Stock Pitch - Water Intelligence (LON:WATR)
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Water Intelligence (LON:WATR) is a high flying water leak prevention company with global ambitions and some eye-catching growth rates. Five-year compound annual growth rates (CAGRs) for revenue, net profit, and operating cash flow per share are 35%, 35.1%, and 42.5% respectively.
In fact, just about the only thing growing faster than the group’s revenue is its share price, up some 242% over the past twelve months. There’s no doubting the trading momentum here but the recent multiple expansion means there is precious little room for error.
The stock was pitched to the Stockopedia Investment Club on Wednesday April 21st 2021 at 806p.
Is this a hidden gem on AIM, with genuine longer term compounding potential? Or, at 48.7x forecast earnings, are we just getting excited about an overpriced franchise network of plumbers?
Summary
Bull points: profitable, high margin corporate/franchise model; increasing growth capex; small, growing player in global structural growth market (water conservation); intellectual property, trademarks, and patents; ESG trends; high QM stock; clear strategy; acyclical essential services provider.
Bear points: high valuation multiples and limited scope for multiple expansion; possible future disruption to clean water issues; growth rates may slow; international expansion could prove trickier than expected.
Profile
About the Stock:
Water Intelligence is a part of the Machinery, Equipment & Components industry group, which belongs in the Industrials sector.
The company was incorporated in England and owns the entire issued capital of American Leak Detection (ALD). This is Water’s principal trading subsidiary.
ALD provides non-invasive water leak detection and remediation services in the USA, Canada, Australia, Spain, Belgium and other countries. Unlike traditional plumbing methods, ALD leak specialists locate leaks without the breaking of walls or floors, allowing for reduced repair costs and better water conservation.
A share price of 929p and an exchange market size of 500, about £4,645k worth of stock can be reliably traded. A spread of 124bps should also be taken into account.
Liquidity issues aside, Water Intelligence is classified as a Speculative Small Cap High Flyer with strong exposure to the Quality and Momentum factors. Its StockRank is 74 and its QM Rank is 96.
About the Opportunity:
This is a small, niche, fast growing business that is being neglected by the market.
Its services are required throughout the economic cycle and tap into powerful long term themes of water conservation and infrastructure optimisation.
Business & Model
What is the company history & what does it do?
ALD serves homeowners, commercial businesses, and municipalities.
Originally ALD focused on small scale domestic issues but it has more recently moved into working with larger infrastructure providers (e.g. local governments) , helping them detect and fix leaks in the 'mains water'. It does this by developing and selling water meter devices that infrastructure operators install across their networks.
Technicians receive training in proprietary methodologies and use innovative technology including infrared, acoustic and correlation equipment. Water Intelligence has patents and proprietary tools for this.
History
ALD’s business was founded in California in 1974 by Richard Rennick. The company expanded steadily across the US through franchise sales and eventually entered the international market in 1989.
In early 2006, ALD was acquired by ALDHC, which is 92% owned by Plain Sight, Patrick DeSouza, Stan Berenbaum and certain other individuals. By 2009, it had become a US brand leader in the leak detection market.
Meanwhile, over in the UK, Qonnectis was incorporated in 2000 and started off providing telematics and IT services to the utility markets to enable more efficient operation of water and energy networks.
In 2006, Qonnectis announced that it had been awarded a project by Thames Water to develop an innovative product called ‘Leakfrog’. However, in the first half of the year to 30 June 2009, a significant order originally placed in the year to 30 June 2008 was not repeated ‘due to circumstances outside the company’s control’.
This contributed to severe working capital constraints, which prompted a downward spiral. Directors requested a share suspension in 2009 pending clarification of its financial position.
Following preliminary discussions with ALD, the company executed a letter of agreement with Plain Sight regarding a reverse takeover in late September 2009. In 2010 it was announced that current executive chairman and majority shareholder Patrick DeSouza and Stan Berenbaum had joined the board as non-execs of the enlarged group.
Since then, Water Intelligence has been steadily growing its revenues. That rate of growth has increased in recent years.
What are the key business segments and revenue breakdown between them?
Just under 60% of sales come from self operated sites (US corporate and International corporate), with the remainder generated from franchise operations (split out as Franchise related and Franchise royalty).
International corporate is exclusively self-owned stores for now, which entails higher levels of capital expenditure. This segment is growing into Europe (Belgium and Spain currently).
US corporate stores (yellow) have remained the central driver of revenue growth in recent years, but we can also see International corporate (green) and Franchise related (red) increasingly contributing to the top line.
