H2O Innovation has a 51 per cent upside, says Beacon

Beacon Securities analyst Gabriel Leung is going with the flow in regards to H2O Innovation (H2O Innovation Stock Quote, Chart, News, Analysts, Financials TSXV:HEO), maintaining a “Buy” rating and C$3.75/share target price for a projected return of 51 per cent in an update to clients on Monday.

Headquartered in Quebec City, H2O Innovation designs and provides integrated water treatment solutions based on membrane filtration technology through its three primary segments: Water Technologies and Services, Specialty Products and Operation and Maintenance Services. The company also operates, maintains and repairs water and wastewater treatment systems, distribution equipment and associated assets.

Leung’s latest analysis comes after H2O Innovation released its second quarter results for the 2022 fiscal year.

“Despite COVID-related challenges which are negatively impacting gross margins over the near-term we believe this is being offset by strong demand along with the company’s sale execution,” Leung said.

The company’s financial results were highlighted by $42 million in revenue, producing a 20.1 per cent year-over-year increase and coming in ahead of the Beacon Securities estimate of $36.8 million. H2O Innovation experienced 16 per cent organic revenue growth in the quarter, while the company’s acquisitions of JCO and Environmental Consultants LLC generated approximately $700,000 in revenue over the final 15 days of the quarter.

All three of the company’s segments came in ahead of projections, as Operation and Maintenance Services headed the cause with $19.7 million in revenue ($18.4 million forecast) for 46.9 per cent of the company’s revenue mix. Meanwhile, Specialty Revenues pulled in $13.8 million in revenue ($11.3 million forecast) to represent 32.9 per cent of the mix, while Water Technologies and Services accounted for $8.5 million in revenue ($7.1 million forecast) and a 20.2 per cent share.

Meanwhile, the company’s EBITDA came in at $3.8 million for a 9.2 per cent margin in the quarter, effectively staying in line with the Beacon Securities estimate of $3.6 million and a 9.7 per cent margin. H2O’s gross margin came in at 26.4 per cent, slightly below Leung’s forecast of a 28.4 per cent margin, with the company attributing the lower margin to issues related to COVID-19, including project delays, higher cost of goods (some which may be passed to customers over time), salary inflation and shortages (due to illness) and higher insurance premiums.

The company ended the quarter with $126.2 million in backlog, though Leung expects that number to get bigger as H2O is in final discussions for a new service contract agreement with Gulfport, Mississippi, H2O’s largest O&M contract (Leung estimates it at about $10 million per year. The analyst said once this deal is finalized there will be an expected uptick in H2O’s O&M backlog.

“Despite the lingering negative impacts of the COVID-19 pandemic and associated labour impacts, raw material cost increases and supply chain issues, our team remains focused,” said Frédéric Dugré, President and Chief Executive Officer of H2O Innovation in the company’s February 14 press release. “We continue to invest in the business to increase sales, grow through disciplined acquisition, and use digital tools to improve our profitability.”

Leung’s annual projections are unchanged, as he continues to forecast the company reaching $166.9 million in revenue for 2022 (all forecasts are in US dollars, unless otherwise noted), implying a year-over-year increase of 15.7 per cent. Looking ahead to 2023, Leung forecasts a jump to $181.7 million in revenue, suggesting year-over-year growth of 25.9 per cent.

In terms of valuation, Leung projects the company’s EV/Net Revenue to improve from 1.8x in 2021 to a forecasted 1.5x in 2022, then dropping to a projected 1.4x in 2023.

Meanwhile, Leung forecasts the company’s adjusted EBITDA margin tightening from 10.3 per cent ($14.9 million) in 2021 to a projected 8.7 per cent ($14.6 million) in 2022 before bouncing back to a projected 10.4 per cent margin ($18.9 million) in 2023.

On a similar trajectory, Leung projects the company’s EV/adjusted EBITDA multiple to slightly rise from 17.4x in 2021 to a forecasted 17.7x in 2022, then dropping to a projected 13.7x in 2023.

“With continued strong macro tailwinds, HEO’s proven sales and operational excellence and potential upside via M&A, we believe the stock remains a compelling investment,” Leung said.

Ahead of its expected graduation to the Toronto Stock Exchange on or before World Water Day on March 22, H2O Innovation has seen its share price dry up with a 15.3 per cent loss over the last 12 months, punctuated by a 5.7 per cent loss since the calendar changed to 2022. The stock was at a 52-week high about a year ago at C$2.95/share on February 16, then hitting a low for the same period of C$2.17/share on June 22 before bouncing back.