Pure Cycle Corp Q2 FY2022 Earnings Call

Good day, ladies and gentlemen, and welcome to the Pure Cycle Corporation Second Quarter 2022 Earnings Call. At this time, all participants have been placed on a listen-only mode and the floor will be opened for questions and comments after the presentation. It is now my pleasure to turn the floor over to your host, Mark Harding, President and CEO. Sir, the floor is yours.

Thank you. Good morning, and I’d like to welcome you all to our second quarter of our fiscal year 2022 earnings call. We do have a deck to this presentation, which you can find on our website. So, if you go to purecyclewater.com and on the Investors page, right on the front page there that will tell you an icon in there that says click to join, if you could join on that. I’ll be able to direct the slides to walk you through the presentation, but that will give you kind of a little bit more tangible view of the earnings call as a whole. With me today – you all hear my voice a lot, and so what I’d like to do is actually bring in some other voices to the call today and the folks within the organization that make things happen. We’ve got a very deep bench with some very talented folks here in the company. As part of the update to our land development activities, you’ll be hearing from the Vice President of Land Development activities, Dirk Lashnits. He’s got over 25 years of experience in land development activities, with a tremendous amount of experience with some of the major homebuilders, some of them are direct partners in Sky Ranch. You’ll also be hearing from our CFO, Kevin McNeill, and he’ll be giving you an update on the financial results of the company. What I’d like to do is give you a high-level overview of kind of the land development and water and single-family rental business aspects of it. For those of you who are more familiar with the company, I will highlight some of our tremendous accomplishments and really give you some color as to the areas that the company is performing on and really how these legacy assets are starting to generate significant shareholder value. So with that, I will start our presentation, move to the first slide, hopefully. Okay. So, our first slide, I’ll read this to get the lawyers out of the room. This is our safe harbor statement that statements that are not historical facts, contained or incorporated or referenced in this presentation are forward-looking statements. I think you all are familiar with forward-looking statements. We really operate in kind of three business segments. We’re reporting in two business segments, but really have these tremendous assets that are driving value for our stakeholders, assets in land and water investments and then also in housing. This could not be more true today than it ever has been. When you take a look at this portfolio of assets, we have about 780 acres remaining in our land portfolio. We originally started out with about 930 acres of land. We have water assets that include water rights in a water-short area. This includes a tremendous amount of assets that we develop to continue to treat, transmit, deliver that water to our customers, collect that water back from our customers, treat that water, and reuse that water supply. Recently, we’ve entered into the single-family home rental market on lots that we are actually developing and delivering to homebuilders. We are keeping some of those lots for ourselves to deliver rental homes on there so that we can maintain that portfolio, continue to grow our asset value and also continue to grow our income on how we get these multiple year revenue streams. Let me talk a little bit about our water segment. We own water in a water-short region. There’s been a lot of attention on the scarcity value of water out west. We were particularly early on acquiring much of these assets. We’ve held them for more than 30 years, and they have continued to appreciate in value. Our real business model here is that we’re developing a utility function with that. We develop, from cradle to grave, all the wells, the treatment, the distribution that takes that to the customer. We get two different fee instruments for that. We get a large upfront capital fee called a tap fee or a connection fee. Those fees are combined water and wastewater tap fees, which are about $33,000. Customers are using that water supply. They take it. They use it in the house and for irrigating outside. We get that water back through a collection system. We treat that water through a state-of-the-art water reclamation facility, and then we reuse that supply for irrigation demand. We have dual distribution systems within our community where we distribute that water back out to our irrigation demand and also use that for industrial water for oil and gas purposes. Our assets continue to grow in value. We’re investing into that infrastructure. We’re expanding our service capabilities each year to add value to the assets and their ability to generate revenues. Customer growth continues to increase. We have customers that are growing both within our service area as well as outside our service area. Our connections are getting close to about 1,000 connections, about 970 some connections, and that continues to grow monthly, both through the service areas that we have at Sky Ranch and Wild Pointe. We’ll talk later about the opportunities on our large service at the Lowry Ranch that’s on the edge of the Denver metropolitan area. In addition to doing the domestic side of the business, we provide water for oil and gas concerns. Colorado has a shale oil deposit play, which continues to grow, and this year has seen favorable improvements in our industrial water users. Sales to our oil and gas interests have hit record water deliveries for us this year. We’re excited to meet that demand, likely to see a positive continuing trend with strong oil prices. As oil remains in the upper $90 range, that certainly enhances the opportunity for oil and gas concerns to continue to develop that asset. Let’s talk about the large service area that we have. One of the things that is very attractive to the Company is that we have a 24,000-acre service area, one of the largest contiguous parcels of property next to an urbanized area in the country. This asset is owned in trust for the state public education system by the Colorado State Land Board, which manages its assets as a fiduciary for public K-12 education in Colorado. This is an illustration that gives you a shot of where our service area positions itself to the Denver metropolitan area. Growth has really expanded to roughly three borders of the property, making it a very attractive parcel. The State Land Board is reviewing what to do with the property. They have a very multifaceted, multigenerational mindset for managing their assets regarding revenue generation, open space opportunities, and what it might generate for the public education system. This is a very highly attractive piece of property, well positioned for future economic growth. So, with that, I’d like to turn the floor over to Dirk Lashnits. I’ll advance the slide. He’ll give you an update on land.

