Afternoon, welcome to Forestar's third quarter 2021 earnings conference call. 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. I will now turn the call over to Katie Smith, Director of Finance and Investor Relations for Forestar.
Thank you, Paul, and welcome to our call to discuss our results for the third quarter of fiscal 2021. Before we get started, today's call includes forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Although Forestar 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 Forestar on the date of this conference call, and we do not undertake any obligation to update or revise any forward-looking statements publicly. Additional information about factors that could lead to material changes in performance is contained in Forestar's annual report on Form 10-K and its most recent quarterly report on Form 10-Q, both of which were filed with the SEC.
This afternoon's earnings release can be found on our website at investor.forestar.com, and we plan to file our 10-Q early next week. After this call, we will post an updated investor presentation to our investor relations site under events and presentations for your reference. I will turn the call over to Dan Bartok, our CEO.
Thank you, Katie, and good afternoon, everyone. In addition to Katie, I am pleased to be joined on the call today by Jim Allen, our Chief Financial Officer, and Jessica Hansen, D.R. Horton's Vice President of Investor Relations. The Forestar team delivered an outstanding third quarter. We have built our team quickly, and they have done an amazing job of executing on our development projects and identifying attractive investment opportunities. We accelerated our development activities last year, and now that those lots are beginning to deliver, it has put us in a position to capitalize on the significant market demand for finished lots. This resulted in significant revenue growth and margin expansion, creating meaningful value for our shareholders. Our development teams and contractors continue to execute solidly, positioning us for long-term profitable growth.
We have delivered over 11,000 lots to home builders fiscal year to date, enabling us to increase our expected deliveries for fiscal 2021 to between 15,500 and 16,000 lots. Executing on our plan is delivering measurable results. Our third quarter gross profit margin increased 610 basis points year-over-year to 17.8%. Several factors contributed to this quarter's gross margin improvement. The demand for developed lots remains incredibly strong as home builders bolster their inventory positions to meet sales demand. This, combined with our strategy of pricing lots closer to the time of delivery, enabled Forestar to take advantage of favorable market conditions when setting finished lot prices in select markets. We also made further progress in delivering more lots from Forestar sourced projects, and we continue to reduce our exposure to lot banking. We are committed to our returns-focused business model.
Our high turnover, low risk manufacturing strategy led us to achieve a 10% return on equity for the trailing 12 months ended June 30th, 2021. This was a 390-basis point improvement year-over-year and our fifth consecutive quarter of ROE improvement. We expect to continue to increase our returns on equity and inventory as our platform gains additional maturity and scale and our team captures increased share in their respective markets. Jim will now discuss our third quarter results in more detail.
Thank you, Dan. In the third quarter, Forestar's net income increased 56% to $15.8 million, or $0.32 per diluted share, compared to $10.1 million or $0.21 per diluted share in the prior year quarter. For the quarter, revenues increased 76% from the prior year to $312.9 million. We sold 3,858 residential lots during the quarter, an increase of 91% year-over-year. The average lot sales price for the quarter was $80,700. 86% of lots sold in the quarter were from development projects, up from 77% in the same quarter in 2020. Lots sold to D.R. Horton during the quarter represented 96% of Forestar's total lots sold, down from 98% in the third quarter of fiscal 2020. We sold lots to 8 builders other than D.R. Horton during the third quarter this year, up from 4 builders in the same quarter last year. Dan?
Our pre-tax income in the third quarter increased 105% to $21.1 million, with a pre-tax profit margin of 6.7%. As previously announced, during the quarter we refinanced our 8% senior notes due in 2024 with 3.85% senior notes that mature in 2026. As a result of the redemption, we recognized a loss on extinguishment of debt of $18.1 million.
However, the refinancing transaction resulted in substantial interest savings. Excluding that $18.1 million charge, our pre-tax income increased 281% to $39.2 million, and our pre-tax profit margin improved 670 basis points to 12.5%. In the third quarter, our gross profit margin increased 610 basis points to 17.8%, from 11.7% in the prior year quarter. The improvement was primarily due to increased margins on lot sales from development projects, which was largely driven by capitalizing on the strong demand for finished lots. We continue to expect fluctuations in our gross and pre-tax margins due to the quarterly mix of our lot deliveries and the timing of track sales. SG&A expense as a percentage of revenues in the third quarter was 5.4%, an improvement of 90 basis points from 6.3% in the prior year quarter.
