Pure Cycle Corporation (NASDAQ:PCYO) Q1 2023 Earnings Call Transcript

Pure Cycle Corporation (NASDAQ:PCYO) Q1 2023 Earnings Call Transcript January 10, 2023

Operator: Good morning and welcome to Pure Cycle Corporation’s first 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. If anyone should require Operator assistance during this conference, please press star, zero on your telephone keypad. Please note this conference is being recorded. I will now turn the conference over to your host, Mr. Mark Harding, President and CEO of Pure Cycle. You may begin.

Mark Harding: Thank you Jenny. Good morning everyone. I’d like to welcome you to our first quarter earnings call for our fiscal year 2023, and happy new year to you all. We have a slide deck for this. If you can surf over to our website at purecyclewater.com on the landing page, you’ll find a button on there where you can click on that and then we will actually forward through the slides, but it will give you the ability to see some of the text in the slides within the presentation. With that, I’m also joined today this morning by Kevin McNeill, our CFO, and Dirk Lashnits, our Vice President and Director of Land Development, who will also give you updates into some of the business segments and the financial reportings, and then at the end we’ll have a brief Q&A for those of you who want to drill down on some of the specifics.

With that, let me first start with our Safe Harbor statement, which I’m sure most of you are familiar with. Statements that are not historical facts that are contained or incorporated by reference in this presentation are forward-looking statements. With that, we’ll get the lawyers out of the room and we’ll start. I’ll just be very brief on some of the overview of the company, but for those of you that are first-timers to the call or new to the company, we really operate on three primary business segments, really that are fundamentally interconnected to each other at the DNA level of the company. We’re a water-wastewater utility company, where we own water in a water-short region here in the State of Colorado and the west. We develop those water rights and we are cradle-to-grave on the water rights, where we develop the wells, the distribution system, put that water to use in both the land segment, which is a parcel of property that we own that we’re doing a master planned community on and we’re building lots for our homebuilder customers, and then we are holding back some of those lots and building homes on those for the single-family rental segment as well, so each of those segments really are interrelated to a vertically integrated platform that we have from the water utility side.

Moving on to just describe a little bit briefly about the water segment itself, we have just that whole network of utility operations, where we have the diversions for the water supply, whether those are taking water sources from our streams and surface water supplies, our groundwater supplies or our reuse supplies. We treat that water, we store it, we distribute that out to our customers. We’re also responsible for some of the development of that distribution system pursuant to our design standards for our community, which is some of the lands that we have but others as well, so we have master planned service areas that are very valuable, which we will highlight a little bit later in the presentation. Our customers use that water, they give it back to us, we collect that, we treat it and then we reuse it, so we have a use and reuse model.

Within that, we get some fee instruments for that on the water utility side. We get connection charges, which are a one-time connection fee which, between the water and the sewer tap fee, are around $32,000, $33,000, and those are paid by the homebuilder, our homebuilder customers, and those are typically added into the cost of the home, but that grants the service connection a permanent entitlement to the water supply and then we get usage fees for that, so we get a base fee which really amortizes some of the cost of operating and maintaining a system, and then a consumption charge which is a tiered consumption charge, and so what this tends to do is it tries to encourage conservation, because the more water you use, the more water–the higher the cost of the water supply.

As you take a look at our water balance, what we look to do is really keep control over that drop of water, where we’re taking that from the supply, we’re treating it, we’re putting it into our system, we’re getting it back from our system, and then we’re reusing that, and so we do have a very closed loop system. We do lose a little bit to outdoor irrigation and some evaporation, but those trends are really decreasing and there’s been a lot of press, I’m sure much of you have seen, about drought and the vulnerabilities of water supply on the left, so the company’s emphasis on technology and controlling that drop of water through its continuous life cycle is very important to our systems, and we want to make sure that we’re good stewards of this water supply.

Taking a little bit of the infrastructure, you know, we build this infrastructure. It’s long-lived assets. The water supplies certainly are long-lived – those are perpetual, and then you have a lot of the brick and mortar that we’re building associated with that, and really this is showing the growth of the company in the last five or six years, really showing about an 86% growth in the capitalized asset class and the various categories of that infrastructure, whether that’s water and wastewater treatment facilities, transmission lines, wells, finished water storage, surface water, groundwater supplies, distribution systems, all the components of a water utility you’ll find in there, so that will continue to grow as we keep seeing that. Moving into how the growth of the utility looks like, our current customer count is up to about 1,250 new connections.

