & CEO of Forestar Real Estate Group.

Let me remind you to please review the warning statements in our press release and our slides concerning forward-looking statements as we will make forward-looking statements during the presentation this morning. This morning Jim DeCosmos and I will present first quarter 2008 financial results. At the completion of our presentation we’ll be happy to take your questions.

Thanks for your interest in Forestar Real Estate Group and I’d now like to turn the call over to Jim.

James D. DeCosmos

Welcome to everybody who’s on the call and the webcast this morning. Before Chris reviews the financials, I want to take just a few minutes and comment on the current state of the business as well as the market. As I said on the last call, we expect 2008 to be at least as challenging as 2007 and after closing the first quarter I will continue to reiterate that commentary. The spring selling season has been generally lack luster, poor buyer and builder sentiment, more stringent mortgage lending standards and excess inventory typically frame the market. Fortunately, the majority of our active projects are in the major markets of Texas, relatively speaking in better balance.

Buyer sentiment and heightened mortgage lending requirements are the primary Texas issue, it’s not price or affordability or excessive inventory. But our low basis portfolio and healthy balance sheet were well positioned for this phase of the cycle. As we stated on numerous occasions we’ll continue [inaudible] full speed ahead creating significant value with minimum investment.

On the development side, we’ll invest with discipline only in projects and markets that generate subsequent sales. As you’d expect with record oil and elevated gas prices mineral activity is encouraging. I’ll provide updates and commentary regarding recent activity. The stress in the housing and the credit markets is expected to create acquisition opportunities. There were no acquisitions in the first quarter yet we’re encouraged by what we’re beginning to see.

Now, let me turn it over to Chris to review the financials for the quarter.

Christopher L. Nines

First quarter 2008 financial results were a net loss of $0.2 million or $0.01 per basic share compared with earnings of $0.6 million or $0.02 per share in the first quarter of 2007 and essentially breakeven results in the fourth quarter 2007. The highlights of the first quarter 2008 financial results include $1.3 million of pre-tax share-based compensation expenses for retirement eligible employees or approximately $0.02 per share after tax. First quarter 2008 weighted average basic shares outstanding were 35.5 million shares.

Now, let me turn to the segment results. In first quarter 2008 we changed our reportable segments to reflect our post spin management of the assets and liabilities transferred to us from Temple-Inland. Please note that all prior period segment information has been reclassified to conform to the current presentation. We manage our operations through three business segments: real estate; mineral resources; and fiber resources.

Our real estate segment secures entitlement and develops infrastructure in our lands principally for single family residential and mix use communities and manages our undeveloped land and commercial properties. Our real estate segment includes about 372,000 acres of land owned directly or through ventures located in 10 states and 13 markets.

Mineral resources includes or 622,000 net acres of oil and gas mineral interests located in Texas, Louisiana, Alabama and Georgia. And, fiber resources include the sales of wood fiber primarily in Georgia and manages our recreational leases.

Our real estate operation reported segment earnings of $3.5 million in first quarter 2008 compared with $3.7 million in first quarter 2007 and a segment operating loss of $0.2 million in fourth quarter 2007. Let me remind you that fourth quarter 2007 segment results include a $3.9 million impairment expense principally associated with the commercial golf club operation and development in Granbury, Texas.

Mineral resources reported segment earnings of $6.5 million in first quarter 2008 compared with $3.4 million in first quarter 2007 and $3.7 million in fourth quarter 2007. This improvement was driven principally from increased mineral leasing activity which Jim will describe in greater detail on a few slides.

Fiber resources reported segment earnings of $2.8 million in first quarter 2008 compared with $0.3 million in first quarter 2007 and $3.8 million in fourth quarter 2007.

First quarter 2008 and fourth quarter 2007 segment earnings benefitted from a $1.4 million and $2.2 million gain respectively from the partial termination of a timber lease with the Jones Company in connection with the formation and operation of the Ironstob venture. During first quarter 2008 we moved 409 acres from our Timber lease with the Jones Company in to the Ironstob venture which was immediately sold for $6,100 per acre.

Now, let me turn the call back over to Jim who will walk you through our real estate pipeline and key performance indicators for our business.

James D. DeCosmos

Our real estate value creation pipeline is comprised of four basic value categories with our strategy being to create value by moving product and acreage through the value chain from the left to the right. At the end of the first quarter 2008 we had approximately 324,000 low basis underdeveloped real estate principally located in and around Atlanta. The majority of this segment is comprised of acreage we selected from the two million acre land portfolio once owned by Temple-Inland.

