Pure Cycle Corp Q2 FY2021 Earnings Call

Greetings. Welcome to the Pure Cycle Corporation’s Second Quarter 2021 Earnings Call. At this time, all participants are in a listen-only mode. A question-answer-session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, President and CEO, Mark Harding. You may begin.

Thank you all for joining our second quarter earnings call for the six-month period ending February 28, 2021. For those following along with our presentation, you can find it at our website, purecyclewater.com. I’ll start off with the necessary legal disclaimer regarding forward-looking statements. For those new to our company, I’ll provide a brief overview of our business and then delve into specifics about each segment before turning the call over to our CFO, Kevin McNeill, for an overview of our strong earnings this quarter. Our company operates in three main business segments: Water Resources, Land Development, and a newly announced Build-to-Rent segment. In the Water Resource segment, we own water rights in a water-scarce region and develop those rights for our own use as well as for wholesale distribution. We hold approximately 29,000 acre feet of water rights, which allows us to serve around 60,000 connections, equating to residential connections. We also build the necessary infrastructure to provide this service. Moving to the Land Development segment, we’ve acquired about 1,000 acres in the Denver area, positioned well for growth. This project has the potential for around 3,400 residential units and several million square feet of commercial space. We’ve already seen positive progress, including our first phase with nearly 300 residents and over 100 homes under construction. We anticipate selling out the available lots in this phase by the end of the year, contributing around $37 million in revenue. Looking into the second phase, we started with about 900 lots and are currently grading the first 230 of these lots. We’ve seen a significant increase in lot prices, estimating about $72.6 million in revenues for this phase. Our plans for this phase include various types of housing products to appeal to a wider range of buyers, which we believe will enhance absorption rates. In terms of new developments, we’re excited about our Build-to-Rent initiative, where we are partnering with homebuilders. This allows us to reserve lots for our projects without competing against our builders. Given the growing demand for entry-level homes in Colorado, we see this as a strong opportunity. We’ve secured competitive financing for this model, projecting positive cash flows of approximately $15,000 per connection. As we look to the future, there is significant potential in selling water to the oil and gas sector, with an increase in water usage per well. We are well-positioned in this market, with a rig currently drilling additional wells. Now, I’ll hand the call over to CFO Kevin McNeill to go over our financial results.

Great. Thanks, Mark. Welcome everyone, and thank you for joining us this afternoon. I want to touch on a few key items without going through the P&L line by line. On the slide, we are looking at slide 23. The top three graphs illustrate the major items: revenue, gross margin, and net income for the six months ending February 28th, compared to previous years, which helps gauge our performance over time. The main point I want to emphasize is in the bottom section regarding reimbursables. As mentioned in prior calls, we previously considered these contingent on payment, which meant they weren't recorded in our books. We had been waiving and postponing the recognition of interest income and project management fee revenue. However, this quarter, with the progress of our second development filing and changes in the mill levy alongside a growing and sustained tax base from the first filing, we conducted an analysis and concluded that these amounts are indeed collectible. Under U.S. GAAP guidelines, we now consider it probable that we will collect these funds. Consequently, we can recognize approximately $19 million as other income related to the reimbursables, in addition to $1.5 million in project management fees and $1.4 million in interest income. This aligns our financials with the actual situation and will help restore our gross margins to expected levels reflecting what is truly happening in the first phase. Moving to the next slide, I will briefly mention a couple of items from the balance sheet. We are maintaining a solid cash balance, which you will see decrease in the upcoming quarter as we continue with the development of the second filing, though we anticipate receiving some milestone payments. The next slide presents the income statement, which will be included in our 10-Q to be filed tomorrow morning. Notably, for the six months ending June 30 this year versus last year, our metered water usage has increased by about $100,000, primarily due to growth in Sky Ranch, where around 300 homes have been constructed. There is also some additional fracking revenue from our oil and gas operations. On the other hand, we have seen a significant decline in land lot fee revenue because the first filing is nearly complete, and all those lots have been sold. We expect revenue from the second filing to be recognized later this year as permits and utility installations progress. That concludes my remarks. We will have a Q&A session at the end, and if you have any questions, feel free to reach out to Mark or me. And now, I will hand it back to Mark.

