Earnings Call Transcript - PCYO Q2 2023

Operator, Conference Operator

Good morning, everybody, and welcome to the Pure Cycle Corporation's Second Quarter 2023 Earnings call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Mr. Mark Harding, CEO and President of Pure Cycle. Mark, over to you.

Mark Harding, CEO & President

Thanks for joining us this morning for our second quarter 2023 earnings call. We have a presentation deck available on our website at purecyclewater.com in the Investor tab for you to follow along. Our first slide presents our Safe Harbor statement, which highlights that historical statements not included here are forward-looking projections. Most of you are likely familiar with this statement, so let's move on to the presentation. For those new to our company, let me give a brief overview of our business. We operate in three interrelated segments, starting with our water and wastewater resource development segment. We have water supply in the Western U.S., where access to water is scarce and valuable. In the Denver Metropolitan Area, we manage about 30,000 acre-feet of water, enabling us to offer services to up to 60,000 single-family homes. We evaluate our customers—whether residential, retail, or commercial—based on their average demand and associated revenue. Colorado's unique water challenges connect water utility services with land development, illustrating how water scarcity impacts both sectors. We serve a wide range of clients, from residential and commercial users to parks and industrial entities like oil and gas companies. Our second segment is land development, where we manage about 930 acres that we are transforming into a master-planned community. This area will accommodate around 3,200 single-family homes and is strategically located along Interstate 70 in the Denver area, which is a hotspot for development. Alongside residential units, we are planning about 2 million square feet of retail, commercial, and light industrial developments. We not only oversee land development but also utilities, giving us a vertically integrated business model. Our newest segment, which I will elaborate on further in this presentation, is in single-family home rentals. Here, we retain lots to build homes for our portfolio, renting them to meet housing demands. Quick information about our water utility segment: we're comprehensively involved in the water cycle. We own water resources, develop wells and treatment facilities, and manage distribution to our customers. After customers use the water, we treat it as wastewater in our state-of-the-art facility, returning it to reusable quality. Our approach includes maintaining a dual distribution system for irrigation, although not at single-family levels. This system supports parks and schools, allowing us to recycle water and resell it. We generate revenue through connection fees, known as tap charges, and usage fees, leading to a sustainable model. Our combined fees average around $33,000 per connection. We have a consistent base fee that covers operational costs regardless of usage, alongside a tiered consumption charge for higher usage. These fees yield about $1,500 per unit annually, although some areas in the Denver area can see monthly bills of $1,000. Within our community, we average around $1,000 yearly from water and approximately $500 from wastewater. Sustainability is important to us; we're reducing water loss from evaporation and irrigation through efficient management. Consumer behavior also leans towards lower outdoor water usage, benefiting our water reclamation efforts. On the next slide, we'll discuss our continued investment in water infrastructure, crucial for serving our growing customer base. Our key areas include Lowry Ranch, our largest, and the Sky Ranch project, where we manage both land and the water utility. This enables us to expand our customer base through tap fees and recurring revenue from water services. One of our significant sectors includes providing water to the oil and gas industry, which experiences seasonal demand fluctuations. After winter, we typically see increased demand from March to July, with stable oil and gas pricing. Our location on the Southern Wattenberg Field, which intersects with our water supplies, allows efficient service delivery to oil and gas customers. We anticipate continued growth in this segment, projecting another record year for water deliveries to the oil and gas sector. This growth is supported by our strategic positioning in relation to the metropolitan area. Sky Ranch, located along Interstate 70, allows us a strong presence in the area, helping with our land development and utility services. I'll now hand over to Dirk Lashnits, Vice President of our Land Development segment, for an update on our activities.

