PESI - Perma-Fix Faces Both Opportunities And Challenges

2023-10-27 13:00:42 ET

Summary

• Perma-Fix Environmental Services specializes in environmental clean-up services, with major customers including the US government.
• The company operates in a heavily regulated industry, which creates both advantages and disadvantages.
• Perma-Fix is positioned for future growth due to increasing power generation needs and potential expansion into new markets.
• Analysts and investors are very optimistic about the stock but its current price offers little margin of safety after a 150% rally YTD.

Perma-Fix Environmental Services ( PESI ) is a small cap company that specialized in environmental clean-up services. The company engages in large scale waste management services and its biggest customers include the federal government of the US including the Department of Energy, the Environmental Protection Agency and the Department of Defense.

The company operates in a heavily regulated industry which comes with advantages and disadvantages. The main advantage is that it creates a very high barrier of entry for competitors and allows the company to enjoy a pretty strong position as a government contractor. The main disadvantage is that it creates a risk for the company if it fails to meet government's high standards and regulations since the government is basically the bread and butter of this company and it might not survive long if it lost this particular customer.

The company has two main business segments called Treatment and Services. The company's Treatment segment is responsible for treating waste materials in a number of facilities owned and operated by the company. This is more or less "operations" side of the company. Services segment consists of scientists, experts and consultants and offers innovative solutions and develops new methods and technologies for waste clean-up and a variety of environmental services. This is the R&D side of the company and it offers more specialized services. The company's Services segment also helps its Treatment segment with creating better methods and solutions so that the company itself can get more efficient over time.

The company works very closely with the power industry, especially those focused in nuclear power generation. Almost every non-renewable method of power generation results in waste materials that need to be disposed of in a safe, clean and cost-efficient manner. Nuclear clean up can be quite costly if done correctly or extremely costly with massive environmental impacts if not done correctly. This is why it's important to use companies that meet all regulations and standards and possess highly specialized expertise in order to get the job done since the consequence of error is too high.

As a society we use a lot of power and this power needs to be generated somewhere. In the future the need of electricity will increase exponentially for a variety of reasons. First, our population is growing and becoming more urbanized which increases the usage of power. Second, there is a shift towards electric vehicles and current power generation levels don't even come close to addressing the future need if electric vehicle adoption truly takes off. Third, increased usage of AI will result in massive amounts of power usage by data centers. It is so much that Microsoft is investing in nuclear power for its AI-related needs.

All these trends are favorable for companies like Perma-Fix and could act as future catalysts for the company's growth. If we increase our power generation exponentially there will be also a need to invest exponentially into waste clean-ups which is where the company comes in.

Furthermore, the company is currently only operating in the US (excluding some very small contracts in Canada). The company is planning on expanding into new markets and it already received some shipments of waste to be disposed of from Europe in small amounts. This could unlock further growth for the company even though it's too early to talk about this. One thing to keep in mind is that environmental regulations and standards might differ vastly from country to country and it might be very costly for the company to expand from one market to another since it would require the company to hire an army of lawyers and attorneys to deal with all the local laws and regulations.

Of course there is the infamous Hanford Cleanup project which the company is participating and it is expected to last at least for another 50 years from today. Basically Hanford was used from 1940s to 1980s to produce plutonium to support America's nuclear weapons program and it used old methods and techniques that were not environmentally friendly at the time. The site has been decommissioned decades ago and its cleanup project has been going on for a very long time. This project allows the company to have steady income visibility until about 2079. The government will spend between $322 billion and $677 billion on this project in the next 56 years and Perma-Fix will be one of the beneficiaries of such large spend.

In recent years the company has been upgrading its facilities and tools within these facilities with newer technology. This has been done in order to increase overall efficiency and productivity as well as reduce the cost of doing business. These types of projects typically have a high initial cost and it pays itself off over time as productivity gains are achieved over the course of time. Some of these upgrades and updates to facilities were conducted by the company's own Services segment so the company paid to itself in a way for some of these upgrades. So far it's unclear if and how exactly the company will benefit from these upgrades but any efficiency gain should be positive for investors.

During the period between 2020 and 2022, the company suffered from a hiccup from the effects of the COVID pandemic. Many of the company's clean-up projects faced administrative delays due to slow response from the government. As of 2023, things seem to be back on track again and the company is working through a pretty sizeable backlog. After posting a loss for 2 years, the company seems to be on its path to profitability again as its revenues and margins have been improving.

As a result of optimism about the company's improving prospects, the stock is up 153% year to date. As a matter of fact, the stock was up 250% just last month before the whole market started to have a correction in reaction to rising interest rates. It is very possible that the stock is a bit overheated right now and it likely needs a healthy level of pullback.

Since this is a small company, its covered by a small number of analysts so I would take analyst estimates with a grain of salt but it's still worth noting that analysts are pretty optimistic about the company's future. The company is expected to earn 20 cents this year, 55 cents next year and $2.07 in 2025 as it gains more government contracts, expands internationally and becomes more cost efficient overall. It is also expected that the company will be able to raise its prices and pass some of its rising costs to its customers (mainly Uncle Sam) in the next year or two with more favorable contracts but we will have to wait see if it actually happens. There is a very serious possibility that the US government might be facing budget cuts in the future if interest rates keep rising the way they have been which might make it less likely that the company will receive any price hikes from the government. If the company can meet analysts' 2025 goals, it will look very cheap with a forward P/E of 4. Even if the company can achieve half of that goal, it will still look cheap at a forward P/E of 8. Based on current earnings the company doesn't look very cheap with a P/E of 43 though so we are looking at a big if.

I would personally like to see either some more progress in profitability or a cheaper valuation before investing into this company. The stock looks a bit overheated after climbing 150% this year and both investors and analysts are highly optimistic about the company's future even with a lot of unknowns and uncertainties. Although it shows a lot of promise and potential, at the current price level, the company offers very little margin of safety for me.

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