UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2008

o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from _________ to _________

FORESTAR REAL ESTATE GROUP INC.

(Exact Name of Registrant as Specified in Its Charter)

Delaware		26-1336998
(State or Other Jurisdiction of		(I.R.S. Employer
Incorporation or Organization)		Identification No.)

(Address of Principal Executive Offices, Including Zip Code)

(Registrant’s Telephone Number, Including Area Code)

     Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

          Yes þ   No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

          Yes o   No þ

     Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

		Number of Shares Outstanding as of
Title of Each Class		July 31, 2008
Common Stock, par value $1.00 per share		35,676,531

 

 

FORESTAR REAL ESTATE GROUP INC.
TABLE OF CONTENTS

PART I — FINANCIAL INFORMATION			1
Item 1. Financial Statements			1
Consolidated Balance Sheets			1
Consolidated Statements of Operations			2
Consolidated Statements of Cash Flows			3
Notes to the Consolidated Financial Statements			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
Item 3. Quantitative and Qualitative Disclosures About Market Risk			24
Item 4T. Controls and Procedures			24
PART II — OTHER INFORMATION			25
Item 1. Legal Proceedings			25
Item 1A. Risk Factors			25
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3. Defaults Upon Senior Securities			25
Item 4. Submission of Matters to a Vote of Security Holders			25
Item 5. Other Information			25
Item 6. Exhibits			25
SIGNATURES			26
Certification of CEO Pursuant to Section 302
Certification of CFO Pursuant to Section 302
Certification of CEO Pursuant to Section 906
Certification of CFO Pursuant to Section 906

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

FORESTAR REAL ESTATE GROUP INC.

		(Unaudited)
		June 30,				December 29,
		2008				2007
		(In thousands)
ASSETS
Cash and cash equivalents		$	7,762			$	7,520
Real estate			582,800				552,210
Investment in unconsolidated ventures			112,178				101,687
Timber			53,201				54,593
Receivables, net			4,439				3,767
Prepaid expense			2,421				2,267
Property and equipment, net			1,835				1,568
Deferred tax asset			8,193				5,106
Other assets			20,014				20,008
TOTAL ASSETS		$	792,843			$	748,726
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable		$	8,288			$	8,002
Accrued employee compensation and benefits			1,963				3,857
Accrued interest			1,250				896
Accrued property taxes			5,822				4,459
Other accrued expenses			15,023				15,318
Other liabilities			10,561				8,349
Debt			297,024				266,015
TOTAL LIABILITIES			339,931				306,896
COMMITMENTS AND CONTINGENCIES
MINORITY INTEREST IN CONSOLIDATED VENTURES			7,985				8,629
STOCKHOLDERS’ EQUITY
Preferred stock, par value $0.01 per share, 25,000,000 authorized shares, none issued			—				—
Common stock, par value $1.00 per share, 200,000,000 authorized shares, 35,707,632 issued at June 30, 2008 and 35,380,385 issued at December 29, 2007			35,708				35,380
Additional paid-in capital			376,240				373,026
Retained earnings			34,153				24,795
Accumulated other comprehensive income			664				—
Treasury stock, at cost, 85,801 shares at June 30, 2008			(1,838	)			—
TOTAL STOCKHOLDERS’ EQUITY			444,927				433,201
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	792,843			$	748,726

Please read the notes to the consolidated financial statements.

FORESTAR REAL ESTATE GROUP INC.
Consolidated Statements of Operations
(Unaudited)

		Second Quarter								First Six Months
		2008				2007				2008				2007
		(In thousands, except per share amounts)
REVENUES
Real estate sales		$	17,061			$	40,304			$	39,851			$	61,571
Commercial operating properties and other			7,057				7,013				12,710				13,312
Real estate			24,118				47,317				52,561				74,883
Mineral resources			24,386				5,186				30,654				9,040
Fiber resources and other			3,093				3,782				5,605				6,818
			51,597				56,285				88,820				90,741
EXPENSES
Cost of real estate sales			(8,479	)			(13,708	)			(21,986	)			(26,372	)
Cost of commercial operating properties and other			(4,564	)			(4,862	)			(8,429	)			(8,810	)
Cost of fiber resources and other			(925	)			(443	)			(1,471	)			(1,822	)
Other operating			(13,833	)			(6,133	)			(22,134	)			(15,312	)
General and administrative			(5,947	)			(4,759	)			(12,784	)			(9,420	)
			(33,748	)			(29,905	)			(66,804	)			(61,736	)
OPERATING INCOME			17,849				26,380				22,016				29,005
Equity in earnings of unconsolidated ventures			2,018				1,478				3,552				2,977
Minority interest in consolidated ventures			(530	)			(2,595	)			(1,030	)			(4,029	)
Interest expense			(5,002	)			(2,534	)			(10,668	)			(4,241	)
Other non-operating income			72				52				154				112
INCOME BEFORE TAXES			14,407				22,781				14,024				23,824
Income tax expense			(4,811	)			(8,349	)			(4,666	)			(8,731	)
NET INCOME		$	9,596			$	14,432			$	9,358			$	15,093
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
Basic			35,422				35,380				35,390				35,380
Diluted			36,117				35,380				36,098				35,380
NET INCOME PER COMMON SHARE
Basic		$	0.27			$	0.41			$	0.26			$	0.43
Diluted		$	0.27			$	0.41			$	0.26			$	0.43

Please read the notes to the consolidated financial statements.

