Description

PICO Holdings, Inc. (PICO), now a pure play collection of western U.S. water assets, is undervalued at today’s prices. Applying a conservative valuation to PICO’s largest and most marketable water assets while valuing the remainder of the assets at $0, and extending the disposition/liquidation timeline up to a decade still results in a reasonable IRR.

PICO was last written up on VIC two years ago and the stock is up 50% adjusted for the 2017 special dividend ($5.00/sh).  However, there have been significant changes at the Company since that time and a recent stock price decline makes this an opportune time to revisit this opportunity.

Introduction

PICO was, just a few years ago, a holding company run by management for management. The company held a variety of extraneous investments ranging from oil and gas to agriculture to homebuilding to water. John Hart, the former CEO, oversaw his empire from the uneconomical headquarters located in the immoderate yet beautiful city of La Jolla, CA. This empire building resulted in high executive compensation and massive shareholder losses.

Over the last two years, the following key events have transpired:

1. Board was declassified, reduced to 5 members, and more shareholder-friendly owners replaced entrenched directors on the Board  
2. CEO John Hart was terminated (albeit with an $11.2m severance package) replaced by CFO Max Webb (and Webb has been subsequently re-purposed, see below)
3. The Company’s 57% stake in UCP, its homebuilding subsidiary, was monetized (at a $11.4M loss), leaving PICO a pure play water company through its Vidler subsidiary.
4. The Company issued a $5/share special dividend paid out of the UCP sale proceeds
5. PICO then initiated a strategic review process, which led to a run up in the stock as investors hoped for a quick sale of the company, but this process ultimately lead to no transaction and an indefinite timeline for selling all remaining water assets
6. PICO made the decision to shut down the La Jolla office and rationally consolidate it with the existing Vidler operations in Carson City, NV ($1.6M moving cost, $650K est, annual OpEx savings)
7. Now a holding company holding just one investment, the Company (belatedly) rationalized its management team and the CEO of Vidler Water Company, Dorothy Timian-Palmer (“DTP”), became CEO, while former CEO, Max Webb, became Executive Chairman
8. The company has repurchased 1,715,678 shares through 9/30/2018 (at an average price of $11.57) and the company plans to continue to do so up to the Board approved level of $50M (at 9/30/2018 there was $30M remaining)

Despite these positive developments, the stock has languished and most recently dropped to a point that provides an attractive entry.

Why Is It Cheap?

• Uncertain timeline for monetization of assets and Company has a history of saying they will be sold “next year”. (Though to be fair, the delays have not been management’s fault)
• Limited information for shareholders from management with the recent elimination of quarterly earnings calls
• Company has no consistent revenue as all revenue is transaction dependent

The Current Situation

PICO’s current business plan is to “creatively monetizing existing [water] assets at maximum possible present value, return proceeds to our shareholders, and reduce costs.”

The company continues to “paint the tape” with small water sale transactions but, given recent Reno City Council approvals for significant residential development projects, it is only a matter of time before larger transactions begin to occur. As the values of a majority of the assets are, over the long term, more likely to rise rather than fall in value given the scarcity of water in PICO’s markets, the timing of asset sale proceed distributions is the most significant variable with respect to valuation.

PICO’s Assets

PICO’s significant assets are water rights in and around Reno, Nevada and Long Term Water Storage Credits (“LTSC”) in Arizona.  While demand for the Reno assets is largely a function of residential development activity, the value of the LTSC is driven by persistent drought conditions in the Rocky Mountain West and a supply-demand imbalance for Colorado River water that will continue to worsen in the years to come.

Nevada

Fish Springs Ranch and Carson-Lyon, PICO’s two largest assets, are located in Nevada. The value of both of these assets is highly correlated with economic conditions and growth in the Reno and Carson City areas.  However, PICO is entitled to a variable rate of return on preference capital it invested in Fish Springs Ranch which would mitigate (somewhat) an extended disposition timeline, should it occur.

Backdrop: Reno Economic Picture

The economic outlook for Reno, NV and the surrounding areas is presently strong. Currently, there is a housing shortage in the Reno/Sparks area. There has been a 22% decrease in homes available for sale and prices continue to grow dear as population and job growth has outpaced housing.

Source: PICO Investor Presentation

Average rents also continue to rise as vacancy rates fall, indicative of a housing market with short supply.

Source: PICO Investor Presentation

Much of the population growth is resulting from the migration of technology companies into the area attracted by relatively inexpensive land, lower costs of living, and tax incentives. The highest profile entrant, and ostensibly the riskiest, is Tesla whose $5 billion Gigafactory is expected to ultimately employ 6,500 people. Google, Amazon, and Walmart are other notable companies buying land or operating in the region.

