Blueprint
 
 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-Q
 
 X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended: May 31, 2016
or
 __ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from __________ to __________
 
Commission file number 0-8814
 
PURE CYCLE CORPORATION
 
(Exact name of registrant as specified in its charter)
 
Colorado
 
84-0705083
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification Number)
 
 
 
34501 E. Quincy Avenue, Bldg. 34, Box 10, Watkins, CO
 
80137
(Address of principal executive offices)
 
(Zip Code)
 
 
 
(303) 292 – 3456
(Registrant’s telephone number, including area code)
 
 
 
 
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes [X] No [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer [ ]
                                                                                                                                     Accelerated filer [X]
Non-accelerated filer [ ] (Do not check if a smaller reporting company)                   Smaller reporting company [ ]
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
 Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of July 6, 2016:
Common stock, 1/3 of $.01 par value                                                                                                          23,754,098
 (Clas                                                                                                                                     (Number of Shares)
 
 
 
PURE CYCLE CORPORATION
INDEX TO MAY 31, 2016 FORM 10-Q
 
 
Page
PART I. FINANCIAL INFORMATION
1
                                                                                                                          
Item 1. Consolidated Financial Statements                                                                                                                    
1
 
 
  Consolidated Balance Sheets:
1
    May 31, 2016 (unaudited) and August 31, 2015 (audited)                                                                                                               
 
 
  Consolidated Statements of Operations and Comprehensive Income (Loss):
2
    For the three and nine months ended May 31, 2016 and 2015 (unaudited) 
 
 
  Consolidated Statement of Shareholders' Equity:
3
    For the nine months ended May 31, 2016 (unaudited)                                                                                                               
 
 
  Consolidated Statements of Cash Flows:
4
    For the nine months ended May 31, 2016 and 2015 (unaudited)                                                                                                               
 
 
  Notes to Consolidated Financial Statements                                                                                                                  
5
 
 
Item 2. Manatment's Discussion and Analysis of Financial Condition and Results of Operations
17
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk                                                                                                                   
29
 
 
Item 4. Controls and Procedures                                                                                                                   
29
 
 
PART II. OTHER INFORMATION                                                                                                                              
30
 
 
Item 6. Exhibits                                                                                                                   
30
 
 
SIGNATURES                                                                                                                              
31
 
 
i
 
 
PART I – FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
PURE CYCLE CORPORATION
CONSOLIDATED BALANCE SHEETS
 
ASSETS:
 
May 31, 2016
 
 
August 31, 2015
 
Current assets:
 
(unaudited)
 
 
 
 
  Cash and cash equivalents
  $5,114,663 
  $37,089,041 
  Short-term investments
    23,148,458 
    - 
  Trade accounts receivable
    151,194 
    399,925 
  Sky Ranch receivable
    - 
    148,415 
  Prepaid expenses
    373,912 
    228,086 
  Assets of discontinued operations
    801,565 
    1,715,472 
  Total current assets
    29,589,792 
    39,580,939 
 
       
       
Long-term investments
    7,034,100 
    - 
Investments in water and water systems, net
    27,969,211 
    27,708,595 
Land and mineral interests
    5,271,313 
    5,091,668 
Notes receivable - related parties, including accrued interest
    788,624 
    591,223 
Other assets
    470,218 
    88,488 
  Total assets
  $71,123,258 
  $73,060,913 
 
       
       
LIABILITIES:
       
       
Current liabilities:
       
       
  Accounts payable
  $99,731 
  $172,634 
  Accrued liabilities
    86,542 
    499,808 
  Income taxes
    - 
    292,729 
  Deferred revenues
    55,800 
    55,800 
  Deferred oil and gas lease payment
    24,000 
    360,765 
  Liabilities of discontinued operations
    3,602 
    117,329 
  Total current liabilities
    269,675 
    1,499,065 
 
       
       
Deferred revenues, less current portion
    1,069,441 
    1,111,293 
Deferred oil and gas lease payment, less current portion
    1,000 
    19,000 
Participating Interests in Export Water Supply
    344,378 
    346,007 
  Total liabilities
    1,684,494 
    2,975,365 
 
       
       
Commitments and contingencies
       
       
 
       
       
SHAREHOLDERS’ EQUITY:
       
       
Preferred stock:
       
       
  Series B - par value $.001 per share, 25 million shares authorized;
       
       
  432,513 shares issued and outstanding
       
       
  (liquidation preference of $432,513)
    433 
    433 
Common stock:
       
       
  Par value 1/3 of $.01 per share, 40 million shares authorized;
       
       
  23,754,098 and 24,054,098 shares outstanding, respectively
    79,185 
    80,185 
Collateral stock
    - 
    (1,407,000)
Additional paid-in capital
    171,145,416 
    172,384,355 
Accumulated other comprehensive income (loss)
    (23,335)
    - 
Accumulated deficit
    (101,762,935)
    (100,972,425)
  Total shareholders' equity
    69,438,764 
    70,085,548 
  Total liabilities and shareholders’ equity
  $71,123,258 
  $73,060,913 
 
 
See accompanying Notes to Consolidated Financial Statements
 
1
 
PURE CYCLE CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(unaudited)
 
 
 
 
Three Months Ended May 31,
 
 
Nine Months Ended May 31,
 
 
 
2016
 
 
2015
 
 
2016
 
 
2015
 
Revenues:
 
 
 
 
 
 
 
 
 
 
 
 
  Metered water usage
  $35,659 
  $73,477 
  $119,832 
  $893,746 
  Wastewater treatment fees
    10,537 
    12,293 
    31,540 
    37,224 
  Special facility funding recognized
    10,377 
    10,377 
    31,131 
    31,131 
  Water tap fees recognized
    3,574 
    3,574 
    10,721 
    10,721 
  Other
    40,705 
    20,639 
    109,980 
    89,490 
  Total revenues
    100,852 
    120,360 
    303,204 
    1,062,312 
 
       
       
       
       
Expenses:
       
       
       
       
  Water service operations
    (65,184)
    (73,679)
    (190,976)
    (303,110)
  Wastewater service operations
    (7,286)
    (9,265)
    (20,555)
    (22,075)
  Depletion and depreciation
    (41,604)
    (42,072)
    (124,834)
    (130,802)
  Other
    (20,763)
    (14,746)
    (51,373)
    (35,771)
  Total cost of revenues
    (134,837)
    (139,762)
    (387,738)
    (491,758)
Gross (loss) profit
    (33,985)
    (19,402)
    (84,534)
    570,554 
 
       
       
       
       
General and administrative expenses
    (431,737)
    (384,323)
    (1,294,585)
    (1,167,179)
Depreciation
    (67,172)
    (44,706)
    (182,999)
    (128,108)
Operating loss
    (532,894)
    (448,431)
    (1,562,118)
    (724,733)
 
       
       
       
       
Other income (expense):
       
       
       
       
  Oil and gas lease income, net
    31,905 
    161,430 
    354,765 
    484,290 
  Oil and gas royalty income, net
    76,400 
    262,097 
    271,002 
    262,097 
  Interest income
    66,253 
    6,465 
    175,356 
    11,587 
  Other
    (2,671)
    12,471 
    (8,004)
    18,418 
  Net (loss) income from continuing operations
    (361,007)
    (5,968)
    (768,999)
    51,659 
  (Loss) income from discontinued operations, net of taxes
    (61,263)
    36,215 
    (21,511)
    (97,099)
  Net (loss) income
  $(422,270)
  $30,247 
  $(790,510)
  $(45,440)
  Unrealized holding losses
    (35,517)
    - 
    (23,335)
    - 
  Total comprehensive (loss) income
  $(457,787)
  $30,247 
  $(813,845)
  $(45,440)
 
       
       
       
       
  Basic and diluted net income (loss) per common share –
       
       
       
       
  Loss from continuing operations
  $(0.02)
    * 
  $(0.03)
    * 
  (Loss) earnings from discontinued operations
    * 
    * 
    * 
    * 
  Net loss
  $(0.02)
    * 
  $(0.03)
    * 
 
       
       
       
       
  Weighted average common shares outstanding – basic
    23,754,098 
    24,037,598 
    23,795,627 
    24,037,598 
  Weighted average common shares outstanding – diluted
    23,754,098 
    24,366,198 
    23,795,627 
    24,037,598 
 
