Situation Overview: CDZI equity is overvalued.  It’s essentially generated no meaningful revenue or profit in its entire existence, and its primary water project which has the potential to justify the current ~$162MM market cap will likely not move forward.  A potential catalyst within the next 90 days signaling the project is not as easy to complete as the company expects presents a nice timing to enter an asymmetric risk-reward situation.

Company Overview:  Cadiz is a renewable resource company which owns 45,000 acres of property 200 miles east of Los Angeles used for (i) organic agricultural operations, and (ii) a proposed water project designed to extract groundwater from the Mojave Desert.  The company is led by CEO Keith Brackpool. You can read about Keith here: http://waterindustry.org/New%20Projects/cadiz-2.htm. His other job is Chairman of the California Horse Racing Board.

CDZI has a market cap of ~$162MM.  Aside from ~$13MM of cash ($11MM raised in Q4 results in 15.4MM common shares currently outstanding), CDZI’s only assets are its real estate.  The company has a $55MM secured private placement convertible note which has traded hands several times PIK’ing at 6% suggesting a total enterprise value of ~$205MM.  The company essentially generates no meaningful revenue today except from farming of just 420 acres of land (<1% of total property) for raisins and lemons.  The company is relying on the water project to justify itself.  It burns about $10MM a year for the overhead (including $4MM in stock based comp) and the PIK adds another $3MM (total of about $1 / share per year).

Water Project Overview and Economics:  Cadiz is hoping to extract water from beneath the Mojave Desert and transport it to Southern California.  This system would require (i) a +40 mile pipeline to its destined pumping station to place the water on Metropolitan Water District’s (“MWD”) aqueduct, (ii) a water delivery and storage agreement with MWD and potentially other water utilities (iii) environmental permits, and (iv) capital.  CDZI currently has soft commitments to purchase 50,000 acre feet of water per year and is in various stages of completing the rest.

Before explaining the challenges to items (i), (ii), (iii) and (iv), let’s just assume for the moment that CDZI pulls this off.  The existing water purchase agreements specify that CDZI would generate ~$775 / acre-feet in revenue with an estimated $60 / acre-feet in opex.  In terms of validating these assumptions, the $775 / acre-feet revenue figure is fairly high.  For reference, the spot water price in the region is generally $250 to $350 / acre-feet.  If you add in certain fees, one could argue that the all-in cost would approach $500 / acre-feet.  However, with limited options for guaranteed long-term water supplies, the demand does exist to pay a premium (though MWD officials will say that given current water supply there is a ~1% chance that water rationing will be required in the next ten years).  CDZI has various commitments or LOIs with 7 different water agencies for approximately 50,000 acre-feet of water per year. This represents the entire delivery capacity of the project.  Each of these LOIs prices the water at the $775/ acre-feet figure.  It’s worth noting that the final cost to the consumer will probably end up in the $1,000+ area because the first hub the water passes through (the MWD) will charge a ~$350 wheeling fee (CDZI will not share in any additional revenues).  But with that background, we’ll assume for the time being that CDZI gets 2x the spot price in exchange for the long-term contract and its opex assumptions are reasonable.

Assuming CDZI’s 50,000 acre ft estimate, this suggests ~$36MM in annual EBIT (yes, your math is the same as mine, that’s a 92% EBIT margin).  Assuming 5% cost of capital for ~$250MM (lower than CDZI’s estimate of $277MM with steel prices largely unchanged), of financing, EBT of $23.3MM.  CDZI has at least $185MM of federal and state NOLs plus another potential $44MM of NOLs dependent on a legal settlement.  Let’s just assume the NOLs are clean and applicable such that EBT = Net Income for the time being.  This equates to ~$1.50 / share in non-GAAP (e.g. cash) EPS so you could argue CDZI trades at 7.1x potential earnings.  Since this would be a contract water supply arrangement with infrastructure-like properties, let’s just assume 15x earnings is doable so the equity value could double to $20+ / share (this would be muted somewhat by the converts with conversion prices between $7.00 and $13.50, depending if they are exercised as currently planned or re-negotiated as they have been in the past).  As a data point, the share price peak of ~$26.60 was reached in 2007 so given the expenses since then, I feel fairly comfortable with this as a reasonable worst case outcome for the short.  I feel very strongly this is a very low probability event, but in shorting a small-cap, it’s worth knowing the extent of how bad it could be.

