Description

Fire is what you fear, come August, when you live in California. For two years, California has gotten extremely lucky with plenty of rain and very little fire activity thanks to lots of storms and an El Nino weather pattern. Unfortunately, that luck has apparently run out.

The Park Fire burning in Northern California is now the fifth largest fire in California history,is currently half the size of Rhode Island. 

https://www.cbsnews.com/news/california-park-fire-one-of-states-largest-on-record-burns-area-half-size-rhode-island/

How did this fire grow so quickly and get so dangerous? I highly recommend you read this excellent post by Paul Kedrosky on how we now have record-low amounts of moisture after two years of abundant rain and lots of plant and tree growth. In other words, we have the perfect fuel conditions for fire.

Further worsening the outlook is that California is looking at a potential La Nina weather pattern this winter, where the West is drier than average and gets less rain. Add in record high temperatures and more extreme weather and there is a lot to worry about.

This also means that the demand for the products made by Perimeter Solutions (NYSE: PRM) is likely to skyrocket. 

Turnaround after a Tough Two Years

Perimeter is the single provider of the fire retardants that firefighting agencies drop on fires from the planes. The company for the last two years has struggled as a new competitor emerged for the first time in decades, and earnings plummeted as the country saw two benign fire seasons. The stock fell as much as 50%. To cap it off, their specialty products business division began to suffer due to an inventory destocking caused by the supply chain havoc posed by COVID.

It has been written up twice before on VIC and I recommend you read those reports: https://www.valueinvestorsclub.com/idea/PERIMETER_SOLUTIONS_SA/2758714296#description

and

https://www.valueinvestorsclub.com/idea/PERIMETER_SOLUTIONS_SA/8954383302#description

However, the winds of change have started to shift in Perimeter’s favor. The most important news is that the risk of an upstart competitor is no more. The competitor’s contract with US Forest Service was not renewed in March after its fire-retardant product failed causing corrosion in the air tankers. 

There are strong  barriers to entry in this market. To summarize- Perimeter doesn’t just produce retardant- but reliably supplies it across 150 air bases within hours in emergencies. It also fully or partially manages airbases and sets up mobile air bases when needed.

To convince highly risk-averse agencies to switch to competitors is a tall ask when the cost of failure is the destruction of property and lives. Since different retardants can’t be mixed inside tanks, an agency would have to completely commit to a competitor. Given that retardants are 3% of overall firefighting revenues, there is little room to undercut in price. 

The disqualification of the new upstart further reinforces Perimeter’s massive moat in Fire Retardants. 

Perimeter also provided a massive signal with the buyback of over 9 million shares (6%) in 2023 and Q1 2024 when the stock price had plummeted on the back of two years of weak earnings. Knowing that the company will take advantage of every weakness in stock price is an excellent boost for a cyclical industry. 

But most importantly- the two weak fire seasons had masked the steady improvement in the company’s underlying business. But after the spectacular Q2 earnings, this becomes abundantly clear.

What Q2 Earnings Reveal about the Business

One way to estimate Perimeter’s earnings is to look at acres burned in the US, ex-Alaska. The more the acres burned, the more retardants have to be used, and the better the earnings are for Perimeter. So with acres burned slightly down in Q2 y-o-y, nobody was expecting what happened.

So how did Perimeter achieve these results? We find the following outlined by management in the earnings call very relevant:

1. Fire Fighting agencies are constantly improving their aircraft fleet (including capacity to carry more retardants) and getting more aggressive in fighting fires

2. Investments made by Perimeter allowed a higher throughput of fire retardants in air bases. Management gave the example of the Albuquerque air base where they increased tanker sizes from 10,000 to 25,000, upgraded the pumps, and a variety of other improvements. The net result was that in responding to fires- the airbase was able to drop 100,000 gallons of retardant in a single day where their annual average for the past 5 years was 144,000 gallons.

3. Pricing increases. Although understandably not mentioned by management in the earnings call- Perimeter has historically increased its prices by 3-4% every year.

The great thing about these reasons is these are all part of a long-term trend along with the increased acres burned and increased urbanization.