FORESTAR REAL ESTATE GROUP INC.
Consolidated Statements of Cash Flows
(Unaudited)

		First Six Months
		2008				2007
		(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	9,358			$	15,093
Adjustments:
Depreciation and amortization			3,467				1,323
Deferred income taxes			(3,443	)			(1,593	)
Equity in earnings of unconsolidated ventures			(3,552	)			(2,977	)
Distributions of earnings of unconsolidated ventures			883				1,593
Minority interest in consolidated ventures			1,030				4,029
Distributions to minority interests			(2,980	)			(4,447	)
Share-based compensation			3,528				1,542
Non-cash real estate cost of sales			20,863				21,478
Real estate development and acquisition expenditures			(50,834	)			(85,309	)
Reimbursements from utility or improvement districts			374				1,047
Other changes in real estate			(290	)			(1,671	)
Gain on termination of timber lease			(1,376	)			—
Cost of timber cut			1,258				1,952
Deferred income			2,331				—
Asset impairments			—				1,500
Other			(821	)			930
Changes in:
Receivables			9				1,227
Prepaid and other			(794	)			(341	)
Accounts payable and other accrued liabilities			273				6,253
Net cash used in operating activities			(20,716	)			(38,371	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Property, equipment, software and reforestation			(1,368	)			(1,744	)
Investment in unconsolidated ventures			(11,339	)			(2,202	)
Return of investment in unconsolidated ventures			4,375				2,800
Proceeds from sale of assets			—				657
Net cash used in investing activities			(8,332	)			(489	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of debt			(39,547	)			(6,828	)
Additions to debt			70,556				26,498
Note payable to Temple-Inland, net			—				24,718
Dividends and other transfers to Temple-Inland			—				(7,513	)
Deferred financing fees			(1,078	)			—
Exercise of stock options			872				—
Payroll taxes on restricted stock and stock options			(1,832	)			—
Tax benefit from share-based compensation			81				—
Other			238				726
Net cash provided by financing activities			29,290				37,601
Net increase (decrease) in cash and cash equivalents			242				(1,259	)
Cash and cash equivalents at beginning of period			7,520				10,350
Cash and cash equivalents at end of period		$	7,762			$	9,091

Please read the notes to the consolidated financial statements.

FORESTAR REAL ESTATE GROUP INC.
Notes to the Consolidated Financial Statements
(Unaudited)

Note 1 — Background

     Prior to December 28, 2007, we were a wholly-owned subsidiary of Temple-Inland Inc. On December 28, 2007, Temple-Inland distributed all our issued and outstanding shares of common stock to its stockholders, and at the same time distributed to its stockholders all the issued and outstanding shares of common stock of Guaranty Financial Group, Inc., another wholly-owned subsidiary of Temple-Inland that operated its financial services business. As a result of the spin-off, our financial statements prior to 2008 reflect the historical accounts of the real estate development, minerals and fiber operations contributed to us and have been derived from the historical financial statements and accounts of Temple-Inland. In 2008, we changed our fiscal year from a 52/53 week year ending the Saturday closest to December 31 to a calendar year.

Note 2 — Basis of Presentation

     Our consolidated financial statements include all subsidiaries, ventures and other entities in which we have a controlling interest, and variable interest entities of which we are the primary beneficiary. We eliminate all material intercompany accounts and transactions. Minority interest in consolidated entities is recognized before income taxes. We account for our investment in other entities in which we have significant influence over operations and financial policies using the equity method (we recognize our share of the entities’ income or loss and any preferential returns and treat distributions as a reduction of our investment). We account for our investment in other entities in which we do not have significant influence over operations and financial policies using the cost method (we recognize as income distribution of accumulated earnings).

     We prepared our unaudited interim financial statements in accordance with U.S. generally accepted accounting principles and Securities and Exchange Commission requirements for interim financial statements. As a result, they do not include all the information and disclosures required for complete financial statements. However, in our opinion, all adjustments considered necessary for a fair presentation have been included. Such adjustments consist only of normal recurring items unless otherwise noted. We make estimates and assumptions about future events. Actual results can, and probably will, differ from those we currently estimate including those related to allocating costs to real estate and measuring assets for impairment. These interim operating results are not necessarily indicative of the results that may be expected for the entire year. For further information, please read the financial statements included in our 2007 Annual Report on Form 10-K.

     Certain prior year items have been reclassified to conform to the current year’s presentation, including reclassification of cost of sales of $1,348,000 and general and administrative expenses of $646,000 to other operating expenses.

Note 3 — New Accounting Pronouncements

     In January 2008, two new accounting pronouncements were effective:

	•		Statement of Financial Accounting Standard (SFAS) No. 157, Fair Value Measures — This standard defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The adoption of this statement did not have a significant effect on our earnings or financial position.
	•		SFAS No. 159, The Fair Value Options for Financial Assets and Financial Liabilities — This standard permits the election of fair value as the initial and subsequent measurement method for many financial assets and liabilities. Subsequent changes in the fair value would be recognized in earnings as they occur. We did not elect the fair value option.

     In addition, there are three new accounting pronouncements that we will be required to adopt in first quarter 2009. Based on our current understanding, we do not expect that adoption of any of these pronouncements will have a significant effect on our earnings or financial position.

