Item 1 - Business
Summary of our business
Pure Cycle Corporation is a vertically integrated, investor owned water utility. We provide water and wastewater services utilizing water assets that we own, which are located throughout Colorado. Primarily we operate in the metropolitan Denver area. Our services include the design, construction, operation and maintenance of water and wastewater systems.
Our overriding philosophy is that water is a precious commodity, one which is often undervalued and used inefficiently. Because of this, our business practices focus on efficient and environmentally responsible water management programs that seek to reduce wasted water. This means we will withdraw, treat, store and deliver water to our customers, collect and treat wastewater from our customers, and reuse that water through our planned “dual distribution” delivery system. A dual distribution system is one in which domestic water demands and irrigation water demands are provided through separate infrastructure which promotes efficient water resource management while maximizing our water supplies to provide a sustainable long-term reliable water solution on a regional basis.
Glossary of terms
The following terms are commonly used in the water industry and are used throughout our annual report:
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Acre-foot - approximately 326,000 gallons of water, or enough water to cover an acre of ground with one foot of water. For some instances herein, as context dictates, acre feet is used to designate an annual decreed amount of groundwater or the amount of surface water that might be available during a typical year.
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Consumptive Use - the amount of water that is evaporated, transpired, incorporated into products or crops, consumed by humans or livestock, or otherwise removed from the immediate water environment.
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Customer Facilities - facilities that carry potable water and reclaimed water to customers from the Retail water distributions system and collect wastewater from customers and transfer it to the retail wastewater collection system. Water and wastewater service lines, interior plumbing, meters and other components are typical examples of Customer Facilities. In many cases, portions of the Customer Facilities are constructed by the developer, but they are owned and maintained by the customer.
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Section - a parcel of land being approximately one square mile and containing approximately 640 acres.
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Single Family Equivalent unit (“SFE”) - is defined in our water and wastewater service rules and regulations as the amount of water required each year by a family of four persons living in a single family house on a standard sized lot, which is equivalent to approximately 0.4 acre-feet of water per year.
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Special Facilities - facilities that are required to extend services to an individual development or are not otherwise classified as a typical “Wholesale Facility” or “Retail Facility.” Temporary infrastructure required prior to construction of permanent water and wastewater systems or transmission pipelines to transfer water from one location to another are examples of Special Facilities. We typically design and construct the Special Facilities using funds provided by the developer in addition to the normal rates, fees and charges that we collect from our customers. We are typically responsible for the operation and maintenance of the Special Facilities upon completion.
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Retail Facilities - facilities that distribute water to and collect wastewater from an individual subdivision or community. Developers are typically responsible for the funding and construction of Retail Facilities. Once we certify that the Retail Facilities have been constructed in accordance with our design criteria, the developer dedicates the Retail Facilities to us or to a quasi-municipal political subdivision of the state and we operate and maintain the facilities.
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Wholesale Facilities - facilities that serve an entire service area or major regions or portions thereof. Wells, treatment plants, pump stations, tanks, reservoirs, transmission pipelines, and major sewage lift stations are typical examples of Wholesale Facilities. We own, design, construct, operate, maintain and repair Wholesale Facilities which are typically funded using rates, fees and charges that we collect from our customers.
Our Water Assets
This section should be read with Item 1A
Item 1A - Risk Factors
Our business, operations, and financial condition are subject to significant risks. These risks include those listed below and may include additional risks of which we are not currently aware or which we currently do not believe are material. If any of the events or circumstances described in the following risk factors actually occurs, our business could be materially adversely affected. These risks should be read in conjunction with the other information set forth in this report.
We are dependent on the development of the Lowry Range, Sky Ranch, and other areas near our Rangeview Water Supply that are potential markets for our Rangeview Water Supply.
Providing water service using our Rangeview Water Supply is one of our principal sources of future revenue. The timing and amount of these revenues will depend significantly on the development of the Lowry Range, Sky Ranch and other potential developments near our Rangeview Water Supply and along the Colorado “Front Range.” The development of these areas is not within our control.
Lowry Range
In June 2007, the Land Board entered into an agreement with Lend Lease for the sole development rights of six section (or approximately 3,900 acres) of the Lowry Range. Of this, approximately two section (or approximately 1,300 acres) are subject to our service rights under the Lease. We have been negotiating for some time with Lend Lease, the City of Aurora and the Land Board to reach a mutually satisfactory service plan for the two sections subject to the Lease and the remaining four sections to be developed by Lend Lease. However, these negotiations have been unsuccessful so far, and ultimately we may not be able to negotiate an agreement satisfactory to all parties.
Additionally, Aurora has disputed our rights to certain reservoir sites on the Lowry Range in the District Court, Water Division I, State of Colorado (the “Water Court”). In that proceeding, Aurora applied for the right to store water in certain reservoir sites on the Lowry Range which had previously been adjudicated by the District and the Land Board dating back to 1988. As part of that Water Court proceeding, Lend Lease filed an amicus curiae brief in support of Aurora’s motion to reconsider a summary judgment requiring Aurora to remove the overlapping reservoir sites from its application. In its brief, Lend Lease claimed, in contradiction to the Lease, that Lend Lease may not be required to obtain water and wastewater service exclusively from us for any portion of the development. Lend Lease has further stated it may annex the development into the City of Aurora. While Aurora has been unsuccessful so far in obtaining rights to the adjudicated reservoirs under the Lease, additional legal action may become necessary to enforce our rights to the reservoirs and to provide water and wastewater service to the Lowry Range. If additional legal proceedings become necessary and our rights under the Lease are adversely ruled upon in such legal proceedings, it could materially adversely impact the value of our interests, including the value of our Rangeview Water Supply.
Subsequent to year end, in October 2008, Lend Lease notified the Land Board that it intends to withdraw from the Lowry Range project on December 31, 2008, unless it is able to obtain sustainable water and wastewater systems for the project at commercially reasonable rates. If Lend Lease withdrawals from the project, any development of the project could be delayed for a significant period of time and could result in the need for us and the Land Board to renegotiate the Lease. Even if we are able to reach satisfactory agreements with Lend Lease, Aurora, the District and the Land Board to provide service to the Lend Lease development, there can be no assurance that development will occur or that water sales will occur on acceptable terms or in the amounts or time required for us to support our costs of operation.
Because of the prior use of the Lowry Range as a military facility, environmental clean-up may be required prior to development, including the removal of unexploded ordnance. There is often significant delay in adoption of development plans, as the political process involves many constituencies with differing interests. In the event water sales are not forthcoming or development of the Lowry Range is delayed, we may incur additional short or long-term debt obligations or seek to sell additional equity to generate operating capital. In addition, the Land Board may not develop large portions of the Lowry Range significantly limiting our ability to utilize the non-Export Water specifically reserved for use on the Lowry Range.
Sky Ranch
The developer of Sky Ranch has filed for Chapter 11 bankruptcy protection. There has been no resolution of the claims against the developer of Sky Ranch and we do not know how the bankruptcy will impact our agreements with Sky Ranch. The Sky Ranch Agreements could be rejected in the bankruptcy proceeding leaving us with unsecured damage claims which would likely have little or no value. In addition to our claims against the developer, a bank holds a security interest in the entire Sky Ranch development, including our agreements. We are not aware of the bank’s intentions with respect to its rights in the development. Until these issues are resolved, there will be no development and consequently no sales of water taps or water at Sky Ranch. We cannot reasonably predict how long this process will take or whether any of our rights related to Sky Ranch will have any value following the bankruptcy.
Colorado housing market
Our operations are affected by general economic conditions and the pace and location of real estate development activities in the greater Denver metropolitan area, most particularly areas which are close to our Rangeview Water Supply. Since 2006, the Colorado housing market has seen declines in new construction, which could continue for some time. The current instability in the credit markets has exacerbated the decline in demand for new homes. New connections to our water and wastewater systems depend on real estate development in our service areas. We have no ability to control the pace and location of real estate development activities which affect our business. If the downturn in the homebuilding and credit markets continues, intensifies, or if the national economy weakens further and economic concerns intensify, it could have a significant negative impact on our business.
We are involved in on-going negotiations with the Land Board to clarify our rights and obligations with respect to our Rangeview Water Supply and such negotiations may not be successful.
Our Rangeview Water Supply rights derive principally from the Lease between the Land Board and the District which was entered into in 1996 prior to any development of the Lowry Range or of areas outside the Lowry Range that utilize our Export Water. The terms of the Lease did not fully anticipate the specific circumstances of development that have arisen and may not clearly delineate rights and responsibilities for the forms of transactions that may arise in the future. We are involved in ongoing discussions with the Land Board to clarify the terms of the Lease. An unfavorable outcome in such negotiations could have a material adverse effect on our financial results. We cannot assure you that such negotiations will be successful.
In order to utilize the Arkansas River water acquired in fiscal 2006, we must apply for a change of use with the Colorado water court and this may take several years to complete.
The change of use of our Arkansas River water requires a ruling by the Colorado water courts, which could take several years and be a costly and contentious effort since it is anticipated that many parties will oppose the change of use and the transfer of the water. There are several conditions which must be satisfied prior to our receiving a change of use decree for transfer of our Arkansas River water. One condition that we must satisfy is a showing of anti-speculation in which we, as the applicant, must demonstrate that we have contractual obligations to provide water service to customers prior to the water court ruling on the transfer of a water right. The water court is also expected to limit the transfer to the “consumptive use” portion of the water right and to address changing the historic use of the water from agricultural uses to other uses such as municipal and industrial use. We expect to face opposition to any consumptive use calculations of the historic agricultural uses of this water. The water court may impose conditions on our transfer of the water rights such as requiring us to mitigate the loss of the farming tax base, imposing re-vegetation requirements to convert soils from irrigated to non-irrigated, and imposing water quality measures. Any such conditions will likely increase the cost of transferring the water rights.
We may not be able to obtain sufficient capital to develop our water rights, in particular the Arkansas River water.
Development of water rights requires a substantial capital investment. We anticipate financing water and wastewater systems primarily through the sale of water taps and water delivery charges to users. However, we cannot assure you that these sources of cash will be sufficient to cover our capital costs. Moreover, the development of the Arkansas River water will require a pipeline or other infrastructure to deliver the water to the Front Range, which is anticipated to cost over $500 million. We likely would be required to partner with others to finance a project of this magnitude and there is no assurance we would be able to obtain the financing necessary to develop our Arkansas River water.
Our valuation of the Tap Participation Fee payable to HP A&M contains estimates and management assumptions. The actual results could differ significantly from those estimates.
As part of our acquisition of the Arkansas River water rights from HP A&M, we granted HP A&M a Tap Participation Fee entitling HP A&M to receive ten percent (10%) of the gross proceeds of our sales of forty thousand (40,000) water taps. For accounting purposes we have estimated the fair value of the Tap Participation Fee payable to HP A&M using available historic market information and estimated future market information. We believe the estimates we used reasonably reflect the fair value of the Tap Participation Fee. Accounting estimates involve matters of uncertainty and judgment and interpreting relevant market data is inherently subjective in nature. Many factors are necessary to estimate future market conditions, including but not limited to, supply and demand for new homes, population growth along the Front Range, tap fee increases at our rate-base districts, and other market forces beyond our control. The actual results could differ materially from our accounting estimates which would result in significantly higher fees being paid to HP A&M than what are reflected in our balance sheet and significantly higher imputed interest being reflected on our future statements of operations associated with the Tap Participation Fee.
In the event of default by HP A&M on promissory notes secured by deeds of trust on our properties, we would be required to cure the defaults or lose the properties.
Certain of the real properties we acquired from HP A&M are subject to promissory notes, aggregating $12.8 million in principal and interest as of August 31, 2008. The notes are secured by deeds of trust on the properties we own, but are solely the responsibility of HP A&M. Because of HP A&M’s financial position and the substantial penalties imposed on HP A&M in the event of a default, the likelihood of HP A&M defaulting on the notes is deemed remote. As a result the promissory notes are not reflected on our balance sheet. However, if HP A&M was to default on the notes, and we did not cure the defaults, we would lose up to approximately 60 of the 80 real properties we acquired and the water rights associated with those properties.
Our net losses may continue and we may not have sufficient liquidity to pursue our business objectives.
We have experienced significant net losses and could continue to incur net losses. For the years ended August 31, 2008, 2007 and 2006, we had net losses of approximately $6.9 million, $6.9 million and $793,000, respectively, on revenues of approximately $282,400, $265,700 and $271,700, in the respective periods. Our cash flows from operations have not been sufficient to fund our operations in the past, and we have been required to raise debt and equity capital to remain in operation. Since 2004, we have raised approximately $21.5 million through the issuance of common stock to support our operations. Our ability to fund our operational needs and meet our business objectives will depend on our ability to generate cash from future operations. If our future cash flows from operations and other capital resources are not sufficient to fund our operations and the significant capital expenditure requirements to build our water delivery systems, we may be forced to reduce or delay our business activities, or seek to obtain additional debt or equity capital, which may not be available on acceptable terms, or at all.
