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 September 30, 2008

OR

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.)

1300 MoPac Expressway South, Suite 3S, Austin, Texas 78746
(Address of Principal Executive Offices, Including Zip Code)

(512) 433-5200
(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):

Large accelerated filer o		Accelerated filer o		Non-accelerated filer þ		Smaller reporting company o
				(Do not check if a smaller reporting company)

     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		October 31, 2008
Common Stock, par value $1.00 per share		35,700,139

 

 

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			17
Item 3. Quantitative and Qualitative Disclosures About Market Risk			29
Item 4T. Controls and Procedures			29
PART II — OTHER INFORMATION			30
Item 1. Legal Proceedings			30
Item 1A. Risk Factors			30
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			30
Item 3. Defaults Upon Senior Securities			30
Item 4. Submission of Matters to a Vote of Security Holders			30
Item 5. Other Information			30
Item 6. Exhibits			31
SIGNATURES			32
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
EX-31.1
EX-31.2
EX-32.1
EX-32.2

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

FORESTAR REAL ESTATE GROUP INC.

		(Unaudited)
		September 30,				December 29,
		2008				2007
		(In thousands)
ASSETS
Cash and cash equivalents		$	7,254			$	7,520
Real estate			598,659				552,210
Investment in unconsolidated ventures			115,029				101,687
Timber			52,004				54,593
Receivables, net			3,835				3,767
Prepaid expense			5,019				2,267
Property and equipment, net			2,033				1,568
Deferred tax asset			12,142				5,106
Other assets			19,046				20,008
TOTAL ASSETS		$	815,021			$	748,726
LIABILITIES AND STOCKHOLDERS’ EQUITY
Accounts payable		$	10,325			$	8,002
Accrued employee compensation and benefits			2,812				3,857
Accrued interest			1,319				896
Accrued property taxes			8,790				4,459
Other accrued expenses			12,802				15,318
Other liabilities			10,885				8,349
Debt			314,586				266,015
TOTAL LIABILITIES			361,519				306,896
COMMITMENTS AND CONTINGENCIES
MINORITY INTEREST IN CONSOLIDATED VENTURES			7,067				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, 35,786,368 issued at September 30, 2008 and 35,380,385 issued at December 29, 2007			35,786				35,380
Additional paid-in capital			377,007				373,026
Retained earnings			35,025				24,795
Accumulated other comprehensive income			463				—
Treasury stock, at cost, 86,229 shares at September 30, 2008			(1,846	)			—
TOTAL STOCKHOLDERS’ EQUITY			446,435				433,201
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	815,021			$	748,726

Please read the notes to the consolidated financial statements.

 

FORESTAR REAL ESTATE GROUP INC.

		Third Quarter								First Nine Months
		2008				2007				2008				2007
		(In thousands, except per share amounts)
REVENUES
Real estate sales		$	14,532			$	33,999			$	54,383			$	95,570
Commercial operating properties and other			6,398				6,385				19,108				19,697
Real estate			20,930				40,384				73,491				115,267
Mineral resources			9,539				7,217				40,193				16,257
Fiber resources and other			3,474				4,031				9,079				10,849
			33,943				51,632				122,763				142,373
EXPENSES
Cost of real estate sales			(6,933	)			(18,775	)			(28,919	)			(45,147	)
Cost of commercial operating properties and other			(4,087	)			(2,954	)			(12,516	)			(11,764	)
Cost of fiber resources and other			(947	)			(1,492	)			(2,418	)			(3,314	)
Other operating			(11,138	)			(7,536	)			(33,272	)			(22,848	)
General and administrative			(5,237	)			(4,504	)			(18,021	)			(13,924	)
			(28,342	)			(35,261	)			(95,146	)			(96,997	)
OPERATING INCOME			5,601				16,371				27,617				45,376
Equity in earnings of unconsolidated ventures			1,436				1,333				4,988				4,310
Minority interest in consolidated ventures			(845	)			(1,010	)			(1,875	)			(5,039	)
Interest expense			(5,079	)			(2,220	)			(15,747	)			(6,461	)
Other non-operating income			79				342				233				454
INCOME BEFORE TAXES			1,192				14,816				15,216				38,640
Income tax expense			(320	)			(5,220	)			(4,986	)			(13,951	)
NET INCOME		$	872			$	9,596			$	10,230			$	24,689
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
Basic			35,518				35,380				35,433				35,380
Diluted			35,828				35,380				35,935				35,380
NET INCOME PER COMMON SHARE
Basic		$	0.02			$	0.27			$	0.29			$	0.70
Diluted		$	0.02			$	0.27			$	0.28			$	0.70