       
       
       
       
* Amount is less than $.01 per share
       
       
       
       
 
See accompanying Notes to Consolidated Financial Statements
 
2
 
PURE CYCLE CORPORATION
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
Nine months ended May 31, 2016
(unaudited)
 
 
 
  Preferred Stock 
 
  Common Stock  
 
 
Additional Paid-in
 
 
 Accumulated Other Accumulated Other Comprehensive
 
 
Collateral 
 
 
Accumulated 
 
 
 
 
 
 
Shares
 
 
Amount
 
 
Shares
 
 
Amount
 
 
Capital
 
 
Loss
 
 
Stock
 
 
Deficit
 
 
Total
 
August 31, 2015 balance:
    432,513 
  $433 
    24,054,098 
  $80,185 
  $172,384,355 
  $- 
  $(1,407,000)
  $(100,972,425)
  $70,085,548 
Share-based compensation
    – 
    – 
    – 
    – 
    167,061 
    – 
    – 
    – 
    167,061 
Collateral stock retired
    – 
    – 
    (300,000)
    (1,000)
    (1,406,000)
    – 
    1,407,000 
    – 
    - 
Net loss
    – 
    – 
    – 
    – 
    – 
    – 
    – 
    (790,510)
    (790,510)
Unrealized holding loss on investments
    – 
    – 
    – 
    – 
    – 
    (23,335)
    – 
    – 
    (23,335)
May 31, 2016 balance:
    432,513 
  $433 
    23,754,098 
  $79,185 
  $171,145,416 
  $(23,335)
  $- 
  $(101,762,935)
  $69,438,764 
 
See accompanying Notes to Consolidated Financial Statements
 
3
 
PURE CYCLE CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
 
 
 
Nine Months Ended May 31,
 
 
 
2016
 
 
2015
 
Cash flows from operating activities:
 
 
 
 
 
 
  Net loss
  $(790,510)
  $(45,440)
  Adjustments to reconcile net loss to net cash
       
       
  used in operating activities:
       
       
  Depreciation and depletion
    307,834 
    258,909 
  Investment in Well Enhancement Recover Systems, LLC
    8,004 
    1,565 
  Stock-based compensation expense
    167,061 
    186,296 
  Interest income and other non-cash items
    (37,299)
    (315)
  Interest added to receivable from related parties
    (22,503)
    (10,812)
  Changes in operating assets and liabilities:
       
       
  Trade accounts receivable
    248,731 
    1,452,996 
  Sky Ranch receivable
    - 
    (83,500)
  Prepaid expenses
    (145,826)
    63,997 
  Notes receivable - related parties
    (26,483)
    (95,500)
  Accounts payable and accrued liabilities
    (486,170)
    (1,115,206)
  Income taxes
    (292,729)
    - 
  Deferred revenues
    (41,852)
    (49,037)
  Deferred oil and gas lease payment
    (354,765)
    (484,290)
  Net cash provided by (used in) operating activities from continuing operations
    (1,466,507)
    79,663 
  Net cash provided by (used in) operating activities from discontinued operations
    1,251,527 
    (535,274)
  Net cash used in operating activities
    (214,980)
    (455,611)
 
       
       
Cash flows from investing activities:
       
       
  Purchase of short-term investments
    (23,142,484)
    - 
  Purchase of long-term investments
    (7,026,424)
    - 
  Investments in water, water systems, and land
    (695,746)
    (1,900,267)
  Purchase of property and equipment
    (441,768)
    (17,186)
  Net cash used in investing activities from continuing operations
    (31,306,422)
    (1,917,453)
  Net cash provided by (used in) investing activities from discontinued operations
    (451,347)
    699,826 
  Net cash used in investing activities
    (31,757,769)
    (1,217,627)
 
       
       
Cash flows from financing activities:
       
       
  Payments to contingent liability holders
    (1,629)
    (7,642)
  Net cash used in financing activities from continuing operations
    (1,629)
    (7,642)
  Net cash provided by financing activities from discontinued operations
    - 
    674,710 
  Net cash (used in) provided by financing activities
    (1,629)
    667,068 
Net change in cash and cash equivalents
    (31,974,378)
    (1,006,170)
Cash and cash equivalents – beginning of period
    37,089,041 
    1,749,558 
Cash and cash equivalents – end of period
  $5,114,663 
  $743,388 
 
       
       
 
       
       
 
       
       
SUPPLEMENTAL DISCLSOURES OF NON-CASH ACTIVITIES
       
       
  Retirement of collateral stock
  $1,407,000 
  $- 
  Net reduction in Tap Participation Fee liability and HP A&M
       
       
  receivable collateral stock and mineral rights received as
       
       
  result of settlement of the Arkansas River Agreement
  $- 
  $1,894,203 
  Assets acquired through WISE funding obligation
  $- 
  $1,400,000 
 
 
See accompanying Notes to Consolidated Financial Statements
 
4
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
NOTE 1 – PRESENTATION OF INTERIM INFORMATION
 
The May 31, 2016 consolidated balance sheet, the consolidated statements of operations and comprehensive income (loss) for the three and nine months ended May 31, 2016 and 2015, the consolidated statement of shareholders’ equity for the nine months ended May 31, 2016, and the consolidated statements of cash flows for the nine months ended May 31, 2016 and 2015 have been prepared by Pure Cycle Corporation (the “Company”) and have not been audited. The unaudited consolidated financial statements include all adjustments that are, in the opinion of management, necessary to present fairly the financial position, results of operations and cash flows at May 31, 2016, and for all periods presented.
 
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended August 31, 2015 (the “2015 Annual Report”) filed with the Securities and Exchange Commission (the “SEC”) on November 9, 2015. The results of operations for interim periods presented are not necessarily indicative of the operating results for the full fiscal year. The August 31, 2015 balance sheet was taken from the Company’s audited financial statements and was modified to reflect the discontinued operations presentation of the Company’s agricultural segment.
 
Use of Estimates
 
The preparation of consolidated financial statements in accordance 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 consolidated 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 a reputable financial institution. At various times during the three and nine months ended May 31, 2016, the Company’s main operating account exceeded federally insured limits. The Company has never suffered a loss due to such excess balance.
 
Investments
 
Management determines the appropriate classification of its investments in certificates of deposit and debt and equity securities at the time of purchase and reevaluates such determinations each reporting period.
 
Certificates of deposit and debt securities are classified as held-to-maturity when the Company has the positive intent and ability to hold the securities to maturity. The Company has $7,034,100 of investments classified as held-to-maturity at May 31, 2016 which represent certificates of deposit and U.S. treasury notes with maturity dates after May 31, 2017. Debt securities for which the Company does not have the positive intent or ability to hold to maturity are classified as available-for-sale, along with any investments in equity securities. Securities classified as available-for-sale are marked-to-market at each reporting period. Changes in value on such securities are recorded as a component of Accumulated other comprehensive income (loss). The cost of securities sold is based on the specific identification method. The Company’s debt securities mature at various dates through February 12, 2018.
 
Concentration of Credit Risk and Fair Value
 
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash, cash equivalents and investments. From time to time, the Company places its cash in money market instruments, commercial paper obligations, corporate bonds and U.S. government treasury obligations. To date, the Company has not experienced significant losses on any of these investments.
 
The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it is practicable to estimate that value.
 
5
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
Cash and Cash Equivalents – The Company’s cash and cash equivalents are reported using the values as reported by the financial institution where the funds are held. These securities primarily include balances in the Company’s operating and savings accounts. The carrying amount of cash and cash equivalents approximate fair value.
 
Trade Accounts Receivable – The Company records accounts receivable net of allowances for uncollectible accounts.
 
Investments – The carrying amounts of investments approximate fair value. Investments are described further in Note 2 – Fair Value Measurements.
 
Accounts Payable – The carrying amounts of accounts payable approximate fair value due to the relatively short period to maturity for these instruments.
 
Long-Term Financial Liabilities – The Comprehensive Amendment Agreement No. 1 (the “CAA”) is comprised of a recorded balance and an off-balance sheet or “contingent” obligation associated with the Company’s acquisition of its “Rangeview Water Supply” (defined in Note 4 – Water and Land Assets to the 2015 Annual Report). The amount payable is a fixed amount but is repayable only upon the sale of “Export Water” (defined in Note 4 – Water and Land Assets to the 2015 Annual Report). Because of the uncertainty of the sale of Export Water, the Company has determined that the contingent portion of the CAA does not have a determinable fair value. The CAA is described further in Note 4 – Long-Term Obligations and Operating Lease – Participating Interests in Export Water Supply.
 
