Pure Cycle Corp.: On Track

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About: Pure Cycle Corporation (PCYO)
by: Bill Cunningham
Summary

Pure Cycle released its May 31, 2019, third-quarter results on July 8, reporting substantially increased revenue and a material amount of income, a trend that should continue.

On July 10, the company also held an "Investors' Day" at its Sky Ranch development, which I attended.

I toured the models of the three builders at Sky Ranch, where sales are going well, as well as some of the nearby housing developments.

Progress is proceeding about as I had anticipated in an article I had posted on Seeking Alpha a year ago, while margins appear to be better than I had anticipated.

Earnings could be in the range of $1/share in FY 2020, which begins Sept. 1, partly due to a potential municipal bond sale.

Introduction

Pure Cycle Corporation (PCYO) is a company with valuable assets that it is beginning to monetize in a significant way. These assets consist mainly of water rights, a scarce resource in the Denver metropolitan area (as well as many other portions of the west), along with a 931-acre property just east of the city of Aurora. This property, "Sky Ranch," has various approvals as a planned community of up to 4,400 residential units and about 1.35 million sf of commercial space where development has now begun. I wrote a detailed article regarding the company a year ago titled "Pure Cycle: On The Cusp Of Rapid Revenue And Income Growth." In this article, I provide an update, with a primary focus on the new housing development which is occurring at Sky Ranch as well as the surrounding area.

Sky Ranch Development

I attended Pure Cycle's "Investors' Day," which took place at Sky Ranch, on July 10. We toured the property, visited the Lowry Range (a former military bombing range), which is the source of most of Pure Cycle's water resource, and received an update on some of the company's activities.

I had also attended its initial "Investors' Day" exactly one year earlier, on July 10, 2018. At that time, the company had signed contracts with three major homebuilders, Richmond American, KB Home (NYSE:KBH), and Taylor Morrison (NYSE:TMHC), while Pure Cycle was basically at the "pushing around the dirt" stage at its 931-acre Sky Ranch development. The major arterial road had been graded, and work was proceeding on the grading of some of the roads and lots in the first 151-acre (506 lot) section of Sky Ranch. Wet and dry utilities were just beginning to be installed.

As of this year's "Investors' Day," the main road and some of the minor roads in this section had been paved, a significant portion of the utility infrastructure had been installed and sewer treatment plant construction was well under way. Most significantly, all three builders had completed model homes and were actively marketing their individual subdivisions. As of July 10, the three builders had a total of 59 homes under contract; Richmond American had 31, KB home had 17, and Taylor Morrison had 11 with three more contracts "in process."

Richmond American began selling homes there this past winter, while the other two had "Grand Openings" in May. Home prices start at about $325,000 but can go up to $450,000 or more. Sky Ranch is generally considered to have the most inexpensive single-family new homes in the Denver metropolitan area.

Although all three builders did some pre-selling prior to officially opening, the pace of contract signings appears to be six or more per builder per month, the rate I had seen a year ago in nearby subdivisions. In fact, Richmond American's sales representative is hopeful that its first section of phase 1, about 82 home sites (not including models), will be sold out by year end. With 51 remaining as of July 10, this would be a pace of close to 10 per month for the remainder of the year.

At least two of the three builders have raised their prices since initial sales began, a pattern I saw a year ago at other nearby subdivisions as well; if sales are much faster than six per month, the builders tend to raise their prices. Although it is more difficult to decrease prices if sales slow down, the builders have a tendency to offer various "concessions" (free upgrades etc.) in that case to keep sales moving.

The "Competition"

I visited a few of the nearby subdivisions and sales were generally at a similar pace at those locations as well. Here is an "Overview" of the area from Pure Cycle's Q2 earnings slide deck:

The section of Sky Ranch that is currently being developed is the westernmost 1/6 of the property (above "Sun Meadow").

There are two builders which are active in "Adonea, just to the west of Powhatan Rd. They are Lennar (NYSE:LEN) and Oakwood Homes (with two projects). Both are in the north-south sliver of land from East 6th Ave. to Alameda Ave. adjacent to Powhatan which appears to be undeveloped in the Overview.

Lennar is active in the northeast corner of Adonea, with a 120-unit subdivision of $400,000+ homes. It began sales in February and currently has 40 units under contract, an average of 8 per month. A site plan is here.

Oakwood Homes has two projects south of Lennar along the remaining property adjacent to Powhatan Rd. I visited the "Carriage House" project on this visit, which is the furthest south, just north of Alameda Ave. The Carriage Houses, starting at about $305,000, are less expensive than the homes at Sky Ranch, but are not traditional single-family configurations with yards; rather they are one step removed from townhouses. Although detached, there is no property to speak of, and there are groups of about half a dozen homes clustered together around a shared driveway. The configurations are similar to townhouses as well, with garages and possibly a multipurpose room on the ground level; the main living areas are usually a floor above, and for most units, bedrooms above that.