Please read the notes to the consolidated financial statements.

 

FORESTAR REAL ESTATE GROUP INC.

		First Nine Months
		2008				2007
		(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	10,230			$	24,689
Adjustments:
Depreciation and amortization			5,258				2,001
Deferred income taxes			(7,285	)			(10,064	)
Equity in earnings of unconsolidated ventures			(4,988	)			(4,310	)
Distributions of earnings of unconsolidated ventures			883				2,054
Minority interest in consolidated ventures			1,875				5,039
Distributions to minority interests			(3,557	)			(5,335	)
Share-based compensation			4,658				1,878
Non-cash real estate cost of sales			27,610				40,256
Real estate development and acquisition expenditures			(76,387	)			(118,726	)
Reimbursements from utility or improvement districts			374				4,332
Other changes in real estate			(521	)			6,126
Gain on termination of timber lease			(1,495	)			—
Cost of timber cut			2,046				3,492
Deferred income			2,010				—
Asset impairments			—				2,600
Other			(450	)			(610	)
Changes in:
Receivables			17				575
Prepaid and other			(2,906	)			342
Accounts payable and other accrued liabilities			6,259				5,278
Net cash used in operating activities			(36,369	)			(40,383	)
CASH FLOWS FROM INVESTING ACTIVITIES:
Property, equipment, software and reforestation			(2,044	)			(2,430	)
Investment in unconsolidated ventures			(14,962	)			(10,932	)
Return of investment in unconsolidated ventures			6,168				3,239
Proceeds from sale of assets			202				657
Net cash used in investing activities			(10,636	)			(9,466	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of debt			(51,649	)			(9,791	)
Additions to debt			100,220				32,615
Note payable to Temple-Inland, net			—				39,174
Dividends and other transfers to Temple-Inland			—				(15,363	)
Deferred financing fees			(1,238	)			—
Exercise of stock options			896				—
Payroll taxes on restricted stock and stock options			(1,840	)			—
Tax benefit from share-based compensation			81				—
Other			269				726
Net cash provided by financing activities			46,739				47,361
Net increase (decrease) in cash and cash equivalents			(266	)			(2,488	)
Cash and cash equivalents at beginning of period			7,520				10,350
Cash and cash equivalents at end of period		$	7,254			$	7,862

Please read the notes to the consolidated financial statements.

 

FORESTAR REAL ESTATE GROUP INC.

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 significant 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 $1,516,000 and general and administrative expenses of $1,048,000 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:

		September 30,				December 29,
		2008				2007
		(In thousands)
Entitled, developed and under development land		$	435,170			$	388,493
Undeveloped land and land in the entitlement process			141,733				141,012
Commercial operating properties			43,834				43,479
			620,737				572,984
Accumulated depreciation			(22,078	)			(20,774	)
		$	598,659			$	552,210

     Included in entitled, developed and under development land are the estimated costs of assets we expect to convey to utility or improvement districts of $63,542,000 at third quarter-end 2008 and $40,843,000 at year-end 2007, including $40,305,000 at third quarter-end 2008 and $25,516,000 at year-end 2007 related to our Cibolo Canyons mixed-use project near San Antonio, Texas. 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 ad valorem tax base to support payment. We billed these districts $18,058,000 in first nine months 2008 and $27,282,000 in first nine months 2007, and we collected $374,000 in first nine months 2008 and $4,332,000 in first nine months 2007.