Notes Receivable – Related Parties – The market value of the notes receivable – related parties: Rangeview Metropolitan District (the “District”) and Sky Ranch Metropolitan District No. 5 are not practical to estimate due to the related party nature of the underlying transactions.
 
Off-Balance Sheet Instruments – The Company’s off-balance sheet instruments consist entirely of the contingent portion of the CAA. Because repayment of this portion of the CAA is contingent on the sale of Export Water, which is not reasonably estimable, the Company has determined that the contingent portion of the CAA does not have a determinable fair value. See further discussion in Note 4 – Long-Term Obligations and Operating Lease – Participating Interests in Export Water Supply.
 
Revenue Recognition
 
Wholesale Water and Wastewater Fees – Monthly wholesale water usage charges are assessed to the Company’s customers based on actual metered usage each month plus a base monthly service fee. The Company recognizes wholesale water usage revenues upon delivering water to its customers or its governmental customer’s end-use customers, as applicable. The export water revenues recognized by the Company are shown gross of royalties to the State of Colorado Board of Land Commissioners (the “Land Board”). The on-site water revenues recognized by the Company are shown net of royalties paid to the Land Board and amounts retained by the District. The Company recognized $35,700 and $73,500 of metered water usage revenues during the three months ended May 31, 2016 and 2015, respectively. The Company recognized $119,800 and $893,700 of metered water usage revenues during the nine months ended May 31, 2016 and 2015, respectively.
 
The Company recognizes wastewater treatment fees monthly based on usage. The monthly wastewater treatment fees are shown net of amounts retained by the District. The Company recognized $10,500 and $12,300 of wastewater treatment fees during the three months ended May 31, 2016 and 2015, respectively. The Company recognized $31,500 and $37,200 of wastewater treatment fees during the nine months ended May 31, 2016 and 2015, respectively. Costs of delivering water and providing wastewater services to customers are recognized as incurred.
 
Tap and Construction Fees – The Company has various water and wastewater service agreements, a component of which may include tap and construction fees. The Company recognizes water tap fees as revenue ratably over the estimated service period upon completion of the “Wholesale Facilities” (defined in Part I, Item 1 of the 2015 Annual Report) constructed to provide service to Arapahoe County, Colorado (the “County”). The Company recognized $3,600 and $10,700 of water tap fee revenues during each of the three and nine months ended May 31, 2016 and 2015, respectively. The water tap fees to be recognized over this period are net of the royalty payments to the Land Board and amounts paid to third parties pursuant to the CAA as further described in Note 4 – Long-Term Obligations and Operating Lease below.
 
6
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
The Company recognized $10,400 and $31,100 of “Special Facilities” (defined in Part I, Item 1 of the 2015 Annual Report) funding as revenue during each of the three and nine months ended May 31, 2016 and 2015, respectively. This is the ratable portion of the Special Facilities funding proceeds received from water agreements as more fully described in Note 2 – Summary of Significant Accounting Policies to the 2015 Annual Report.
 
As of May 31, 2016, and August 31, 2015, the Company has deferred recognition of approximately $1,125,200 and $1,167,100, respectively, of water tap and construction fee revenue from the County, which will be recognized as revenue ratably over the estimated useful accounting life of the assets constructed with the construction proceeds as described above.
 
Royalty and Other Obligations
 
Revenues from the sale of Export Water are shown gross of royalties payable to the Land Board. Revenues from the sale of water on the “Lowry Range” (described in Note 4 – Water and Land Assets in Part II, Item 8 of the 2015 Annual Report) are shown net of the royalties to the Land Board and the amounts retained by the District.
 
Oil and Gas Lease Payments
 
As further described in Note 2 – Summary of Significant Accounting Policies in Part II, Item 8 of the 2015 Annual Report, in March 2011, the Company entered into a Paid-Up Oil and Gas Lease (the “O&G Lease”) and a Surface Use and Damage Agreement (the “Surface Use Agreement”) which was subsequently purchased by a wholly owned subsidiary of ConocoPhillips Company. Pursuant to the O&G Lease, during the year ended August 31, 2011, the Company received an up-front payment of $1,243,400 for the purpose of exploring for, developing, producing and marketing oil and gas on approximately 634 acres of mineral estate owned by the Company at its “Sky Ranch” property (described in Note 4 – Water and Land Assets to the 2015 Annual Report). The Company began recognizing the up-front payments as income on a straight-line basis over three years (the initial term of the O&G Lease) on March 10, 2011. The Company received an additional payment of $1,243,400 during February 2014 to extend the O&G Lease an additional two years through February 2016, which was recognized as income on a straight-line basis over two years (the extension term of the O&G Lease). During the fiscal year ended August 31, 2014, the Company received an up-front payment of $72,000 for the purpose of exploring for, developing, producing, and marketing oil and gas on 40 acres of mineral estate the Company owns adjacent to the Lowry Range (the “Rangeview Lease”). The Company recognized $31,900 and $161,400 during the three months ended May 31, 2016 and 2015, respectively, of lease income related to the up-front payments received pursuant to the O&G Lease and the Rangeview Lease. The Company recognized $354,800 and $484,300 during the nine months ended May 31, 2016 and 2015, respectively, of lease income related to the up-front payments received pursuant to the O&G Lease and the Rangeview Lease.
 
As of May 31, 2016 and August 31, 2015, the Company has deferred recognition of $25,000 and $379,800, respectively, of income related to the O&G Lease and the Rangeview Lease. The balance as of May 31, 2016 will be recognized into income ratably through July 2017. $354,800 of the balance as of August 31, 2015 was recognized into income during the nine months ended May 31, 2016.
 
During the three months ended February 28, 2015, two wells were drilled within the Company’s mineral interest. Beginning in March 2015, both wells were placed into service and began producing oil and gas and accruing royalties to the Company. In May 2015, certain gas collection infrastructure was extended to the property to allow the collection of gas from the wells and accrual of royalties attributable to gas production. During the three months ended May 31, 2016 and 2015, the Company received $76,400 and $262,100, respectively, in royalties attributable to these two wells. During the nine months ended May 31, 2016 and 2015, the Company received $271,000 and $262,100 respectively, in royalties attributable to these two wells.
 
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.
 
7
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
Capitalized Costs of Water and Wastewater Systems and Depletion and Depreciation of Water Assets
 
Costs to construct water and wastewater systems that meet the Company’s capitalization criteria are capitalized as incurred, including interest, and depreciated on a straight-line basis over their estimated useful lives of up to 30 years. 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. The Company depletes its groundwater assets that are being utilized on the basis of units produced (i.e., thousands of gallons sold) divided by the total volume of water adjudicated in the water decrees.
 
Share-Based Compensation
 
The Company maintains a stock option plan for the benefit of its employees and non-employee directors. The Company records share-based compensation costs as expense over the applicable vesting period of the stock award using the straight-line method. The compensation costs to be expensed are measured at the grant date based on the fair value of the award. The Company has adopted the alternative transition method for calculating the tax effects of share-based compensation, which allows for a simplified method of calculating the tax effects of employee share-based compensation. Because the Company has a full valuation allowance on its deferred tax assets, the granting and exercise of stock options has no impact on the income tax provisions. The Company recognized $58,200 and $53,700 of share-based compensation expense during the three months ended May 31, 2016 and 2015, respectively. The Company recognized $167,100 and $186,300 of share-based compensation expense during the nine months ended May 31, 2016 and 2015, respectively.
 
Income Taxes
 
The Company uses a “more-likely-than-not” threshold for the recognition and de-recognition of tax positions, including any potential interest and penalties relating to tax positions taken by the Company. The Company did not have any significant unrecognized tax benefits as of May 31, 2016.
 
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 year 2013 through fiscal year 2015. The Company does not believe there will be any material changes in its unrecognized tax positions over the next 12 months.
 
The Company’s policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. At May 31, 2016, the Company did not have any accrued interest or penalties associated with any unrecognized tax benefits, nor was any interest expense recognized during the three or nine months ended May 31, 2016 or 2015.
 
