Description

Short Cadiz

(CDZI $12.15)

8/14/2017

Cadiz has been identified many times as a short by various idea sites and short newsletters, including two short pieces on VIC in 2012 and 2014. Three years later the stock trades at a higher price despite annual dilution and cash burn. The reason is Trump’s victory, which dramatically improved the company’s prospects for its water transport project. That said, there are still hurdles to the project’s approval, combined with a relatively full valuation even if the project goes ahead. As such the stock still looks like a good short at its current $12.10 bid. In addition, there are relatively inexpensive puts available.

Background

Cadiz proposes to provide several California municipalities with up to 50,000 acre-feet of water annually, piped from Cadiz owned land in the Mojave desert. Roughly a fifth of the water would go to the Santa Margarita Water District. That district’s agency reviewed and approved the project’s environmental status, despite being more than 200 miles from San Bernardino county, where the water resides. San Bernardino could have asserted its position as the municipality best positioned to assess environmental impacts, but then county supervisor Brad Mitzelfelt chose to forego that action. Mitzelfelt soon after received a substantial contribution from Cadiz in his unsuccessful California congressional campaign.

At its heart, the Cadiz project pits California municipalities against the state government.  The local municipalities represent small affluent communities and like the idea of secondary water supplies. The state of California, led by California Senator Dianne Feinstein and various state legislators, is concerned with the longer term environmental impact of siphoning large amounts of water from the Mojave desert. The proposed 50,000 annual acre feet of water represents less than 0.1% of California’s annual water supply, making it very much a ‘special interests’ issue. Given how small the Cadiz project is in the relative scheme of California’s water management, it is remarkable how much time, energy, and state and federal legislative attention it has garnered.

I have linked at the bottom of this note to a succinct history of the project as well as some recent commentary. For the purposes of this thesis it’s helpful to understand a few key points:

1)      To move water from Cadiz’ reservoir to CA municipalities requires the water to travel over Federal lands, which would require a Federal environmental review. An unbiased environmental review would take more time, and based on widely circulated environmental research might well conclude that Cadiz’ planned water extraction would dry out critical desert aquifers. To bypass this review, in 2008 Cadiz entered a lease agreement with the Arizona & California Railroad company. The company’s goal was to exempt its project from Federal review based on right of way exemptions issued to railroads. However legislation related to railroad ROW specifies that qualifying projects serve a railroad purpose, which does not include selling water to third parties. Cadiz argued its water could be used to extinguish railroad fires. The California branch of BLM ruled against this argument.

2)      Cadiz appealed that ruling , but appeared headed for failure prior to the 2016 election. The Trump administration breathed new life into the project, issuing a directive the BLM that widened the meaning of a ‘railroad use’. The administration also indicated that on appeal the project would be reviewed by the BLM’s Washington office. Further, David Bernhardt was confirmed in July as deputy secretary of the Interior. Bernhardt was previously co-chair with Cadiz’ CEO Scott Slater at the law firm Brownstein Hyatt Farber Schreck.

3)      Those developments greatly increased the probability the company would receive an exemption from federal review. In response, state assemblywoman Laura Friedman, D-Glendale, moved a bill out of committee that would require state environmental review of projects that involved large water pumping in the desert. The bill was specifically designed to require a state review of the Cadiz project, a point confirmed by Friedman herself.

4)      It is not easy to pass legislation in California, however both houses of the state legislature are heavily democratic, and for many legislators it’s not clear that there is much reason to oppose the legislation. Friedman passed the bill as a member of the water committee by changing the language of a pre-existing water conservation bill to specifically target Cadiz. Having passed Friedman’s NRW committee the bill has been referred to the senate appropriations committee for a vote on August 21^st. If it passes the appropriations committee it would then be scheduled for a vote before the full Senate. If approved by the Senate it would move back to the assembly for a full vote. If passed there it would go to the governor for signing. Progress of the bill can be monitored here: https://leginfo.legislature.ca.gov/faces/billStatusClient.xhtml?bill_id=201720180AB1000

5)      Based on the makeup of the senate appropriations committee, the bill has a reasonable chance of approval. The committee has five democrats and two republicans. Committee chair Ricardo Lara and Senator Scott Wiener both have pro-environment, pro conservation platforms, and are likely ‘yes’ votes. The two committee republicans, Patricia Bates and Jim Nielsen, are likely ‘no’ votes given precincts (Bates represents some receivers of Cadiz water) and past voting.  To move the legislation forward, two of the remaining three democrats would need to vote in favor. Jerry Hill represents Silicon Valley and strikes me as a likely ‘yes’ based on his constituency while Jim Beall representing San Jose also has a liberal record, although it’s focused on housing. The final democrat, Steven Bradford, is a less reliable vote given he received past support from supporters of the project.  So Jim Beall may end up being the swing vote here.