We measure that in terms of the number of single family equivalent connections on it, and so we have a combination of residential customers which would be a standard single family equivalent, but then we also have commercial and irrigation connections attributable to those, and so just because you might have one irrigation connection, that might represent as many as a couple hundred as you see down in Lowry, because we have large irrigation requirements down there of connections. We rate that to the number of how we build those out, so the number of base charges that we get for each of those. I talked a little bit about our residential connections at Sky Ranch, which is our development. We have our first phase, which is completely built out, 500 homes.

We are into our second phase, very robust tap sales in our second phase – Dirk will drill down into that a little bit, but we’ve got 124 taps there, and then a service area that we picked up a couple of years back, where we have more than 200 connections between the residential and the commercial connections as well. Moving on, another one of our big customers on the utility side is the industrial space, where we sell a lot of water to the oil and gas industry through a number of different operators. Our water supply, our service areas, and really–you know, the City of Colorado is located over a fairly prolific oil and gas field that’s gotten a little bit more attention more recently with the shale oil play, but we are seeing operators drill a number of pads in a number of formations here that consume a tremendous amount of water for oil and gas, and so we continue to see those sales.

This is the distribution of how those sales go by quarter, and as you can see, it’s kind of all over the map. There’s not a lot of predictability to it. They drill year round, they frac year round, and a lot of this is really dependent on a permitting process and how aggressive they are. The leasehold interest particularly in our particular field has changed hands a number of times, which is pretty typical in the oil and gas industry, but it started out probably in 2015, ’16 time frame with a lot of the field assessment and field definition, and now it’s kind of moved into more of a well development, so they’re developing the field, so they don’t do a lot of exploration, they don’t do a lot of changing to it. Each rig has a much stronger capacity to drill more wells per pad per year, and so what we’re seeing is when you get a dedicated rig out here, that can drill as much as 25 to 30 wells a year.

They’re pretty significant wells. They’re two mile lateral wells on this thing. I think they’re experimenting with some three-mile lateral wells on it, and so they’ll continue to increase the amount of water that they’re using, depending on their laterals on it. This is kind of an illustration, if you look at the right-hand side of this, that will be kind of the Denver metropolitan area and kind of the growth of the metropolitan area. The two red areas or pink areas that you see in there, those are service areas. If you look at the one, kind of transition between the green and the grey there, that’s our Sky Ranch project, which is ideally located – it’s on the I-70 corridor, and it really is in the strongest area of growth in the Denver metropolitan area, and we as a developer are really targeting the entry level housing product, which I think inures very well for us both in very strong markets as well as in challenging markets, and so Dirk will talk a little bit more about that.

Then our service area at Lowry, it’s the very large pink area which continues to be really an untapped asset for us. The land is owned by the State of Colorado in trust for the public education system here, and it’s one of the most unique assemblages of land in the country. As you can see by the picture on the left there, most of the development has really come up to the border of that property, and so it depends on how the state looks to move forward with that, but that’s certainly an opportunity for us over the next few years that we look forward to doing the utilities for that. We’re the exclusive water-wastewater provider for that 24,000 acres of continuous property. That gives you kind of a sense of the utility side and some of the segments that we have in there.

I’m going to hand this off to Dirk Lashnits, who will talk a little bit about our land development activities.

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Dirk Lashnits: Thanks Mark, good morning. Land development – so here’s our flagship project, called the Sky Ranch. Every time I see it, it’s overall view, it always reminds me of the dreaded Tetris piece from that game. This is 930 acres, like Mark said, on the developing edge of development out on the east side of Denver. It has 3,200 residential lot capacity and 2 million square feet of commercial capacity, and we’re about 15 miles east of downtown Denver. Sky Ranch has probably got about a 10 to 15-year build-out that will be heavily dependent on our market conditions. We’re going to build this out in multiple phases. Over the last probably four or five years, you’ve heard us talk a lot about our first phase – that’s the first 500 lots, that’s pretty much in the books, and we’re now moving onto our second phase.