Good morning, everyone. I’m Dirk Lashnits, the Vice President of Land Development. I’ve been at Pure Cycle for about five years, since the onset of Sky Ranch. As Mark mentioned, I’ve done development in the Front Range, Colorado for the last couple of decades. We’ve worked on a lot of big projects around, such as Highlands Ranch or Stapleton. The 930-acre site at Sky Ranch is considered a significant development in the overall market area. Developing 930 acres of Sky Ranch provides 3,200 residential lots that tie back into the integration of our water assets. We’re developing our new water customers. The previous slide showed 60,000 SFEs of water available, which equates to about 3,200 of those SFEs. Also, we saw the 29,580 acre-feet of water usage from Sky Ranch. Sky Ranch has a large commercial parcel with great frontage on the I-70 corridor, the major east-west thoroughfare through the metro area. Our project is located on the east side of Denver, about a 20-minute drive from town. The picture on the screen is of our first phase, which consisted of 509 lots. We’ve sold, transferred all 509 of them. We have 505 of those sold to builder partners, shown on the screen, which include KB, Taylor Morrison, and Richmond. We’ve retained four lots and are doing our best for our build-to-rent segment. Three of those lots have been completed and are currently rented out, with the fourth lot in the process of completion. So, we have 405 occupied houses as our current water customers, through 500 of our 505 taps sold. We should be built out of this phase in the next couple of months. We've received $10.5 million in reimbursables from a bond offering done a year or two ago, with favorable terms for that deal. The $22.7 million in receivables are on the books, including future revenue from taxes. This also includes our project management fees. Pure Cycle functions as the project manager for our Metro District, tied back to the reimbursable moneys used to build public infrastructure. The $36.7 million in lot revenue to date reflects the sale of our lots to builders. The $15.1 million in tap fees applies to the Rangeview Water District. This is a little drone footage of our project, moving from west to east. You can see the last of the houses being built, with one being the last BTR lot for this phase. We’ll move on to our second phase, which consists of roughly 850 lots from the total 3,200 we mentioned earlier. The second phase is subdivided into four different quadrants. The first of those sub-phases is highlighted in yellow. Currently, there are 229 lots under construction, and we're expecting to deliver those by this spring. We’ve turned over a few of those lots to start the construction of model homes. If you drive out on site today, you’ll see model homes being constructed from KB Homes and foundations for the other three builders starting as well. Let’s click and enter some drone footage on this. Here, you see our new streets installed. At the bottom of the screen, that's where a charter school is coming into the community, and just off to the side will be a future recreation and amenity center for the neighborhood. Construction is underway there. Regarding this phase, we have approximately $70 million in lot sales, $20.9 million in tap fees, $61 million in reimbursable costs for public infrastructure, and $73 million in total development costs to bring this second phase online. I’ll turn it over to Kevin now to get into the numbers.

Thanks, Dirk. So, yes, Kevin McNeill, CFO. I have been back for a couple of years now. The slide up shows how these phases of Sky Ranch develop. Three of the contracts with the builders are under milestone payments, meaning we get paid along the way as we complete certain tasks, like wet utilities, streets, and roads. This summarizes our efforts in the four phases. As Dirk noted, the second phase is broken into four distinct phases that we’re developing one at a time. We may overlap them in the market soon, but this really summarizes the revenue, lot revenue, tap revenue, and reimbursables by those phases and how they roll through. The second phase is progressing nicely, and we’re about 57% done in this first sub-phase. The next slide will show where we are at in this current sub-phase, which as Dirk noted was about 219 lots sold to homebuilders, with a total of 229, ten of which we’re retaining for our single-family rental division. The builders take these down in pieces as we complete tasks, as mentioned previously. The first two takedowns are complete, which are platted lots and wet utilities. The third will be finished lots, which will be for the three builders under milestone payments. The fourth builder, DR Horton, will take all their lots at one time. They paid a premium for that, as they take on more risk during the development stage. The bottom graph summarizes what the different builders are building and the lot types. In this phase, we have significantly more product diversity including townhomes and paired homes. This slide gives a good summary of the different builders’ outputs.

