As a complete solution provider, H2O Innovation (TSXV: HEO) designs, manufactures and commissions customized membrane water treatment systems and provides operation and maintenance services as well as a complete line of specialty products such as chemicals, consumables, couplings, fittings, and cartridge filters for multiple markets. In addition, H2O Innovation provides a full range of maple equipment and products to maple syrup producers.

Investment Rationale

• Bagged Six New Projects: The company has recently been awarded six new capital equipment projects in its Water Technologies & Services business line and reached substantial completion on six others. These new contracts, with a total value of CAD 4.8 million, bring the WTS backlog to CAD 34.8 million. These projects highlight the ability of H2O Innovation to understand and solve their customers' issues, whether the limitations or challenges are processes, design, or water-quality related.

• Strong Backlog Driving Excellent Revenue Visibility: At the end of the Q3FY21, 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.

• Reported Strong Profitability and Strong Cash Flow in Q3FY21: In Q3FY21, the company reported revenue growth of 8.6% on the back of the recent wave of projects captured as well as the resumption of work following the delays caused by the COVID-19 pandemic. Adjusted EBITDA was 11.5%, increased by 100bps on a YoY basis; Net profit stood at CAD 2.1 million compared to net loss reported in the same period of the previous financial year. Cash flow from operating activities stood at CAD 10.2 million compared to CAD 0.9 million reported a year before.

• Strong Water Technologies and Services Segment Performance: During the quarter under consideration, the company's reported revenue stood at CAD 10.1 million representing a 50.1% increase, while EBAC increased by 1811 % from Q3FY20. Further, the segment is well-positioned for future growth with a well-diversified backlog of CAD 35 million with an increased proportion of industrial-related projects (34.2 % compared to 30.8 % in Q3FY20).

• Deleveraging Balance Sheet: Net debt at the end of the third quarter of FY21 stood at CAD 3.3 million compared to net debt of CAD 10.5 million at the end of the previous year, led by strong free cash flow generation on account of topline growth and margin expansion. The debt/Equity ratio at the end of March 31, 2021, stood at 0.34x compared to 0.42x at the end of December 31, 2020. Further, debt protection metrics also improved, with Net Debt/EBIDTA stood at 4.26x compared to 6.27x a quarter before, which implies that the company is generating sufficient earnings to manage its debt comfortably.

• Long-term Uptrend: On the monthly price chart, HEO shares were hovering in a bullish trend, with momentum indicator 14 Period RSI hovering above 60, which implies that the long-term uptrend is quite strong. Further, on Bollinger Band©, its shares were hovering above the middle band and moving towards the upper band. These technical indicators indicate that the stock is in the long-term bullish zone, and buying on dip would be a good strategy to play in this stock.

Monthly Price Chart (as on September 07, 2021). Source: REFINITIV, Analysis by Kalkine Group

• Trading Above the Crucial Support Levels: On the daily price chart, its shares traded well above the crucial short-term as well as long-term support levels of 200-day and 50-day SMAs, which implies that HEO shares are hovering in a bullish zone. Moreover, despite the last two days of consecutive fall in the stock, its shares have not breached its last Engulfish candle that appeared on Friday (September 03, 2021), which implies that the bulls are heavy over bears.

Daily Price Chart (as on September 07, 2021). Source: REFINITIV, Analysis by Kalkine Group

• Risk Associated with Investment: The company is exposed to a variety of risks ranging from shrink in the order book, delay in project rollout due to COVID-19, forex risks, and interest rate risks.

Financial Highlights: Q3FY21

Source: Company Filing

• In the third quarter of fiscal 2021, the group’s reported 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.
• Solid top-line performance was primarily driven by stellar top-line 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 last fiscal year
• Topline growth was partially impacted by 8.4% decline in the Specialty segment revenue.
• In the quarter under review, company’s recurring revenues represented 82.6% of the Corporation’s total revenues, compared to 88.2 % for the comparable quarter of 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 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%. The decrease of gross profit margin (%) before depreciation and amortization is because of business mix, with more sales coming from the WTS business pillar and less sales coming from the Specialty Products business pillar.
• During the quarter the company’s SG&A reached 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 last fiscal year.
• Finance costs, net stood at CAD 0.9 million for the third quarter of fiscal year 2021, compared with CAD 0.5 million for the same period of previous fiscal year, representing an increase of CAD 0.4 million, or 83.8% compared to the previous fiscal year.
• The Corporation’s adjusted EBITDA increased by CAD 0.7 million, or 19.5% to reach CAD 4.5 million during the third quarter of fiscal year 2021, from CAD 3.8 million for the comparable period of fiscal year 2020.

Shareholding Pattern

Top-10 share holders are holding approximately 38.50% stake in the company with Investissement Québec and Caisse de Depot et Placement du Quebec are among the major shareholders holding approximately 11.5% and 10.5%, respectively.

Valuation Methodology (Illustrative): EV/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: The company exited the third quarter on a strong note and is well-positioned to capitalize its growth catalyst in the coming quarters on the back of a strong order book backlog and consistently winning of new orders.

Recently, the company won 6 new orders worth CAD 4.8 million. Further, during the third quarter, it was awarded the engineering contract on a capital equipment project for the largest electric vehicle manufacturer in the US, as well as four new municipal and industrial capital equipment projects, totaling CAD 3.2 million of new contracts to the Corporation’s WTS sales backlog.

Further, the company reported solid financial performance in the Q3FY21, on the back of organic and inorganic growth. Recurring revenue has also increased to 87% of the revenue at the end of Q3FY21 (LTM Basis) from 49% in FY14, which reflects the strength of the business model.

Also, revenues coming from the WTS business pillar increased by CAD 3.4 million compared to the same quarter of the fiscal year 2020. 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.

From the technical standpoint, its shares are hovering in a bullish trend, and more importantly, on the monthly price chart, the trend looks quite strong.

Therefore, based on the above rationale and valuation, we recommend a “Speculative Buy” rating on the stock at the closing price of CAD 2.54 on September 07, 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 (as on September 07, 2021). Analysis by Kalkine Group

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

*Recommendation is valid at September 8, 2021 price as well.

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