Mindset on Fire

The Mindset Value Q2 2024 Investor Letter

Disclaimer: The below post is my Q2 2024 Investor Letter that I sent one week ago to investors in the Mindset Value Fund. This post is NOT a solicitation. I talk about stocks that I own and my view of the future. It is imperative that you do your own due diligence and not rely on anything written below. I’m posting this in order to show how my writing translates to actual performance. With that, I hope you enjoy and gain insights.

Mindset Value Fund Q2 2024 Letter

The Mindset Value Fund finished the second quarter up 21.6% on a net basis and is up 57.4% for the year.

Mindset on Fire

Fire. That’s what you fear, come August, when you live in California. For two years, California has gotten extremely lucky with plenty of rain and very little fire activity thanks to lots of storms and an El Nino weather pattern.

Unfortunately, that luck has apparently run out.

The Park Fire burning in Northern California is now the fifth largest fire in California history, is currently half the size of Rhode Island and is only 18% contained as of Thursday.

How did this fire grow so quickly and get so dangerous? I highly recommend you read this excellent post by Paul Kedrosky on how we now have record low amounts of moisture after two years of abundant rain and lots of plant and tree growth. In other words, we have the perfect fuel conditions for fire.

Further worsening the outlook is that California is looking at a potential La Nina weather pattern this winter, where the West is drier than average and gets less rain.

Add in record high temperatures and more extreme weather and there is a lot to worry about.

Two years ago, I wrote about Perimeter Solutions (NYSE: PRM). I called Perimeter the fire monopoly because the company has a lock on providing the flame retardant that firefighters drop on fires from planes.

Soon after I wrote about the company, struggles ensued. A new competitor emerged, California saw significant rain and fire activity soon vanished thanks to El Nino. The stock fell as much as 50%.

However, the winds of change have started to shift in Perimeter’s favor. The most important news is that the risk of an upstart competitor is no more. The competitor’s contract with US Forest Service was not renewed in March after its fire-retardant product failed, causing corrosion in the air tankers.

Then Perimeter announced in February it bought over 6 million shares back in 2023 and in May it bought another 3 million shares just in Q1. That is over 6% shares that the company bought back in a relatively short period.

And with no competition, we return to fire and fighting fire. We are seeing a big increase from last year on acres burnt, but more importantly for Perimeter, California acres burned is now higher than any year in the last four years.

And we know that Perimeter has delivered over 8 million gallons of fire retardant so far through July, which is almost 50% of what they delivered in 2021, and we are just now entering peak fire season.

Revenue and earnings have been abnormally low the last two years due to the very low fire activity in California.

And it’s not just California that is burning, but Canada as well.

The Jasper fire, currently considered to be "out of control," is one of 125 active wildfires in Alberta. Other wildfires of note being battled elsewhere in the province include the Cattail Lake Complex, the Kettle River Complex, the Semo Complex and the Algar Lake Complex fires. 

If you go back into my post from two years ago, I wrote this:

By virtue of being the sole supplier of an input that accounts for only 2% to 3% of total fire spend, Perimeter has been able to consistently raise both its volume and the prices. Here’s what the CEO of Perimeter had to say in a recent earnings call:

In addition to mid- to high single-digit volume growth, we expect to deliver consistent price growth in our Fire Safety business to reflect the increasing value we provide to our customers.”

So, Perimeter has been raising prices every year and this has been hidden by the abnormally low fire activity in California.

Perimeter reminds me of Transdigm (NYSE: TDG) and I wrote about this two years ago:

What made Transdigm such a great investment is they built a business around being the supplier of hundreds of thousands of small, highly engineered low-dollar aircraft parts that may represent a miniscule part of the aircraft or maintenance but are critical in nature. This has given Transdigm pricing power to the extent that the company has been able to realize EBITDA margins of approximately 50%. 

Here is a stock chart of Transdigm:

Nick Howley, the Chairman of Transdigm is also the co-Chairman of Perimeter.

But there is another reason I think that Perimeter’s long-term outlook has substantially improved, and it has to do with insurance. As many have experienced or read about, insurance costs have soared for properties, especially those in high-risk areas. And if they aren’t soaring, it’s because insurance companies are simply walking away and not renewing coverage. Why?

Because as weather becomes more extreme and temperatures soar, so do losses when damage comes. Early estimates of insured losses from one catastrophic fire in Jasper, Alberta this year may exceed $700 million. One small town in Canada causing almost $1 billion in insured losses is eye-opening.

In the absence of insurance or affordable insurance, states and countries will have to spend more money fighting and preventing fires. Again, two years ago, I wrote:

Here too Perimeter is well placed thanks to a smart acquisition of LaderaTech. Its product Fortify is a gel that can be applied to high-risk areas and can withstand one inch of rain or more. This is highly valuable especially for utility companies that face huge liabilities from potential fires they may cause, and are investing billions of dollars in fire prevention. This is a potential market north of $2 Billion a year, and a much more recurring revenue stream than a Fire-Retardant business which can be highly seasonal depending upon the severity of fires. While the company has already announced a few deals for Fortify, it has down played its immediate prospects.

