Perma-Fix Environmental Services: An Intriguing Risk-Reward

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Micro Magnate
171 Followers

Summary

  • Company has right-sized core business and is working on new avenues for growth.
  • We think the company is chasing two potential game-changing contracts to be awarded this year.
  • We feel the current valuation does not reflect even the slightest chance of them winning one or both of these opportunities.

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Thesis Summary

As this is our first contribution to Seeking Alpha, we will keep this article at a 10,000 foot level as our fund has a stake in this company, and we always recommend that anyone do their own due diligence and not rely on our opinions to make their own investment decisions. We have been involved with micro-cap hedge funds for over 20 years and have rarely seen a risk reward that we believe to be as attractive as Perma-Fix Environmental Services (NASDAQ:PESI) is today, with the core business set to generate at least $5 million in EBITDA and the company bidding on one contract with what we believe to be at least $10 million in EBITDA potential and executing towards the next phase of a contract that could be worth another $9-20 million in Phase 3 and potentially $30-120 million plus a year if commercial volumes kick in.

Quick Background

Those of you who have followed micro-caps for years are probably groaning at the mere mention of the name as they have been the model for the “over-promise, under-deliver” problem that plagues micro-cap investing. From the plateau contract, to tritium, PCBs, mercury, transuranic, and most recently, PFM PW (medical division), PESI has a long and storied history of over-promoting opportunities that have either failed to materialize or have underwhelmed upon arrival. In fact, management has missed their bonus targets in each of the last 5 years, and 2018 will fall well short of their goal of $7,682,000. That said, we do think the dangerous words “this time, it is different” apply here, and it is worth a new look at these levels. For those of you new to the story, Perma-Fix is a nuclear remediation company with two divisions. The Service segment is lower margin but more stable revenue stream, while the Treatment division is higher margin but much more volatile as often tied to the vicissitudes of government spending. The company operates out of three facilities in Richland, WA (adjacent to Hanford, the largest nuclear cleanup in the country), Kingston, TN (near Oak Ridge National Laboratory), and Gainesville, FL.

Current Valuation

From a current valuation standpoint, PESI is, at best, fairly valued. Management and the board have worked hard to cut costs and, we believe, have finally matched their expense structure to a rational revenue level. This should allow them to generate around $5 million a year in EBITDA (a level they have only achieved once since 2011) and a significant haircut from management’s 2019 bonus target of $6.78 million. Our number could be higher as the company has been working on several new business lines, including a partnership where they have installed Veolia Environnement’s (OTCPK:VEOEY) GeoMelt system in their Richland location, all of which should add some additional revenue streams to the business mix. Encouragingly, recent speeches made by Department Of Energy Environmental Management Secretary Ann White (Assistant Secretary White Emphasizes 'Progress Through Action' in WMS Address) exhorting the department to treat and dispose of more waste bodes well for PESI’s higher margin treatment division. In fact, the company recently indicated that they have received meaningful new service contracts with significant earnings potential (Perma-Fix Reports Preliminary Results for Fiscal 2018). However, given the persistent execution problems, we will use a conservative estimate and be pleasantly surprised should there be upside. When you look at enterprise value, it is worth noting that the company has a hidden asset on its balance sheet with $15.9 million in a sinking fund that covers their bonding requirement. The company has said that a portion of that (roughly $5 million) will be freed up if and when the regulators give them the final approval for the closure of their M&EC facility. Given the extraordinarily high barriers to entry in this business, permitting, physical locations, etc. at roughly 7-8x EV/EBITDA, the company would appear to be fairly valued, or maybe even a touch overvalued, given the company’s repeated inability to achieve its own goals.

Tank Closure Contract

We have outlined some of the historical problems and even why we think the company is fairly valued based on the core business. Now, we will address the two potential opportunities we do not feel are discounted in the current stock price. The most proximate is the Tank Closure Contract at Hanford. One of two big service side contracts recently put out to bid at Hanford, the Tank Contract was worth roughly $100 million annually (for 10 years) to PESI the last time they bid (and lost) in 2008. With inflation, changes in focus at DOE and Perma-Fix’s increased capabilities, we believe the opportunity could be materially higher than that historical figure. The contract specifically mentions the Test Bed Initiative (will be discussed later) briefly in one place, and a few other points in the language bode well for Perma-Fix (even the name change from the Tank Maintenance Contract to the Tank Closure Contract would seem to benefit the company as they have a treatment facility physically adjacent to the site). That said, the company would only be a subcontractor on the bid, so any assumption they will win the contract is speculative at best. While the service division is the lower margin part of Perma-Fix’s business (5-10% EBITDA margins), we believe this contract would be at the top end of the range due to increased treatment volumes being driven by the work.

