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Forestar Real Estate Group Inc. (NYSE:FOR)

Q2 2008 Earnings Call

August 6, 2008 10:00 am ET

Executives

Christopher L. Nines - Chief Financial Officer

James M. DeCosmo - President, Chief Executive Officer and Director

Analysts

Mark Winetraub - Buckingham Research

[Analyst for Ben Lawrence - Suttonbrook]

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 second quarter 2008. Joining me this morning is Jim DeCosmo, President and 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 this presentation. This morning Jim DeCosmo and I will provide an update on our value creation activities for second quarter 2008. At the completion of the presentation we will be happy to take your questions. Thanks for your interest in Forestar Real Estate Group.

I’d now like to turn the call over to Jim.

James M. DeCosmo

Good morning and welcome to the call and the webcast. Before Chris reviews the financials, I want to make a few comments relative to the quarter current state of business in the markets.

With regard to housing markets my comments certainly won’t be a surprise. The markets continue to slow and are best characterized by poor buyer and builder sentiment, tightening mortgage requirements, minimal credit availability, high inventories and foreclosure rates. Fortunately, the majority of our active projects are in the major markets of Texas where we continue to generate sales albeit at a slower rate and our prices are stable. Given our mix of markets, a low basis portfolio, natural resources and a healthy balance sheet we’re well positioned for this phase of the cycle.

As you would expect, record oil and elevated gas prices in the second quarter generated significant activity in our mineral assets. We’ll provide additional detail and commentary in upcoming slides.

The distress in the housing and the financial markets are expected to create acquisition opportunities. There were no projects acquired in the quarter. To date there have been very few distressed properties priced at levels that meet expected returns. Generally speaking bid and ask spreads are still too wide.

In the next few slides I’ll briefly comment on our performance related to our strategy. In the second quarter we saw just over 500 undeveloped acres at an average price of approximately $5,900 an acre. As you’d expect in today’s market, most sales are all cash. Very little financing is available which limits the buyer pool. We moved 4,500 undeveloped acres into the entitlement process and we secured entitlements on 2,000 acres with a solid mix between residential and commercial uses. Real estate sales were 264 lots at an average price of $55,000 per lot and 47 commercial acres at an average price of just over $271,000 per acre. We continue to stay focused and advance execution of our real estate strategy.

In the second quarter we leased approximately 47,000 acres and were granted an option on another 17,000 acres. A map illustrating the location of activities is provided in the mineral section of our presentation. Our royalty interest generated $5.1 million in revenue and was driven by our net production of 277 million mcf of natural gas and 23,000 barrels of oil. We’re encouraged by the recent activity in the market and especially the addition of Flavious Smith who will lead our minerals business. He comes to us with an extensive experience and a proven track record in creating value through minerals, oil and gas.

Our fiber resources segment sold 218,200 tons of pulpwood and 44,000 tons of sawtimber yielding timber revenues of approximately $2.6 million. Our objective is to maximize timber revenues while enhancing real estate values. Timber is a unique asset. Trees left on the stump continue to grow volume and value providing flexibility with regards to timing sales. With this flexibility we’ll meet our contractual agreements yet remain disciplined during down timber markets holding volume for improved conditions.

Now let me turn it back over to Chris to review financials for the quarter in comparative financial metrics.

Christopher L. Nines

Despite challenging market conditions for our real estate segment, net income for second quarter 2008 was $9.6 million or $0.27 per diluted share outstanding compared with net income of $14.4 million or $0.41 per diluted share in the second quarter 2007 and a net loss of $0.2 million or $0.01 per share in the first quarter 2008. Second quarter 2008 results reflect the benefit of our value creation strategy in maximizing the value of our natural resources by increasing leasing activity on our mineral acres.

Second quarter 2008 financial results included a $2.3 million after-tax charge or $0.06 per diluted share principally related to environmental remediation activities at our San Joaquin River project located near Antioch, California. This 288-acre site located outside of Oakland was transferred to us from Temple-Inland prior to our spinout last year. Portions of this site were used for a container-board mill which was shut and dismantled in 2002. To date we have received environmental certification of completion on approximately 180 acres and we are currently working on the balance of the site. This project is located along the San Joaquin River, a major shipping lane, and its greatest value will most likely include commercial and/or industrial uses following the completion of our remediation activities.

