H2O Innovation Inc (TSXV: HEO) is a Canada-based company. It provides water treatment solutions based on membrane filtration technology for municipal, energy, and natural resources end-users. The company has three divisions that are water technologies & services (WTS), specialty products, and operation and maintenance services(O&M). The WTS segment provides water treatment solutions based on membrane filtration technology, and it has technologies for water treatment systems such as FiberFlex and flex MBA. The specialty products segment offers specialty chemicals, consumables, specialized products for the water industry, and maple equipment and products. Its geographical segments include Canada, the United States, Spain, Saudi Arabia, and other countries.

Revenue Mix

Source: Annual Report 2020

Investment Rationale

• Strong Backlog Driving Excellent Revenue Visibility: On March 31, 2021, the combined backlog of secured contracts between WTS and O&M reached CAD 101.4 million compared to CAD 143.8 million as of March 31, 2020. This combined backlog provides excellent visibility on revenues for the coming quarters of the fiscal year 2021 and beyond. The business model developed over the past years is also translating into a healthy backlog, well-balanced between O&M contracts and WTS contracts.

• Water Technologies and Services Segment Moving Well: WTS' revenues stood at CAD 10.1 million during the third quarter of the fiscal year 2021, compared to CAD 6.7 million for the same quarter of last fiscal year, representing a CAD 3.4 million, or 50.1 % increase. The increase was primarily due to the recent wave of projects captured as well as the resumption of work following the delays caused by the COVID-19 pandemic, compared to the same quarter of the last fiscal year. The gross profit margins before depreciation and amortization stood at CAD 1.9 million, or 19.2% for the third quarter of the fiscal year 2021, compared with CAD 1.3 million, or 18.6% for the same quarter of last fiscal year, representing an increase of CAD 0.6million, or 54.9%.

• Acquisition of GMP would Bolster Specialty Segment: On February 1, 2021, the corporation announced the acquisition of the remaining 76% of the issued and outstanding shares of Genesys Membrane Products, S.L. ("GMP"), located in Madrid, Spain. The acquisition of GMP should be seen as the next logical step in its goal of developing the world's largest membrane specialty chemicals and associated services supplier sold through a large distribution network. GMP's laboratory is globally recognized as the preeminent membrane autopsy facility in the industry and would support its Genesys and PWT teams in the sales efforts going forward. The addition of GMP is expected to generate more cross-business synergies, a clear focus of H2O Innovation's 3- Year Strategic Plan.

• Strong Flow of Recurring Revenue: Recurring revenues remain high at 87% on an LTM basis, supported by the unique business model. The business model is allowing the group to gain predictability and, through the integrated offering combining systems design and manufacturing to O&M and Specialty Products, it is maintaining long-term relationships with customers. Hence, recurring sales tend to increase continuously as the group is commissioning new systems and adding new O&M contracts. The corporation's recurring revenues are coming from the Specialty Products and O&M business pillars as well as the service activities of the WTS business pillar.

• Signs a New Contract: The organization recently reported that it had been granted a CAD 10.4 million Operations and Maintenance ("O&M") contract for the City of Laurel, increasing its total O&M sales backlog to CAD 83.2 million. We believe the contract is strategic for the company as it expands its O&M presence in Southern Mississippi.

• Reduced Debts: The company's net debt was CAD 3.3 million on March 31, 2021, down from CAD 10.5 million on June 30, 2020. A reduction of CAD 7.2 million, or 68.6%, was mainly due to the cash flows generated by operating activities and beneficial adjustments in working capital items.

• Higher Institutional Ownership: The institutional ownership in the company stood at 25.75%, which is decent given the penny-cap market classification of the company. Mutual Fund holding in the company stood at 12.5%, which is relatively high given the penny market size of the company. Moreover, other private equity holding is also closed to 11.48%, which reflects that the fund houses are also bullish on the stock, as they are still in the game despite a splendid return handed by HEO shares over the last 1-Year Also, higher institutional ownership in penny-cap stocks increases investor's confidence.

• Technical Indicators are Suggesting a Potential Upside: On the weekly chart, HEO stock prices are continuously sustaining above the upward trend line and taking support of the same. In addition, stock prices are also taking the support of its horizontal trend line at CAD 2.11 and bounced from that level. Moreover, the prices are trading above the trend-following indicators 50-period SMA, indicating a bullish trend. The leading indicator RSI (14-period) is trading at ~51.82 level and showing strength in the prices.