We remain focused on efficiently managing our SG&A expenses as we build out our platform to support our significant growth. We believe we will continue to manage our business at a mid-single digit SG&A %. Katie?
Forestar's underwriting criteria for new development projects includes a minimum 15% annual pre-tax return on inventory and a return of the initial cash investment within 36 months. During the third quarter, our investments in lots, land, and development totaled $400 million, of which roughly 40% was for land and 60% was for land development. For the fiscal year to date, our investments in lots, land, and development totaled $1.25 billion. We now expect to invest at least $1.6 billion in lots, land, and development for the full year of fiscal 2021. Forestar's lot position at June 30th increased 91% from a year ago to 96,600 lots, of which 64,200 lots are owned and 32,400 lots are controlled through purchase contracts. Of our 64,200 owned lots, 33% are under contract to sell to D.R. Horton, representing at least $1.6 billion of future revenue.
Another 28% of our owned lots are subject to a Right of First Offer to D.R. Horton under the master supply agreement. Lots sourced by Forestar continue to grow as a percentage of the company's owned lot portfolio, supporting long-term improvement in our gross margins. Of the company's owned lot position at June 30th, 51% were sourced by Forestar, up from 34% a year ago. We are continuing to target a three-to-four-year owned inventory of land and lots. Jim?
Forestar remains focused on maintaining a strong balance sheet with ample liquidity and modest leverage. We ended the quarter with $470 million of liquidity, including $120 million of unrestricted cash and $350 million of available capacity on our revolving credit facility. Total debt at June 30th was $704 million, and our net debt to capital ratio at quarter end was 37.8%. As previously announced, during the quarter, we amended our revolving credit facility to increase the facility size to $410 million and extended the maturity date from 2022 to 2025. At June 30th, stockholders' equity was $970 million, and our book value per share increased to $19.58, up 11% from a year ago. Dan?
Looking ahead, we remain confident in the outlook for our business. Continued execution of our strategic and operational plan, supported by favorable market tailwinds across our diverse national footprint, positions Forestar for further success. Forestar is uniquely positioned to gain market share through housing market and economic cycles in the highly fragmented lot development industry. Based on our results for the fiscal year to date and current market conditions, we now expect to deliver between 15,500 and 16,000 lots, generating approximately $1.3 billion of revenue in fiscal 2021. We are now expecting our pre-tax profit margin for the full year of fiscal 2021 to be in the range of 11.5%-12%, excluding this year's $18.1 million loss on extinguishment of debt. Additionally, we expect our tax rate for the full fiscal year to be approximately 25%, which does imply a tax rate of approximately 26% for the fourth quarter.
Before we turn to questions, I'd like to remind everyone of Forestar's investment highlights. We have a unique lot manufacturing business model that is very different from a typical land developer. We have no unentitled land. We are focused on developing lots for the affordably priced housing market. We have a seasoned management team that is experienced in consolidating market share and in navigating through market cycles. We have a strong balance sheet and liquidity position with low net leverage. We have been increasingly profitable and are managing our business to a mid-single-digit SG&A percentage. Most importantly, we have a unique competitive advantage due to our relationship with D.R. Horton, the nation's largest builder. This highly strategic relationship allows us to expand our platform nationally while minimizing risk. To summarize, we are continuing to execute on our plan and are positioned for continued success.
Paul, at this time, we'll now open up the line for questions.
Thank you. We will now be conducting a question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would 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. One moment please while we poll for questions. Thank you. Our first question comes from Ryan Gilbert with BTIG. Please proceed with your question.
