|Shares Out. (in M):||16||P/E||0.0x||0.0x|
|Market Cap (in M):||101||P/FCF||0.0x||0.0x|
|Net Debt (in M):||85||EBIT||0||0|
Elevator Pitch: Distressed water extraction project facing what are likely insurmountable hurdles to approval. Significant existing debts and visibility of project economics offer conviction that there is little chance for any positive equity value. Near-term catalyst from resolution of CEQA litigation.
This idea has been previously covered on VIC before but, in our view, is as timely as ever. Accordingly, I will offer a broad review of the thesis, summarize recent key developments, and draw attention to the pending CEQA court ruling which offers a potential near-term catalyst. The recent drought-inspired rally aside, CDZI is a distressed credit in which the lenders appear to be very firmly in control, and I find it extremely difficult to conjure up a plausible scenario in which the equity retains any meaningful value.
Estimating the project’s maximum potential revenue is facilitated by the presence of signed LOIs for CDZI’s water as well as established maximum allowable extraction volumes, which are stipulated by the company’s various environmental approvals to date. To this one can apply management’s estimates of project operating costs, initial start-up costs (which appear significantly understated at $250mm), start-date, and life expectancy to determine project value. Even when assuming an extremely generous, municipally-backed refinancing of CDZI’s debt (i.e. a 0% 50 year note), assuming the company is able to use the full face value of its NOLs, and applying a discount rate only modestly above the company’s current cost of debt, I find it difficult to generate meaningful positive equity value for the project. There are several reasons why I believe these estimates to be unduly conservative, not least of which being that extraction must stop if there is observable drawdown in the water table at any point. Given the arid desert climate and management’s stated intention to pump water at a rate well above their own apparently aggressive estimates of the natural recharge rate, I view this outcome as being more likely than not.
CDZI faces several hurdles it must overcome before it has a shovel-ready project on its hands. These principally include:
To summarize the opponents, in the red corner we have a wide ranging of interest lining up to kill this project, including:
Fundamentally, the merits of the project rest upon the complex process of analyzing the potential impact of the project on the hydrology of the region. This is a difficult process of geological guesswork, and assessments vary widely as to the nature of the aquifer. Getting these numbers wrong has potentially severe consequences as a drawdown of the aquifer is likely to cause irreparable damage, not to mention directly threaten the operations of the only other significant economic activity in the immediate vicinity, the Tetra salt works.
We have no ability to assess the hydrology but question the fundamental ability to accurately predict the behavior of the aquifer with any degree of precision given the complex, interrelated nature of these systems, and believe that the preponderance of geological surveys of the area suggest that the company’s estimates are aggressive, as they represent a significant outlier in comparison to all other independent estimates. The aggressiveness of management’s assumptions are compounded by their proposed plan to pump water from the project site at a rate above their own (Likely inflated) estimate of the area’s natural recharge rate
These estimates include surveys by the USGS, which is the only evaluating party not to have a dog in the fight, while the company hired CH2M Hill to prepare its own estimates. Simply put, we question as to why there is such a significant variation in estimates, and, given the irreparable consequences that would likely be inflicted upon the aquifer and the surrounding region (including a significant portion of the Mojave National Preserve), I would hope that the courts will apply the experience of the Owens Valley disaster and err on the side of caution.
CEQA is a notoriously complicated and arcane law, and I will largely leave the legal handicapping here to more qualified parties. However, I will highlight a few points I believe are relevant to assessing the potential outcomes of the litigation. Although CDZI’s press releases have joyfully touted the dismissal of the initial series of lawsuits, we do not believe that these dismissals offer much informational content about the merits of the current cases. The first of these cases was brought by labor union interests, who in our view were likely looking to secure union jobs on the project, while the second case was brought by a local archaeologist, whose case collapsed for what we believe to be procedural reasons and limited financial resources.
The remaining lawsuits come from parties which we believe have significantly better standing to challenge the project under CEQA as well as much greater financial resources. These parties have retained well-known law firms with significant experience in California environmental litigation. A decision on these cases is due in the next 90 days or so and offers an asymmetrical catalyst for shorts: if the litigation succeeds, we believe it will likely be terminal for CDZI; if not, they have a whole host of other challenges to address before they can start pumping. For what its worth, one of the parties (The Center for Biological Diversity) touts a >90% success rate in its legal challenges in its marketing materials, although this is likely to be somewhat self-serving spin.