The chart below further exemplifies the acute housing crisis Reno is experiencing. This bodes well for increased development in the area and thus increased demand for PICO’s water assets which are the only source of water for new developments in the North Valleys.

Source: PICO Investor Presentation

Fish Springs Ranch

It bears repeating, PICO’s Fish Springs Ranch (“FSR”) is the only source for water for new development in the North Valleys (Reno/Sparks).  Any new development, of which there likely will be many, will be required to purchase water from FSR.

PICO owns a 51% managing member interest in Fish Springs Ranch. FSR owns 12,984 acre-feet (“AF”) of total permitted water rights (excluding sales mentioned below). An acre-foot is the amount of water needed to cover one acre with one foot of water. Of these 12,984 AF, 7,984 AF are currently transferable to Reno and Sparks. The remaining 5,000 AF, while permitted, require updates to federal rights of way before they will become transferable.

• Recent Pricing
• June 2018 agreement to sell 70.52 AF at $35,000/AF
• Expected to close in Q4 2018
• September 2018 sold 3.61 AF for Industrial/Commercial developments at $35,000/AF
• Importantly, PICO can unilaterally change the price of an AF with 10 days notice to the Truckee Meadows Water Authority (“TMWA”)
• Truckee Meadows Water Authority is a public authority providing water services in the Truckee Meadows of Washoe County in Northern Nevada, which serves more than 330,000 residents.

PICO fronted all capital costs for the FSR project and thus is entitled to recoup their partner’s share of the costs plus a financing fee of LIBOR + 450 bps per annum prior to any pro rata distributions from water sales. At December 2017, the total value of this preference capital was $169.6M ($75M of which was accrued interest) and the applicable rate at this time was 6.2%. Thus, $169.6M, or roughly ~$8/share is effectively compounding at LIBOR + 450 while we wait.

In addition to the currently non-transferable 5,000 AF of water, other assets at FSR which we value at $0 for conservatism, are the FSR ranchlands, agriculture water rights on the property, and the excess pipeline capacity.

FSR: Reno Development Updates

Below is a table from the May 2018 PICO Shareholder Meeting investor deck showing proposed  development projects in the North Valleys that would need to purchase water from PICO/FSR in order to be completed.

Source: PICO Investor Presentation

Stonegate

The Stonegate development recently received city council approval as can be read here. PICO initially estimated that water would be sold to Stonegate in 2018, but the timeline has been extended to late 2019/early 2020 due to the length of the approval process and some unexpected weather conditions in previous years. PICO estimates the entire project will require 2,023 AF. At current pricing of $35,000/AF results in gross proceeds of  ~$71M. The recent approval is a positive development for PICO. However, the project is expected to be completed in phases with infrastructure improvements to roadways required at various stages. As such, water demand, and therefore sales, will likely be phased as well.

Train Town & White Lake Vistas

Management expects these two projects to follow Stonegate, but they are in the vicinity and will benefit from infrastructure installed for Stonegate. Together these two projects are expected to require 976 AF (~$34M at current pricing).

Silver Hills

Silver Hills is noteworthy because the development is currently approved for 600 units, but the developer has chosen to expand it and therefore is seeking a new approval for up to 2,300 units. While this delays PICO water sales, it is a good problem to have as the ultimate development stands to purchase a larger quantity. Unfortunately at the time of writing there is no indication that Silver Hills has returned to the approval process as of yet. The final project is expected to require 1,178 AF (~$41M at current pricing).

Pricing Power

In the North Valleys, PICO is free to adjust pricing on its water with a ten-day notice to the public water utility, TMWA. The price at which PICO has agreed to sell water today is $35,000/AF. This price can be increased if market dynamics indicate an increase in demand and that the fair market price per AF has increased. While we recognize this pricing power, we have not included any change in price for FSR water in our valuation.

Scarcity

It is also important to note that there are more AF of water demanded by just the currently anticipated developments shown on the chart above than there is permitted water at FSR (9,824 AF vs. 7,984 AF).  Recall that FSR is the only source of water for these developments. PICO’s CEO commented in the August 2018 earnings call that once about half of the FSR water is sold, there may be urgency by developers to secure water from FSR to ensure their projects are viable.  This could lead to a meaningful acceleration in water sales at FSR.

Carson-Lyon Water Credits

The USA Parkway (State Route 439) was recently completed. The project began as a privately funded six mile road connecting Interstate 80 with the Tahoe-Reno Industrial Center (“TRIC”). The public project extended the original road another twelve miles to span the distance between Interstate 80 and State Route 50.

