Occasionally in small caps, a thematic arises where everything appears to line up perfectly. Regulatory, political and social factors converge to create a ‘perfect storm’ for both the fundamentals of the businesses in the space and, importantly, the attention they attract from investors.
In FY19 it was Fintechs. The drivers were things like open banking, ramifications from the Royal Commission, millennials discarding traditional finance products and a string of new listings in the space.
You could have tried to pick one or two of the biggest winners (APT, Z1P, WZR etc) or you could have bought an equal weighted basket of everything in the space and you would have done very well over the course of FY19. The thematic was hot and the right play was to make sure you had exposure, regardless of how you approached it.
This year we’ve made a bet that the next hot thematic will be what I’m going to define as the Water Stocks. I know, it doesn’t sound as cool as Fintech, but the space is equally as exciting.
In my definition, these are the companies involved in providing chemicals, technology and services for the purpose of wastewater treatment, processing of industrial or mining waste, and emission & pollution reduction.
There are many companies on the ASX focused on improving the environment (call it CleanTech), and because the space is heating up they may all do relatively well in the short to medium term, but we are focused only on those businesses with attractive fundamentals.
We want substantial, fast growing and predominantly recurring revenues, a real and validated technology advantage, at or near sustainable profitability, significant insider ownership, a long runway for growth and a valuation that does not reflect the extent of the opportunity in front of it.
When you filter it down like this there are only three small cap stocks that fit the criteria and they all operate quite similar business models. Understand the business model and market opportunity for one and you’ll have an easy time grasping it for the others.
These three companies - SciDev, DeMem and CarbonXT - also happen to be hitting important inflection points at the same time. They are growing revenues rapidly, have massive pipelines of work ahead of them and are either already cashflow positive, or will be very soon.
The factors driving both revenue growth and investor interest in the space are well known. Climate change and emissions are a hot topic Regulators are becoming increasingly strict on waste management processes, environmental impact and limits on new vs recycled water usage. We’ll touch on more of this throughout this wire.
Capital H owns shares in all three of the companies outlined below, but has weighted them according to our level of conviction. We’ll start with the largest - Scidev.
SciDev - Rapid Growth in a Land of Giants
SciDev (ASX:SDV) is a specialist in the separation of solids from liquids in the mining, mineral processing, wastewater, oil & gas and food & beverage industries.
As one example, miners (and oil sands producers, shale, etc) need to separate minerals from ore, a process which requires enormous amounts of water. The wastewater from this process is deposited in tailings ponds, which are typically very large lake-like structures.
The solids and liquids need to be separated so that the waste can be efficiently removed and disposed, and the recycled water can be reused in the mining process.
Water usage, such as the amount of new vs recycled water that can be used, are becoming increasingly stringent, increasing the importance of extracting as much reusable water as possible.
Further, the more liquid that can be pulled from the solids, the smaller the mass, requiring less waste volume to be stored and transported, benefiting costs, downtime and wear & tear on processing equipment. Less downtime means more production and improved profitability for the customer, in addition to the environmental benefits and regulatory requirements.
SDV do this through two products - OptiFlox and MaxiFlox.
OptiFlox is SDV’s process control technology that measures and analyses certain parameters and then optimises the dosages of chemicals. This is done 24/7 and delivered to the operator over the cloud so that adjustments can be made in real time.
MaxiFlox is their range of chemicals and polymers that are used to drive the separation. This is the lucrative side of the business as it generates large, recurring revenues. The video below provides an example of MaxiFlox in action.
The SDV business model is to sell the OptiFlox technology on a monthly subscription (typically $7-$8k/month) and then feed in their range of chemicals and polymers.
OptiFlox is a key differentiator and a competitive advantage because it can measure certain aspects of the clay fraction that no other competitor is capable of, allowing bespoke solutions to be built for the customer that other (much larger) competitors find difficult to compete with.
The chemistries used and how they fit the specific requirements of the customer are typically the key selling points, so this part of SDV’s technology is critical.
That then allows SDV to feed in the sale of their MaxiFlox chemicals, which is where the real revenues are generated, and forms the bulk of SDV’s revenue base.
The gross margins on chemical revenues tend to start off around 30% but will typically increase over the life of the contract.
