Description

Sixth time’s the charm . . .

PICO has been written up five previous times on VIC, essentially annually over the last five years.  Nevertheless, the investment situation, ownership dynamic, corporate strategy and financial disclosures have changed sufficiently that I feel an update and refresh are justified.  The value in hand is attractive relative to pricing, and there is now an identifiable catalyst.

Summary

PICO Holdings (PICO) is a California-based holding company that trades at a substantial discount to NAV.  Importantly, there are near-term catalysts in place to close the price-value discrepancy.

In July 2015, PICO closed on the sale of one of its three primary subsidiaries – Northstar, a canola seed crushing operation.  This transaction left PICO with only two material assets:

• Vidler Water Company – a private water resources development business; and

• UCP – 57.2% interest in a publicly-traded land holding company and homebuilder that is priced at < 70% of book value.

In the wake of the Northstar sale, PICO is at a crossroads.  The Company is a holdco with two assets, both of which are undervalued by the market.  Simultaneously, PICO is under significant shareholder pressure to monetize assets, realize value and return capital to shareholders.  These dynamics should lead to near-term corporate actions that increase market pricing.

Vidler Water Company

Vidler acquires and develops water resources and water storage operations in the southwestern United States, with assets and operations in Nevada, Arizona, Colorado and New Mexico.  The book value of this segment is $203mm.

Vidler is PICO’s jewel and perhaps worth >2x book value.

A summary of Vidler’s primary assets:

• Fish Springs Ranch

• Reno, Nevada

• Developed and permitted water rights with 35-mile pipeline to Reno

• Carson-Lyon

• Carson City, Nevada

• Tule Desert

• Lincoln County, Southern Nevada

• Arizona projects

• Various underground storage projects and land with associated water rights

As assessed by Central Square Management - a 6% PICO shareholder for whom PICO comprises 17% of its reported portfolio - Vidler has historically generated >2x and ~20% annualized returns on its investments.  See Appendix for referenced analysis.  Central Square also highlights a Carson-Lyon example – one of these two properties has a book value of $4mm, but was under option pricing that would have netted Vidler $40 to $60mm.

Importantly, the Vidler valuation process was greatly simplified with last week’s investor meeting and the related investor presentation that laid out detail concerning the Vidler assets.  Vidler valuation information is now updated and aggregated in one place, rather than requiring teasing information out of old filings and management.  Here’s my napkin math, which meshes with management commentary and Central Square work around Vidler being worth >2x BV.  I apply valuation discounts to the second set of credits for each project - reasoning for discount in each case should be clear from the notes.

Management commentary on the subject.  From the 4Q14 call:

We estimate that Vidler's water portfolio could have a value of approximately 2.2 times carrying cost. This estimate does not include 5,000 acre-feet of Fish Springs Ranch water, which has not been approved for importation at this time or that there will be any more water permitted from our 100,000 Lincoln County applications.

Lastly, Central Square performed a DCF analysis of each individual asset.  The DCF exercise was premised upon inputs derived from conversations with water brokers, private equity investors, government agencies and water experts.  Central Square’s analysis suggests an NPV of $400mm to $500mm, which aligns with the asset-by-asset build-up driven by management’s investor day slide deck.

Vidler has a reported book value of $203mm.  However, PICO impaired its Vidler investment by ~$40mm across the credit crisis.  As such, I believe it’s reasonable to use $245mm BV for valuation purposes.  In my base valuation, I utilize $400mm for valuing Vidler, a ~1.6x BV multiple.  

UCP, Inc.

UCP is a land owner/developer and homebuilder with acquisition and entitlement expertise in California, Washington, North Carolina, South Carolina, and Tennessee.  UCP was founded in 2004, and acquired by PICO in 2008.  See Appendix for UCP detail.

Following the PICO acquisition, UCP’s strategy was cogent – acquire cheap land and lots in the wake of the credit crisis at distressed prices.  UCP focused these efforts on Central California and the Bay Area.  There was no homebuilding aspect.