Dirk Lashnits, Vice President of Land Development

Thanks, Mark. Good morning, everyone. For our regular listeners, this is going to be a little repeat information and a little redundant to what Mark already talked about. This is our Sky Ranch project located on the east side of the metro area along the I-70 corridor. You can see that running along the north side of the screen there. 900 acres with residential and commercial use, and situated on the frontage of the new development area. So, we started development in 2018. We have our first phase in the books, that's the Western square on this image here, and that was about 509 lots. We've started our second phase, which is roughly 850 lots that we've subdivided into four sub-phases. Those are the phases 2A through 2D, roughly 200 lots each. Our first update 2A, all those lots have been delivered. We've been building those out. Our second quarter was pretty uneventful through the winter. We had a pretty brutal winter. And so, we're working on the infrastructure for that 2A phase, and then starting to kick off our Phase 2B. Our biggest milestone in this period was the award of our utility contract for Phase 2B, that's a $4 million contract for our water and sewer infrastructure that we're going to be kicking off here. We have been making some progress on our K-8 charter school. That school site is shown on here. That's going to open here in August. K-7, looking at about 300 students starting there in August. That's pretty exciting. We've also expanded our rental portfolio. So, we're adding some lots for that build-to-rent segment that Mark mentioned. You can see our builder partners listed here. We got a pretty good diverse group to help us build our lots.

Mark Harding, CEO & President

Thanks. Yes, I just want to highlight a little bit of the activity. One of the key takeaways in this quarter is, as Dirk was mentioning, our second phase of this, we divided that into four sub-phases, where we delivered the 229 lots in that phase last summer. That was very timely for us. We delivered that right before some of the heavy weights started to hit the market on that. As we look to deliver lots for our homebuilder partners on this, we try to do this on a real-time basis, where neither we nor our homebuilder partner retains a lot of that inventory. So, as we're delivering each sub-phase, we can accelerate or decelerate depending on market conditions. When we delivered those, we worked towards the next phase of that. Our homebuilder partners asked us to provide them three months over the winter, which is typically poor seasonal time for us. Looking at our success in the single-family rental market, we had reserved 40 lots in our second filing, 10 in each sub-phase of this. We have 10 units under construction at this point, delivering lots right alongside our homebuilder partners for rent and, therefore, sale product. We were interested in increasing that portfolio in the subsequent phases. It turned out to be a real opportunity for both us and our homebuilder partners, because we could tell them, 'Hey, here are the lots that we've retained previously. We'd like some additional lots right next to those. In fact, we could be one of your customers. You can roll into this next phase and start out with instead of maybe 10 homes, we were looking to increase that inventory up to 20 homes in the second phase—the second sub-phase—and really give our homebuilder partners an advantage where they could pre-sell those and fee-build for us on that.' Now, we're still working on those contracts with fee-build, and we're still working with our existing partner. Some product lines fit within that portfolio. Some product lines don't, but that's a great opportunity for us. One of the takeaways from this quarter is that we were able to successfully almost double the portfolio for that as we roll forward. It gives you a few metrics on where these lots are, how they're contiguous with some of the other areas that we're building. We have debt financing. The vertical cost on this, we have the advantage of being able to finance that with pretty low cost, even while looking at the mortgage rates. Our mortgage rates on the lots we had are at pretty advantageous rates. We've noted that they've gone up a bit, but there's still mortgage-type money. We're building these with a financing component of about $300,000 to $325,000. We're at 68% to 70% loan-to-value on that. The bank loves that. We have tremendous equity in it. Many of the homes that we're delivering are close to $550,000, and you're seeing that $550,000 continue to appreciate at a significant rate, around 4% to 5% per year. The price range for our rentals is very competitive with what people see in apartments and multifamily. So, a bit more space, certainly a lot more amenities for lifestyle issues, and we are finding continued demand. We have a ton of applications for everything we bring online. We get multiple qualified applications for that. So, we're very excited about that. It's kind of a win-win working with both us and our builders on that.