Hi, everyone. Thanks for taking my questions. The first question is just on, I guess, the overall market. Dan, I'd appreciate any color or detail you can add on the demand that you're seeing from home builders. I think that there's been some concern in the market that home buyer demand is leveling off a bit, and maybe there's a sense that that might be bleeding back into the land market, although from your results, that certainly doesn't seem to be the case. Just any color or details that you could give us on demand from home builders would be helpful.
As it relates to what home builders are seeing, I don't really have strong visibility as to whether they're really seeing a fall-off in demand. What I know is that they have a hunger for lots that seems to be, at this point at least, insatiable. Our number of finished lots that we have in our inventory actually went down this quarter, even though we delivered really strong lot deliveries. As fast as we can deliver them, they're buying them, and obviously based on our guidance for the rest of the year, we expect the fourth quarter to be a record breaker for us. At this point, we're not seeing any lack of demand from home builders that want to buy lots. I think one of their constraints is the ability to get lots to build houses on.
Okay, great. Thank you. The second question is just on 2022. I think you've discussed a 20% sustainable growth rate, with no additional capital needed on the balance sheet going forward, and that's kind of how I've been thinking about 2022. Your land bank is up 91% year-over-year, so it seems like you have the lots in place to do better than 20% growth. Do you think you can produce ahead of that growth rate in 2022, or would any color on 2022 be helpful?
Yeah. At this point, it's probably too early to give any real guidance for next year, although we thought about it a lot preparing for this call, and I'm not backing off that 20%. I feel very good that we will be able to hit that 20% growth rate, based on the lots that we have under development today. Obviously, market conditions are strong right now, and we hope that those continue. At this point, I feel really good about that 20% guidance, Ryan. As I said, I think next quarter, we're going to try to tighten that up and give you some better color going forward.
Okay, great. Then my last question is just on pricing. It looks like your average selling price is pretty flat sequentially from the second quarter. I'm assuming that's mostly mix, but maybe you can just talk about what you're seeing in the market in terms of finished lot price appreciation and how that compares to the pricing of undeveloped lots.
Yeah, it's mixed. We are definitely seeing some pricing power. I think that showed up in the margins. As you remember, last quarter, we were probably guiding you down for the rest of the year, and we were able to overachieve on that. We are definitely seeing strength, but we really, again, look at every project on a project-by-project basis and think about the returns that we're trying to achieve. We're really looking at velocities and making sure that as we believe there's pricing power there, we're being very careful not to hamper the affordability of the house lot package. Again, I felt really good about the quarter, obviously better than we probably had anticipated for the quarter in pricing power. I'm really looking forward to seeing what the future brings as we say we have a lot of lots under development right now.
Okay, great. Thanks very much.
Thank you. Our next question comes from Anthony Pettinari with Citi. Please proceed with your question.
Good afternoon. Can you talk a little bit about what drove the change in lot delivery guidance, I guess 1,000 units at the midpoint? How much of the raised guidance was Q3 deliveries above maybe your internal expectations versus sort of the outlook for the balance of the year?
Yeah, I don't know that I have a specific number of what was delivered in the third quarter versus the fourth quarter. I think it's probably more driven by fourth-quarter expectations. There's been a lot of talk in the market, at least from our perspective, of delays in being able to get certain materials. There have been potential delays in getting projects completed. We are very careful in making sure what guidance we give, we're comfortable with. As this quarter has unfolded and we see where we're at on deliveries for next quarter, it made us comfortable in raising that guidance. I feel really good about what we're seeing for the next quarter.
Okay. That's very helpful. Then, in terms of just sort of hitting the higher or lower end of guidance, do you think it's mostly a function of demand materializing on the part of the builders, or maybe just timing? Is it sort of those maybe labor, permitting, material-related bottlenecks that are driving the greatest risk to the upside and the downside?
Yeah, I think the risk of upside versus downside is really on the delivery side. We have not seen any falloff in demand for lots. If anything, I think the demand has increased, which again, has given us a little bit of pricing power. I think it's predominantly based on the ability to complete those projects that we see hitting substantial completion this quarter and being able to deliver those lots.