Discontinued Operations
 
In August 2015, the Company sold its Arkansas River water and land properties. Pursuant to the terms of the purchase and sale agreement, the Company continued to manage and receive the lease income until December 31, 2015. The operating results and the assets and liabilities of the discontinued operations, which formerly comprised the agricultural segment, are presented separately in the Company’s Consolidated Financial Statements. Summarized financial information for the discontinued agricultural business is shown below. Prior period balances have been reclassified to present the operations of the agricultural business as a discontinued operation.
 
8
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
 
Discontinued Operations Income Statement
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Three Months Ended May 31,
 
 
Nine Months Ended May 31,
 
 
 
2016
 
 
2015
 
 
2016
 
 
2015
 
Farm revenues
  $- 
  $270,582 
  $275,991 
  $818,925 
Farm expenses
    (22,674)
    (23,131)
    (56,042)
    (70,001)
  Gross (loss) profit
    (22,674)
    247,451 
    219,949 
    748,924 
 
       
       
       
       
General and administrative expenses
    48,346 
    140,366 
    287,787 
    617,914 
  Operating (loss) profit
    (71,020)
    107,085 
    (67,838)
    131,010 
Finance charges
    9,757 
    7,909 
    42,054 
    17,622 
Gain on sale of farm assets
    - 
    - 
    4,273 
    - 
Interest expense
    - 
    (78,779)
    - 
    (221,915)
Interest imputed on the Tap Participation
       
       
       
       
  Fee payable to HP A&M
    - 
    - 
    - 
    (23,816)
  Income (loss) from discontinued operations
  $(61,263)
  $36,215 
  $(21,511)
  $(97,099)
 
The Company anticipates continued expenses through the end of calendar 2016 related to the discontinued operations. The Company will continue to incur expenses related to the remaining agricultural land the Company continues to own and for the purpose of collecting outstanding receivables.
The individual assets and liabilities of the discontinued agricultural business are combined in the captions “Assets of discontinued operation” and “Liabilities of discontinued operation” in the consolidated Balance Sheet. The carrying amounts of the major classes of assets and liabilities included part of the discontinued business are presented in the following table:
 
 
Discontinued Operations Balance Sheet
 
 
 
 
 
 
 
 
 
 
May 31, 2016
 
 
August 31, 2015
 
Assets:
 
 
 
 
 
 
Trade accounts receivable
  $351,218 
  $307,913 
Escrow receivable
    - 
    1,342,250 
Land held for sale (*)
    450,347 
    - 
Prepaid expenses
    - 
    65,309 
Total assets
  $801,565 
  $1,715,472 
 
       
       
Liabilities:
       
       
Accounts payable
  $135 
  $25,704 
Accrued liabilities
    3,467 
    90,725 
Deferred revenues
    - 
    900 
Total liabilities
  $3,602 
  $117,329 
 
 
(*) Land Held for Sale. During the fiscal quarter ended November 30, 2015, the Company purchased three farms for approximately $450,300. The Company acquired a total of 700 acres. The farms were acquired in order to correct dry-up covenant issues related to water only farms in order obtain the release of the escrow funds related to the Company’s farm sale to Arkansas River Farms, LLC. The Company intends to sell the farms within the next fiscal year.
 
Income (Loss) per Common Share
 
Income (loss) per common share is computed by dividing net income (loss) by the weighted average number of shares outstanding during each period. Common stock options and warrants aggregating 338,100 and 341,100 common share equivalents were outstanding as of May 31, 2016 and 2015, respectively, and have been included in the calculation of net income per common share but excluded from the calculation of loss per common share as their effect is anti-dilutive.
 
9
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
Recently Issued Accounting Pronouncements
 
The Company continually assesses any new accounting pronouncements to determine their applicability. When it is determined that a new accounting pronouncement affects the Company’s financial reporting, the Company undertakes a study to determine the consequence of the change to its consolidated financial statements and ensure that there are proper controls in place to ascertain that the Company’s consolidated financial statements properly reflect the change. New pronouncements assessed by the Company recently are discussed below:
 
In May 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients. ASU 2016-12 provides for amendments to ASU No. 2014-09, Revenue from Contracts with Customers, amending the guidance on transition, collectability, noncash consideration and the presentation of sales and other similar taxes. Specifically, ASU 2016-12 clarifies that, for a contract to be considered completed at transition, all (or substantially all) of the revenue must have been recognized under legacy GAAP. In addition, ASU 2016-12 clarifies how an entity should evaluate the collectability threshold and when an entity can recognize nonrefundable consideration received as revenue if an arrangement does not meet the standard’s contract criteria. The Company is assessing the impact of ASU 2016-12, but it does not expect the adoption of ASU 2016-12 to have a material impact on its financial statements.
 
In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing. ASU 2016-10 provides for amendments to ASU No. 2014-09, Revenue from Contracts with Customers, reducing the complexity when applying the guidance for identifying performance obligations and improving the operability and understandability of the license implementation guidance. The Company is assessing the impact of ASU 2016-10, but it does not expect the adoption of ASU 2016-10 to have a material impact on its financial statements.
 
In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net). ASU 2016-08 provides for amendments to ASU No. 2014-09, Revenue from Contracts with Customers, clarifying the implementation guidance on principal versus agent considerations in the new revenue recognition standard. Specifically, ASU 2016-08 clarifies how an entity should identify the unit of accounting (i.e., the specified good or service) for the principal versus agent evaluation and how it should apply the control principle to certain types of arrangements. The Company is assessing the impact of ASU 2016-08, but it does not expect the adoption of ASU 2016-08 to have a material impact on its financial statements.
 
In April 2014, the FASB issued ASU No. 2014-08, Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity. ASU 2014-08 changes the presentation and disclosure requirements for discontinued operations. The update was adopted by the Company in fiscal year 2016.
 
NOTE 2 – FAIR VALUE MEASUREMENTS
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date in the principal or most advantageous market. The Company uses a fair value hierarchy that has three levels of inputs, both observable and unobservable, with use of the lowest possible level of input to determine fair value.
 
Level 1 — Valuations for assets and liabilities traded in active exchange markets, such as the NASDAQ Stock Market. The Company had none of these instruments as of May 31, 2016 or August 31, 2015.
 
Level 2 — Valuations for assets and liabilities obtained from readily available pricing sources via independent providers for market transactions involving similar assets or liabilities. The Company had 35 Level 2 assets as of May 31, 2016, which consist of certificates of deposit and U.S. treasury notes. The Company had no Level 2 assets or liabilities as of August 31, 2015.
Level 3 — Valuations for assets and liabilities that are derived from other valuation methodologies, including discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker-traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities. The Company had no Level 3 liability as of May 31, 2016 or August 31, 2015.
 
10
 
 \
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
The Company maintains policies and procedures to value instruments using what management believes to be the best and most relevant data available.
 
Level 2 Asset – Available for Sale Securities. The Company’s available for sale securities are the Company’s only financial asset measured at fair value on a recurring basis. The fair value of the available for sale securities is based on the values reported by the financial institutions where the funds are held. These securities include only federally insured certificates of deposit.
 
The Company’s non-financial assets measured at fair value on a non-recurring basis consist entirely of its investments in water and water systems, land held for sale, and other long-lived assets. See Note 3 – Water and Land Assets below.
 
The following table provides information on the assets and liabilities measured at fair value on a recurring basis as of May 31, 2016:
 
 
 
 
 
 
 
 
 
Fair Value Measurement Using:
 
 
 
 
 
 
 
 
 
Cost / Other
 
 
Quoted Prices in Active Markets for Identical Assets
 
 
Significant Other Observable Inputs
 
 
Significant Unobservable Inputs
 
 
Accumulated Unrealized Gains and
 
 
 
Fair Value
 
 
Value
 
 
(Level 1)
 
 
(Level 2)
 
 
(Level 3)
 
 
(Losses)
 
Available for sale
  $23,148,500 
  $23,171,800 
  $- 
  $23,148,500 
  $- 
  $(23,300)
 
NOTE 3 – WATER AND LAND ASSETS
 
The Company’s water rights and current water and wastewater service agreements are more fully described in Note 4 – Water and Land Assets in Part II, Item 8 of the 2015 Annual Report. There have been no significant changes to the Company’s water rights or water and wastewater service agreements during the three and nine months ended May 31, 2016.
 