That first phase is the block on the left side of the picture, and then our second phase is kind of the middle portion of the parcel, and then future phases will grow out to the east, and our commercial piece is the northern block adjacent to I-70. We plan to build about on average, probably about 250 lots per year out here, and we’ll layer in our schools and commercial pieces and rec centers, all those things that go along with a master planned community. Phasing–as I mentioned, Phase 1 in the books, that was 500 lots. We also had our pilot program for our build-to-rent lots, so we had four occupied units in that phase, 100% complete. Then moving into our second phase, this is 850 lots. We’re sub-dividing this into four sub-phases – that’s 2A through 2D.

We are well underway in our Phase 2A – that’s about 80% complete, and we’ll have that completed later this year, beginning of 2024. We’ve started our infrastructure for Phase 2B. We’re hoping to start that in earnest quarters two through four of this year, and then the third and fourth sub-phases, 2C to 2D, we’ll build out in subsequent years. Our Phase 2A, we just had our first few residents move in there, so that’s exciting. We have delivered all our lots to the builder customers there. As you saw by our water taps number on the previous slides, those are indicative of the number of homes that the builders have started, so we’re right about that 120, 130 houses started. I think the builders have sold probably about 20, 25% of their lots, and they’ll look to have those sold out the remainder of this calendar year, and then we’ll be looking to have that second phase come online for the next batch of lots to not interrupt that sales cycle.

All right, so this is the details on the phasing. These are–this is the Phase 2, 850 lots broken down into the four sub-phases. We’ve got our lot revenues – those numbers are what we–our income from sales of the lots to the builders, and we have our tap revenues, those are the water and sewer connection components that Mark mentioned. Then we have our costs to develop the lots and then we have our reimbursable component, and those are the costs attributable to public infrastructure that are eligible for receivable reimbursement through public dollars, whether that’s taxes or bonding. The graphs on the bottom of the sheet here, the bar graph and then the far right pie chart those are our builder breakdown, builder distribution. We have our four builders in this phase, and that’s by builder, and then our–that center pie chart is our product mix, so those six slices of that pie represent our–the different product market, product segmentation which we think is a good balance of product offerings and good diversity.

Moving onto some market conditions here, sort of the news of the day, start with our–the good, so the positive things. The pent-up demand for new home sales, we think there’s good upside here. Back in the ’05 – ’06 time frame, there was about 1.4 million in home sales, and even in this latest upswing in ’01 – ’02–or ’21, ’22, we’re only at 600,000, so I think that represents good upside for us. In that first quarter, we’ve seen the mortgage rates start to stabilize. They’re kind of hovering around 6%, and that’s in historical norms. Lot delivery is still trailing home starts, so in other words, we are still selling more homes than we are delivering finished lots, so from our standpoint, being in the business of selling lots, that’s good potential there, like to see that, that demand.

We’ve got–our homebuilders in Sky Ranch are all ranked nationally. All four in the second phase are in the top 15, I think three of them are in the top 10, two of them are in the top five, so that’s–

Mark Harding: We’ve got the top one.

Dirk Lashnits: Yes, the top one, top two even. Good for stability and in it for the long haul. They’ve certainly seen some of the market swings and are good partners in helping mitigate that. Low unemployment, this is obviously a really important one, we hope that stays positive. House prices still appreciating by now, still a good investment. Lower average days on the market – houses are still selling pretty quickly and those are some typical numbers there. Last year, we were down–in Denver at least, we were under 10 days on average, and houses were selling above asking price sight unseen, day of asking. A year ago, we had that peak and even today with some of the slowdown, we’re still seeing, based on market, in the 20s, so that’s all still good outlook.

Onto the bad, or opportunities that we have here, again the abrupt uptick in interest rates kind of shocked the system, and I think we’re slowly adjusting to that. Again, we’re still in kind of historical norms. A lot of the important metrics still trending downward – builder confidence is down, applications for mortgages are down, buyer traffic in the model homes is down, home sales are all down, and then combine that with higher material and labor costs and then our cancellations on contracts are still up. You know, I do think at the end of the day for us, houses are too costly. We need to figure out ways to recalibrate that. The land development side that we do is a link in that chain and how do we adjust for those changing markets, and the way we do that is mostly on a timing–from a timing standpoint, and that’s really our challenge, is trying to time our deliveries.