A less bullish bull view could be that a contracted asset like this should trade at ~15x EBIT or $525MM of enterprise value.  Less the debt they raise and just treating the existing converts as debt, equity value would be $230MM equating to a $15.30 share price, which shows a downside to the short of about 41% from current levels.  It’s worth noting that the conversion prices for the convertible debt have been changed several times as the company has been negotiating to extend the maturities.  It’s possible this occurs again.  It seems as lenders have been fairly generous to CDZI, so building in a further margin of safety here, if you think of the converts as debt, you could be surprised to the upside since their convertibility would only drain more value away from existing common shareholders.

Challenges to the Project:  story short, I do not believe this project which has been in the works for at least 12 years, now in its second iteration, will get off the ground.  Here are a few of the complications:

1. Cadiz’s water project was first proposed in 2000. At the time there was a significant lack of water storage available for southern California. Seeking to fill this void, MWD (the agency responsible for delivering water to 19 million people in 26 cities across Southern California) agreed to sponsor Cadiz’s water project for the primary purpose of storing water in its underground aquifer. While MWD was open to pumping existing water from the aquifer, the primary motivation for the project was storage. Because many water experts and environmentalists felt that pumping water from Cadiz basin was unsustainable and would have an adverse effect on the environment (including the recently established Mojave National Preserve) the project was highly controversial. Sen. Feinstein, who was instrumental in establishing the preserve and advancing the protection of endangered species such as the desert tortoise, actively worked to stop the project. In the end, MWD decided to back out, citing concerns about the risk that an excessive drawdown of the basin or other unforeseen issues (such as a high levels of chromium in the aquifer) could cause the project to be halted after construction and leave MWD holding the bag for several hundred million dollars.  Now, MWD hates Cadiz because of a subsequent lawsuit.
2. The project itself has potential environmental problems.  Sucking water out from underneath the desert (or any land for that matter) can have dangerous consequences including potential sink holes, permanent damage to the underlying aquifers, damage to local ecology, etc.  Conversations with Sen. Feinstein’s office (D-CA), officials at the Mojave National Preserve and a representative of area Native American land conservancy indicate that there is significant and powerful opposition to the project (honestly, you could probably stop reading here).  These groups were successful in killing the project a decade ago. Now with a less influential agency partner (e.g. MWD is not on board), I believe the same result is likely.
3. Water rights are extremely complicated.  Resolving disputes can take a decade or more, and these disputes often continue in perpetuity.  The short story is that there are numbers of precedents involved and it can quickly escalate to a major political mess.  For example, water rights are generally viewed as perpetual where a first mover gains immense advantages.  Water availability in the Southwest is a fierce issue, and any actions that may affect others pre-existing rights or prevent others from tapping the new resource in perpetuity generate immense local, county, state and federal interest.  Not to complicate the matter further, but tribal matters also disrupt this given arcane water rights precedents allowing any nearby tribe to lock up the project.
4. Cadiz has claimed that an opinion from the office of the solicitor exempts them from the federal review process through the Bureau of Land Management. We have reviewed this opinion.  Unless you think a water project is a railroad use, I think the reading should be the exact opposite. If this is the case, then they have a MUCH more difficult road ahead just as cable/fiber layers who tried to use railroad ROR’s experienced.
5. ‘Mining’ of the aquifers can result in increased dust storms.  Recently, this has caused severe damage to local agricultural in Arizona and is attracting significant scrutiny.
6. Land near this area is under immense scrutiny for the protection of local wildlife, namely the desert tortoise.  This may sound like a joke from an outsider, but the deserts are replete with special fixtures to allow the tortoise to move without interference.  This will add to costs and put certain environmental lobbies against CDZI.

Furthermore, even if the project gets built, there are multiple events that could cause it to be shut down or constrained after completion.  These issues include observable drawdown in the aquifer, sink holes, and potential water quality issues (some have reported high chromium levels in these water sources).  With those issues present, not only would you have to worry about a subsequent bankruptcy / liquidity problem, but it also highlights the problems with financing.  I think my assumption of a 5% cost of capital is too low.  In speaking with one of the current shareholders, the bull belief is that the ~$277MM of financing can be obtained at municipal bond rates.  Without the sponsorship of MWD and extreme opposition from Feinstein and other political bodies, that might be too optimistic.

Expected Value Analysis:  I’m generally not a believer in straight expected value analysis, but it’s helpful to (i) frame the likely scenario paths and (ii) back into the street’s implied probability of project approval.  The event path below is designed for the long-term perspective but it’s difficult to ignore the short-term.  If the company runs into a regulatory or political roadblock sooner, shares will fall sharply in the near-term but I lack the crystal ball of how much option value the street will leave in the valuation.  My suggestion is you use these events as potential outcomes with varying points in time, and you use your own judgment to assign probabilities.