The Company’s Investments in Water and Water Systems consist of the following costs and accumulated depreciation and depletion at May 31, 2016 and August 31, 2015:
 
 
 
May 31, 2016
 
 
August 31, 2015
 
 
 
Costs
 
 
Accumulated Depreciation and Depletion
 
 
Costs
 
 
Accumulated Depreciation and Depletion
 
Rangeview water supply
  $14,444,600 
  $(9,000)
  $14,444,600 
  $(8,800)
Sky Ranch water rights and other costs
    6,444,500 
    (268,000)
    6,440,800 
    (194,600)
Fairgrounds water and water system
    2,899,900 
    (864,800)
    2,899,900 
    (798,700)
Rangeview water system
    1,256,300 
    (141,400)
    1,256,300 
    (110,300)
Water supply – other
    4,479,000 
    (271,900)
    3,973,300 
    (193,900)
Totals
    29,524,300 
    (1,555,100)
    29,014,900 
    (1,306,300)
Net investments in water and water systems
  $27,969,200 
       
  $27,708,600 
       
 
 
Capitalized terms in this section not defined herein are defined in Note 4 – Water and Land Assets to the 2015 Annual Report.
 
Depletion and Depreciation. The Company recorded depletion charges of $100 and $500 during the three months ended May 31, 2016 and 2015, respectively. The Company recorded depletion charges of $200 and $6,700 during the nine months ended May 31, 2016 and 2015, respectively. During the three and nine months ended May 31, 2016, this related entirely to the Rangeview Water Supply, and during the three and nine months ended May 31, 2015, this related to the Rangeview Water Supply and the Sky Ranch water assets.
 
11
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
The Company recorded $108,700 and $86,300 of depreciation expense during the three months ended May 31, 2016 and 2015, respectively. The Company recorded $307,600 and $252,200 of depreciation expense during the nine months ended May 31, 2016 and 2015, respectively.
 
NOTE 4 – LONG-TERM OBLIGATIONS AND OPERATING LEASE
 
The Participating Interests in Export Water Supply is an obligation of the Company that has no scheduled maturity date. Therefore, maturity of this liability is not disclosed in tabular format, but is described below.
 
Participating Interests in Export Water Supply
 
The Company acquired its Rangeview Water Supply through various amended agreements entered into in the early 1990s. The acquisition was consummated with the signing of the CAA in 1996. Upon entering into the CAA, the Company recorded an initial liability of $11.1 million, which represented the cash the Company received from the participating interest holders that was used to purchase the Company’s Export Water (described in greater detail in Note 4 – Water and Land Assets to the 2015 Annual Report). 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 return for their initial $11.1 million investment. The obligation for the $11.1 million was recorded as debt, and the remaining $20.7 million contingent liability was not reflected on the Company’s balance sheet because the obligation to pay this is contingent on the sale of Export Water, the amounts and timing of which are not reasonably determinable.
 
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.
 
As the proceeds from the sale of Export Water 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. Because the original recorded liability, which was $11.1 million, was 35% of the original total liability of $31.8 million, approximately 35% of each payment remitted to the CAA holders is allocated to the recorded liability account. The remaining portion of each payment, or approximately 65%, is allocated to the contingent obligation, which is recorded on a net revenue basis.
 
From time to time, the Company repurchased various portions of the CAA obligations, which retained their original priority. The Company did not make any CAA acquisitions during the nine months ended May 31, 2016 or 2015.
 
As a result of the acquisitions and the sale of Export Water, as detailed in the table below, the remaining potential third-party obligation at May 31, 2016, is approximately $1 million, and the Company has the right to approximately $29.8 million in Export Water proceeds:
 
12
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
Export Water Proceeds Received
 
 
Initial Export Water Proceeds to Pure Cycle
 
 
Total Potential Third-Party Obligation
 
 
Paticipating Interests Liability
 
 
Contingency
 
Original balances
  $– 
  $218,500 
  $31,807,700 
  $11,090,600 
  $20,717,100 
Activity from inception until August 31, 2015:
       
       
       
       
       
  Acquisitions
    – 
    30,428,900 
    (30,428,900)
    (10,622,100)
    (19,806,800)
  Option payments - Sky Ranch
       
       
       
       
       
  and The Hills at Sky Ranch
    110,400 
    (42,300)
    (68,100)
    (23,800)
    (44,300)
  Arapahoe County tap fees *
    533,000 
    (373,100)
    (159,900)
    (55,800)
    (104,100)
  Export Water sale payments
    569,200 
    (445,800)
    (123,400)
    (42,900)
    (80,500)
Balance at August 31, 2015
    1,212,600 
    29,786,200 
    1,027,400 
    346,000 
    681,400 
Fiscal 2016 activity:
       
       
       
       
       
  Export Water sale payments
    39,300 
    (34,600)
    (4,700)
    (1,600)
    (3,100)
Balance at May 31, 2016
  $1,251,900 
  $29,751,600 
  $1,022,700 
  $344,400 
  $678,300 
 * The Arapahoe County tap fees are net of $34,522 in royalties paid to the Land Board.
 
The CAA includes contractually established priorities that call for payments to CAA holders in order of their priority. This means the first payees receive their full payment before the next priority level receives any payment and so on until full repayment. The Company will receive approximately $6 million of the first priority payout (the remaining entire first priority payout totals approximately $6.7 million as of May 31, 2016).
 
WISE Partnership
 
During December 2014, the Company, through the District, consented to the waiver of all contingencies set forth in the Amended and Restated WISE Partnership – Water Delivery Agreement, dated December 31, 2013 (the “WISE Partnership Agreement”), among the City and County of Denver acting through its Board of Water Commissioners (“Denver Water”), the City of Aurora acting by and through its Utility Enterprise (“Aurora Water”), and the South Metro WISE Authority (“SMWA”). The SMWA was formed by the District and nine other governmental or quasi-governmental water providers pursuant to the South Metro WISE Authority Formation and Organizational Intergovernmental Agreement, dated December 31, 2013 (the “SM IGA”), to enable the members of SMWA to participate in the regional water supply project known as the Water Infrastructure Supply Efficiency partnership (“WISE”) created by the WISE Partnership Agreement. The SM IGA specifies each member’s pro rata share of WISE and the members’ rights and obligations with respect to WISE. The WISE Partnership Agreement provides for the purchase of certain infrastructure (i.e., pipelines, water storage facilities, water treatment facilities, and other appurtenant facilities) to deliver water to and among the 10 members of the SMWA, Denver Water and Aurora Water. Certain infrastructure has been constructed, and other infrastructure will be constructed over the next several years.
 
By consenting to the waiver of the contingencies set forth in the WISE Partnership Agreement, pursuant to the terms of the Rangeview/Pure Cycle WISE Project Financing Agreement (the “WISE Financing Agreement”) between the Company and the District, the Company has an agreement to fund the District’s participation in WISE effective as of December 22, 2014. The Company’s cost of funding the District’s purchase of its share of existing infrastructure and future infrastructure for WISE is projected to be approximately $5.8 million over the next five years. See further discussion in Note 6 – Related Party Transactions.
 
Operating Lease
 
Effective January 2016, the Company entered into an operating lease for approximately 2,500 square feet of office and warehouse space. The lease has a one-year term with payments of $3,000 per month.
 
13
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
 
NOTE 5 – SHAREHOLDERS’ EQUITY
 
The Company maintains the 2014 Equity Incentive Plan (the “2014 Equity Plan”), which was approved by shareholders in January 2014 and became effective April 12, 2014. Executives, eligible employees, consultants and non-employee directors are eligible to receive options and stock grants pursuant to the 2014 Equity Plan. Pursuant to the 2014 Equity Plan, options to purchase shares of stock and restricted stock awards can be granted with exercise prices, vesting conditions and other performance criteria determined by the Compensation Committee of the board of directors. The Company has reserved 1.6 million shares of common stock for issuance under the 2014 Equity Plan. The Company began awarding options under the 2014 Equity Plan during January 2015. Prior to the effective date of the 2014 Equity Plan, the Company granted stock awards to eligible participants under its 2004 Incentive Plan (the “2004 Incentive Plan”), which expired April 11, 2014. No additional awards may be granted pursuant to the 2004 Incentive Plan; however, awards outstanding as of April 11, 2014, will continue to vest and expire and may be exercised in accordance with the terms of the 2004 Incentive Plan.
 
