Wednesday, November 28, 2012

PICO Holdings

I generally don't invest in capital allocation type holding companies (or closed end funds) as you give portfolio management duties to another party, resulting in exposure to certain asset classes you like, but certain asset classes or business models you'd rather avoid.  From the manager's perspective, these vehicles have the advantage of a permanent capital base allowing the manager to avoid short term market fluctuations and focus on the long term returns.  This lesson was learned by many hedge fund and hedge fund investors during the credit crisis where managers were forced to sell assets, particularly illiquid ones, at almost any price in order to meet investor redemption requests.

While I don't normally invest in these structures, I do find them interesting to track in order to gain manager insights and see what markets others with similar styles see as attractive.  One such company I follow is PICO Holdings (, headed by John Hart since 1996, their strategy is to buy significantly undervalued or "unique" assets and generate superior long-term growth in book value per share.  Since 2007, PICO hasn't met its goal of growth in book-value (see the below screenshot, in thousands), decreasing book value by 32.2% per share.  However, many of the investments the company made recently could be on the cusp of realizing significant profits if the economy continues to recover.

Operating Businesses
PICO Holdings currently has three main operating businesses: water resource and water storage operations (Vidler Water Company), real estate operations (UCP), agribusiness operations (Northstar), and then a sprinkling of other assets including a start-up company and two legacy insurance companies (in discontinued operations below) that were recently sold to White Mountains Insurance Group.

Two of PICO's three operating businesses are heavily levered to a rebound in housing prices, especially to the hard hit states of California, Arizona, and Nevada.  After 6 long years, there are signs of a housing bottom and a sustainable national recovery, as the Case-Shiller index is showing year over year gains and there has been a noticeable reduction in mortgage delinquencies.

Home Prices Rise for the Sixth Straight Month According to the S&P/Case-Shiller Home Price Indices
October Month-End Data Shows Decline in Delinquencies and Foreclosures

Vidler Water Company (Water Resource and Water Storage Operations)
PICO's water resource and storage business, Vidler Water Company, makes up 46% of the company's book value or $220 million.  The company primarily operates in the southwest where population growth rates have exceeded the national averages and water resources are scarcer due to the desert climates.  Vidler generates its revenue by selling water resources for both residential and industrial use, and through water storage.  The development of water assets is a long term process, lasting many years between the acquisition of the asset and the sale.  Since the timing of the water resource asset sales is discretionary, Vidler's revenue is volatile and infrequent.

The demand for water resources are correlated with housing and real estate demand; as new developments are built, developers need to secure adequate water sources to sustain the development.  Vidler has many of their water assets in Arizona and Nevada, two of the hardest his states by the mid-2000s housing bubble.  As a result, new housing developments have been few and far between and the demand for Vidler's water assets shrunk causing write-downs.

Arizona's housing market and economy have clearly been impacted by the housing bubble, but green shoots of recovery are appearing.  Arizona still ranks #7 nationally in population growth, and with 10,000 baby boomers turning 65 each day, the desert climate still remains an appealing retirement destination.

Reno, Nevada is another region where Vidler has large assets, it's housing market also appears to have bottomed out and is showing an improvement of 5.5% year-over-year according to Zillow's local index.  Reno is also particularly attractive to retirees as Nevada does not have state income taxes, which puts it at an advantage over neighbor Lake Tahoe in California.  To the north of Reno, one of Vidler's major assets is a 51% interest in the Fish Springs Ranch project that includes 13,000 acre-feet of permitted water use and a 35 mile pipeline to deliver 8,000 acre-feet annually.  In the aftermath of the housing bubble, PICO took heavy impairment charges against this asset, it's now carried at $84.9 million.  It appears the prospects for this asset have improved since the write-down, John Hart commented in the 2011 annual letter that the carrying value of Fish Springs Ranch is now about 1/3rd of current comparable market transactions.

So while its hard to put a price on the value of the water assets, it appears management has been conservative in taking impairments and several other of Vidler's water assets have been on the books at cost since the late 1990s.  As the southwestern U.S. real estate market continues to improve, so should the value of Vidler's water assets.