Great. So a couple of highlights there, one important aspect is the impact of COVID on our operations. The main effect was a delay in processing our approvals for the second phase. This was unavoidable, as we had to submit detailed designs and engineering documents to the county while they were figuring out how to transition their staff to remote work and manage timelines for processing applications alongside public hearings. We had hoped for better overlap in these processes. Although the timing did not work out as planned, we are optimistic about improved management going forward. If I were to summarize the COVID impact on the company, that would be the key point. In terms of staffing, we have maintained our team in the office through rotating occupancy and are gradually increasing our presence. Most of our team is coming into the office, and those in the field have consistently been delivering water and wastewater services. With that, I will turn it back over to the moderator for any questions you may have.

Thank you. Our first question is from Tucker Andersen with Above All Advisors. Please proceed with your question.

Hi, Mark.

Tucker, good to hear from you.

Very informative presentation. You guys are getting really professional. I don’t recognize you anymore. A few questions, could you talk about any color on when and how you may proceed with the commercial development?

We have strengthened our Board by bringing in a top expert in commercial opportunities from a local private developer who is not a competitor. His name is Jeff Sheets, and along with Patrick Beirne, who has extensive experience at Pulte, they have both expressed that they've never regretted selling their commercial properties. They wished they could have held onto those until they reached full value. There's a careful balance between holding for value and presenting that value effectively. Currently, we are in contact with various commercial users, including grocery anchors and big box stores, to understand their needs. They recognize our location as ideal, particularly because of the interstate interchange, but they're looking for a bit more residential density in the area. We consider this to be a later stage in our second phase, potentially when we have around 1,000 units, which isn't too far off given the absorption we’ve noticed. In the second phase, we anticipate a similar absorption rate to the first phase, estimating about five units per product type per month, which could lead to around 30 per month. By next summer, we expect to be actively pursuing lease opportunities. Our goal is to deliver the entire pad site for the actual end user, avoiding scenarios where we lose control of the property. This analysis helps us optimize both the value chain and the present value of our commercial properties.

That’s great color. The follow-up I would have to that is, as you develop more of the residential, does it make the remaining residential lots more attractive and perhaps your pricing better. If you have like, let’s say, an operating grocery store and some basic amenities for the people who are residing at Sky Ranch and is that also an additional consideration?

It is. It is very much additional consideration. And actually you are touching on one of the key points why we went to this Build-to-Rent, because everything that we are doing that we are otherwise going to do is going to continue to increase the value of those homes. And so, for example, getting a charter school operator on there, getting commercial out there, getting roadway improvements, getting a rec center, getting all of the parks and amenities up, every time we do that, that increases not only the value of the lot, but the value of the home, if it increases the value of a $100,000 lot by 5%, that’s great for us. But if it increases the value of a $450,000 home by 5%, that’s almost 4.5 times greater for us. So that’s why we like that.

Yeah. Yeah. The Build-to-Rent is very interesting and if I could ask just a couple more questions, I don’t want to take up all your time. Is your Build-to-Rent financing specific mortgage financing for that project or is it financing that has recourse to your general balance sheet?

It is directly related to the residential units, not against the balance sheet.

Okay. And the only other question I had is, what’s happening to affordability both in your Sky Ranch development in general and then the Denver area in particular with the other pressure on builders with regard to costs for things like that? And I know for now it looks like mortgage rates are clear, so I am not including mortgage rates, but just in terms of the general delivered product cost and how that’s affecting affordability there?

It is a concern in any market and particularly in ours. Lumber prices and labor availability are significant factors in this regard. One of the key considerations in our BTR model was to partner with national builders since they offer the best cost per square foot. Custom building these homes poses challenges due to increased costs, and we want to remain competitive. This is why we are exploring a second phase with greater density compared to the first phase, which includes townhome products. Increased density enhances assessed value, improving the recoverability of our reimbursables. All these factors enable us to remain at the forefront as Denver’s most affordable master-planned community.

Thanks. Keep up the value creation for us long-term shareholders. That’s all I have to say.

You have been one of those and thank you for your confidence through the years.

Thank you. Our next question is from William Miller, a Private Investor. Please proceed with your question.

Okay, Mark. I loved everything you said, but you haven’t told me about what I think is a critical component of your future. Why aren’t you going out and buying more land for your rental endeavors? I mean that’s so much...

What...

...that’s so much best...

You...

...opportunity you have and you have got the best cash flow, it’s recurring revenue, which is what people will ultimately pay for in your stock?