The following table summarizes the combined stock option activity for the 2004 Incentive Plan and 2014 Equity Plan for the nine months ended May 31, 2016:
 
 
 
Number of Options
 
 
Weighted-Average Exercise Price
 
 
Weighted-Average Remaining Contractual Term
 
 
Approximate Aggregate Instrinsic Value
 
Oustanding at August 31, 2015
    312,000 
  $6.61 
 
 
 
 
 
 
Granted
    36,000 
    4.26 
 
 
 
 
 
 
Exercised
    - 
    - 
 
 
 
 
 
 
Forfeited or expired
    (10,000)
    13.25 
 
 
 
 
 
 
Outstanding at May 31, 2016
    338,000 
  $4.77 
    5.94 
  $185,660 
 
       
       
       
       
Options exercisable at May 31, 2016
    268,667 
  $4.70 
    5.42 
  $177,360 
 
The following table summarizes the combined activity and value of non-vested options under the 2004 Equity Plan and 2014 Incentive Plan as of and for the nine months ended May 31, 2016:
 
 
 
Number of Options
 
 
Weighted-Average Grant Date Fair Value
 
Non-vested options oustanding at August 31, 2015
    59,333 
  $4.59 
Granted
    36,000 
    - 
Vested
    (26,000)
    - 
Forfeited
    - 
    - 
Non-vested options outstanding at May 31, 2016
    69,333 
  $5.04 
 
All non-vested options are expected to vest.
 
Stock-based compensation expense was $58,200 and $53,700 for the three months ended May 31, 2016 and 2015, respectively. Stock-based compensation expense was $167,100 and $186,300 for the nine months ended May 31, 2016 and 2015, respectively.
 
At May 31, 2016, the Company had unrecognized expenses relating to non-vested options that are expected to vest totaling $104,200, which options have a weighted average life of less than three years. The Company has not recorded any excess tax benefits to additional paid-in capital.
 
14
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
NOTE 6 – RELATED PARTY TRANSACTIONS
 
On December 16, 2009, the Company entered into a Participation Agreement with the District, whereby the Company agreed to provide funding to the District in connection with the District joining the South Metro Water Supply Authority (“SMWSA”). On November 10, 2014, the Company and the District entered into the WISE Financing Agreement, whereby the Company agreed to fund the District’s cost of participating in a regional water supply project known as the WISE partnership. The Company anticipates investing approximately $1.2 million per year for each of the next five years for additional payments for the water transmission line and additional facilities, water and related assets for the WISE project.
 
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% (5.25% at May 31, 2016) and the maturity date of the loan is December 31, 2020. Beginning in January 2014, the District and the Company entered into a funding agreement that allows the Company to continue to provide funding to the District for day-to-day operations and accrue the funding into a note that bears interest at a rate of 8% per annum and remains in full force and effect for so long as the 2014 Amended and Restated Lease Agreement remains in effect. The $619,200 balance of the note receivable at May 31, 2016, includes borrowings of $255,000 and accrued interest of $364,200.
 
In November 2015, but effective as of January 1, 2014, the Company entered into a funding agreement obligating the Company to provide funding to Sky Ranch Metropolitan District No. 5, a related party, for calendar years 2014 and 2015 up to a maximum amount of $350,000. The funding was accrued into a note that bears interest at a rate of 6% per annum. No payments are due for a minimum of five years after the date of borrowing. The funding relates to costs associated with establishing and operating the district. The Company anticipates repayment of the note through future revenues from property tax assessments. The $169,400 balance of the note receivable at May 31, 2016, includes borrowings of $156,900 and accrued interest of $12,500. Upon the execution of the note, the amount was reclassified to long-term and is recorded as part of Notes Receivable – related parties.
 
NOTE 7 – SIGNIFICANT CUSTOMERS
 
The Company sells wholesale water and wastewater services to the District pursuant to the Rangeview Water Agreements (defined in Note 4 – Water and Land Assets to the 2015 Annual Report). Sales to the District accounted for 78% and 48% of the Company’s total water and wastewater revenues for the three months ended May 31, 2016 and 2015, respectively. Sales to the District accounted for 77% and 13% of the Company’s total water and wastewater revenues for the nine months ended May 31, 2016 and 2015, respectively. The District has one significant customer. Pursuant to the Rangeview Water Agreements, the Company is providing water and wastewater services to this customer on behalf of the District. The District’s significant customer accounted for 63% and 40% of the Company’s total water and wastewater revenues for the three months ended May 31, 2016 and 2015, respectively. The District’s significant customer accounted for 66% and 11% of the Company’s total water and wastewater revenues for the nine months ended May 31, 2016 and 2015, respectively.
 
Revenues related to the provision of water for the oil and gas industry to one customer accounted for 46% and 83% of the Company’s water and wastewater revenues for the three and nine months ended May 31, 2015, respectively. The Company had no revenues related to the provision of water for the oil and gas industry for the three or nine months ended May 31, 2016.
 
The Company had accounts receivable from the District which accounted for 88% and 87% of the Company’s wholesale water and wastewater trade receivables balances at May 31, 2016 and August 31, 2015, respectively. Accounts receivable from the District’s largest customer accounted for 73% and 76% of the Company’s water and wastewater trade receivables as of May 31, 2016 and August 31, 2015, respectively.
 
NOTE 8 – ACCRUED LIABILITIES
 
At May 31, 2016, the Company had accrued liabilities of $86,500, of which $3,600 was for estimated property taxes, $51,400 was for professional fees, and $31,500 was for operating payables.
 
At August 31, 2015, the Company had accrued liabilities of $499,800, of which $400,000 was for accrued compensation, $4,800 was for estimated property taxes, $52,500 was for professional fees and the remaining $42,500 was related to operating payables.
 
15
 
 
PURE CYCLE CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MAY 31, 2016
 
 
NOTE 9 – LITIGATION LOSS CONTINGENCIES
 
The Company has historically been involved in various claims, litigation and other legal proceedings that arise in the ordinary course of its business. The Company records an accrual for a loss contingency when its occurrence is probable and damages can be reasonably estimated based on the anticipated most likely outcome or the minimum amount within a range of possible outcomes. The Company makes such estimates based on information known about the claims and experience in contesting, litigating and settling similar claims. Disclosures are also provided for reasonably possible losses that could have a material effect on the Company’s financial position, results of operations or cash flows.
 
NOTE 10 – SEGMENT INFORMATION
 
Prior to the sale of the Company’s agricultural assets and the residual operations through December 31, 2015, the Company operated primarily in two lines of business: (i) the wholesale water and wastewater business; and (ii) the agricultural farming business. The Company has discontinued its agricultural farming operations. The Company will continue to operate its wholesale water and wastewater services segment as its only line of business. The wholesale water and wastewater services business includes selling to customers using water rights owned by the Company and to develop infrastructure to divert, treat and distribute that water and collect, treat and reuse wastewater.
 