The second point worth highlighting is that CA courts tend to regard the testimony of public agencies in CEQA cases as being highly credible, which we believe will generally favor the plaintiffs in this case. However, as is typical of much modern legislation, the standards which CEQA seeks to apply are vague and subjective and have been interpreted in a number of ways by courts, who generally apply their own standards as they see fit, as no one has ever bothered to defined the “thresholds of significance” which the law establishes as a standard. However, to challenge the project successfully, the plaintiffs will likely have to demonstrate either that Cadiz is defining the scope of the project inconsistently (a potentially cogent line of argument given that the project’s stated goals have evolved from extraction to ‘conservation’ over time, and simultaneously depict the project’s application as being both for extraction and storage), argue that SMWD inappropriately delegated to San Bernardino County (this seems to be a more difficult charge), or demonstrate that the EIR inadequately addresses potential risks. The latter of these arguments seemingly offers the most promising line of argument, but the logical and rational appeal of this argument must be set against the fact that the courts have generally upheld conclusions of EIRs if they are supported by “substantial evidence”, even if project opponents can produce “substantial evidence” to the contrary. Welcome to the judicial, Kafka-esque administrative hell created by sloppy if well-intentioned legislation, which benefits lawyers as much as it does the environment.
Demonstrating minor errors in the EIR will not be sufficient, and any challenges must generally be limited to issues brought up during the initial administrative review process. Given the long history of the project, we believe that the latter concern is not likely to be an issue in this case, as the opposition here has been in place since well before the most recent CEQA EIR was drafted. Furthermore, from my perspective it seems difficult to argue that the Draft Environmental Impact Report (EIR) adequately addresses the potential concerns of Tetra, whose salt-mining operations are vulnerable to any potential changes in the hydrology. Given CDZI’s distressed position, and the challenges it would likely face if the project were halted, we fail to see how CDZI’s proposed solution of financially compensating Tetra for any future losses is a reasonable remedy; if they can’t pay Tetra now, how could they compensate them if their only source of revenue evaporates (sorry couldn’t help this one)?
Furthermore (and this is ancillary to the CEQA litigation) I believe that the project does not comply with San Bernardino County Code, to whit:
Section 33.06553 of County ordinance defines Groundwater Safe Yield as the “maximum quantity of water that can be annually withdrawn from a groundwater aquifer (i) without resulting in overdraft (ii) without adversely affecting aquifer health and (iii) without adversely affecting the health of associated lakes, streams, springs and seeps or their biological resources.
But that is perhaps another challenge for another day; the crooked County Supervisor overseeing the approval process is long gone, having already been run out of office after it came to light that he had been a significant recipient of donations from CDZI, a fact which he failed to disclose in his hurry to approve the project against significant grassroots opposition.
A CEQA victory for CDZI would likely cause short-term pain for shorts, but the real challenges for the project would just be beginning, despite management’s airy depictions of the project as being practically shovel-ready.
CDZI needs to figure out how to deliver water to customers and has 2 proposals in place to move its water from the middle of nowhere desert to the California water system:
1) Re-using existing railroad rights of way
2) Using a 96.0mi pipeline acquired from EPNG
We believe option 1 is an unambiguous impossibility.
We believe there is a substantial body of evidence supporting the view that railroad rights of way cannot be used for non-railroad uses, and that CDZI’s evolving attempts to end-run around this will not be successful. CDZI originally attested that the pipeline would meet a railroad use as it will provide ‘fire suppression’ along the route, but now plans to build a scenic steam railway. While a historic, tourist-oriented railway is certainly an allowable railroad use, we do not believe that this is some sort of minimum threshold which then permits CDZI to utilize the right of way as it sees fit, i.e. they cannot then just set up a pipeline, install fiber-optic cable, high voltage transmission lines, whatever. Furth more, as discussed in the past write-up, the review of the rights of way must be conducted by the Department of the Interior and not by the local office of the Bureau of Land Management due to specific clauses in the law inserted by Dianne Feinstein in her bid to kill this project.
