Pure Cycle Corp (PCYO) 2011 Q2 法說會逐字稿

Good day ladies and gentlemen. Thank you for standing by. Welcome to the Pure Cycle financial results for the six months ended February 28, 2011.

At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder, this conference is being recorded.

Now I'll turn the program over to Mark Harding, President and CEO.

Thanks very much. I'd like to welcome you all to our midyear earnings call. As in past calls, we have a slide deck on our website at PureCyclewater.com; it's on the front page there. You all can click on that and go through the slides with me. I will try and note the transition of the slides as we progress through the presentation. So with that, I'd like to start with our Safe Harbor statement and say that statements are not of historical fact, and these are forward-looking statements that involve risk and uncertainty, and actual results may vary from the presentation that we have before you today.

What I want to do is spend a little bit of time talking about first and foremost our acquisition late last year. It was a significant event for the Corporation and has had a number of important implications to not only what the opportunities are available to us today but also some of the trending and some of the objectives that management together with our Board had taken a look at as a strategic initiative in our fiscal year last year.

First and foremost, the acquisition really accounted for purchase of a piece of property. It was a piece of property the Company did have an interest in, about 940 acres of undeveloped property right along Interstate 70, approximately 12 miles east of downtown Denver. It was about four miles north of the Lowry Range, about five miles south of [DIA], so it was really between the Lowry Range and DIA right along Interstate 70 corridor. The property is unique because it has direct access to the interstate. It was a piece of property the Company had entered into an agreement back in 2005 for water service to the property, and we had committed a portion of our portfolio to provide water service to the development on that particular property.

The property fell victim to the housing downturn and the developer of the property filed for bankruptcy protection early in the process, back in 2008, and really sitting in bankruptcy for the last 2.5, 3 years. We took a look at it as an opportunity on several fronts -- one, to take a look at the diversification and being able to put more control within the Company's asset dispositions, and also the opportunity to pick up service to the property, not only on the water side but on the waste water side and be able to [incentivize] development to the property.

So the project was financed through transactions that really were an equity-based financing. Back in September, we sold common stock off of a shelf of $5.5 million worth of common stock, and then we issued a convertible note to one of our shareholders that would convert upon shareholder approval of that shareholder exceeding a 20% holding. While it was two-staged financing, it really boiled down to common stock equity issuance which is ultimately issuing up to about 4 million shares to get right at the $11 million to not only acquire the property but also add to working capital for the Company.

It's been a positive acquisition for us. We've received approximately 1000 acre-feet of water which we were under contract to purchase for approximately $2.6 million. So if you deduct the water from the cost basis in the land, it really lowers our cost basis in the land if you apply that to 4850 single-family equivalents to less than $900 per lot. So we believe we not only acquired the property at a good and value-added purchase price, but also added to the Company's water portfolio and our ability to be able to hit the ground with taps to the development out there.

Shortly after our acquisition, we were approached by several oil and gas companies. This has generated a lot of interest, both for us and for our investors on a very fast-moving oil and gas play here in the state of Colorado in the formation known as the Niobrara formation. This formation has predominately been interested in northeast Colorado, southeast Wyoming, and it really was uncertain as to how extensive or how large the formation extended.

A lot of major oil and gas companies started to take a look at existing well logs throughout the state and found that the formation extended down into this particular area. Then several of the companies made a concerted effort to go after a specific play here in what we are calling the DIA Aurora area. Companies we spoke with regarding this particular lease were Conoco Phillips, Chesapeake Oil and Anadarko. There were several others but those were the three big names that we took a look at. And ultimately the Company selected Anadarko.

If you move to Slide 4, what we want to describe is a little bit of the consideration that the Company took a look at and the analysis of this oil and gas lease, and maybe give you some insight as to why we chose Anadarko. One of the key reasons was that Anadarko held the majority position of lease interests of property surrounding Sky Ranch. They had a number of lease interests they had, existing lease interests from some railroad grant lands that they purchase from Union Pacific, as well as being very aggressive very early on in picking up these positions in and around this area.

