In Management's Discussion and Analysis of Financial Condition and Results of
Operations (MD&A), "we," "us," "our" and "Pure Cycle" refer to Pure Cycle
Corporation and all entities owned or controlled by Pure Cycle Corporation. You
should read the following discussion in conjunction with our consolidated
financial statements and accompanying notes, related MD&A and discussion of our
business included in our Annual Report on Form 10-K for the year ended August
31, 2022 (2022 Annual Report) filed with the United States (U.S.) Securities and
Exchange Commission (SEC) and the unaudited consolidated financial statements
and accompanying notes included in this Form 10-Q. The results of operations
reported and summarized below are not necessarily indicative of future operating
results, and future results could differ materially from those anticipated in
forward-looking statements (refer to "Disclosure Regarding Forward-Looking
Statements" in this Form 10-Q; and Part I, Item 1A. "Risk Factors" in our 2022
Annual Report for further discussion).
We are a diversified water resource and land development company. At our core,
we are a wholesale water and wastewater service provider, and we develop land we
own into master planned communities. Our newest business is the development of
single-family homes held for rental purposes. Both the land development and
single-family home rental lines of business generate customers and usage fees
for our water and wastewater resource development business.
Recent Developments and Economic Conditions
The housing market experienced tremendous growth for several years through 2022.
However, in the third quarter of 2022, the housing market deteriorated rapidly.
This has continued through the date of this filing and shows signs of continuing
into 2023. This deterioration was caused by multiple factors including; the war
in Ukraine, which has impacted supplies of food, fertilizer and fuel, increasing
inflation; and the ongoing COVID-19 pandemic which continues to impact global
economies, mortgage interest rates, the rate of inflation, supply chains,
distribution networks and consumer behavior around the world. The United States
Federal Reserve System (Federal Reserve) remains aggressive in its actions to
combat inflation, which is having a negative impact on the housing market due to
rising mortgage rates. As a result, 30-year fixed mortgage rates continued to
rise and ended the quarter at their highest level in over 15 years. The
magnitude and speed of these recent rate increases has caused many buyers to
pause and reconsider a home purchase.
Despite this, we believe several long-term land development and housing market
fundamental factors remain positive. For example, available lots and housing
supply-demand remain imbalanced due to a decade-plus of underproduction of new
homes in relation to population growth, and low resale home inventory. While we
remain confident in the long-term growth prospects for the industry given these
and other factors, the current demand for new homes is subject to continued
uncertainty due to many factors. The combination of sharply higher mortgage
interest rates since early 2022, several years of rising housing prices,
elevated inflation, and various other macroeconomic and geopolitical concerns
are moderating housing demand, which are expected to continue into 2023. Like
many other businesses, our contractors have experienced delays in receiving
materials and parts, rising costs, and labor shortages. However, we have been
able to adjust our purchases and operations enough to reduce the impact these
factors have on our construction and other activities. Specifically, we have
delayed the start of construction on Phase 2B to avoid incurring development
costs when market demand has declined, and it is uncertain how long demand will
remain depressed. Given current conditions, we plan to continue to monitor
market dynamics and surrounding community performance to determine timing of
additional construction expenditures at Sky Ranch. We believe our reasonably
priced lots and the low inventory of entry level housing in the Denver market
will help Sky Ranch navigate the changing market better than other surrounding
and significantly higher priced communities. The severity and duration of the
COVID-19 pandemic and the Ukraine war, as well as the current inflationary
environment, remain uncertain and it is difficult for us to estimate the extent
to which these conditions will impact our financial results and operations in
future periods.