The rates we are allowed to charge customers on the Lowry Range are limited by the Lease with the Land Board and our contract with the District and may not be sufficient to cover our costs of construction and operation.
The prices we can charge for our water and wastewater services on the Lowry Range are subject to pricing regulations set in the Lease with the Land Board. Both the tap fees and our usage rates and charges are based on the average of the rates of our rate-base districts. Annually we survey the tap fees and rates of our rate-base districts and set our tap fees and rates and charges based on the average of those charged by this group. Our costs associated with the construction of water delivery systems and the production, treatment and delivery of our water are subject to market conditions and other factors, which may increase at a significantly greater rate than the prices charged by our rate-base districts. Factors beyond our control and which cannot be predicted, such as drought, water contamination and severe weather conditions, like tornadoes and floods, may result in additional labor and material costs that may not be recoverable under our rate structure. Either increased customer demand or increased water conservation may also impact the overall cost of our operations. If the costs for construction and operation of our water services, including the cost of extracting our groundwater, exceed our revenues, we may petition the Land Board for rate increases. There can be no assurance that the Land Board would approve a rate increase request beyond the average of the rate-base districts. Our profitability could be negatively impacted if we experience an imbalance of costs and revenues and are not successful in receiving approval for rate increases.
We only have three employees and may not be able to manage the increasing demands of our expanding operations.
We currently have only three employees to administer our existing assets, interface with applicable governmental bodies, market our services and plan for the construction and development of our future assets. We may not be able to maximize the value of our water assets because of our limited manpower. We depend significantly on the services of Mark W. Harding, our President. The loss of Mr. Harding would cause a significant interruption of our operations. The success of our future business development and ability to capitalize on growth opportunities depends on our ability to attract and retain additional experienced and qualified persons to operate and manage our business. State regulations set the training, experience and qualification standards required for our employees to operate specific water and wastewater facilities. Failure to find state-certified and qualified employees to support the operation of our facilities could put us at risk, among other things, for operational errors at the facilities, for improper billing and collection processes, and for loss of contracts and revenues. We cannot assure you that we can successfully manage our assets and our growth.
We may be adversely affected by any future decision by the Colorado Public Utilities Commission to regulate us as a public utility.
The Colorado Public Utilities Commission (“CPUC”) regulates investor-owned water companies operating for the purpose of supplying the public. The CPUC regulates many aspects of public utilities’ operations, including the location and construction of facilities, establishing water rates and fees, initiating inspections, enforcement and compliance activities and assisting consumers with complaints.
We do not believe we are a public utility under Colorado law. We currently provide services by contract to the District, which supplies the public. Quasi-municipal metropolitan districts, such as the District, are exempt by statute from regulation by the CPUC. However, the CPUC could attempt to regulate us as a public utility. If this were to occur, we might incur significant expense challenging the CPUC’s assertion of jurisdiction, and we may be unsuccessful. In the future, existing regulations may be revised or reinterpreted, and new laws and regulations may be adopted or become applicable to us or our facilities. If we become regulated as a public utility, our ability to generate profits could be limited and we might incur significant costs associated with regulatory compliance.
There are many obstacles to our ability to sell our Paradise Water Supply.
We currently earn no revenues from our Paradise Water Supply, which as of August 31, 2008 has a recorded cost of approximately $5.5 million. Our ability to convert our Paradise Water Supply into an income generating asset is limited. Due to the nature of the Paradise Water rights and agreements with other western slope water interests, our use of the Paradise Water Supply is limited to opportunities along the western slope. As part of our water court decree for the Paradise Water Supply, we are permitted to construct a storage facility on the Colorado River. However, due to a stipulation entered into with various objectors to our Paradise Water rights and the strict regulatory requirements for constructing a reservoir on the main stem of the Colorado River, we do not anticipate completing the storage facility at its decreed location. We cannot assure you that we will ever be able to make use of this asset or sell the water profitably.
Our Paradise Water Supply is also conditioned on a Finding of Reasonable Diligence from the water court every six years. To arrive at that finding, the water court must determine that we continue to diligently pursue the development of the water rights. If the water court is unable to make such a finding, our right to the Paradise Water Supply would be lost and we would be required to impair the Paradise Water Supply asset and incur a $5.5 million charge against earnings. The fiscal 2005 review was completed in 2008 but not without objectors and not without us having to agree to certain stipulations to remove the objections. In order to continue to maintain the Paradise water right, over the next six years we must (i) select an alternative reservoir site; (ii) file an application in Water Court to change the place of storage; (iii) identify specific end users and place(s) of use of the water; and (iv) identify specific source(s) of the water rights for use.
Conflicts of interest may arise relating to the operation of the District.
Our officers and employees constitute a majority of the directors of the District. Pure Cycle, along with our officers and employees and one unrelated individual, own, as tenants in common, the 40 acres that form the District. We have made loans to the District to fund its operations. At August 31, 2008, total principal and interest owed to us by the District was approximately $494,800. The District is a party to our agreements with the Land Board and receives fees of 5% of the revenues from the sale of water on the Lowry Range. Proceeds from the fee collections will initially be used to repay the District’s obligations to us, but after these loans are repaid, the District is not required to use the funds to benefit Pure Cycle. We have received benefits from our activities undertaken in conjunction with the District, but conflicts may arise between our interests and those of the District, and with our officers who are acting in dual capacities in negotiating contracts to which both we and the District are parties. We expect that the District will expand when more properties are developed and become part of the District, and our officers acting as directors of the District will have fiduciary obligations to those other constituents. There can be no assurance that all conflicts will be resolved in the best interests of Pure Cycle and its shareholders. In addition, other landowners coming into the District will be eligible to vote and to serve as directors of the District. There can be no assurances that our officers and employees will remain as directors of the District or that the actions of a subsequently elected board would not have an adverse impact on our operations.
We are required to maintain stringent water quality standards and are subject to regulatory and environmental risks.
We must provide water that meets all federal and state regulatory water quality standards and operate our water and wastewater facilities in accordance with these standards. We face contamination and pollution issues regarding our water supplies. Improved detection technology, increasingly stringent regulatory requirements, and heightened consumer awareness of water quality issues contribute to an environment of increased focus on water quality. We cannot assure you that in the future we will be able to reduce the amounts of contaminants in our water to acceptable levels. In addition, the standards that we must meet are constantly changing and becoming more stringent. Future changes in regulations governing the supply of drinking water and treatment of wastewater may have a material adverse impact on our financial results.
Our water supplies are subject to contamination, including contamination from naturally occurring compounds, pollution from man-made sources and intentional sabotage. In addition, we handle certain hazardous materials at our water treatment facilities, primarily sodium hypochlorite. Any failure of our operation of the facilities or any contamination of our supplies in the future, including sewage spills, noncompliance with water quality standards, hazardous materials leaks and spills, and similar events could expose us to environmental liabilities, claims and litigation costs. If any of these events occur, we may have to interrupt the use of that water supply until we are able to substitute the supply from another source or treat the contaminated supply. We cannot assure you that we will successfully manage these issues, and failure to do so could have a material adverse effect on our future results of operations. We might not be able to recover the costs associated with these liabilities through our rates and charges or insurance or such recovery may not occur in a timely manner.
Our contracts for the construction of water and wastewater projects may expose us to certain completion and performance risks.
We intend to rely on independent contractors to construct our water and wastewater facilities. These construction activities may involve risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering, environmental, permitting or geological problems and unanticipated cost increases. These issues could give rise to delays, cost overruns or performance deficiencies, or otherwise adversely affect the construction or operation of our water and wastewater delivery systems.
In addition, we may experience quality problems in the construction of our systems and facilities, including equipment failures. We cannot assure you that we will not face claims from customers or others regarding product quality and installation of equipment placed in service by contractors.
Certain of our contracts may be fixed-price contracts, in which we may bear all or a significant portion of the risk for cost overruns. Under these fixed-price contracts, contract prices are established in part based on fixed, firm subcontractor quotes on contracts and on cost and scheduling estimates. These estimates may be based on a number of assumptions, including assumptions about prices and availability of labor, equipment and materials, and other issues. If these subcontractor quotations or cost estimates prove inaccurate, or if circumstances change, cost overruns may occur, and our financial results would be negatively impacted. In many cases, the incurrence of these additional costs would not be within our control.
We may have contracts in which we guarantee project completion by a scheduled date. At times, we may guarantee that the project, when completed, will achieve certain performance standards. If we fail to complete the project as scheduled, or if we fail to meet guaranteed performance standards, we may be held responsible for cost impacts and/or penalties to the customer resulting from any delay or for the costs to alter the project to achieve the performance standards. To the extent that these events occur and are not due to circumstances for which the customer accepts responsibility or cannot be mitigated by performance bonds or the provisions of our agreements with contractors, the total costs of the project could exceed our original estimates and our financial results would be negatively impacted.
Our customers may require us to secure performance and completion bonds for certain contracts and projects. The market environment for surety companies has become more risk averse. We secure performance and completion bonds for our contracts from these surety companies. To the extent we are unable to obtain bonds; we may not be awarded new contracts. We cannot assure you that we can secure performance and completion bonds where required.
We may operate engineering and construction activities for water and wastewater facilities where design, construction or system failures could result in injury to third parties or damage to property. Any losses that exceed claims against our contractors, the performance bonds and our insurance limits at such facilities could result in claims against us. In addition, if there is a customer dispute regarding performance of our services, the customer may decide to delay or withhold payment to us.
Our business is subject to seasonal fluctuations, which could affect demand for our water service and our revenues.
Demand for our water during the warmer months is generally greater than during cooler months due primarily to additional requirements for water in connection with cooling systems, irrigation systems and other outside water use. Throughout the year, and particularly during typically warmer months, demand will vary with temperature and rainfall levels. If temperatures during the typically warmer months are cooler than expected or there is more rainfall than expected, the demand for our water may decrease and adversely affect our revenues.
Weather conditions and overuse may interfere with our sources of water, demand for water services, and our ability to supply water to our customers.
We depend on an adequate water supply to meet the present and future demands of our customers and to continue our expansion efforts. Unexpected conditions may interfere with our water supply sources. Drought and overuse may limit the availability of water. These factors might adversely affect our ability to supply water in sufficient quantities to our customers and our revenues and earnings may be adversely affected. Additionally, cool and wet weather, as well as drought restrictions and our customers’ conservation efforts, may reduce consumption demands, also adversely affecting our revenue and earnings. Furthermore, freezing weather may also contribute to water transmission interruptions caused by pipe and main breakage. If we experience an interruption in our water supply, it could have a material adverse effect on our financial condition and results of operations.
Item 1B
Item 1B - Unresolved Staff Comments
We have no unresolved Staff comments.
Item 2
Item 2 - Properties
We currently occupy approximately 1,800 square feet of office space at a cost of $1,000 per month, which is leased from the estate of Ryan Clark at the address shown on the cover page. The lease is a month-to-month agreement that can be cancelled by either party at any time.
In addition to the water rights we own in the Denver metropolitan area which are described in Item 1: Our Water Assets, we also own a 500,000 gallon water tank, a deep water well and pump station, and approximately four miles of pipeline in Arapahoe County Colorado. Additionally, although owned by the District, we operate and maintain another 500,000 gallon water tank and pump station and the District’s wastewater treatment plant. These assets are used to provide service to our existing customers.
In addition to the real property we own in the Arkansas River Valley as described in Item 1: Our Water Assets - Arkansas River Water, we also own various water delivery fixtures located on our real properties. These items consist mainly of irrigation pumps, irrigation ditches, irrigation pipelines as well as various structures and agricultural related buildings.
Item 3
Item 3 - Legal Proceedings
We are involved in ordinary and routine litigation incident to our business, none of which are material.
Item 4
Item 4 - Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of stockholders during the quarter ended August 31, 2008.
PART II
Item 5
Item 5 - Market for Registrant’s Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities
(a) Market Information
Our common stock is traded on the NASDAQ Capital Market under the symbol “PCYO”. The high and low sales prices of our common stock, by quarter, for the fiscal years ended August 31, 2008 and 2007 are presented with the Selected Quarterly Financial Information in Item 8 below.
(b) Holders
On October 31, 2008, there were approximately 3,400 holders of record of our common stock.
(c) Dividends
We have never paid any dividends on our common stock and expect for the foreseeable future to retain all of our earnings from operations, if any, for use in expanding and developing our business. Any future decision as to the payment of dividends will be at the discretion of our board of directors and will depend upon our earnings, financial position, capital requirements, plans for expansion and such other factors as our board of directors deems relevant. The terms of our Series B Preferred Stock prohibit payment of dividends on common stock unless all dividends accrued on the Series B Preferred Stock have been paid.
(d) Securities authorized for issuance under equity compensation plans
Table F - Securities Authorized for Issuance Under Equity Compensation Plans
(e) Performance Graph 1
This graph compares the cumulative total return of our common stock for the last five years with the cumulative total return for the same period of the S&P 500 Index and a peer group index. The graph assumes the investment of $100 in common stock in each of the indices as of the market close on August 31 and reinvestment of all dividends.
1.
