Weitz Analyst Corner: Perimeter Solutions
Perimeter Solutions (NYSE:PRM) is a specialty chemicals company with a primary business in fire safety, which includes supplying wildfire retardants, firefighting and industrial fire suppressants, and preventative fire retardants. Perimeter has a smaller secondary specialty chemicals business which is a provider of niche engine oil additives. Perimeter is the market leader in its primary and secondary businesses, and it has a near monopoly in wildfire retardants and 70% market share in oil additives.
Perimeter is led by founder and Co-Chairman Nick Howley alongside a management team that we have had a long and successful history with through our investment in TransDigm (an aerospace manufacturing company co-founded by Howley and led by a number of members of Perimeter's management team). Additionally, Perimeter utilizes an operational and capital allocation playbook that our investment team is quite familiar with. At the core of its operating strategy is market segmentation, a strategy achieved by investing in structurally attractive markets where a business can have market leadership and deploying capital into the highest value-added niches within these markets. This often means mission-critical products and/or services in applications where a business represents a relatively small piece of the overall cost structure.
Perimeter Solutions makes good use of this playbook. Fire retardants are a critical but small portion of a larger value stream. Having the right fire retardants at the right place at the right time is critical to fighting wildfires and comes alongside high-hazard risks (property destruction, environmental impact, and potential loss of life). While mission critical, the all-in costs for these solutions are only about 5% of the total cost of wildfire management where there are large labor costs and high capital expenditures (airtankers, helicopters, air bases). Adding further to the attractiveness of the market structure are customers who are highly risk averse, creating advantages for incumbents and creating barriers to entry.
Perimeter's operating strategy is modeled after TransDigm. It consists of a highly decentralized organizational structure which provides focus and agility while creating a culture of local accountability and ownership. We believe this structure leads to greater talent retention and better on-the-ground decision making. We have seen initial traction with Perimeter as it has quickly decentralized the business into seven units. Management has also implemented The Three P's: 1) pricing for value, 2) profitable new business and 3) productivity improvements. We expect this organizational focus will drive stronger relationships with customers, ultimate spend per customer, higher organic growth, higher margins, and higher free cash flow.
Wildfire Retardants
Perimeter's wildfire retardants business offers a wholistic solution for fighting wildfires. Perimeter provides not just the fire retardant but the logistics, mixing and dispensing equipment, ground application vehicles, and importantly, highly trained service teams who are located at their customers' bases and airstrips doing the actual mixing and loading of fire retardants.
We think the secular growth story in wildfire retardants presents an attractive investment opportunity. There is industry cyclicality, as volumes are dependent upon weather events, within this secular uptrend. This cyclicality has given us an opportunity to grow our position in Perimeter at what we believe to be a large discount to intrinsic value. Perimeter's stock declined nearly 50% through the first three quarters of 2022, as we are experiencing a year where wildfire events are down nearly 30% and acres burned are down 35%.
Despite this large decline in fire events, we have seen Perimeter's fire safety revenue hold up significantly better, declining at a rate less than half of the rate of decline in fire events. We think this highlights the attractiveness of the market structure and the strength of Perimeter's competitive positioning. Perimeter has favorable contracts with its customer base, where price per gallon of retardant is volume-dependent (high prices for initial volumes, lower prices per gallon for higher-volume years). On top of this contractual indexing, we have seen strong organic pricing power in this business with structural price increases of 4-5% annually. These pricing levers help cushion revenue and margins during periods of weak volumes.
While there will be volatility in fire seasons from year to year, there are several secular trends which have led to longer-term market growth in the high-single-digits to low-double-digits. Going back to data from the 1970s, we have seen a cyclical but gradual uptrend in both the length of the fire season and in the number of acres burned per year. The step-up in acres burned has been large over past 10 years, growing at a 6% compound annual growth rate (CAGR).
The other secular growth factor impacting retardant volumes is growth in retardant usage per acre. The application of fire retardants per wildfire has grown as we have seen greater wildland-urban interface (WUI) and growth in residential property in wildlife areas outside of city centers. The number of fires from human ignitions on residential properties has grown, but even more important is the fact that the demand for firefighting in these areas has grown as there are more lives and property at risk.
The other driver impacting greater retardant application per wildfire is on the supply side as state and local governments have increased investment in capabilities and capacity to fight wildfires. Supply growth comes from a combination of growth in the number of airtankers in the field and from the average capacity of those airtankers (newer fleets have higher gallon capacity per run). The California Department of Forestry and Fire Protection, or CAL FIRE, is Perimeter's largest customer, making up one third of its revenue. CAL FIRE owns their own air tanker fleet, and is adding 21 thousand gallons of capacity over the next four to five years to its current capacity of 20 thousand gallons. Other states and government agencies partner with third-party contractors who own their own airtankers. We have seen expanding budgets and outlays for capacity growth at these third-party contractors as well. These secular tailwinds to wildfire retardant volumes along with attractive pricing creates a compelling growth story for Perimeter's fire safety business.