The contract terms are usually 3 years (2+1) but customers are very sticky and renewals are the norm if you keep the customer happy, owing to the difficulty of changing such a critical part of the process, and means revenues are largely recurring.
The sales cycle is long (6-12 months) and customers extensively test the product. Bespoke solutions are built, trialled and validated. The upside to this, as mentioned, is that the product is then hard for competitors to disrupt.
Dancing With Giants
One of the important things to understand for all three of the companies mentioned in this wire is that they are playing in a land of giants, both on the customer side and amongst their competitors.
SDV's market is worth $8b per annum and growing. The industry has undergone a wave of consolidation and is now dominated by the majors.
Key competitors are BASF (€60b market cap), Solenis (which merged its water treatment business with BASF earlier this year), EcoLab (US$50b market cap), Kemira (€2.6b revenue) and SNF (who have a leading 40% share in SDV’s target market).
SDV’s customers are the likes of Glencore, Iluka Resources, BHP, Peabody, Xstrata, large construction companies, governments and local councils.
It is also worth noting that the second largest producer in this market (behind SNF) is Nuoer Group. Nuoer are a substantial shareholder in SDV and their primary supplier.
The above lends itself to massive contract sizes. As an example, SDV recently won a $12m contract ($4m per annum) with Iluka Resources, which was their largest to date, yet this will look small next to some of the other opportunities in the pipeline.
The Catalyst – New Management
This growth phase was kicked off by the recent change in management, driven by the new MD Lewis Utting. He was appointed to the role in April this year but was engaged in the business for a short time prior to this.
Lewis is highly regarded in the industry. He put his own money into the company (acquired ~4% and has options for more), brought in his own team, established new relationships with key suppliers (Nuoer Group) and has already delivered on some big contract wins, most notably Iluka.
Since April the momentum in this business has simply taken off. SDV did $2.3m of revenue in the September quarter alone vs $2.9m for the entirety of FY19.
By November the core business will be run-rating at $12-$13m revenue and will be further boosted by the recent acquisition of ProSol which will take group revenues to a $15m+ run-rate.
They are now cashflow positive (notwithstanding working capital movements as they fulfil the large pipeline of new work) and well capitalised to fund continued growth with ~$5m of cash on the balance sheet.
Iluka Contract - Validating the Technology
In late August, after extensive trials, SDV announced they had secured a 3 year contract with Iluka Resources for the supply and service of MaxiFlox to their Jacinth Ambrosia operation. They won this against the multinational competitors mentioned earlier.
Iluka spent months trialling the product and comparing it to the alternatives offered by the majors. This no small operation - Jacinth Ambrosia is the largest zircon mine in the world.
SDV’s chemistries were better. They were able to build a bespoke solution to fit Iluka’s requirements and will build in the Optiflox technology into that service.
While the Iluka deal is material financially the most significant aspect of the contract is how it validates the tech, its value proposition and the ability of SDV to compete and win big deals against the majors.
It will allow the market to price in significantly higher odds of further large contract wins.
In October SDV announced the acquisition of ProSol, a chemicals and engineering business based in NSW with customers in mining and wastewater treatment.
The business generates $2-$4m of revenue, towards the higher end based on current run-rate, and is profitable. SDV paid $1.9m in a mix of cash and equity.
The initial benefits from this acquisition are obvious. $2-$4m of revenue, profitable in its own right (a fair estimate would be c.15% EBIT margins, so $500-$600k) and they are paying a very reasonable price with a large portion of scrip and deferred cash payments over time, allowing the acquisition to pay for itself.
They are acquiring an experienced and culturally aligned team in an industry where people are a very important asset. With the vendors taking equity at 50c they are well incentivised and have bought into the future of the combined group.
But the market is yet to realise the strategic significance of this acquisition.
ProSol sells chemicals, currently acquired from some of the major suppliers, at a cost roughly 50% higher than SDV’s cost of goods. Post integration there will be an immediate uplift in the margins generated on chemical sales. All else equal margins would almost double on chemical revenue, assuming no change to the selling price.
ProSol provides specialist engineering services to some of the biggest producers in the region, including managing very large tailings plants. They generate engineering and professional services fees for doing this, but the real upside is in the chemicals revenue.
As a small business ProSol were likely unable to fulfil the massive chemicals contracts in the Hunter Valley. Some of these opportunities are twice the size of Iluka and as part of SDV they will be well positioned to win, particularly given ProSol is already engaged in key processes of these customers value chains.
This looks like a smart deal that will act as a blue print for future acquisitions and in the strategy of adding complimentary services over time and then pulling through large chemicals sales from cross selling.
At some point, a deal like this is possible in North America, which would get the market quite excited.
A Look At The Pipeline
As it stands SDV will be run-rating at c.$15m revenue by November (when Iluka kicks in and ProSol completes) and will be cash flow positive.
Management believe that with the team they have today (post a couple of recently announced additions) they could support US$50m revenue, highlighting the leverage in the business model now that they have hit scale.
Any further large contract wins are likely to drop straight to the bottom line. It is now all about the size of the pipeline, their likelihood of conversion and what sort of revenue trajectory it will generate.
In their latest quarterly report SDV outlined the long list of opportunities they are chasing across a range of sectors. Based on this, and discussions with management, the pipeline of opportunities they have actively engaged with is nearing $100m.
Anyone interested should read the quarterly report closely, but I’ll outline some of the larger opportunities below.
The Game Changers - US Shale & Canadian Oil Sands
In July SDV announced their first sale into the US oil & gas market. This was for A$1.08m of chemicals for a trial set to last less than a month. The implied annual volumes for this customer, should a contract eventuate, is therefore worth north of ~$10m per annum.
Those that read the quarterly report closely may have noticed SDV’s positive update on this prospect. The company said:
“The field evaluations are complete, and the Company is pleased to announce that the technical hurdles have been exceeded. The technology was fit for purpose at high salt concentrations allowing for clean water to be preserved and process water recycled and reused in the extraction process.”
My assumption is that this prospect has progressed to the discussion of commercial terms. If it follows the timeline of past deals we may expect news in the next 3-6 months.
If this contract were to drop it would open up a new market with extensive opportunities, as SDV outlined:
“…other US trials are progressing well and results will be reported in due course. Importantly the company is finding that there is significant demand and support for its bespoke chemical solutions, which augers well for the success of the US initiative.”
The Canadian Oil Sands market is one that the management seem particularly excited about. It is a high cost activity (not dissimilar to offshore production) at a time where the oil price is far from favourable. And it continues to face uncertainty from rising regulatory & political attention.
SDV recently had highly favourable laboratory results that will now likely proceed to commercial trials and revenues, perhaps not dissimilar to the initial trials in the US market. They stated:
“SDV MaxiFlox® technology reached a milestone in the Canadian oil fields as it passed both environmental and performance hurdles at the laboratory scale. Preparations are underway for field- scale evaluations of the technology, which represents a significant market for the MaxiFlox® technology.”
Contracts in this space are potentially worth $10-$20m per annum. The phrase ‘game changer’ is overused in investment lexicon, but the US oil & gas and Canadian oil sands markets truly fit that definition.
Keep an eye on any progress in these two industries as they will be key drivers of the share price.
SDV recently entered the Asian nickel-cobalt market with lab programs and site audits being provided in partnership with Nuoer Group to the Ramu mine in PNG. They stated that the:
“…laterite nickel processing segment is strategically relevant for SDV and represents one of the largest chemical opportunities in the mining market, with large volume users in Australia, Papua New Guinea, Philippines, New Caledonia and several other regions. Technical programs are planned for the coming quarters with operators in the Asian region.”
Base and Precious Metals
The company received an order of MaxiFlox for full plant evaluations from a gold producer in Australia, and is awaiting similar for a gold mine in PNG.
Technical evaluations have begun at a large scale copper operation in Peru with the company stating that:
“Commercial and technical documents are now with the client and the Company expects an update in the coming quarters.”
OptiFlox was commissioned at a copper-gold operation in Asia and the trial will proceed in line with the mining plan over coming months. Further, an order for MaxiFlox was received from an Eastern Australian copper producer.
Metallurgical and Thermal Coal
SDV has an ongoing trial with a major coal producer in the Bowen Basin which may eventually lead to good news.
They may also benefit from the restart of a large-scale coal handling preparation plant in the Bowen Basin as SDV is the preferred supplier of both chemicals and equipment, as well as professional services.
SDV noted that “several technical programs are being executed with MaxiFlox” and that new opportunities are arising in the Bowen Basin and Hunter Valley.
The quarterly report was written before the acquisition of ProSol which will be a real boost to their operations in the Hunter Valley. Not the least of which is the opportunity to now provide chemicals to the clients that ProSol are already servicing, some of which are contracts that are significantly larger than the Iluka deal.
While historically SDV has been focused on mining, their products have applications in a number of other industries, one of the more exciting being wastewater and water treatment markets. Under Lewis, progress here has gotten off to a solid start.
SDV is part of a “major national tender” with a large industry service provider and will commence further trials in both NSW and WA.
They are also noting “strong leads across NSW and QLD” and that “final commercial negotiations are in place.”
MaxiFlox will also be used at the wastewater treatment plan of a major country meat producer, once construction is complete.
This is a new vertical for SDV with the first trials kicking off in December. The company has noted their intention to update shareholders on the opportunity to support some of the large infrastructure projects occurring around Australia.
SDV - Top Pick For The Space
SDV is in the early stages of what looks like an exciting growth story.
In the context of a ~$100m pipeline, an $8b market opportunity and a proven ability to compete for and win large chemical contracts against the majors, the current $60m market cap looks significantly undervalued.
The market will be watching closely for news of progress in the US or Canada, as well as any new contracts that may drop. If and when this happens the stock looks primed to move higher.
With regards to longer term strategy, Lewis initially spoke about winning a large contract against the multinational competitors to prove SDV can play at that level. The Iluka contract achieved this milestone.
The next phase is all about scaling. The pipeline is massive but what counts is conversion. There is enough in the pipeline to take SDV’s revenue to US$50m+ annually within the next 3 years, sooner if they have success in the US or Canada.
The phase after that will likely involve building out their offering by scaling the services side of the business around the base of recurring chemical revenues. These large customers might spend $1 on chemicals but another $2-$3 on professional services, engineering, plant management, etc and SDV could access that part of the value chain. This would obviously grow revenues but the important piece would be about moving from selling a bespoke product to selling an entire solution.
This will likely occur through both organic and acquisitive growth, and the ProSol acquisition is a good early example.
You can’t look at historical revenues to value SDV as the business is simply growing so quickly. The metric driving the SDV share price is run-rate revenue.
It is at $15m currently, but it seems entirely reasonable to expect it to hit a run-rate of ~$25m during FY20 off the back of the current pipeline, and that growth trajectory will likely continue into FY21. If they can do this I see no reason why the stock would not be trading north of $1 and beyond that if they have real success in the US or Canada
De.Mem - Building A One-Stop-Shop
De.Mem (ASX:DEM) is a decentralised water and wastewater treatment business that designs, builds, owns and operates water and wastewater treatment systems. It services clients in industries such as chemicals, oil & gas, mining, food & beverage and electronics.
The name De.Mem comes from the combination of designing and building decentralised, on-site treatment systems (in contrast to large scale treatment plants) and the use of membrane technology in these systems, through a mix of company owned IP and technology licensed from Nanyang Technology.
I’m going to leverage off this excellent blog on DEM by another investor. If you’re interested in learning more about the technology and the business, have a read of that.
DEM’s strategy was to start with some interesting core technology and then build or acquire the solutions around it in order to eventually offer a one-stop-shop for decentralised water treatment systems.
First they acquired Akwa-Worx, a designer and manufacturer of packaged water and wastewater treatment systems.. Since acquisition they have successfully grown this business and gone about selling core technologies through to end clients. The acquisition of PumpTech expanded their geographical reach and gave them a larger list of clients to service.
That took DEM’s revenue to $10m+ and approaching cash flow break even. About 35% of that revenue was recurring from Build-Own-Operate contracts. They provided guidance that the existing order book for contracted sales in the current financial year was set to exceed revenues of the prior year ($10m) and that profitability was expected in the near term.
More recently, and importantly from investor’s perspective, DEM acquired 75% of Geutec, a German based provider of chemicals to the wastewater treatment market. Geutec was generating c.$2m of revenue and c.$200k of PBT. DEM paid $915k.
This is important for a few reasons:
- It expands DEM into a more attractive revenue stream. Chemicals tend to be recurring and is part of the reason why SDV is trading higher than DEM.
- Cross sell opportunity is substantial. DEM are already selling some of Geutec’s products.
- The acquisition takes them very close to being cash flow positive.
DEM is backed by a Singaporean VC fund at which the current CEO, Andreas Kroell, use to work before taking the full time role of boss of DEM. The fund has gradually increased their stake and is by far the largest shareholder.
Perennial own 11% acquired through two placements. Astute observers may have noted that they are also substantial in SDV.
DEM’s balance sheet is strong, they will shortly be sustainably cash flow positive and, like SDV, there are some very large contracts in the pipeline. Part of the reason for the recent capital raise was to ensure they were in a position to fund these contracts. Large customers want to see flexible balance sheets before awarding these sorts of deals.
DEM has a market cap of $46m and an EV of c.$40m. I would expect that if and when the company announces it has become profitable that the stock will re-rate. Big contract wins would be another nice boost, as would further acquisitions to build out the offering.
DEM is the Fund’s second largest position in this space.
CarbonXT - Growing Pains Resolved
CG1 produces patented, non-brominated, activated carbons that are used to eliminate mercury and other toxic pollutants from industrial flue gas and waste water streams. They have two manufacturing plants in the US (a key differentiator) and service customers such as coal fired power stations, cement plants and manufacturers.
Unlike peers, CG1 produces non-brominated products, which is of increasing concern to industry as a pollutant and corrosive. The business model is more like SDV than DEM, as they sell a single-use consumable into a large and important part of the customers value chain, making revenues sticky and recurring.
Gross margins also range from 25-40%, contracts are multi-year and the business achieved profitability in June.
CG1 is interesting because it already generates more revenue than the companies mentioned previously, and has similarly strong backing from large investors. Yet its market cap is the smallest of the three.
The reason for this is that they went through a period of growing pains. A key customer ordered far larger volumes than CG1 were prepared for and it resulted in cost over runs, delays to profitability and a stretching of the balance sheet.
The flip side to that is they smashed their prospectus revenue forecasts and that large customer is still ordering at volumes well above initial expectations, and is now being serviced profitably. They have turned the corner.
Like SDV and DEM, the immediate term opportunity for CG1 is enormous. The pipeline of opportunities currently in trial or negotiation is worth A$20m per annum. The recently announced revenue guidance for FY20 ($24-$29m) implies growth of 31-58%, and the company is stating it will be profitable.
The recently announced Purafil contract alone has the potential to fill up CG1’s remaining pellet capacity should a few things go their way. Pellets represent the really exciting part of the growth story.
CG1 is a material position in the Fund, but I’m going to label this as ‘one to watch’ for the time being. The only missing piece of the puzzle is the balance sheet. If and when that is resolved I think it becomes a very strong buy and will re-rate quickly.
The Next Hot Thematic
As investors are waking up to the opportunities in this space it is coinciding with all three stocks mentioned here approaching inflection points in their growth stories. This feels like a recipe for strong returns.
When a thematic starts to come of age it is usually led by one company that paves the way. For the Water Stocks, this may be Phoslock (ASX:PET) which fought for years to crack the opportunity of selling water treatment solutions in China.
For a handful of reasons the Fund doesn’t own PET but it has certainly been a phenomenal performer for holders and has demonstrated the kind of revenue growth, operating leverage and shareholder returns that can be delivered when these sorts of business models get it right. It would not be surprising to see some of the money that did well in PET flow into the stocks mentioned here.
So, if it is a space you like, the time to pick which stocks you think will be the next big winners is probably now. We’ve taken the biggest swing at SDV, but DEM and CG1 are both material positions, and I think the sector as a whole will do well.
Place your bets.
Disclaimer: The author owns shares in SDV, DEM and CG1 through the Capital H Inception Fund.
Congrats Harley on some excellent insights. Graeme N.
Interesting read. Would love to see thoughts on Fluence Corporation (ASX:FLC), given their excellent fundamental performance in the water space, yet continued frustration for shareholders over the last fews years.
Is Fluence in this industry?
Harley, Thank you for the write-up. I think another company in a similar vein is Calix (listed about 12 months at a guess) which has a good product and is making a US acquisition. I agree with Mark G and Ron G below that Fluence is a comparable business, your thoughts?
good article. agree that it is an exciting area. any thoughts about FLUENCE Jeff
Hmmm, Lots of questions here about Fluence. I don’t profess to be an expert but seems very strange indeed the FLC wasn’t mentioned in this article. A bit like the elephant in the room.