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Summary

  • Current share price of $23 yields a $518 million market cap.
  • Book value of $551 million at 3/31/14 and cash of $92 million at 3/31/14.
  • PICO owns water rights in areas starved for this precious commodity, including Arizona and Nevada.
  • The key risks include uncertain demand in the water business and losses in the Canola business.

PICO Holdings (NASDAQ:PICO) has risks tied to two segments of its business. The first is lack of sales in the water subsidiary (Vidler) and the second is losses tied to the canola processing business. First, here is an overview of the company:

  • Vidler Water - This subsidiary acquires and develops water resources and water storage assets in the southwestern United States.
  • UCP - A 58% owned subsidiary, which acquires and develops residential housing lots in selected markets in California.
  • Northstar is an 88% owned subsidiary, which operates a canola seed crushing facility near Hallock, Minnesota, to produce canola oil and meal. The plant commenced full-scale production in the third quarter of 2012 and has shown losses since opening.

The first two companies are what investors may consider growth markets. The scope of this article will outline key risks to Northstar and Vidler.

Vidler Water generates revenues by:

  • Selling developed water rights to project developers including real estate developers, power generating facilities or other commercial and industrial users who must secure rights to an assured supply of water in order to receive permits for their development projects.
  • Leasing water, farmland or ranch land while further developing the water resource.

A water right is the legal right to divert water and put it to beneficial use. Water rights are real property rights, which can be bought and sold. The value of a water right depends on a number of factors, which may include location, the seniority of the right, whether or not the right is transferable, or if the water can be moved from one location to another.

The following table outlines several important water rights and water storage assets as of December 31, 2013. As identified in the table, water rights are commonly measured in acre-feet, which is a measure of the volume of water required to cover an area of one acre to a depth of one foot and is equal to 325,850 gallons.

Name and location of asset

Brief Description

Present commercial use

Arizona

Vidler Arizona Recharge Facility

Vidler constructed and permitted an underground water storage facility with permitted storage capacity exceeding 1 million acre-feet of water. Over the years, Vidler has purchased and stored Colorado River water from the Central Arizona Project and has 250,683 acre-feet of water stored at this facility.

Also located 70 miles west of Phoenix.

Stored water is available to support development through sale, lease or partnering arrangements.

Phoenix AMA Water Storage

Vidler utilizes water storage capabilities operated by the Central Arizona Project and the Roosevelt Water Conservation District. Vidler has a total of 157,238 acre-feet of water stored at five different sites.

Water is stored in the Phoenix Metro Active Management Area.

Stored water is available to support development through sale, lease or partnering arrangements.

Nevada

Fish Springs Ranch, LLC

(51% Interest)

7,544 acres of ranch land, 12,984 acre-feet of permitted water rights, 7,984 acre-feet of which are transferable to other areas within Washoe County. Vidler constructed a 35-mile pipeline to deliver this water to the north valleys of Reno. Vidler owns the exclusive right to the capacity of the pipeline.

Located 40 miles north of Reno.

Generating lease income from cattle grazing.

Water rights are available to support development through sale, lease, or partnering arrangements.

Key Risks for Vidler

The Arizona Recharge Facility is one of the few private sector water storage sites in Arizona. To date, Vidler has stored approximately 251,000 acre-feet at the facility for its account. Additionally, Vidler has approximately 157,000 acre-feet of water stored in the Phoenix AMA. PICO has not stored any water on behalf of any customers, and has not generated any revenue from the recharge facility or from the water stored in the Phoenix Active Management Area. The company believes that the best economic return on the assets arises from storing water when surplus water is available and selling this water in periods when water is in more limited supply. However, the eventual sale price may not provide an adequate economic profit.

Summary: The water resource and water storage operations are concentrated in a limited number of assets, making growth and profitability vulnerable to conditions in a limited number of local economies.

Northstar

Northstar is looking to capitalize on the growth of the canola industry, bringing heart healthy canola oil and high protein canola meal production to the United States. The company operates a fully integrated canola processing and refining facility in Kittson County, MN.

Northstar has an agreement with Purina Animal Nutrition, which commits Purina to guarantee the sale of 100% of the canola oil and canola meal output from the company's canola seed crushing plant at market based prices for five years ending December 31, 2017.

During the first quarter of 2014, Northstar crushed at an average rate of 830 U.S. tons per day compared to 766 tons per day during the first quarter of 2013. However, it had crushed 1,041 U.S. tons per day in the fourth quarter of 2013.

Risk Associated with Northstar Debt

As of March 31, 2014, Northstar had total debt of $86.9 million principally comprised of an $82 million term loan (non-recourse) and $4.8 million outstanding on a revolving credit facility (also non-recourse).

If PICO's canola business continues to report losses, it is possible that PICO would need to invest additional capital into the business.

Conclusion

Yes, PICO does own water rights in areas that are currently starved for this precious commodity. However, valuing these is a difficult endeavor.

Given the losses at Northstar, the balance sheet (which is seemingly liquid with cash of $92 million at 3/31/14) could become strained if covenant waivers are not provided. My feeling is that a stock (or any investment) is worth the present value of properly discounted cash flows. Because the water business is so untested, the future cash flow is very uncertain. Until a ready market develops for these water rights, any purchase of PICO's stock is a speculation on future prices.

Don't buy this stock unless you are willing to see significant drops in the stock price. Instead, look for companies generating current cash flow now. I would mention Phillips 66 (NYSE:PSX) or ConocoPhillips (NYSE:COP) for investors looking for current cash flow, income and dividend growth plays (including oil sands and North American shale plays).

PICO's water resource and water storage operations are concentrated in a limited number of assets, making growth and profitability vulnerable to a limited number of local economies (including Washoe and Lyon County in Nevada).

For investors to purchase the stock, they must first understand the supply and demand characteristics of the water markets in these essentially rural counties, or make an educated guess as to when water stored ("banked") at the Vidler Arizona Recharge Facility or Phoenix AMA Water Storage might be liquidated. Bad puns aside, this is not a stock for conservative investment or income production.

Source: PICO Holdings: Growth Industries Served, But Further Downside Ahead