Pure Cycle Stock: Hard-Asset Company With A Conservative NAV (NASDAQ:PCYO)

Investment Thesis

Pure Cycle Corporation (NASDAQ:PCYO) is an under-the-radar land and water resource company trading at a discount to a conservative NAV (~0.5x-0.7x P/NAV). Despite trading at a discount, there are a ton of free call options attached. This is a good opportunity to invest in hard assets (land, water) at a discount alongside management which owns ~21% (CEO owns ~4%).

Background

PCYO is a diversified land and water resource development company.

• Land Development Segment: develops master planned communities along the I-70 corridor of the Denver metropolitan area; this segment came about from the need to control the addition of water and wastewater customers to PCYO’s systems (as opposed to waiting for third-party entities to contract with them or for growth to go to them); they are currently developing the Sky Ranch (~930 acres, bought in 2010 for $7.5m), which plans to include up to 3,200 single family and multifamily homes, parks, open spaces, trails, recreational centers, schools and over two million sq. ft. of retail, commercial and industrial space
• Water Segment: a vertically integrated water and wastewater service provider that owns and develops a portfolio of water rights in a water short region; specifically, they control the water and infrastructure to (i) withdraw, treat, store and deliver water (ii) collect, treat, store and reuse wastewater and (iii) treat and deliver reclaimed water for irrigation use; they also provide raw water for oil and gas operations, but this subsegment is unpredictable and prone to fluctuations
• Single-Family Home Rental or Build-To-Rent (upcoming segment): the company will retain single-family homes that they will own, maintain and rent

The company believes that the eastern I-70 corridor will continue to experience substantial growth over the next few decades.

The development for Sky Ranch has 3 phases and will take ~8-10 years to complete:

1. Phase I is 99% complete. They delivered all 505 lots in this development phase.
2. Phase II is underway (started Feb 21). This phase will include 850 residential lots (250 acres of residential and 160 acres for commercial, retail and light industrial; 804 lots for homebuilders and 46 reserved for their “build-to-rent” segment).
3. Phase III has relatively few details as of now.

PCYO has 24m shares outstanding; at a current price of $11.64, the market cap is ~$280m.

Valuation

The valuation for PCYO is a little tricky since it has eventual assets / revenue streams, so we should look at the destination of the company to assess its value.

Based on numbers from its latest 10-K:

Debt: PCYO has no debt, total liabilities of ~$15m

Cash: $20m

The company has a few sources of revenue / assets:

• Non-Recurring Revenue: Lot Sales, One-Time Connection Fees (water tap- ~$27k, sewer tap; ~$5k), Selling Water to Oil / Gas for Fracking
• Recurring Revenue: Water and Waste Management (Sky Ranch + Others), Build-To-Rent Segment

Lot Sales (Non-Recurring)

Sky Ranch is estimated to have ~5,000 single-family equivalents (SFEs) (an SFE is a customer, whether residential, commercial or industrial, that imparts a demand on the water system based on the demand of a family of 4 people living in a single-family house on a standard sized lot), 500 lots of which were already in Phase I for ~$72k / lot. Phase II lots are expected to sell for ~$82k on average. So the remaining 4,500 lots: 4,500 x 82,000 = $369m.

If we assume future development costs of ~20% (I used estimated numbers from the recent presentation– estimated lot revenues of $70m, total development costs of $73.4m and reimbursable costs of $61.1m: (73.4 – 61.1) / 70 = ~18%) and discount it back 10 years using a 10% discount rate, we get a present value of ~$113m.

One-Time Water Connection Fees (Non-Recurring)

The company estimates that with the water rights they own, they can service ~60,000 SFEs. They collect ~$32k for a one-time connection fee, so that is ~$1.9b in future revenue. If we assume that it will take 20 years for PCYO to realize the full value and discount $1.9b back using a 10% discount rate, we get a value of ~$282m.

So just using what we’ve calculated so far including cash and debt, we get $400m (113 + 282 + 20 – 15) of NAV and with a current market cap of $280m, we get a P/NAV of 0.7x.

In other words, we are just paying for the one-time lots and water connection fees at a discount; everything else is a free option.

Recurring Water Fees

Water demand is pretty inelastic.

PCYO estimates that it will collect ~$1,500 / SFE / year for annual usage use. Using the 5,000 SFEs in Sky Ranch, that’s $7.5m in revenue a year. This should command a higher multiple given the recurring nature of the cashflow. In theory, if PCYO can utilize all 60,000 SFEs, it could generate $90m in recurring revenue per year. Assuming a 5x multiple, you get between $37.5m and $450m.

Adding that to our NAV calculation, we get an NAV between $440m and $851m (P/NAV between 0.33x and 0.64x). Taking the average we get to ~0.50x P/NAV.

This is also not considering any increases in land and water prices, revenue obtained from supplying water to oil and gas companies, revenue from some mineral royalties and the build-to-rent segment.

Risks

• Denver stops growing and development stops because there is no demand for housing.
• Any economic recession or crisis might halt the development of Sky Ranch.
• Inflation is on everyone’s mind these days. PCYO will be able to raise prices and the land value should also increase alongside inflation.

The main thing to note here is that the company is in great financial shape – it has no debt; the long-term value will remain as long as the company keeps operating.

Catalysts

• Denver keeps on developing and growing
• Progress of Sky Ranch Phase II / III
• Increasing revenues from the water segment
• Insiders own ~21% and the CEO owns ~4%

Conclusion

PCYO is a developing story and if all goes well, it is currently trading at a conservative 0.5-0.7x P/NAV considering only lot sales, one-time water connection fees, and recurring water fees. It also contains a few free embedded call options that are not incorporated in the calculation.

Based on the analysis above, I recommend a long position in PCYO with a holding period of a few years.