We have a long lead time in the development business. We’re probably anywhere from at the earliest six months, but more likely a year out from when that demand comes online, so we have that challenge on trying to find the right time to build our lots. Here is just a slide, it’s a couple of the–it touches on the job growth chart, interest rates and some sales information. Back to Mark.

Mark Harding: I’m going to push this over to Kevin and he’ll give you an update on some of the rental segment, and also just some brief stats on the quarterly performance.

Kevin McNeill: Thanks Mark, thanks Dirk. Yes, so our single family rental, our newest division that we launched in 2021, we continued growing it. We’re up to–we’ve got four houses completed now as of December 15. We’ve got 10 more under construction, and those will be delivered throughout the year, throughout our fiscal 2023. The four that are rented are all rented from $2,800 a month to $3,000 a month, pretty stable renters, we think, so still very optimistic about this market. With this new segment, especially with interest rates continuing to climb, with home values continuing to stay high and the slowing of that market, the rental rate market in Colorado especially is going to be very strong. This is some projections that we put together using our fiscal year from last year, our 2022 results, just because the first quarter is a smaller piece to look at.

We’ve projected out with 14 home and 50 homes. Fifty would be the entire Phase 2, 46 homes there and four homes in Phase 1. What you see is our current projections, obviously depending on cost and interest rates and everything else, is about a million dollars a year, just short of a million dollars a year in free cash flows from operations of just the rental units. It doesn’t include obviously overhead or anything like that, but–. The financial results for the quarter, it wasn’t the strongest quarter we’ve obviously had. There was, from a water-wastewater standpoint, as Mark touched on earlier, we continue to invest in the water infrastructure, a little over $67 million now in water rights, which we can pass that water rights themselves and supply infrastructure to bring the water to our customers.

We delivered about 67 million gallons this quarter, which is down a little bit from last year, which is predominantly down because there wasn’t a lot of oil and gas activity during the quarter, and also construction activity was down, so the Phase 2A being done and 2B not really started yet, we didn’t sell as much water to construction activities. Dirk obviously touched on the land development side, which you’ll see when we get to the balance sheet and income statement as well, and then single family rentals continued to grow. From a graph standpoint, you can see obviously the revenue and segment revenues were down for this quarter compared to each of the last few quarters. One thing I’ll point out is in that Q1 2020 quarter, that was kind of an anomaly.

We recognized a bunch of revenue in that year to catch up some contingencies that we had, and also there was a big–there was a lot of lot sales that year. Phase 1 was going very strong, Phase 2A was getting ready to start, and so it was just a–it was a great year. This year, you’ll see the revenues are down, predominantly again because we talked about the housing market slowdown. We delayed a little bit of Phase 2B in order to match our lot availabilities with their–with the homebuilders’ sales, so that was somewhat intentional, but obviously with the housing market and interest rates, that was hard to control. From a net income standpoint, you’re going to see the same thing, that income dropped during the first quarter compared to the other quarters – same reason, revenues were down.

We were able to offset some of the revenue declines with a little over a million dollars in surface use and other payments from oil and gas companies, which we think is a pretty strong indicator of a good 2023, we hope, for fracking and drilling, and continuing out throughout the rest of the year throughout our service area, and then obviously there’s our diluted earnings per share. There will be a little more information on this coming out when we actually file the Form 10-Q, which we’ll do in about four or five years, which we anticipate filing here in the next few days. A few upcoming dates – we have our annual shareholders meeting tomorrow, which is–you know, there won’t be any big presentations, it’s more a formality, so not expecting a big event for that.

Our 10-Q, like I said, the filing date is January 17, but we file before then, and then if you haven’t seen it, our ESG report, we launched in November so that’s on our website, gives you a little more detail into our–what we’re doing from an environmental standpoint, how we’re trying to be good stewards of the environment and our money and the shareholder money. Real quickly, the balance sheet and income statement, you can see we had a pretty good pick-up in cash last year. The Sky Ranch cap did a bond offering and was able to repay a little over $24 million in total to us of reimbursables, and so we invested that in some short term treasuries and capitalized on some of those interest rates, continued to grow the balance sheet in terms of assets, and investing in new water rights and infrastructure.