UCP (Real Estate Operations)
Their real estate operation, UCP, is possibly the crown-jewel of PICO.  UCP was formed following the housing bubble bursting in 2008, to take advantage of the distressed housing markets in California and Washington.  UCP currently owns 5,268 residential lots in various stages of development, and has also been constructing homes or remodeling existing homes where it sees the opportunity to add additional value.  PICO has invested $134 million dollars in UCP to acquire these lots and has really just begun efforts to monetize this investment as the housing market strengthens.  In the first nine months of 2012, PICO has sold 17 homes for $4.3 million ($254,000 per home) and 224 residential lots for $23.9 million ($107,000 per lot) while achieving a 27% margin on both.

As referenced earlier, the Case-Shiller index is showing signs of a modest national housing recovery.  Additional indicators of a housing recovery include declining inventory levels (especially for entry - level homes), reduced foreclosures (in California, for instance, new foreclosures have fallen to their lowest level since 2007), record low mortgage rates, affordable home prices, and increasing rent costs.  An illiquid investment like thousands of residential lots in the hardest hit housing markets is a perfect investment for a holding company to make as it can afford to wait and be opportunistic in realizing profits.  There are several funds pursuing similar strategies, but none that I know of are currently available to the public, and likely won't be until a housing recovery is more established, and more expensive. 

UCP groups their residential lot holdings into four different geographical regions, each of which is showing signs of improvement in year over year values according to Zillow:

Santa Clara County:
Puget Sound:
Monterey, California (East Garrison):

The East Garrison ( lots are a little different animal as its a master planned community that UCP gained control of in 2009 when it purchased a delinquent note for $22.6 million, and subsequently foreclosed on after the original developer fell into bankruptcy.  As part of the first phase of development, UCP is currently constructing a 66-unit affordable housing project expected to be finished and ready for occupancy by May 2013.  Affordable housing is typically a drag on real estate values in the surrounding areas, but UCP has plans to build another 441 homes as part of phase 1 and 959 more homes as part of phases 2 and 3 with all lots to be sold by 2016 and homes completed by 2021.

With the improved outlook for housing, UCP is stepping up their construction and sale activities.  They currently have 56 completed or under construction homes in California, and it is their intention to start construction on additional 140 homes in California in the next twelve months.  If the housing market continues to show strength, presumably UCP would pick up sales activity to take full advantage.  

A quick valuation exercise, if UCP can continue to average a 27% margin, and sells all of its lots for the 2012 average of $107,000, that's an additional profit of $152 million over time.  As the housing market continues to improve and UCP can add value in the construction of homes (UCP maintains the 27% on finished homes for additional $40,000 per sale), this number could be much higher, but there is the risk of a double dip in housing prices and it will take some time to realize the profits so an appropriate discount rate should be applied.  But it's safe to say that UCP's assets, even conservatively valued, are significantly higher than their carrying value on the balance sheet.

Northstar (Argibusiness Operations)
In 2010, PICO purchased an 88% ownership interest in a new operation, Northstar, which built and now operates a canola seed processing plan strategically located near Hallock, Minnesota (about 150 miles north of Fargo), with approximately one million acres of canola currently planted within a 100 mile radius of the plant.  PICO believes this strategic location will result in cost efficiencies.  Another appealing factor to PICO is the trend toward healthy eating, canola oil contains the least amount of saturated fat of any cooking oil.

Northstar just began operations and has had a troublesome start, resulting in an initial operating loss due to margins that were tighter than projected.  As a result, Northstar has already breached its debt covenants due to ongoing operating losses that the company insists are due to temporary conditions and less than full capacity initial start-up operations.  To solve the covenant failure, PICO will convert their preferred capital position of $10.5 million to equity, and if necessary add additional equity to Northstar.  Either way the lender syndicate hasn't exercised their option to declare a default and PICO believes the failure will be resolved before year end.  Northstar has also taken other actions to mitigate their current struggles, (1) they have entered into fixed margin pricing swap agreements from October 2012 to March 2013 for 67% of the capacity or 19,500 tons per month with ING, and (2) Northstar is reducing their capacity sufficiently to only match their forward sales obligations.

The agricultural industry is not an area where I have much insight or expertise, so I'm open to other's points of view on the canola plant outlook, but in the case of most commodities, it's hard to earn an economic profit over the long term.  But PICO sees more opportunity as they have secured a second processing plant in Enid, Oklahoma, with ground breaking on the plant in the fall of 2013 and completion in 2015 (Northstar Agri Industries Announces Oklahoma Expansion Plan).  The combination of a debt covenant failure and a new plant opening is an odd one, and potentially a major cause for the recent sell off in the stock.

