Quarterly report pursuant to Section 13 or 15(d)

Note 4 - Long-Term Obligations And Operating Lease

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Note 4 - Long-Term Obligations And Operating Lease
 9 Months Ended
May 31, 2012
Debt and Capital Leases Disclosures [Text Block]
NOTE 4 – LONG-TERM OBLIGATIONS AND OPERATING LEASE

At May 31, 2012 and August 31, 2011, the Company had no debt obligations with contractual maturity dates.

The Participating Interest in Export Water supply and the Tap Participation Fee payable to HP A&M are obligations of the Company that have no scheduled maturity dates. Therefore, these liabilities are not disclosed in tabular format but they are described below.

Participating Interests in Export Water Supply

The Company acquired its Rangeview Water Supply through various amended agreements entered into in the early 1990’s. The acquisition was consummated with the signing of the CAA in 1996. Upon entering into the CAA, the Company recorded an initial liability of $11.1 million, which represented the cash the Company received from the participating interest holders which was used to purchase the Company’s Export Water (described in greater detail in Note 4 to the financial statements contained in the Company’s 2011 Annual Report on Form 10-K).  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 investments.  The obligation for the $11.1 million was recorded as debt, and the remaining $20.7 million contingent liability is not reflected on the Company’s balance sheet because the obligation to pay this is contingent on 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, 35% of each payment remitted to the CAA holders is allocated to the recorded liability account.  The remaining portion of each payment, or 65%, is allocated to the contingent obligation, which is recorded on a net revenue basis.

In fiscal years 2007 and 2008, in order to reduce the long term impact of the CAA, the Company repurchased various portions of the CAA obligations in priority.  The Company did not make any CAA acquisitions during the three and nine months ended May 31, 2012 and May 31, 2011.  As a result of the acquisitions, and due to the sale of Export Water, as detailed in the table below, the remaining potential third party obligation at May 31, 2012 is $3.5 million:

   
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, 2011:
                                 
  Acquisitions
    –       28,077,500       (28,077,500 )     (9,790,000 )     (18,287,500 )
  Option payments - Sky Ranch and The Hills at Sky Ranch
    110,400       (42,300 )     (68,100 )     (23,800 )     (44,400 )
  Arapahoe County tap fees *
    533,000       (373,100 )     (159,900 )     (55,800 )     (104,200 )
  Export Water sale payments
    85,100       (59,600 )     (25,500 )     (8,900 )     (16,600 )
Balance at August 31, 2011
    728,500       27,821,000       3,476,700       1,212,100       2,264,400  
Fiscal 2012 activity:
                                       
  Export Water sale payments
    14,300       (10,000 )     (4,300 )     (1,400 )     (2,700 )
Balance at May 31, 2012
  $ 742,800     $ 27,811,000     $ 3,472,400     $ 1,210,700     $ 2,261,700  

  *  The Arapahoe County tap fees are less $34,522 in royalties paid to the Land Board.

The CAA includes contractually established priorities which call for payments to CAA holders in order of their priority.  This means the first three payees receive their full payment before the next priority level receives any payment and so on until full repayment.  The Company will receive $5.1 million of the first priority payout (the remaining entire first priority payout totals $7.3 million as of May 31, 2012).

Arkansas River Agreement Obligations

The Tap Participation Fee

The $67.4 million Tap Participation Fee liability at May 31, 2012, represents the estimated discounted fair value of the Company’s obligation to pay HP A&M 20% of the Company’s gross proceeds, or the equivalent thereof, from the sale of the next 19,433 water taps sold by the Company.  Initially the obligation was to pay 10% of the Company’s gross proceeds, or the equivalent thereof, from the sale of 40,000 water taps sold after the date of the Arkansas River Agreement.  The 40,000 water taps was reduced to 19,433 water taps as a result of (i) Arkansas River Valley land which was sold in 2006 and 2009, (ii) the sale of unutilized water rights owned by the Company in the Arkansas River Valley in 2007, (iii) a 50% reduction in water taps subject to the Tap Participation Fee when HP A&M elected to increase the percentage from 10% to 20%, also described further below, and (iv) the allocation of 26.9% of the estimated Net Revenues received by HP A&M related to the management of the farm leasing operations which is described in greater detail below.  Pursuant to the Arkansas River Agreement, following the fifth anniversary (September 1, 2011) of the Arkansas River Agreement, HP A&M elected to increase the Tap Participation Fee percentage from 10% to 20% and take a corresponding 50% reduction in the number of taps subject to the Tap Participation Fee.