In 2010, UCP – in an effort to generate more consistent cash flow – formed Benchmark Communities, a homebuilding subsidiary.  UCP went public in July 2013, pricing at $15.00/share.  At its IPO, UCP had a BV similar to its current BV, yet UCP market pricing is now ~$7.60/share, a decline of almost 50% from the IPO.

At < 70% of BV, UCP’s market pricing is non-fundamental relative to asset value.  ~40% of UCP’s lots were acquired between 2008-2010 at prices below current market values (based on July investor presentation).  This disconnect between price and value is likely a function of UCP’s odd nature - ~$60mm public float with minority ownership.

PICO management recognizes this disconnect, and I believe is actively working to address the valuation discount, likely through a sale of the business.  This belief is bolstered by shareholders’ specific demands and management commentary:

• 4Q14 conference call

• In addition, we are confident that UCP's management is exploring all avenues to extract maximum value for shareholders.  UCP's board and management is always looking at opportunities to enhance shareholder value which in addition to making improvements in terms of operational efficiencies and continuing to grow their market would include other type of transactions that might beat the enhanced shareholder value.

• Annual report

• “A closer analysis of peer group data suggests that currently a company’s float and market capitalization has more of a correlation to relative market value than operating performance. Unless UCP’s small float and market cap is addressed, the market will most likely continue to undervalue them. UCP’s management and board are exploring various strategies to improve the current situation.”

• 2Q15 conference call

• Also as we've seen the recovery gain a little bit of traction. Clearly, the land is worth more than book value in aggregate and that's really what I was referring to.

• [A]t current levels the price is highly disconnected from its intrinsic value. . . . [W]e believe the value of the company and its underlying asset should be greater today than when it went public.

In the base valuation, a 1.0x BV is utilized for marking UCP’s value to PICO (along with ~$10mm of non-UCP net assets with PICO’s real estate segment).  Relative to peers and the fact BV includes a material portion of land that was acquired opportunistically between 2008-2010, I do not believe this valuation assumption is too optimistic.  

Lastly, UCP is interesting in its own right – $7.60/share versus $11/share BV, or 45% upside associated with a business that is likely being actively marketed.  Not surprisingly, River Road and Central Square own 8% and 7% of UCP, respectively.  However, with only ~$300k daily volume, UCP is less investable.

Shareholder-Management Dynamics

PICO management has allocated capital poorly over the past decade (outside of Vidler) and is materially over-compensated.  In conjunction with market price and book value declines, this management dynamic has compounded over the past several years to create what is an acutely restive shareholder base.  Unhappy and concentrated shareholders can drive positive corporate action.

Central Square is a leading actor, owning 6% of PICO and having filed an initial 13D on February 9, 2015.  Central Square has not historically been an activist investor; PICO is Central Square’s first 13D investment.  The investment firm’s hand has likely been forced in this instance as PICO constitutes 17% of Central Square’s portfolio.

River Road, a 9% owner, filed a 13D two weeks following Central Square’s initial filing .  Again, River Road is not an activist, but is likely  motivated to act here given PICO’s performance and the rather evident steps that can be taken to drive shareholder value.

The refrain from both Central Square and River Road is the same:

1. Monetize Northstar (recently disposed Canola crushing operation),

2. Monetize UCP,

3. Return proceeds to shareholders via tender offer or a special dividend, and

4. Determine whether Vidler should remain a public company

In addition, on April 24, 2015, River Road filed a shareholder proposal recommending PICO’s board take the steps necessary to de-classify the board.  The voting results were quite telling.  88% of shares voted (very high turnout) with 91% of cast votes supporting declassification and 55% of cast votes opposing NEO compensation.

In early-August 2015, Central Square pressed further, immediately requesting three seats on PICO’s board (three seats are up for election at the 2016 shareholder meeting).  Central Square likewise reiterated its call for monetization of UCP followed by a PICO self-tender.  Again, on October 13, 2015, Central Square filed an updated 13D, attaching a letter in which it specifically called for the appointment of three board candidates, two of whom are affiliated with Steel Partners.