Yeah.

And you have got to get more land and own it now.

I completely agree with you, Bill. We are actively pursuing opportunities. We have reached out on several fronts regarding various properties and will keep you informed. A significant part of our strategy is focused on growing the business through all possible avenues we can manage, as well as through acquisitions and partnerships. Whether it's purchasing land directly or collaborating with others who possess zoning approval, including utilities, all of these are components of our growth strategy. We remain active in this area and understand the importance of demonstrating tangible success to you, our Board, and others. However, we also approach this with discipline and intelligence. We recognize that we may not find another opportunity as favorable as Sky Ranch, and that is not our benchmark. At the same time, we have the capability to invest more in land than some competitors might because we have access to water resources that can be integrated. Therefore, we are being proactive in the marketplace, so stay tuned for updates.

Well, is it a very competitive marketplace at this time?

It is indeed competitive. Many people are making offers, but the situation is somewhat unique for the properties near Sky Ranch due to limited water availability. Prospective buyers may recognize the value of the land but may hesitate because of the water issue. I believe this gives us a competitive edge.

And what is going to act as a catalyst for you to actually get something done?

That's a good question, but I don't have a definitive answer. Ultimately, it depends on what's right for the seller. Sometimes, sellers aren't ready to sell at any price. Other times, the pricing expectations may be unreasonable. Additionally, we are navigating some logistics with specific buyers and sellers. All these factors come into play. We've spoken with individuals who have indicated that while they are aware of the current market, they're not interested in selling right now due to their personal circumstances, such as estate planning. Some sellers are open to selling, but their price expectations may be inflated because they want to factor in our water resources rather than pricing based on their current situation. Then there are sellers who have reasonable pricing, and we are working to facilitate a transaction with them.

Mark, what took you so long to get to the idea of a rental property?

Just like my wife says, I am a slow learner. It’s the gender problem. I have a gender problem with that.

Okay. Well, now that you are overcoming your gender problem, I hope you will speedily go to the next phase of your issues and get some more land, so that we can start factoring in what this is going to look like in three years to five years.

Yes. Excited to do that too.

Okay. Great. Well done.

Thanks.

Thank you. Our next question is from Justin Xie with Black Diamond Investors. Please proceed with your question.

Hey, Mark. Great to hear from you. I wanted to ask a couple questions on the Rental segment. First is like, could you walk me through sort of the financing process for the Build-to-Rent construction? And it seems to me like your capitalized costs are less than sort of the leverage you are getting, is that right and are you able to recycle all of your capital?

Yes, that's a great question, Justin. While my Board has indicated that I can't use any of our balance sheet for this purpose, I am using a portion of it. We will construct the units ourselves and finance the $1 million needed to build all three units. After obtaining Certificates of Occupancy from the county, we'll use each unit as collateral for the $1 million. This means the bank will reimburse me the $1 million and take a deed of trust on each unit. If it costs about $320,000 or $330,000 to build each unit and the expected sale price is $450,000, we can avoid PMI insurance due to the strong margin. This setup allows us to generate positive cash flow, covering not only our debt service but also contributing additional margins to the bottom line.

Yeah. That sounds wonderful. Great to hear that. And then, secondly, I guess, how are you thinking about the percentage of properties that end up being Build-to-Rent versus for sale? Because at least in my impression, Build-to-Rent seems to be like the most value accretive thing? So how are you thinking about the proportion of properties in those categories?

That's a great question. The Board has a strong preference for a tangible demonstration of success. They might say, for example, we will provide you with 100 units to manage and assess your performance. Can you construct these units as promised? Will you be able to handle the rentals and generate the projected income? If we consider that 100 homes represent less than 10% of the total 1,400 units, we're looking at about 7% overall. For the additional 2,000 residential units we have, targeting 10% to 15% for this initiative seems balanced as it aligns well with community needs. We're considering distributing these units in various locations throughout the community, but we may also opt for a block of around 60 units to streamline maintenance and enhance operational efficiency. Our goal is to adjust our strategy as needed and continue to build upon it. I would suggest that our acceptable level might be between 300 to 400 units in Sky Ranch. Following Mr. Miller's comments, we will seek additional land to continue this initiative, as we are seeing positive value being generated. We plan to maintain around 10% to 15% of our developments in a Build-to-Rent model.

Got it. Sounds great. And in terms of property management, is that being done in-house or are you finding some third property manager or third-party property manager?