Oakwood began selling here in early 2018 and has sold 130 homes so far, with an additional 40 sites still available. It hopes to sell out by the end of the year. This is a sales pace of about 7/month.

The adjacent Oakwood project, "Park House," is much larger, with 600-800 home sites, I believe. They are more typical single-family homes with yards, and start at about $355,000. A website for both Oakwood developments is here.

There is also a new 1,380 acre planned community under development adjacent to Sky Ranch called "Harmony." It is on the sites labeled "Sandy Creek" plus "Sun Meadow" in the Overview and will eventually have as many as 3,900 homes. Only one of the three builders at Harmony, Richmond American, has completed models. (The other two are D.R. Horton (NYSE:DHI) and Dream Finders). The sales representative there stated that the homes are a bit more expensive than the ones they are building at Sky Ranch due to the fact that there will be amenities including a pool, sports facilities, etc. Richmond American began sales there this past winter and has 12 homes under contract so far, a somewhat slower sales pace than the other nearby locations. The Harmony Community and Richmond American at Harmony websites can be found here and here.

Potential Profitability of Sky Ranch Phase 1

Profitability of Land Sales

In its recent financial filings, Pure Cycle has been providing estimates of the potential profitability of land sales to builders in phase 1.

Accounting for the actual land sales gets a bit complicated. The company is currently only reporting a 6% gross margin on the sales, so income from this source is relatively insignificant.

However, PCYO is generally allocating the cost of the infrastructure (roads, drainage etc.) to the land, and will be reimbursed for that through municipal bond sales, possibly at a 100% profit or close to it. The infrastructure is purchased by a local taxing district (a "CAB") from Sky Ranch, which pays for it by issuing bonds. The homeowners' tax rate then reflects the debt service on the bonds, so ultimately, the purchasers of the homes there are also paying for the infrastructure

As a result, both of these items really need to be looked at together to determine the economics of the land sales. Per the 10-Q:

"We estimate that the development of the finished lots for the first phase (506 lots) of Sky Ranch will require total capital of approximately $35 million, which includes estimated reimbursable costs of approximately of $27 million that will be reimbursable to us by the CAB from the anticipated sale of the municipal bonds. Lot sales to home builders will generate approximately $36 million in revenues, providing a margin on lots of approximately $1 million prior to receipt of reimbursable costs."

In other words, total profit from phase 1 is estimated to be about $28 million, not including tap fees. Furthermore, the company announced in its Q3 earnings press release and in its 10-Q that bonds might be issued prior to calendar year end, which would reimburse a large portion of the company's infrastructure investment. Specifically:

"Mr. Harding also reported that the Sky Ranch Community Authority Board, a political subdivision and a public corporation of the State of Colorado responsible for the construction, design and financing of Sky Ranch (the "CAB"), is exploring the possibility of a bond offering, perhaps as early as the end of this calendar year, dependent upon market and other conditions. The offering would be intended to satisfy some or all of the CAB's obligations to reimburse Pure Cycle for its construction of infrastructure and other improvements at Sky Ranch, including roads, curbs and gutters, park amenities, street and traffic signs, water and sanitary sewer mains, storm water management facilities and lot and grading improvements. As of May 31, 2019, those reimbursable costs aggregated to approximately $13.7 million."

Profitability of Tap Fees

Pure Cycle currently receives about $31,000 per home in up front tap fees for water and sewer connections. For Sky Ranch phase 1, the company is essentially attributing a 100% gross margin to this activity as can be inferred from its segment reporting on p.23 of its May 31, 2019 10-Q:

With 506 lots in phase 1, that represents $15.7 million in tap fee income, over $1.76 million of which, for 57 taps, has been recognized as of May 31, leaving a remaining balance of close to $14 million.

In order for a builder to get a building permit from the county, it needs to have a guaranteed source of water and therefore needs to purchase a "TAP" prior to applying for the permit. This is typically done shortly after signing a contract with a home purchaser, if not before in the case of a spec. home. As a result, knowing that purchase contracts are being executed at a rate of about 20 per month (60 per quarter), we can expect quarterly tap fee income to be roughly $1.86 million.

Timing and Total Phase I Profitability

If 20 homes per month are sold, then the entire first phase of Sky Ranch should sell less than two years from now. If we add the anticipated $28 million of land sale profits to the $15.7 million of tap fee income, there will be total income of $43.7 million, only a small fraction of which has been recognized to date.

