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PURE CYCLE CORP - 10-Q - 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.



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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%



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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


                                                          Average                             Average
                                                          price per                           price per
                                 Sales       kgal         kgal       Sales       kgal         kgal
Customer Type
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

                                                           Average                               Average
                                                           price per                             price per
                                 Sales       kgal          kgal       Sales        kgal          kgal
Customer Type
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       $161,400       $(129,500)     -80%
  Oil and gas
royalty
income, net     $76,400       $262,100       $(185,700)     100%
  Interest
income          $66,300       $6,500         $59,800        920%






Table 4b - Other Items


              Nine Months Ended May 31,


              2016          2015          $ Change     % Change


Other income
items:
  Oil and gas
lease income,
net             $354,800      $484,300      $(129,500)     -27%
  Oil and gas
royalty
income, net     $271,000      $262,100      $8,900         100%
  Interest
income          $175,400      $11,600       $163,800       1412%



                                       22


The oil and gas lease income amounts represent a portion of the up-front
payments we received on March 10, 2011, upon the signing of a Paid-Up Oil and
Gas Lease that was subsequently purchased by a wholly-owned subsidiary of
ConocoPhillips Company (the "O&G Lease") and a Surface Use and Damage Agreement
(the "Surface Use Agreement"). During fiscal year 2011, we received payments of
$1,243,400 for the purpose of exploring for, developing, producing and marketing
oil and gas on 634 acres of mineral estate we own at our Sky Ranch property. The
income received was recognized in income ratably over the initial three-year
term of the O&G Lease, which began on March 10, 2011. During February 2014, we
received an additional payment of $1,243,400 to extend the initial term of the
O&G Lease by an additional two years through February 2016. The income received
for the extension was recognized in income over the two-year extension term of
the O&G Lease.
The oil and gas royalty income represents amounts received pursuant to the O&G
Lease. The amount includes royalties from oil and gas production from wells in
our mineral estate at Sky Ranch. During the three months ended February 28,
2015, two wells were drilled within our mineral interest. At that time both
wells were placed into service and began producing oil and gas and accruing
royalties to us. 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. The first 10,000-foot horizontal well
generated royalty revenue of approximately $58,900 and $210,900 for the three
and nine months ended May 31, 2016, respectively and $204,300 for each of the
three and nine months ended May 31, 2015, 20% gross (net of taxes), based on the
Company's 3/8ths interest of the total production of this 1,280-acre pooled
mineral estate. This first well recorded production of approximately 17,200
barrels and 65,500 barrels for the three and nine months ended May 31, 2016,
respectively and approximately 68,000 barrels for each of the three and nine
months ended May 31, 2015. The second 10,000-foot horizontal well generated
royalty revenue of approximately $17,500 and $60,100 for the three and nine
months ended May 31, 2016, respectively, and $57,800 for each of the three and
nine months ended May 31, 2016, 20% gross (net of taxes), based on the Company's
1/8ths interest of the total production of this 1,280-acre pooled mineral
estate. This second well recorded production of approximately 16,000 barrels and
59,600 barrels for the three and nine months ended May 31, 2016, respectively,
and approximately 58,700 barrels for each of the three and nine months ended May
31, 2015.

Interest income represents interest earned on the temporary investment of
capital in cash and cash equivalents, available-for-sale securities, finance
charges, and interest accrued on the notes receivable from the District and Sky
Ranch Metropolitan District No. 5. The increase was primarily attributable to
the investment of cash received from the sale of our farms in August 2015 in a
money market fund at a bank, certificates of deposit, and investments in U.S.
treasury securities.
Discontinued Operations
For additional information about our discontinued operations, see Notes to
Consolidated Financial Statements.
The following table provides the components of discontinued operations:

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