	•		SFAS No. 141(R), Business Combinations — This new standard requires most identifiable assets, liabilities, noncontrolling interests and goodwill acquired in a business combination to be recorded at full fair value. The new standard also changes the approach to determining the purchase price; the accounting for acquisition cost; and the accounting practices for acquired contingencies, restructuring costs, long-lived assets, share-based payment awards, indemnification costs and tax benefits.
	•		SFAS No. 160, Noncontrolling Interest in Consolidated Financial Statements — This new standard specifies that noncontrolling interests be reported as a part of equity, not as a liability or other item outside of equity. Currently, we report noncontrolling interests as a liability.
	•		SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities–an amendment of FASB Statement No. 133 — This new standard requires enhanced disclosures about derivative instruments including how and why they are used; how they are accounted for; and how they affect an entity’s financial position, financial performance and cash flows.

Note 4 — Real Estate

     Real estate consists of:

		June 30,				December 29,
		2008				2007
		(In thousands)
Entitled, developed and under development land		$	420,067			$	388,493
Undeveloped land and land in the entitlement process			140,613				141,012
Commercial operating properties			43,746				43,479
			604,426				572,984
Accumulated depreciation			(21,626	)			(20,774	)
		$	582,800			$	552,210

     Included in entitled, developed and under development land are the estimated cost of assets we expect to convey to utility or improvement districts of $57,234,000 at second quarter-end 2008 and $40,843,000 at year-end 2007. These costs relate to water, sewer and other infrastructure assets for which the utility or improvement districts have agreed to reimburse us, typically when these districts achieve adequate tax bases to support payment. We billed these districts $14,814,000 in first six months 2008 and $26,140,000 in first six months 2007, and we collected $374,000 in first six months 2008 and $1,047,000 in first six months 2007.

     Depreciation expense, primarily related to commercial operating properties, was $852,000 in first six months 2008 and $1,006,000 in first six months 2007 and is included in other operating expense.

Note 5 — Investment in Unconsolidated Ventures

     At second quarter-end 2008, we had ownership interests ranging from 25 to 50 percent in 15 ventures that we account for using the equity method. We have no real estate ventures that are accounted for using the cost method. Our two largest ventures are CL Realty and Temco, in both of which we own a 50 percent interest and Cousins Real Estate Corporation owns the other 50 percent interest. Information regarding CL Realty and Temco follows:

	•		CL Realty, L.L.C. was formed in 2002 for the purpose of developing residential and mixed-use communities in Texas and across the southeastern United States. At second quarter-end 2008, the venture had 15 residential and mixed-use communities, of which 10 are in Texas, 3 are in Florida and 2 are in Georgia.
	•		Temco Associates, LLC was formed in 1991 for the purpose of acquiring and developing residential real estate sites in Georgia. At second quarter-end 2008, the venture had 5 residential and mixed-use communities, all of which are located in Georgia. The venture also owns approximately 6,100 acres of undeveloped land in Georgia.

     Combined summarized balance sheet information for our ventures accounted for using the equity method follows:

		June 30, 2008																December 29, 2007
										Other																Other
		CL Realty				Temco				Ventures				Total				CL Realty				Temco				Ventures				Total
		(In thousands)
Real estate		$	124,378			$	60,658			$	147,092			$	332,128			$	122,659			$	59,992			$	75,061			$	257,712
Total assets			125,375				61,958				159,167				346,500				124,419				63,481				125,323				313,223
Borrowings, principally non-recourse			5,563				3,300				59,211				68,074	(a)			6,350				3,397				62,888				72,635	(a)
Total liabilities			8,838				3,940				87,051				99,829				9,903				4,437				82,565				96,905
Equity			116,536				58,019				72,116				246,671				114,516				59,044				42,758				216,318
Our investment in real estate ventures
Our share of their equity (b)			58,268				29,010				32,576				119,854				57,258				29,522				22,590				109,370
Unrecognized deferred gain (c)			(7,062	)			—				(614	)			(7,676	)			(7,069	)			—				(614	)			(7,683	)
Investment in real estate ventures		$	51,206			$	29,010			$	31,962			$	112,178			$	50,189			$	29,522			$	21,976			$	101,687

     Combined summarized income statement information for our ventures accounted for using the equity method follows:

		Second Quarter								First Six Months
		2008				2007				2008				2007
		(In thousands)
Revenues:
CL Realty(d)		$	1,590			$	6,520			$	4,675			$	7,970
Temco			1,613				2,501				2,290				3,595
Other ventures			3,461				5,064				6,711				7,625
Total		$	6,664			$	14,085			$	13,676			$	19,190
Earnings:
CL Realty(d)		$	3,094			$	1,565			$	5,407			$	3,553
Temco			488				401				209				359
Other ventures			125				1,009				(136	)			816
Total		$	3,707			$	2,975			$	5,480			$	4,728
Our equity in their earnings:
CL Realty(c) (d)		$	1,547			$	782			$	2,690			$	1,776
Temco			244				201				103				180
Other ventures(b)			220				381				752				740
Recognition of deferred gain(c)			7				114				7				281
Total		$	2,018			$	1,478			$	3,552			$	2,977

     In first six months 2008, we invested $11,339,000 in these ventures and received $5,258,000 in distributions. In first six months 2007, we invested $2,202,000 in these ventures and received $4,393,000 in distributions. Distributions include both return of investments and distributions of earnings.

Note 6 — Debt

     Debt consists of:

		June 30,				December 29,
		2008				2007
		(In thousands)
Term loan facility — due in 2010, interest payable at LIBOR + 4% (6.47% at June 30, 2008)		$	175,000			$	175,000
Revolving loan facility — due in 2010, interest payable at LIBOR + 4%			30,000				—
Secured promissory note — due in 2008, interest payable at 7.30%			16,142				16,431
Other indebtedness due through 2011 at variable interest rates based on prime (5.00% at June 30, 2008) and fixed interest rates ranging from 6.00% to 9.50%			75,882				74,584
		$	297,024			$	266,015

     Our senior credit facility and other debt agreements contain terms, conditions and financial covenants customary for such agreements including minimum levels of interest coverage and limitations on leverage. At second quarter-end 2008, we had complied with the terms, conditions and financial covenants of these agreements.