Source: PICO Investor Presentation

In May 2018, management stated that they were seeing an increase in activity in the area, and recent talks with management suggest this continues to be true. DTP stated that the area was likely to require 6,000 new single-family units per year. The area is attractive as a source of affordable housing to serve the TRIC (both employees and workers on future developments).  There is significant development pressure in the area.

In the Carson City Lyon County area, PICO owns 1,268 AF municipal water, with another 1,779 AF likely to be converted from agricultural to municipal use. Filings suggest that an ultimate total of 4,000 AF is expected in the area. We value everything, other than the currently available for sale municipal water rights, at $0 in our valuation.

• Recent Pricing
• June 2018 sold 500 AF at $20,000/AF for proceeds of $10M (and a smaller sale of 11 AF @$25,000/AF)

• The $20K/AF recent sale price was related to a transaction that also resulted in PICO securing important easements from the purchaser of the water to potentially enable future water and sewer development in the area.  In other words, the consideration for the 500AF was greater than the $20K/AF print.
• Management stated that the easements could add as much as an additional $5K/AF to remaining water rights. We assume no additional incremental value, and use today’s pricing ($20K/AF) in our valuation.

Tule Desert Groundwater Basin

As part of a teaming agreement with Lincoln County, Vidler (PICO) owns a 50% interest in the Tule Desert project. The project sold its first permitted 2,100 AF @$7,500/AF in 2005 and currently has 2,900 AF of permitted water rights with an additional 4,340 AF, which we have valued at $0, potentially available many years from now after staged pumping and development. PICO funded the project and is due cost reimbursements of $17M before a pro rata 50/50 split. There are no existing option agreements at this time and we use the 2005 price in our valuation.

PICO also owns the Toquop Energy project which we value at $0.

Arizona

PICO’s Arizona Long Term Storage Credits are the most significant asset in Arizona. Unlike the Nevada assets which are dependent upon increased growth and development in the Reno area, the Arizona asset value is much less elastic with respect to the economy. The structural deficits in the Colorado River system (see below) along with Arizona’s junior position in the event a shortage is declared, not only make PICO’s long term storage credits an attractive asset, but also an attractive option for the State of Arizona to help it meet its pressing water needs.

Backdrop: The Colorado River Basin

In 2015, nearly 40 million Americans relied on the Colorado River system for water. The Bureau of Reclamation estimates that by 2060 in its Rapid Growth scenario, the population relying on the Colorado River could be 76.5 million people.  In the same year, the imbalance between supply and demand is projected to exceed 3.2 million AF/year. The executive summary to the report can be found here.

Over the last two decades, the West has experienced significant population growth and protracted drought conditions. In the Forward to the executive summary, in regards to the Colorado River Basin, the Commissioner of the  Bureau of Reclamation wrote, “in the absence of timely action to ensure sustainability, there exists a strong potential for significant imbalances between water supply and demand in coming decades.”

As the levels at Lake Mead fall, Arizona must take the greatest cuts to its water allocations from the Colorado River system. Arizona’s annually receives 2.8M AF from the Colorado River. As Lake Mead’s surface level falls, Arizona’s permitted annual water allocation falls as follows:

For shortage declaration purposes, this level is measured every year on January 1st. A 24-month study released by the Bureau of Reclamation suggests Lake Mead is projected to reach the 1,075 ft level by May 2019. Study can be found here.

While this is an extremely concerning fact for those living in the West, it supports the Company’s optimism that its assets are well positioned and our assertion that the values of the Arizona assets are relatively inelastic with respect to the economy.

Arizona Long Term Storage Credits

PICO owns LTSCs in both the Phoenix AMA and Harquahala INA. Most recent sales have occured in the Phoenix AMA as those assets are in the Phoenix area and do not require additional infrastructure investment. The Harquahala LTSC are outside the Phoenix area and will require additional infrastructure to transport to the Phoenix area. Management estimates the difference in pricing today to be $100 per credit, but expects pricing to equalize as the imbalances in the Colorado River system worsen. We value the Phoenix AMA credits at $350 and the Harquahala credits at $250 accordingly.

• Background
• Sold 102,500 LTSC in 2017 at ~$250
• Remaining LTSC (including those under option): 304,499.22
• Indication of Current Pricing
• 13,650 LTSC under Contract (read “under option”)
• Apache Sun Golf: 1,150 AF
• Prices escalating between [$306.26, $375.18]
• terminates 9/30/21
• Roosevelt Water Conservation District: 12,500 AF
• prices escalating between [$367.50, $423.50]
• terminates 12/31/19
• 2017 sale price: $250/credit. Most recent Phoenix AMA contract starting price: $350/credit. Roughly 40% increase in two years.