We have 31,070 acres in entitlement process, just under 14,000 acres in title and just over 300,000 acres in the development category yielding our real estate portfolio of just under 372,000 acres. In addition, we have an estimated 24,400 lots in the entitled category and just under 5,000 lots in development for a total estimated lot count of just over 29,000. Not reflected in this acreage is 17,000 acres of undeveloped acreage in the Ironstob venture that we formed in the fourth quarter 2007. This acreage is principally located in Paulding, Polk and [Harrison] County with Paulding being one of the fastest growing counties in the US.

Now, the next two Slides are real estate key performance indicators. In essence, it’s a reconciliation of our progress in executing our strategy of creating value by moving acreage through the pipeline. Residential lot sales were up in the first quarter 2008 compared to the fourth quarter 2007 and lower than the first quarter of 2007. Included in the first quarter 2008 lot sales are 192 lots at $24,300 a lot at our City Park project in Houston. These lots are for a product very similar to a townhome or a villa. They are tightly spaced with minimal maintenance and upkeep. Also included are seven custom lots in Cibolo Canyons that sold for $175,000 a lot. Given the quality and success of Cibolo Canyons, this project has been selected to host the San Antonio 2008 Parade of Homes. Our success has enabled us to continue to move lot product towards higher end housing.

The single commercial sale of 22 acres is for a planned assisting living center at our Parks of Deer Creek project in Fort Worth. This is a project where residential sales have been slow so we’re encouraged by this sale as well as the activity. 13,049 acres of undeveloped unentitled land was sold for an average sales price of $4,600 per acre and it includes what Chris previously mentioned, the 409 acres at $6,100 an acre from our Ironstob venture. As you would expect, the number of viable buyers in the market for land is also impacted by consumer buyer sentiment as well as the credit markets.

Now, let me shift to entitlement activities. In the first quarter 2008 we moved 28,088 acres into the entitlement process. This acreage is in addition to our Fincher Road entitlement project located in Cherokee County Georgia. This mix used mix

master plan entitlement project now encompasses just over 3,900 acres. One entitlement project located in Pickens County, Georgia was secured for the quarter, and I'll provide additional details related to the project on the next slide.

Our project currently titled Pickens School in Pickens County, Georgia received its entitlements in the first quarter of 2008. The 420 acre project is zoned for 120 acres residential and 260 acres commercial. Adjoining the Northeast side of the project is Highway 515. It's a four-lane divided highway, essentially it's the extension of I-575, which begins at I-75 just above Marietta.

In addition to zoning for residential communities the 260 acres zoned as highway business allows us the flexibility to mix retail office and multi-family in a way that optimizes value at a given location, the existing infrastructure and the zoning. This project is one of our sites earmarked for economic development at the region as well as the state level. I also want to call your attention, if you'll look at the Site Plan at the bottom right hand of slide, you'll see that we own an additional 350 acres just across Highway 515.

Shifting gears to minerals. Given increases in commodity prices for oil and gas, there's been a lot of activity associated with Forestar Minerals. We leased approximately 5,300 acres in the first quarter at an average lease rate of $678 an acre. This acreage includes a one-year lease of 241 mineral acres at $6,500 an acre in Tarrant County Texas, an active part of the Barnett Shale play. These mineral interests are part of Summer Creek Ranch, one of our venture development projects with Cousins Properties. Oil and gas production are both down from Q407 resulting from the mix as well as the timing of wells coming online.

Most recently, we've seen a significant increase in activity in the James Lime in Cotton Valley. Horizontal drilling and approved technology and completion methods is beginning to generate additional volumes of natural gas in a number of plays in Arkansas, Louisiana, Texas Basin to include the Cotton Valley in James Lime.

In particular, Cabot Oil and Gas Corporation's recent success in James Lime has generated heightened attention. Indications are that the trend is moving south. The map illustrates the location of the James Lime in Cotton Valley and approximately 74,000 net mineral acres we have to the south in Angelina, St. Augustine, and Sabine Counties. As we've previously noted, the principal drivers for mineral value is the price of oil and gas, location, and technology. Currently all three components are at work.

Now let me shift gears to the newest segment, fiber resources. Fiber volumes, price and revenues are down in the first quarter of 2008 versus the first and the fourth quarter of 2007. Volumes are primarily influenced by how much is harvested under the Temple-Inland Supply Agreement. From a pricing perspective, saw timber is at a 10 year low and down 12% in the first quarter of 2008 versus the fourth quarter of 2007.

Pine-pulpwood prices are relatively stable. Given the current market conditions and the ability to inventory saw timber on the stump, our sales plan is skewed toward pulpwood. This is one of the benefits of fiber resources. Saw timber trees left uncut will continue to grow value and volume from both a timber as well as a real estate perspective. In both cases, bigger trees have greater future value.

As Chris stated in his comments, we further segmented natural resources into two segments: minerals; and fiber resources. Given the change, we've provided you with a quarterly reclassification of segment earnings for 2007. As you can see, and we have stated on a number of occasions, this tends to be a lumpy business.

