Perimeter Solutions: Doing Difficult Things Well

9 May 2024 | by Ensemble Capital

During our first quarter portfolio update, we profiled portfolio holding, Perimeter Solutions. (PRM). Below is a replay of our live commentary on the company from our quarterly portfolio update WEBINAR and an excerpt from our QUARTERLY LETTER.

Perimeter Solutions: Perimeter Solutions is the sole company that sells fire retardant to the US Forest Service. This mission critical component, the red stuff you see dropped out of planes during major fires, is needed to protect people, property and forests from out of control wildfires. Around the country, and even outside the US, government agencies that are tasked with protecting society from wildfires often look to the US Forest Service’s list of approved products and only buy items from this list. The general idea is that if it is good enough to pass the Forest Service’s extensive testing requirements, it is good enough for any agency to use.

But the Perimeter Solutions story is bigger than just wildfires. The company was founded by a group of investors led by Nick Howley, the founder of a very successful airplane parts maker called Transdigm. We owned Transdigm for many years until we sold it just before the COVID pandemic hit and over those years we came to appreciate Howley’s highly successful approach to M&A, running businesses in a profit maximizing way, and aggressively managing the capital structure to the benefit of equity owners.

So while we believe the Perimeter Solutions business by itself justifies a much higher share price, we also think that in the years ahead Perimeter will engage in a number of acquisitions that will drive significant increases in the intrinsic value of the business.

But the path to realizing these anticipated gains has not come easy so far. Last year ended up being the mildest fire season of the last three decades in the critical western region of the US. It seems to us that the stock ended up trading almost like a futures contract on estimated 2023 acres burned. Of course, the value of Perimeter is related to the long term cash flows it will generate over the next couple of decades of wildfire fighting. But even one Wall Street analyst came out with a report suggesting that the mild fire season may mean that the long term risk of wildfires was not as dire as previously thought.

But the evidence is clear that wildfires are a significant and growing risk in the US and around the world. This outlook is not conditioned on climate change triggering ever more risky weather, although we do believe that the science on this risk is very clear. Rather much of the risk comes from many decades of excessive fire suppression that allowed dry fuel to accumulate paired with the climate conditions that are already here.

Importantly, the validity of this risk is something that apolitical, profit seeking insurance companies have been warning everyone about. In California, where insurance regulators require insurers to assume that wildfire risk in the years ahead will be no higher than the average risk of the past 20 years, most home insurance companies have simply refused to write new policies in large part because they know that wildfire risk is in fact much higher.

And after the energy utility PG&E was bankrupted and convicted of manslaughter for their role in triggering massive wildfires, utility companies around the world have been sounding the alarm about wildfire risk as well. In his annual letter this year, Berkshire Hathaway’s Warren Buffett warn about the risk of wildfires saying that the big increase in wildfire activity, which he expects to continue to increase, risks the financial success of utilities to the extent they may need to become partially publicly funded entities.

Given Perimeter’s long term working partnership with so many government agencies, most importantly the US Fire Service and California’s Department of Forestry and Fire Protection, and their role as the only provider of fire retardant, the real risk to long term shareholders is not a mild fire season, but a breakdown in the natural monopoly position that Perimeter finds themselves in.

When we first initiated our position in Perimeter, a startup called Fortress had already become the first competitor to have its retardant product added to the Forest Service’s Qualified Product List. But the key to understanding Perimeter’s competitively advantaged business model is in understanding how challenging it actually is to supply retardant under life or death situations.
Rather than the company selling fire retardant as a product, Perimeter often fully staffs and maintains service operations on aerial firefighting bases. Inventory management of fire retardant is challenging because you need every base to be prepared to start fighting a fire at a moment notice, while also recognizing that many bases may not even have a fire each year.

The pilots of these firefighting planes take massive risks to protect the rest of us. A misloaded plane, or the slow loading of a plane, risks lives and properties. Going so far as running out of retardant during an active fire is unacceptable.

The best analogy we’ve come up with is the difference between selling tires and running a pit crew at a NASCAR race. The limiting factor to being a successful pit crew is not just obtaining qualified tires. Rather, running a pit crew is about operating flawlessly under mission critical circumstances. And operating flawlessly for decades is exactly what Perimeter has done.

But last year, as pessimism over the mild fire seasons pressured Perimeter’s stock price, it also became apparent that the federal government was going to give Fortress every possible opportunity to win part of the Forest Service’s annual fire retardant contract. While no one doubts how well Perimeter’s product works, and Fortress has been clear that their service wouldn’t be any cheaper than Perimeter, the federal government has a mandate to minimize sole source vendor relationships. Sole source means there is only one provider. And it appeared clear that despite concerns from firefighters about experimenting with an unproven product, Fortress was going to win at least some of the Forest Service contract.

We had bought Perimeter with this risk in mind because we believed that simply getting on the qualified products list was not winning, but rather Fortress still had a lot to prove in terms of their ability to actually deliver.

Last month, the challenges of this industry because clear when the Forest Service announced that they would not be signing a contract with Fortress because further testing had shown that their product corroded the airtanker planes it was used in.

In a press release, Fortress stated, “we have to assume based on this new information that Fortress’ proprietary, magnesium chloride-based aerial fire-retardant formulation will not be utilized for the foreseeable future in the fight against wildfires.”

There are many different kinds of competitive moats that give rise to lucrative businesses. But one of the least discussed is simply “doing truly difficult and important things really well.” We think Perimeter Solutions is a great example of just this sort of moat.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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