Return on assets has been improving in the US segment, but a comparison with the other segments suggests that if the company can grow its franchise royalty (blue) and franchise related segments, this could increase margins and profitability due to higher potential ROA.
In contrast, the International corporate segment has so far generated poor returns on capital although revenue growth has been more encouraging. This might be a risk going forward: its lowest ROCE segment is also where the most capital is being allocated.
At some point, international corporate might reach an inflection point in terms of profitability.
What is the business model? How does it make money?
The Water Intelligence platform has two wholly-owned subsidiaries: American Leak Detection (ALD) and Water Intelligence International (WII).
ALD
ALD is the core business and is a leader in using infrared technology to pinpoint and repair water leaks without destruction across residential, commercial, and municipal properties.
In FY20 it generated more than $130m of sales to end-users as of FY20, which the group describes as reaching ‘critical mass’.
WII
Meanwhile, WII, is the UK-based operation acquired in Q4 2016. This focuses on technology-centred municipal solutions. It is an exclusively corporate-run unit that leads the group’s international expansion.
WII does have the capability to execute ALD service offerings and is currently doing so in Sydney. WII also cross-sells complementary municipal offerings and residential wastewater solutions to ALD for municipal customers in the US.
Market & Competition
What is the state & size of the company's market?
Public infrastructure spending is expected to total $41 trillion globally from 2005 through 2030, with $23 trillion spent on water and sewer issues.
Water Intelligence notes that water demand has increased 6x in the last century (i.e. roughly linear with population growth), and that 45 million cubic meters of water a day are lost through leakage.
Who are the company's key competitors?
ALD faces competition from independent plumbers, repair services, and other leak detection companies and services. Competitors are out there but the market is fragmented and these businesses tend to be small owner run-operations.
Operating margins have been steadily increasing since 2017.
What is the company's strategy?
At the highest level, Water Intelligence hopes to transform water infrastructure services through reinvestment in its own technology.
In FY19 Water Intelligence came to the end of a five-year growth plan that produced compounded annual growth in sales of 35% and profits before tax of 33%.
Water Intelligence is evolving into a ‘one-stop shop’ for technology products and services for water infrastructure problems.
The mix of work between municipal, commercial, and residential varies across the group’s markets.
The next step in the strategy is to continue to fill-in the overlaps: layer-in municipal work in the US; add residential and insurance channels in the UK; and add insurance channels in Australia and Canada.
There are also additional geographies to expand into.
How does it derive its competitive advantage (if any)?
Some obvious competitive advantages are around patents/trademarks Water has in its leak detection tech.
Perhaps a bigger advantage is that they have a lot of experience now of dealing with and selling to local governments and similar. This is not easy to do and quite a difficult thing to overcome for new businesses.
Is the competitive advantage durable and is there any evidence of one in the financials?
Return on capital employed has remained stable between 12% and 13% over the past six years, occasionally breaking above that level.
There are possible durable advantages in the form of the group’s proprietary products but the more salient driver of growth in the medium term might be Water Intelligence’s existing scale, financial capabilities, and first mover advantage in a fragmented global market.
Financials & Ownership
What is the record of growth & profitability?
Excellent steady revenue growth, even through covid (not included in the chart, but group revenue grew by 17% in FY20 and by 38% in Q1 FY21).
Diluted normalised earnings per share have been on a similarly consistent upward trajectory.
What is the state of the balance sheet?
Water Intelligence tends to maintain a net cash position. It’s Z-score of 9.39 is strong.
The balance sheet is quite small, with total assets of $28.1m and total liabilities of $10.6m. The group does have $11m of goodwill and intangible assets though, so when you strip these out the company has a net tangible asset value of just $6.5m.
Is there evidence of historic share dilution or buy backs?
Shares in issue have increased over the years and this is worth monitoring. Compound revenue and profit growth has comfortably exceeded the growing number of shares in issue.
What is the ownership structure of the company and do management have stakes?
About 45% is owned by directors and a meaningful amount is held by other private investors.
Valuation
This is the weakest spot for the pitch. According to pretty much all relative valuation metrics, Water Intelligence looks very expensive.
The market fully recognises the trading momentum so there is little room for multiple expansion. The company must continue to meet market expectations in terms of international growth going forwards.
Trends & Catalysts
But the company’s global market opportunity has great potential, and the international rollout should drive further revenue growth. Alongside that, Water has established a profitable and high margin business model incorporating both corporate and franchise operations.
Water Intelligence is also investing in its own technology.
- During 2020, it began to commercialize a new technology-driven solution for diagnosing sewer blockages more effectively. It hopes to accelerate the growth of this line of business during 2021.