Option 2 presents its own hurdles, namely that this project also requires a further CEQA review. We struggle to see how the company’s current capital structure will allow it the time and resources to weather another CEQA battle, even if its lemon-farming gambit is wildly successful (not a joke, more on this later). If the current plaintiffs are unsuccessful in their CEQA litigation, we would not be surprised to see them have another crack at CDZI in any subsequent review surrounding the pipeline project. An additional CEQA review has the potential to further push the potential date of project completion much further down the road, and would likely be another expensive time-suck for CDZI.
This was covered in the last write-up, but MWD is one of the biggest water buyers in the state and carries significant weight in the California water system. MWD hates CDZI. This is a big problem.
There has been a lot of back and forth between the company and potential customers about the chromium content of its water. CDZI maintains that the levels of hexavalent chromium are somewhere in the range of 10-16 parts per billion, that this is safe, and that this is a result of the naturally occurring geology, and not from the site’s history as a military training center and ordnance test-range. Under the current standards, this level of chromium is acceptable, but these standards had not been updated for some time. In a more recent development from last year, the California Department of Public Health decided to update these standards, proposing a maximum level of 10 parts per billion, and will make a final ruling sometime in 2014 if no further delays occur after the comment period closed late last year. If this Maximum Contaminant Level is adopted, it will pose a further barrier to CDZI in the form of additional capital costs for on-site treatment facilities as well as incremental opex costs ranging somewhere between $150-$40/acre foot, according to the CEO. In our view, this alone would potentially wreck the project economics, unless CDZI was able to convince its customers to take up this burden, which we view as questionable given an all-in price to end-customers which already exceeds $1,000/AF.
Who’s Going to Pay for All of This?:
Even if CDZI’s legal hurdles were to end tomorrow, the company would need to figure out how to come up with the $250mm necessary to finance the project build-out. This figure is supplied by management and we view it as likely being a minimum figure, noting that their estimate has gradually increased over time and does not include the potential contingencies discussed above (i.e. additional treatment). Accounting for some incremental cash burn, we estimate that CDZI’s net debt today is probably somewhere around $90mm. CDZI claim they have sufficient liquidity to survive until mid-2015, which is probably about right if maybe a little optimistic, as it seems to be assuming that their legal expenses disappear once the current litigation is settled.
CDZI recently completed a major refinancing after its primary loans were discharged at a significant discount by the holders to a distressed buyer, MSD Capital (Michael Dell’s family office). MSD consolidated the company’s debt and offered a new senior tranche of $10mm at 8% due 06/30/17 (PIK, no payments until maturity), while moving $31mm of the company’s existing debt to 2016 and another $55mm to 2018. MSD gets the proceeds of any land sales after the first $5mm, and also gets 700k shares of equity at a nominal cost, with some restrictions on their ability to sell.
At MSD Capital’s likely low basis in the existing loans, we can see how the economics of this deal may make sense for them given the potential downside value of the land (which is generally quite minimal in our view, unless Michael is looking for a spot for a new ranch). However, we can’t see how any future lender would want to participate junior to MSD unless we are talking about some kind of sweetheart municipal deal (not impossible, but probably not very likely either given the increasing public distaste for such deals).
We view the significant debt burden, MSD Capital’s distressed purchase of the loan, the terms imposed by the lenders, and the liberal issuance of equity to lenders as evidence of the lotto-ticket nature of the equity stub here.
CA Drought – A Lifeline to CDZI?:
Shares of CDZI seem to have enjoyed a big run-up due to the most severe drought in the recorded history of the state, as well as on the buying from a handful of institutional investors. I am not especially concerned about these buyers (a dedicated water fund, a mysterious pharma billionaire with a history of high-stakes gambles in small-cap names, 1 small fund, & Crispin Odey) with perhaps the exception of Odey. I can only speculate as their potential motivations, other than to note that a speculator might view CDZI as an opportunistic vehicle for trading CA drought news. 2 other significant holders with bigger stakes than these parties (Altima & Zesiger) seem to have been trapped in the stock for several years and appear to be slowly unwinding their sizeable positions, so I think the technical dynamics generally favor a short unless one of the existing buyers decides they want to own >10% of the company. Not impossible, but given the fundamental situation I am willing to sell to any willing buyer here, no matter how fancy the name on their door might be.
