PICO Holdings Inc. (“PICO” or the “Company”) owns a portfolio of water rights and water-related infrastructure in the southwestern United States through its wholly-owned subsidiary Vidler Water Company (“Vidler”). PICO also participates in the homebuilding industry through the Company’s 56.9% stake in UCP, Inc. (“UCP”). PICO has historically owned a variety of businesses including insurance companies, a Nevada land company, and a canola crush facility. PICO exited many of these businesses following the Great Recession and most recently sold its canola plant in 2015. PICO was incorporated in 1981 and is headquartered in La Jolla, California.

PICO acquired the Vidler Water Company in 1995 and subsequently acquired and developed water rights and waterrelated infrastructure across the western United States. As a brief overview, a water right is a legal right to divert water and put it to beneficial use. Water rights vary by state, but are generally divided into riparian water rights and prior appropriation water rights. Riparian water rights allocate water among those that possess land along its path and are common in the eastern United States. Prior appropriation water rights allow the first person that takes a quantity of water from a water source to use that quantity of water in the future. Subsequent users can take the remaining water for their beneficial use, provided they do not infringe on the rights of prior users. This system is common in the western United States where water rights are real property that can be bought and sold with or without the underlying land. Water rights are generally measured in acre-feet, which equates to 325,850 gallons or the amount of water needed to cover an acre of land with one foot of water. Vidler owns a number of valuable water assets, and we highlight two of the most promising assets below.

The Fish Springs Ranch is likely Vidler’s most valuable asset and consists of 7,360 acres of land and 12,984 acrefeet of permitted water rights in the Honey Lake Valley located 40 miles north of Reno, Nevada. Vidler owns a 51% stake in the Fish Springs Ranch and also has a preferred return entitling Vidler to collect the first $165 million in proceeds from water sales. In the mid-2000’s Vidler financed the construction of a 35-mile pipeline to transport the water at Fish Springs Ranch to the North Valleys, a set of communities about 10 minutes northwest of downtown Reno. After a sharp downturn in construction activity following the Great Recession, the Reno area is undergoing a rapid economic expansion, as companies such as Tesla, Switch, eBay, and Amazon have all opened facilities. Following the construction of the pipeline, the Fish Springs Ranch now has a near-monopoly on the water supply to the North Valleys. At the Company’s 2016 annual meeting, Vidler professionals noted they expect the current pace of residential and commercial construction to result in the sale of over 8,000 acre-feet of water rights in the North Valleys by the middle of 2018. Professionals we spoke with both at Vidler and the local water authority expect water rights in the North Valleys to sell for over $30,000 per acre-foot. If we assume the first 8,000 acre-feet of water rights are sold for $30,000 per acre-foot, the Fish Springs Ranch would collect $240 million in proceeds with Vidler receiving over $200 million in proceeds given its preferred return. Additionally, Vidler is also working on obtaining permits to allow for the transportation of an additional 5,000 acre-feet of water into the North Valleys.

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Vidler has also accumulated 409,000 acre-feet of water storage credits in and around Phoenix, Arizona. Unlike water rights which essentially grant perpetual use, these credits are one-time assets for a specific amount of water. The credits include 251,000 acre-feet of water storage credits held at the Vidler Recharge Facility in the Harquahala Valley and over 157,000 of water storage credits located in the Phoenix Active Management Area. Vidler purchased and stored most of these water credits at attractive prices when the state of Arizona had an excess supply of water from the Colorado River. Demand for water in Arizona has increased recently given prolonged drought conditions and an economic expansion. Additionally, the elevation of the water level of Lake Mead recently fell below 1,075 feet, which is the level where water allocations from the Colorado River begin to be reduced. The state of Arizona faces the most severe cutbacks in water allocations from the Colorado River if the elevation level of Lake Mead remains below 1,075 feet. These dynamics have resulted in a sharp increase in the price of water in the Phoenix area with recent water credits recently selling for between $325 and $350 per acre-foot. Should Vidler be able to monetize its water storage credits at similar rates, the proceeds for Vidler’s 409,000 acre-feet of water storage credits would exceed $130 million.

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In addition to the water rights at the Fish Springs Ranch and the water credits in Arizona, Vidler also owns a number of additional water assets in Nevada, Arizona, and New Mexico. These include 4,000 acre-feet of water rights around Carson City, Nevada, 6,000 acre-feet of water rights in the Harquahala Valley in Arizona, a 50% partnership interest in the potential development of over 40,000 acre-feet of water in Lincoln County, Nevada, development rights to a power plant in southern Nevada, and a number of other water rights and real estate holdings. We valued the Vidler Water Company’s individual assets using a discounted cash flow analysis incorporating both conservative and base-case assumptions and obtained a value for Vidler’s water assets of $275 million at the low-end and over $750 million at the high-end. We would highlight that even the low-end valuation exceeds the current market capitalization of PICO.

In addition to the Company’s water assets, PICO also owns 10,593,000 Series A Units of UCP that are exchangeable into common stock. Given UCP’s share price of $8.34, PICO’s stake in UCP is currently valued at over $85 million. UCP is a regional homebuilder and land developer operating in the states of California, Washington, North Carolina, South Carolina, and Tennessee, constructing homes under the Benchmark Communities brand. UCP owns over 4,600 lots and controls another 727 lots, with over 40% of the lots purchased between 2008 and 2010 when land prices were relatively inexpensive. UCP’s operating results have improved dramatically in recent periods as the company transitions from an owner of land into a homebuilder. Despite these improvements, UCP trades at approximately 70% of stated book value, which represents a sizeable discount to its peers. This suggests that UCP also has a sizeable margin of safety and upside potential.

Before providing our final valuation of PICO, it should be noted that PICO has historically made a number of poor capital allocation decisions and has also been the target of a significant amount of shareholder activism. As a result, PICO recently modified its corporate strategy and is now committed to monetizing the Company’s assets and returning proceeds to shareholders either through dividends or share repurchases. Importantly, this change greatly reduces the risk of further misallocations of investor capital. PICO also has undergone almost a complete overhaul in the composition of its board of directors, with 5 of the Company’s 8 directors added since December 2015. We would note the new board members have their professional reputations on the line and are likely to be highly incentivized to reverse the poor share price performance that has plagued the Company for the last ten years.

When evaluating any potential investment, Gate City Capital Management considers what it would pay for the entire company. PICO currently has a market capitalization of $230 million. PICO has no debt (all debt listed on the balance sheet is held at UCP), has almost $10 million in cash at the corporate level, controls an $85 million equity stake in UCP, and owns a number of valuable water assets. Our target value for PICO was obtained by using a sumof-the-parts valuation which utilized the valuations of Vidler Water and UCP provided earlier. Reductions to this valuation were made to account for 5 years of general and administrative expenses (approximately the time to monetize the Company’s assets), potential management incentive compensation awards, and potential income taxes from asset sales (partially reduced by $135 million in prior net operating losses). An average of the low and high valuations was used to produce a target market capitalization for PICO of $397 million or $17.25/share, representing a 72% premium over the Company’s current share price. We would also note that the valuation obtained in the most conservative scenario resulted in a target market capitalization of $254 million and target share price of $11.04/share, which is almost 10% higher than the recent closing price. This attractive risk/reward dynamic has provided us with the conviction needed to make PICO an important holding in the Fund.

[us_separator] The above post has been excerpted from a recent letter of Gate City Capital Management.

Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2015 has undergone an Audit by Spicer Jeffries LLP. Performance for 2016 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014. The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.