     Depreciation expense, primarily related to commercial operating properties, was $1,303,000 in first nine months 2008 and $1,493,000 in first nine months 2007 and is included in other operating expense.

 

Note 5 — Investment in Unconsolidated Ventures

     At third 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 three largest ventures are CL Realty, Temco and Palisades West. We own a 50 percent interest in both CL Realty and Temco and Cousins Real Estate Corporation owns the other 50 percent interest. We own a 25 percent interest in Palisades West, Cousins Properties Incorporated owns a 50 percent interest and Dimensional Fund Advisors LP owns the remaining 25 percent interest. Information regarding these ventures 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 third 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, representing about 7,600 residential lots and 576 commercial acres.
	•		Temco Associates, LLC was formed in 1991 for the purpose of acquiring and developing residential real estate sites in Georgia. At third quarter-end 2008, the venture had 5 residential and mixed-use communities, representing about 1,560 residential lots, all of which are located in Paulding County, Georgia. The venture also owns approximately 5,600 acres of undeveloped land in Paulding County, Georgia. In third quarter 2008, the venture sold approximately 486 acres of undeveloped land for $6,300 per acre.
	•		Palisades West LLC was formed in 2006 for the purpose of constructing a commercial office park in Austin, Texas. The project includes two office buildings totaling approximately 375,000 square feet and an accompanying parking garage. Construction of the project will be completed in fourth quarter 2008 at which time it will be approximately 67% leased. Our remaining contractual commitment for investment in this venture as of third quarter-end 2008 is $4,359,000. We have entered into a 10-year operating lease for approximately 32,000 square feet that we will occupy as our corporate headquarters commencing in fourth quarter 2008.

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

		September 30, 2008																				December 29, 2007
		CL								Palisades				Other								CL								Palisades				Other
		Realty				Temco				West				Ventures				Total				Realty				Temco				West				Ventures				Total
		(in thousands)
Real estate		$	123,642			$	60,278			$	98,133			$	87,710			$	369,763			$	122,659			$	59,992			$	38,627			$	36,434			$	257,712
Total assets			125,149				61,411				98,449				97,854				382,863				124,419				63,481				40,444				84,879				313,223
Borrowings, principally non-recourse(a)			4,600				3,249				—				69,322				77,171				6,350				3,397				—				62,888				72,635
Total liabilities			7,933				3,996				32,818				84,638				129,385				9,903				4,437				7,584				74,981				96,905
Equity			117,216				57,415				65,630				13,215				253,476				114,516				59,044				32,860				9,898				216,318
Our investment in real estate ventures:
Our share of their equity(b)			58,608				28,707				16,851				18,536				122,702				57,258				29,522				9,362				13,228				109,370
Unrecognized deferred gain(c)			(7,059	)			—				—				(614	)			(7,673	)			(7,069	)			—				—				(614	)			(7,683	)
Investment in real estate ventures		$	51,549			$	28,707			$	16,851			$	17,922			$	115,029			$	50,189			$	29,522			$	9,362			$	12,614			$	101,687

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

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Revenues:
CL Realty(d)		$	3,040			$	785			$	7,714			$	5,823
Temco			3,681				1,779				5,971				5,374
Palisades West LLC			51				77				160				232
Other ventures			1,330				4,493				7,933				11,963
Total		$	8,102			$	7,134			$	21,778			$	23,392
Earnings:
CL Realty(d)		$	1,280			$	599			$	6,686			$	4,152
Temco			1,597				152				1,806				511
Palisades West LLC			53				127				143				199
Other ventures			(1,938	)			769				(2,163	)			1,513
Total		$	992			$	1,647			$	6,472			$	6,375
Our equity in their earnings:
CL Realty(d)		$	640			$	300			$	3,330			$	2,076
Temco			798				75				901				255
Palisades West LLC			13				32				36				50
Other ventures(b)			(18	)			860				711				1,582
Recognition of deferred gain(c)			3				66				10				347
Total		$	1,436			$	1,333			$	4,988			$	4,310

     In first nine months 2008, we invested $14,962,000 in these ventures and received $7,051,000 in distributions. In first nine months 2007, we invested $10,932,000 in these ventures and received $5,293,000 in distributions. Distributions include both return of investments and distributions of earnings.

