Earnings Call Transcript - PCYO Q3 2022

Operator, Operator

Good morning, ladies and gentlemen, and welcome to the Pure Cycle Corporation Third Quarter Nine Months Ending May 31, 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, Mr. Mark Harding, President and CEO of Pure Cycle. Sir, the floor is yours.

Mark Harding, President and CEO

Thank you very much, Jenny. I’d like to, first of all, say good morning, and welcome to our nine months 2022 earnings call. We do have a deck for this presentation. If you go to our website, purecyclewater.com and in the Investor section, you’ll find the link that will allow you to follow along with the slides that we have here. With me today, I have our CFO, Kevin McNeill, who will provide an overview of some of the financial metrics for the nine months ending. I also have Dirk Lashnits, who is our Vice President of Land Development, and he will highlight a little bit of our progress on Phase 2 of our Sky Ranch development. After we complete the deck, we’ll have a brief Q&A for some insights regarding the quarter and the year, and maybe how we plan to close out our fiscal year. So if you have any questions, please hold those until the end. With that, let’s get started. I’ll begin with our Safe Harbor statement to clarify that the statements contained in this presentation are not historical facts or incorporated as such; they are forward-looking statements, of which most of you are likely familiar. So as we get the lawyers out of the room, we can commence with the presentation. I’m going to assume most of you are relatively familiar with the company, so I’ll quickly overview our operations. We operate in multiple complementary business segments, with our main focus being our Water, Wastewater Resource Development segment. In this area, we provide water utilities in a locality where we own a portfolio of water rights, which is significant, especially in an area with limited water supplies that has been in the news due to the ongoing drought, particularly in the West. Our portfolio has the capacity to provide about 60,000 single-family equivalents. We have a typo in the slide, so it's actually 60,000, not 600 or 600,000; it’s 60,000 in the Denver Metropolitan Area. We provide water and wastewater services to land developments that we are managing, as well as to other customers in the regional area. Our Land Development segment is centered on a particular property in the I-70 Corridor, which is among the most sought after segments in the Denver Metropolitan Area, located directly south of Denver International Airport, about four miles south of it, along the interstate with an interchange accessing our property. We maintain a property interest of about 0.5 miles of frontage along the interstate. In addition to residential opportunities with approximately 3,000 to 3,400 residential opportunities, we also plan to develop several million square feet of commercial, retail, and industrial properties. We develop residential and commercial lots for national homebuilders while providing water and wastewater service. Recently, we are withholding some lots that we are developing within our community, as we’re moving into constructing homes on those. We’ll contract with someone to build those homes for us and retain them in our portfolio to rent them out to the marketplace, establishing a single-family rental segment of our business, which is growing and profitable, where we can leverage the equity value in our water and land segments. Moving to the next slide, I want to highlight our ESG efforts: environmental, social, and governance. We recently brought in a new ESG initiatives specialist who will work to improve the company’s written format on ESG matters. The company is committed to being environmentally sensitive, and one issue we've recognized is that many stakeholders are not aware of our initiatives and how we operate. As we process water and treat wastewater, we are committed to reusing every drop of water, and we want to highlight our policies and investments to show the rating agencies how seriously we take environmental and social governance. You will see an ESG tab growing on our webpage, which is new, and will include comprehensive documentation. Under the environmental section, we will update our policies to assess, track, and disclose energy management usage, network efficiencies, and water and wastewater management practices. The social updates will enhance our human rights policies and address employee satisfaction, water affordability, conservation, and diversity within the company. In governance, we will continue updating our policies. We have a robust governance policy we want to share with the marketplace and NASDAQ, presenting all aspects included in our policies and charters. Moving to the water segment, we possess a significant portfolio of water rights totaling about 29,000 acre-feet, composed of both groundwater and surface water, with the capacity to serve approximately 60,000 connections. Our valuable surface rights allow us to operate a comprehensive system, from ownership of the water and infrastructure used to divert, treat, and distribute that supply. We collect connection fees—one-time fees typically paid by homebuilders for access to the water and wastewater services. Our current tap fees are approximately $32,000. Homeowners then incur metered monthly water bills, averaging about $1,000 per connection for water and around $500 for sewer. We manage this wastewater through our reclamation facility for reuse, making sure every drop is utilized adequately for irrigation or industrial purposes. Investing in our water utility segment continues to show growth with over $60 million in assets, including wastewater reclamation facilities, transmission lines, storage facilities, and wells, forming substantial infrastructure across our service area. We’re also expanding our customer base, currently over 700 customers, with many commercial customer conversions. This increase also derives from our service area at Sky Ranch, as well as Lowry and Wild Pointe service areas. Now, a brief note on oil and gas: With rising gas prices, oil activity has increased, particularly in Colorado due to the active shale plays in the Wattenberg Field and the Niobrara Formation. This facilitates our operations as we supply water to wells, which are heavily reliant on our services, managing up to $250,000 of water deliveries per well. The regulatory climate in Colorado has remained predictable over the past years. Given the positive conditions in oil prices, we see strong revenue growth opportunities for 2022, with expectations to continue expanding through 2023 and 2024. Regarding our metropolitan area growth, our assets' proximity to development can be seen through our aerial map. The prominent pink areas represent our Lowry and Sky Ranch service areas, highlighting active developments. We are excited about this growth, which continues to provide a robust pipeline for future opportunities in the attractive I-70 Corridor of Arapahoe County. I’ll now turn the mic over to Dirk Lashnits, who will provide an update on our Land Development activities and further elaborate on our Sky Ranch project.