This performance graph is not “soliciting material,” is not deemed “filed” with the Commission and is not to be incorporated by reference in any of our filings under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing.
2.
The Peer Group consists of the following companies that have been selected on the basis of industry focus or industry leadership: American States Water Company, Aqua America, Inc., Artesian Resources Corp., California Water Service Group, Connecticut Water Service, Inc., Middlesex Water Company, Pennichuck Corp., SJW Corp., and The York Water Company. In 2007 we included BIW Limited, which ceased trading in 2007 and is therefore no longer included in our Peer Group.
(f) Recent Sales of Unregistered Securities
There were no sales of unregistered securities during the three months ended August 31, 2008.
Item 6
Item 6 - Selected Financial Data
Table G - Selected Financial Data
We did not declare or pay any cash dividends in any of the five years presented.
The following items had a significant impact on our operations:
Item 7
Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operation
Overview
The discussion and analysis below includes certain forward-looking statements that are subject to risks, uncertainties and other factors, as described in “Risk Factors” and elsewhere in this Annual Report on Form 10-K, that could cause our actual growth, results of operations, performance, financial position and business prospects and opportunities for this year and the periods that follow to differ materially from those expressed in, or implied by, those forward-looking statements. Readers are cautioned that forward-looking statements contained in this Form 10-K should be read in conjunction with our disclosure under the heading: “SAFE HARBOR STATEMENT UNDER THE UNITED STATES PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995” on page 3.
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and our financial condition and should be read in conjunction with the accompanying financial statements and the notes thereto included in Part II, Item 8 of this Annual Report on Form10-K. This overview summarizes the MD&A, which includes the following sections:
Our Business - a general description of our business, our services and our business strategy.
Critical Accounting Policies and Estimates - a discussion of our critical accounting policies that require critical judgments, assumptions and estimates.
Results of Operations - analysis of our results of operations for the three years presented in our financial statements. We present our discussion in the MD&A in conjunction with the accompanying Financial Statements.
Liquidity, Capital Resources and Financial Position - an analysis of our cash position and cash flows, as well as a discussion of our financing arrangements.
Our Business
Pure Cycle is an investor owned water and wastewater service provider engaged in the design, operation and maintenance of water and wastewater systems. We operate primarily in the Denver metropolitan area and own nearly 12,000 acre-feet of groundwater and/or certain surface water rights in the Denver area. We also own approximately 60,000 acre-feet of Arkansas River water, we have the exclusive rights to use over 15,000 acre-feet of groundwater located at the Lowry Range through the year 2081, and we own 70,000 acre-feet of conditional Colorado River water rights on the western slope of Colorado. We plan to utilize our Denver assets and our Arkansas River water to provide large scale residential/commercial water and wastewater services to customers located along the Front Range of Colorado. We are also exploring ways to use our western slope water for commercial or agricultural purposes along the western slope of Colorado.
Critical Accounting Policies and Use of Estimates
Our financial statements are prepared in accordance Accounting Principles Generally Accepted in the United States of America (“GAAP”), which requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent liabilities at the date of the financial statements, and reported amounts of revenues and expenses during the reporting period. Actual results could differ significantly from those estimates.
For further discussion of our significant accounting policies, please refer to Note 2 in the accompanying financial statements.
Results of operations
Executive Summary
The results of our operations for the years ended August 31, 2008, 2007 and 2006 were as follows:
Table H - Summary Results of Operations
Water and Wastewater Usage Revenues
Our water service charges are based on a tiered pricing structure that provides for higher prices as customers use greater amounts of water. Our rates and charges are established based on the average of three surrounding communities, referred to as our rate-base districts. Table B in Item 1 - Business, outlines our tiered pricing structure and changes during fiscal 2008, 2007 and 2006, respectively.
Our wastewater customers are charged flat monthly fees based on their number of tap connections.
Fiscal 2008 compared to fiscal 2007
Water deliveries during fiscal 2008 dropped approximately 4% over water deliveries in fiscal 2007, due mainly to precipitation being higher in fiscal 2008. However, water usage fees in fiscal 2008 increased 7% over fiscal 2007 which is mainly a result of the timing of water usage and an increasing block pricing scale (as of July 1, 2007) for an entire fiscal year in 2008 versus two months in fiscal 2007.
Wastewater usage fees remained at $39.50 per wastewater tap per month and before that they increased July 1, 2007, from $34.80 to $39.50 per wastewater tap per month. Consistent with water taps, the increased wastewater fees in fiscal 2008 is a result of the higher usage fees being charged for the entire fiscal 2008 versus two months in fiscal 2007.
Gross margins for water services remained constant from fiscal 2007 to fiscal 2008. Gross margins for wastewater services in fiscal 2008 increased 10% over fiscal 2007 due to certain testing and compliance expenses incurred during fiscal 2007 not experienced in fiscal 2008.
Fiscal 2007 compared to fiscal 2006
Water deliveries during fiscal 2007 dropped approximately 22% over water deliveries in fiscal 2006. This was a result of high precipitation experienced throughout the Front Range of Colorado starting in December 2006 and lasting into the spring of 2007. Increased precipitation results in our customers using less water for irrigation. Water usage fees in fiscal 2007 decreased 9% over fiscal 2006, despite the 22% decrease in gallons delivered. This was a result of increased usage fees effective July 1, 2007.
Wastewater usage fees increased July 1, 2007, from $34.80 to $39.50 per wastewater tap per month and before that they increased on July 1, 2005, from $33.70 to $34.80 per wastewater tap per month, which accounted for the changes in revenues between the fiscal years.
Gross margins for water and wastewater services declined in fiscal 2007 over fiscal 2006. This is due to declines in the amount of water delivered. Decreased water deliveries do not typically equate to a decrease in the energy usage within the systems, and therefore, in reduced delivery years, gross margins will typically be lower. The decline is also due to certain testing and compliance expenses incurred during fiscal 2007 not experienced in the previous year.
General and Administrative and Other Expenses
General and administrative (“G&A”) expenses for fiscal 2008, 2007 and 2006 were impacted by the stock-based compensation recognized pursuant to the adoption of SFAS No. 123 (revised 2004) Share Based Payment (“SFAS 123(R)”), as follows (amounts are approximate):
Table I - G&A Expenses
The changes in G&A expenses are mainly attributable to the following:
Fiscal 2008 compared to fiscal 2007
From Fiscal 2007 to fiscal 2008, G&A expenses decreased approximately 6%, which is mainly a result of:
The above decreases were offset by the following significant increases.
Fiscal 2007 compared to fiscal 2006
From Fiscal 2006 to fiscal 2007, G&A expenses increased approximately 60%, which is mainly a result of:
Depreciation and depletion charges for the years ended August 31, 2008, 2007 and 2006 were approximately $381,300, $366,100 and $20,100, respectively. Fiscal 2008 and 2007 were consistent, but the increase from fiscal 2006 to fiscal 2007 is mainly a result of additional depreciation charges associated with the water delivery fixtures acquired from HP A&M on August 31, 2006 (depreciation began on September 1, 2006) and depreciation of capitalized legal costs associated with the HP A&M asset acquisition. In addition, in late fiscal 2006 we began depreciating the costs incurred to extend the water system to the Fairgrounds. We expect the depreciation and depletion charges going forward to remain consistent with the fiscal 2008 charges.
Interest income totaled approximately $283,600, $155,700 and $191,000 in fiscal 2008, 2007 and 2006, respectively. This represents interest earned on the temporary investment of capital in cash equivalents or available-for-sale securities, interest accrued on the note payable by the District and interest accrued on the Special Facilities construction proceeds receivable from the County. The increase from fiscal 2007 to fiscal 2008 of approximately $127,900 was due to additional funds being invested in interest bearing accounts as a result of the proceeds raised in the July 2007 equity offering. The decrease of approximately $35,300 from fiscal 2006 to fiscal 2007 was due to fewer funds being invested and earning interest as a result of the County construction project in fiscal 2006 and cash used in operations. Cash that was invested was not raised until the July 2007 equity offering so during fiscal 2007 we had lower investment balances.
Imputed interest expense related to the Tap Participation Fee payable to HP A&M totaled approximately $4.4 million, $4.7 million and $0 for fiscal 2008, 2007 and 2006, respectively. This represents the expensed portion of the difference between the relative fair value of the liability and the net present value of the liability recognized under the effective interest method. The decrease in the imputed interest expense of approximately $300,000 was a result of the updated valuation performed in the first quarter of fiscal 2008 which is explained in greater detail in Note 7 to the accompanying financial statements.
Interest expense - related parties was approximately $0, $0 and $7,100 in fiscal 2008, 2007 and 2006, respectively. All interest bearing debt - related parties, was paid off or extinguished as of August 31, 2006. Further, in October 2007, we repaid approximately $26,500 of non-interest bearing related party debt and now we no longer have any debt with scheduled maturities.
Interest expense - non-related parties was approximately $0, $0 and $19,300 in fiscal 2008, 2007 and 2006, respectively. All interest bearing debt was extinguished as of August 31, 2006.
Our net losses, as reported in our statements of operations in fiscal 2008, 2007 and 2006, were approximately $6.9 million, $6.9 million and $792,900, respectively. Our reported net losses have been materially impacted by the imputed interest on the Tap Participation Fee and stock-based compensation expense recognized pursuant to SFAS 123(R). In table J below, we have presented a non-GAAP financial disclosure to provide a quantitative analysis of the impact of the imputed interest and stock-based compensation expenses on our reported net losses and loss per share. Because these items do not require the use of current assets, management does not include these items in its analysis of financial results or how we allocate our resources. Because of this, we deemed it meaningful to provide this non-GAAP disclosure of the impact of these significant items on our financial results.
Table J - Non-GAAP Financial Disclosure
Net losses increased in each of the years presented above, after the effects of the stock-based compensation and interest on the Tap Participation Fee, mainly as a result of the items discussed in the G&A section above, and as a result of the impact to our operations of the CAA transactions described in Note 5 to the accompany financial statements.
Liquidity, capital resources and financial position
At August 31, 2008, our working capital, defined as current assets less current liabilities, was approximately $5.3 million, and we had cash and cash equivalents on hand totaling approximately $5.2 million. We also have an effective shelf registration statement pursuant to which we may elect to sell up to another $5.7 million of stock at any time and from time to time. We believe that at August 31, 2008, we have sufficient working capital to fund our operations for the next year. However, there can be no assurance that we will be successful in marketing the water from our primary water projects in the near term. In order to generate working capital to support our operations, we may incur additional short or long-term debt or seek to sell additional equity securities.
Development of the water that we own, have rights to use, or may seek to acquire, will require substantial capital investments. We anticipate that capital required for the development of the water and wastewater systems will be financed through the sale of water taps to developers and water delivery charges to users. We anticipate tap fees will be sufficient to generate funds with which we can design and construct the necessary Wholesale Facilities. However, once we receive tap fees from a developer, we are contractually obligated to construct the Wholesale Facilities for the taps paid for, even if our costs are not covered by the fees we receive. We cannot assure you that these sources of cash will be sufficient to cover all our capital costs.
Pursuant to the Arkansas River Agreement we agreed to pay HP A&M 10% of our water tap fees received on the sale of the next 40,000 water taps. As of August 31, 2008, we have estimated the value of the Tap Participation Fee at approximately $53.8 million based on a discounted cash flow valuation analysis, which was originally prepared at August 31, 2006, and was updated as of November 30, 2007. See Note 7 in the accompanying financial statements for the impact of the revaluation. The actual amount to be paid could exceed our estimates. Tap participation payments are not payable to HP A&M until we receive water tap fee payments. We did not sell any taps or make any Tap Participation Fee payments during the year ended August 31, 2008. As of August 31, 2008, there are 38,965 taps that remain subject to the Tap Participation Fee.
We are obligated to pay the FLCC annual water assessment charges which are the charges assessed to the FLCC shareholders for the upkeep and maintenance of the Fort Lyon Canal. The payments are due to the FLCC each calendar year. In December 2007, the board and shareholders of the FLCC approved an increase in the calendar 2008 assessments from $12.50 per share to $15.00 per share, which equates to an increase in our water assessments from approximately $265,000 per year to approximately $325,000 per year.
On August 3, 2005, we entered into the County Agreement to provide water service to the Fairgrounds. In accordance with GAAP, upon completion of construction of the Fairgrounds facilities and the initiation of water service to the Fairgrounds in July 2006, we began ratably recognizing deferred tap fee revenues as income. The tap fees received from the County are being recognized in income over the estimated useful life of the constructed assets, or 30 years. In addition, we started recognizing deferred Special Facilities funding as revenues in fiscal 2006, which will also be recognized over the useful life of the constructed assets. See also Note 3 to the accompanying financial statements for information regarding the amendment to the County Agreement in regards to the Special Facilities funding and the receipt of water rights in August 2008.
Repayment of all related party and non-related debt
In October 2007, we repaid our sole outstanding note to a related party. Therefore, at August 31, 2008, we had no outstanding related party or non-related party debt.
Operating Activities
Operating activities include revenues we receive from the sale of water and wastewater services to our customers, costs incurred in the delivery of those services, G&A expenses, and depletion/depreciation expenses.