You’ll see the income statement, obviously I won’t spend a lot of time here, but it will come out in the Q, and then the press release we issued last night has a lot more information on it, but you can see the revenue decline that we discussed predominantly in the land development, lot sale area in that commercial water sale area. Our overhead stayed fairly consistent – you know, we’re keeping our headcount strong, and then you can see in that other net, the $1.2 million of other income, that was basically surface use payments and future–in anticipation of future drilling and oil and gas operations on our land. With that, I’ll turn it back over to Mark for closing statements and questions.

Mark Harding: Thank you. Okay, so what are our takeaways here? I guess takeaways for management would be the stewardship of how we handle our business model. We’ve got very valuable, very low cost basis legacy assets here, both in terms of the water and the land side of the equation, and what we’ve done successfully is really make sure that we carefully position you all with your invested capital to market exposures, and so one of the ways that we do that is through how we handle our builder contracts, and those of you that are familiar with the company kind of had this appreciation, but we have a lot delivery agreement structure where our builders are working in partnership with us on delivery of this very expensive infrastructure, when you’re in a high cost business where we’re delivering horizontal infrastructure for master planned communities and then the housing side of it, the vertical side is handled by the homebuilders.

But that infrastructure is very expensive, and we want to make sure that neither we nor the builders, our builder partners have too much exposures in softer markets, and we’re in a softer market right now. Really, the validation of that business model is the fact that we don’t have any exposure in there, right? As you saw in the presentation and Dirk highlighted, we’ve got about 15% of the Phase 2B, which really would be the grading and the over-excavation components of that, that we’ve invested in, and that’s been covered by our homebuilder customers, so that’s not a significant investment in there. Then as their lot deliveries, and this is about pace, right – this is about how many lots they want to have in inventory because they want to match their sales cycle, and maybe in Phase 1, each builder was doing seven to eight homes a month, so that absorption was pretty high.

In Phase 2B, we’re seeing maybe three, but we are still seeing that and it’s three homes per builder, so that gives you a cycle for that. We find ourselves in the right market segment, that entry level product, and so as the homebuilders come out there and look for buying opportunities, Dirk really highlighted the continued demand for single family homes in the marketplace, and that’s still–we’re seeing that in the marketplace, we’re seeing that in terms of the builders and the building permits that they’re pulling and the spec homes that they’re building out of Sky Ranch, and then also that they’ve having sales, you know, that we’ve got customers that have moved out there in the last 30 days and continuing to really see that absorption. We continue to inject value into the community.

We’re opening up our school, which is going to be a tremendous asset for them because it’s a local school, a charter school that we’ve partnered with a national charter operator out of Michigan – National Heritage Academy, and they have a website, the Sky Ranch Academy has a website. You can take a look at that, but really good delivery device for education for new families out there. Then taking a look at kind of diversity, one of the things that we like and Kevin mentioned was single family rental business. There’s still a ton of demand for more space at your home because of the work balance, the work-from-home balance. You’re seeing a lot more dual income families looking for more space so that they can have offices at home, and our home product–you know, we’ve diversified from either a 45-foot lot or a 45-foot lot in Phase 1A, and now we’ve got six different product categories, and that’s inuring very well to the market segment.

You have six different price points in there as opposed to just a couple of price points, depending on finishes, so a lot of those design features that we had in our master planned community really is inuring well and will stand the test in both good markets as well as headwind markets. Then ultimately continued sales of water in industrial operations, so we’re going to see a little bit of uptick in oil and gas demand, but that’s really a steady-eddy customer for us. We like making sure that we supply that segment water supply and then can convert that water supply over into the potable supply, so there’s a really good balance in how we’re extending and developing into these assets. Then continued growth – you know, we continue to grow the company, small tuck-in acquisitions of assets.