That's very helpful. Maybe just one quick follow-up. In terms of cycle times, it seemed like you were able to sort of accelerate cycle times in the wake of the pandemic because of some looseness in the labor markets. Obviously, that's probably tightened quite a bit. In terms of cycle times, where do they stand now? Are they stable, improving, or perhaps deteriorating? Just any color you can give there.
I think, as compared to where they were six months ago, we are definitely seeing cycle times extend. Again, you're right. We were able to kind of accelerate cycle times when we really stepped on the gas earlier last year when a lot of people were not. It's really into lots of things. It's delivery of certain materials. It's the ability to get inspections. A little bit has been weather. I always hate to use weather, but it's been a pretty rainy season in certain parts of the country. We're definitely seeing an extension, but probably back to more what was normal for us a year ago or a year and a half ago. Extended definitely from earlier this year.
Okay. That's helpful. I'll turn it over.
Thank you. Our next question comes from Deepa Raghavan with Wells Fargo Securities. Please proceed with your question.
Hey, good evening, Dan, Jim, and Katie. Thanks for taking my question. Just following up, I'm trying to get a little bit more clarity on the kind of growth you're experiencing, but also trying to manage your operations for that level of growth. Are there any new challenges that cropped up this quarter? You mentioned a little bit about the cycle time, but labor seems like it should be more of a challenge, just given the way you're growing. I'm just curious, did anything new actually crop up this quarter, any new challenges? If you can generally talk about how you're managing this kind of growth, especially with regards to operations, that would be pretty helpful.
I guess I'll start with the second question or second part of your question first. We have been planning for our growth for quite a while and have been staffing up pretty considerably. We've almost doubled our headcount from a year ago, really preparing for the volumes that we have today. From a labor standpoint for Forestar itself, I think we're very well positioned to continue to execute on our business plan. Obviously, we'll need to continue to add staff as we continue down the growth path. As it relates to our operators and getting projects completed, again, to some extent, I feel very fortunate. We're not really seeing any delays related to the contractors not being able to get people on the jobs to complete them.
We are hearing that they're having more turnover where operators are moving to another operator for two extra dollars an hour. They've been able to replace those people, so we feel good about that. Probably the one thing that I would say, last quarter, I was talking about hearing about shortages in material. We are starting to experience some delays in getting things like fittings to put PVC pipe together. We have seen some delays related to concrete allocations, not being able to get full-day pours in on certain projects where you're kind of limited in the amount of concrete you can pour. I think some of the things that last quarter we were hearing about, we are starting to see some impact of, but nothing that at this point has been dramatic. Again, I think we're trying to stay ahead of the curve.
We're making sure materials are ordered earlier in the process than would normally have been appropriate. Part of it is relying on really good contractors. Our customer base is strong, and our contractor base is strong, and we've aligned ourselves with, I think, some of the best people in the various markets. That has, I think, been very beneficial for us.
Okay, that's helpful. My second question is on the lot price increases. It's kind of flattish, but still, the trajectory is not down or inflected. It's already at $80K. Is this where you're starting to see it stabilize a bit at this point in time, or do you think the backdrop is still pretty strong demand-wise, and there's still a supply imbalance? I think, in all fairness, the expectation is lot prices still have more to run. They're not stabilizing here. From your side, are you taking any steps? Are you undertaking any measures to keep that average lot pricing under a certain affordability threshold? How are you thinking about that?
Well, we think about it on a project-by-project basis. We really look at the sales velocity that the builders are experiencing in those projects, or in the case of a new project, what we think is a comparable project. We try to make sure that we're balancing price versus velocity. At this point, even with an average sale price of a little over $80,000, we still think it keeps us in those affordable price points. An interesting fact is, even though our average is $80,000, our median price is closer to $70,000. Over half of the lots that we sell are under $70,000, which again, I think really sets us up well for that affordable price house today.
Yeah, as far as just trying to manage, it's probably where we spend a significant amount of time: on a project-by-project basis as we're setting prices and trying to negotiate appropriate pricing, is making sure that we're keeping velocity to keep our returns high.
All right, my final one. Any updates on how July is trending so far? Just curious, and I'll leave it there. Thank you.