In addition, let me remind you that first quarter 2008 results included $1 million after-tax charge or $0.02 per share related to share-based compensation expenses for retirement eligible employees. Second quarter 2008 weighted average basic shares outstanding were 36.1 million shares.

Now let me turn to our segment results. We manage our operations through three business segments: Real estate, mineral resources, and fiber resources. Real estate secures entitlements and develops infrastructure on our lands primarily for single family residential and mixed-use communities and manages our undeveloped land in commercial properties. Our real estate segment includes about 371,000 acres of land owned directly or through ventures located in 10 states and 13 markets. Mineral resources include about 622,000 net acres of oil and gas mineral interests located in Texas, Louisiana, Alabama and Georgia. Fiber resources include the sale of wood fiber primarily in Georgia and manages our recreational leases.

Our real estate operation reported segment earnings of $0.9 million in second quarter 2008 compared with $23 million in second quarter 2007 and $3.5 million in first quarter 2008. Second quarter 2008 real estate segment results included a $3.5 million pre-tax charge associated with our environmental remediation activities at our San Joaquin River project located near Antioch, California. Second quarter 2007 segment results include a $13 million gain on the sale of commercial land. Jim will walk you through our real estate sales and entitlement activity for second quarter 2008 in a few slides.

Mineral resources reported segment earnings of $23.2 million in second quarter 2008 compared with $4.7 million in second quarter 2007 and $6.5 million in first quarter 2008. This improvement was driven principally from increased mineral leasing activity. During second quarter 2008 Forestar leased over 47,000 net mineral acres generating $18.5 million in bonus payments. Jim will provide greater transparency into second quarter 2008 mineral leasing activity and our royalty interest in a few slides.

Fiber resources reported segment earnings of $1.4 million in second quarter 2008 compared with $2.4 million in second quarter 2007 and $2.8 million in first quarter 2008. First quarter 2008 segment earnings include a $1.4 million gain associated with the partial termination of a timber lease with the Jones Company in connection with the operation of the Ironstob venture. Given current market conditions and pricing for sawtimber, we are reducing the amount of non-contracted sawtimber sales. Pulpwood prices have held up far better than sawtimber and we continue to harvest pulpwood which is consistent with our strategy to maximize fiber sales while enhancing real estate value.

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

James M. DeCosmo

Our real estate value creation pipeline’s comprised of four distinct value categories with the strategy being to create value by moving acreage and product through the value chain from left to right. At second quarter end 2008 we had approximately 319,000 low basis undeveloped acres of real estate principally located in and around Atlanta. The majority of this segment is comprised of acreage we selected from the 2 million acre land portfolio once owned by Temple-Inland. We’ve got 33,600 acres in the entitlement process, just under 15,000 acres entitled, and just over 3,500 acres in the development category yielding our real estate portfolio of just under 371,000 acres.

In addition we have an estimated 25,000 lots in the entitled category and 4,793 lots in development for a total estimated lot count of just over 29,000. Not reflected in this acreage is our 58% ownership interest in Ironstob venture which controls approximately 17,000 acres. This acreage is principally located in Paulding, Polk and Harrison Counties with Paulding being one of the fastest-growing counties in the US.

The next two slides are our real estate key performance indicators which is in essence a reconciliation of our progress in creating value by moving acreage through the pipeline. Residential lot sales were down in the second quarter 2008 yet price and profit per lot continue to hold. Over 90% of our lot sales were in the major markets of Texas which is a positive reflection of our portfolio. Texas inventories are in generally pretty good shape and prices are stable principally due to the fact that Texas didn’t experience excessive run-up in price in the first half of the decade and job creation continues to exceed the national average.