 

Note 6 — Debt

     Debt consists of:

		September 30,				December 29,
		2008				2007
		(In thousands)
Term loan facility — due in 2010, interest payable at LIBOR + 4% (6.49% at September 30, 2008)		$	175,000			$	175,000
Revolving loan facility — due in 2010, interest payable at LIBOR + 4%			43,000				—
Secured promissory note — due in 2008, interest payable at 7.30%			15,994				16,431
Other indebtedness due through 2011 at variable interest rates based on prime (5.00% at September 30, 2008) and fixed interest rates ranging from 6.00% to 9.50%			80,592				74,584
		$	314,586			$	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 third 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. At our option, we can borrow at LIBOR plus 4 percent or Prime plus 2 percent. 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 $24,548,000 was outstanding at third 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 third quarter-end 2008, we had $187,452,000 in net unused borrowing capacity under our senior credit facility.

     All borrowings under the senior 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 senior credit facility provides for releases of real estate provided that borrowing base compliance is maintained.

     At third quarter-end 2008, unamortized fees related to our senior credit facility were $7,817,000 and are included in other assets. Amortization of these fees was $2,622,000 for first nine months 2008 and is included in interest expense.

     At third quarter-end 2008, commercial operating properties with a book value of $21,333,000 were subject to liens in connection with $15,994,000 of debt. On October 1, 2008, we refinanced this debt through 2010 with interest payable at LIBOR plus 2.5 percent or Prime, at our option. At third quarter-end 2008, entitled, developed and under development land having a book value of $155,052,000 was subject to liens in connection with $80,592,000 of principally non-recourse debt.

Note 7 — Derivative Instruments

     We periodically 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. The swap agreement was designed to offset the cash flow variability of interest rate payments associated with the first $100,000,000 of our variable-rate borrowings. 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 (6.49 percent at third quarter-end 2008).

     At third quarter-end 2008, the fair value of the interest rate swap agreement was an $872,000 asset that is included in other assets. In third quarter 2008 the fair value of our interest rate swap agreement decreased and as a result we recognized an after-tax loss of $201,000 that is included in accumulated other comprehensive income. 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.

     The effectiveness of the hedge relationship is periodically assessed by comparing the present value of the cumulative change in the expected future 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 nine months 2008, hedge ineffectiveness was not significant.

 

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.

     Environmental remediation liabilities 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 are in 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 $5,600,000, 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 third quarter-end 2008, Temple-Inland and Guaranty directors and employees held 28,000 equity-settled restricted stock 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 third 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

1,822

$

19.34

5

$

2,158

Exercisable

1,409

$

16.84

5

$

2,158

 

Note 10 — Other Comprehensive Income

     Other comprehensive income consists of:

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Net income		$	872			$	9,596			$	10,230			$	24,689
Change in fair value of interest rate swap agreement, net of taxes			(201	)			—				463				—
Other comprehensive income		$	671			$	9,596			$	10,693			$	24,689

Note 11 — Net Income per Share

     Our basic and diluted weighted average common shares outstanding are as follows:

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Weighted average common shares outstanding — basic			35,518				35,380				35,433				35,380
Dilutive effect of stock options			212				—				327				—
Dilutive effect of restricted stock and restricted stock units			98				—				175				—
Weighted average common shares outstanding — diluted			35,828				35,380				35,935				35,380

     For third quarter and first nine 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 third quarter-end 2008, the effect of 1,645,000 stock options and unvested shares of 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.

     Assets allocated by segment are as follows:

		September 30,				December 29,
		2008				2007
		(In thousands)
Real estate		$	719,001			$	658,813
Mineral resources			165				—
Fiber resources			52,394				55,011
Assets not allocated to segments			43,461				34,902
Total assets		$	815,021			$	748,726

     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 nine months 2008, revenues from one customer of our mineral resources segment represent about 10% of our total revenues.