Sky Ranch Later Phases

At the Investors' Day, Mark Harding, Pure Cycle's CEO, was somewhat "tight lipped" about Phase 2 of Sky Ranch, which would include 480 acres of commercial, as well as multifamily and single-family residential property. I interpreted this as good news; I suspect the company is in the midst of detailed negotiations with builders/developers regarding some of the property in this phase and he likely didn't want to tip his hand or do partial disclosures to a select group of individuals. In prior communications, the company had indicated that it would be focusing on this phase once sales had begun in Phase 1 and it could better assess the market. I would be very surprised if there is not a significant announcement by the company no later than this fall when the FY 2019 earnings are released. It does sound like the multifamily portion may not be a priority though, until the area becomes more densely populated.

Water Sales

After a very slow winter quarter, metered water sales (mainly for fracking) increased dramatically in Q3 (March 1-May 31), to almost $1.4 million, and the gross margin improved to 71%. Sales are always somewhat impacted by seasonality, but this winter was particularly severe. Low oil prices in the fall may have had a bit of an impact as well, although Mr. Harding generally expects water revenues to be fairly consistent, or possibly increasing, irrespective of short-term oil price fluctuations. In fact, the company has seen the average quantity of water used to frack each well continue to increase.

Quarterly Financial Projections

I have presented some near-term quarterly financial projections below. The first column contains the actual results for Q3, ending May 31, 2019. I then made some changes to those numbers, mainly reflecting expected tap fee and land sales revenue/income. The projections are mainly applicable to the next one and a half to two years, the time it should take for phase 1 to be built out.

As previously indicated, tap fees, at 60 sales per quarter and about $31,000 per water and sewer tap, would generate about $1.86 million of income per quarter. For purposes of estimating quarterly revenue and income generated by the land sales to the builders, I am assuming it will require seven quarters. As indicated above, the company has estimated total sales revenue of $36 million and income of $1 million. I subtracted the revenue and income Pure Cycle has received to date for Phase 1 and allocated 1/7 of the remaining $27.8 million of revenue and remaining $556,000 of income to the "typical quarterly" figures presented below. I also increased the quarterly G & A by 10%.

I then made one further change in the final two columns to account for the potential bond sale income (technically asset sale income from Pure Cycle's perspective). In the "other" category, I added the full sales proceeds in the first of these columns, while I added only half of it to the final one, which means there would be two quarters like that one. There are still a number of uncertainties with the bond issuance, and in fact, as indicated above, only about half ($13.7 million) of the final reimbursable cost amount of $27 million has been invested to date, so this may be the more prudent and realistic approach than allocating the entire income to one quarter.

For the remaining items in the model, most of which are minor, I have simply used the Q3 numbers. I have tried to make the model as transparent as possible so that it would be easy for readers to substitute their own assumptions in it. The resulting model is as follows:

Observations

The second column in the chart should be a reasonably accurate representation of what to expect in the current quarter, which ends August 31. It suggests a 40% increase in revenue and a 57% increase in net income over the prior quarter.

The municipal bond issuance will cause some very lumpy quarterly results; therefore I believe it is best to look at annual results. I would be inclined to conservatively assume that half the profit is reported in the upcoming fiscal year (commencing Sept. 1) with the remainder possibly deferred until FY 2021. This would result in total FY 2020 income of about $.89 per share. ($.65 +3 x $.08). A 20 P/E for a rapidly growing company does not seem at all unreasonable, so that could suggest a stock price of $18 or more in the near future.

These projections basically address the next year and a half ( the current quarter plus six more) and only focus on those items which are material and for which there is reasonably good visibility. I did not include revenue-generating activities at the later phases of Sky Ranch, which hopefully will commence prior to Phase 1 winding down. I also did not address the occasional tap that Pure Cycle is likely to sell at Wild Pointe Ranch, nor the fact that we will begin to see some ongoing water/sewer revenue from the new homeowners at Sky Ranch.

Longer term, there is the significant progress that has been made among the 10 water utilities and agencies in the Denver area participating in the WISE (Water Infrastructure Supply Efficiency) System, which allows water to be moved among the participants. In water short Denver, this may provide Pure Cycle with opportunities to sell water to other WISE participants, particularly during dry years. It also may ultimately make one of the two reservoir sites that Pure Cycle owns on the Lowry Range, which it doesn't expect to need for its own use, quite valuable, as it could be linked to the WISE pipeline system.

Of course, there remains Pure Cycle's 800 lb. gorilla; it owns enough water to eventually be able to sell about 55,000 taps even after allocating almost 5,000 for Sky Ranch development. At $31,000 per tap, this can eventually generate revenue of over $1.7 billion, although it could be 30 years or more before they are all utilized.

Finally, There is the important fact that Pure Cycle has absolutely no debt (zero, zilch, nada) and is beginning to generate significant amounts of cash. How will it deployed? Additional investments? Dividends? Stock buybacks? A combination of all three? We'll have to wait and see.

Disclosure: I am/we are long PCYO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.