|Shares Out. (in M):||15||P/E||0.0x||0.0x|
|Market Cap (in $M):||162||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||55||EBIT||0||0|
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:
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 1st. 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 13th. 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.
|Subject||Great write up|
|Entry||02/08/2012 06:48 PM|
|We are short this as well. Agree on all points.|
|Subject||Comment Period Extended 30 Days|
|Entry||02/10/2012 06:29 PM|
Not sure this is a catalyst on its own, but it does somewhat legitmize the scope of the opposition.
|Subject||RE: Comment Period Extended 30 Days|
|Entry||02/11/2012 11:48 AM|
Yes, I'm not surprised. I have some messages into IR and the Santa Margarita Water District so will see if we can get more color.
I think this site provides a very comprehensive and more factual account of the numerous legal minutia that could affect CDZI: http://theguzzler.blogspot.com/
The key accusations are that:
1 - The whole public review process is being administered by a water agency in Orange County while the water is being taken from San Bernadino. Quoting former Mayor of Huntington Beach: "This is one of the most outrageous proposals I have seen in my 25 years as an environmental activist... That in this day and age a private developer would come in and extract groundwater from an ecologically sensitive desert aquifer without any kind of recharge is unbelievable. That a water agency from the coastal area is going that far inland to take water out of the desert, as if the desert has no need for the water, makes no sense. What entitles them to pull that water out of the ground and sell it elsewhere?”
2 - The way the process is being handle itself is providing grounds for allegations of misconduct. Because those affected were not provided notice, that the hearing were conducted hundreds of miles away, because the local water agency is not noted at the lead agency, etc. has prompted a former local councilwoman to file a complaint with the local district attorney.
3 - The draft environmental report is not comprehensive and misses key issues including the interconnectedness of the aquifers
4 - The more traditional views of water rights would allow Cadiz to use the amount of water it currently uses for its small agricultural operation which is estimated between 2,000 and 5,000 acre-feet per year (e.g. between 4% and 10% of stated project capacity of 50,000 acre-feet per year)
You can give some of the website's more outlandish accusations of corruption or other malfeasance your own weight. I don't think you need any of that to materialize for this short to work, but it's a signal of the type of opposition that will be launched against this project.
|Subject||Opposition Forming / Further Info|
|Entry||03/27/2012 02:02 PM|
Apologies for the tardy post, but some of the environmental and conservation organizations are beginning to coalesce. Please see the attached memo signed by 14 different environmental organizations calling for a review of the process, selection of the lead agency, description of shortcomings in the current draft EIR, etc.
Also, for what it's worth, I would also review the US Dept of Interior's original review of CDZI's 2001-vintage project (remember, the new incarnation of the project is more environmentally aggressive than this earlier version because that version related to mostly water storage whereas this new CDZI plan is more about water extraction) calling out several troubling oversights in that draft EIR. Over 10 years, markets can change, CEOs can promote, etc. but the rules of geology and hydrology don't.
|Subject||RE: Opposition Forming / Further Info|
|Entry||03/27/2012 04:33 PM|
thanks for posting. this comment letter is basically a 78 page short thesis written by attorneys itching to file a lawsuit. i've spoken to a number of them. i am very certain they will file lawsuits as soon as there is something to contest.
also, i've recently spoken to some water investors who have looked at the project. they are uniformly bearish and can't understand why water asset management gave these guys $4.5MM.
|Subject||#2 Shareholder dumping 1/2 of its stake|
|Entry||03/29/2012 09:42 AM|
Per S3 filed yesterday afternoon, #2 and 9.4% shareholder Altima is attempting to sell ½ of its position… presume this will cause a share price reaction. Altima bought ~666k shares in a December private placement for $6.0MM or ~$9.0 / share (excluding value of warrants). Altima also received 222k warrants struck at $13 which expire in Dec 2014. The S3 indicates Altimate may sell 888k shares (e.g. more than they bought in the private placement just 4 months ago) as well as their warrants. Might as well bail while the getting is good.