As you’ve heard me talk about in prior acquisitions, we’re on the hunt for more land and to really kind of build our land portfolio. Don’t have anything really substantive to talk, so I’m going to forecheck some of your questions on what’s the update on acquisitions for land development. There are a number of opportunities that we’re pursuing and we’re very aggressive about doing that. One of the nice things we have is we can be aggressive about that – you know, we have a very liquid balance sheet. We’ve managed this capital well, we’ve been disciplined with our board to be making those investments and then also making investments in ourselves with the stock buyback, so those are kind of the capital allocation structures for us. So with that, I’m going to turn it over to the lovely Jenny in Scotland, who is waiting for her lunch, and see if there’s any questions that you might have on drilling down some of the detail.

Q&A Session

Operator: Thank you very much – I am indeed waiting for my lunch as it’s five past two. Your first question is coming from Robert Howard from Boiling Point Resources. Robert, your line is live.

Robert Howard: Good morning.

Mark Harding: Good morning Robert.

Robert Howard: I just had a–hi, I just had a quick question on the–for the new customers that are getting added on. You talked about $1,500 of annual revenue from the water customers when they come on. I was just wondering, at least maybe at Sky Ranch, as you’re adding customers, how much additional costs might there be? Are the–you know, is the infrastructure and kind of everything in place so that $1,500 is really kind of almost all incremental, or is there additional costs that kind of get layered on as you’re still kind of building up stuff, or have you kind of reached a critical mass when maybe the costs are decreasing a lot slower than they were earlier in the project?

Kevin McNeill: That’s a good question, and really we segment some of that brick and mortar cost for adding those connections into the tap fee charges. Typically, the way we see it is that the connection charges, that $33,000 for a tap fee charge, we build the wells, the treatment facilities, all of the brick and mortar stuff that delivers that water to the customer through that capital allocation base, and a lot of that is sub–is early on investment that we’ve had, and then also what we see is the oil and gas revenues tend to allow us to expand that system apart from the tap. The way we usually look at is that’s a 50% margin business, but it becomes a little bit better margins because some of the oil and gas revenue, we can allocate to expanding that supply side in advance of those tap connections.

When we get the actual connections, the $1,500 connection per year which is really your point, there are additional costs in that because we have an operating entity where we’ve got chemical costs to make sure that we disinfect the water, we have lab costs because we have to continuously sample our water and make sure that our water meets all of the primary and secondary clean water standards, so that business we typically also look at as a 50% business, 50% margin business, and it’s not so much on the capital side as it is on the operating side. We have operators that are making sure that they’re going out, making sure the system is operating correctly, taking a look at whatever’s occurring daily, nightly, weekly on those sorts of things, in addition to really the lab costs.

That’s how that divides out. There’s not a significant uptick in that – as a matter of fact, it’s usually a little bit better on the front end because everything is brand new and it operates the way it’s supposed to. But we really–we look at those margins as about those 50% in each segment of that, if that answers your question.

Robert Howard: Yes, sure. Then just that $1,500 number, I think you guys have kind of been talking about that for a number of years. Is there pressure on that, or I don’t know, is the market rate elsewhere in Denver, are other people charging that amount, or is there possible pressure for that going up, just inflation in general? How are you able to kind of keep the customer rates flat?

Mark Harding: Yes, and I would say there’s two rates there. There’d be the tap fee rate and then the usage rate. The tap fee rate probably has a little bit more upward mobility just because of the scarcity value, and as you continue to hear about the competitiveness of water rights and the incremental costs, because we have to go farther and farther out to reach for those water supplies, I’d say our tap fees have a little higher upside than, say, necessarily usage rates. The usage rates will continue to grow. We continue to grow those for making sure that we keep up with our inflation costs as well as anticipatory costs for whatever the evolving regulatory climate is going to look like, but that’s a little bit more inflation-oriented as opposed to the value of water in water short areas and the cost of water, acquiring those water rights from farther and farther areas.

When you take a look at those two revenue streams, there’s probably a little more strength in the tap fee side, which is going to be our big number. You apply that to our portfolio – we have 60,000 connection worth of that, so that’s over $2 billion worth of revenue potential over time as opposed to that $1,500. That’s been a stagnant number. We’re probably a little bit above that – that’s just been a metric number that we continue to look at. I would say that that continues to go at 3%, 3.5% per year.

Robert Howard: Okay, great. That’s all I’ve got. Thanks a lot.