Cash used by operating activities was approximately $1.3 million, $2.3 million and $767,600 for fiscal 2008, 2007 and 2006, respectively. The decrease of approximately one million dollars from fiscal 2007 to fiscal 2008 is a result of 2007 having a gain on the extinguishment of CAA interests of approximately $270,100 whereas fiscal 2008 had a loss on the extinguishment of CAA interests of approximately $273,700, which is a $544,800 year over year impact to the cash flow statement. The remaining difference was due to the timing of payments and receipts related to operating assets.
As a result of the Arkansas River Agreement signed on August 31, 2006, we imputed approximately $4.4 million, $4.7 million and $0 of interest on the Tap Participation Fee in fiscal 2008, 2007 and 2006, respectively. These are reflected as non-cash items in the statements of cash flows.
During fiscal 2008, 2007 and 2006 we accrued interest on the note receivable from the District of approximately $19,100, $23,500 and $21,500, respectively, which is comparable period over period. We also accrued approximately $35,900, $49,900 and $0 of interest on the construction proceeds receivable from the County during 2008, 2007 and 2006, respectively. The decrease in the construction proceeds interest income is a result of payments made by the County since the prior year, which reduced the interest income recognized under the effective interest method, and due to the amendment to the County Agreement reached with the County as described in Note 3 to the accompanying financial statements. There was no interest recognized in fiscal 2006 because the construction was not completed until the end of our fiscal 2006.
We incurred approximately $382,600, $369,000 and $20,100 of depreciation, depletion and other non-cash charges during fiscal 2008, 2007 and 2006, respectively. As noted above, the increase from 2006 is a result of the depreciation of capitalized legal costs associated with the HP A&M asset acquisition, the depreciation of water delivery equipment in the Arkansas River valley, both of which started on September 1, 2006 and in late fiscal 2006 we began depreciating the costs incurred to extend the water system to the Arapahoe County Fairgrounds.
We will continue to provide domestic water and wastewater service to customers in our service area and we will continue to operate and maintain our water and wastewater systems with our own employees.
Investing Activities
On October 31, 2003 we entered into the Denver Groundwater Purchase Agreement (the “DGPA”) with the developer of Sky Ranch. The DGPA provides us the right to purchase a total of 223 acre-feet of adjudicated decreed water rights owned by the developer. Under the DGPA, we have the right to acquire 44.6 acre-feet of water per year (or 20% of the total 223 acre-feet) for a payment of $50,000 (acquiring the entire 223 acre-feet requires payments totaling $250,000). On March 26, 2004 and May 26, 2005, we exercised our rights and purchased a total of 89.2 acre-feet of Denver aquifer groundwater for payments totaling $100,000. During our fiscal 2007 and fiscal 2006 we made the two required $50,000 payments pursuant to the DGPA; however, we have not received the water rights deeds from the developer, nor has the developer cashed either of the payments. In November, 2007, the developer of Sky Ranch filed for Chapter 11 bankruptcy protection. Because of the bankruptcy and since we have not received our water rights deeds from Sky Ranch, we have cancelled the two un-cashed checks issued to Sky Ranch and have reversed the $100,000 that was included in the Prepaid Expenses account on our Balance Sheet. We will continue to follow the bankruptcy proceedings of Sky Ranch and vigorously seek to enforce our rights under the DGPA and other Sky Ranch agreements. However, our rights related to Sky Ranch may have no value following the bankruptcy. Refer to the Risk Factors in Item 1A for additional information on the bankruptcy.
We continue to invest in legal and engineering fees associated with our water rights, and we continue to invest in the right-of-way permit fees to the Department of Interior Bureau of Land Management and legal and engineering costs for our Paradise Water Supply.
Cash provided (used) by investing activities for fiscal 2008, 2007 and 2006 was approximately $466,100, $2.5 million and ($1.6) million, respectively. Investing activities in 2008 consisted mainly of $790,600 received from the maturity of available-for-sale securities, offset by $270,500 of investments in water rights. The fiscal 2007 cash provided by investing activities was positively impacted by the sale of “LAWMA” shares, as more fully described in Note 3 to the accompanying financial statements and the sale of approximately $1.5 million of available-for-sale securities. The fiscal 2006 investing activities were negatively impacted by a net investment in available-for-sale securities of approximately $1.0 million and approximately $2.4 million of investments in water assets as a result of the County Agreement.
Financing Activities
Cash provided by financing activities was approximately $29,500, $5.5 million and $807,500 for fiscal 2008, 2007 and 2006, respectively. Financing activities in fiscal 2007 was positively impacted by the $9.0 million raised in the equity offering offset by the $2.6 million used to extinguish contingent obligations as described in Note 5 to the accompanying financial statements. Fiscal 2006 was positively impacted by approximately $1.18 million of funds received from the exercising of stock options.
Off-Balance Sheet Arrangements
Our off-balance sheet arrangements consist entirely of the CAA, which is more fully described in Note 5 to the accompanying financial statements.
Recently Adopted and Issued Accounting Pronouncements
See Note 2 to the accompanying financial statements regarding recently adopted and issued accounting pronouncements.
Total Contractual Cash Obligations
Table K - Contractual Cash Obligations
(a)
Our only operating lease is related to our office space. The lease is month-to-month and is cancelable upon thirty days notice. Due to this not being a long-term lease, payments cannot be reasonably estimated beyond one year.
(b)
The participating interests liability is payable to the CAA holders upon the sale of Export Water, and therefore, the timing of the payments is uncertain and not reflected in the above table by period.
(c)
The Tap Participation Fee payable to HP A&M is payable upon the sale of water taps. Because the timing of these water tap sales is not fixed and determinable, the estimated payments are not reflected in the above table by period. The amount listed above includes an unamortized discount of approximately $54.6 million. The valuation of the Tap Participation Fee payable to HP A&M is a significant estimate based on available historic market information and estimated future market information. Many factors are necessary to estimate future market conditions, including but not limited to, supply and demand for new homes, population growth along the Front Range, cash flows, tap fee increases at our rate-base districts, and other market forces beyond our control. Because the estimates and assumptions used to value the Tap Participation Fees payable to HP A&M are subjective, actual results could vary materially from the estimates.
Item 7A
Item 7A - Quantitative and Qualitative Disclosures About Market Risk
General. Pure Cycle has limited exposure to market risks from instruments that may impact the Balance Sheets, Statements of Operations, and Statements of Cash Flows, such exposure is due primarily to changing interest rates.
Interest Rates. The primary objective for our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in diversified short-term interest bearing investments. As of August 31, 2008, we no longer have any investments which are subject to market risks as the majority of our capital is invested predominately in overnight money market funds related to US Treasury Obligations which earn interest at stated rates. We have no investments denominated in foreign country currencies and therefore our investments are not subject to foreign currency exchange risk.
Item 8
Item 8 - Financial Statements and Supplementary Data
Index to Financial Statements and Supplementary Data
Report of Independent Registered Public Accounting Firm
Board of Directors and Stockholders
Pure Cycle Corporation
We have audited the accompanying balance sheets of Pure Cycle Corporation as of August 31, 2008 and 2007, and the related statements of operations, stockholders’ equity, and cash flows for each of the years in the two-year period ended August 31, 2008. We also have audited Pure Cycle Corporation’s internal control over financial reporting as of August 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Pure Cycle Corporation’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Pure Cycle Corporation as of August 31, 2008 and 2007, and the results of its operations and its cash flows for each of the years in the two-year period then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Pure Cycle Corporation maintained, in all material respects, effective internal control over financial reporting as of August 31, 2008, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ GHP HORWATH, P.C.
Denver, Colorado
November 13, 2008
Report of Independent Registered Public Accounting Firm
The Board of Directors
Pure Cycle Corporation:
We have audited the accompanying statements of operations, stockholders’ equity, and cash flows of Pure Cycle Corporation (the “Company”) for the year ended August 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Pure Cycle Corporation for the year ended August 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 2, effective September 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment.”
/s/ Anton Collins Mitchell LLP
Denver, Colorado
November 10, 2006
PURE CYCLE CORPORATION
BALANCE SHEETS
See accompanying Notes to Financial Statements
PURE CYCLE CORPORATION
STATEMENTS OF OPERATIONS
See accompanying Notes to Financial Statements
PURE CYCLE CORPORATION
STATEMENTS OF STOCKHOLDERS’ EQUITY
See accompanying Notes to Financial Statements
PURE CYCLE CORPORATION
STATEMENTS OF CASH FLOWS
See accompanying Notes to Financial Statements
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 1: ORGANIZATION
Pure Cycle Corporation (the “Company”) was incorporated in Delaware in 1976 and reincorporated in Colorado in 2008. The Company owns water assets in the Denver, Colorado metropolitan area, in the Arkansas River Valley in southern Colorado, and on the western slope of Colorado. The Company is currently using its water assets located in the Denver metropolitan area to provide water and wastewater services to customers located in the Denver metropolitan area.
The Company provides a full line of water and wastewater services which includes designing and constructing water and wastewater systems as well as operating and maintaining such systems. The Company’s business focus is to provide water and wastewater service to customers throughout the Denver metropolitan area as well as along the Colorado Front Range.
With approximately $5.2 million of cash and cash equivalents, $5.3 million of working capital and an open shelf registration statement allowing the Company to sell up to approximately $5.7 million of stock, at August 31, 2008, the Company believes it has sufficient working capital and financing sources to fund its operations for at least the next year. However, there can be no assurance that the Company will be successful in marketing its water on terms that are acceptable to the Company. The Company’s ability to generate working capital from its water and wastewater projects is dependent on its ability to successfully market the water, or in the event it is unsuccessful, to sell the underlying water assets. In the event increased sales are not achieved or the Company is unable to sell its water assets at a sufficient level, the Company may have to issue additional short or long-term debt or seek to sell additional shares of the Company’s common or preferred stock to generate sufficient working capital.
NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition
The Company generates revenues mainly from three sources:
(i)
water and wastewater tap fees,
(ii)
construction fees, and
(iii)
monthly water usage fees and wastewater service fees.
Each of the items above is typically included in a single contract with the Company’s customers. Emerging Issues Task Force Issue No. 00-21 Revenue Arrangements with Multiple Deliverables (“EITF 00-21”), governs how to identify when goods or services, or both, that are separately delivered but included in a single sales arrangement should be accounted for separately. Therefore, in accordance with EITF 00-21, the Company accounts for each of the items addressed in its service agreements separately.
Tap and Construction Fees. Proceeds from tap fees and construction fees are deferred upon receipt and recognized in income either upon completion of construction of infrastructure or ratably over time, which is based on whether or not the Company owns the infrastructure constructed with the proceeds.
Tap and construction fees derived from agreements in which the customer will own the assets constructed with the fees (for example the assets constructed for use on the Lowry Range pursuant to the Company’s service agreement with the Rangeview Metropolitan District (the “District”)) are recognized in accordance with Statement of Position 81-1 Accounting for Performance of Construction-Type and Certain Production-Type Contracts, whereby the Company recognizes revenue and costs of construction using the percentage-of-completion method.
Tap and construction fees derived from agreements for which the Company will own the infrastructure (for example the assets constructed for use at the Arapahoe County Fairgrounds (the “Fairgrounds”) - also referred to a “Special Facilities funding”) are recognized in accordance with Staff Accounting Bulletin No. 104 Revenue Recognition (“SAB 104”), whereby the up-front fees are recognized ratably over the estimated service life of the facilities constructed, starting at completion of construction.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
The Company recognized approximately $14,300, $14,300 and $1,200 of water tap fee revenues in fiscal 2008, 2007 and 2006, respectively, related to the Water Service Agreement (the “County Agreement”) with Arapahoe County (the “County”) entered into in August 2005. In accordance with SAB 104 and Accounting Principles Generally Accepted in the United States of America (“GAAP”), the Company began recognizing the water tap fees as revenue ratably over the estimated service period upon completion of the Wholesale Facilities in its fiscal 2006. The water tap fees to be recognized over this period are net of the royalty payments to the State of Colorado Board of Land Commissioners (the “Land Board”) and amounts paid to third parties pursuant to the Comprehensive Amendment Agreement No. 1 (the “CAA”) as further described in Note 5 below.
The Company recognized approximately $41,500, $41,500 and $3,500 of Special Facilities funding as revenue in fiscal 2008, 2007 and 2006, respectively. This is the ratable portion of the Special Facilities funding proceeds from the County pursuant to the County Agreement as more fully described in Note 3 below.
As of August 31, 2008, the Company has deferred recognition of approximately $1.6 million of tap and construction fee revenue from the County, which will be recognized as revenue ratably over the estimated life of the assets constructed with the construction proceeds as described above.
Monthly Usage and Service Fees. The Company recognizes water usage revenues upon delivering water to its customers. The water revenues recognized by the Company are shown net of royalties to the Land Board and the District, as applicable.
The Company recognizes wastewater processing revenues monthly based on flat fees assessed per single family equivalent (“SFE”) unit served. An SFE is the amount of water required each year by a family of four persons living in a single family house on a standard sized lot which is equivalent to the use of approximately 0.4 acre-feet of water per year. The monthly wastewater service fees are shown net of royalties to the District.