Dirk Lashnits, Vice President of Land Development

Good morning. I am Dirk Lashnits, overseeing our Land Development. I’ll provide a brief overview of our Sky Ranch project and reiterate some key points Mark has shared. Sky Ranch is our 930-acre master-planned community on the east side of the metro area. This project is planned to develop in about six phases over the next 7 to 10 years. We have completed our first phase and are currently working on the second phase, which we will discuss in more detail in later slides. At buildout, we estimate around 3,000 to 3,500 residential lots, with around 150 acres of the 930 acres designated for commercial usage overlooking the I-70 Corridor. As more rooftops emerge, we expect commercial activity to increase in the coming years, especially given our proximity to significant transport links like the E-470 Toll Beltway. Our first phase began approximately four to five years ago in 2018, and it's nearing completion. The aerial view shows some remaining lots currently being developed. We started with a total of 509 lots, and approximately 475 houses are now occupied. All the taps have been paid. Financially, we spent around $35 million to build these out, and we generated approximately $36.7 million from lot payments made by builders. We undertook an initial bond offering, yielding about $11 million and have an additional $20 million projected for future tax collections and bonds. The revenue we’ve seen is aligned with our spending, plus margins related to reimbursement. For the second phase of Sky Ranch, which involves 850 lots, we are currently turning over some of the first lots to builders. We aim to release this phase incrementally in four intervals, each encompassing about 220 lots. This phase will include a new charter school designed to serve the community, with allocated land for a recreational center too. Residents will likely begin moving in towards the end of this fiscal year or potentially in early Q1 of next year. We’re setting aside some lots for our Single-Family Rental segment, projecting about $70 million in lot revenues compared to the $35 million from Phase 1, and we’re expecting a new tap fee figure of $20 million. The estimated reimbursable for this phase, including the previous phase, totals about $61 million, showing a rise from our first phase as well as a slight increase in development costs. That concludes my construction update, and I'll hand it back to Mark for financial details.

Mark Harding, President and CEO

Let me detail the financial metrics for these two phases. Phase 1 involved about 509 lots, while the second phase includes various product classifications. We are working with three new builders and one returning builder to deliver diverse housing products. The delivery of these lots occurs in increments, which allows us and homebuilders to manage horizontal costs effectively. Each builder under our lot development agreements acts as a partner, with three equal payments aligning with lot deliveries, facilitating investment in essential water and sewer infrastructure. The gross proceeds from the second phase are expected to rise, and so will our reimbursable costs, as the community expansion often requires more infrastructure investment. The next slide will illustrate how we plan to complete this first phase. We’ve delivered the first two lots and expect the major delivery soon. We anticipate completing all 229 lots this fiscal year, thereby yielding substantial cash flow gains. Looking at the charter school, it was crucial for us to establish a local school within the neighborhood for residents to access easily. We have collaborated with the local school district to authorize a charter school and have partnered with National Heritage Academy, a top charter school operator establishing over 100 schools in nine states. Our K-8 school will open by August of next year, serving grades K through 7 initially, with plans to add high school grades in subsequent years. This project stands out as a superb amenity for our community, providing significant value to our residents and the school district.