Method #1: Multiple scenario analysis

Event A: Project is completed below budget with 5% financing.  CDZI is re-rated to 15x P/E (e.g. 6.7% earnings yield) on $1.50 of earnings.  Tax NOLs are fully applied, existing debt is extinguished with minimal dilution and street looks optimistically to cash EPS instead of GAAP EPS.  Ending share price of $22.50.  Expected probability of 10%

Event B: Project is built but trades to 15x EBIT.  Ending share price of $15.30.  Expected probability of 10%.

Event C: Project is built but requires 10% debt resulting in $0.70 of EPS but still trades to 15x P/E.  Ending share price of $10.50.  Expected probability of 10%.

Event D: Project is built but then is shut down or constrained after completion with $250MM-$300MM of debt outstanding.  Roller coaster ride, but eventual bankruptcy filing results in zero value for equity holders.  Expected probability of 10%.

Event E: Project is not built and CDZI gives up quickly.  Asset value of ~$45MM or $1,000 / acre of desert and agricultural land not sufficient to cover existing debt holders.  Zero value for existing equity holders.  Expected Probability of 10%

Event F: Project is not immediately built, but CDZI vows to keep up the fight for several years.  Equity continues slow burn of ~$1 / share per year.  While ultimately headed to zero, for next 2 years, CDZI keeps shareholders enticed but loses the $2 / share in opex.  Temporary share price of $8.70.  Expected Probability of 30%.

Event G: Project faces extreme opposition and it becomes very clear the project will not be completed regardless of CDZI’s efforts.  Zero value for existing equity holders.  Expected probability of 20%.

Looking at these events, and understanding they may not be on the same time scale, this results in an expected value of ~$7.44 per share offering 30% returns to the short in the near-term.  We would note that shares traded hands below this level in November briefly and there have been no fundamental reasons for the advance other than a capital raise and issuance of a draft environmental report.  Given these were two potentially positive catalysts, the next catalyst will likely be a negative one.  The next event here is for an opponent to establish their position and scheme for opposition.  This has not yet happened and is very likely to occur in the next 90 days.  Eventually, if the event paths progress such that you gain comfort the project will not or cannot be built, you have a more clear path to a zero.

Method #2: Implied street probability of approval

Let’s just make the math easier and assume either the project is approved or not.  If approved, the share price goes to $22.50, and if not, it’s worth zero.  At the current share price of $10.70, this implies the market believes there is a 48% chance of the project moving forward quickly, ignoring any time value of money or discount for potential risks.  You can see in the Method #1, the total probability of the project being built adds up to 40% with a following 25% chance the project is shut down after construction.  I would say my margin of safety is embedded in this analysis because my gun-to-the-head answer on expected probability of project completion is probably less than 20%.

Conclusion:  The equity is probably a slow-burn zero here.  While the debt matures in 2013, the holders seem to be philosophical supporters of the cause and probably don’t represent as hard a catalyst as one would think.  The Company has financed itself through synthetic equity issues (e.g. converts which just lower convert prices instead of payouts) to the detriment of shareholders.  Potentially there is some non-earnings related asset value, but your guess is as good as mine for real estate in the Mojave which requires intensive irrigation to be good for anything other than scenery.  Near term catalysts will likely include a public litigation to prevent CDZI from progressing which, if it occurs, will happen in next 3 months.  They’ve published some environmental studies supporting their side for the project.  A public rebuke or lawsuit could jeopardize, delay or make the project more costly.

Timing: The final public comment session for review of the project and its draft Environmental Impact Report (“EIR”) was held on February 1^st. While I wouldn’t consider it NYTimes level reporting, you can find a bit of an overview of the meeting contents here: http://chanceofrain.com/2012/02/high-good-low-bad-mead-in-january-2012/#more-18333. The public comment period is scheduled to end on February 13^th. It is possible that a catalyst, such as an announcement to extend the public comment period or some filing of opposition to the project, occurs prior to this date. However, my view for timing of a near-term catalyst is simply “sometime in the next 90 days.”  Other than a forceful opposition which kills the project, refer to the event path to help think through the potential outcomes.  As much as I would think a zero is possible with time, it's entirely possible you could find a gradual erosion of value, where your guess is no better than mine on how long it will take for the music to stop.