The drought has led the President to pledge a $183mm of existing federal funds for drought relief programs in CA, which seems to largely be going to existing water distribution infrastructure in and around the distribution bottleneck of the San Joaquin Valley. There are various other state and federal funding proposals under way, none of which seem likely to end up in CDZI’s pockets at present. If anything, we believe additional emergency funding measures could very well end up detracting from the potential economics of the CDZI project as the most cost-effective (not to mention politically palatable) targets for funding will be further efficiency and conservation measures rather than expensive extraction projects. Simply put, a lot of water can be freed up through some simple, common sense steps, such as imposing water metering across the state, or by paying farmers to upgrade to more efficient systems of irrigation. This discussion entails a much larger conversation than appropriate for this write-up, but much of CA’s water problem seems to be needlessly self-inflicted, largely being the product of inefficient, nonsensical agricultural practices, such as the general reliance on flood irrigation and the cultivation of water-intensive crops in the desert, etc., and we believe there is a significant amount of water supply which can be freed-up at significantly lower cost than buying water from CDZI.
When Life Gives You Lemons….
One more updated development worth highlighting is management’s decision to lease 320 acres of land to Limoneira to farm lemons in mid 2013. Limoneira has an option to plant up to 1,280 acres in total over the next 5 years, at $200 an acre + 20% of the net cash proceeds of the harvest, not to exceed $1,200/acre, as well as some participation rights in the project. This is a very small-scale farming operation (my grandmother farms more acreage) and the proceeds are unlikely to come close to paying for the company’s significant ongoing overhead.
We believe that this development speaks to the remote chances of a near-term development of the project, as CDZI is receiving significantly less for its water rights than it would have by selling this water on to municipal users. Furthermore, we have our doubts about the commercial viability of this project and question whether the CEO may have inappropriately used his position on the board of Limoneira to secure a nominal commitment from the company (which Limoneira may have little intention of fulfilling) in order to bolster CDZI’s prospective negotiating position with lenders.
|Subject||Post CEQA Update|
|Entry||05/21/2014 12:50 PM|
My apologies for not updating this sooner.
As the original write-up had contemplated, the court upheld the draft EIR certified by SMWD, and upheld the County’s approval of a Groundwater Monitoring Mitigation & Management Plan as well as the MOU related to the proposed groundwater extraction. It seems that the ruling reflects the narrow judicial scope of CEQA review and did not address the key hydrological assumptions of the project. My sense had been that a CEQA challenge was always going to be an uphill battle, but a loss here is disappointing if not terribly surprising given the incoherent nature of CEQA and the limited basis upon which CEQA EIRs can be challenged.
CDZI shares rose almost 30% following the announcement, but this was always likely the weakest catalyst for shorts and the victory ultimately does nothing to remove the most significant hurdles between equity holders and the future cash flows of the proposed water project. We retained a significant short position prior to the announcement in the belief that a negative ruling from the court would have been terminal for CDZI, while a victory would offer short-term pain but would do little to move the project towards being a shovel ready project. If you’ve been sitting on the sidelines, we believe this valuation offers an extremely compelling entry point with very little possibility of permanent loss of capital.
To recap, we will offer a little bit greater detail of the project economics which were somewhat glossed over in the initial write-up, in case one gets the impression that this thesis hinges on arcane legal and hydrological matters; at the end of the day, the thesis rests on the dubious economics of the project. The bull thesis seems to be that the project is worth several multiples of the stock price if it moves forward; while this may have been the case several years ago, the existing leverage burden and the growing potential scope of the project make this assumption tenuous. Instead, we believe the current price more than discounts the most highly optimistic outcomes for Cadiz, which in any case we view as being patently unrealistic.