Minor Projects - Imminent Monetization

Dodge Flat, Nevada

• Background
• 1,078 acres of land under purchase agreement for $9M (closing anticipated 2/1/2019)
• 1,428 AF of water under contract, expected to net $8.5M
• Both are at the purchaser's option, but DTP says they have been making option pmts and its likely they close in 2019 [2018 annual meeting].
• Valuation

Kane Springs, Nevada

Kane Springs is located 60 miles north of Las Vegas. The company currently has an option agreement with a developer to sell the remaining 500 AF. DTP stated at 2018 annual meeting and reaffirmed in Q2 earnings call that she expects they will close in 2019 and the net proceeds to be $3,800,000.

The Company also has priority applications for ~17,375 AF in Kane Springs working its way through the application process. We value this at $0.

Corporate

Company has estimated an operating expense burn of $6.2M per year.  It is reasonable to think this number can come down in future years, but we have not assumed any change.

NOLs

At 12/31/17, PICO had federal and state net operating loss carryforwards of approximately $185.5 million and $174.7 million, respectively.  Total book value of remaining assets was $167mm at 9/30/18. We estimate impairment charges on the major water assets (FSR, Carson/Lyon, and Tule) at around $~40M resulting in an estimated tax basis of $210M. (Note we also use this value as the floor (threshold) for the bonus payout to management of 8.75%).

Combined Valuation

We approach valuation with intentional conservatism to illustrate how cheap the Company is at today’s share price even given a potentially prolonged asset disposition timeline. We value the Company’s major water assets at today’s pricing and value the remainder of the portfolio at zero (see PICO Holdings Portfolio table below).  Given the limited supply of water in the West generally, and in PICO’s markets specifically, pricing for its assets is unlikely to remain flat in the coming years. We also conservatively assume a lump-sum terminal payout to shareholders at various time horizons. We could estimate interim distributions, but our guess is as good as anyone’s with respect to the actual timing of asset sales.  In order to establish a range of outcomes, we vary the timing of distributions to shareholders from asset sale proceeds.

The following IRR calculations are solely based on conservative estimates related to PICO’s largest and most readily saleable assets.

Aggregate Undiscounted Value of Major Assets

Sensitivity Analysis: IRR vs. Timeline

Assuming a $6.2M annual burn and the entire distribution of asset sales proceeds coming in the final year (this is undoubtedly conservative), at today’s share price of roughly $9.78, PICO offers the following IRRs:

Illustrative Calculation - 5 years

This a conservative baseline valuation.  The following are sources of upside:

• Values for unpriced assets in table above
• Increase in value of AZ LTSC due to political and/or meteorological pressures.  (An existing contract has a 10% per year price escalation built in.)
• Increase in FSR and/or Carson-Lyon price per AF due to continued development pressure in Reno
• Decreases in corporate expenses
• Continued accretive share repurchases and/or special dividends
• Option premiums paid by developers to secure water rights

Clearly, in this model, any asset sale distributions coming sooner than the assumed final year lump-sum payment will improve IRR. PICO boasts a significant margin of safety over the long term.  

Strategic Review Process

In October 2017, the Company engaged a third party financial advisor (JMP Securities “JMP”) and legal team to explore strategic alternatives. The review was initiated after PICO was “approached by a large and well-respected institution” which had indicated an interest in the Company. JMP approached 160 investors, of which 34 executed NDAs, of which “several” expressed further interest. Ultimately, the process did not lead to a transaction as the Board decided that none of the alternatives adequately compensated shareholders.

Some in the market have suggested that this was a result of PICO’s assets having lower than anticipated values. However, we see it differently. The timing of asset sales is uncertain. It is likely that a bidder who came to the same IRR conclusion we have, would have been deterred by the requirement to pay an acquisition premium above a stock price that was, at the time, 25% higher than today’s price.  In addition, a change of control would result in potential impacts to PICO’s NOLs.

Risks

• Timeline of asset dispositions extended due to slow municipal approvals of development projects in Reno and/or economic slowdown.  The FSR and Carson-Lyon asset values, in particular, are driven in large part by Greater Reno economy. A recession or slow down could both extend disposition timeline and depress values temporarily.  However, there is no other water coming to the region, so ultimately these assets have value
• Assets are concentrated geographically
• Historically, PICO has not been aggressive about cost cutting.  Continued G+A expenses will impact NAV as timeline extends

Catalyst

• Lake Mead threshold breached
• Further asset sales
• Opportunistic share buybacks - note that a buyback 10b5-1 plan is in place, but limited in the daily volume among other statutory restrictions
• Residential development in the North Valleys
• Pricing power per acre-foot (“AF”)