The fair value of the Tap Participation Fee liability is an estimate prepared by management of the Company.  The fair value of the liability is based on discounted estimated cash flows subject to the Tap Participation Fee calculated by projecting future annual water tap sales for the number of taps subject to the Tap Participation Fee at the date of valuation.  Future cash flows from water tap sales are estimated by utilizing the following historical information where available:

 
·
New homes constructed in the area known as the 11-county “Front Range” from the 1980’s through the valuation date.  The Company utilized data for this length of time to provide development information over many economic cycles because the Company anticipates development in its targeted service area to encompass many economic cycles over the development period.

 
·
New home construction patterns for large master planned housing developments along the Front Range.  The Company utilized this information because these developments are deemed comparable to projects anticipated to be constructed in the Company’s targeted service area (i.e. these master planned communities were located in predominately undeveloped areas on the outskirts of the Front Range).

 
·
Population growth rates for Colorado and the Front Range.  Population growth rates were utilized to predict anticipated growth along the Front Range which was used to predict an estimated number of new homes necessary to house the increased population.

 
·
The Consumer Price Index since the 1980’s which was utilized to project estimated future water tap fees.

 
·
Net Revenues from the farm leasing operations in 2010 obtained from HP A&M.  This was used to project annual farm leasing operations through September 2014 which is the date through which the management agreement was extended as described below.  The Company is permitted to allocate 26.9% of the Net Revenues against the Tap Participation Fee through September 2014.

Utilizing this historical information, the Company projected an estimated new home development pattern in its targeted service area sufficient to cover the sale of the water taps subject to the Tap Participation Fee at the date of the revaluation, which was September 1, 2011.  The estimated proceeds generated from the sale of those water taps resulted in estimated payments to HP A&M over the life of the projected development period of $120.6 million, which is an increase of $7.5 million from the previous valuation completed in fiscal 2009.  The estimated payments to HP A&M are then discounted to the current valuation date and the difference between the amount reflected on the Company’s balance sheet at the valuation date and the total estimated payments is imputed as interest expense over the estimated development time using the effective interest method.  The implied interest rate for the most recent valuation was 5.3% which was a 1.0% decrease from the prior valuation completed in fiscal 2009.  As a result of the change in the net realizable value and the interest rate, the amount of interest the Company imputed during the three and nine months ended May 31, 2012, decreased $157,000 and $456,900, respectively, compared to the interest the Company would have imputed in accordance with the valuation completed in fiscal 2009.  This equates to $.01 per basic and diluted share for both the three and nine months ended May 31, 2012.  This will result in a decrease in the imputed interest of $620,900 for the fiscal year ending August 31, 2012, which is $.03 per basic and diluted share based on the weighted average shares outstanding at May 31, 2012.

The $67.4 million balance at May 31, 2012, includes $22.9 million of interest which has been imputed since the acquisition date, recorded using the effective interest method.  Payment of the Tap Participation Fee may be accelerated in the event of a merger, reorganization, sale of substantially all assets, or similar transactions and in the event of bankruptcy and insolvency events.

Actual new home development in the Company’s service area and actual future tap fees inevitably will vary significantly from the Company’s estimates which could have a material impact on the Company’s financial statements. An important component in the Company’s estimate of the value of the Tap Participation Fee, which is based on historical trends, is that the Company reasonably expects water tap fees to continue to increase in the coming years. Tap fees are market based and the continued increase in tap fees reflects, among other things, the increasing costs to acquire and develop new water supplies.  Tap fees thus are partially indicative of the increasing value of the Company’s water assets.  The Company continues to assess the value of the Tap Participation Fee liability and updates its valuation analysis whenever events or circumstances indicate the assumptions used to estimate the value of the liability have changed materially. The difference between the net present value and the estimated realizable value will be imputed as interest expense using the effective interest method over the estimated development period utilized in the valuation of the Tap Participation Fee.