Test Bed Initiative

Finally, we arrive at the most recent news and the genesis for this article. Perma-Fix is currently involved in stage two of a three-stage contract with the DOE called the Test Bed Initiative (TBI). The TBI is designed to test new ways of treating waste out of the Tank Farm at Hanford (site of the former Manhattan project), which is one of the largest nuclear waste cleanup sites in the world and the largest contributor to our country’s immense environmental liability (3rd largest liability on the US balance sheet). As an aside, for anyone who wants to do a deep dive on these issues, we highly recommend reading the GAO reports on Hanford and the Vitrification plant, as they are truly eye-opening (and nauseating). We would like for investors to do their own due diligence, so we will not summarize their findings here. If you do take the time to read those, please realize that the costs as they are outlined in those reports have materially increased with a recent report summarized in this article. Recently, the Trump government included funding phase 3 of the TBI in its 2020 budget. The importance of this to PESI is immense. For 20 years, the company has suggested they felt they could help the government with the legacy waste at Hanford. For those who followed the company, that always seemed to be wishful thinking, and DOE seemed to be firmly behind the Vitrification plant as the only way to address this critical issue. Even after the company began Phase I of the TBI, DOE didn’t seem fully engaged, but that attitude has slowly changed in the last year. In July of 2018, the DOE posted this fact sheet, giving the public more information about the TBI. At the end of January, the company was allowed to announce the task order for Phase II of the project, which seemed to be a break from the secrecy that shrouded the project in the past. Recent speeches by Ann White and the Trump budget would seem to indicate that this is now the chosen path forward for at least a portion of the tank waste at Hanford. Since nothing is easy with this company, the implications for PESI are extremely large, but exceedingly difficult to quantify. The Trump budget mentions 300,000-500,000 gallons for Phase 3 (which is a meaningful upsize from the company’s own deck mentioning only 100,000+) but earmarks only $10,000,000 to do so. The company has not tipped their hand on pricing, but we’ve seen numbers anywhere from $50 to $150/gallon (vs. $1,000+ a gallon if the vitrification plant is ever completed), so clearly $10,000,000 will not be enough funding to cover the proposed volumes. We have seen projects like this get funded from several different pots, and my reading of the Tank Closure Contract would seem to indicate there may be some money available there, but that is my own opinion, and I could be wrong. I think it is appropriate to use $100 a gallon as this is a significant discount from the number that DOE is estimating for a somewhat similar project at another site. If we are correct, Phase 3 should be worth from $30,000,000 to $50,000,000 with at least the historical treatment margins. In practice, I think the incremental EBITDA margins generated by this contract could and should be much higher than PESI's historical treatment margins but will keep the historical numbers as a conservative estimate. Using these assumptions, Phase III could be worth $9-20 million in EBITDA. A commercial contract could be in the millions of gallons as there is in excess of 50,000,000 gallons at the site. Phase II is slated to be finished in the fall, and Phase III announcement could come at any time or be assumed if it is included in the final budget. A commercial contract in the millions of gallons could be worth $100,000,000 to $300,000,000 in revenues and $30,000,000 to $120,000,000 in EBITDA annually for many years to come, given the large amount of waste in the Tanks at Hanford.

Downside Protection

Clearly, the biggest risks going forward are that the company strikes out on the TCC contract and, despite passing Phase I, somehow fails Phase II. They also have not proven they can be profitable on a consistent basis, so our $5 million estimate could prove aggressive. Should this scenario occur, we believe the facilities and their proximity to large ongoing cleanups would be attractive to potential acquirers.

Conclusion

Clearly, we are aware that this is highly speculative and that these numbers are wide enough to drive several trucks through. There is the very real possibility that the company will not win the Tank Closure contract and, for some reason, fail to perform on Phase II. We will note that, in our own research, we have not come across anyone who believes there will be any scalability issues here, but our research could well be incomplete. Our point in this article was not to do a deep dive, this is a highly complicated issue with countless layers at every level. We have no expertise in nuclear chemistry and have relied solely upon the judgement of others as to the feasibility of the Test Bed Initiative. We just wanted to put out there that this company seems fairly valued on the surface and has two proximate catalysts that would make its current enterprise value seem like a bargain if the company is successful in securing one or both contracts. In our opinion, the $35-40 million in current enterprise value is fair for a company that we feel would do $5 million (our) to $6.78 million (company's goal) in EBITDA in 2019. However, we do not feel it reflects a potential to exit 2019 with contracts that would allow it to earn $24-35 million in EBTIDA in 2020 and $45-135 million in EBITDA if the TBI proceeds to commercial levels in 2021.

This article was written by

Micro Magnate profile picture
171 Followers
We have 20 years of experience in small and micro-cap focused hedge funds. We try to ferret out under-followed and under appreciated names before the rest of Wall Street.
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Disclosure: I am/we are long PESI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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