Source: REFINITIV, Analysis by Kalkine Group

• Risk Associated with Investment: The Corporation is exposed to a variety of financial risks: credit risks, liquidity risks and market risks (including currency risk and interest risk). Further, the company is exposed to credit risk of its counterparties, as the situation is dynamic and the impact of COVID-19 on the Corporation’s operations and financial conditions will be impacted by the duration of government-mandated measures and overall customer demand.

Financial Highlights: Q3FY21

Source: Company Filing

• In the third quarter of fiscal 2021, the group’s revenue increased by 8.7% to CAD 39.16 million compared to CAD 36.01 million reported in the same quarter of the previous financial year.
• The solid topline performance was primarily driven by stellar topline growth reported in Water Technologies & Services segment, where Q3FY21 revenue jumped by 50.1% to CAD 10.10 million compared to CAD 6.7 million. The increase was primarily due to the recent wave of projects captured as well as the resumption of work following the delays caused by the COVID-19 pandemic, compared to the same quarter of the last fiscal year.
• Topline growth was partially impacted by an 8.4% decline in the Specialty segment revenue.
• In the quarter under review, recurring revenues represented 82.6% of the corporation’s total revenues, compared to 88.2% for the comparable quarter of the previous fiscal year.
• H2O Innovation gross profit margin before depreciation and amortization stood at CAD 11.1 million, or 28.3%, during the third quarter of the fiscal year 2021, compared to CAD 10.3 million, or 28.7% for the previous fiscal year, representing an increase of CAD 0.8 million, or 7.2%.
• During the quarter, the company’s SG&A expense stood at CAD 6.5 million against CAD 6.8 million reported in the same period of the corresponding fiscal year, representing a decrease of CAD 0.3 million or 4.1 %, while the revenues of the corporation increased by 8.6%. The decrease is driven in part by lower travel expenses due to the COVID-19 pandemic and the decrease in the USD exchange rate compared to the same quarter of the last fiscal year.
• Net finance costs stood at CAD 0.9 million for the third quarter of the fiscal year 2021, compared with CAD 0.5 million for the same period of the previous fiscal year, representing an increase of CAD 0.4 million, or 83.8% compared to the previous fiscal year.

Top-10 Shareholders

Top-10 shareholders together holds 37.31% stake in the company, with Investissement Québec and Caisse de Depot et Placement du Quebec are the major shareholders in the company with an outstanding position of 11.48% and 10.45%, respectively. The institutional ownership in the company stood at 25.75% and Strategic ownership stood at 12.55%.

Valuation Methodology (Illustrative): EV to Sales based Valuation Metrics

Note: Premium (discount) is based on Company’s assessment of the growth drivers, economic moat, competitive advantage, stock’s current and historical multiple against peer group average/median and investment risks.

Stock Recommendation:  With three strong and complementary business pillars, HEO is well balanced and not dependent on a single source of revenue, which demonstrates the robustness of its business model. Even though a business line may have volatility in its revenues caused by specific market conditions, the corporation still manages to deliver growth and improve its profitability.

The acquisition of Genesys enables the group to expand its manufacturing capabilities in order to ensure continuous manufacturing and supply of specialty chemicals to its customers. It also allows the group to avoid certain commercial tariffs in place and reduce some freight costs to clients in the proximity of the manufacturing facilities (the UK and California). Moreover, the acquisition of GMP should be seen as the next logical step in the corporation's goal of developing the world's largest membrane specialty chemicals and associated services supplier sold through a large distribution network. GMP's laboratory is globally recognized as the preeminent membrane autopsy facility in the industry.

Moreover, a strong business model is allowing the group to gain predictability, and it is maintaining long-term relationships with customers. Hence, recurring sales are likely to increase as the company is commissioning new systems and adding new O&M contracts. Moreover, with the addition of Hays in FY2019 and more recently GUS, to the O&M business pillar, new opportunities are opening in a strategic geographical market such as the State of Texas.

Moreover, on the weekly price chart, technical indicators are suggesting a potential upside in the stock.

Therefore, based on the above rationale and valuation, we recommend a "Speculative Buy" rating on the stock at the closing price of CAD 2.34 on July 27, 2021.

*Depending upon the risk tolerance, investors may consider unwinding their positions in a respective stock once the estimated target price is reached.

Technical Analysis Summary

1-Year Price Chart. Source: REFINITIV, Analysis by Kalkine Group

*The reference data in this report has been partly sourced from REFINITIV.

*Recommendation is valid at July 28, 2021 price as well.

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