So, for the time being, we think we are going to keep that in-house and one of the reasons for doing that is, one of the reasons I would attribute a lot of our success on the development side is, we have got a combination of doing utilities together with Land Development. And really where the efficiencies come in on this thing, when you go out and you bid your Land Development, right? We are not going to grade the ground or do a lot of the wet utility, the retail distribution system or the dry utilities or any of that work. We bid that out to the market. And the market comes back very competitive when they first bid these things out. And you never can know everything when you are getting in the Land Development. There’s always surprises. So you always get this change orders and the things that we have done successfully is we have guys that are capable of doing this work, right? They are very talented with the big iron, the loaders, the excavators, the equipment that needs to be able to install the facilities for our Utility segment and they can do the same thing on the other side. So when these change orders come up rather than being that high priced dollar on the change order, we take care of that. So having that team on-site also gives us the ability that these guys can do everything. And so if we have got a plumbing issue over it so and so’s house they can be dispatched over there and it really won’t be a significant intrusion into our overall business model because we have them doing productive work all the time. As opposed if you have got a management agency and you have got to get a guy dispatched to go out and commute an hour each way, 30 minutes each way. You got a 15-minute on-site fix and another 30 minutes back, that kills you in terms of the management of that. So we like that because we are already on-site. We already have the talent and the resources to do that. And so that’s why we like maintaining it ourselves, we will see. Maybe I am wrong. Maybe it becomes too consuming and then we sort of say either we stuff into that when you get 100 units, when you get 300 units, you certainly can easily stuff in and have those dispatched directly on-site between zero and 300. I think we can manage that with the talent that we have.

Got it. Sounds good. And just to be sure the financing on the Build-to-Rent are these fixed rate or these variable rate loans?

They are fixed rate.

Okay. Fantastic. And then one last question for me, I guess, when you think about the acquisitions in the pipeline and the deals you are considering. Is there any thought to using leverage for these acquisitions to lower your cost of capital, or are you planning to draw directly from your cash balance?

We will see. It depends on the size.

Hey, Mark. How are you doing?

Bill Musser, good to hear from you.

Quick question on the Lowry Range, where is the landlord’s head at with respect to the development of a portion of that property now that there is so much development in the area? And secondarily, is there any role for you guys in helping them move forward on something?

The landlord is actively collaborating with the county on two main issues: determining how much of the 27,000 acres should be preserved and establishing the appropriate percentage for conservation. Recently, they have taken steps to work with the county on this matter, seeking clarity on entitlement and zoning for the portions of the property that will not be conserved. This process may take a few years as they explore entitlements and conservation prospects to ensure a solid plan for land development and revenue generation across the entire portfolio. Their actions suggest a more proactive approach to managing the property compared to the last decade, and we are eager to support and engage in this process. If an opportunity arises for us to participate in land development, we will consider it, especially since we already have utilities in place. However, our involvement will depend on our other projects and acquisitions at that time.

Thank you. Ladies and gentlemen, we have reached the end of the question-and-answer session. I will now turn the call over to management for closing remarks.

So let me close with this. One of the things that has been helpful and for those of you who haven’t had an opportunity to travel out here and kick the tires, there’s nothing quite like seeing it. And so we will set something up probably in the mid-July timeframe to be able to have everybody have the opportunity to travel out here, take a look at it. Also be on the lookout for a new website. We were hoping to have that up and live for this call but the gods just didn’t align for us on that. But you will see a new improved website, which will have a webcam on there. So you will be able to click on that and be able to see the dirt movers, the graders moving around the site and some of all of the activities that we have got going on there and continue to have sort of that virtual presence in the marketplace as well. If anybody didn’t get their question queued from a technology standpoint, don’t hesitate to give me a call. We will probably be a bit more active in the investor side of doing a little bit more conferences and getting either in-person or virtual conferences. So if you see us in a conference, stop by, say hello or give us a shout-out. And then if you all have other folks that we should add to our investor mailing list, don’t hesitate to send those over as we are getting a bit more active on both sending out notices in Twitter and social media, so there will be a bunch more opportunities to see the company’s updates through that venue as well. So, with that, I will bring it to a close and again thank you all for your continued confidence in your invested capital.

Thank you. This concludes today’s conference and you may disconnect your lines at this time. Thank you for your participation and have a great day.