equity research report...report, in 2011 55% of china’s groundwater was considered unfit for human...

Equity Research Report

Emefcy Group Limited

Recommendation N/A

Current share price 0.81

52-week range $0.19 - $1.18

Shares Outstanding (m) 222

Market Cap (A$m) 180

Avg. Daily Turnover ($m) 0.4

Net cash CY16F (US$m) 22

CY16F Gearing (ND/E) % (84%)

Three Key Points

Using assumptions detailed in this report, our DCF based valuation ranges from $1.47-$4.54/share. This represents a premium of 81% - 460% above the current share price.

EMC has first mover advantage on scalable waste water plants that are energy efficient. The Reuse as a Service business model provides a long-term annuity stream that could see EMC carry a high multiple (similar to a utility).

The potential for high growth in China is compelling, with US$40bn set to be spent under the current five-year plan on rural waste water plants and related infrastructure.

Early stage, but lots of potential

EMC has developed an off grid, scalable, low capex, low opex, odourless, decentralised waste water treatment solution that is likely to be disruptive; particularly in rural and remote regions. EMC has first mover market advantage and it offers considerable cost savings over competing technologies.

Our base case forecast assumes that EMC gains 10% market share of rural waste water plants to be installed under China’s current five-year plan. This is equivalent to US$1.5bn of revenue for EMC (150k individual modules). Sales of this level would scale EMC up to develop markets in other regions (i.e. China is likely to be the tip of the iceberg).

In the long term, EMC is likely to look more like a utility. Its Reuse as a Service (RaaS) model looks to clip the ticket for water treated on a take or pay basis. Due to the significantly lower opex of EMC systems, their water treatment systems reduce the overall water bill of clients, provide a financier with an agreed IRR and also provide a return to EMC. The model will take some time to gain scale, but once it does, the market is likely to apply a high multiple, due to its recurring nature.

EMC has several other innovative products that suit additional markets (estimated to represent >US$4bn pa in total market size) that EMC could look to target. We haven’t included sales of these products in our forecasts yet.

With potential for near term Raas contract wins, additional partners in China and pending approvals in China, EMC is likely to have near term catalysts. It is also a takeover target.

Investment Considerations

EMC is poised to commence a ramp up of sales in 2H CY17. We run different sales scenarios that capture different market shares within China (Bear – 5%, Base – 10% and Bull – 15%).

EMC has a management team that has previously developed start-ups into successful large companies. In our opinion, they are a very backable team.

EMC’s share price is discounted due to uncertainty of future earnings, start-up risk and a lack of market research on the stock. Whilst EMC has a high-risk profile, the risk reward equation appears compelling, in our opinion.

Share Price Performance and Volume

Source: Cap IQ

Source: Cap IQ

0

2

4

6

8

10

0

0.4

0.8

1.2

18/12 18/02 18/04 18/06 18/08 18/10

Volu

me (

m)

Share

Price (

$)

Volume Share Price

Emefcy Group Limited (EMC:ASX) Add this to your Christmas list

20 December 2016

Heath Andrews

[email protected]

James Emonson

[email protected]

Scenario analysis based on different sales volumes

No. modules sold in a year 1,500 10,000 33,000 50,000

No. modules installed, RaaS 13 22 38 66

Revenue (US$m) 14.7 100.0 330.5 501.5

EBITDA (US$m) (3.0) 9.9 73.0 153.2

EBIT (US$m) (3.5) 8.8 71.2 150.3

Normalised NPAT (US$m) (2.5) 6.3 51.3 108.7

Normalised EPS (US¢) -1.0 2.5 20.0 42.3

EV/EBITDA (x) -51.3 17.7 1.7 0.5

EV/EBIT (x) -46.0 18.9 1.8 0.5

Normalised P/E (x) -81.6 32.5 4.0 1.9

Emefcy Group Limited (EMC:ASX)

Who Are They & What Do They Do?

The MABR (Membrane Aerated Biofilm Reactor) is Emefcy’s flagship product. It provides a scalable solution to wastewater treatment. It uses 90% less energy, just-in-time capex which is typically 30-50% less than competitors (though this may not be the case in China) and 50% lower levels of opex.

The Appeal of EMC’s Solution vs. Traditional Technology

According to EMC,

there is no equivalent

competing product in

the market

Large centralized wastewater treatment plants:

Have a huge footprint – Not in my backyard;

Extremely high capex – built for long term capacity;

Are connected to an extensive grid of pipelines to connect and disperse waste water (expensive to build);

High opex – energy intensive operation;

Noisy and Odorous; and

Water is hard to reuse – without large deployment of new pipe work and increased capex.