 

     Segment revenues and earnings are as follows:

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Revenues:
Real estate		$	20,930			$	40,384			$	73,491			$	115,267
Mineral resources			9,539				7,217				40,193				16,257
Fiber resources			3,474				4,031				9,079				10,849
Total revenues		$	33,943			$	51,632			$	122,763			$	142,373
Segment earnings:
Real estate		$	1,656			$	12,954			$	6,073			$	39,730
Mineral resources			8,182				6,801				37,934				14,873
Fiber resources			1,938				1,479				6,189				4,177
Total segment earnings			11,776				21,234				50,196				58,780
Items not allocated to segments(a)			(10,584	)			(6,418	)			(34,980	)			(20,140	)
Income before taxes		$	1,192			$	14,816			$	15,216			$	38,640

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
General and administrative expense		$	(4,454	)		$	(4,204	)		$	(14,808	)		$	(12,255	)
Share-based compensation expense			(1,130	)			(336	)			(4,658	)			(1,878	)
Interest expense			(5,079	)			(2,220	)			(15,747	)			(6,461	)
Other non-operating income			79				342				233				454
		$	(10,584	)		$	(6,418	)		$	(34,980	)		$	(20,140	)

 

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 nine months 2008:

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

     The aggregate current value of non-vested awards as of September 30, 2008 is $78,000.

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 nine months 2008:

						Weighted
						Average
						Grant
		Equivalent				Date Fair
		Units				Value Per Unit
		(In
		thousands)
Non-vested as of December 29, 2007			—			$	—
Granted			51				22.52
Vested			(51	)			22.52
Forfeited			—				—
Non-vested as of September 30, 2008			—			$	—

     The total fair value of awards vested in first nine months of 2008 was $1,350,000, of which $600,000 are deferred.

 

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 nine months 2008:

						Weighted
						Average
						Grant
		Restricted				Date Fair
		Shares				Value Per Share
		(In
		thousands)
Non-vested as of December 29, 2007			—			$	—
Granted			162				27.45
Vested			—				—
Forfeited			(6	)			28.85
Non-vested as of September 30, 2008			156			$	27.39

The aggregate current value of non-vested awards as of September 30, 2008 is $2,301,000, or $14.75 per share.

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 nine months 2008:

						Weighted				Weighted
						Average				Average
						Exercise				Remaining
		Options				Price per				Contractual
		Outstanding				Share				Term
		(In
		thousands)								(In years)
Balance as of December 29, 2007			—			$	—				—
Granted			624				28.85
Exercised			—				—
Forfeited			(2	)			28.85
Balance as of September 30, 2008			622			$	28.85				9
Options Exercisable as of September 30, 2008			14			$	28.85				9

 

     There was no aggregate intrinsic value for stock options outstanding or exercisable at September 30, 2008.

     Stock options are valued based upon the Black-Scholes option pricing model. Awards granted in first nine 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 (years)			6
Weighted average estimated fair value of options granted		$	10.22

     We have limited historical experience as a stand alone company so we utilized alternative methods 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 third quarter-end 2008, following the adjustments described previously, follows:

						Aggregate
		Equivalent				Current
		Units				Value
		(In thousands)
Awards on Forestar stock			38			$	561
Awards on Guaranty stock			38				150
Awards on Temple-Inland stock			114				1,741
						$	2,452

     In first nine 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 third quarter-end 2008, following the adjustments described previously, follows:

														Aggregate
														Intrinsic
														Value
						Weighted				Weighted				(Current
						Average				Average				Value
						Exercise				Remaining				Less
						Price				Contractual				Exercise
		Shares				per Share				Term				Price)
		(In												(In
		thousands)								(In years)				thousands)
Outstanding on Forestar stock			86			$	21.12				6			$	93
Outstanding on Guaranty stock			86				13.55				6				—
Outstanding on Temple-Inland stock			254				16.90				6				551
														$	644
Exercisable on Forestar stock			57			$	17.64				5			$	93
Exercisable on Guaranty stock			57				11.32				5				—
Exercisable on Temple-Inland stock			170				14.14				5				551
														$	644

     The intrinsic value of options exercised in first nine months 2008 was $146,000.