6)       It is worth noting that much of the mainstream press coverage of the project has been negative – for example this LA times op-ed http://www.latimes.com/opinion/op-ed/la-oe-brooks-cadiz-project-water-mojave-desert-20170521-story.html.

7)      Even if this particular legislative challenge fails, Cadiz is not out of the woods. The company still needs a favorable BLM ruling, and various parties in California could look for other ways to delay or stop the project.

8)      A further possible obstacle is water quality. Cadiz’ project would require it to pipe its water into facilities managed by California’s Metropolitan Water District (MWD), which would represent the last mile distribution to the receiving municipalities. Cadiz’ water has higher than permitted levels of the carcinogen hexavalent chromium (chromium 6), and will have to reach agreement with the MWD regarding treatment of the water to reach satisfactory purity.

Taken as a whole, the project’s odds of success have improved but are far from certain. If one thinks the state legislative challenge has a 20% chance of success, and that failing that there is another 5% chance the state finds some further way of impeding the project’s progress, and that failing that there is at least a 5% chance the BLM denies the company’s appeal, and failing that the company still needs to reach consensus with the MWD on water treatment, I’d argue the project still has less than a 70% chance of approval. I believe the current share price reflects a much higher probability of success.

Prior to the 2016 election, CDZI’s shares were priced at $7, roughly 40% below today’s price, and many close followers of the company viewed that as generous. The company has not shown the ability to generate profits as a going concern, and currently has $130 million of debt, in addition to a $275 million market cap for a current EV of $400 million. I think sub $7 is realistic price target on a significant new setback. If investors become convinced the project is completely untenable, I think the stock is a zero, given the current debt load.

The next question is what would CDZI be worth in the event the project proceeds – I think not much more than it trades for today. Assuming the high end of the company’s estimates for volume and price of 50,000 acre feet sold for $1,000 per year, implies $50 million of annual revenue.  The company currently has roughly $10 million of annual G&A, and incremental costs associated with pumping water have not been identified, but I think conservatively would have to run north of $5 million a year. In that scenario, the company could plausibly generate $35 million in annual EBITDA.

To get to that point the company would have to finance the construction of pumping and more significantly, water treatment, and has obtained $240 million of contingent construction financing from Apollo for the project. While I suspect the company would supplement that funding with equity, conservatively assuming that funding represents the total project cost it lifts the pro-forma EV to $700 million, or 20x projected EBITDA. That would be on the very high end of infrastructure multiples for a project that would remain controversial, and for volumes that could decline over time if the company does indeed deplete its aquifers more quickly than it estimates. The main upside would be if the company charges much higher than advertised delivery prices for its water. However this will be a tough proposition, given falling prices for recycled water (see first linked article above).

Given those numbers and with the stock currently trading above $12, I think a straight short is attractive. The risk reward on the puts also looks interesting, although getting the timing right is important. There is a clear event on August 21 (senate vote) which could be a catalyst. Various puts may makes sense, for example the September 10 puts trade for $0.10 - $0.15, which could provide an outside payoff if the legislative process appears to be working against the company.

 For a good synopsis of the Cadiz story: http://sbcsentinel.com/2017/07/assembly-bill-would-stop-cadiz-inc-s-mojave-h2o-to-orange-county-plan/

Actual Friedman bill: https://leginfo.legislature.ca.gov/faces/billNavClient.xhtml?bill_id=201720180AB1000

Friedman bill in press: http://www.sbsun.com/environment-and-nature/20170706/bill-would-curb-massive-cadiz-desert-water-project

Catalyst

Progression of Friedman bill, negative BLM ruling on appeal, impasse with MWD, declining recyled water prices, setbacks on project construction.