|Subject||First Lawsuit and Request for New Impact Report|
|Entry||06/04/2012 06:11 PM|
Looks like an area salt miner is the first to file a lawsuit. Delaware Tetra Technologies is suing San Bernardino, alleging they violated the California Environmental Quality Act (CEQA) when the County approved the MOU with Cadiz. Also, the Center for Biological Diversity has requested a new environmental impact report (EIR) based on new project details that were introduced in the MOU and not covered in the EIR.
|Subject||equity raise likely|
|Entry||06/04/2012 06:42 PM|
also, CDZI has <$7MM in cash remaining. they spent $4MM in Q1. my guess is that they will do a raise in the next few months.
|Subject||CDZI Receives Approval|
|Entry||08/01/2012 11:06 AM|
Does today's approval represent the final approval hurdle that CDZI needed to overcome or just the most significant. I'd assume an equity raise is coming given their current cash position is sub $7M. However, given your downside risk projections if they did receive approval, do you see any reason to remain short the stock here?
|Subject||RE: CDZI Receives Approval|
|Entry||08/01/2012 12:35 PM|
Unfortunately due to my new employer's compliance rules, I cannot comment further on public forums.
|Subject||RE: CDZI Receives Approval|
|Entry||08/01/2012 01:53 PM|
Since Dakota can’t comment, I’ll chime in. The approval by SMWD was almost a foregone conclusion. The stock price reaction to this news seems extreme since there was never really any opposition from SMWD to the project. SMWD has endorsed the project wholeheartedly and has been its primary sponsor. They also stand to get reimbursed by Cadiz for about $500,000 of expenses they incurred related to the approval process. The key to the short thesis is that now all of the environmental groups, who adamantly oppose the project, can finally initiate legal challenges. Our conversations with people in these organizations made it clear that the project had to be approved by SMWD before they could take legal actions to stop it.
For those interested, watch this video from PBS SoCal (http://video.pbssocal.org/video/2219870939/) starting at about minute 3.50. Dianne Feinstein claims “we’ll lose everything” if this project moves forward. She has given every indication that she will rally her environmental allies to stop this from happening. The legal challenges that are almost sure to come will be a big drain on Cadiz’s limited financial resources (but a boon for Brownstein Hyatt Farber Schreck, the law firm that represents Cadiz and where Scott Slater, President and General Counsel of Cadiz, is a partner).
Finally, Metropolitan Water District ("MWD") still has to provide Cadiz with access to their aqueduct. Look at what Brett Barbre, a director at MWD, says about the project at minute 6. MDW is concerned about both chromium levels in Cadiz’s water (http://www.vvdailypress.com/news/cadiz-35731-water-company.html) and having space available on the aqueduct. Also, MWD and Cadiz had a nasty falling out and court battle when this projected was killed the first time. I wouldn't expect any deal with MWD to come easily or be friendly.
Watch the video until the end. The LA Business Journal reporter states emphatically that “the environmentalist will sue.” I think he is right. And I think the environmental groups will have cogent legal arguments on their side.
|Subject||RE: RE: RE: CDZI Receives Approval|
|Entry||07/09/2013 07:29 PM|
sorry for the delay. i've been wanting to offer a more thoughtful response, but i just haven't had the time.
setting thoughtfulness aside, i think their asset valuation is nuts. i spoke with the county assessor and he gave me an undeveloped ag value of $200-1000/acre. he didnt't know a good value for developed land, but said it could be $7k, if you include the lemon/grape/whatever trees on it. cadiz has developed around 1,200 ag acres. it's not profitable. 9,600 acres are permitted for ag. i don't know where they are getting 14k acres and i certainly don't agree with that value. the mitigation value is unreasonable as well. for reference, this land is appraised by the county at around $150/acre. there are no sale comps bc this is the middle of nowhere. when i asked the county appraiser who i should talk to, he said cadiz was the only land buyer he was aware of. i think the last time cadiz bought land was in 2001.
i don't think there is any way they could monetize their interest in the pipeline option.
the cash on hand will be spent.
i still like the short quite a bit.