The Company recognized approximately $159,600, $149,500 and $163,600 of water usage revenues in fiscal 2008, 2007 and 2006, respectively. The Company recognized approximately $67,000, $60,300 and $59,000 of wastewater revenues in fiscal 2008, 2007 and 2006, respectively.
Costs of delivering water and providing wastewater service to customers are recognized as incurred.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Cash and Cash Equivalents
Cash and cash equivalents include all highly liquid debt instruments with original maturities of three months or less. The Company’s cash equivalents are comprised entirely of money market funds maintained at high quality financial institutions. The Company has no investments in equity instruments.
Financial Instruments - Concentration of Credit Risk and Fair Value
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents and investments in marketable securities. The Company places its cash equivalents and investments with a high quality financial institution. At various times throughout fiscal 2008, cash deposits have exceeded federally insured limits. The Company invests its excess cash primarily in money market instruments, commercial paper obligations, corporate bonds and US government treasury obligations. To date, the Company has not experienced significant losses on any of these investments.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
The carrying value of all financial instruments potentially subject to valuation risk (principally consisting of cash, cash equivalents, accounts receivable, accounts payable, and notes receivable) approximates fair value based upon prevailing interest rates available to the Company. The fair value of the note receivable from the District is not practicable to estimate due to the District being a related party.
Cash Flows
The Company did not pay any interest or income taxes during the three years ended August 31, 2008.
Marketable Securities
All marketable securities held by the Company matured or were sold during the year ended August 31, 2008. The funds were transferred to other temporary investments with original maturities of three months or less and are included in cash and cash equivalents on the balance sheet as of August 31, 2008.
The following is a summary of marketable securities at August 31, 2007 - this table is not presented as of August 31, 2008, because the Company no longer has any investments in marketable securities:
For the years ended August 31, 2008, 2007 and 2006 gross realized gains totaled approximately $2,000, $100 and $10,400, respectively.
Accounts receivable
The Company records accounts receivable net of allowances for uncollectible accounts (none as of August 31, 2008 or 2007). Any allowance for uncollectible accounts would be determined based on specific review of past due accounts.
Long-Lived Assets
The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the eventual use of the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. The Company believes there are no impairments in the carrying amounts of its long-lived assets at August 31, 2008.
Water and Wastewater Systems
If costs meet the Company’s capitalization criteria, costs to construct “Wholesale Facilities” and “Special Facilities” are capitalized as incurred, including interest, and depreciated over their estimated useful lives. The Company capitalizes design and construction costs related to construction activities and it capitalizes certain legal, engineering and permitting costs relating to the adjudication and improvement of its water assets.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Depletion and Depreciation of Water Assets
The Company depletes its water assets that are being utilized on the basis of units produced divided by the total volume of water adjudicated in the water decrees. Water systems are depreciated on a straight line basis over their estimated useful lives of 30 years.
Share-based Compensation
Effective September 1, 2005, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment, (“SFAS 123(R)”) and selected the modified prospective method to initially report stock-based compensation expense in the financial statements. Under the fair value recognition provisions of SFAS 123(R), share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the applicable vesting period of the stock award using the straight-line method. Prior to adoption of SFAS No. 123(R), the Company provided the disclosures required under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). Pursuant to APB 25, no expense was recognized in the financial statements unless the exercise price of the option was lower than the quoted market price on the date of grant.
In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123(R), which the Company has applied in its adoption of SFAS 123(R).
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards. The Company has adopted the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and statements of cash flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R). Because the Company has a full valuation allowance on its deferred tax assets, the granting and exercise of stock options during the years ended August 31, 2008 and 2007 had no impact on the income tax provisions.
Stock-based compensation expense recognized under SFAS 123(R) for the years ended August 31, 2008, 2007 and 2006, was approximately $351,500, $287,300 and $209,600, respectively.
Income Taxes
On September 1, 2007, the Company adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 prescribes a “more-likely-than-not” threshold for the recognition and de-recognition of tax positions, providing guidance on the accounting for interest and penalties relating to tax positions and requires that the cumulative effect of applying the provisions of FIN 48 be reported as an adjustment to the opening balance sheet of retained earnings or other appropriate components of equity or net assets in the statement of financial position. The Company did not have any significant unrecognized tax benefits and there was no material effect on its financial condition or results of operations as a result of implementing FIN 48.
The Company files income tax returns with the Internal Revenue Service and the State of Colorado. The tax years that remain subject to examination are fiscal 2005 through fiscal 2008. The Company does not believe there will be any material changes in its unrecognized tax positions over the next twelve months.
The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of the date of adoption of FIN 48, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the quarter.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Accumulated Comprehensive Income (Loss)
In addition to net loss, comprehensive loss includes the unrecognized changes in the fair value of marketable securities that are classified as available-for-sale as noted in the following table:
Prior to August 31, 2008, the Company had marketable securities that were recorded as available-for-sale and therefore any unrecognized changes in the fair value of these marketable securities was included as a component of other comprehensive income. During fiscal 2008, all of the Company’s marketable securities either matured or were sold and the Company invested these funds in cash equivalent accounts and not available-for-sale securities. Therefore after the sale / maturity date of the available-for-sale securities the only items included in comprehensive income is the Company’s net loss.
Loss per Common Share
Loss per common share is computed by dividing net loss by the weighted average number of shares outstanding during each period. Common stock options and warrants aggregating 155,092, 140,092, and 661,428 common share equivalents as of August 31, 2008, 2007 and 2006, respectively, have been excluded from the calculation of loss per common share as their effect is anti-dilutive.
Recently Issued Accounting Pronouncements
The Company continually assesses any new accounting pronouncements to determine their applicability to the Company. In the case where it is determined that a new accounting pronouncement effects the Company’s financial reporting, the Company undertakes a study to determine the consequence of the change to its financial statements and assures that there are proper controls in place to ascertain that the Company’s financials properly reflect the change. New pronouncements assessed by the Company this recently are discussed below:
In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”). SFAS No. 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in preparing financial statements that are presented in conformity with GAAP for nongovernmental entities. SFAS No. 162 is effective 60 days following the SEC’s approval of the Public Company Accounting Oversight Board Auditing amendments to AU Section 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles. The Company does not believe that the provisions of SFAS No. 162 will have a material impact on its financial statements.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Liabilities-Including an amendment of FASB Statement No. 115 (“SFAS 159”). SFAS 159 expands the use of fair value accounting but does not affect existing standards which requires assets or liabilities to be carried at fair value. The objective of SFAS 159 is to improve financial reporting by providing companies with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. Under SFAS 159, a company may elect to use fair value to measure eligible items at specified election dates and report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Eligible items include, but are limited to, accounts receivable, accounts payable, and issued debt. If elected, SFAS 159 is effective for fiscal years beginning after November 15, 2007 (September 1, 2008 for the Company). The Company is currently evaluating the impact of this standard on its financial statements.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement, (“FAS 157”), which establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. FAS 157 is effective for fiscal years, and the interim periods within those fiscal years, beginning after November 15, 2007 (September 1, 2008 for the Company). The Company is currently evaluating the impact of this standard on its financial statements.
Reclassifications
Certain amounts in the prior year financial statements have been reclassified to conform to the current year presentation.
NOTE 3: WATER ASSETS
The Company’s water and water systems consist of the following costs and accumulated depreciation and depletion as of August 31:
Depletion and Depreciation
The Company recorded approximately $600, $600 and $900 of depletion charges in fiscal 2008, 2007 and 2006, respectively. This related entirely to the use of the Rangeview Water Supply. No depletion is taken against the Arkansas River water, the Paradise Water Supply or Sky Ranch Water Supply because these assets have not been placed into service as of August 31, 2008.
The Company recorded approximately $380,700, $365,500 and $19,200 of depreciation expense in fiscal 2008, 2007 and 2006, respectively.
Arkansas River Valley Assets
Arkansas River Water. The Company owns approximately 60,000 acre-feet of senior water rights in the Arkansas River and its tributaries. The Company anticipates that of this, approximately 40,000 acre-feet will be available for non-agricultural uses along the front range of Colorado sometime in the future. The Company acquired its Arkansas River Valley assets from High Plains A&M LLC (“HP A&M”) pursuant to an Asset Purchase Agreement (the “Arkansas River Agreement”) entered into on August 30, 2006. The Company acquired the Arkansas River Water Rights to enhance and better balance its water portfolio by increasing its rights to senior surface water which is being demanded by developers, cities and municipalities throughout the Colorado Front Range, and to increase its inventory of water and capacity to serve additional customers.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
In order to utilize the Arkansas River water in the Company’s service areas, the Company will be required to convert this water to municipal and industrial uses. Change of water use must be done through the Colorado water courts and several conditions must be present prior to the water court granting an application for transfer of a water right. A transfer case would be expected to include the following provisions: (i) a provision of anti-speculation in which the applicant must have contractual obligations to provide water service to customers prior to the water court ruling on the transfer of a water right, (ii) the applicant can only transfer the “consumptive use” portion of its water rights (the Company expects to face opposition to any consumptive use calculation of the historic agricultural uses of its water), (iii) applicants likely would be required to mitigate the loss of tax base in the basin of origin, (iv) applicants would likely have re-vegetation requirements requiring them to restore irrigated soils to non-irrigated, and (v) applicants would be required to meet water quality measures which would be included in the cost of transferring the water rights.
The $81.2 million of capitalized costs represents the estimated value of the consideration paid to HP A&M as of August 31, 2006 because the value of the consideration was deemed more reliable than the value of the acquired assets at the date of acquisition. The consideration paid is comprised of equity (3.0 million shares of the Company’s common stock) and the Tap Participation Fee (described in Note 7 below). Because the estimated value of the consideration paid was less than the total estimated fair value of the assets acquired by the Company, the relative values assigned to the assets were ratably reduced.
Land. Currently the Arkansas River water owned by the Company is being used for agricultural purposes on the 80 properties the Company owns (approximately 17,500 acres). Approximately 60 of the properties are subject to promissory notes maintained by the seller as further described in Note 7. The land is located in the counties of Bent, Otero and Prowers in Southern Colorado. Each of the properties is subject to operating leases (which expire at various dates through 2010) which the Company assumed title to effective with the closing. Pursuant to a property management agreement (described below) between HP A&M and the Company, HP A&M will manage the leases for a period of five years (through August 31, 2011) and will receive all lease payments from the lessees as a management fee. Because the Company does not have the risk of loss associated with the leases (HP A&M’s management fee is equal to the lease income for the next five years, and contractually HP A&M has the risk of loss on the leases), in accordance with Emerging Issues Task Force No. 99-19 Reporting Revenue Gross as Principal versus Net as an Agent, the lease income and management fees are reflected on a net revenue basis throughout the term of the management agreement. The Company also owns certain contract rights, tangible personal property, mineral rights, and other water interests related to the Arkansas River water and land.
The Company and HP A&M entered into a five year property management agreement, pursuant to which, HP A&M holds the right to pursue leasing of the land and Arkansas River water to interested parties. All lease income associated with leasing the land and Arkansas River water, together with all costs associated with these activities including but not limited to, overhead obligations, real property taxes, and personnel costs, are the sole opportunity and obligation of HP A&M.
Fort Lyon Canal Company (“FLCC”) Shares. The water rights are represented by over 21,600 shares of the FLCC, which is a non-profit mutual ditch company established in the 1800’s that operates and maintains the 110 mile Fort Lyon Canal between La Junta, Colorado and Lamar, Colorado. The shares in the FLCC represent the amount of water the Company owns in the Fort Lyon Canal.
Pursuant to the Arkansas River Agreement, the Company pledged to HP A&M: (i) one-half of the shares of FLCC purchased by the Company, (ii) all shares of FLCC hereafter issued to the Company by means of any dividend or distribution in respect of the shares pledged hereunder (together with the shares identified in (i), the “Company’s Pledged Shares”), (iii) the certificates representing the Company’s Pledged Shares, (iv) the land associated with the water represented by the Company’s Pledged Shares, and (v) all rights to money or property which the Company now has or hereafter acquires in respect of the Company’s Pledged Shares. This pledge agreement will terminate upon payment of the Tap Participation Fee.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Sale of irrigation well. During the year ended August 31, 2008, the Company sold an irrigation well for $1,000. At August 31, 2008, the carrying value of this well was $1,270, which resulted in a loss on sale of $270, which is reflected in the accompanying Statement of Operations.
Lower Arkansas Water Management Association (“LAWMA”) Shares. During the year ended August 31, 2007, the Company sold 509 LAMWA shares for approximately $849,700. See Note 7 below for details on how this impacted the Tap Participation Fee. Because the LAWMA shares were sold at their allocated fair value, the Company did not recognize any gain or loss on the transaction.