I might take it back and talk a little bit about the single-family rental market. One of the things we considered was how we can continue to add value to the assets we have. As a developer, we create value in the community through our horizontal land work – constructing streets, curbs, gutters, extensive amenities, parks, landscaping, and trails. This amenities addition adds significant value to what we’re looking at. We believe there is an opportunity for us to grow our asset value as well as income potential through the single-family rental market. The dynamics are compelling. Many large players have entered the market by buying homes and beginning to acquire lots to build on those, looking for vertical integration. We find it beneficial because we carry forward a lot of the equity value we have in the land and water utilities. When we bring a new home to market, we build it on a lot with significant intrinsic value. Many of you familiar with the company have asked how we can accelerate the single-family market business. We’re pacing it out to ensure each phase pays for 100% of the cost of horizontal development for our homebuilder customers and what we retain to ensure returns on investment into roads, curbs, and gutters. We leverage attractive financing rates to facilitate this, seeing about 70% loan to value due to the significant equity value. We put up our first three homes, rented them within two weeks at the top of the market. Demand is tremendous. There are private homeowners renting houses, but we believe we have a substantial advantage with our capable construction team maintaining properties efficiently. This segment is thriving. The first three homes generate about $2,850 each, translating to an annual revenue of almost $34,000. After operations and debt service on taxes and interest, this yields about $15,000 to $16,000 in margin. Not only are we seeing asset appreciation, with about a 4% or 5% increase in overall home value, but we’re also generating free cash flow. It’s a fantastic opportunity for us. Very excited about how this rolls out. This illustration of the first three phases shows they are all efficient for building and we’re contracting but not building those ourselves. Our homebuilder partner did a fantastic job on these for us, and we have them contracted for our fourth phase, actively working on the next ten to ensure delivery efficiency. This gives you an overview of costs of around $330,000, including some capitalized costs for landscaping. The market value of these homes is in the mid-500s, highlighting community appreciation. We continue to be very excited about this segment. I will turn this back over to Kevin for details on financial performance for the six months ended.

All right, thanks, Mark. Now for the fun stuff, the numbers. The top three graphs show three operating metrics: revenue, operating income, and net income for the six months ended February 28, 2022 compared to the previous four years of the same period to provide you insights on trends. The revenue saw a big jump starting in 2020 due to lots and taps being sold in the first phase. Comparing this year to last year, there is a slight decline, but last year included approximately $1.5 million in project management revenues that we recognized from prior years. Factoring that, this year actually increased by just over $1 million, largely due to the success of Phase 2. Operating income remained steady around $3 million, with slight impact from prior project management fees. Net income showed a drastic-looking increase last year but was due to $19 million recognized from public improvements which we couldn’t substantiate until last year. Factor that out, and this year shows pretty steady growth. The bottom provides a little more detail regarding the three segments we report on. Water and wastewater assets continue to grow, with a noted 65% increase in investment this year. During the second quarter, we delivered 137 million gallons of water. A significant portion of that was for oil and gas operators in the drilling process, reflecting strong demand from those sectors. Land development, as Dirk explained, is progressing with consistent gross margins, and we’re making headway on our second development phase. Single-family rentals are also performing well with three current rentals, all under non-cancelable one-year terms, and our fourth one is now complete in construction, with expectations to come online around the same time next year. The next slide highlights last year's fiscal completed year-over-year comparisons, showing where we stand with key metrics. Finally, focusing on capital allocation, we aim to execute across all three segments: land, water, wastewater, and single-family rentals, ensuring cohesive operations between them. We’re also continuously seeking new land or water deals. Shareholder returns are a major focus, with single-family rentals providing a solid recurring revenue stream. This year, we're enhancing our ESG reporting by hiring a specialist to improve our identification and reporting on environmental and social aspects.

Let me close and highlight a few things. We’re seeing strong continued execution and performance. A newcomer to the stock could wonder how we’re generating this income off our asset base. It’s because these legacy assets accumulated over years render great value. In inflationary periods, hard assets like land and water are essential, and this company is firmly positioned, especially with land and water assets that have strong demand. Each segment demonstrates remarkable growth, leading us to improve shareholder performance. Please realize, as we push these revenue results, we’re acknowledging our homebuilder partners' successes alongside ours, emphasizing a thriving community. This partnership with national homebuilders is successful, facilitated by our dedicated team. We anticipate hearing from our shareholders and hope to provide ongoing communication about our performance.

Thank you. Our first question today is coming from Elliot Knight at Knight Advisors.