EMCs decentralized scalable MABR solution:

Small and flexible footprint – blends into the neighbourhood;

Just in time capex – for near-term capacity;

Provides additional water for non-potable applications i.e. Irrigation, toilet flushing and air conditioning;

Can be off grid and requires a small amount of collection and dispersion pipelines;

High energy efficiency – much lower opex;

Odourless and quiet;

Reusable local water – limited capex on additional pipe network and electrical infrastructure (it can use solar).

The MABR’s point of

difference is it uses

90% less energy

leading to ~50%

lower opex relative

to competing

technology

The MABR solution is aimed at rural villages, hotels, resorts, golf courses and municipalities.

A waste water plant is made up of a variable number of MABR modules, depending on the volume of waste water and the biological load to be treated. We have assumed on average each module is capable of treating 30 m³/day. However, a MABR plant could treat up to 5000m³/d (equivalent to 167 modules).

The MABR module is EMC’s answer to the China Opportunity and supports the RaaS strategy.

Figure 1: MABR Solution

Source: EMC Announcements

Figure 2 shows EMC’s progress in achieving plant deployment. Currently 3 plants are operational, most notably the first Chinese plant begun wastewater treatment in mid-December CY16, with 4 more plants expected in early CY17. These reference sites will be instrumental in establishing sales in China, other regions (US & Africa) and the RaaS sales model.

Figure 2: Current Deployments & Milestones


Q3CY-14 Q1CY-15 Q3CY-15 Q1CY-16 Q3CY-16 Q1CY-17 Q3CY-17

Caesaria Israel First Resort Deployment

Virgin Islands Plant Completed

Wuxi, China Plant Deployed with 3 more Expected in Early

CY17

Ha-Yogev Israel First Municipal Deployment

Backdoor Listing on the ASX

Mekele Uni Ethiopia Plant

Contracted


MABR is Disruptive Technology that has appeal in many markets

Over time, EMC is

likely to commence

sales in many regions

around the world

MABR is not intended to compete with existing centralised waste water treatment plants found in most large cities of developed countries. The largest potential for MABR is when:

The region/country doesn’t already have sophisticated waste water treatment solutions;

A cheaper solution is often required, particularly when electricity supply is limited and/or expensive; and

Smaller plants close to the source of the waste water is a more viable solution than transporting waste water large distances to a central plant.

MABR challenges existing waste water solutions in a similar manner that computers moved from centralised to decentralised and offers a solution that is likely to have a lot of appeal in the following locations:

Latin America and Africa. Developing economies with badly polluted groundwater, electricity scarcity, with lots of rural communities looking for a waste water solution;

North America – Water shortages and tight nitrogen emission standards;

Caribbean and sub-tropical islands – Water shortages (seasonal), high electricity costs and year-round tourism requiring consistent water supply

Asia – Countries like India also face similar polluted water issues as China.

Our model focuses on the China opportunity, however China is just one country where EMC’s solution has merit. Overtime, EMC intends to target other regions, as demonstrated by the installation of a plant in the Virgin Islands and Ethiopia.

The China Opportunity

Very high and increasing levels of water pollution throughout China have resulted in an extraordinarily large opportunity for water treatment. According to China Water Risks 2013 State of Environment Report, in 2011 55% of China’s groundwater was considered unfit for human consumption. By 2013, this had grown to 60%.

The Size of the Opportunity

US$40bn spend with

~US$15bn potential

market for EMC’s

MABR product

In February 2016, China announced its 13th five-year plan, covering 2016-2020. One of its objectives is to increase the volume of rural waste water treated to 70%, from currently ~10%. EMC estimates that this implies the following:

Additional waste water plants will need to be constructed for ~440m people;

This equates to an approximate US$40bn spend on treatment plants (before additional infrastructure to collect and disperse the water). EMC estimates that of the US$40bn, US$15bn is applicable to use it MABR product (~1.5m individual modules). Including large cities, the five-year plan has set aside US$85bn for waste water treatment);

Responsibility for rolling out the plan rests with each province and no partner has exclusivity to a province; and

The main question is what percentage of the market does EMC capture. Our forecasts range from 5 – 15%.

The 12th Five-Year Plan resulted in an actual spend of 22% beyond what was budgeted for in relation to waste water treatment. This highlights that when China is committed to a project, it has a high likelihood of success and indicates the spend could again be larger than budgeted.