As of August 31, 2008, the Company owns 45 remaining LAWMA shares valued at approximately $77,900, which are valued based on the sales value of the 509 LAWMA shares sold. Because the Company plans to dispose of these LAWMA shares, pursuant to SFAS 144, Accounting for the Impairment of Long-Lived Assets, the net book value of the remaining LAWMA shares has been reflected on the balance sheet as held for sale. The LAWMA shares are not currently being depleted. Management continues to evaluate offers and believes that the estimated selling price less estimated cost to sell equals or exceeds the net book value of the LAWMA shares remaining and therefore there is no impairment loss.
Non-Solicitation Agreement. Pursuant to the Arkansas River Agreement, each of the owners of HP A&M agreed, for three years (i) not to solicit the Company’s customers or potential customers to provide water in the Company’s service areas or potential service areas, (ii) not to solicit employees of the Company, (iii) not to engage in certain activities competitive with the Company and (iv) not to engage in the purchase of water or water rights without first offering such water or water rights to the Company.
Rangeview Water Supply and Water System
The Rangeview Water Supply consists of 26,700 acre-feet and is a combination of tributary surface water and storage rights and nontributary groundwater rights associated with the Lowry Range, a 27,000 acre property owned by the Land Board, which is located approximately 15 miles southeast of Denver. The $14.4 million of capitalized costs represents the costs of assets acquired or facilities constructed to extend water service to customers located on and off the Lowry Range. The recorded costs of the Rangeview Water Supply includes payments to the sellers of the Rangeview Water Supply, design and construction costs and certain direct costs related to improvements to the asset including legal and engineering fees.
The Company acquired the Rangeview Water Supply beginning in 1996 when:
(i)
The Company entered into the Agreement for Sale of Export Water with the District, a quasi-municipal political subdivision of the State of Colorado;
(ii)
The District entered into the Amended and Restated Lease Agreement with the Land Board, which owns the Lowry Range; and
(iii)
The Company entered into the Service Agreement with the District for the provision of water service to the Lowry Range (collectively these agreements are referred to as the “Rangeview Water Agreements”).
The Rangeview Water Agreements require 15,050 acre-feet of the total 26,700 acre-feet be used specifically on the Lowry Range, which the Company has the exclusive rights to use. The Rangeview Water Agreements also provide for the Company to use surface reservoir storage capacity in providing water service to customers both on and off the Lowry Range. The Company owns the rights to use the remaining 11,650 acre-feet of non-tributary groundwater, which can be exported off the Lowry Range to serve area users (referred to as “Export Water”). The Company also has the option with the Land Board to exchange an aggregate gross volume of 165,000 acre-feet of groundwater for 1,650 acre-feet per year of adjudicated surface water.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Based on independent engineering estimates, the 15,050 acre-feet of water designated for use on the Lowry Range is capable of providing water service to approximately 46,500 SFE units, and the 11,650 acre-feet of Export Water owned by the Company can serve approximately 33,600 SFE units throughout the Denver metropolitan region.
Pursuant to the Rangeview Water Agreements, the Company will design, finance, construct, operate and maintain the District’s water and wastewater systems to provide service to the District’s customers on the Lowry Range. On the Lowry Range, the Company will operate both the water and the wastewater systems during the contract period and the District will own both systems. After 2081, ownership of the water system servicing customers on the Lowry Range will revert to the Land Board, with the District retaining ownership of the wastewater system. The Company owns the Export Water and will use it to provide water and wastewater services to customers off the Lowry Range. The Company will also own all the facilities required to extend water and wastewater services off the Lowry Range. The Company plans to contract with third parties for the construction of these facilities.
Rates and charges for all water and wastewater services on the Lowry Range, including tap fees and usage or monthly fees, are governed by the terms of the Rangeview Water Agreements. The Company’s rates and charges are reviewed annually and are based on the average of similar rates and charges of three surrounding municipal water and wastewater service providers. These represent gross fees and to the extent that water service is provided using Export Water, the Company is required to pay royalties to the Land Board ranging from 10% of gross revenues to 50% of net revenue after deducting certain costs. In exchange for providing water service to customers on the Lowry Range, the Company will receive 95% of all water service fees received by the District, after the District pays the required royalties to the Land Board totaling 12% of gross revenues received from water sales. In exchange for providing wastewater service for the District’s customers, the Company will receive 100% of the District’s wastewater tap fees and 90% of the District’s wastewater usage fees.
The Company delivered approximately 42.8, 44.4 million and 56.6 million gallons of water to customers on the Lowry Range in fiscal 2008, 2007 and 2006, respectively.
Paradise Water Supply
In 1987, the Company acquired water, water wells, and related assets from Paradise Oil, Water and Land Development, Inc., which constitute the Paradise Water Supply. The $5.5 million of capitalized costs includes costs to acquire the Paradise water supply, as well as certain direct legal and engineering costs relating to improvements to the asset. The Paradise Water Supply includes 70,000 acre-feet of conditionally decreed tributary Colorado River water, a right-of-way permit from the United States Department of the Interior, Bureau of Land Management, for the construction of a 70,000 acre-foot dam and reservoir across federal lands, and four unrelated water wells.
Every six years the Paradise Water Supply is subject to a Finding of Reasonable Diligence review by the water court and the State Engineer to determine if the Company is diligently pursuing the development of the water rights. During fiscal 2005, the water court began the latest review, which the Company received its official Finding of Due Diligence in August 2008. During the diligence review, the Company received objections from two parties to its Paradise Water rights. The Company and the objectors reached an agreement on the objections, which resulted in the Company receiving its finding of due diligence. The agreement with the objectors called for the Company to, among others, perform the following during the next six years: (i) acknowledge that the Company is required to use its Paradise Water within the geographical boundaries of the Colorado River Water Conservation District; (ii) investigate reservoir sites that are not located directly on the main channel of the Colorado River and proceed with filings with the Colorado Water Court to change the location of the reservoir sight; and (iii) identify specific end uses and users of the Paradise Water.
Arapahoe County Fairgrounds Agreement for Water Service
The Company owns approximately 321 acre-feet of groundwater purchased pursuant to the County Agreement. The Company plans to use this water in conjunction with its Rangeview Water Rights in providing water to areas outside the Lowry Range. The $2.9 million of capitalized costs includes the costs to construct various Wholesale and Special Facilities, including a new deep water well, a 500,000 gallon water tank and pipelines to transport water to the Fairgrounds.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Pursuant to the County Agreement, the County has or will pay the Company the following:
Since the Company is utilizing Export Water to provide water service to the Fairgrounds, the sale of the water taps generated a royalty payment to the Land Board of $34,522. The agreement with the Land Board requires royalty payments on Export Water sales based on net revenues, which are defined as proceeds from the sale of Export Water less direct and indirect costs, including reasonable overhead charges, associated with the withdrawal, treatment and delivery of Export Water. Based on this, in September 2005, the Company made the required $34,522 royalty payment to the Land Board, which is 10% of the net tap fees received from the County.
In addition, tap fees under service agreements in which Export Water will be utilized are subject to the CAA, which is described in more detail in Note 5 below. Net tap fees subject to the CAA totaled $532,968, which were the tap fees received from the County less the $34,522 Land Board royalty. The $532,968 was distributed by the escrow agent as required by the CAA in September 2005. Based on the CAA positions held by the Company at the time, the Company received $373,078, or 70%, of the distribution and external parties received $159,890, or 30%.
The tap fees retained by the Company were used to fund construction of the Wholesale Facilities required to extend water service to the Fairgrounds. In July 2006 the Company completed construction of the Wholesale Facilities and in accordance with SAB 104 began ratably recognizing $428,000 of tap fees in income. The $428,000 is comprised of the tap fees received by the Company of $567,490, decreased by (i) royalties to the Land Board of $34,522; and (ii) 65% of the total payments made to external CAA holders (which is more fully described in Note 5 below) or $104,136. For the years ended August 31, 2008, 2007 and 2006, the Company recognized approximately $14,300, $14,300 and $1,200 of tap fee revenue, respectively.
The total construction funding of $1.25 million is deferred and will be recognized as revenue over the expected service period, which is also the estimated useful life of the Special Facilities constructed with the funds. During the years ended August 31, 2008, 2007 and 2006, the Company recognized approximately $41,500, $41,500 and $3,500 of Special Facilities revenue, respectively.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Amendment to the County Agreement. Because the County had not transferred the 336 acre-feet of groundwater to the Company as required in the County Agreement, the County was making interest payments to the Company totaling $600 per month until such time as the required water rights transfer was made. In August 2008, the Company and the County entered into Amendment No. 1 to Agreement For Water Service (the “County Amendment”), whereby the County transferred to the Company 294 acre-feet of water valued at approximately $206,000, and made a cash payment of approximately $34,100. The County Amendment was necessary because prior to the signing of the County Agreement, some of the water rights to be transferred to the Company had previously been adjudicated to another party. As a result, the acre-feet to be transferred from the County to the Company were reduced from 336 acre-feet to approximately 294 acre-feet. As a result of the reduction in the acre-feet transferred to the Company, the County made an additional cash payment of approximately $34,100 in August 2008. As a result of the transfer of the water rights and the cash payment, the County will no longer make the required $600 monthly interest payments to the Company. The value of the water rights was included in the Construction proceeds receivable account on the accompanying balance sheet until the transfer, and then $206,000 was capitalized as part of the investment in Arapahoe County water.
Sky Ranch Water Supply and Water Service Agreements
The Company owns approximately 89 acre-feet of water located beneath Sky Ranch together with the right to purchase an additional 671 acre-feet of water (for a total of 760 acre-feet), which will be used to provide water service to the initial 1,500 taps purchased at Sky Ranch. The $100,000 of capitalized costs is comprised of the cash payments made to the developer of Sky Ranch to acquire the 89 acre-feet of water rights.
The Company acquired these water rights pursuant to the October 31, 2003, and May 14, 2004 Water Service Agreements (collectively the “Sky Ranch Agreements”) with the developer of Sky Ranch, an approximately 950 acre property located 4 miles north of the Lowry Range. Pursuant to the Sky Ranch Agreements, if the project commences, the Company will provide water service to the homes, businesses, schools and other developments that are expected to be built at Sky Ranch, which could include service to up to 4,850 SFEs.
As reported in the Company’s Interim Reports on Form 10-Q throughout 2008, the developer of Sky Ranch has filed for bankruptcy protection, therefore, the status of the Sky Ranch Agreements is uncertain as of the date of this filing. The Sky Ranch Agreements could be rejected in the bankruptcy. Alternatively the Company may need to renegotiate the Sky Ranch Agreements with whomever the developer of the property may be and the result of those negotiations could result in significantly different terms than those in the Sky Ranch Agreements. As of the date of this filing, the Company has not received any payments for tap purchases from the developer and has no information on if or when development of the project will occur or when the purchasing of water taps will begin.
As part of the Sky Ranch Agreements, the developer is required to dedicate approximately 537 acre-feet of water to the Company in exchange for a $3,400 per tap credit for the first 767 water taps purchased. Additionally, pursuant to the Sky Ranch Agreements, the developer is required to pay the Company $3.41 million for the construction of certain Special Facilities required to extend service to Sky Ranch. As of August 31, 2008, none of this water has been dedicated to the Company because Sky Ranch has not yet purchased any water taps, and construction of the Special Facilities has not occurred so therefore none of the $3.41 million for construction of the Special Facilities has been paid.
The Company also entered into a five year groundwater purchase agreement with Sky Ranch to acquire the 223 acre-feet of Denver Aquifer groundwater located at Sky Ranch for payments totaling $250,000. As of the date of this filing, the Company has acquired 40% of this water, or 89.2 acre-feet for payments totaling $100,000. The 89.2 acre-feet of water acquired from Sky Ranch does not have to be used at Sky Ranch. Instead, at the discretion of the Company, it can be used throughout the Company’s service area. Due to the developer’s bankruptcy filing, the Company has not been able to complete the acquisition of the final 60% of the groundwater located at Sky Ranch and the Company is unsure if it will be able to complete the acquisition of the remaining groundwater.
If Sky Ranch is developed, the Company plans to initially develop the 760 acre-feet of water beneath the Sky Ranch property. This water is sufficient to provide water service to approximately 1,500 taps. Any taps purchased by Sky Ranch in excess of 1,500 will be serviced utilizing Export Water and are subject to royalty payments to the Land Board and payments to the CAA holders.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
The Sky Ranch Agreements granted the developer two options to use a combined 1,200 acre-feet of Export Water per year at Sky Ranch after a defined number of taps have been purchased for use at Sky Ranch. The two options were to be paid in annual installments of $50,000 over five years (the “Sky Ranch Option”), and $10,400 over five years (the “Hills Option”), respectively. Installment payments received before the options are exercised or expire will not be refunded and are deferred and recognized into income ratably until the next installment payment is due.
In fiscal 2005 and 2004, the developer remitted the first two $50,000 payments for the Sky Ranch Option which were both distributed in order of priority to the CAA holders. In February 2005, the developer remitted the first payment for the $10,400 Hills Option which was distributed in order of priority to the CAA holders. As of August 31, 2008, the developer of Sky Ranch has not remitted the payments for the Sky Ranch Option or the Hills Option due in our fiscal 2008, 2007 or 2006, and therefore the payments are past due. Notwithstanding Sky Ranch being in default on its payments, the Sky Ranch Agreements remain in effect. Continued default by Sky Ranch on these payments for Export Water places the Sky Ranch development at risk of not being able to use the Company’s Export Water to service development in excess of the 1,500 single family units.