Our future performance and the strategies we implement (and adjust or refine as
necessary or appropriate) will depend significantly on prevailing economic,
homebuilding industry, credit, and financial market conditions and on a stable
and constructive political and regulatory environment (particularly regarding
housing and mortgage loan financing policies). The Federal Reserve's aggressive
raising of the federal funds interest rate and other measures during calendar
2022 to moderate persistent U.S. inflation, and the further actions it has
stated it intends to take, are expected to be an ongoing headwind for the
housing market into 2023 as they have elevated mortgage loan interest rates and
created macroeconomic uncertainty and volatility across financial markets. In
addition, we and our homebuilding partners continue to experience services and
supply constraints and rising and volatile raw material prices. Prolonged supply
chain disruptions and other production-related challenges could extend or delay
our construction cycle times and intensify construction-related cost pressures
beyond our experience in fiscal 2022. In addition, consumer demand for our
homes, and our ability to grow our scale,
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revenues, and returns in fiscal 2023 could be materially and negatively affected
by the above-described monetary policy impacts or other factors that curtail
mortgage loan availability, employment or income growth or consumer confidence
in the U.S. or in the Colorado markets. The potential extent and effect of these
factors on our business is highly uncertain, unpredictable, and outside our
control, and our past performance should not be considered indicative of our
future results.
Additionally, as the COVID-19 pandemic continues, we continue to enforce many
safety measures enacted to protect the health and well-being of our employees,
customers, business partners, and their families. We have been able to maintain
our level of efficiency with the use of video conferencing and electronic data
sharing platforms. We were informed that our builder customers continue to use
precautionary measures to ensure the safety of their employees, customers,
business partners, and their families. The most dramatic impact on our
operations has been the delay in inspections, the permit process and other
activities requiring the involvement of governmental agencies due to employee
shortages and pandemic-related restrictions imposed on their operations. All our
operations are in Colorado and travel and related restrictions have not impacted
our operations.
Our Business Strategy
For more than three decades we have accumulated a large portfolio of valuable
water rights and land interests in Colorado. We have added an extensive network
of wholesale water production, storage, treatment and distribution systems, and
wastewater collection and treatment systems that we use to serve domestic,
commercial, and industrial water demands in the eastern Denver metropolitan
region. Our primary land asset, Sky Ranch, is in one of the most active
development areas in the Denver metropolitan region along the rapidly developing
I-70 corridor, and we are developing lots at Sky Ranch for residential,
commercial, retail, and light industrial uses. We also have launched a
single-family rental business where we rent homes in Sky Ranch to families under
annual lease agreements. We plan to expand this new line of business to more
than 200 rental units over the next several years.
Although we currently report our results of operations through our water and
wastewater resource development segment and our land development segment, we
operate these segments as a cohesive business designed to provide a cost
effective, sustainable, and value-added business enterprise.
Water and Wastewater
Water resources throughout the western United States and more prominently in
Colorado are a scarce and valuable resource. Our portfolio of over 29,900
acre-feet of water is comprised of groundwater, designated basin groundwater,
and surface water supplies. Our other significant water assets include 26,000
acre-feet of adjudicated reservoir sites, two wastewater reclamation facilities,
water treatment facilities, potable and raw water storage facilities, wells and
water production facilities, and roughly 50 miles of water distribution and
wastewater collection lines. Our water supplies and wholesale facilities are in
southeast Denver, an area which is limited in both water availability and
infrastructure to produce, treat, store, and distribute water and wastewater. We
believe this provides us with a unique competitive advantage in offering these
services.
We provide wholesale water and wastewater service to local governments for both
residential and commercial customers. The local governments we service include
the Rangeview Metropolitan District (Rangeview District), Arapahoe County, the
Sky Ranch Community Authority Board (Sky Ranch CAB), and the Elbert and Highway
86 Commercial Metropolitan District (Elbert 86 District). Our mission is to
provide sustainable, reliable, high-quality water to our customers and collect,
treat, and reuse wastewater using advance water treatment systems, which produce
high quality reclaimed water we can reuse for outdoor irrigation and industrial
demands. By using and reusing our water supplies, we proactively manage our
valuable water rights in the water-scarce Denver, Colorado region which
dramatically reduces the environmental impact of our water resource operations.
