PFIE - Profire Energy Is Expensive Compared To Cycle Average Earnings

Summary

• PFIE designs PLCs that control burners used in the O&G industry.
• The company has shown cyclical revenues and high operational leverage caused by an SG&A structure that eats most profits.
• Because the company is transitioning through a cycle peak (or upward portion at least), current earnings are no parameter of long-term profitability.
• Using cycle average, I find PFIE trades at a P/E ratio of 17x, too high for a company that shows no competitive advantages in its sector.

Profire Energy ( PFIE ) is a Canadian designer of PLCs for the O&G industry. The company's products control burners used in the industry for several processes, including burning polluting materials like methane.

PFIE's revenues and earnings are very cyclical, following a close pattern to U.S. investment in O&G rigs. Unfortunately, the company has a relatively fixed and very high level of SG&A, which I believe is related to the non recurrent nature of its business.

For that reason, and the fact that the industry is in the upper portion of the cycle, I don't believe that current prices provide a good opportunity to purchase PFIE.

Note: Unless otherwise stated, all information has been obtained from PFIE's statements with the SEC .

The business

PLCs for O&G burners : PFIE design PLCs that are installed on burners to control them without the need for personnel to control them. These controllers are critical for the automatic operation of O&G rigs.

High correlation with U.S. oil investment : The company sells more than 90% of its products in the US. Their revenues show a cyclical pattern that is very correlated with U.S. investment in oil rigs. It is clear that the company has been operating on a cycle marked by U.S. exploitation of unconventional O&G.

Outsourced assembling keeps gross margins stable : PFIE does not assemble its own products. The company sources them from an assembler in Edmonton, Alberta, called Logican. I guess this has helped the company keep its gross margins relatively stable across the cycle without absorbing significant overhead at the factory level.

SG&A is fixed and high : The Achilles' heel of many companies is an inefficient SG&A structure that is sticky and absorbs most profits.

Revenue is non recurring : The SG&A monster is a pattern I have seen in other companies, particularly in Orion Energy ( OESX ), which also sells a one-time product. That level of SG&A is needed because no long-term relations are formed with either OEMs or the oil drillers, and therefore each sale has to be fought for. Management makes a lot of effort in earning calls to comment on how revenues are getting more recurring, again a sign of their lack of it.

Financially strong : PFIE has no debts and holds a cash and securities stash of about $14.5 million as of 3Q22 .

Not crazy capital allocation : The company has not made any significant acquisitions, nor expended a lot in capital investments. It has not returned capital to investors in the form of dividends or buybacks either. Rather, it has slowly eaten away its cash reserves to sustain its SG&A efforts during the downturn portion of the cycle. This pattern is also similar to the one seen in OESX.

Recent context

The upward portion of the cycle : PFIE is propelled by a secular trend in the U.S. marked by the exploitation of unconventional O&G. On a shorter time scale, it is currently riding the upward portion of the investment cycle marked by the recent increase in O&G prices since 2021 and particularly in 2022. Therefore, current earnings cannot be considered permanent or sustainable.

Efforts to reduce emissions : The O&G industry is under scrutiny to reduce emissions. In particular, natural gas is considered a transition energy source, but unconventional gas is suspected of producing higher emissions than its conventional cousin. The reason is that unconventional exploitation liberates methane in the atmosphere, and methane is much more polluting than CO2. Burners and their controllers are a way the industry can improve in this area. Here PFIE has a long-term trend supporting its products. The company has also commented on recent earnings calls that it is developing a controller that helps measure emissions more correctly.

Valuation

Income across the cycle : As Peter Lynch would beware, investing in 'low multiple' cyclical stocks at their cyclical peak is a very good way to lose half your money. PFIE can be valued only through the averages across the cycle.

Of course, that is not an easy task given that a period to calculate the average has to be chosen. In this case, I use the 2013 to 2020 period, which incorporates two complete cycles. Below you can also find the average for a longer time period, which I believe underestimates the cycle average.

Multiples and quality : Using the shorter period operating income average, plus an effective income tax rate average of 35%, we arrive at an average of $3 million in yearly net income. At current prices of around $51 million for the company, that implies a P/E ratio of 17x.

I do not believe PFIE's business conditions of cyclicality and operational leverage justify such a premium over the long-term average.

Conclusions

Although PFIE shows financial strength and has not squandered cash, the company seems expensive in terms of historical earnings. Readers should consider long-term cycle earnings averages for multiple calculations, rather than recent earnings, particularly given that the company is benefiting from its industry's upward portion of the cycle.

In order for me to pay a premium in terms of multiples, the company should have quality characteristics. Unfortunately, PFIE does not seem to have these: its industry is competitive and cyclical, and the company is not great at managing expenses like SG&A.

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