Kevin McNeill, CFO

Great. Thanks, Mark. Yes. The slide we're looking at now shows the three segments, just highlights of them—the three segments Mark talked about earlier, the water and wastewater, land development, and single-family rentals. Each three segments are continuing to grow. For the year-to-date, we've provided about 79 million gallons of water this year, which is lower than the last couple of years, but as Mark talked about, oil and gas was a big part of that. Dirk went over the land development, where we're at on that. We're about 87% complete on Phase 2A. Phase 2B, which is the next one in there, will start sometime in the next few weeks. During our third quarter, we'll see a pretty good pickup in revenue from that. The rental homes continued; we have four rented right now in the $2,400 to $3,000 a month under one-year non-cancelable leases. The next 10 should start coming on here in the next few weeks, with two or three each week for a month. By the end of the year, we should have all 10 of those rented out as well.

Mark Harding, CEO & President

Great. So, really, a couple of the significant key takeaways here are, even though we've got a rising interest rate market and a bit of headwinds in the housing industry, we saw an enthusiastic response from our homebuilder partners to continue to build out at Sky Ranch. We see that not only in terms of the existing development underway, but we also see the lots we delivered going through the difficult construction season this winter has yielded positive results. We have residents who have already moved into that filing. Our homebuilder partners were very supportive in continuing to build out at Sky Ranch. As I believe Dirk highlighted, this is an issue of segmentation for us. We're offering an entry-level product where you can buy homes out there in the $400,000 range. There are townhome products that even start in the $300,000 range at Sky Ranch, and that's really unheard of in the Denver market. This is probably one of the most affordable master plan communities in the Denver metro area. Because of our structure and how we deliver these lots, the homebuilders appreciate partnering with us, as we effectively manage deliveries in a real-time manner, allowing them to keep track of their absorption of homes.

Operator, Conference Operator

Thank you very much. We will now open the floor for questions. And we have a question coming from Elliot Knight of Knight Advisors. Elliot, your line is live.

Elliot Knight, Analyst

Thank you. Good morning, Mark.

Mark Harding, CEO & President

Good morning, Elliot.

Elliot Knight, Analyst

Somewhere in this press release, and I can't find it right now, I think I saw something about you bought some water in the quarter. Is that right?

Mark Harding, CEO & President

Yes, it was a very small acquisition. It was just a well that was right next to one of our other wells. It was around $300,000.

Elliot Knight, Analyst

Does it make any sense to think about how much you paid per acre foot to estimate the value embedded in the company given the vast water reserve that Pure Cycle has?

Mark Harding, CEO & President

Yes, it's a good question. One that we get a lot is to say, how do you take a look at your inventory, and what are the comparable sales for those types of water rights? This particular well was a one-off opportunity. It had been idle for several years. It didn't have a lot of consumptive use on it, and it has a very good appropriation, which means there's a high level of water you can take from it, but it hadn't had a lot of water taken from it. This allowed us to optimize the acquisition price. The water we have been buying in this area has gone up significantly. It's nearly doubled over the five years that we've started acquiring water in this area of Colorado. We bought some wells about five years ago for about $8,000 an acre foot. Those wells are now trading for $14,000 to $15,000 an acre foot. When you take a look at trying to transpose that over to the full portfolio that we have at 30,000 acre-feet, it gives you a sense of scale. Water is a lot like real estate. When you take a look at valuation, it depends on where and what you're doing with it and when. The value of the portfolio continues to grow year in and year out, and even more so, more recently. We're not in the business of buying low and selling high. We're in the business of buying right and developing forever, so we have a customer and revenue source that continues to generate revenue for our shareholders.

Elliot Knight, Analyst

If you tried to come up with some range of what the average current market value of that 30,000 acre-feet is, what would you say that range might be?

Mark Harding, CEO & President

I'd like to think of it in the high end of that range, around that $15,000 per acre-foot range. Certainly, when we're selling that water to our industrial segment, we're generating something close to $5,000 per acre-foot per year on it. When you take a look at whether it is fairly valued or undervalued at $15,000, I certainly could make a case that it's undervalued. One of the challenges that the optics of the company has is that we have had these assets for 30 years, and they're recorded at cost. You look at our cost basis on it, and it might be $20 million where you have $1 billion worth of potential on that balance sheet. The market has appreciated so much over time. That is a low value recorded on the balance sheet. That's kind of how we look at that question.