Kevin McNeill, CFO

All right. Thank you, Mark. The next slide summarizes our Single-Family Rentals that Mark discussed earlier, which began in November. We currently have three houses built and rented since then with a fourth underway. The rental market remains strong, and we expect this trend to continue. The pro forma details shared reflect what we're witnessing with our first three rentals and our anticipated fourth. We have a timeline demonstrating the progression of these houses, noting that photo of our fourth house, which is currently under construction with windows installed recently. We plan to deliver the next ten throughout the upcoming months in a staggered manner over six months, ensuring we manage our portfolio efficiently. An overview of our financial metrics for the nine months that concluded on May 31 indicates that our revenue aligns well within expectations. The top left chart compares our nine-month revenue with previous years, and the trend appears steady. While revenues dipped in 2021, we expect a robust performance shortly. This quarter, we've sold about 40 taps, driven primarily by model homes. We usually sell taps alongside building permits rather than with lot agreements. Our operating income is up around $300,000 from the previous year, partly attributable to increased revenue and an earned income credit for retaining employees during COVID of about $200,000. The net income may appear lower due to last year’s one-time recognition of $16.5 million in public improvements reimbursement; thus, it skews metrics. This year’s expected net income appears consistent with previous years, and we project to close this fiscal year higher due to the anticipated increase from ongoing lot sales. During this quarter, we've delivered approximately 59.8 million gallons of water spread across the Sky Ranch and Wild Pointe residents as well as to oil and gas operators.

Mark Harding, President and CEO

I would like to highlight some financial metrics. Regarding public improvements, we fund the construction of roads and drainage facilities that municipalities own, which can lead to reimbursement through property taxes. Colorado operates on a model where growth funds itself, so individual developments accrue property taxes to cover their public improvements. Due to delayed reimbursements, we previously deferred revenues, but after assessing local municipalities’ growth confidently, we've shifted to recognizing revenue incrementally, promoting a more stable income stream. This explains why year-over-year metrics may appear somewhat inconsistent, as before, we recognized substantial amounts at once after bonding, versus the gradual recognition we adopt now. Ultimately, I see this pattern favorably as we advance, allowing us to achieve abnormal stability in our financial reporting. Moving on, I’d like to open the floor to Q&A. To start, what impacts do rising interest rates have on development? With our second phase, we have contracted for all lots with national homebuilders. In the Denver market, our homes are among the most affordable, starting from high $300,000s to high $400,000s, while the median home price in the area exceeds $675,000. We've found the rising interest rate condition has weakened traffic for homes exceeding that $650,000 price threshold while directing more interest in properties priced under $600,000, where all our homes fall. Our lot delivery agreements allow us to manage inventory closely, minimizing risk for both us and our builders, ensuring homes are built on a timely basis to avoid holding excessive lots. So far, traffic appears consistent with that of our first phase, and homebuilders anticipate bringing homes to market incrementally which keeps availability steady.

Unidentified Analyst, Analyst

All right. Good morning. Very good morning, Mark.

Mark Harding, President and CEO

Good morning, Bill.

Unidentified Analyst, Analyst

How are you? I’m wondering how you’re going to benefit from or get hurt by inflation. You have your energy area producing inflation; how many wells do you have on your CAD and what is the production revenue?

Mark Harding, President and CEO

Let me sort that into two segments regarding inflation. We observed a slight increase in delivery costs for roads, curbs, gutters, and other energy-associated materials. To accommodate these costs, our lot delivery contracts with homebuilders incorporate a 4% inflation rate; however, actual inflation rates are outpacing that. Our homebuilders are experiencing inflation in lumber and similar materials, but valid supply chain issues are being managed effectively. The labor shortage situation has also improved, allowing for consistent production rates. On the energy side, we anticipate another pad's construction by our operator later this year, looking to drill the remaining wells at Sky Ranch. An estimate forecasts approximately 12 to 14 wells may be expected, with our operator keen to maximize yields. The energy market demonstrates steady growth, yet we don’t foresee surges from increasing wells significantly. It’s essential to note that rising interest rates indirectly affect home prices because more income is necessary to qualify for certain mortgages, leading to a softening effect on lots selling for higher home values. However, our competitive advantage lies in our entry-level lots, typically priced around $100,000, which remain attractive despite rising rates.

Unidentified Analyst, Analyst

Great. Tell me about the ability to raise your rental income? You’ve got a refresh coming in November; can you raise the rents, or is that not possible?