In the second quarter we sold 47 acres of commercial property for just over $271,000 an acre and 504 acres of undeveloped land at an average price of $5,900 an acre. Second quarter segment revenue and earnings were respectively $24.1 million and $0.9 million. As Chris mentioned the second quarter real estate earnings were adversely impacted by a $3.5 million pre-tax charge principally related to environmental remediation at our 288-acre San Joaquin project located near Antioch, California. The river site is comprised of two parcels: 155-acre island directly off shore from a 109-acre parcel which was historically the mill site. A separate and additional 24-acre site is located to the north. Regarding the mill site, following the remediation of environmental certification the commercial/industrial zoning, the dock facility, significant water supply and real access generate multiple options and will be key in determining the highest and best use.

Shifting to entitlement activities. In the second quarter of 2008 we moved 4,520 acres into the entitlement process more than in the second quarter of 2007 and the first quarter of 2008. The next slide provides additional project level transparency. Consistent with our strategy seven projects were moved into the entitlement process and only one is expected to be purely residential. Six of the seven will either be mixed use or commercial. Creekview, Hutchison Mill and Three Creeks are in Troup County and are targeted to capitalize on the economic expansion driven by the Kia plant which is scheduled to open early next year. The regional economy is expected to benefit from 2,700 direct jobs and an additional 10,000 ancillary jobs. We’re committed to our mission: Managing each and every acre to its greatest benefit. Entitlement work creates significant value with low capital investment. Given our low basis land and strategy, we’re competitively advantaged in the Atlanta market.

Four projects: Two residential, one mixed use and one commercial totaling 2,073 acres received entitlements in the second quarter this year. Creating value through entitlements is a core competency and a component of our strategy. Our low basis enables us to continue entitle and hold in preparation for improved market conditions. This is a distinctive advantage of our business and one which we’ll continue to leverage.

One project I’d like to highlight this quarter is the Coweta South Industrial project. The Coweta industrial park is located at the intersection of Highway 29 and I-85 with CSX rail adjoining the southern border. The site is approximately 35 miles along the I-85 corridor from both the Atlanta Airport and the Kia plant. 152 acres received entitlements in the second quarter permitting 1.1 million square feet for industrial and/or distribution uses.

Also in the second quarter we purchased 43 acres adjoining the west side of the project for approximately $10,000 an acre. The addition is currently in the entitlement process and we’ve identified it for the cross-hatching. We expect the 43 acres to be permitted for an additional 900,000 square feet yielding a total of 2 million square feet for industrial distribution of the 195-acre project; clearly a synergistic addition. South Coweta is a good example of creating multiples of value through entitlement and complementary land investment.

Shifting gears to minerals. Our mineral performance is principally driven by acres leased, bonus per acre, and royalty interests which is generally 18% to 27% of top line production revenue. Given the recent oil and gas price increases and recent success in certain plays, there has been significant activity in our mineral interests.

Leasing has generally averaged over 20,000 acres per year for the last three years. In the second quarter of this year we leased over 47,000 acres and granted options on an additional 17,000 acres. These are short-term options that if exercised will reflect market lease rates. Unexercised this acreage becomes available to the market. The next slide provides greater transparency in detail related to the second quarter leases and options. Given the magnitude of the second quarter activity and the balance of acreage available for lease, we expect near-term leasing activity to be in line with the first quarter 2008.

With just a few exceptions the second quarter 2008 mineral KPI’s segment revenue and earnings were up substantially relative to quarterly comparisons. Now the map that you see illustrates the location of our second quarter leasing and option activity and the generalized location of trends of the James Lime, Cotton Valley and the Haynesville plays. The oil and gas industry has recently experienced success in all three plays; however, the Haynesville has generated the greatest amount of press and transaction activity. The core of the Haynesville is approximately 65 to 75 miles to the north and east of any significant Forestar mineral interests. It will take time for further exploration and drilling to determine the extent and economics of the Haynesville play. Regardless, we are committed to maximizing the value created and realize from our mineral assets by leveraging our interests, engaging a new organization, and proactively participating in the oil and gas industry. In addition we’ll continue to prove our transparency and disclosures to facilitate valuation.