As I was working on this writeup, Perimeter announced blockbuster Q2 earnings. And the company highlighted a few very important things. First, the company announced that there is a much more aggressive response by agencies to fight fires.

Then the company also mentioned that they have significantly invested in capacity and throughput at their airbases such as their Albuquerque, New Mexico base which produced 100k gallons of retardants in one day, where its previous annual output was 145k gallons.

Perimeter also mentioned that their fire suppression business was also much stronger than expected and this immediately confirms our belief that insurance costs and the lack of insurance is a long-term tailwind to Perimeter’s business.

After struggling for a few years, Perimeter is now stronger than ever with pricing power and a market that needs its products like never before. And the longer-term outlook may be even better because if there is no insurance backstop, the only alternative is to aggressively spend to prevent fire and to fight every fire that erupts. Perimeter’s fire retardant and prevention business could not be more valuable with a world on fire.

The Odds of Cannabis Rescheduling Before the Election Have Soared

I estimate the odds of rescheduling happening before the election have soared since Biden announced he would not run for reelection. Why do I think this?

Because while Presidential elections are about talking about hot button issues and firing up your base to come out to vote, the real election is about convincing the center or marginal voter to vote for you and your party. And this is where cannabis comes in.

What other topic or opportunity do the Democrats have to show common sense leadership on an issue that is very popular with Americans? There is only one that I can think of: cannabis. For more, I wrote a post about my thinking on how rescheduling should be soon:

https://mindsetvalue.substack.com/p/the-silver-platter

Grown Rogue Is About to Turn on New Jersey

However fun it is to speculate on Federal Reform, our focus remains on fundamental research and on our portfolio investments. Our largest position continues to be Grown Rogue (OTC: GRUSF). The company’s focus is on craft cannabis cultivation with emphasis on quality and hyper-efficiency. Grown Rogue is profitable in Oregon at $800 to $900 a pound and even more profitable in Michigan at $900-$1000 a pound.

Very shortly, Grown Rogue will turn on its new New Jersey facility that will produce Oregon quality cannabis, but New Jersey wholesale prices are $3500 a pound. And with limited competition, the quality in New Jersey is far lower than exists in Oregon or Michigan. Grown Rogue’s cash flow should explode. To be conservative, let’s assume instead of costs at $600 a pound to cultivate flower, Grown Rogue’s costs soar to $1000 a pound in NJ. With 9,600 pounds of annualized production and assuming a lower wholesale price of $3000 a pound, Grown Rogue should produce over $19 million in EBITDA from New Jersey alone.

Then after New Jersey, they are turning on Illinois in 2025, where wholesale prices are $2500 a pound.

With no sell-side coverage, and only one independent analyst following it, few are running any kind of forward estimates or analysis.

I think the company could hit a run rate of approximately $40 million annualized EBITDA with operating margins above 50% while growing at triple digits. As of the writing of this letter, the company has a fully diluted market cap unlevered of $170 million. I’m not sure what the right valuation is, but the fastest growing company with the highest margins and one of the cleanest balance sheets should not be trading at one of the lowest valuations or anywhere near four times EBITDA.

Our Early Conversion of Grown Rogue

And this is exactly why we have continued to grow our position in Grown Rogue. We converted our remaining convertible debt into shares in June. You can see the filing of our updated ownership in this SEC filing. Please note that on a fully diluted basis, we own 14.43% of the company. The SEC uses basic share count, which doesn’t include all options and warrants.

New Private Investment Coming

I’m very excited that after almost two years of work, we have come to terms to invest in one of the premier private cannabis companies in the country with one of the best management teams. This company has taken very little outside capital but has built one of the few real brands in cannabis. We will be only the second outside investor in the company, and this opportunity is available only to Mindset, there are no other investors participating.

The plan is for the Mindset Venture Fund to lead the investment round and both the Mindset Value Fund and Mindset Value Wellness Fund to make smaller investments. I’m in the process of creating a new side partnership to fund the rest of the capital raise. If you are interested in participating, please let me know.

New Research Consultant to TOKE

This quarter we became the research consultants to the cannabis ETF TOKE, which is run by Cambria Associates. There are many investors who do not qualify for our fund, and we believe there is an opportunity for a fundamentally researched, well diversified cannabis ETF. We wrote about TOKE and how we are helping them.

Also, the CEO of Cambria, Meb Faber, had me on his podcast for a discussion on the opportunity in cannabis.

Summary

The next five months should have numerous catalysts from company specific to federal cannabis reform. I’m expecting there should be lots of fireworks and lots of opportunity for us to continue our strong performance.

Please also note that slowly but surely, as our cannabis investments play out, the Mindset Value Fund will be returning its portfolio to be more and more special situation and value investments and not just so heavily focused on cannabis.

Thank you for your trust and support and as always if you have questions or comments feel free to reach out.

Sincerely,

Aaron M. Edelheit