Share-Based Compensation Expense

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

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Cash-settled awards		$	310			$	220			$	505			$	1,360
Equity-settled awards			—				—				750				—
Restricted stock			360				34				877				108
Stock options			460				82				2,526				410
		$	1,130			$	336			$	4,658			$	1,878

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

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

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
General and administrative expense		$	829			$	300			$	3,258			$	1,669
Other operating expense			301				36				1,400				209
		$	1,130			$	336			$	4,658			$	1,878

 

Unrecognized share-based compensation for post-spin awards not vested was $7,357,000 at third quarter-end 2008. It is likely that this cost will be recognized as expense over the next three years. Unrecognized share-based compensation for pre-spin awards not vested was $854,000 at third quarter-end 2008. It is likely that this cost will be recognized as expense over the next two years.

     In connection with restricted stock vested and stock options exercised, we withheld shares having a value of $1,840,000 for payment of payroll taxes in first nine 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.

Note 14 — Income Taxes

     Our effective tax rate was 27 percent in third quarter 2008 and 33 percent in the first nine months 2008. Our effective tax rate was 35 percent in third quarter 2007 and 36 percent for the first nine months 2007. We anticipate that our effective tax rate in 2008 will be about 33 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 Food, Conservation and Energy Act of 2008 which was enacted in June 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;
	•		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;
	•		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;
	•		fluctuations in oil and gas prices;
	•		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.
	•		our customers may be unwilling or unable to meet lot takedown commitments due to liquidity limitations or slowing market conditions.

     Other factors, including the risk factors described in Part II, Item 1A of this Quarterly Report on Form 10-Q and 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
	•		growth through strategic and disciplined investment in real estate.

     Unless otherwise indicated, information is presented as of September 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 nine 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 $872,000, or $0.02 per diluted share, in third quarter 2008, compared with $9,596,000, or $0.27 per diluted share, for third quarter 2007. Net income for first nine months 2008 was $10,230,000, or $0.28 per diluted share, compared with $24,689,000, or $0.70 per diluted share, for first nine months 2007.

     Current conditions in the residential development industry are difficult due to the 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. Some home builders are experiencing liquidity shortfalls and are unwilling or unable to close committed lot purchases. 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 and into 2009.

     Market conditions in the oil and gas industry have declined as oil and gas prices have decreased. Exploration and production companies have reduced capital expenditures for lease acquisition and production due to reduced oil and gas pricing and tightened credit markets. These conditions may impact the demand for new mineral leases.

     Fiber demand from the pulp and paper industry is stable. Pulpwood prices in our market areas have increased modestly due to balanced demand for containerboard. Sawtimber prices have declined due to the decrease in demand for lumber products consistent with the decline in the housing industry.

     A summary of our consolidated results follows:

		Third Quarter								First Nine Months
		2008				2007				2008				2007
						(In thousands)
Revenues:
Real estate		$	20,930			$	40,384			$	73,491			$	115,267
Mineral resources			9,539				7,217				40,193				16,257
Fiber resources			3,474				4,031				9,079				10,849
Total revenues		$	33,943			$	51,632			$	122,763			$	142,373
Segment earnings:
Real estate		$	1,656			$	12,954			$	6,073			$	39,730
Mineral resources			8,182				6,801				37,934				14,873
Fiber resources			1,938				1,479				6,189				4,177
Total segment earnings			11,776				21,234				50,196				58,780
Items not allocated to segments:
General and administrative expense			(4,454	)			(4,204	)			(14,808	)			(12,255	)
Share-based compensation expense			(1,130	)			(336	)			(4,658	)			(1,878	)
Interest expense			(5,079	)			(2,220	)			(15,747	)			(6,461	)
Other non-operating income			79				342				233				454
Income before taxes			1,192				14,816				15,216				38,640
Income tax expense			(320	)			(5,220	)			(4,986	)			(13,951	)
Net income		$	872			$	9,596			$	10,230			$	24,689