As originally appeared in the Troubled Company Reporter.
PICO Holdings, Inc. (Nasdaq:PICO), based in La Jolla, Calif., is a diversified holding company reporting recurring losses since 2008. PICO owns 57% of UCP, Inc. (NYSE:UCP), 100% of Vidler Water Company, Inc., a securities portfolio and various interests in small businesses. PICO has $662 million in assets and $426 million in shareholder equity. Central Square Management LLC and River Road Asset Management LLC collectively own more than 14% of PICO. Other activists at http://ReformPICONow.com/ have taken to the Internet to advance the shareholder cause.
The bloggers provide commentary that relates to UCP’s Second Quarter results.
“We have three comments about UCP’s gross margins:
(A) Homebuilders mostly capitalize interest and then expense it through cost of goods sold. UCP’s borrowing costs are twice that of competitors. Therefore, UCP will always have lower gross margins than industry average.
(B) UCP’s gross margins were abnormally high in Q2 because weather delayed sales in the Southeast, and this Division produces significantly lower margins. As low-margin sales were a smaller part of the mix, consolidated gross margins increased.
(C) UCP is currently selling significant amounts of its vintage land. This land, in California and Washington, carries far higher margins than recently purchased land. Gross margins are temporarily inflated and will remain so, as long as this valuable resource exists. But eventually, the vintage land will be depleted and UCP’s gross margins will likely fall from the level today. As an enterprise, UCP’s value will correspondingly fall.”
Next, the bloggers delve into some accounting intricacies.
The bloggers note that a category of expense exists “off-income statement.” They write, “We said for months that UCP’s net income was overstated due to lack of income tax expense. Then in Q2, a large number appeared on UCP’s cash flow statement, in the “financing activities” section. “Distribution to noncontrolling interest $4,830,” caught our eye (this outflow appeared in previous financial statements, but it was small so we left it alone).
UCP is subject to a “Tax Receivable Agreement” with PICO. UCP must reimburse PICO for certain cash tax savings it receives as a result of the exchange of the Series A units.
UCP has been reporting inflated net income for accounting purposes, but with this cash flow statement entry, we can get a clearer idea of UCP’s economic net income.
This nuance of accounting is not the result of deception by either UCP or PICO executives — it is how GAAP and tax accounting juxtapose under a somewhat uncommon arrangement.
RPN isolated and combined the UCP financial statements for the last half of 2015 and the first half of 2016 to re-create a 12-month income statement that more closely resembles economic reality (we generously ignore the Bakersfield impairment of $2.4 million). The first income statement is coherent with GAAP while the latter includes the distribution from UCP to PICO as tax expense (all figures in millions).
Model GAAP Economic
—– —- ——–
Revenue $331.7MM $331.7MM
Gross Margin $62.6MM $62.6MM
Expenses $46.8MM $48.6MM
Pretax Income $13.6MM $13.6MM
Net Income $13.6MM $8.7MM
Examined without adjustment, an analyst would believe that UCP earned net income of $13.6 million over the last 12 months. But by referencing the cash flow statement and appropriately tweaking the income statement, we provide a clearer result: UCP earned $8.7 million over the last 12 months — a reduction of 36%. Return on equity goes from 6.3% to 4%.”
The bloggers next delve into the arcane subject of cost of capital.
“In a footnote entitled ‘Contingent Consideration’ on page 91 of the UCP 10-K, we learn that UCP used a risk-adjusted discount rate of roughly 14% to calculate the fair value of the earnout from the Citizens acquisition.
Using the 14% discount rate as a cost of equity capital for UCP may not be perfect, due to several unknown variables. But it should be close, and that’s good enough for RPN. We are not sticklers for minute numerical details.
Applying a 14% cost of equity capital to UCP produces a hurdle of about $30 million annually (0.14 x 215 million). At a 38% tax rate, this equates to pretax income of about $48 million. As noted above, UCP’s pretax income for the last 12 months was $13.6 million, so they came up a little short.”
The bloggers conclude by questioning the value of UCP’s noncontrolling interest. “UCP has been reporting its ‘Debt to Capitalization Ratio’ and ‘Net Debt to Capitalization Ratio’ since IPO in mid-2013. For the record, these figures were 43.1% and 40.3%, at June 31, 2016, respectively. Debt to cap ratios in the ’40s’ would place UCP on the conservative side of industry averages.
We view these ratios as suspect due to the significant noncontrolling interest. For those who are not accounting nerds, noncontrolling interest represents PICO’s ownership share in UCP; it is recorded in UCP’s shareholder’s equity and in this case, amounts to 57% of book equity.
We view the Debt to Cap Ratios as suspect for two reasons related to the noncontrolling interest. First, PICO does not have the resources to help UCP if the latter came under distress. Daniel Mannes of Avondale Partners justifiably asked on the earnings call about corporate resources and Tangled Webb vaguely indicated that there weren’t many (apparently the owners of the business are not allowed to know what a company in liquidation is liquidating). Mr. Marino stated at the Annual Meeting that PICO would not be borrowing funds.
If PICO is selling assets to pay monthly bills and the Chairman is not in a borrowing mood, seems to us like UCP is on its own, come hell or high interest rates. In that case, what good is the noncontrolling interest as a form of capital?
Second, the market value of the minority interest is far below its carrying value. PICO’s noncontrolling interest is recorded in UCP’s shareholder’s equity at $122 million, but current market value is only about $90 million. Speaking hypothetically, if PICO were to acquire UCP outright today, the entire equity account would be much reduced and hence debt capacity would be much reduced.
Removing PICO’s noncontrolling interest from the equation, UCP has a “Debt To Capitalization Ratio” of almost 64% and “Net Debt To Capitalization Ratio” of 61%. Such results would put UCP at the riskier end of industry averages.
We believe our adjusted debt to cap ratios partially explain UCP’s borrowing costs that are significantly higher than competitors. These borrowing costs are also far higher than other builders with 40% +/- debt to cap ratios.”