16
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
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” in our 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 fiscal year and 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 Quarterly Report on Form 10-Q should be read in conjunction with our disclosure under the heading “Disclosure Regarding Forward-Looking Statements” below.
The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand our results of operations and financial condition and should be read in conjunction with the accompanying consolidated financial statements and the notes thereto and the financial statements and the notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended August 31, 2015 (the “2015 Annual Report”). This section focuses on the key indicators reviewed by management in evaluating our financial condition and operating performance, including the following:
●
Revenue generated from providing water and wastewater services and from farming operations through December 31, 2015, at which time it became a discontinued operation;
●
Expenses associated with developing our water and land assets; and
●
Cash available to continue development of our water rights and service agreements.
Our MD&A section includes the following items:
Our Business – a general description of our business, our services and our business strategy.
Results of Operations – an analysis of our results of operations for the periods presented in our consolidated 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 financial obligations.
Critical Accounting Policies and Estimates – a discussion of our critical accounting policies that require critical judgments, assumptions and estimates.
Our Business
Pure Cycle Corporation (“we,” “us,” or “our”) is a Colorado corporation that (i) provides wholesale water and wastewater services to end-use customers of governmental entities and to commercial and industrial customers and (ii) until the end of calendar 2015, managed land and water assets for farming.
Wholesale Water and Wastewater
These services include water production, storage, treatment, bulk transmission to retail distribution systems, wastewater collection and treatment, irrigation water treatment and transmission, construction management, billing and collection and emergency response.
We are a vertically integrated wholesale water and wastewater provider, which means we own or control substantially all assets necessary to provide wholesale water and wastewater services to our customers. This includes owning (i) water rights which we use to provide domestic, irrigation, and industrial water to our wholesale customers (we own surface water, groundwater, reclaimed water rights and storage rights); (ii) infrastructure (such as wells, diversion structures, pipelines, reservoirs and treatment facilities) required to withdraw, treat, store and deliver water; (iii) infrastructure required to collect, treat, store and reuse wastewater; and (iv) infrastructure required to treat and deliver reclaimed water for irrigation use.
We own or control a total of approximately 3,300 acre feet of tributary surface water, 20,450 acre feet of non-tributary groundwater, and approximately 26,000 acre feet of adjudicated surface reservoir sites we refer to as our “Rangeview Water Supply.” We estimate that our water supplies can provide wholesale water service to approximately 60,000 single family equivalent (“SFE”) connections.
We currently provide wholesale water and wastewater service predominantly to two local governmental entity customers. Our largest wholesale domestic customer is the Rangeview Metropolitan District (the “District”). We provide service to the District and its end-use customers pursuant to the Rangeview Water Agreements (defined in Part I, Item 1 – Business – Our Water and Land Assets in the 2015 Annual Report). Through the District, we serve 258 SFE water connections and 157 SFE wastewater connections located in southeastern metropolitan Denver. In the past three years, we have been providing water to industrial customers in the oil and gas industry located in our service areas and adjacent to our service areas for the purpose of hydraulic fracturing. Oil and gas operators have leased more than 135,000 acres within and adjacent to our service areas for the purpose of exploring oil and gas interests in the Niobrara and other formations, and this activity had led to increased water demands. As a result of the recent decline in oil prices, drilling has been significantly reduced, and we are not currently selling water to the oil and gas industry.
 
17
 
 
We plan to utilize our significant water assets along with our adjudicated reservoir sites to provide wholesale water and wastewater services to local governmental entities, which in turn will provide residential/commercial water and wastewater services to communities along the eastern slope of Colorado in the area generally referred to as the Front Range. Principally we target the I-70 corridor, which is located east of downtown Denver and south of Denver International Airport. This area is predominantly undeveloped and is expected to experience substantial growth over the next 30 years. We also plan to continue to provide water service to commercial and industrial customers.
Discontinued Agricultural Operations and Leasing
On August 18, 2015, we and our wholly owned subsidiary, PCY Holdings, LLC, sold approximately 14,600 acres of real property and related water rights in the Fort Lyon Canal Company (“FLCC”) to Arkansas River Farms, LLC, for approximately $45.8 million in cash. Pursuant to the purchase and sale agreement, we retained our farm leasing operations through December 31, 2015.
After closing the sale of our farm portfolio, we purchased approximately 700 acres of real property in the area to resolve certain dry-up covenants on three properties in order to obtain the release of the remaining approximately $1.3 million in proceeds from the sale. During the quarter ended February 29, 2016, we resolved the dry-up covenant issues, the escrow proceeds were distributed to us, and the 700 acres are held as “land for sale” within Assets of Discontinued Operations.
We have discontinued our farm operations and will continue to liquidate the remaining assets in this line of business.
Sky Ranch
We also own 931 acres of land along the I-70 corridor east of Denver, Colorado. We are currently leasing this land to an area farmer until such time as the property can be developed.
These land interests are described in the Arkansas River Assets and Sky Ranch sections of Note 4 – Water and Land Assets in Part II, Item 8 of the 2015 Annual Report.
 
 
 
18
 
 
Results of Operations
Executive Summary
The results of our operations for the three and nine months ended May 31, 2016 and 2015 are as follows:
 
Summary Table 1a
 
 
 
Three months ended May 31,
 
 
 
 
 
 
2016
 
 
2015
 
 
Change
 
 
% Change
 
Millions of gallons of water delivered
    4.3 
    7.4 
    (3.1)
    -42%
Metered water usage revenues
  $35,700 
  $73,500 
  $(37,800)
    -51%
Operating costs to deliver water
  $65,200 
  $73,700 
  $(8,500)
    -12%
  (excluding depreciation and depletion)
       
       
       
       
  Water delivery gross margin %
    -83%
    0%
       
       
 
       
       
       
       
Wastewater treatment revenues
  $10,500 
  $12,300 
  $(1,800)
    -15%
Operating costs to treat wastewater
  $7,300 
  $9,300 
  $(2,000)
    -22%
  Wastewater treatment gross margin %
    30%
    24%
       
       
 
       
       
       
       
Other income
  $40,700 
  $20,600 
  $20,100 
    98%
Other income costs incurred
  $20,800 
  $14,700 
  $6,100 
    41%
Other income gross margin %
    49%
    29%
       
       
 
       
       
       
       
Tap and specialty facility revenues
  $14,000 
  $14,000 
  $- 
    0%
 
       
       
       
       
General and administrative expenses
  $431,700 
  $384,300 
  $47,400 
    12%
Loss from continuing operatons
  $361,000 
  $6,000 
  $355,000 
    5917%
(Loss) income from discontinued operations
  $(61,300)
  $36,200 
  $(97,500)
    269%
Net (loss) income
  $(422,300)
  $30,200 
  $(452,500)
    1498%
 
 
 
 
Summary Table 1b
 
 
 
Nine months ended May 31,
 
 
 
 
 
 
2016
 
 
2015
 
 
Change
 
 
% Change
 
Millions of gallons of water delivered
    14.8 
    83.7 
    (68.9)
    -82%
Metered water usage revenues
  $119,800 
  $893,700 
  $(773,900)
    -87%
Operating costs to deliver water
  $191,000 
  $303,100 
  $(112,100)
    -37%
  (excluding depreciation and depletion)
       
       
       
       
  Water delivery gross margin %
    -59%
    66%
       
       
 
       
       
       
       
Wastewater treatment revenues
  $31,500 
  $37,200 
  $(5,700)
    -15%
Operating costs to treat wastewater
  $20,600 
  $22,100 
  $(1,500)
    -7%
  Wastewater treatment gross margin %
    35%
    41%
       
       
 
       
       
       
       
Other income
  $110,000 
  $89,500 
  $20,500 
    23%
Other income costs incurred
  $51,400 
  $35,800 
  $15,600 
    44%
Other income gross margin %
    53%
    60%
       
       
 
       
       
       
       
Tap and specialty facility revenues
  $41,800 
  $41,800 
  $- 
    0%
 
       
       
       
       
General and administrative expenses
  $1,294,600 
  $1,167,200 
  $127,400 
    11%
(Loss) income from continuing operatons
  $(769,000)
  $51,700 
  $(820,700)
    -1587%
Loss from discontinued operations
  $(21,500)
  $(97,100)
  $75,600 
    -78%
Net loss
  $(790,500)
  $(45,400)
  $(745,100)
    1641%
 
19
 
 
 
Changes in Revenues
 
Metered Water Usage Revenues – Our water service charges include a fixed monthly fee and a fee based on actual amounts of metered water delivered, which is 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 rates and charges of three surrounding water providers.
 
Water deliveries decreased 42% and water revenues decreased 51% during the three months ended May 31, 2016, compared to the three months ended May 31, 2015. Water deliveries decreased 82% and water revenues decreased 87% during the nine months ended May 31, 2016, compared to the nine months ended May 31, 2015. The decreases in water deliveries and revenues are primarily the result of a reduction in demand for water by the oil and gas industry, which was used primarily to frack wells drilled in the Niobrara formation. The decrease in the price of oil has caused oil and gas producers in the area to limit drilling, which has in turn reduced demand for water. As a result of the difference in metered rates for fracking water compared to rates for tap customers, revenues received for fracking water have a greater margin. Increases and decreases in water deliveries charged at different rates will result in disproportionate increases and decreases in revenues. The following table details the sources of our sales, the number of kgal (1,000 gallons) sold, and the average price per kgal for the three and nine months ended May 31, 2016 and 2015, respectively.
 