Extension of the farm management agreement

The 17,500 acres acquired by the Company pursuant to the Arkansas River Agreement are being leased to area farmers.  Those leases are managed by HP A&M and HP A&M retains all income generated by the farm leasing operations.  During the extended term, all Net Revenue retained by HP A&M is required to be applied to repayment of the outstanding promissory notes owed by HP A&M.  These promissory notes are secured by deeds of trust on the farm properties owned by the Company.  The initial term of the management agreement with HP A&M expired on August 31, 2011.  Because certain events in the Arkansas River Agreement did not occur prior to August 31, 2011, the management agreement remains in effect until 60 days after HP A&M repays all remaining farm debt (described below) owed by HP A&M or September 23, 2014, whichever comes first.  During the extended term of the management agreement, the Company is permitted to allocate a defined percentage of the Net Revenues (defined as all lease and related income received from the farms less employee expenses, direct expenses for managing the leases and a reasonable overhead allocation) paid to HP A&M against the Tap Participation Fee.  The allocation rate is calculated as the total consideration paid to HP A&M pursuant to the Arkansas River Agreement divided by $50.0 million.  The total consideration is calculated as any Tap Participation Fee payments made to HP A&M plus the value of the Company’s common stock granted to HP A&M over a defined six month period between the date of the Arkansas River Agreement and August 31, 2011.  The value of the common stock is based on the average closing price of the common stock during a defined six months period.  This calculation resulted in a 26.9% allocation rate. Effective September 1, 2011, the Company began applying this rate to the Net Revenues received by HP A&M related to their management of the Company’s farm leases.    

Promissory Notes Payable by HP A&M

This note should be read in conjunction with Note 11: Subsequent Events regarding defaults by HP A&M and related settlement negotiations.  Certain of the properties the Company acquired from HP A&M are subject to outstanding promissory notes payable to third parties with principal and accrued interest totaling $9.4 million and $10.0 million at May 31, 2012 and 2011, respectively.  In addition, HP A&M has balloon payments totaling $6.5 million due within twelve months of May 31, 2012.  These promissory notes are secured by deeds of trust on the properties. The Company did not assume any of these promissory notes and is not responsible for making any of the required payments under these notes. This responsibility remains solely with HP A&M.  In the event of default by HP A&M, at the Company’s sole discretion, the Company may make payments pursuant to any or all of the notes and cure any or all of the defaults. If the Company does not cure the defaults, it will lose the properties securing the defaulted notes.  If HP A&M defaults on the promissory notes, the Company can foreclose on a defined amount of stock issued to HP A&M and reduce the Tap Participation Fee by two times the amount of notes defaulted on by HP A&M.  If HP A&M were to default on all of the notes, the Company would lose 60 of the 80 (approximately 75%) real property interests it acquired and a comparable percentage of the water rights the Company acquired, which are associated with those properties, unless the Company cured the notes in default.  The Company currently does not have enough funds to cure all of the notes.  If that were to occur, the Company would need to seek additional financing or selectively choose the properties it would want to retain. Note 11

Because the outstanding notes are collateralized by the Company’s properties and Arkansas River water, HP A&M is deemed to be a Variable Interest Entity (“VIE”) per GAAP.  However, because the Company will not absorb any of HP A&M’s expected losses or receive any of HP A&M’s expected gains, the Company is not deemed the “Primary Beneficiary” of HP A&M and therefore is not required to consolidate HP A&M.  HP A&M became a VIE to the Company on August 30, 2006 when the Company acquired the Arkansas River water rights and properties subject to the outstanding promissory notes.  HP A&M is a holding company that acquires water rights and related properties for investment and sale purposes.

Operating Lease

Effective December 29, 2010, the Company entered into an operating lease for 1,200 square feet of office space.  The lease has a two year term with payments of $1,500 per month.