Some of the things that were very sensitive to the Company are that this property is a zoned master-planned community. That status was very important to the Company. One of the things we did not want to do was compromise our opportunity to develop the property by oil and gas exploration. I think Anadarko really had a leadership effort in demonstrating how oil and gas exploration and oil and gas development was not inconsistent with master planning communities and residential development.

In addition to that, one of the things that they were very interested in and one of the thing the Company was important to do upfront was to enter into a surface use agreement specifically defining the number of well sites, where those well sites could be located, access to those well sites, extension of roads and utilities to those sites, and how those sites would ultimately be developed and reclaimed.

One of the things that was important to us was if we were going to have these industrial sites where we had oil and gas facilities, we similarly will be developing water facilities. So we had similar site in terms of structure where we would be developing wells on a particular pad site where we would have our water facilities, if the Company was able to co-locate those facilities on the same pad sites, then that maintained the same footprint that we were looking at for net developable properties. They were very amenable to that, very willing to include that type of language in these sites. So when we were looking at this thing, it was important for us not only to have an operator partner that took into account the business opportunity of what we were doing as a water utility play, but also that this Company is a master planning community and had the architectural standards that we were looking for, for reclaimed sites.

As we have mentioned in previous press releases, the Company is set to receive a bonus payment as well as a retained gross production royalty interest. So our bonus payment was around $1.268 million, and then we are also looking at a 20% gross production royalty interest as they develop the oil and gas play.

Additionally, as you might imagine, if there are oil and gas prospects under our property, there are likely similar prospects under another property that the Company has an interest in, which is the State Land Board's Lowry Range. I think there's been widely reported press in the local business journals about the prospects for the State Land Board at the Lowry Range reaching as much as $500 million.

And so one of the things that also interests us about Anadarko was that they were underway with a seismic survey. In Slide 4, it kind of gives you the footprint, the general outlines of the footprint of a 150 square mile seismic survey that they have underway, and they are out in the field as we speak doing the seismic survey. They are hoping to have that completed sometime this summer and evaluate the information from that and then evaluate how they would like to progress with their drilling operations.

In addition to having the predominant lease interest in and around the properties of the Lowry Range -- or of the Sky Ranch property, Anadarko does have some interest, very small interest, in existing oil and gas pieces on the Lowry Range. I know they are very interested in what the State Land Board ultimately decides to do on putting that property up for bid, and whoever is the successful bidder out there.

If you move to the next slide, the thing that this slide really tries to detail is sort of the operations of our focal point, some of our existing customers being Arapaho County Fairgrounds where some of our existing facilities are, the existing infrastructure that's coming into the property, the Prairie Waters pipeline, the Aurora water treatment plant, and how sort of the Land Board was looking previously at the Lowry property being divided into three segments of a development parcel, a water resource parcel, a conservation parcel.

Lately, really the discussions at Lowry have been all about the Niobrara oil play. That has dominated most of the discussions out at Lowry and taking a look at how they can pursue that opportunity while in similar context making sure that they preserve some of the key features that are important for them. That is also to take a look at development opportunities that they might have on Lowry as well as conservation opportunities they might have out there.

While the development picture is unclear, and by unclear the housing market is -- we don't have a lot of clarity as to how the housing market will look at Lowry in any current timeframe. What is still a very unique opportunity is what the water opportunity and the storage assets are out at Lowry. We continue to pursue those assets not only with the opportunity to participate with the 15 other members of the South Metropolitan Water Supply Authority that the [ranging] Metropolitan District, which we are members of that joined that group back in 2009, together with Denver and the City of Aurora, on taking a look at regional water cooperation out there. A component of that is obviously some of the storage opportunities that we have at Lowry as well as interconnecting a lot of the water systems that are out and about on each of the individual water providers that are participating in that effort.