Given the resounding voting results, recent performance and a spotlight now being shone on the Company and board, movement is underway.  On July 31, 2015, PICO closed the sale of Northstar for $105mm, netting $12mm cash to the Company (with the potential for $10mm held in escrow).  Likewise, I believe an active effort is underway to monetize UCP along with some of the Vidler assets.

Furthering this view, last week the Company announced a $50mm share repurchase authorization to be funded via prospective asset monetizations.  This addresses one of the largest risks with PICO - current management ineffectively reallocating capital - and share repurchases would represent a great investment in shares trading at a significant discount to underlying value.  In addition, PICO reduced the CEO’s salary by >50% and improved the bonus comp structure (calculated off realizations in excess of current book value and only payable upon return of capital to shareholders).  While the comp structure is still too high and poorly structured (at a minimum, hurdle should be invested capital not current book value, given historic writedowns), this does represent incremental improvement, and more importantly, signals the initial thawing of what has been an insular, untenable management and governance dynamic.  

A sampling of management commentary from PICO’s August 10, 2015 call and the associated press release:

In the wake of Northstar and Mindjet, our board has been engaged in urgent, thorough, and holistic review of our capital allocation and investment decision and criteria. Simply put while there is significant value to be harvested in our company, we have not been performing. We know this, you know this, and we need to fix this.  Before strategic review concentrates on PICO's remaining subsidiaries, UCP, Inc. and Vidler Water Company, which together represent 93% of our shareholders' equity. While the current year stock price performance of UCP has been extremely disappointing, we believe that at current levels the price is highly disconnected from its intrinsic value. The homebuilding operation hasn't dissipated the value of the land, and doesn't prevent them from selling land. Our 57.2% holding of UCP has approximately the same book value as when they went public, giving UCP's dramatic growth since going public two years ago, and the increased geographical diversity it now has, we believe the value of the company and its underlying asset should be greater today than when it went public. . . .

[O]ur focus is on continuing to preserve but also enhance the value of UCP and Vidler and that includes monetization events in a timely fashion. . . .

Our board and management team are, however, moving with urgency to maximize the value of our assets and to return it to shareholders in the form of share repurchases as appropriate and when possible.

Prospective Financials & Valuation

Tying this all together, on the heels of the Northstar transaction, PICO has a relatively clean balance sheet.  Applying the valuation assumptions discussed above suggests a PICO NAV of $21 to $28 per share.  Furthermore, modeling a cash tender along the lines suggested by Central Square suggests PICO NAV of $24 to $37.  The range of upside suggested by these valuations is 97% to 245%.

Importantly, PICO’s projected monetizations as presented here should be tax efficient.  The base valuation assumes UCP monetization at BV, so there should be limited adverse tax consequences to PICO.  Further, PICO has $143mm of federal NOLs, so any realistic excess monetization of UCP would be non-taxable too.  In fact, PICO could monetize a majority of Vidler at the base valuation and still avoid federal taxes, effectively enabling liquidation of much of the Company (this assumes the ability to utilize the NOLs against these monetizations).  This tax asset is worth >$2.00/share, and is not otherwise considered in the analysis.

On the downside, PICO is currently washed out and trades at ~70% of BV.  UCP is priced at < 70% of BV and is not materially burning cash (excluding incremental real estate investments).  Vidler assets have already been impaired through the 2008-2011 downturn, while the Western water and economic growth situations remain positive as relates to the value of these assets.  The primary risk I see is stasis with respect to PICO shareholder relations and valuation of UCP and Vidler, and corporate opex continuing at its heightened rate.  I project this would drive economic book value to ~$12/share, which on the current book multiple suggests pricing of ~$8.50/share.  Call it 20% downside.  I view this outcome as unlikely given PICO’s asset mix has been winnowed to UCP and Vidler – there simply are not other significant assets that can be impaired.  Further, there are multiple shareholders actively involved toward driving positive outcomes; management appears to be playing along.   

Appendix

Central Square Realized Return Analysis

Vidler Water Company

UCP

Catalyst

Sale of UCP and/or Vidler assets.  Share repurchases.  Reconstituted board and/or management based on shareholder activism.