PURE CYCLE CORP quarterly report, Q1 FY2012

Pure Cycle Corporation — Form 10-Q Summary

Reporting period: Fiscal first quarter ended November 30, 2011; comparative income and cash-flow figures are for the three months ended November 30, 2010. The interim financial statements are unaudited. Pure Cycle provides wholesale water and wastewater services, primarily in the Denver area.

Financial results and position

Metric	Q1 FY2012	Q1 FY2011
Revenue	$67,559	$67,986
Gross margin	$20,381	$26,490
Operating loss	$632,592	$448,053
Net loss	$1,361,735	$1,460,813
Net loss per share, basic and diluted	$0.06	$0.07
Cash used in operations	$432,574	$265,593

• Revenue was nearly unchanged year over year. Water revenue rose 15% to about $41,600, while wastewater revenue fell 32% to about $12,000. The company sold no water or wastewater taps in either period.
• Gross margin declined to about 30% of revenue from about 39%. Water-service costs rose 31%, attributed mainly to higher energy costs from pumping for oil and gas drilling and fracking; wastewater costs rose 23% while fees declined.
• General and administrative expense increased 42% to about $599,500. The company cited employee bonuses and increased legal and professional fees, including costs related to its Land Board dispute.
• Net loss improved by about $99,000, partly reflecting $103,600 of oil-and-gas lease income and the absence of the prior-year $91,000 convertible-note interest expense. These benefits were partly offset by higher G&A and $851,400 of imputed interest expense on the Tap Participation Fee.
• At November 30, 2011, total assets were $115.5 million, cash was $350,092, marketable securities were $3.85 million, working capital was approximately $3.84 million, and shareholders’ equity was $46.0 million. Cash and marketable securities together were approximately $4.2 million.
• The company reported no debt obligations with contractual maturity dates. However, it carried a $65.8 million Tap Participation Fee liability and a $1.2 million recorded participating-interest liability. These obligations have no scheduled maturity dates; payments depend on specified events or proceeds. The Tap Participation Fee liability is a discounted estimate, not a conventional borrowing balance.
• Investing activities provided $699,285, principally from net sales and maturities of marketable securities. Financing activities provided $11,586. Cash and cash equivalents ended the quarter at $350,092.

Material changes and unusual items

• HP A&M elected to double its Tap Participation Fee percentage from 10% to 20%, while halving the remaining covered taps to 19,458. A revised valuation increased estimated total future payments by $7.5 million and raised the recorded liability from $65.0 million at August 31 to $65.8 million at November 30. The liability includes $21.1 million of imputed interest to date; the quarter’s $851,400 imputed interest was a noncash expense.
• The revised Tap Participation Fee valuation used a 5.3% implied interest rate, down from 6.3%. Management said this reduced quarter interest expense by $147,800 versus the prior valuation assumptions and expected a $620,900 reduction for FY2012. These are estimates dependent on projected development and tap fees.
• The company recognized oil-and-gas lease income over the lease term from a $1.24 million upfront payment received in FY2011. At quarter-end, $949,900 remained deferred, with recognition expected through February 2014.
• Sales to the Rangeview Metropolitan District accounted for 71% of revenue; the District’s largest end customer accounted for 68%. The District and that end customer represented 81% and 73%, respectively, of trade receivables.

Outlook, risks and contingencies

• Management stated that approximately $4.2 million of cash and marketable securities and available working capital were sufficient to fund operations for the next fiscal year. It also reported an effective shelf registration statement that could permit up to $4.45 million of additional stock sales. No specific operating or earnings guidance was provided.
• On December 19, 2011, the company and the District sued the Colorado State Land Board, alleging breach of agreements protecting Pure Cycle’s exclusive water-service rights at the Lowry Range in connection with a proposed oil-and-gas lease. They seek damages to be proven at trial; the filing provides no clear estimate of potential recovery or exposure.
• HP A&M’s third-party farm-property notes totaled approximately $10.0 million, with $5.5 million in balloon payments due within 12 months. Pure Cycle did not assume those notes, but a default could put acquired properties and associated water rights at risk unless the company cures defaults. Management deemed default remote and said it was unaware of any default; it also said it lacked funds to cure all notes.
• Other principal risks include the pace of housing development and tap sales, water-rights and permitting outcomes, construction and operating costs, access to capital, weather and regulatory conditions, and estimates used to value water assets and the Tap Participation Fee. The company noted that it must meet specified development steps by 2014 to maintain its Paradise Water Supply rights.
• The Fort Lyon Canal Company approved an assessment increase effective January 1, 2012, expected to add about $33,000 in annual cost. Disclosure controls were reported effective, with no material quarterly change in internal control over financial reporting.

Most important facts for investors to verify

• Whether development, future tap fees and discount-rate assumptions supporting the $65.8 million Tap Participation Fee liability remain reasonable, and how revisions affect future noncash interest expense.
• Whether the Land Board lawsuit affects the company’s Lowry Range service rights, and the potential timing, costs and outcome of the litigation.
• Whether customer concentration, limited cash on hand and ongoing operating cash use create a need for additional financing despite management’s stated one-year liquidity assessment.
• Whether HP A&M continues to meet its third-party note obligations and whether the company could preserve affected properties and water rights if defaults occur.
• Progress on Paradise Water Supply diligence requirements and the company’s ability to convert its water portfolio into customer connections and cash-generating tap sales.