So with that as a brief introduction, what I'd like to do is get down to some of the nuts and bolts about the first half of the year. As most of you know, if you move over to the next slide, Slide 6, as most of you know, most of our overhead is front-loaded within the first six months of the year with the majority of those costs incurred in our first six months. The year was a little heavier in operating expenses through some unusual one-time non-recurring elements of that; some of that was some bonuses that the Board paid management for a successful acquisition and the capital raise, some higher legal and consulting costs related to the acquisition and also our discussions with the regional water framework as well as some non-capitalized acquisition costs on Sky Ranch itself.

Moving to the next slide, Slide 7, I guess that really describes some of those specific elements. The revenues and gross margins for the first six months of the year were positively impacted by two things -- one, small increases in our rates, our water and wastewater rates effective July 1, 2010. Each year the Company evaluates its rates and charges and takes a look at the average of our three surrounding rate-base districts and sets our rates accordingly associated with that.

Then the second side of that was seasonal variations in water and weather patterns and we've had a dryer first half of the year than we had in the previous period. Operating expenses are slightly higher, as I explained in the components in the last discussion. Then more specifically, the details in our G&A expenses talking about our cash operations are included later in some other slides.

Moving to Slide 8, one of the things we do like to highlight and really explain time again is the complications due to the Tap Participation Fee liability. The Tap Participation Fee liability is recorded at an estimated fair market value of what we anticipate that liability to be, to be payable to the interest that we acquired the Arkansas asset for. We adjust that whenever events or circumstances indicate a change to the fair value. The fair value is based on management's estimates of future water tap sales based on forecasts of housing market data. As you might appreciate, that's a complicated forecast for us to do and for us to continue to maintain.

The difference between the recorded value and the estimated net realizable fair value is recorded and then [computed] as interest expense. So what you see in our net loss calculations is a large component of that, more than two-thirds of our NOLs are really due to these non-cash recording elements, whether that's going to be the Tap Participation fee which is going to be the largest component of that, or share-based compensation expense, which is our 123R calculations, or depreciation and depletion expenses that we occur. So it somewhat complicates the readers' view of our net operating losses, but what we try to do is clarify that for our institutional and retail owners and shareholders so that they have a better understanding of where the Company spends its dollars and what the balance sheet and the income statement look like.

So let me move to -- Slide 9 is a summary position of our balance sheet. Our current assets -- we have a cash and cash equivalency of about $4.4 million and current assets about $4.7 million. Total assets are up about $10 million due to the acquisitions, about $9.5 million.

The net liabilities -- the Company has no debt. Our current liabilities are up a little bit from prior year or from the year-end reporting period, but that's due to timing of payables and spanning over the closing period. But still the long-term liability, the most significant component of that is going to be the Tap Participation Fee liability which is a component of as we add new taps to our system, the Company is obligated to pay a portion of those taps to the holders of that. So we try and estimate the fair value of that and kind of keep that current, but that's again an obligation. It's not a debt obligation but it's an obligation as we incur -- as we actually receive revenue from adding new tap systems, then we have what's very similar to a production royalty payment to that asset holder.

Moving on to Slide 10, some of the summary statements and changed explanations, significant balance sheet items. Cash and cash equivalents obviously $4.4 million, so we have our existing asset inventory up. That's mostly just due to the capital raised and the acquisition.

Investments in the water and water systems in land Sky Ranch increased mainly as a result of the acquisition. Then the long-term liabilities are consistent and that still has the large factor of the Tap Participation Fee liability.

Moving over to Slide 11 on the statement of cash flows, cash flows are in line with really prior-period February 28, 2010. Then the investing activities are up significantly. That's due to the issues with the acquisition and financing activities similarly.

Slide 12 gives you an explanation of each of those elements of that and investing activities and financing activities.

Moving onto sort of the graphic illustration of the quarter and the six months ended, taking a look at G&A expenses, G&A expenses are up a little bit, probably about 26%, but mainly as a result of some of those bonuses and increased costs associated with the acquisitions. Those will probably normalize a little bit more over the year-end period, but they are up a little bit. We are still very mindful of making sure that we keep our costs and optimize and be efficient as possible while we are continuing to develop these assets. Total revenues are up slightly, and that's attributable to small rate increases as well as seasonality of precipitation in the area.