- Scalable IT infrastructure - Water has launched a strategic relationship with Salesforce.com to automate its entire business from secure data management to scheduling to dispatch to reporting.
Risks, Threats & Hurdles
Execution risk of international expansion - this is soaking up a lot of the group’s capital and, while revenues are growing, it is still early days in terms of profits.
Valuation risk - Water Intelligence shares trade at a considerable premium and a lot of good performance is priced in. There is precious little margin for error here, and a profit warning could hit the share price hard.
Corporate governance - the company does not appear to update the market with preliminary results whereas most other companies do.
Recent Trading & News
February 2020 - FY20 results:
- Group revenue +17% to $37.9m (2019: $32.4m),
- ALD revenue +15% to $33.6m (2019: $29.1m),
- Royalty income from franchisees +3% to $6.7m, despite continued franchise reacquisitions,
- Franchise-related sales +18% to $9.5m,
- Key insurance business-to-business channel +20% to $8.5m,
- Corporate location sales +21% to $17.4m,
- Adjusted profits before tax +49% to $5.1m,
- Net Debt: $2m.
The most recent update to the market can be found in this SCVR post from the 27th April 2021. It shows that Water’s strong trading momentum continues.
Conclusion
Water Intelligence has a global opportunity and enviable trading momentum. It is hard to find this level of growth elsewhere.
But the best returns are made up of two components: earnings growth and multiple expansion.
It’s hard to see the latter happening at Water Intelligence, but the company certainly paints a promising picture of the future, and so perhaps we might expect the former.
Valuation was the main concern for the Club but members ultimately voted 60:40 to buy Water Intelligence at 806p.
This is an exciting, off the radar company with some great quality characteristics, a large addressable market, and compounding potential… But has the Club overpaid?
Disclaimer
This is not financial advice. Our content is intended to be used and must be used for information and education purposes only. Please read our disclaimer and terms and conditions to understand our obligations.
17 comments
I bought in at 326p last August and decided to heavily cut my position when 900p was hit as whilst I like what the company is doing and where it's going I just the valuation crazy at the moment. I have now a smallish holding and will keep it. If it remains elevated I may eventually cash in but if it goes backdown to about 600p I may add back in.
Long term I still think there's a lot of growth potential
This is still a trucks and tools business; a plumbing repair service for consumers that also has some public sector business. Many years ago the business was franchised out, and since PdeS took over it's been buying back. EC has described this very well here and on advfn. I invested in2016 and heavily therafter butmust learn the art of patience. I had 40 k shares ave 180p, sold ave 350p. (covid reasons primarily) but I thought the corporate issues were too loaded, a one man boat. Well done those who held on, but it's way overvalued now imho for reasons already stated.
Used to be in this a couple of years back , maybe I should have stayed in it for the ride!
Can anyone tell me why (WATR) Water Intelligent is down 58.75p (6.46%) today?
It has taken out my stop, so I was wondering why.
Profit-taking. I would say it got a bit ahead of itself last month.
Hi Terry,
WATR is heavily overpriced in my opinion. As Effortless Cool has stated the share price has got ahead of itself. Its forward PE is 47. I am reluctant to buy companies when their PE rises above 20. I believe at 862p the price is too high and the true price is somewhere between 513p - 707p and I expect the share price to pull back to somewhere in this range.
David.
Hello Jack,
Thanks for this very comprehensive report.
I have a small investment in this Company.
There are three things I would add.
1) Expenditure by the new US administration has been specfically targeted towards updating the US water infrastructure. This should have some benefits for Water Intelligence.
2) There are a lot of US properties which do not benefit from mains drainage. This places the onus in case of sewage blockage on Private Householders. Water Intelligence;s plan to assocate with house insurers seems a good move.
3) Finally I think there is merit behind the plans to buy some of the Franchise Operations, who can then provide support to expand business of other privately owned operations as well as expend their own sales.
First quarter profits more than doubled from a year ago. It's a very small Company. Difficult to value. My strategy is to buy on share price weakness.
Hmm.
Effortless Cool has reported extensively on this stock over the years on the SCVR, and a fine job of it he has done too. So, most regular readers of the SCVR should already be aware of this one. That and the way the share price has been run up suggests to me that this is not a hidden gem.
In the past there has been quite a bit of discussion about De Souza having some reputation baggage that makes this a high risk investment. I recall looking at some of the numbers, sorry cannot remember which, and thinking that they were so remarkably consistent it made me wonder if they were real. Perhaps this was too soon after the Patisserie Valerie debacle.