The net result is that each year, Perimeter would be able to generate more revenue and even more EBITDA per acres burnt, as is borne out by official statistics. In an earlier earnings call, management mentioned that they expect “mid-teens EBITA improvement in fire safety per year assuming a normalized fire season.”  We think that has been clearly been demonstrated this quarter.

Strong Q3 Outlook

Getting back to how we started the essay- the US is staring down the barrel of a strong fire season, particularly in California. 

As we can see, so far Acres burned are similar to 2021, the last great fire year. What’s even more encouraging is that Acres burned in California are up nearly 60%, and an analysis of acres burned and retardant dropped data reveals that California is significantly more important for Perimeter than other states.

* Total Retardant dropped was assumed to be the sum of retardants dropped by the USDA and by Calfire

This above table underestimates the contribution of California as Federal agencies are also heavily involved in fighting fire in California, and likely dropped a large amount of retardant in the area as well. 

If we apply the per-year mid-teens EBITDA improvement to 2021’s figure of $97M in EBITDA for fire safety, the company could easily report close to $150M in Adj EBITDA from Fire Safety alone. For context, in all of 2023, the Perimeter reported $97M in Adj EBITDA

A Quick Note on their Other Business

Besides Retardants- Perimeter also has a fire suppressants business and a specialty chemicals business.

In 2023, the revenue of their Fire Supressants business has increased by 40% as the market switches to Fluorine-free foams- an area where Perimeter is a clear leader. The strong performance has continued in 2024 as H1 Revenue has increased by 11M y-o-y. Management also mentioned that the cost per unit for fire suppressants has come down by 20% over the past 18 months as a result of multiple efforts to drive efficiency. 

In its specialty chemicals business, it is one of only three suppliers in the West of Phosphorous Penta-Sulfide- a key ingredient for engine oil. After a strong start in 2022, the business began to struggle as the industry went through a prolonged destocking caused by the supply chain imbalance from COVID. Thankfully, it seems like the destocking activity is behind them and the business has had a strong performance so far in 2023.
Like Retardants, both of these businesses have limited competition and are a critical but small portion of larger value streams, allowing the company to improve profitability by raising pricing each year.

This is right out of the Transdigm playbook, which isn’t surprising given that Nick Howley is also the co-Chairman of Perimeter.

Here is a stock chart of Transdigm:

Long-term outlook

There is one more reason I think that Perimeter’s long-term outlook has substantially improved, and it has to do with insurance. As many have experienced or read about, insurance costs for properties, especially those in high-risk areas are soaring. And if they aren’t soaring, it’s because insurance companies are simply walking away and not renewing coverage. Why?

As weather becomes more extreme and temperatures soar, so do losses when damage comes. Early estimates of insured losses from one catastrophic fire in Jasper, Alberta this year may exceed $700 million. One small town in Canada causing almost $1 billion in insured losses is eye-opening.

In the absence of insurance or affordable insurance, states and countries will have to spend more fighting fires and spending money on preventing fires. Again, two years ago, I wrote:

Here too Perimeter is well placed thanks to a smart acquisition of LaderaTech. Its product Fortify is a gel that can be applied to high-risk areas and can withstand one inch of rain or more. This is highly valuable especially for utility companies that face huge liabilities from potential fires they may cause, and are investing billions of dollars in fire prevention. This is a potential market north of $2 Billion a year, and a much more recurring revenue stream than Fire Retardant business which can be highly seasonal depending upon the severity of fires. While the company has already announced a few deals for Fortify, it has down played its immediate prospects.

After struggling for a few years, Perimeter is now stronger than ever with pricing power and a market that needs its products like never before. And the longer-term outlook may be even better because if there is no insurance backstop, the only alternative is to aggressively spend to prevent fire and to fight every fire that erupts. Perimeter’s fire retardant and prevention business could not be more valuable with a world of fire.

Catalyst

Insurance carriers pulling out of fire prone areas

More fires in the West

More states and countries aggressively fighting fires due to lack of insurance and having no choice

Earnings blowing out estimates as more fire retardant is used and the price of retardant doesn't matter, so PRM has pricing power