     Our senior credit facility provides for a $175,000,000 term loan and a $290,000,000 revolving line of credit. We may, upon notice to the lenders, request an increase in the credit facility to provide for a total of $500,000,000. The revolving line of credit includes a $100,000,000 sublimit available for letters of credit, of which $22,048,000 was outstanding at second quarter-end 2008. Total borrowings under our senior credit facility (including the face amount of letters of credit) may not exceed a borrowing base formula, and there is a $35,000,000 minimum liquidity requirement at each quarter-end. At second quarter-end 2008, we had $175,703,000 in net unused borrowing capacity under our senior credit facility.

     All borrowings under the credit facility are secured by (a) a pledge of approximately 250,000 acres of undeveloped land, (b) assignments of current and future leases, rents and contracts, including our mineral leases, (c) a security interest in our primary operating account, (d) pledge of the equity interests in current and future material operating subsidiaries or joint venture interests, or if such pledge is not permitted, a pledge of the right to distributions from such entities, and (e) negative pledge (without a mortgage) on all other wholly-owned assets. The credit facility provides for releases of real estate provided that borrowing base compliance is maintained.

     At second quarter-end 2008, unamortized fees related to our credit facility were $8,695,000 and are included in other assets. Amortization of these fees was $1,739,000 for first six months 2008 and is included in interest expense.

     At second quarter-end 2008, commercial operating properties with a book value of $21,666,000 were subject to liens in connection with $16,142,000 of debt, and entitled, developed and under development land having a book value of $148,990,000 were subject to liens in connection with $75,882,000 of principally non-recourse debt.

Note 7 — Derivative Instruments

     We use interest rate agreements in the normal course of business to mitigate the risk inherent in interest rate fluctuations by entering into contracts with major U.S. securities firms. In first quarter 2008, we entered into a $100,000,000 notional amount interest rate swap agreement that matures in 2010.

     Under this swap agreement, we pay a fixed interest rate of 6.57 percent and receive a floating interest rate of one month LIBOR plus 4 percent (6.47% at second quarter-end 2008). The interest rate swap was designed to offset the cash flow variability of probable interest rate payments associated with our variable-rate debt. The hedged cash flows are the interest rate payments associated with the first $100,000,000 of our variable-rate borrowings. Our interest rate swap meets the conditions required for effectiveness under the variable cash flows methodology of SFAS No. 133, Accounting for Derivatives Instruments and Hedging Activities. The effectiveness of the hedge relationship is periodically assessed by comparing the present value of the cumulative change in the expected future interest cash flows on the variable leg of the swap and the present value of the cumulative change in the expected future hedged cash flows. In first six months 2008, hedge ineffectiveness was not significant.

     The fair value of the interest rate swap agreement was determined using quoted prices in active markets for identical assets (Level 1) under SFAS No. 157. At second quarter-end 2008, the fair value of the interest rate swap agreement was a $1,066,000 asset which is included in other assets. The effective change in fair value of our interest rate swap agreement, net of taxes, was $994,000 in second quarter 2008 and is included in other comprehensive income.

Note 8 — Contingencies

     We are involved in various legal proceedings that arise from time to time in the ordinary course of doing business and believe that adequate reserves have been established for any probable losses. We do not believe that the outcome of any of these proceedings should have a significant adverse effect on our financial position, long-term results of operations or cash flows. It is possible, however, that charges related to these matters could be significant to our results or cash flows in any one accounting period.

     Liabilities in connection with environmental remediation arise from time to time in the ordinary course of doing business and we believe we have established adequate reserves for any probable losses. We own 288 acres near Antioch, California, portions of which were sites of a Temple-Inland paper manufacturing operation that need remediation. In second quarter 2008, we increased our reserves for environmental remediation by about $2,900,000. We estimate the cost we will likely incur to complete remediation activities will be about $6,250,000, which is included in other accrued expenses and will likely be paid in 2008 and 2009.

Note 9 — Capital Stock

     Pursuant to our shareholder rights plan, each share of common stock outstanding is coupled with one-quarter of a preferred stock purchase right (Right). Each Right entitles our shareholders to purchase, under certain conditions, one one-hundredth of a share of newly issued Series A Junior Participating Preferred Stock at an exercise price of $100. Rights will be exercisable only if someone acquires beneficial ownership of 20 percent or more of our common shares or commences a tender or exchange offer, upon consummation of which they would beneficially own 20 percent or more of our common shares. We will generally be entitled to redeem the Rights at $0.001 per Right at any time until the 10^th business day following public announcement that a 20 percent position has been acquired. The Rights will expire on December 11, 2017.

     Please read Note 13 for information about additional shares of common stock that could be issued under terms of our share-based compensation plans.

     As a result of our spin-off from Temple-Inland, all of Temple-Inland’s outstanding share-based compensation awards were equitably adjusted into separate awards: one related to our common stock, one related to Temple-Inland common stock and one related to Guaranty common stock. All awards issued as part of this adjustment are subject to their original vesting schedules.

     At second quarter-end 2008, Temple-Inland and Guaranty directors and employees held 82,000 equity-settled awards on our stock.