As of July, again, we're issuing our guidance today for the full year, which again, implies a record-breaking quarter for us in lot deliveries. At this point, as I sit here on July 20th, I feel really good about July, and I feel really good about the next two-plus months ahead of us.
Thanks so much. I'll pass it on.
Thank you. Our next question comes from Truman Patterson with Wolfe Research. Please proceed with your question.
Hey, good afternoon, everyone, and thanks for taking my questions. I just wanted to touch on your balance sheet and kind of spending going forward. You're approaching that 40% net debt to total capital threshold. Your own lots, over 64,000, are four years owned, if you look at kind of 2021 closings. I guess, going forward, assuming that development work takes up a decent amount of net working capital, right, are you all comfortable going above that 40% threshold? Should we just expect your lot acquisition to start to moderate a little bit over the next, we'll call it, 6-12 months?
Well, our sales velocity should continue to accelerate. The need to replace the existing lots will be there. As far as whether I am comfortable going over 40%, we're really managing to that 40% number. It may trend over 40% for a while, but our goal will be to bring it back down. It's still about finding those projects that we believe fit our operating model and our underwriting requirements. Frankly, it's also a little bit harder to find those with as many other people that are out there trying to bid up the price of land, especially in those smaller, shovel-ready projects. There may just be fewer that fit our underwriting requirements today anyway. I feel good about our pipeline. I think that we're going to be very careful in making sure that we're only buying projects that we think are really good, solid projects.
Again, we're going to guide to that 40%. We don't look to exceed 40 for very long or by very much if that happens at all.
Okay. You all are finding lots that are hitting your underwriting. There is clearly some lot pricing power in the market right now, very strong builder demand in your markets. When I look back at the past couple quarters, gross margin in that 18% range, same thing, just looking at your guidance, it seems like it will be at least in that range. Is it safe to assume, just given the kind of tailwinds in the market, that this is kind of a new normal that we should see at least maintain out into 2022? Are there any big items that we need to think about?
We're still maturing our portfolio. I think you're still going to see some fluctuations from quarter to quarter. I wouldn't take that 18% as a run rate. I think what I've now done, at least to myself, and I think maybe to you folks as well, is show that we can actually hit 18% more than just once, which is really good. If it were me, I wouldn't be betting that I'm going to do that every quarter for the next umpteen quarters. Hopefully, that will happen. I can't say that it's impossible. The market's still the market, and I have to make those pricings fit the market. We were really fortunate when you really think back a year ago, and we had those quarters—was it our first quarter of the year or maybe last quarter, when we bought a lot of land.
It was really outsized for us, and it was before all these prices ran up. Whether it was luck or just that we were really smart people, we bought a lot of land at a really good point in the market and feel really good about the inventory that we have.
Truman, as you've heard Dan and the team say over and over, the focus is more on returns than on gross margins. They've reported a fifth consecutive quarter of improvement in ROE, and the gross margin will be what it will be based on market conditions, but they're going to maximize their portfolio to drive the best possible return.
Okay. Fair enough. Then just a final one from me. There's been a lot of talk already on the call about very strong demand, and builders are basically short lots right now. Just hoping you could give a little more color. Are there any markets that you're scaling back investment? Just any metros where you perceive a bit of a frothy land environment, or are there any markets where you're starting to see or hear builders push back a little bit or their appetite for lots soften a little bit?
Yeah, I don't think there's really anywhere we're seeing a slowdown in demand. When our investor presentation decks get published and you compare our map against the map last quarter, you'll probably see we have less exposure in the Pacific Northwest than we did before. Again, further increased exposure in Florida and in Texas. Our focus has been on markets where we know we can get velocity, and are hopefully not as governmentally regulated as other markets, where we can have a more plannable and deliverable lot timeframe. Again, it's not from lack of demand, it's more from looking at opportunities and making sure that the projects that we're underwriting, we can deliver on. I'd say you will see less allocation of our dollars and lots into the Pacific Northwest right now.
Okay. Thank you, and good luck on the upcoming quarter.
Great. Thanks, Truman.