To some extent, the argument here is whether this stock deserves a tech type rating or a more modest rating associated with service companies. I really struggle to believe that they have developed any significant tech that is not available to others so I would say that the stock does not deserve a tech rating. It is significant to my mind that they have made little progress in the UK when our water utilities are notorious for their leaks and there is strong regulatory pressure on them to improve this performance. It suggests that their tech is nothing special. Also, could it be that the biggest competition in some countries is actually the in house leak detection and repair capability that the water companies have here? The theory that they can roll out the same business internationally must be questionable.
It seems to me that the historic growth has not been organic, rather it has been buying back franchises, which is more like a growth by acquisition strategy. This has a natural limit by the number of franchises if nothing else so is not sustainable. The insurance business in the US does look promising however.
I was surprised the investment club decided to buy this but it’s good to be surprised now and again. Hopefully it works out well for you. No position myself, as you’ve probably already deduced.
Whilst being an holder for 9 months and making a nice return I do welcome the diversity here on these forums and someone offering the bear argument. I've ben considering top slicing a part of this given the current valuation and your comments give me more things to ponder, thanks
Hi Brookeda
You’re welcome. One thing to note of course is that I have been consistently bearish on this one and so ‘wrong’ in as much as the share price has risen a lot, whereas Effortless Cool has been consistently bullish and so he’s called this one ‘right’.
We all get some wrong and hopefully more correct. I like many others often think of all the bullish points relating to my stocks and need reminding of the bears so I take every viewpoint as just another data point.
I have for a long time loved the Water story - there is a pressing need to maximise the use of this precious resource - and leak detection and thus reduction in wastage is a crucial part of the story..... but, this is very richly priced stock. I understand wanting to get on board with this long term trend but why not e.g. Xylem (US:XYL)? Arguably a safer bet on this story. I personally would prefer a number of other stocks before this one with as good momentum and better value.
Your Club's a bit late to the party here, Jack, although I am cautiously optimistic there is more to come from Water Intelligence (LON:WATR).
There are a couple of important points omitted from your note that are worth highlighting, I think.
Firstly, the engine of growth in their US Corporate segment has been buying back their own franchisees. This has obviously suppressed growth in the Franchise Royalty segment as the number of non-corporate franchises has reduced as the corporate franchise count has risen. This strategy has suppressed earnings over the last few years as the US Corporate segment delivered lower margins than the Franchise Royalty segment. However, US Corporate margins have been tracking up, as shown in the exhibit below (green actuals, red my forecasts) and are now close to the Franchise Royalty levels. Additionally, this reinvestment strategy has absorbed large amounts of cash that would otherwise have accrued on the balance sheet. The underlying cash generative capability of the business is much greater than recent years net cash generation would suggest.
Secondly, the Franchise-Related segment is really two segments in one. It originally covered franchise territory sales and sales of parts and equipment to franchisees, but has subsequently expanded to cover business sourced through agreements with national insurance companies, six or so of which have been signed up since 2019 H1. It is these national insurance accounts that drive growth in this segment. It is lower margin business than otherwise, but serves to strengthen WATR's stranglehold on the sector.
Malcolm Stacy at Shareprophets picked up on this stock a while ago and it has been an excellent tip. What I like about it is, sector, market opportunity and decent financial performance. I have to say I fretted about the price at £5 and I very much regret not buying more at the time. Its high risk but i think the quality will show in the end. If the share price does re-rate lower as long as the issue is not structural it may well pay to accumulate more as water is getting increasingly precious and the demand for this service must rise.
Good stuff. Question: the secret sauce is presumably the " innovative technologyincluding infrared, acoustic and correlation equipment."
Given the $23 trillion market mentioned, perhaps inevitable somebody elbows in with an alternative technological answer - given the size of the pot, and the arms race in 'disruption' - so that it's not just Pimlico Plumbing etc competing against them?
Apols in advance if dummy question
Hi Traver,
Not a dummy question at all and it is a risk to Water Intelligence (LON:WATR) that some kind of technological disruption changes the picture, or competition picks up in some form.
But the company is growing fast into a very large market so it looks like the demand is there for now. Its core business has been growing steadily for many years. And WATR itself is hoping to bring about some of this tech disruption with its own R&D.
With a market cap of £144m and such a high forecast PE ratio, the market is anticipating quite a lot of growth. Water can meet these expectations - but it will have to stay ahead of the curve and continue to invest in its technologies in order to provide a leading service. It looks like this is happening.
At these prices though it is fair to say that the good performance has to continue and there's not much room for error.
Perfect, thanks Jack.
As for "And WATR itself is hoping to bring about some of this tech disruption with its own R&D." - that makes sense, and perhaps should have been obvious to me. D'Oh!