We design, permit, construct, operate and maintain wholesale water and
wastewater systems that we own or operate on behalf of governmental entities. We
also design, permit, construct, operate, and maintain retail distribution and
collection systems that we own or exclusively operate on behalf of our
governmental customers. Additionally, we handle administrative functions,
including meter reading, billing and collection of monthly water and wastewater
revenues, regulatory water quality monitoring, sampling, testing, and reporting
requirements to the Colorado Department of Public Health and Environment.
Revenues for our water operations are dependent on us growing the number of
customers we serve. If we are unable to add customers to our systems and sell
taps to builders, our revenues could be negatively impacted. We currently are
the developer of the Sky Ranch Master Planned Community which is the main driver
of our tap sales. Additionally, prolonged periods of hot and dry weather
generally cause increased water usage for watering lawns, washing cars, and
keeping parks irrigated. Conversely, prolonged periods of dry weather
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could lead to drought restrictions and limited water availability. Despite our
substantial water supply, customers may be required to cut back water usage
under such drought restrictions which would negatively impact metered usage
revenues. We have addressed some of this vulnerability by instituting minimum
customer charges which are intended to cover fixed costs of operations under all
likely weather conditions.
Land Development
Our Land Development segment is primarily focused on developing the Sky Ranch
Master Planned Community located along the booming I-70 corridor to provide
residential, commercial, retail, and light industrial lots. Sky Ranch is zoned
to include up to 3,200 single-family and multifamily homes, parks, open spaces,
trails, recreational centers, and schools. Additionally, Sky Ranch is zoned to
include over two million square feet of retail, commercial, and light industrial
space, which is the equivalent of approximately 1,800 residential units, meaning
the Sky Ranch community at build-out will include a total of roughly 5,000
residential and equivalent units. Our land development activities include the
design, permitting, and construction of all the horizontal infrastructure,
including, storm water, drainage, roads, curbs, sidewalks, parks, open space,
trails, and other infrastructure to deliver "ready to build" finished lots to
home builders and commercial customers. Our land development activities generate
revenue from the sale of finished lots as well as construction revenues from
activities where we construct infrastructure on behalf of others. Land
development revenues come from our home builder customers under specific
agreements for the delivery of finished lots. Additionally, pursuant to certain
agreements with the Sky Ranch CAB and its related metropolitan districts, on
their behalf we construct public infrastructure such as roads, curbs, storm
water, drainage, sidewalks, parks, open space, trails etc., the costs of which
are reimbursed to us by the Sky Ranch CAB through funds generated from property
taxes, fees or the issuance of municipal bonds.
Our land development activities provide a strategic complement to our water and
wastewater services because a significant component of any master planned
community is providing high quality domestic water, irrigation water, and
wastewater to the community. Having control over land and the water and
wastewater services enables us to build infrastructure for potable water and
irrigation distribution, wastewater and storm water collection, roads, parks,
open spaces, and other investments efficiently and to manage delivery of these
investments to match take-down commitments from our home builder customers
without significant excess capacity in any of these investments.
We have been developing the Sky Ranch community since 2017. We are developing it
in phases, which is anticipated to take approximately eight to ten more years
until it is fully built out. In 2017, we began the initial development phase of
Sky Ranch when we entered separate contracts with Richmond American Homes,
Taylor Morrison, and KB Home, pursuant to which we sold a total of 505
single-family, detached residential lots at Sky Ranch. Pursuant to these
agreements, we were obligated to construct infrastructure and other public
improvements as well as wholesale infrastructure improvements (i.e., a
wastewater reclamation facility and wholesale water facilities), all of which
are complete as of November 30, 2022.
During our fiscal 2021, we began construction on the second development phase at
Sky Ranch. For this phase, we entered into separate contracts with KB Home,
Lennar Colorado, Melody (a DR Horton Company) and Challenger Homes to sell 804
single-family attached and detached residential lots at Sky Ranch, and we
retained 46 lots for use in our single-family home rental segment. The second
development phase will incorporate approximately 250 acres and is planned to be
completed in four sub-phases (referred to as Phase 2A, 2B, 2C and 2D). Due to
our strong performance in the first phase of the Sky Ranch project, we were able
to realize an approximate 40% increase in our average lot prices. For example,
we increased our sales price for a 50' foot lot from $75,000 to $108,000 and
added an escalation clause that increases the prices depending on timing of
payments. The timing of cash flows includes certain milestone deliveries such as
the completion of governmental approvals for final plats, installation of wet
utilities, and final completion of lot deliveries.