In closing, the housing markets have a number of issues however, with the majority of our activity projects in the major markets of Texas, our low basis portfolio, mineral resources, and a healthy balance sheet, we're well positioned for this phase of the cycle. Our portfolio business model and strategy provide a distinct advantage. We'll continue in title full speed ahead creating significant value with minimal investment and exercise discipline in our investments and development, investing only in those projects and markets that will generate subsequent sales.

We'll continue to realize and maximize mineral resource value by being proactive in the oil and gas markets. We'll accomplish this by providing better market access and transparency of our mineral assets resulting in more acreage in play, with the ultimate objective of increasing [inaudible] revenue.

The upside to the downside; the challenges in the housing and credit markets are expected to create acquisition opportunities. We'll be patient, disciplined, and continue to position Forestar to be in the right place at the right time.

Once again let me thank you for your interest in Forestar and joining us this morning. And I'd like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Weintraub - Buckingham Research.

Mark Weintraub - Buckingham Research

The $20 million that you spent on development, can you explain a little bit about what that was? And obviously, it looks like your debt went up by a similar type of amount which is not surprising since earnings were flat. What should we be looking for excluding any potential acquisition opportunities that might develop in terms of development expenses? And what are you comfortable in terms of increasing your debt outstanding to fund the development activities?

James D. DeCosmos

I'll begin to answer your three-part question. With regards to investment and development of a little over $20 million, over 25% of that was in Cibilo Canyon, a project that's doing extremely well. I made some comments with regards to hosting a Parade of Homes. And as we said in previous calls, we also have a commitment in our support of the development of the Marriott. So over 25% of that development expense in the first quarter was invested in Cibilo Canyon.

With regards to the path forward, I think that if you look at our balance sheet Mark, and given what we see in front of us we don’t expect any future stress. As I said in my prepared remarks we pay very close attention to our credit facilities as well as the balance sheet and we'll be very disciplined with regards to our investments and development.

Mark Weintraub - Buckingham Research

Can you give us an estimate of roughly how much additional development investment, again excluding acquisitions you'd expect over the next three quarters as we try and model cash flows?

James D. DeCosmos

Mark, you know that we don't provide forecasts or guidance but what I would do is just go back and reiterate that we're going to be very disciplined and pay very close attention to any investment we make in development. Our expectation is that when we make an investment development in this phase of the cycle that it's going to be followed up by a subsequent sale.

Mark Weintraub - Buckingham Research

When you say follow up with subsequent sale, do you mean very quickly? Because, that's not necessarily always the case. And just as the second part of that is given that I'm fairly new at understanding what the expectations or what your game plan is, is the first quarter's development type of activity spending that we saw there, would you say that that's typical, is that more than normal, is it less than normal?

James D. DeCosmos

Mark, I think you can go back and look at some of the previous run rates and previous information we've provided in the Ks and in the Form 10 and get a sense of what our investment in development looks like. And when I mentioned that followed by subsequent sale, there's generally a lag time of maybe nine months between investment and development when you start a phase until you generate lot sales. But the comment is directed toward our level of confidence in the project as well as the market and our ability to be able to ensure that those lots will be sold or taken down by builders.

Operator

Your next question comes from David Woodyett - Keeley Asset Management

David Woodyat - Keeley Asset Management

A little over 80% of your land is undeveloped still. Can you give us at least some general sense of timing on when the years you would expect the land to be effectively developed?

James D. DeCosmos

With regards to our real estate portfolio all the selections of properties that we made from the Temple-Inland portfolio were made under the belief, or with the belief, that these properties in time had the opportunity or the potential to create multiple the value through a higher and better real estate use. We've examined all of these properties we continue to examine them to make sure that in time that they’ve got the potential to create value that meets our return expectations.

So when I was making comments with regards to our real estate portfolio and that pipeline I intentionally said that it is a real estate pipeline and we believe, fundamentally believe, that we can create multiple the value by moving this acreage and product through the value creation strategy that have. And, of course, when I say that the underlying belief is that you can do it in a timely fashion that would meet our return expectations.

David Woodyat - Keeley Asset Management

A somewhat similar question with regard to the mineral area again, about 80% of the net acres, mineral interests are yet to produced revenues. Can you give us at least some general sense of the likelihood of that 500,000 and some acres actually having some minerals underneath that are going to ultimately produce at least some reasonable revenues?

James D. DeCosmos

David, the one thing that you need to understand is that a majority of these leases have a three-year term. So if you look at what is currently under lease, when it expires, when the lease expires if it's not re-leased it goes back into that available for lease category. So, within that segment of available for lease, properties moved in and out of that category over time. There are some properties that may have been leased two or three times.