Inflation is much in the news. Would you talk a little bit about how rates are being set for tap fees and monthly rates, what’s the process? What do you think the outlook is for increases from here on to protect against inflation? That’s question one. And question two is, would you give us an update on the status of the two reservoir sites the Pure Cycle controls? Thanks.

Okay. Sure. Rates and charges for water include capital fees, or tap fees, paid by homebuilders during building permits. Large capital sums, like the $32,000 for tap fees, help fund our system's development. We’ve been proactive in investing, creating our infrastructure without debt. Tap fees are regulated through an agreement with Colorado, averaging surrounding water providers’ rates. Competition with our nearest rival, the City of Aurora, informs our pricing strategy. The rates are reflective of scarcity values and cost increments. The monthly rate pressures are lower than tap fees, due to development costs. Second question, regarding reservoirs; both are major assets with embedded value. Given Colorado's low precipitation and rapid spring thaw, storing water is vital. These reservoirs are non-jurisdictional. We have interest from regional water providers, and we're collaborating with them to expedite development. There’s nothing tangible to report right now, but our partnership with South Metro continues to develop these assets significantly.

Going back to the tap fee though, do you see tap fees going up this year?

They will go up. We have notified our customers and expect a tap fee increase of around 2.5%. A year ago, we incorporated an increase, and we’ve observed surrounding water providers’ growth as well. We seek consistent year-over-year increases to avoid drastic fluctuations.

Our next question today is coming from Bill Cunningham with Seeking Alpha.

Yes, I’m a private investor but I do write occasionally for Seeking Alpha. That description might have not been 100% perfect. In any case, your earnings this quarter were okay, but if somebody is looking at the number, they’re not going to be blown away by it. I think what might not be recognized, and correct me if I’m wrong, is that you’re kind of in a trough now where Phase 1 has basically been almost done and Phase 2 is just about to ramp up, so the GAAP numbers don’t fully reflect where you are right now.

That’s a fair statement. It’s important to highlight our various revenue-generating options and the present seasonality effects in our land development outcomes. Weather can hinder outdoor construction activities in Colorado. However, we continue year-round construction activities efficiently. We managed to complete utilities and dirt work during winter for spring deliveries. Our projections suggest that we’ll deliver all 229 lots on schedule. The contract types allow us flexibility in payments with a consistent overspend in construction as we progress towards revenue generation. Expect subsequent returns in Q3 and Q4 to reflect our steady growth.

Well, I even know with your projections from last quarter that you're showing the revenue from lot sales as you’re finishing lots to be in relatively low now, and you’ve got a kind of a bigger number for a couple of quarters away, which is even in your current slide show that. So, this shouldn’t be a surprise to anyone, but...

No, very predictable. You're right. The liquidity in the company allows the flexibility to capitalize on the execution of our business lines, evident in the increased investment over winter for spring and summer returns.

Also, anyone who’s been a long-term investor in Pure Cycle knows you have many assets that have not yet been monetized. I know some of your short-term investors wish you’d monetize them immediately; more long-term investors might prefer a quicker monetization, but to the extent they’re not being monetized, they’re increasing in value. Last year’s CPI number was over 8%. You’ve got land assets and water rights that keep increasing significantly in value, acting as an inflation hedge.

When looking at tremendously valuable assets recorded at book value, recognize that great returns from asset sales are not always visible in quarterly results until sold. This creates uncertainty for some investors who question how we generate returns based on relatively modest asset bases. However, our accumulated cost base enhances value over time.

Can you go through what the status is with the models being built in Phase 2 and what’s happening there? You haven’t really mentioned much about that.

Yes. We’ve got four builders, each with three model home permits for field construction. KB was the most proactive, with model homes constructed prior to road completions. All builders are securing permits, focusing on production. This reflects the strength of the housing market in Denver. While average home values continue to increase, we maintain a competitive edge in the entry-level product space, as evidenced by sales. We are excited about a planned Investor Day in July after the 4th. Those attending will see significant on-site progress across all business units.

Thank you. Our next question today is coming from Geoffrey Scott at Scott Asset Management.

Two questions. One, you haven’t talked at all about the commercial activity and the commercial possibilities going forward. What is the timing for it? And how has your outlook changed over the last three months? The second question relates to the rise in interest rates and the potential slowdown in builder activity. Are you expecting any decrease in builder visits and how will increased interest rates impact future bond sales?