Moving on to Slide 15, if you take a look at both water usage and water usage revenue, those are both up both in terms of gross gallons of water delivered as well as revenue associated with those.

Then the NOLs on the next slide, Slide 16, again, two-thirds of those being that non-cash component -- so that you get an understanding and appreciation for that.

Finally, taking a look at the last components of sort of the asset side, current assets increased through 2011. 2010 is a bit skewed because we had a partial payment under the Sky Ranch contract prior to year-end, so what you saw was sort of a very large gap between 2009 and 2010 because a portion of that was attributable to use of those cash funds prior to fiscal year-end when we actually closed on the asset after year-end. Investments in water and water systems, again that went up as a result of the acquisition itself.

Then total equity again, by the component of the raise, about $8 million on that.

So also we'd like to give you kind of a snapshot of the housing market. Housing continues to improve, but continues to be uninspirational. 2009 looked better than 2008; 2010 looks better than 2009; and 2011 looks to be better than 2010. But again, it's a slow improving market segment, our housing market.

Really the thing we take a look at for the most part is that entry-level housing market. Annual starts are up significantly; they are up about 36% in the 11-county Front Range area, and about 40% in the -- if you drill down specifically into the eight-county Denver metropolitan area. So the largest part of the market continues to be that starter home market.

Then what we're looking at is sort of the vacant lot deliveries, the amount of physical supply. While the amount of physical supply looks like that's at a high level, it's at a -- on an actual number, it's at one of the all-time lows in terms of the actual number of inventory that we have, but then because you have such a low absorption rate to that, it skews the results in terms of the month of the supply. And so the market will kind of define how that's going to work its way through. Most of those vacant lots are going to be at a price point that's at the midrange and the upper midrange levels. What we are seeing is really a strong decrease in the entry-level lots. If there's any pressure for new product to be made available, it's going to be at that entry-level product area.

So in summary, I guess what I'd like to do is maybe really summarize the past year, where management, together with our Board, really sought to achieve two specific objectives. One was to decouple our near-term revenue opportunities away from the State Land Board's Lowry Range property. Now, the State Land Board and the Lowry Range water asset remain our most valuable partnership and remain a tremendous part of our water portfolio. It has prospects for generating and serving customers, both near-term and long-term, so the asset remains a critical component to our value of the Company's shareholders, value as well as the opportunity to monetize those assets. But what we were looking at was really moving away from expectations out on the Lowry range physical property.

Then secondly was to diversify some of our revenue drivers. What we were looking for were opportunities where any diversification would have been synergistic with the Company's existing assets. What we've tried to do, we are and we remain a water company, one where we believe, as the value of water and water short areas continues to grow, those values of our asset will continue to grow.

But what we were looking for was our diversification of investments. We're concentrating in areas where we had more control over the timing of developing those assets. Really that was quantified by owning Sky Ranch. What we are looking to do with Sky Ranch is where we can develop the water not only for the opportunities on Sky Ranch but also for other uses, such as industrial applications. Perhaps we can have the opportunity to provide water for some of the oil and gas plays through water fracing that they are doing in conjunction with some of their oil exploration.

While the Denver market continues to perform well, I think what we've done is successfully diversified our portfolio, granting us and our shareholders greater flexibility in our existing asset portfolio as well as new assets that we -- that look very favorable for us and that we have a very strong outlook for for returns for our shares in the near term. These asset diversifications have not and will not detract our focus as a water company. We now own land interest. However, we are not a developer and we are not seeking to become a developer. We are fortunate that some of our land interests may have oil and gas but we are not and oil and gas play. And we are not counting our chickens before they hatch. As the play develops and as the picture clarifies itself, we will update you on to those developments and those opportunities. While they do look good, we are very bullish and we're very optimistic about how this play looks. We will continue to update you as that information becomes available to us, and we look forward to that.