As I said earlier in the comments, what really drives the value here is price and technology. For example, as new technology is developed there's oftentimes interesting going back to same formations or the same plays with a newer technology that makes the extraction economical. So it's not our expectation that 100% of this acreage is in play at any one time. What's important is to keep it in play and active and available to the market.

The last comment I made with regards to minerals David, is that there's about approximately 360 acres, 360,000 acres are in that magnitude in Georgia and Alabama which has historically been an area that has had no activity at all. I have mentioned on previous calls and in other meetings that we leased 9,000 acres in the second half of 2007 in the [Conswego] and the Floyd gas play. We're encouraged by that activity. There continues to be a lot land men and court houses in that basin and in that play, so it's a little bit early but we are encouraged by what we see.

I misspoke just a minute ago David, that the mineral interests, net mineral acres in Georgia and Alabama is approximately 265,000 acres. So that's an area that has historically has had no activity.

David Woodyat - Keeley Asset Management

Would it be fair to say that at least a large portion of this 622,000 net acres is located in areas where there's reason to believe that there could be some decent minerals underneath?

James D. DeCosmos

Yes. David, if you look at that [Aquatecs] Basin, if you look at East Texas and West Louisiana, that basin or region alone produces 15% of the continental US gas production. And if you look at over time where rigs have moved to and the amount of activity in the US, you'll see that that Texas and Louisiana basin is one of the most active in the US.

David Woodyat - Keeley Asset Management

And how many acres do you have in that particular area?

James D. DeCosmos

There's approximately 360,000 net mineral acres in East Texas and West Louisiana.

Operator

Your next question comes from Robert Holt - Holt Capital Partners.

Robert Holt - Holt Capital Partners

I'm trying to reconcile your interest expense which roughly tripled in the quarter with your total debt which was up only marginally and I'm guessing that there was some unusual item in the prior quarter because of your Temple-Inland ownership?

James D. DeCosmos

Yes Robert, I think you're heading in the right direction.

Christopher L. Nines

In the fourth quarter of 2007, December 14, we closed on our new credit facility $416 million. The pricing of that was LIBOR plus 400 basis points so the real impact of that incremental interest expense really didn't occur until the first quarter of 2008. In the majority of the fourth quarter of 2007, we were borrowing money from Temple-Inland on an intercompany note at a lower price.

Robert Holt - Holt Capital Partners

And does your credit facility, does 100% of that float?

Christopher L. Nines

At the end of the year it did. In the first quarter of 2008 we entered into $100 million interest rate swap at a rate of 6.57% so as you look at the outstandings today, everything floats except the $100 million at 6.57%.

Robert Holt - Holt Capital Partners

If I just do the quick math of a $465 million facility and $285 million of debt outstanding at the end of the first quarter, does that imply that your maximum appetite for acquisitions would be $180 million?

Christopher L. Nines

Well, that's certainly what's available under our facility but as we look at growing the business, and Jim will talk about this, there are many ways we can grow and acquire assets either wholly-owned by using our balance sheet, but ultimately we can use strategic capital partners and venture partners to grow the business as well.

Robert Holt - Holt Capital Partners

In terms of real estate acquisitions using all those various methods, can you give us a general range of order of magnitude of deals that you might be looking at?

James D. DeCosmos

Let me respond to that. It's very difficult to give you an order of magnitude or a range, size, number of deals, what they may look like, I think it's really going to be determined by what the market has to offer. So I think it would be a little bit presumptuous to say that it's one or two large deals or it's a number of smaller deals.

We do believe that there are going to be some attractive opportunities in front of us in this phase of the cycle, yet I would tell you that we're going to be opportunistic as it aligns with our strategy which is in specific markets as well as the right products that we can create value with. Chris alluded to the sources of capital, we're very well connected to the markets in the right places to make sure that we're seeing the opportunities in a timely fashion of the right product with what we believe to be an appropriate level of discount or distress.

Robert Holt - Holt Capital Partners

And most of those properties would be somewhere close to the development process or in the entitlement process I assume, instead of more rural forest land that might have some minerals underneath it?

James D. DeCosmos

I think that's generally an accurate statement.

Operator

There are no further questions in the queue.

James D. DeCosmos

I'd just like to thank everybody for joining us this morning and your interest in Forestar. As I said in the prepared comments, we are very encouraged by the position of our business today even though the markets are difficult. We'll continue to stay in touch. If there are any further questions, we'd encourage you to certainly give Chris Nines a call, who wears a number of hats. In addition to being the Chief Financial Officer, he also handles investor relations for us. So that's the end of the call, and we wish everybody a good day.

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Source: Forestar Real Estate Group Inc. Q1 2008 Earning Call Transcript
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