Management assumes initial capex of $200-$250mm, which can then be recovered over 30 years in the form of a surcharge to the customers, and assumes that construction can begin in late 2015, with first water being shipped in 2017 (although this seems to assume there are no hurdles relating to distribution, which is an assumption I question). We take the mid-point of this capex estimate, and also take at face value management’s assumptions of $75/AF of opex (again, excluding any potential incremental treatment costs), and assume the project is consistently able to extract the full 50k AF/pa over the 50 year life of the project. Even if we assume there are no financing costs, no SG&A spend, full use of the NOLs, and assume a 5% discount rate, the project’s lifetime NPV is some $295mm, suggesting modest upside to equity from current levels. If we make even modestly realistic assumptions, however, this value plummets. If we assume the project can be fully funded by low cost debt (5%, implying a massive refinancing of existing debt), SG&A drops to $3.5mm p/a (a small fraction of the company’s historical run-rate to date), and apply a 6% discount rate, this NPV gets cut in half to some $150mm. How do we then reconcile this to the current enterprise value of some $215mm+, and against a credit which is currently paying 8% + an equity kicker to distressed debt investors to borrow? We believe the creditors own this project, and that the sums required to advance the project make it unlikely that current equity will participate in the Cadiz project even if it moves forward in a timely fashion.
And so, with that in mind, we return to the project timetable, and why the project remains far away from being shovel ready:
Assuming that there is no further appeal, CDZI must now address the question of how it would connect its water to California’s distribution system. We previously touched on why we felt the company’s preferred option (using existing railroad rights of way) was an unambiguous impossibility, but did not fully elaborate on the difficulties involved in the company’s proposed back-up plan – using an existing natural gas pipeline running from Cadiz to Barstow, CA (thanks to the thoughtful consideration of another VIC member for reminding us of how dubious this option is). The Bureau of Land Management is likely to comprehensively close off the original railroad right of way option before too long (although assessing the timing of a ruling here is speculative), which will highlight the numerous questions surrounding the proposed Barstow solution.
Barstow is still some 60 miles away from the California aqueduct (the nearest large waterway), and unlike the vicinity surrounding Cadiz, the area between Barstow and Victorville is comparatively developed; this would not merely be a matter of laying pipe through empty desert. We believe this option would significantly increase initial capex, not to mention necessitate a further series of lengthy and time-consuming approvals. We find it difficult to reconcile the challenges associated with the Barstow solution with the NPV calculations we have made above, and that this is a likely insurmountable hurdle for the project as it stands.
The distribution issue is a major problem for equity holders, but less so for CEO Scott Slater (https://twitter.com/slaterwaterlaw if you want to see what he does on a day to day), who can continue to draw a salary, maintain an office, and funnel millions of fees to his partners at Brownstein Hyatt Farber Shreck LLP while the never-ending Cadiz saga drags on. With their options now buried well out of the money, we believe management has only a moderate interest in seeing the project get built in a timely fashion and would probably rather just draw this one out for as long as possible so as to suck as much money out of their public vehicle as they can. It is worth noting that management’s compensation has typically reflected what we view to be the maximum possible draw against the company’s liquidity at any given time, and we believe that run-rate SG&A expenses are likely to be not insignificant should the project actually move forward, despite our relatively modest assumptions made about SG&A in our NPV calculations.
A further reminder on the chromium content issue discussed previously; the original standard contemplated for a vastly elevated chromium threshold will become law barring any objections from the Office of Administrative Law, which will make its final determination by 05/30/14. If this standard is upheld, it will add another significant layer of capex and opex cost for Cadiz and make the above discussion of project NPV almost wholly irrelevant, above and beyond the Barstow hurdle. Combined, a pending BLM decision and the final announcement of chromium limits present another set of short catalysts, above and beyond the eventual question of how the project gets financed without wiping out current equity.
At the time of this update, a small borrow was available at a modest low single digit rate. Although the liquidity here limits this opportunity to small funds and personal accounts, we believe the visibility of the prospective project economics offer an extremely high level of conviction in assessing what we to believe to be an inordinately favorable risk/reward.
|Entry||05/22/2014 02:45 PM|
looks like insiders have purchased nearly $800k worth of stock this month @ $7.93-8/share.
|Entry||04/21/2015 07:36 PM|
|Entry||04/21/2015 08:08 PM|
just goes to show investing acumen is not genetic. i was part of a team to represent disque dean and found him to be a brilliant investor. his son, jr., apparently not according to the SA article
|Subject||dont see cdzi mentioned in this article|
|Entry||04/25/2015 11:06 PM|
about water asset management http://online.barrons.com/articles/water-asset-management-hunting-liquid-assets-1429925102?mod=BOL_hp_highlight_4
|Entry||10/06/2015 08:38 PM|
pretty much as expected: