H2O Innovation Inc (TSXV: HEO) is a Canada-based company. It is engaged in providing 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 flexMBR. 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.

Source: Company Presentation

Revenue Mix

Source: Annual Report 2020

Investment Rationale

• Solid Q2FY21 Performance: H2O Innovation continues to improve its profitability in the second quarter of 2021, with net earnings amounted to CAD 0.3 million for the second quarter of the fiscal year 2021, compared to a net loss of CAD 0.9 million for the comparable quarter in the previous fiscal year. The profitability was driven by revenue growth of 4.9%, reaching CAD 35.0 million. Gross margin expanded 26.8% for the second quarter of the fiscal year 2021, compared to 24.8 % for the second quarter of the previous fiscal year.
• New Contract Win: The company continues to build momentum and signed CAD 3.2 million new industrials and wastewater contracts. These new contracts would bring the Corporation’s Water Technologies & Services (“WTS”) sales backlog to CAD 37.1 million. The company’s WTS business has been very active, and the efforts are highlighted by the recent wave of projects the company has captured, keeping the WTS backlog very healthy. With its business model, the projects it executes also lead to opportunities for the other business units down the line. Also, these projects are characterized by higher gross profit margins, and the company is continuously expanding its presence in Texas, which is a strategic market for the group.
• Long-term Bullish Trend is Largely Intact: HEO shares have recorded a spectacular rally over the past one year. HEO shares have surged approximately 167% over the last 1-year, and after a solid long run, the stock resting and consolidating for the next big move. Also, the long-term bullishness is largely intact as its shares are trading significantly higher from the long-term 200-day SMA support level of CAD 1.70, which implies a positive spread of 49% between the last traded price and 200-day SMA. Recent consolidation should be taken as an opportunity to accumulate shares as the stock is trading in a strong bullish zone.

Technical Price Chart (as on March 02, 2021). Source: Refinitiv (Thomson Reuters)

• High Institutional and Strategic Holding: The combined institutional and strategic ownership in the company stood at 30.67%, which is decent, given the penny-cap market classification of the company. Mutual Fund holding in the company stood at 14.9%, which is relatively high, given the market cap of the company. This reflects that the fund houses are also bullish on the stock, as they are still in the game despite a splendid return handed by the stock over the last 1-Year. Also, higher institutional ownership in penny-cap stocks typically provide confidence to small investors, and they tend to trust institutional research behind their investments.

• Strong Relative Outperformance Over Past 3-Years: Not only during the recent bull run witnessed by the global markets but over the time horizon of 3-year HEO shared have significantly outperformed the benchmark TSX Venture Index. The relative outperformance of HEO shares against the TSX Venture index stood at ~64% over the past three years. This shows that the long-term relative strength in the HEO shares is quite high, so near-term weaknesses should be seen as an opportunity to join the game.

3-Year Relative Outperformance of HEO vs TSX Venture Index. Source: Refinitiv (Thomson Reuters)

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

Financial Highlights: Q2FY21

Source: Refinitiv (Thomson Reuter)

• Consolidated revenues from the Corporation’s three business pillars, for the three-month period ended on December 31, 2020, increased by CAD 1.7M, or 4.9 %, to CAD 35.0M compared to CAD 33.3M for the comparable quarter of the previous fiscal year. This overall increase is fueled by the acquisition of GUS on July 1, 2020, which contributed CAD 1.7M in revenues during this quarter.
• Genesys, which was acquired on November 15, 2019, contributed CAD 3.0M to the revenues of the second quarter of the fiscal year 2021, compared to CAD 1.6M for the same quarter of the fiscal year 2020.
• The Corporation’s SG&A reached CAD 5.8M during the second quarter of the fiscal year 2021, compared to CAD 5.9M for the same period of the previous fiscal year, representing a decrease of CAD 0.1M, or 0.9 %. The decrease was driven by the reduction in selling and general expenses in the WTS business pillar following the restructuring implemented by the Corporation in the fourth quarter of the fiscal year 2020, partly offset by the acquisition of GUS on July 1, 2020, and the acquisition of Genesys on November 15, 2019, which contributed CAD 0.1M and CAD 0.4 M respectively in SG&A expenses.
• Finance costs – net stood at CAD 0.5M for the second quarter of the fiscal year 2021, compared with CAD 0.6M for the same period of the previous fiscal year, representing a decrease of CAD 0.1M, or 12.5% compared to the previous fiscal year.
• The Corporation’s adjusted EBITDA increased by CAD 1.3M, or 54.0%, to CAD 3.6M during the second quarter of the fiscal year 2021, from CAD 2.3M for the comparable period of the fiscal year 2020. The adjusted EBITDA margin improved and reached 10.2% for the second quarter of the fiscal year 2021, compared to 6.9% for the same quarter of the last fiscal year.
• Net earnings amounted to CAD 0.3M and CAD 0.003 per share for the second quarter of the fiscal year 2021 compared to a net loss of CAD 0.9M and CAD 0.014 per share for the comparable quarter of the fiscal year 2020. The variation was impacted by the increase in the Corporation’s consolidated revenues, the improvement in gross profit margins, lower acquisition and integration costs that were compensated by higher taxes expenses and higher other losses resulting from fluctuations in the foreign exchange rates.
• As of December 31, 2020, the combined backlog of secured contracts between WTS and O&M reached CAD 112.0M compared to CAD 142.7M as of December 31, 2019. This combined backlog provides excellent visibility on revenues for the coming quarters of the fiscal year 2021 and beyond.

Top-10 Shareholders

The top 10 shareholders have been highlighted in the table, which together forms around 38.35% of the total shareholding. Investissement Québec Caisse de Depot et Placement du Quebec holds the maximum interests in the company at 11.48% and 10.82%, respectively. The institutional ownership in the ENB stood at 20.8%, and ownership of the strategic entities stood at 9.87%.

Source: Refinitiv (Thomson Reuters).

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

(Note: All forecasted figures and peers have been taken from Thomson Reuters).

Peer Comparison

Source: Refinitiv (Thomson Reuters)

Stock Recommendation: The company reported decent performance in the second quarter of 2021, with consolidated revenues from the Corporation’s three business pillars increased by 4.9% to CAD 35.0M compared to CAD 33.3M for the comparable quarter of the previous fiscal year. This overall increase is fueled by the acquisition of GUS, which contributed CAD 1.7M in revenues during this quarter. Genesys, which was acquired on November 15, 2019, contributed CAD3.0 M to the revenues of the second quarter of the fiscal year 2021, compared to CAD1.6 M for the same quarter of the fiscal year 2020. The first quarter of the fiscal year 2021 was strong for the Specialty Products business pillar, including the delivery of significant orders. Therefore, having an exceptional first quarter, with several large-scale orders delivered before September 30, 2020, had the effect of having fewer orders delivered in the second quarter and, consequently, less revenue recognition.

Further, the O&M business pillar was positively impacted by the acquisition of GUS and showed organic growth of CAD 0.3M this quarter. During the second quarter, the O&M team started a new 3-year contract for a municipality in Florida, which also impacted the revenues of this business pillar positively. With three strong and complementary business pillars, the Corporation is well balanced and not dependent on a single source of revenue.

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 March 02, 2021.

Source: Refinitiv (Thomson Reuters)

 

*Recommendation is valid at March 3, 2021 price as well.

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