Elliot Knight, Analyst

So, it's really a matter of time. The value is there. I mean, you and I have been talking for all of those 30 years.

Mark Harding, CEO & President

That's true.

Elliot Knight, Analyst

And it's almost inevitable that at some point that value is going to be realized.

Mark Harding, CEO & President

That's true, and we are seeing that. We are seeing that as the metropolitan area has grown out to where our service area is, as we vertically integrated some of the development activities and continue to leverage the value that water brings for land. We're seeing that in our connection charges. That’s the tangible way to value this—it involves looking at previous acquisitions, tap fees were $6,000 a tap. Now, most of the market is around $35,000; many north of $40,000. We'll continue to pace our connection charges with the market, doing that every couple of years, and during this year, we will take a look at benchmarking our tap fees compared to our neighbors. You will see some strength growing in that.

Elliot Knight, Analyst

Okay. Thanks very much, as always.

Mark Harding, CEO & President

You bet.

Operator, Conference Operator

Thank you. We have another question coming from Greg Sterling, a private investor. Greg, your line is live.

Unidentified Analyst, Analyst

Yeah. Hi, Mark. Thanks for taking my call. I'm just curious about the lot pricing adjustments with the two homebuilders. Was that purely a function of taking back those homes for rental, or was there an actual price adjustment in the lot pricing itself?

Mark Harding, CEO & President

Both. We incorporated a time value of money component in our contracts, recognizing that inflation would be a factor. I think our inflator is around 4% in most of these contracts. So, you see that gross number continue to roll up. Even though we had a three-month deferral of starting our wet utility package, that continued to grow. The clawback of some lots allowed us to continue growing that segment given the success we've seen in the first 14 units. Overall, we want to get up to 80 to 90 units from the first and second phases and grow to maybe over 200 units in our single-family rental segment.

Unidentified Analyst, Analyst

Thanks for that clarity. I also noticed that it doesn't look like D.R. Horton has started selling their homes yet. Is there any update on that?

Mark Harding, CEO & President

They are bringing out new product lines, but they were a little late getting the home plan sets approved. The other builders were quicker with the process. They are one of the largest in the country, and typically quite aggressive on the spec build. You are going to see them get everything done all at once and then line build from there. They're also excited about moving forward with additional lots.

Unidentified Analyst, Analyst

Has there been any speculation around the demand? The school is going to be fully open starting the school year. Have they started recruiting students, or has demand increased for homes in the area because of that?

Mark Harding, CEO & President

There is indeed. The K-8 school is opening soon. They anticipated around 500 students but have received about 400 applications. They're exceeding their benchmarks. Many applications are coming from our development and surrounding areas. It's critical for new families to know about school access, and that aspect is a focal point of our community. We're thrilled about the absorption rate for our families at Sky Ranch, and our homebuilder partners take active note of the school since it drives demand.

Unidentified Analyst, Analyst

Finally, could you explain the motivations behind the share repurchase program? What would prompt action, especially given the current stock pricing?

Mark Harding, CEO & President

We initiated the program to understand and appreciate the market's disconnect between equity value. We allocated a program to do that, but were patient and monitored the market. The stock's strength has kept it above our acquisition benchmark. However, we plan to be a little more aggressive in Q3 and Q4, as we want to invest in ourselves while protecting our balance sheet and considering opportunities in land development, water investments, and single-family rentals.

Unidentified Analyst, Analyst

Okay, that sounds good. Thanks for taking my questions. Good luck the rest of the year.

Mark Harding, CEO & President

Thanks. Appreciate your support.

Operator, Conference Operator

Thank you. The next question is coming in from Greg Fernett, who is a private investor. Greg, your line is live.

Unidentified Analyst, Analyst

Good morning. When I've been out in Denver, driving to the airport, I've noticed a huge amount of development going on towards the West, along 56th Avenue, including commercial and multifamily. Where are those people getting their water from? At some point, do you have water in that area that if that development continues, you could be a water provider?

Mark Harding, CEO & President

Great question. Denver consists of 70 different jurisdictions, and the city and county in Denver is about 650,000 people. The development you referred to is in the city of Aurora. Every jurisdiction has exclusive franchise service areas, meaning, when you're developing in Aurora or Denver, you must obtain utilities from them. Those jurisdictions have to focus on their own annexations and make sure they have enough water to meet their needs. We're all competing to acquire more water rights as we grow, as we also aim to lower the overall water usage. In our developments, we have focused on minimizing outdoor turf usage and are working with artificial turf as a viable solution. While we can't serve that specific development, we can continue to grow with our existing focus areas like Sky Ranch.

Unidentified Analyst, Analyst

On the rental homes, are these financed with a fixed-rate long-term mortgage?

Mark Harding, CEO & President

Yes, they are.

Unidentified Analyst, Analyst

So, there are no variable rates?

Mark Harding, CEO & President

No, they're not variable rates. Corporations typically can't have a mortgage, but our bank provides something comparable to a 30-year mortgage-type product.

Unidentified Analyst, Analyst

If you account for appreciation, what is the return on capital for the amount that you're putting into these rental homes based on the rent and paying the debt service?

Mark Harding, CEO & President

Our Board asked us that same question. When we're taking a look at these properties on an IRR basis, these yield over 20% IRR for us. They represent significant opportunities due to the retained equity value of the land and tap fee on it. We are renting these out as $550,000 houses that cover the mortgage of around $330,000. That coverage on debt service gives us a free cash flow of around 30%, and potentially an IRR around 40% to 45%.

Unidentified Analyst, Analyst

Are there any rules in your area about having affordable housing, where a certain number of units need to be for lower-income renters or buyers?

Mark Harding, CEO & President

There are no mandates on that, although affordability continues to be a topic for everybody. Denver used to be a very affordable marketplace. The average home value is now closer to $650,000, making entry-level homes starting in the $400,000 range a challenge. Our ability to deliver homes in the entry-level market contributes positively to our homebuilder partners.

Unidentified Analyst, Analyst

Once you see growth at Sky Ranch, do you expect that to be your focus for the next three or five years, or do you see another area being developed?

Mark Harding, CEO & President

Yes, Sky Ranch will continue to grow. We're actively working on acquiring more land, both to develop and partner with others, with the intention of becoming a utility. We believe that growing the investment in our existing service area around Sky Ranch is critical as we ensure utility provision efficiently. We do see a long-term demand for our water utility services in that area.

Unidentified Analyst, Analyst

You currently don't have anything in your inventory for that, is that correct?

Mark Harding, CEO & President

We do have an inventory of 24,000 acres, which is our exclusive service area. This can support all of our existing water requirements as the metropolitan area continues to grow. We have the entire 30-year portfolio of land inventory to fulfill our need for water and utility services.

Unidentified Analyst, Analyst

Are you anticipating that the City of Aurora will eventually have to come to you for water?

Mark Harding, CEO & President

Currently, Aurora is a significant utility. They don't have enough water to serve what they've already annexed and zoned. Despite this, it's typically rare for utilities to rely on each other for supplies. However, it may change over time based on regional needs. We participate in projects like WISE where regional cooperation on projects is possible. Thus, while providing water to Aurora's utility might not be feasible now, conditions could alter in the future.

Unidentified Analyst, Analyst

When do you expect to generate revenue from that, or do you already?

Mark Harding, CEO & President

Yes, we are already generating revenue from that water project.

Unidentified Analyst, Analyst

Okay. Thank you very much.

Mark Harding, CEO & President

Thank you all for your continued support. We're optimistic about our achievements and the integration of our land development and water utilities. Our partnerships with builders continue to create an attractive opportunity for us, as does the single-family rental segment. Please visit our Investor Day this summer for a further look at our assets and strategies.

Operator, Conference Operator

Thank you, everybody. This concludes today's conference call. You may disconnect your phone lines at this time and have a wonderful day. Thank you for your participation.