Asset formula

Pure Cycle Stock: Sustainable asset company with a conservative net asset value (NASDAQ: PCYO)

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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 the discounted trading, there are a ton of free buy options attached. This is a good opportunity to invest in sustainable assets (land, water) at a discount alongside management who owns ~21% (CEO owns ~4%).

Background

PCYO is a diversified land and water resources development company.

  • Land use segment: develops planned communities along the I-70 corridor of the Denver metro area; this segment was born out of the need to control the addition of water and wastewater customers to PCYO’s systems (instead of waiting for third-party entities to contract with them or for growth to accrue to them); they are currently developing the Sky Ranch (~930 acres, purchased in 2010 for $7.5 million), which plans to include up to 3,200 single and multi-family homes, parks, open spaces, trails, centers recreation, schools and over two million square feet. ft of retail, commercial and industrial space
  • Water sector: a vertically integrated water and sanitation service provider that owns and develops a portfolio of water rights in a water-scarce region; more specifically, they control water and infrastructure to (i) abstract, treat, store and distribute water (ii) collect, treat, store and reuse wastewater and (iii) treat and supply reclaimed water to irrigation purposes; they also supply raw water for oil and gas operations, but this sub-segment is unpredictable and subject to fluctuations
  • Single Family Home Rental or Build-To-Rent (upcoming segment): the company will keep the single-family homes that it will own, maintain and rent

The company estimates that the eastern corridor of I-70 will continue to experience substantial growth over the next several decades.

The development of Sky Ranch has 3 phases and will take approximately 8 to 10 years:

  1. Phase I is 99% complete. They delivered the 505 batches of this development phase.
  2. Phase II is ongoing (started February 21). This phase will include 850 residential lots (250 acres 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 contains relatively few details at this time.

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

Evaluation

The valuation of PCYO is a bit tricky since it has possible assets/income streams, so we need to look at where the business is going to assess its value.

Based on the numbers from his latest 10-K:

Debt: PCYO has no debt, total liabilities around $15 million

Species: $20 million

The business has a few sources of income/assets:

  • Non-recurring revenue: Lot sales, one-time connection fee (water tap – ~$27,000, sewer tap; ~$5,000), oil/gas water sale 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 approximately 5,000 Single Family Equivalents (SFEs) (an SFE is a customer, whether residential, commercial, or industrial, that places a demand on the water system based on the demand of a family of 4 people living in a single family home on a standard size lot), of which 500 lots were already in Phase I for ~$72k/lot. Phase II lots are expected to sell for around $82,000 on average. So the remaining 4,500 lots: 4,500 x 82,000 = $369 million.

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

One-time water connection fee (non-recurring)

The company estimates that with the water rights it owns, it can serve approximately 60,000 SFEs. They collect about $32,000 for one-time connection fees, which is about $1.9 billion in future revenue. If we assume that it will take PCYO 20 years to realize the full value and discount $1.9 billion using a 10% discount rate, we get a value of ~$282 million.

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

In other words, we only pay for single lots and discounted water connection fees; everything else is a free option.

Recurring water charges

Water demand is quite inelastic.

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

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

It also does not take into account increases in land and water prices, revenues from water supply from oil and gas companies, revenues from certain mining royalties and the construction segment for rental.

Risks

  • Denver stops growing and development stops because there is no demand for housing.
  • Any recession or economic crisis could halt the development of Sky Ranch.
  • Inflation is on everyone’s mind these days. PCYO will be able to raise prices and land values ​​are also expected to rise in line with inflation.

The main thing to note here is that the company is in excellent financial health – it has no debt; the long-term value will remain as long as the business continues to operate.

Catalysts

  • Denver continues to develop and grow
  • Sky Ranch Phase II/III Advancement
  • Increase revenue from the water segment
  • Insiders own ~21% and CEO owns ~4%

Conclusion

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

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


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