PICO anticipates EBITDA of between $35 and $58 million annually from the Minnesota plant, put a 5 multiple on the low end projection and you come out a value close to the book value.  So the business is pretty conservatively valued and has the potential to be beneficial to shareholders if business operations improve as PICO's management suggests.

Other Investments
In 2008, PICO made a $6 million venture capital investment in internet start up Spigit (after subsequent capital raises, PICO's stake is currently at 28% of the start-up).  Spigit's software platform helps customers with idea generation and social collaboration, it's designed to tap into the collective intelligence of an organization and transform it into actionable, predictive information, crowd sourcing within one's organization essentially.  PICO uses the equity method of accounting for their stake in Spigit as they believe they have significant influence over the operations.  Due to the consistent losses that Spigit has experienced, PICO's balance sheet value of Spigit has been written down to zero.  But how much is Spigit really worth?  In March 2012, Warburg Pincus (with $30 billion under management) led a syndicate of investors in another capital raise (Spigit Closes Series E Financing Led By Warburg Pincus).  As a result of Warburg's $15.2 million additional investment, PICO's stake was reduced from 30% to 28%, which implies a value back in March of $212 million for Spigit (PICO's 28% would be worth $59.5).  This capital raise occured pre-Facebook IPO and following aftermath of other failed social media IPOs, so this could have been a lofty valuation at the time, but any value realization event could be a windfall to PICO's balance sheet.

PICO doesn't break out their holdings in common stocks ($41.6 million) and corporate bonds ($11.4 million), but they describe their holdings as small-capalization value stocks, which is consistent with their overall strategy of buying overlooked and sometimes illiquid investments ($18.8 million of the equities are in OTC stocks). 

PICO also recently freed up some additional cash by selling their two insurance subsidiaries that have been in run-off mode (not writing new insurance contracts) for some time.  Selling the insurance operations frees up $44 million in cash, $28.9 of which was paid to the company in the form of a pre-close dividend.  On November 21, the company announced the closing of the transaction which resulted in the remaining $15.5 being distributed to the holding company.

Insider Ownership
My major concern with PICO is a lack of management ownership, John Hart has a curiously small bi-weekly purchase plan of about 900 shares a pop, and he currently owns 29,954 shares (~$530,000).  A small amount for someone who has been in charge since 1996 and receives a base salary of $2 million per year (plus cost of living adjustments).  If he was a larger shareholder, his incentives would be greater aligned to take actions to push the stock price closer to fair value.

PICO is currently trading at $17.66, about 15% below book value and below it's historical price-to-book ratio.  At current prices it gives an investor the opportunity to purchase assets at a discount that are heavily levered to the ongoing housing recovery. The stock price's recent dip is the result of the poor performance in the Northstar business and the subsequent announcement of a second plant, while it was a disappointment (although maybe a timing issue that will reverse), the real estate assets of PICO and the potential value of Spigit are appealing enough to balance out the underperforming canola business. 

Disclosure: No position in PICO, but may add in the future.


  1. Barron's wrote up PICO, nice bounce today (10/7/13):

  2. Hi MDC -

    Any chance this is still on your radar? I noticed a new activist in the stock so piqued my curiousity...

    1. Yes, still on my radar and it's tempting to me as well.

      My big question is what's Vilder worth? The west coast is in the middle of a water crisis and there still doesn't seem to be much movement or price discovery on that asset. I'm also concerned about potential eminent domain risk? Would the US government potentially seize water assets if the crisis got bad enough? Have any idea how to value it? But the activists seem to have the right idea, PICO in hindsight had no business starting Northstar from scratch and it's destroyed value, UCP appears to be under-managed as well. John Hart is fairly entrenched in there despite not owning a lot of shares, bloated salary and a potential golden parachute, good work if you can get it.

      The price looks about right as it's come down after spiking on the activist news and another Barron's mention.

    2. Yes - Barrons has been on this thing for quite some time. This name has also been written up several times on VIC... it has proven to be a true value-trap. After reading the latest proxy and looking at the shareholder value destruction under this guy Hart's "regime", I am going to stay on the sidelines. The sum-of-parts case is I think at least five, if not ten years old. The US Govt's seizing water is down the list of my worries - my issue is - how much longer will Hart stay in charge? He has actively destroyed value while his pay has gone from $800K in 2008 to $5M in 2014!! I think that the few recent moves by the Board/management are simply window-dressing to give a false impression of change. If this guy is fired or resigns, then it becomes very interesting.