     The following table summarizes outstanding stock option awards on our stock held by Temple-Inland and Guaranty directors and employees at second quarter-end 2008:

Weighted

Aggregate

Weighted

Average

Intrinsic Value

Average

Remaining

(Current Value

Exercise Price

Contractual

Less Exercise

Shares

per Share

Term

Price)

(In thousands)

(In years)

(In thousands)

Outstanding

1,827

$

19.35

6

$

5,955

Exercisable

1,412

$

16.84

5

$

5,955

Note 10 — Other Comprehensive Income

     Other comprehensive income consists of:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Net income		$	9,596			$	14,432			$	9,358			$	15,093
Change in fair value of interest rate swap agreement, net of taxes			994				—				664				—
Other comprehensive income		$	10,590			$	14,432			$	10,022			$	15,093

Note 11 — Net Income per Share

     We computed net income per share by dividing income by weighted average shares outstanding using the following:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Weighted average common shares outstanding — basic			35,422				35,380				35,390				35,380
Dilutive effect of stock options			511				—				509				—
Dilutive effect of restricted stock and restricted stock units			184				—				199				—
Weighted average common shares outstanding — diluted			36,117				35,380				36,098				35,380

     For second quarter and first six months 2007, we computed basic and diluted net income per share based upon the number of shares of our common stock distributed by Temple-Inland on December 28, 2007.

     At second quarter-end 2008, the effect of 1,434,000 stock options and unvested restricted stock were not included in the computation of diluted weighted average shares outstanding because their impact would have been anti-dilutive.

Note 12 — Segment Information

     In first quarter 2008, we changed our reportable segments to reflect our post-spin management of the operations transferred to us from Temple-Inland. All prior period segment information has been reclassified to conform to the current presentation. We manage our operations through three segments: real estate, mineral resources and fiber resources. Real estate secures entitlements and develops infrastructure on our lands for single-family residential and mixed-use communities and manages our undeveloped land and commercial operating properties. Mineral resources manages our mineral interests, and fiber resources manages our timber and recreational leases.

     We evaluate performance based on segment earnings before unallocated items and income taxes. Segment earnings consist of operating income, equity in earnings of unconsolidated ventures and minority interest expense in consolidated ventures. Unallocated items consist of general and administrative expense, share-based compensation, other non-operating income and expense and interest expense. All our revenues are derived from U.S. operations and all our assets are located in the U.S. For first six months 2008, revenues from one customer of our mineral resources segment represent about 14% of our total revenues.

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Revenues:
Real estate		$	24,118			$	47,317			$	52,561			$	74,883
Mineral resources			24,386				5,186				30,654				9,040
Fiber resources			3,093				3,782				5,605				6,818
Total revenues		$	51,597			$	56,285			$	88,820			$	90,741
Segment earnings:
Real estate		$	874			$	23,040			$	4,417			$	26,776
Mineral resources			23,247				4,693				29,752				8,072
Fiber resources			1,411				2,353				4,251				2,698
Total segment earnings			25,532				30,086				38,420				37,546
Items not allocated to segments (a)			(11,125	)			(7,305	)			(24,396	)			(13,722	)
Income before taxes		$	14,407			$	22,781			$	14,024			$	23,824

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
General and administrative		$	(5,348	)		$	(4,139	)		$	(10,354	)		$	(8,051	)
Share-based compensation			(847	)			(684	)			(3,528	)			(1,542	)
Interest expense			(5,002	)			(2,534	)			(10,668	)			(4,241	)
Other non-operating income			72				52				154				112
		$	(11,125	)		$	(7,305	)		$	(24,396	)		$	(13,722	)

		June 30,				December 29,
		2008				2007
		(In thousands)
Assets:
Real estate		$	700,812			$	658,813
Mineral resources			39				—
Fiber resources			53,602				55,011
Assets not allocated to segments			38,390				34,902
Total assets		$	792,843			$	748,726

Note 13 — Share-Based Compensation

Post-spin Awards

     A summary of the awards granted under our 2007 Stock Incentive Plan follows.

Cash-settled awards

     Cash-settled awards vest 50 percent after year one and 50 percent after year two from the date of grant and provide for accelerated vesting upon retirement, death, disability or if there is a change in control. The following table summarizes the activity of awards granted under our plan for first six months 2008:

						Weighted				Aggregate
		Equivalent				Average Grant				Current
		Units				Date Fair Value				Value
		(In thousands)								(In thousands)
Non-vested as of December 29, 2007			—			$	—
Granted			6				28.85
Vested			—				—
Forfeited			(1	)			28.85
Non-vested as of June 30, 2008			5			$	28.85			$	103

Equity-settled awards

     Equity-settled awards in the form of restricted stock units granted to our directors are fully vested at the time of grant and payable upon retirement. The following table summarizes the activity of awards granted under our plan for first six months 2008:

						Weighted				Aggregate
		Equivalent				Average Grant				Current
		Units				Date Fair Value				Value
		(In thousands)								(In thousands)
Non-vested as of December 29, 2007			—			$	—
Granted			41				28.26
Vested			(41	)			28.26
Forfeited			—				—
Non-vested as of June 30, 2008			—			$	—			$	—

     The total fair value of awards vested in first six months of 2008 was $1,147,000, of which $397,000 are deferred director fees.

Restricted stock

     Restricted stock awards vest after three years if we achieve a minimum one percent annualized return on assets over such three-year period. The following table summarizes the activity of awards granted under our plan for first six months 2008:

						Weighted
		Restricted				Average Grant				Total
		Shares				Date Fair Value				Fair Value
		(In thousands)								(In thousands)
Non-vested as of December 29, 2007			—			$	—
Granted			139				28.75
Vested			—				—			$	—
Forfeited			(6	)			28.85
Non-vested as of June 30, 2008			133			$	28.74

Stock options

     Stock options have a ten-year term, generally become exercisable ratably over three to four years and provide for accelerated or continued vesting upon retirement, death, disability or if there is a change in control. Options were granted with an exercise price equal to the market value of our stock on the date of grant. The following table summarizes the activity of awards granted under our plan for first six months 2008:

										Weighted				Aggregate
						Weighted				Average				Intrinsic Value
						Average				Remaining				(Current Value
		Options				Exercise Price				Contractual				Less Exercise
		Outstanding				per Share				Term				Price)
		(In thousands)								(In years)				(In thousands)
Balance as of December 29, 2007			—			$	—				—			$	—
Granted			624				28.85
Exercised			—				—
Forfeited			(2	)			28.85
Balance as of June 30, 2008			622			$	28.85				10			$	—
Options Exercisable as of June 30, 2008			14				28.85				10			$	—

     Stock options are valued based upon the Black-Scholes option pricing model. Awards granted in first six months 2008 were valued based upon the following assumptions:

Expected dividend yield			0.0	%
Expected stock price volatility			31.0	%
Risk-free interest rate			2.7	%
Expected life of options in years			6
Weighted average estimated fair value of options granted		$	10.22

     As we have limited historical experience as a stand alone company, we utilized other sources in determining our valuation assumptions. The expected life was based on the simplified method utilizing the midpoint between the vesting period and the contractual life of the awards. The expected stock price volatility was based on historical prices of our peers’ common stock for a period corresponding to the expected life of the options. Pre-vesting forfeitures are estimated based upon the pool of participants and their expected activity.

Pre-spin Awards

     Prior to the spin-off, we participated in Temple-Inland’s share-based compensation plans, and as a result, certain of our directors and employees received share-based compensation in the form of restricted or performance stock units, restricted stock, or options to purchase shares of Temple-Inland’s common stock. Concurrent with Temple-Inland’s distribution of our common stock, all outstanding Temple-Inland awards were adjusted into three separate awards: one related to Forestar common stock, one related to Guaranty common stock and one related to Temple-Inland common stock.

     In 2007, the expense for share-based compensation awards granted to our employees under Temple-Inland’s plans was allocated to us by Temple-Inland. We continue to recognize share-based compensation expense over the remaining vesting periods associated with our employees’ and directors’ awards in Forestar, Guaranty and Temple-Inland stock.

Cash-settled awards

     Cash-settled awards generally vest and are paid after three years from the date of grant or the attainment of defined performance goals, generally measured over a three-year period. A summary of cash-settled awards outstanding to our directors and employees at second quarter-end 2008, following the adjustments described previously, follows:

						Aggregate
		Equivalent				Current
		Units				Value
		(In thousands)
Awards on Forestar stock			38			$	724
Awards on Guaranty stock			38				204
Awards on Temple-Inland stock			114				1,286
						$	2,214

     In first six months 2008, we paid $138,000 to settle vested cash awards.

Restricted stock

     All outstanding restricted stock awards at year-end 2007 vested in first quarter 2008. The total fair value of these awards was $474,000.

Stock options

     Stock options have a ten-year term, generally become exercisable ratably over four years and provide for accelerated or continued vesting upon retirement, death, disability or if there is a change in control. Options were granted with an exercise price equal to the market value of Temple-Inland common stock on the date of grant. A summary of stock option awards outstanding to our directors and employees at second quarter-end 2008, following the adjustments described previously, follows:

										Weighted				Aggregate
						Weighted				Average				Intrinsic Value
						Average				Remaining				(Current Value
						Exercise Price				Contractual				Less Exercise
		Shares				per Share				Term				Price)
		(In thousands)								(In years)				(In thousands)
Outstanding on Forestar stock			86			$	21.12				6			$	234
Outstanding on Guaranty stock			86				13.55				6				—
Outstanding on Temple-Inland stock			256				16.84				6				182
														$	416
Exercisable on Forestar stock			57			$	17.64				5			$	234
Exercisable on Guaranty stock			57				11.32				5				—
Exercisable on Temple-Inland stock			172				14.07				5				182
														$	416

     The intrinsic value of options exercised in first six months 2008 was $128,000.

Share-Based Compensation Expense

     Pre-tax share-based compensation expense for post-spin and pre-spin awards consists of:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Cash-settled awards		$	55			$	566			$	195			$	1,140
Equity-settled awards			—				—				750				—
Restricted stock			328				34				517				74
Stock options			464				84				2,066				328
		$	847			$	684			$	3,528			$	1,542

     The fair value of awards granted to retirement-eligible employees and expensed at the date of grant was $1,321,000 in first six months 2008.

     Pre-tax share-based compensation expense is included in:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
General and administrative		$	598			$	620			$	2,429			$	1,369
Other operating			249				64				1,099				173
		$	847			$	684			$	3,528			$	1,542

     Unrecognized share-based compensation for post-spin awards not vested was $8,085,000 at second quarter-end 2008. It is likely that this cost will be recognized as expense over the next four years. Unrecognized share-based compensation for pre-spin awards not vested was $1,266,000 at second quarter-end 2008. It is likely that this cost will be recognized as expense over the next three years.

     In connection with restricted stock vested and stock options exercised, we withheld shares having a value of $1,832,000 for payment of payroll taxes in first six months 2008. These shares are accounted for as treasury stock. Payroll taxes on restricted stock and stock options are reflected in financing activities in our consolidated statement of cash flows.

     Our effective tax rate was 33 percent in second quarter 2008 and first six months 2008 and 37 percent in second quarter 2007 and first six months 2007. We anticipate that our effective tax rate in 2008 will be about 34 percent.

     The 2008 rate reflects a one-time tax benefit for the adjustment of deferred taxes resulting primarily from a federal income tax rate change for qualified timber gains due to the Heartland, Habitat, Harvest and Horticulture Act of 2008.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations in our 2007 Annual Report on Form 10-K.

Forward-Looking Statements

     This Quarterly Report on Form 10-Q and other materials we have filed or may file with the Securities and Exchange Commission contain “forward-looking statements” within the meaning of the federal securities laws. These forward-looking statements are identified by their use of terms and phrases such as “believe,” “anticipate,” “could,” “estimate,” “likely,” “intend,” “may,” “plan,” “expect,” and similar expressions, including references to assumptions. These statements reflect our current views with respect to future events and are subject to risk and uncertainties. We note that a variety of factors and uncertainties could cause our actual results to differ significantly from the results discussed in the forward-looking statements. Factors and uncertainties that might cause such differences include, but are not limited to:

	•		general economic, market or business conditions;
	•		the opportunities (or lack thereof) that may be presented to us and that we may pursue;
	•		future residential or commercial entitlements;
	•		expected development timetables and projected timing for sales of lots or other parcels of land;
	•		development approvals and the ability to obtain such approvals;
	•		the anticipated price ranges of lots in our developments;
	•		the number, price and timing of land sales or acquisitions;
	•		estimated land holdings for a particular use within a specified time frame;
	•		absorption rates and expected gains on land and lot sales;
	•		the levels of resale inventory in our development projects and the regions in which they are located;
	•		the development of relationships with strategic partners;
	•		the pace at which we release lots for sale;
	•		fluctuations in costs and expenses;
	•		demand for new housing, which can be affected by the availability of mortgage credit;
	•		government energy policies;
	•		demand for oil and gas;
	•		competitive actions by other companies;
	•		changes in laws or regulations and actions or restrictions of regulatory agencies;
	•		the results of financing efforts, including our ability to obtain financing with favorable terms;
	•		the ability to complete merger, acquisition or divestiture plans; regulatory or other limitations imposed as a result of a merger, acquisition or divestiture; and the success of the business following a merger, acquisition or divestiture; and
	•		the final resolutions or outcomes with respect to our contingent and other corporate liabilities related to our business.

     Other factors, including the risk factors described in Item 1A of our 2007 Annual Report on Form 10-K, may also cause actual results to differ materially from those projected by our forward-looking statements. New factors emerge from time to time and it is not possible for us to predict all such factors, nor can we assess the impact of any such factor on our business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement.

     Any forward-looking statement speaks only as of the date on which such statement is made, and, except as required by law, we expressly disclaim any obligation or undertaking to disseminate any updates or revisions to any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events.

Introduction

     In first quarter 2008, we changed our reportable segments to reflect our post-spin management of the operations transferred to us from Temple-Inland. 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 strategy is to maximize and grow long-term stockholder value through:

	•		entitlement and development of real estate;
	•		realization of value from natural resources; and
	•		accelerated growth through strategic and disciplined investment in real estate.

     Unless otherwise indicated, information is presented as of June 30, 2008, and references to acreage owned include all acres owned by ventures regardless of our ownership interest in a venture.

     Our operations are affected to varying degrees by supply and demand factors and economic conditions including availability of mortgage credit; changes in interest rates; new housing starts; real estate values; employment levels; market prices for oil, gas and timber; and the overall strength of the U.S. economy.

Critical Accounting Policies and Estimates

     There have been no significant changes in our critical accounting policies or estimates in first six months 2008 from those disclosed in our 2007 Annual Report on Form 10-K.

Recent Accounting Standards

     Please read Note 3 to the Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q.

Results of Operations

     Net income was $9,596,000, or $0.27 per diluted share, in second quarter 2008, compared with $14,432,000, or $0.41 per diluted share, for second quarter 2007. Net income for first six months 2008 was $9,358,000, or $0.26 per diluted share, compared with $15,093,000 or $0.43 per diluted share, for first six months 2007.

     Current conditions in the residential development industry are difficult due to an oversupply of housing, declining sales volume for existing and new homes, flat to declining sales prices and a significant tightening of mortgage credit. A decline in consumer confidence is also evident. All geographic markets and products have not been affected to the same extent or with equal severity, but most have experienced declines. It is likely these conditions will continue throughout 2008.

     Market conditions in the oil and gas industry are strong, with continued long-term growth in demand for oil and gas expected. As a result, oil and gas prices are at near record levels.

     A summary of our consolidated results follows:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Revenues:
Real estate		$	24,118			$	47,317			$	52,561			$	74,883
Mineral resources			24,386				5,186				30,654				9,040
Fiber resources			3,093				3,782				5,605				6,818
Total revenues		$	51,597			$	56,285			$	88,820			$	90,741
Segment earnings:
Real estate		$	874			$	23,040			$	4,417			$	26,776
Mineral resources			23,247				4,693				29,752				8,072
Fiber resources			1,411				2,353				4,251				2,698
Total segment earnings			25,532				30,086				38,420				37,546
Items not allocated to segments:
General and administrative			(5,348	)			(4,139	)			(10,354	)			(8,051	)
Share-based compensation			(847	)			(684	)			(3,528	)			(1,542	)
Interest expense			(5,002	)			(2,534	)			(10,668	)			(4,241	)
Other non-operating income			72				52				154				112
Income before taxes			14,407				22,781				14,024				23,824
Income tax expense			(4,811	)			(8,349	)			(4,666	)			(8,731	)
Net income		$	9,596			$	14,432			$	9,358			$	15,093

     Significant aspects of our results of operations follow:

Second Quarter and First Six Months 2008 and 2007

	•		Mineral resources segment earnings increased as result of bonus payments received for leasing about 52,700 net mineral acres, of which over 47,000 acres were leased in second quarter 2008. This leasing activity was located principally in East Texas and was driven by our proximity to the Cotton Valley, James Lime and Haynesville natural gas formations.
	•		Real estate segment earnings declined principally due to decreased commercial sales activity, a decrease in the sales of residential real estate and increased costs associated with environmental remediation activities. First six months 2007 included the sale of 38 acres of undeveloped commercial real estate on which we recognized a gain of $9,945,000.
	•		Fiber resources segment earnings for first six months 2008 increased primarily as a result of gain from partial termination of a timber lease.

	•		Interest expense increased as a result of higher debt levels and higher borrowing costs.
	•		Share-based compensation increased primarily due to accelerated expense recognition in conjunction with awards granted to retirement-eligible employees, and an increase in the number of participants in our plan.
	•		General and administrative expenses increased as a result of costs associated with the continued development of corporate functions necessary as a stand alone public company.

Real Estate

     We own directly or through ventures about 371,000 acres of real estate located in ten states and 13 markets. Our real estate segment secures entitlements and develops infrastructure on our lands, primarily for single-family residential and mixed-use communities. We own approximately 302,000 acres in a broad area around Atlanta, Georgia, with the balance located primarily in Texas. We also invest in new projects principally in our strategic growth corridors, regions of accelerated growth across the southern half of the United States that possess key demographic and growth characteristics that we believe make them attractive for long-term real estate investment.

     A summary of our real estate results follows:

		Second Quarter								First Six Months
		2008				2007				2008				2007
						(In thousands)
Revenues		$	24,118			$	47,317			$	52,561			$	74,883
Costs and expenses			(24,481	)			(23,160	)			(49,631	)			(47,055	)
			(363	)			24,157				2,930				27,828
Equity in earnings of unconsolidated ventures			1,767				1,478				2,517				2,977
Minority interest expense in consolidated ventures			(530	)			(2,595	)			(1,030	)			(4,029	)
Segment earnings		$	874			$	23,040			$	4,417			$	26,776

     In second quarter 2008 and first six months 2008, costs and expenses include a $3,500,000 charge principally related to environmental remediation activities.

     Revenues and units sold consist of:

		Second Quarter								First Six Months
		2008				2007				2008				2007
		(In thousands, except lots and acres)
Residential real estate		$	10,261			$	18,325			$	24,931			$	34,511
Commercial real estate			3,829				15,762				5,692				19,352
Undeveloped land			2,971				6,217				9,228				7,708
Commercial operating properties			6,218				5,843				11,373				10,436
Other			839				1,170				1,337				2,876
Total revenues		$	24,118			$	47,317			$	52,561			$	74,883
Residential real estate — lots sold			175				356				499				650
Commercial real estate — acres sold			15				51				37				62
Undeveloped land — acres sold			504				886				1,853				1,154

     Residential real estate revenues principally consist of the sale of single-family lots to national, regional and local homebuilders. In first six months 2008, residential real estate revenues declined as a result of decreased demand for single-family lots due to the overall decline in the housing industry. We expect this trend to continue throughout 2008.

     In second quarter 2008, we sold 175 lots in our owned and consolidated projects for average revenue per lot of $58,600 as compared to 356 lots sold in second quarter 2007 for average revenue per lot of $50,400. In first six months 2008, we sold 499 lots in our owned and consolidated projects for average revenue per lot of $48,900 (primarily in the major markets of Texas), as compared to 650 lots sold in first six months 2007 for average revenue per lot of $52,500.

     In second quarter 2007 and in first six months 2007, commercial real estate revenues include $12,400,000 related to the sale of 38 acres of undeveloped real estate on which we recognized a gain of $9,945,000.

     In second quarter 2008, undeveloped land revenues decreased as a result of selling 504 acres for an average price of $5,900 per acre as compared to 886 acres sold in second quarter 2007 at an average price of $7,000 per acre. In first six months 2008, undeveloped land revenues increased as a result of selling 1,853 acres for an average price of $5,000 per acre as compared to 1,154 acres sold in first six months 2007 at an average price of $6,700 per acre.

     Information about our real estate projects and our real estate ventures follows:

		Second Quarter-End
		2008				2007
Owned and consolidated ventures:
Entitled, developed and under development land
Number of projects			56				52
Residential lots remaining			20,737				20,434
Commercial acres remaining			1,604				1,224
Undeveloped land and land in the entitlement process
Number of projects			24				22
Acres in entitlement process			32,680				26,100
Acres sold (for first six months)			1,853				1,154
Acres undeveloped			312,880				325,115
Ventures accounted for using the equity method:
Ventures’ lot sales (for first six months)
Lots sold			153				416
Revenue per lot sold		$	52,549			$	54,505
Ventures’ entitled, developed and under development land
Number of projects			21				22
Residential lots remaining			9,086				9,734
Commercial acres remaining			654				721
Ventures’ undeveloped land and land in the entitlement process
Number of projects			2				2
Acres in entitlement process			920				860
Acres sold (for first six months)			—				—
Acres undeveloped			6,127				6,258