And so with that, what I'd like to do is maybe turn it over to you and see if any of you had some specific questions that we might be able to drill down into some of the elements of this that you would like clarified. So with that, I'll turn it back over to the moderator.

(Operator Instructions). Robert Kirkpatrick, Cardinal Capital.

Thank you. Good afternoon. Is there an opportunity to sell to Anadarko additional water? Because I would think they would be using a great deal of water in their oil and gas drilling process.

That's a great question. Certainly, that's something -- a conversation we've had with Anadarko. Really there are sort of two divisions we've been working with, land guys in the leasing operation and then they've handed us off to our operational folks. And so you are right. All of this exploration involves new techniques which include horizontal drilling and include hydro fracturing. They use a lot of water in these hydro fracs. They use anywhere from between 4 million and 5 million gallons of water per frac -- or per well. They are looking at literally hundreds of wells in this region.

So what the opportunity presents itself is they are going to need a ton of water come and the Company has a lot of water. Not only does it have the water, but it has the water in the right place, whether that's on the Lowry Range itself where we certainly know that we have the exclusively to provide water to all of those surface lessees and tenants on there. So if Anadarko ultimately becomes the successful bidder on the State Land Board property or whomever, we certainly look forward to supplying all of those wells, which is a very significant contiguous block of property, and then really competing on Sky Ranch and all the surrounding areas.

Really the attraction for us is that we'll have facilities where we can deliver water through a direct system, where they don't have to haul that through trucks. You might imagine hauling 5 million gallons of water for each and every well is a lot of haul costs. If they can save some money, that becomes a very attractive opportunity for them and also a very attractive opportunity for us.

I'm sorry. Did you say how many wells you thought would be on Sky Ranch?

What they look for is about two wells per section. So our property is not really a square block as you would normally see for a section, so they are looking at somewhere between three and five wells on our property.

Okay. What is their timing in terms of when they would begin to drill, and then, if successful, when they would begin to produce?

Boy, that's one that we ask often and I don't think they have a lot of clarity to yet. Certainly what they have responded to us is some of the things they know they are doing. One of them is that they know they've got their seismic people in the field, and so they think that would probably be done some time June/July timeframe, and then allowing them 60, 90 days to interpret and evaluate the results and develop their plan. They would like to be out in this particular area, in this sub area of their play, in this 150 square mile area where they shot their seismic with some well and drilling operations. It may be multiple wells sort of late this year. What we just don't know is where are the wells going to be first? We certainly would like to be among those. I think we are in a good position that we are attractive because we have pretty good access off the interstate with the interchange right there at our property. We have an existing surface use agreement in place so that doesn't have to hold up their discussions on getting landowner approval on where they want to put these sites and how they'll extend the surface facilities and all of the mechanics that we did upfront in the discussion. Typically, they don't go through the surface, the trouble of a surface use agreement, until they have more definition to the play, but one of the things that was important to us was that we do that upfront for several reasons. It was important to them because they liked the positioning of our property.

So while I would like to and I'm going to do everything I can to encourage them to have our property be among those first areas that are drilled on, we just don't know until they get their seismic back and get a real detailed look at what this formation looks like and how they want to attack it.

Great, thank you so much. Congratulations on getting that deal done.

Thanks very much.

(Operator Instructions).

If any of you who are listening or if you're listening in on the rebroadcast want to talk about something off-line, don't hesitate to give me a call. Again, this is an important acquisition. I think it's some important developments for us. It has done some tremendous things for the Company in terms of putting some liquidity into the Company, in terms of adding value to the asset base that we have. We are truly excited about it. It's something that I think we will have continuing development and continuing news on that, that we'll give you updates on to give you some more certainty and some more timing on that. But one of the things I think this does for us is it provides a significant increase in clarity and control over how we continue to develop these assets, so we are very excited about that.

So again, I want to thank you all for your participation. I want to thank you for your continued support. If you do have any questions, don't hesitate to give me a call.

Ladies and gentlemen, this does conclude today's program. Thank you for your participation. Have a wonderful day.