Thank you. Our next question comes from Michael Rehaut with JP Morgan. Please proceed with your question.
Hi, this is Maggie, on for Michael. Thanks for taking my questions. I was hoping to zero in a little bit on the gross margins this quarter. You listed several factors driving the upside: demand, pricing the lots closer to delivery, and delivering more Forestar-sourced lots. I was wondering if you could maybe rank order the different drivers of that upside and perhaps give a little more color there.
Oh, boy. Rank order. That's a tough one. What I can say is, if I had to pick the top two, it would be Forestar-sourced transactions where we didn't price earlier in the transaction, and strong market demand. We happened to be in a position last quarter where we were delivering lots that had been recently priced into the market strength. Again, a lot of that is driven by Forestar-sourced transactions versus builder-sourced transactions. We're growing our portfolio in that area. Now, over 51% of the lots that we own are in Forestar-sourced transactions.
Got it. Thanks. Second, just on SG&A, I know you spoke to a mid-single-digit range. I know in the past you had talked about maybe being comfortable in the the 5%-6% range, so mid-single digits. As we look forward into 2022 and the next few years, can you talk about the ability to continue to see some leverage on that line, and how we should be thinking about SG&A over the more medium to longer term?
Yeah, I think 5% is a pretty darn good rate, at least the way I was brought up, and I think that we can manage that. Is it going to be 6? Is it going to be 4? I think you'll see some variability quarter-over-quarter based on volumes. As far as whether it can be leveraged further, I think as our platform continues to mature and scale up, you will probably see some leverage, but I don't know that I could quantify that for you today.
Got it. Thank you.
Thank you. Our next question comes from Alex Barron with Housing Research Center. Please proceed with your question.
Yeah. Thanks for taking my question. I was hoping you could help me understand how sensitive your lot prices are relative to home prices. In other words, if home prices start to move up, as they have in the last couple of quarters, how quickly could you reprice your lots? Are the lots priced as a function of the home price, or is there some other metric you guys are using? Thanks.
Well, I think as far as our ability to continue to move up lot prices, it is probably more based on the builders' margins than it is on the house price itself. Obviously, they're trying to manage with certain margins themselves, and if I can squeeze some of that increased margin out of it, I will. As far as metrics, we don't have any kind of true-up based on a percentage of the house price. That's not the way we're pricing our lots. We do our best to try to get a sense of what the market pricing is in an area. Really, it's focused on project by project, trying to understand that balance between velocity and pricing, and hitting that number where we're really maximizing our returns on our invested dollars.
Got it. If I could ask another question about materials. As you mentioned, builders have been facing various material supply chain issues, and I think I heard you mention concrete. I was curious if you could give us a sense of whether you guys are experiencing shortages of concrete, and if so, is it just in one market or is it pretty widespread across the country?
It is really in only certain isolated markets, basically a couple of things that we're seeing delays on, and that is in some places we are seeing concrete allocations where you're only allowed so much concrete per day as they're allocating out to their various jobs. Again, it's not widespread. It's only in certain locations. The other thing that we're seeing, again, more delays on is pipe fittings. We're able to pretty much get pipe, but it's the fittings that put the sections of PVC pipe together. There seems to be a shortage of that.
My understanding is that a lot of that is being manufactured in India, and because of some of the COVID issues in India, those factories have either been closed down or are operating only marginally. This has created somewhat of a shortage for those fittings, at least from the suppliers that we're getting things through. We've still been able to get them. We're trying. We've learned to order them earlier in the process. In some cases, we have had some delays in getting them to the job site. Again, it's pretty isolated. Some of our contractors inventory more things than others. Some of them only buy to outfit your job. It isn't that widespread, but these are things that we're seeing.
Thank you very much.
Thank you. There are no further questions at this time. I would like to turn the floor back over to Dan Bartok for any closing comments.
Thank you, Paul, and thanks to everyone on the Forestar team for your focus and hard work. It was a great quarter. 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. We look forward to speaking with you again in November to share our fourth-quarter and full-year results. Thank you.
This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful evening.