The Company has dedicated approximately 1,200 acre-feet, or 10%, of the Export Water supply (which is about 4.5% of the Company’s overall Rangeview Water Supply) for this project under the Sky Ranch options.
NOTE 4: INVESTMENT IN WELL ENHANCEMENT AND RECOVERY SYSTEMS, LLC
Effective January 30, 2007, the Company entered into an Operating Agreement with Energy Technologies, Inc. and Hydro Resources Holdings, Inc. (collectively the Company, Energy Technologies, Inc. and Hydro Resources Holdings, Inc. are referred to as the “LLC Owners”) to form Well Enhancement and Recovery Systems, LLC (“Well Enhancement LLC”). Well Enhancement LLC was established to develop a proprietary new deep water well enhancement tool which the LLC Owners believe will increase the efficiency of deep water wells in the Denver metropolitan area. Each of the LLC Owners holds a 1/3 interest in Well Enhancement LLC. The president of the Company acts as the manager of Well Enhancement LLC.
The Company accounts for its investment in Well Enhancement LLC under the equity method pursuant to Accounting Principles Board Opinion No. 18 The Equity Method of Accounting for Investments in Common Stock (as amended) and Emerging Issues Task Force Issue No. 03-16 Accounting for Investments in Limited Liability Companies. As of August 31, 2008, the Company’s Investment in Well Enhancement and Recovery Systems, LLC account on its balance sheet includes $87,000 of capital contributions made to date by the Company and its 1/3rd share of the approximately $252,700 of net losses of Well Enhancement LLC, inception through August 31, 2008. As of August 31, 2008, Well Enhancement LLC’s assets and liabilities consisted entirely of approximately $10,700 of cash and approximately $600 of accrued professional fees. For the years ended August 31, 2008 and 2007, Well Enhancement LLC posted net losses of approximately $146,000 and $106,700, respectively. The net losses are primarily a result of research and development costs associated with the design of the well enhancement tool.
NOTE 5: PARTICIPATING INTERESTS IN EXPORT WATER
The Company acquired its Rangeview Water Supply through various amended agreements entered into in the early 1990’s. The acquisition was consummated with the signing of the CAA in 1996. Upon entering into the CAA, the Company recorded an initial liability of approximately $11.1 million, which represents the cash the Company received and used to purchase its Export Water Supply. In return, the Company agreed to remit a total of $31.8 million of proceeds received from the sale of Export Water to the participating interest holders. In accordance with EITF Issue No 88-18 Sales of Future Revenues, the obligation for the $11.1 million was recorded as debt, and the remaining $20.7 million contingent liability is not reflected on the Company’s balance sheet because the obligation to pay this is contingent on sales of Export Water, the amounts and timing of which are not reasonably determinable.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
In recent years, in order to reduce the long term impact of the CAA and provide the Company with additional cash flows to fund operations and pursue other business opportunities that may arise, the Company has repurchased various portions of the CAA obligations in priority.
In October 2007, the Company acquired the rights to approximately $4.7 million of CAA interests in exchange for 211,228 shares of the Company’s restricted common stock valued at approximately $1.9 million. The Company recorded a loss on the acquisition of the CAA interests in October 2007 of approximately $273,700.
In July 2007, the Company acquired the rights to approximately $10.5 million of CAA interests in exchange for cash payments of approximately $2.6 million, which was raised in the Company’s equity offering in July 2007. The Company recorded a gain on the acquisition of the CAA interests made in July 2007 of approximately $1.0 million. Of this, approximately $765,000 was recorded as a capital contribution because the CAA interests acquired by the Company for approximately $7.8 million were held by parties that are deemed related to the Company.
In August 2006, the Company acquired the rights to approximately $4.7 million of CAA interests, and retired approximately $896,000 of debt (which included approximately $471,500 of accrued interest) in exchange for the issuance of 242,169 shares of restricted common stock valued at approximately $2.1 million. The Company agreed to register these shares, which was completed in fiscal 2007. As a result, the Company recorded a gain on the extinguishment of debt and acquisition of the CAA of $390,900 during the fiscal year ended August 31, 2006.
As a result of the CAA acquisitions made in recent years, and due to the sale of Export Water, as detailed in the table below, the total remaining potential third party obligation as of August 31, 2008 is approximately $3.5 million.
The CAA obligation is non-interest bearing, and if the Export Water is not sold, the parties to the CAA have no recourse against the Company. If the Company does not sell the Export Water, the holders of the Series B Preferred Stock are also not entitled to payment of any dividend and have no contractual recourse against the Company.
The CAA includes contractually established priorities. Following the CAA acquisition made by the Company, the Company’s priority levels include $5.1 million of remaining amounts payable at the highest priority level, $2.5 million in the third priority level, and the remaining $20.3 million at various other priority levels.
As the proceeds from the sale of Export Water (described below) are received, and the amounts are remitted to the external CAA holders, the Company allocates a ratable percentage of this payment to the principal portion (the Participating Interests in Export Water supply liability account) with the balance of the payment being charged to the contingent obligation portion. The amount allocated to the liability is approximately 35%, which is the percentage the $11.1 million represented of the original total $31.8 million obligation. The remaining portion, or approximately 65%, is allocated to the contingent obligation. The portion allocated to principal will be recorded as a reduction in the Participating Interests in Export Water liability account while the amounts applied to the contingency are recorded on a net revenue basis when funds are received.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 6: ACCRUED LIABILITIES
At August 31, 2008, the Company had accrued liabilities of approximately $70,500, of which $62,800 was for professional fees with the remainder relating to operating payables. At August 31, 2007, the Company had accrued liabilities of approximately $85,900, of which $79,500 was for professional fees with the remainder relating to operating payables.
NOTE 7: LONG-TERM DEBT
As of August 31, 2008, the Company has no debt with contractual maturity dates. The last note payable the Company had outstanding of $26,542 was paid in full in October 2007 and was non-interest bearing and un-secured.
As further described in Note 5 above, in August 2006 the Company issued 242,169 shares of restricted common stock as consideration for the extinguishment of approximately $896,000 of debt and accrued interest and $4.7 million of CAA interests. The net gain on this transaction was approximately $390,900 which is reflected in the Company’s statement of operations.
The Participating Interest in Export Water supply and the Tap Participation Fees payable to HP A&M are obligations of the Company that have no scheduled maturity dates. Therefore, these liabilities are not disclosed in tabular format. However, the Tap Participation Fee is described below.
Tap Participation Fee
Pursuant to the Arkansas River Agreement, on August 31, 2006, the Company granted HP A&M the right to receive ten percent (10%) of the Company’s gross proceeds, or the equivalent thereof, from the sale of the next 40,000 water taps (the “Tap Participation Fee”). The Tap Participation Fee is due and payable once the Company has sold a water tap and received the consideration due for such water tap. The Company did not sell any water taps during the years ended August 31, 2008 and 2007.
The 40,000 figure was reduced to 39,470 at the August 31, 2006 closing date because HP A&M sold certain assets and properties not related to the FLCC shares which were subject to the Arkansas River Agreement and were available for credit against the Tap Participation Fee. The 39,470 figure was reduced to 38,965 during the year ended August 31, 2007, when the Company sold 509 LAMWA shares for approximately $849,700. Pursuant to the Arkansas River Agreement, 100% of the proceeds from the sale of the LAWMA shares were required to be paid to HP A&M, which resulted in a credit to the Tap Participation Fee equivalent to the sale of 505 water taps.
The Tap Participation Fee was valued at approximately $45.6 million at the acquisition date using a discounted cash flow analysis of the projected future payments to HP A&M. The $53.8 million balance at August 31, 2008 includes $9.1 million of imputed interest, recorded using the effective interest method. The Company determined the value of the Tap Participation Fee by estimating new home development in the Company’s service area over an estimated development period. This was done by utilizing third party historical and projected housing and population growth data for the Denver, Colorado metropolitan area applied to an estimated development pattern supported by historical development patterns of certain master planned communities in the Denver, Colorado metropolitan area. This development pattern was then applied to future water tap fees that were estimated using historical water tap fees. Based on the declining new home market in the Denver metropolitan area, the Company updated its estimated discounted cash flow analysis at November 30, 2007. An analysis of the value of the tap participation fee was performed by management as of August 31, 2008. Based on the lack of significant changes in the assumptions, no change in the tap participation fee was determined necessary as of August 31, 2008. The November 30, 2007 update resulted in the following changes from the prior year valuation model:
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Actual development may differ substantially from the estimated new home development in the Company’s service area, which may have a material effect on the estimated fair value of the Tap Participation Fee and such differences may have a material impact on the financial statements. The valuation of the Tap Participation Fee is a significant estimate based on available historic market information and estimated future market information. Many factors are necessary to estimate future market conditions, including but not limited to, supply and demand for new homes, population growth along the Front Range, cash flows, tap fee increases at the Company’s rate-base districts, and other market forces beyond the Company’s control.
The Company imputes interest expense on the unpaid Tap Participation Fee using an effective interest method over the estimated development period utilized in the valuation of the liability. The Company imputed interest of approximately $4.4 million, $4.7 million and $0 related to the Tap Participation Fee during fiscal 2008, 2007 and 2006, respectively.
After five years, under circumstances defined in the Arkansas River Agreement, the Tap Participation Fee can increase to 20% of the Company’s tap fees and the number of water taps subject to the Tap Participation Fee would be correspondingly reduced by half. The Tap Participation Fee is subject to acceleration in the event of a merger, reorganization, sale of substantially all assets, or similar transactions and in the event of bankruptcy and insolvency events.
Promissory Notes Payable by HP A&M
Certain of the properties the Company acquired from HP A&M as described in Note 3 are subject to outstanding promissory notes with principal and accrued interest totaling approximately $12.8 million at August 31, 2008. These promissory notes are secured by deeds of trust on the Properties. The Company did not assume any of these promissory notes and is not responsible for making any of the required payments under these notes. This responsibility remains solely with HP A&M. In the event of default by HP A&M, at the Company’s sole discretion, the Company may make payments pursuant to any or all of the notes and cure any or all of the defaults. If the Company does not cure the defaults, it will lose the properties securing the defaulted notes. If HP A&M defaults on the promissory notes, the Company can foreclose on a defined amount of stock issued to HP A&M and reduce the Tap Participation Fee by two times the amount of notes defaulted on by HP A&M. Because HP A&M would lose such a substantial amount of equity and Tap Participation Fee, and based on the financial stability of HP A&M and its owners and affiliated companies, the probability of HP A&M defaulting on the notes is deemed remote. As far as the Company is aware, as of August 31, 2008, HP A&M has not defaulted on any of the promissory notes.
Because the outstanding notes are collateralized by the Company’s Properties and Arkansas River Water, HP A&M is deemed to be a Variable Interest Entity (“VIE”) as defined by FASB Interpretation No. 46(R) Consolidation of Variable Interest Entities (as amended) (“FIN 46R”). However, because the Company will not absorb any of HP A&M’s expected losses or receive any of HP A&M’s expected gains, the Company is not deemed the “Primary Beneficiary” of HP A&M and therefore is not required to consolidate HP A&M. HP A&M became a VIE to the Company on August 30, 2006 when the Company acquired the Arkansas River Water Rights and Properties subject to the outstanding promissory notes. HP A&M is a holding company that acquires water rights and related properties for investment and sale purposes. If HP A&M were to default on the notes, the Company would lose approximately 60 of the 80 real property interests it acquired and the water rights associated with those Properties, unless the Company cured the notes in default.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 8: SHAREHOLDERS’ EQUITY
Preferred Stock
The Company’s non-voting Series B Preferred Stock has a preference in liquidation of $1.00 per share less any dividends previously paid. Additionally, the Series B Preferred Stock is redeemable at the discretion of the Company for $1.00 per share less any dividends previously paid. In the event that the Company’s proceeds from sale or disposition of Export Water rights exceed $36,026,232, the Series B Preferred Stock holders will receive the next $432,513 of proceeds in the form of a dividend.
Equity Compensation Plan
The Company maintains the 2004 Incentive Plan (the “Equity Plan”) which was approved by stockholders in April 2004. Executives, eligible employees and non-employee directors are eligible to receive options and restricted stock grants pursuant to the Equity Plan. Under the Equity Plan, options to purchase shares of stock, and restricted stock awards, can be granted with exercise prices and vesting periods determined by the Compensation Committee of the Board. The Company initially reserved 1.6 million shares of common stock for issuance under the Equity Plan. As of August 31, 2008, the Company has 1,445,000 shares that can be granted to eligible participants pursuant to the Equity Plan.