Perimeter's competitive position is strengthened by the regulatory barriers to entry within wildfire retardants. Products need to be tested and qualified by the U.S. Forest Service (USFS) and added to the Qualified Products List (QPL). This is a lengthy process taking over two years from start to finish. Over time, we do expect a competitive response where a secondary supplier gets qualified on the QPL. However, due to its scale and service network advantages, we expect Perimeter to maintain market leadership and for share gains from new entrants to be modest and gradual. Firefighting bases can hold just a few days of inventory on site, and Perimeter, given its logistics network, is able to deliver retardants to any of its bases within hours of request. Perimeter has service teams at the airbases who handle logistics, retardant unloading and mixing, and dispensing directly onto airtankers. Perimeter also operates mobile bases to respond to complex or remote fires. These factors, along with a customer and end-user who are highly incentivized to mitigate risk, will likely mean slower shifts in market share over time.
Preventative Retardants
Outside of fire retardants and fire suppressants that are applied directly onto fires, Perimeter has a preventative fire retardants business through its legacy Phos-Chek brand as well as its Fortify brand, which Perimeter acquired in 2020. The preventative business includes retardants that are sprayed onto property, structures, and in high-risk areas that may be in an existing wildfire's path, and it also includes seasonal retardants that are applied regularly during fire season for protection against possible events. Preventative retardants are utilized on utility/transmission lines, railroad tracks, utilities, industrial facilities, and commercial and residential properties.
The preventative market is growing at high double-digits for Perimeter. We expect a large use case for preventative applications for properties that are in the pathway of wildfires once they break out. This is another just-in-time use case with a high service component, which could lead to attractive financial metrics and returns for Perimeter. While Perimeter's preventative retardants business is nascent, the value proposition is playing out. We have seen extremely high return-on-investment (ROI) for California's largest energy utility company Pacific Gas and Electric (PG&E) which has partnered with Perimeter for preventative retardants and rapid response application to utility poles and other infrastructure. The bottleneck for market expansion is a shortage of local contractors and service teams for application. As we see this labor pool expand, we expect this piece of the preventative market to be meaningful to Perimeter's business long-term.
The seasonal preventative market is more of a wildcard. There could be potential use cases in the highest-risk areas where we see recurring wildfires and/or ageing infrastructure (transmission lines), but in many cases the return on investment is harder to prove out for customers. We expect we would need to see more movement within property insurers for this piece of the preventative market to be significant for Perimeter.
Capital Allocation
Perimeter's management team's capital allocation process is data-driven and focused on highest and best returns on invested capital. Despite many companies espousing this philosophy, there are relatively few who execute it well. While management has a predisposition towards mergers & acquisitions (M&A) where they believe they can add meaningful value though their operational and strategic playbook, when we saw large dislocations in the company's stock price this year, management took advantage of the return on investment (ROI) opportunity in repurchasing stock at a large discount to their estimate of intrinsic value.
Over the long-term we can expect M&A to be Perimeter's primary use of capital. We expect bolt-on acquisition in fire retardants, and we also expect to see new platform acquisitions into new businesses. Management has a long track record of successful M&A and has put in place what we believe to be an attractive strategy and guardrails to mitigate risk. The core tenants of Perimeter's acquisition strategy are:
Purchasing businesses with high recurring and predictable revenue streams
Strong organic growth and secular growth tailwinds
Products and services that account for a small portion of larger value streams
Significant free-cash-flow generation and high return on capital
Market that has potential for opportunistic consolidation
We believe the combination of a strong management team, attractive organizational structure and strategy, value creating capital allocation, and strong secular growth drivers all at an attractive valuation make Perimeter a compelling investment opportunity.
IMPORTANT DISCLOSURES
As of 09/30/2022, the following portfolio company constituted a portion of the net assets of Balanced Fund, Hickory Fund, Partners III Opportunity Fund, Partners Value Fund, and Value Fund as follows: Perimeter Solutions: 0.0%, 2.8%, 3.0%, 0.0%, and 0.0%; Transdigm: 0.0%, 0.0%, 0.0%, 0.0%, and 0.0%.
Holdings are subject to change and may not be representative of the Fund's current or future investments.
The opinions expressed are those of Weitz Investment Management and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through 11/22/2022, they are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor's specific objectives, financial needs, risk tolerance and time horizon.
Investors should consider carefully the investment objectives, risks, and charges and expenses of a fund before investing. This and other important information is contained in the prospectus and summary prospectus, which may be obtained at weitzinvestments.com or from a financial advisor. Please read the prospectus carefully before investing.
Weitz Securities, Inc. is the distributor of the Weitz Funds.
This article first appeared on GuruFocus.