Fiber volume was down from the second quarter of 2007 up from the first quarter of 2008. Our price has been generally stable primarily driven by the heavy mix of pulpwood which has held price better than most classes of sawtimber. Second quarter 2008 earnings were in line with the first quarter 2008 excluding the $1.4 million gain from the partial termination of the Ironstob timber lease. We’ll continue to plant and harvest consistent with contractual commitments and market conditions.

In addition the recently passed Tree Act, part of the annual Farm Bill, is estimated to generate an annual tax benefit in the range of $1 million to $1.5 million per year based on timber harvest levels. We expect about seven months of benefit this year.

Going forward, with the majority of our active projects in the major markets of Texas, our low basis portfolio and healthy balance sheet, we’re well positioned for this phase of the cycle. Our portfolio, business model and strategy are a distinctive advantage. We’ll continue to entitle full speed ahead creating significant value and exercise discipline in investing in development, investing only in those projects and markets that will generate subsequent sales.

Our minerals are well positioned and we believe the long-term energy fundamentals are in our favor. We’ll continue to create realized value from mineral resources by leveraging our interest and engaging our new organization and proactively participating in the oil and gas industry.

In closing, the housing markets have a number of issues yet it’s these same issues that we believe will create opportunities.

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

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Winetraub - Buckingham Research.

Mark Winetraub - Buckingham Research

Can you help us understand as you are looking at the mineral rights opportunities, the tradeoff between leasing versus selling the mineral rights? Obviously International Paper announced the other day how they were selling some at De Soto which was very central to Haynesville and we’re getting a very handsome price for that. How do you look at the tradeoff between leasing it versus just actually selling it outright?

James M. DeCosmo

I think it’s a fairly standard view that we take and that if you look at minerals and their values over time and what creates the greatest value, it typically has not just been in sales. There are a number of examples where significant value was created through the leasing and the proving up of these properties prior to any sale. There’s a significant difference between our minerals today and the sale that you mentioned. That sale is in I would say the core or in a proven part of the Haynesville play. The majority of our minerals as I said in my prepared comments have yet to be proven and I think at some point in time we would consider those alternatives. I would say today it’s much too early.

Mark Winetraub - Buckingham Research

If I understand correctly, basically since you don’t really have proven plays it doesn’t make a lot of sense to be selling them. So when we see on the map for instance on page 17, which is great, and we see that there are “held by production,” how does that distinguish from proven or how should we understand to differentiate between potential values of headline numbers we see out of for instance the International Paper sale and what we see on this chart here?

James M. DeCosmo

The held by production is a term that’s used to indicate that there is production on those properties by active production in sales of wells. One thing you’ve got to understand is that the penetration of these wells may be in a certain formation; they could be 7,000 feet or 9,000 feet; it could be in a younger formation; whereas there’s real potential value at a deeper formation. If you look at that chart and you see a James Lime and Cotton Valley and Haynesville, they could all be under the same surface acre at various depths. So that production is related to one of the formations so we would tell you yes, there is production there. Has the greatest value been realized? We believe not.

Operator

Our next question comes from Analyst for Ben Lawrence - Suttonbrook.

[Analyst for Ben Lawrence - Suttonbrook]

I just want to follow up on that same page again. It seems that given the [inaudible] of Haynesville I just want to see how many acres you have there and if you have the mineral rights at all those acres? I want to see how many acres in particular you own in the Haynesville Shale and whether you own mineral rights in all of those acres.

James M. DeCosmo

Currently in the active Haynesville Shale play we do not own any acres. As I said in my remarks we’re currently about 65 to 75 miles from the most active part of the Haynesville play. As I said, it’s going to take time to see if this acreage is going to produce with the Haynesville but that’s going to take exploration and drilling to prove that up.

That’s the last question. Once again we want to thank you for your time this morning and interest in Forestar. And we wish everybody the best of the day.

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Source: Forestar Real Estate Group Inc. Q2 2008 Earnings Call Transcript
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