Stock-based compensation expense recognized in the Company’s statements of operations for the years ended August 31, 2008, 2007 and 2006, included:
(i)
Compensation expense for share-based payment awards granted prior to, but not yet vested as of, September 1, 2005. The stock-based compensation expense for these options was recognized pursuant to the pro forma provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), and
(ii)
Compensation expense for share-based payment awards granted subsequent to September 1, 2005. The stock-based compensation expense for these options was recognized pursuant to SFAS 123(R).
SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company uses the Black-Scholes option-pricing model (“Black-Scholes model”) for the pro forma information required under SFAS 123 as well as the compensation expense recorded pursuant to SFAS 123(R). Using the Black-Scholes model, the value of the portion of the award that is ultimately expected to vest is recognized as a period expense over the requisite service period in the statement of operations. Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. The Company does not expect any forfeiture of its option grants and therefore the compensation expense has not been reduced for estimated forfeitures. No options were forfeited by option holders during the three years ended August 31, 2008. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised if necessary, in subsequent periods if actual forfeitures differ from those estimates. The Company attributes the value of stock-based compensation to expense using the straight-line single option method for all options granted.
The Company’s determination of the estimated fair value of share-based payment awards pursuant to SFAS 123(R) on the date of grant is affected by the following variables and assumptions:
•
The grant date exercise price - is the closing market price of the Company’s common stock on the date of grant;
•
Estimated option lives - based on historical experience with existing option holders;
•
Estimated dividend rates - based on historical and anticipated dividends over the life of the option;
•
Life of the option - pursuant to the Equity Plan, all option grants have a 10 year life;
•
Risk-free interest rates - with maturities that approximate the expected life of the options granted;
•
Calculated stock price volatility - calculated over the expected life of the options granted, which is calculated based on the weekly closing price of the Company’s common stock over a period equal to the expected life of the option; and
•
Option exercise behaviors - based on actual and projected employee stock option exercises and forfeitures.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
During the years ended August 31, 2008 and August 31, 2007, the Company granted the following options to its directors pursuant to the Equity Plan. The stock-based compensation expenses calculated pursuant to SFAS 123(R) for these option grants is being expensed monthly over the vesting period.
No options were exercised during the year ended August 31, 2008.
During the year ended August 31, 2007, the Company issued 538,836 shares of common stock upon the exercise of stock options. The options were exercised at a price of $1.80 per share. The exercise price for the options exercised was paid for by the option holders utilizing 126,521 shares of Company common stock held by the option holders for more than six months with a combined market value at the dates of exercise totaling approximately $969,900, which was recorded as Treasury Stock at the time of exercise (see the Treasury Stock section below).
The following table summarizes the stock option activity for the Equity Plan for the year ended August 31, 2008:
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
The following table summarizes the activity and value of non-vested options as of and for the year ended August 31, 2008:
The total fair value of options vested during the year ended August 31, 2008 was approximately $195,400.
Stock-based compensation expense for the years ended August 31, 2008, 2007 and 2006, was approximately $351,500, $287,300 and $209,600, respectively.
At August 31, 2008, the Company has unrecognized expenses relating to non-vested options that are expected to vest totaling approximately $131,200. The weighted-average period over which these options are expected to vest is less than 1 year. The Company has not recorded any excess tax benefits to additional paid in capital.
Restricted Stock
On August 27, 2007, the Company granted 34,189 shares of restricted common stock to the President of the Company pursuant to the Equity Plan. The Company is recognizing compensation expense on this grant based on the grant date fair value of the stock. The grant date fair value of the restricted stock was based upon the closing sales price of the Company’s common stock on the date of the grant and is being amortized to compensation expense over the vesting term of two years. A summary of the status of the restricted stock at August 31, 2008, and changes during fiscal 2008, are as follows:
As of August 31, 2008, there was approximately $129,700 of unrecognized compensation expense related to restricted stock awarded under the Equity Plan, which is expected to be recognized over the following year.
Treasury Stock
Effective January 15, 2008, the Company changed its state of incorporation from Delaware to Colorado. This was approved by the Company’s stockholders at the annual stockholders’ meeting. Additional information regarding this change can be found in the Company’s Definitive Proxy Statement for its January 2008 annual stockholders’ meeting filed with the Securities and Exchange Commission on December 14, 2007. Colorado corporate laws do not permit a corporation to hold treasury stock. Therefore, effective with the reincorporation, the Company effectively retired the treasury stock reflected on its balance sheet. All the treasury stock held by the Company was acquired through mature share exchanges related to stock option exercises. The result of the treasury stock retirement was a reduction of the Company’s par value and additional paid in capital of approximately $2.0 million.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
Warrants
As of August 31, 2008, the Company had outstanding warrants to purchase 92 shares of common stock at an exercise price of $1.80 per share. These warrants expire six months from the earlier of:
(i)
The date all of the Export Water is sold or otherwise disposed of,
(ii)
The date the CAA is terminated with respect to the original holder of the warrant, or
(iii)
The date on which the Company makes the final payment pursuant to Section 2.1(r) of the CAA.
No warrants were exercised during fiscal 2008 or 2007. During fiscal 2006, the Company issued 15,520 shares of common stock upon the exercise of 15,520 warrants. The warrant holder paid the exercise price of $27,936 in cash.
Pledged Common Stock Owned by HP A&M
Pursuant to the Arkansas River Agreement, HP A&M pledged, transferred, assigned and granted to the Company a security interest in and to (a) 1,500,000 shares of Pure Cycle common stock, (b) all shares of Pure Cycle Common Stock hereafter issued to HP A&M by means of any dividend or distribution in respect of the shares pledged hereunder (together with the shares identified in (a), the “Pledged Shares”), (c) the certificates representing the Pledged Shares, and (d) all rights to money or property which HP A&M now has or hereafter acquires in respect of the Pledged Shares. The Pledged Shares are being held by the Company’s corporate legal counsel.
Registration Rights Agreement
Pursuant to the Arkansas River agreement the Company granted HP A&M one demand right to request the registration of 750,000 shares of Pure Cycle common stock and piggyback rights to register an additional 750,000 shares of Pure Cycle common stock.
Pursuant to the demand right, upon the request of HP A&M, the Company is required to file a registration statement for up to 750,000 shares of the Company’s common stock owned by HP A&M and to use its reasonable best, diligent efforts to cause the registration statement to become effective. Provided the Company exercises the appropriate efforts, it has no liability to HP A&M if the registration statement is not declared effective. Furthermore, HP A&M has no right to put its Company common stock to the Company or to otherwise require the Company to purchase its shares. As of August 31, HP A&M has not requested the Company to register these shares.
HP A&M exercised its piggyback rights in July 2007 and therefore the Company registered 750,000 shares of common stock held by HP A&M.
Voting Rights Agreement
Pursuant to the Arkansas River Agreement Mr. Mark Harding, the Company’s President, agrees to vote shares of Pure Cycle common stock owned by him (which totals 727,243 shares at August 31, 2008) for HP A&M’s designated board member (Mark Campbell).
Gain on Extinguishment of Related Party CAA Obligations and Debt
See Note 13 - Related Party Transactions regarding gain on extinguishment of related party CAA obligations and debt recorded as additional paid in capital.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 9: SIGNIFICANT CUSTOMERS
The Company had accounts receivable from two customers totaling approximately $63,800 and $61,200 as of August 31, 2008 and 2007, respectively. During the years ended August 31, 2008, 2007 and 2006, those same two customers accounted for 72%, 72% and 79% of our total revenues, respectively.
NOTE 10: INCOME TAXES
There is no provision for income taxes because the Company has incurred operating losses. Deferred income taxes reflect the tax effects of net operating loss carryforwards and temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets as of August 31 are as follows:
The Company has recorded a valuation allowance equal to the excess of the deferred tax assets over the deferred tax liability as the Company is unable to reasonably determine if it is more likely than not that deferred tax assets will ultimately be realized.
Income taxes computed using the federal statutory income tax rate differs from our effective tax rate primarily due to the following for the years ended August 31:
At August 31, 2008, the Company has approximately $12.2 million of net operating loss carryforwards available for income tax purposes which expire between fiscal 2009 and 2023. Utilization of these net operating loss carryforwards may be subject to substantial annual ownership change limitations provided by the Internal Revenue Code. Such an annual limitation could result in the expiration of the net operating loss carryforwards before utilization.
Net operating loss carryforwards of approximately $315,400, $1.1 million and $430,300 expired during the years ended August 31, 2008, 2007 and 2006, respectively.
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 11: 401(k) PLAN
Effective July 25, 2006, the Company adopted the Pure Cycle Corporation 401(k) Profit Sharing Plan (the “Plan”), a defined contribution retirement plan for the benefit of its employees. The Plan is currently a salary deferral only plan and at this time the Company does not match employee contributions. The Company pays the annual administrative fees of the Plan, and the Plan participants pay the investment fees. The Plan is open to all employees, age 21 or older, who have been employees of the Company for at least six months. During the years ended August 31, 2008, 2007 and 2006, the Company paid fees of approximately $2,400, $3,400 and less than $1,000, respectively, for the administration of the Plan.
NOTE 12: SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES
PURE CYCLE CORPORATION
NOTES TO FINANCIAL STATEMENTS
AUGUST 31, 2008, 2007 AND 2006
NOTE 13: RELATED PARTY TRANSACTIONS
On July 30, 2007, the Company acquired approximately $10.5 million of CAA interests, for cash payments totaling approximately $2.6 million, resulting in a gain on extinguishment of approximately $1.02 million. Certain of these parties were deemed related to the Company and therefore, approximately $765,000 of this gain was recorded as a contribution of capital in fiscal 2007.
The Company paid HP A&M approximately $49,700, $37,200, and $0 during the years ended August 31, 2008, 2007 and 2006, respectively, for fees related to work performed by an HP A&M employee on behalf of the Company as it relates to operations of the agricultural property owned by the Company in the Arkansas River valley.
See Note 7 above regarding Tap Participation Fee payments made to HP A&M pursuant to the Arkansas River Agreement in fiscal 2007 as a result of the sale of LAWMA Shares.
In October 2007, the Company repaid approximately $26,500 to a party related to our former CEO, Mr. Thomas Clark. This represented the only remaining note payable with a scheduled maturity.
The Company leases office space from the estate of the son of its former CEO. The Company leases the office space on a month-to-month basis for $1,000 per month.
In 1995, the Company extended a loan to the District, a related party. The loan provided for borrowings of up to $250,000 is unsecured, bears interest based on the prevailing prime rate plus 2% (7.0% at August 31, 2008) and matures on December 31, 2008. The approximately $494,800 balance of the note receivable at August 31, 2008 includes borrowings of approximately $229,300 and accrued interest of approximately $265,500. The Company extended the due date to December 31, 2009 and accordingly the note has been classified as non-current.
NOTE 14: SUPPLEMENTAL DATA: SELECTED QUARTERLY FINANCIAL INFORMATION (unaudited)
*****
Item 9
Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
There were no changes in or disagreement with accountants on accounting and financial disclosures.
Item 9A
Item 9A - Controls and Procedures
(a)
Evaluation of Disclosure Controls and Procedures
Our management is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in the Exchange Act Rule 13a-15(f). Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP.
The President and Chief Financial Officer assessed the effectiveness of internal control over financial reporting as of August 31, 2008 based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based upon this evaluation, the President and Chief Financial Officer concluded that the Company’s disclosure controls and procedures have been designed and are being operated in a manner that provides reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. A system of controls, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the system of controls are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.
(b)
Management’s Report on Internal Control Over Financial Reporting
The management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934. The Securities and Exchange Act of 1934 defines internal control over financial reporting as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America and includes those policies and procedures that:
•
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
•
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
•
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management assessed the effectiveness of the Company’s internal control over financial reporting as of August 31, 2008. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment, we determined that, as of August 31, 2008, the Company’s internal control over financial reporting was effective based on those criteria.
GHP Horwath P.C. (“GHP”) our independent registered public accounting firm has performed an audit of the effectiveness of the Company’s internal control over financial reporting as of August 31, 2008. This audit is required to be performed in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our independent auditors were given unrestricted access to all financial records and related data. The report of the Company’s independent registered public accounting firm is included in Item 8. Financial Statements and Supplementary Data.
(c)
Changes in Internal Controls
No changes were made to our internal control over financial reporting during our most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 9B
Item 9B - Other Information
None
PART III
Information concerning Items 10 through Items 14 will be contained in our definitive Proxy Statement pursuant to Regulation 14A promulgated under the Securities Exchange Act of 1934 for the 2008 Annual Meeting of Stockholders and is incorporated herein by reference, which is expected to be filed on or about December 12, 2008.
PART IV
Item 15
Item 15 - Exhibits and Financial Statement Schedules
(a)
Financial Statements
1.
See “Index to Financial Statements and Supplementary Data” in Part II, Item 8 of this Form 10-K.
2.
Financial Statement Schedules: None
3.
Exhibits: The exhibits listed in the accompanying “Index to Exhibits” are filed or incorporated by reference as part of this Form 10-K
Index to Exhibits
*
Filed herewith
**
Indicates management contract or compensatory plan or arrangement in which directors or executive officers are eligible to participate.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
PURE CYCLE CORPORATION
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacity and on the dates indicated.
EXHIBIT INDEX