In February 2021, we began construction on Phase 2A at Sky Ranch, which is
platted for 229 residential lots. We have retained ten of these lots for use in
our single-family rental business. As of November 30, 2022, we have received
plats and substantially completed wet and dry utilities, roads, and sidewalks
for Phase 2A. Contracts with three of the four homebuilders include milestone
payments as construction progresses, with the contract with the fourth
homebuilder having one payment due at delivery of the finished lot (i.e. the
transfer of the title). As of November 30, 2022, we have received substantially
all payments related to the sale of the 219 lots in Phase 2A, which totaled
$18.4 million. We recognize revenue earned under these contracts over time using
the percentage of completion method to measure progress, which aligns the
recognition of revenue with the requisite service period. During the three
months ended November 30, 2022 and 2021, due to the construction progress, we
recognized $0.5 million and $2.9 million of lot sale revenue related to
construction at Sky Ranch. Phase 1 of the Sky Ranch development is complete, and
all revenue has been recognized. Phase 2A is
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approximately 80% complete, for which we have recognized $14.6 million of lot
sales revenue since construction began on Phase 2A, with the remaining $3.8
million of revenue to be recognized over time as Phase 2A construction is
completed, which we expect will be before the end of our fiscal 2023.
Payments for lot sales and the related revenue for Phases 2B, 2C, and 2D will
occur as construction of those phases occurs. We believe construction of Phase
2B will begin in the summer of 2023, which we delayed the start of Phase 2B due
to the slowing of the housing market in late 2022. We further believe it will
take approximately three more years to complete construction and sell the
finished lots in all four subphases depending on the market conditions and
permitting process.
In addition to the lot sales described above, from the start of development at
Sky Ranch through November 30, 2022, we have received $18.5 million of water and
wastewater tap fees from the homebuilders, which is for all 505 taps sold in
Phase 1 and 117 of 219 taps sold in Phase 2A. Timing of tap sales is dependent
on when homebuilders begin requesting building permits. Fees charged per water
tap are dependent on lot sizes and average water usage across a broad range of
housing product types including duplexes and townhomes. For Phase 2A we estimate
water and wastewater tap fees will exceed $4.0 million.
Single-Family Rentals
During our fiscal 2021, we launched a new line of business we are referring to
as our single-family rental business. During Phase 1 of Sky Ranch, we retained
ownership of four residential lots for use in this business. As of November 30,
2022, we have finished building three single-family homes which we own,
maintain, and have leased to qualified renters under one-year lease terms.
Construction of the fourth home began in 2022 and it was completed and rented to
a qualified renter in December 2022. We intend to expand our single-family
rentals in our second development phase of Sky Ranch by building and renting
homes on the 46 lots we did not sell to our home builder partners, ten of which
are in Phase 2A and are currently under construction, which we expect to be
ready for rental at various dates throughout our fiscal 2023.
We capitalize the costs of the homes and when applicable depreciate the costs
over periods not exceeding thirty-years. Lease income is recorded monthly as
earned. We began recognizing monthly lease income for the first three rental
units on November 1, 2021.
Results of Operations
Executive Summary
For the three months ended November 30, 2022, we generated net income of $0.2
million, a decline from the comparable period in 2021 of $1.3 million or 89%.
The decrease was primarily driven by decreased lot sales being recognized as we
slowed construction on Phase 2A due to the decline in the housing market and
weather conditions resulting in the delay in planned landscaping construction,
and a reduction in water being used by oil and gas operators electing to drill
wells in other counties due to lease deadlines and other factors outside our
control. The items noted above were partially offset by one time income events
related to additional land use payments received from oil and gas operators for
future drilling purposes and interest income recognized on the note receivable
from the Sky Ranch CAB.
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