 
Table 2a - Water Revenue Summary
 
 
 
Three months ended May 31,
 
 
 
2016
 
 
2015
 
Customer Type
 
Sales
 
 
kgal
 
 
Average price per kgal
 
 
Sales
 
 
kgal
 
 
Average price per kgal
 
On Site
  $25,400 
    3,331.7 
  $7.62 
  $25,000 
    3,140.0 
  $7.96 
Export - Commercial
    10,300 
    951.5 
    10.83 
    7,700 
    489.4 
    15.73 
Fracking
    - 
    - 
    - 
    40,800 
    3,727.4 
    10.95 
 
  $35,700 
    4,283.2 
  $8.33 
  $73,500 
    7,356.8 
  $9.99 
 
  Table 2b - Water Revenue Summary                     
 
  Nine months ended May 31,                     
 
  2016           
  2015           
Customer Type
 
Sales
 
 
kgal
 
 
Average price per kgal
 
 
Sales
 
 
kgal
 
 
Average price per kgal
 
On Site
  $84,900 
    12,453.0 
  $6.82 
  $83,000 
    9,268.5 
  $8.96 
Export - Commercial
    34,900 
    2,393.9 
    14.58 
    28,100 
    1,835.1 
    15.31 
Fracking
    - 
    - 
    - 
    782,600 
    72,547.6 
    10.79 
 
  $119,800 
    14,846.9 
  $8.07 
  $893,700 
    83,651.2 
  $10.68 
The gross margin on delivering water decreased to a loss of 83% and 59% during the three and nine months ended May 31, 2016, respectively, compared to a loss of less than 1% and a profit of 66% during the three and nine months ended May 31, 2015, respectively, due to the decrease in water deliveries. The Company is obligated to pay certain lease and operating costs related to the ECCV system (defined under Liquidity, Capital Resources and Financial Position below). The system currently costs approximately $8,500 per month to maintain without any production. We have not had production through the ECCV system since November 2014, which has negatively impacted our gross margin for the three and nine months ended May 31, 2016. We will continue to retain the ECCV system as an integral part of our long-term water system and anticipate the system will continue to have a negative impact on our gross margin until such time as we can utilize the system capacity for future water sales.
 
Wastewater Treatment Revenues – Our wastewater customer is charged based on the amount of wastewater treated.
 
Wastewater fees decreased 15% during each of the three and nine months ended May 31, 2016, compared to each of the three and nine months ended May 31, 2015, respectively. The decreases were primarily the result of decreased demand from our only wastewater customer. Wastewater operating costs and gross margin fluctuate based on timing of expenses and regulatory requirements, but generally fluctuate consistent with demand.
 
20
 
 
 
 
 
Tap and Special Facility Revenues – We have various water and wastewater service agreements, a component of which may include tap fees and construction fees. We recognize water tap fees as revenue ratably over the estimated service period upon completion of the “Wholesale Facilities” (defined in the 2015 Annual Report) constructed to provide service to Arapahoe County, Colorado (the “County”). We recognized $3,600 and $10,700 of water tap fee revenues during each of the three and nine months ended May 31, 2016 and 2015, respectively. The water tap fees to be recognized over these periods 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 “CAA,” which is described in Note 4 – Long-Term Obligations and Operating Lease to the accompanying consolidated financial statements.
 
We recognized $10,400 and $31,100 of “Special Facilities” (defined in the 2015 Annual Report) funding as revenue during each of the three and nine months ended May 31, 2016 and 2015, respectively. This is the ratable portion of the Special Facilities funding proceeds received from the County pursuant to a water service agreement as more fully described in Note 2 – Summary of Significant Accounting Policies to Part II, Item 8 of the 2015 Annual Report.
 
At May 31, 2016, we have deferred recognition of $1.1 million of water tap and construction fee revenue from the County, which will be recognized as revenue ratably over the estimated useful accounting life of the assets constructed with the construction proceeds as described above.
The District’s water tap fees are $24,620 per SFE, and wastewater tap fees are $4,988 per SFE. We did not sell any water or wastewater taps during the three or nine months ended May 31, 2016 or 2015.
Other Income – Other income consisted principally of consulting fees of $24,400 and $16,400 for the three months ended May 31, 2016 and 2015, respectively. Other income consisted principally of consulting fees of $57,700 and $33,900 for the nine months ended May 31, 2016 and 2015, respectively. The increase in fees is the result of our management of additional water systems. We have gone from managing two systems during fiscal 2014 to four systems during fiscal 2016. Our margins have fluctuated as we allocated additional staff costs to system management. Other income also included $11,200 and $34,900 for the nine months ended May 31, 2016 and 2015, respectively, from a cost-sharing arrangement for our industrial water sales to the fracking industry.
General and Administrative Expenses
 
Significant balances classified as general and administrative (“G&A”) expenses for the three and nine months ended May 31, 2016 and 2015, respectively, were:
 
Table 3a - Signficant Balances in G&A
 
 
 
Three months ended May 31,
 
 
 
 
 
 
2016
 
 
2015
 
 
$ Change
 
 
% Change
 
Salary and salary-related expenses:
 
 
 
 
 
 
 
 
 
 
 
 
  Including share-based compensation
  $223,500 
  $188,000 
  $35,500 
    19%
  Excluding share-based compensation
  $165,300 
  $134,300 
  $31,000 
    23%
Professional fees
  $58,300 
  $74,000 
  $(15,700)
    -21%
Fees paid to directors (including insurance)
  $38,000 
  $27,800 
  $10,200 
    37%
Public entity related expenses
  $28,100 
  $19,300 
  $8,800 
    46%
 
21
 
 
 
Table 3b - Signficant Balances in G&A
 
 
 
Nine months ended May 31,
 
 
 
 
 
 
2016
 
 
2015
 
 
$ Change
 
 
% Change
 
Salary and salary-related expenses:
 
 
 
 
 
 
 
 
 
 
 
 
  Including share-based compensation
  $682,500 
  $592,100 
  $90,400 
    15%
  Excluding share-based compensation
  $515,400 
  $405,800 
  $109,600 
    27%
Professional fees
  $193,800 
  $227,100 
  $(33,300)
    -15%
Fees paid to directors (including insurance)
  $110,700 
  $98,500 
  $12,200 
    12%
Public entity related expenses
  $83,700 
  $60,400 
  $23,300 
    39%
 
Salary and salary-related expenses – Salary and salary-related expenses including share-based compensation increased 19% and 15% for the three and nine months ended May 31, 2016, as compared to the three and nine months ended May 31, 2015, respectively. The increase was primarily the result of pay increases and the addition of one new employee, which was partially offset by a reduction in share-based compensation expenses. The salary and salary-related expenses noted above include $58,200 and $53,700 of share-based compensation expenses during the three months ended May 31, 2016 and 2015, respectively. The salary and salary-related expenses noted above include $167,100 and $186,300 of share-based compensation expenses during the nine months ended May 31, 2016 and 2015, respectively.
Professional fees (mainly accounting and legal) – Legal and accounting fees decreased 21% and 15% during the three and nine months ended May 31, 2016, as compared to the three and nine months ended May 31, 2015, respectively. The decrease was primarily due to decreased legal fees of approximately $6,400 and $27,200 for the three and nine months ended May 31, 2016, as compared to the three and nine months ended May 31, 2015, respectively.
Fees paid to directors (including insurance) – Directors’ fees, including D&O insurance, increased 37% and 12% for the three and nine months ended May 31, 2016, as compared to the three and nine months ended May 31, 2015, respectively. These fees vary due to the number of meetings. For the three and nine months ended May 31, 2016, the increase in fees was primarily due to the addition of one new member to the board of directors on January 27, 2016.
Public entity expenses – Costs associated with corporate governance and costs associated with being a publicly traded entity increased 46% and 39% for the three and nine months ended May 31, 2016 as compared to the three and nine months ended May 31, 2015. The fluctuations are due to the timing and number of filings and compliance costs for filing with the Securities and Exchange Commission (the “SEC”).
Other Income and Expense Items
 
 
Table 4a - Other Items
 
 
 
Three Months Ended May 31,
 
 
 
 
 
 
 
 
 
2016
 
 
2015
 
 
$ Change
 
 
% Change
 
Other income items:
 
 
 
 
 
 
 
 
 
 
 
 
  Oil and gas lease income, net
  $31,900