Mark Harding, President and CEO

That’s why we prefer annual leases to ensure both tenant and landlord satisfaction to operate competitively. The Single-Family Rental market is bolstered by significant equity in the lots and respective utilities. For instance, we contracted to build at $330,000, while properties appraised around $550,000, allowing for substantial rental margins. We aim to keep rental rates aligned with market expectations, responding to fluctuating interest rates while maintaining necessary competition and tenant satisfaction.

Unidentified Analyst, Analyst

Well said. Thank you.

Elliot Knight, Analyst

Good morning, Mark and Kevin.

Mark Harding, President and CEO

Good morning.

Elliot Knight, Analyst

Expanding on the build-to-rent, that was my inquiry. With rates rising, will Pure Cycle’s profits be impacted as this program began when rates were lower? Will margins be squeezed, or will increasing rents offset that?

Mark Harding, President and CEO

While increasing interest rates don’t directly affect lot prices, they do influence builders' capacities to purchase homes. The impact is most felt on homes priced above $600,000, where interest rates drive buyers towards more affordable options. Our lots remain substantially more affordable than average—around $100,000. Increased interest rates can affect rental costs; however, maintaining equity gives us a competitive edge, enabling favorable rent pricing to align with market expectations, therefore improving margins.

Unidentified Analyst, Analyst

Okay. Thank you.

Mark Harding, President and CEO

You’re very kind to me today. I greatly appreciate that.

Operator, Operator

We do have another question if you want to take it.

Unidentified Analyst, Analyst

It’s from Greg Rabalachelski of Benchmark. Greg, go ahead.

Greg Rabalachelski, Analyst

Hey, Mark. How are you?

Mark Harding, President and CEO

Great. Thanks. How are you, Greg?

Greg Rabalachelski, Analyst

Good. I jumped in at the last minute. I have a quick question. Regarding Single-Family Rentals, the model looks good. Have you given thoughts to add capacity in future phases for multi-family complexes, such as 50 to 200-unit developments?

Mark Harding, President and CEO

Great question. We indeed have a multi-family component in our overall master plan, potentially accommodating around 450 units. It might be possible for us to retain one or more buildings for our rental program; however, we must carefully consider management options for this segment. While we focus on single-family rentals, the varying product classes we offer will provide substantial rental entry points. Furthermore, residential investments are gradually increasing equity, driven by parks and other community developments enhancing overall value. These efforts enrich the project, benefiting both builders and homebuyers alike.

Greg Rabalachelski, Analyst

Okay. Awesome. I noticed a minor acquisition of water rights for around $3.5 million. Can you elaborate on the benefits and any insight on valuation relative to your existing water assets?

Mark Harding, President and CEO

You're correct; the water resource segment remains foundational to our operations. The recent purchase included three wells near previously acquired sites, consolidating our resources effectively. While I can't definitively say we got a deal, we aim for fair acquisition strategies, especially regarding undervalued water rights. We secured these wells for approximately $10,000 acre-foot, similar to our earlier purchasing three years ago, indicating stable water value appreciation. Our large water rights portfolio necessitates prudent management due to their finite nature, leading us toward strategic acquisitions with continuing potential for value growth. We often evaluate acquisitions, land expansions, and capital deployment options for shareholders carefully. Operations generating recurring revenue, particularly water supply, are highly prioritized given their historic reliability. This ongoing capital allocation discourse among management and the board ensures we maintain robust endeavors while watching liquidity closely during periods where deliveries affect cash flow cycles positively. While evaluating these options, we’ll seek potential shareholder returns through effective capital allocations while scaling our operational benefits.

Unidentified Analyst, Analyst

Okay. Yeah. That’s valuable insight. Definitely, you’ve maintained quality oversight on development, fostering early success. Also, significant value creation noted, yet markets reflect a notable discount compared to previous valuations. Balancing development with share buybacks may create flexibility for your team.

Mark Harding, President and CEO

Thank you for your remarks. We've been fortunate to have a great management team. Ongoing thought and debate contribute to our strategic direction at the board level, and I appreciate your engagement. For those facing technical difficulties or who think of questions after the call, feel free to reach out. For those attending tomorrow’s Investor Day, we will include a follow-up Q&A, so please RSVP for virtual attendance. I appreciate everyone’s participation today, and I wish you all a productive rest of your summer.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today’s conference call. You may disconnect your phone lines at this time. Have a wonderful day, and thank you for your participation.