Great questions. On interest rates, we anticipate rising rates will affect housing sentiments. We think our entry-level products afford a competitive edge. Amid price hikes for average homes in Denver, our product remains a viable option for buyers. While those in the middle market are sensitive to interest costs, entry-level buyers may lean toward more affordable options here. We do see some incremental cost increases related to our horizontal works. However, we’ve positioned to recover these through reimbursables without impacting margins. Potential bond market interest increases may arise, but increasing property values will help offset impacts. Regarding commercial opportunities, we actively pursue commercial operators. The light-industrial sector is attractive for us due to several parcels with promising attributes like access and proximity to interstates. Creating efficient and effective commercial developments is essential for increasing tax value and opportunities across sectors, ultimately driving overall growth.

Our next question is coming from Greg Sterling, a private investor.

Most of my questions have been answered, but I was just wondering about your outlook for fracking water sales for the balance of this year and going into next?

Good question. Certainly, we had robust demand in the first half of the year. Considering the second half, oil's performance is favorable. Many operators we see, around 3 or 4, are working permits and arranging rig availability. We expect another 4 well pad fracs within 60 days. These fracs are in unique patterns as designs continue to evolve, leading to higher water usage per frac. It's challenging to provide firm guidance, but this fiscal year will yield record revenues from fracking. How we proceed next year will depend on permits and market strength. Both indicators look promising, with additional drilling slated for Sky Ranch early next year.

Our next question is coming from Tucker Andersen with Above All Advisors.

Good to hear from you. If I can take a moment of personal privilege, good to hear from Elliot Knight too; I should now work with friends forever, coworkers. I apologize. I missed a few minutes of the call, so if you covered what I’m going to ask, just tell me and I’ll go back and listen to the replay. My question involves both inflation and labor shortages. Are any of these affecting either your subs working on development or your builders? Many builders delay deliveries due to labor shortages. What are you seeing in the Denver area?

It's a complex question, but we have managed well amid any potential disruptions. National builders efficiently flex their labor and contractors based on project yields. We have not encountered significant hindrances in home deliveries. In our BTR segment, we advise managing supply chain variables and pre-order materials to help maintain efficiencies. We have warehousing to store materials if early deliveries occur. We anticipate some inflation-related cost increases as well, but because these are reimbursable, we will recover these without impacting, protecting their margins while ensuring smooth delivery.

Our next question is coming from Greg Bennett, a private investor.

I had two questions. One, the oil and gas business that you mentioned on Sky Ranch, are you in the oil and gas business? How do you structure those deals or those wells? Are you doing it through a partnership with somebody who knows something about oil and gas, or are you doing this on your own?

Neither. We lease the minerals owned on Sky Ranch. We maintain a 640-acre mineral estate, leasing to oil and gas interests. Our original lease, which dates back to Anadarko, was later assigned to Conoco and ultimately Civitas, a new public company. We act as a mineral estate owner, while they develop the resources and we receive a 20% gross royalty interest. Careful consideration was given to locate oil and gas sites away from residential areas, ensuring strong buffering between developments.

I take it the homeowners are disclosed to prevent any pushback?

Yes, absolutely. Adequate disclosures are provided, ensuring substantial setbacks and buffer zones are incorporated due to extensive open space in the community.

The water you’re selling for oil and gas, is that on federally leased property, or is that on private property since the Biden administration seems to be pushing back on federal leases?

It’s all private. Some state interests exist, but primarily, the service area—24,000 acres—is owned by Colorado. These resources can be utilized without restrictions by federal regulations on leasing.

I think this is my final question. 1031 exchanges for property, you’re a taxpaying company now. Is that correct?

Yes, we are. We’re exploring 1031 exchange structures for commercial property developments, maintaining properties to create evergreen income streams.

Is there a way to structure a ground lease for commercial properties?

Absolutely. This is precisely what we are pursuing.

When do you think commercial opportunities like grocery stores might materialize?

Great question. We've engaged discussions with national grocers like Kroger. They prefer larger footprints and target demographics. We see these opportunities materializing in a few years, as we explore light industrial prospects. We're working to integrate all components, including residential, ensuring we position effectively for future demand.

Is the exchange fully executed for your property concerning interstate access?

Yes, improvements to the interchange are necessary. We've coordinated with CDOT and the county to ensure timelines and capacity align with both residential and commercial constructions, utilizing impact fees for support.

We have no further questions in the queue at this time.

Terrific. Let me close by thanking Kevin and Dirk for weighing in on this and giving you the opportunity to hear from some of the true talent in the organization executing results. The quarterly outcomes are impressive, but we aim for an even better finish as the year closes out. We appreciate your continued interest. Colorado summers are lovely, and we welcome you to visit in July and see our substantial work across all business units. Thank you for your participation.

Thank you. Ladies and gentlemen, this concludes today’s event. You may disconnect at this time and have a wonderful day. We thank you for your participation.