On the 25th November, EMC indicated that it had a near term pipeline with potential for almost A$800m of revenue, with A$130m of revenue in the first year of deployment. Based on the time frame for plant deployment, securing approvals and building the first production line, the first year of deployment is likely to start around the beginning of 4Q17. This more or less coincides with CY18 in our forecasts.

Whilst EMC has not provided guidance (it is not really in a position to know itself what the ramp up profile will look like, the A$130m (~US$100), of revenue could be considered a rough proxy for CY18 revenue and is more or less in line with our base case forecast.

Figure 3 shows the size of the potential opportunity announced to date with each Chinese partner over the course of the current five-year plan (we assume it takes longer than five years, plus two trialling years to install this many plants). As EMC intends to secure additional partners covering differing provinces, the volume potential in China for EMC should continue to grow above what is in Figure 3.


Figure 3: Volume Potential for China in the Next Five – Seven Years

China Wuxi Design Sinorichen Jiangsu

Total Institute (SOE) Agreement Jinzi CGGC

Module potential units k 1500 100 100 250 100 *

Module potential US$m 15000 1000 1000 2500 1000

No. provinces 30 1 North China South China 3

Time period (years) 5+ 5+ 5+ 5+ 5+

First installation date 4Q16 1Q17 1Q17 1Q17

Initial sales guided US$m NA 9 NA 19

Total guided sales US$m NA 100 NA NA

1st Module Installed Yes Ordered Ordered Ordered

* After the first 60k modules ordered, EMC has an agreement to have a dedicated production line for CGGC

Source: EMC Announcements and Henslow estimates

The Mechanics of Operating in China

Lower opex, results

in an estimated 14-

15% IRR for a plant

owner, compared to

6-8% for traditional

solutions.

Financially, it makes

sense to use the EMC

product

The Chinese Central government is proposing to pay a tariff (estimated to be approximately 1rmb for each cubic metre of water treated). Public and state owned enterprises (SOE’s) will fund and build waste water treatment plants, with a guaranteed revenue stream from the central government. Companies can bid for particular regions/sites and over the long term, generate an internal rate of return (IRR) that makes the investment worthwhile.

The three factors that dictate the level of the IRR for the waste water plant owners are:

1. Opex in running the waste water plants. EMC has indicated its plants generate significantly

lower levels of sludge (which needs to be disposed of to landfill) and require ~90% less electricity to run. According to EMC, their plants opex is 50% lower than competing plants;

2. Capex on building the plant. EMC have indicated that their solution is on par with existing

technology in China in terms of capex (though cheaper outside of China); and

3. Access to electricity. Installing traditional waste water treatment plants in rural locations may

require additional investment in power generation and transmission lines. The EMC solution can be powered via solar, making it the likely solution of choice for areas with poor or no electricity services.

The plant owners will have long term contracts with the Chinese Central Government. The low opex of the EMC plants is the key factor that is likely to see their solution deliver higher IRR’s for the plant owners/constructors. EMC estimate its product can generate ~14-15% IRR’s, versus 6-8% for other traditional solutions.

EMC has been proactive in courting partners in China and to date has had 33 Chinese waste water construction companies visit them in Israel to view their technology in operation. One key to success in China is partnering with companies that can fund and build plants. The first plant commenced operating in China this month and was guided as delivering water of an excellent standard, implying EMC expects to meet the water emission standards required for approval. Three other plants are being installed in China now.

China has 30 provinces, with different construction operators being stronger in different provinces. In theory, approval is required for each province, though once approvals are granted in several larger provinces, the approval process in other provinces should occur more easily. First approvals in China are expected within Q1 CY17 and this should be a material catalyst for the stock.

EMC’s unlocking of the China Opportunity is best measured through the completion of milestones, which is a four stage process:

Figure 4: China Milestones Process

1. Distribution & Deployment Partnerships

Four signed, including the very large CGGC (SOE) with several more partners expected to be signed in CY17.

2. Deployment of Initial Plant Under Partnerships

One plant is currently operational with three under construction (commence operating in Q1 CY17).

3. Provincial Certification Granted With Use of Initial Reference Site

First operating site (Wuxi) is collecting data to obtain certification for the Jiangsu province by the end of Q1 CY17 and another 3 certifications are expected to follow in Q2 CY17.

4. Ramp up of production The first production line is expected to be operating in China early in Q3 CY17. The production line is under construction already in Israel and the factory location has been identified.



It is likely that certification of plants in larger provinces will speed up the certification process in other provinces.

Manufacturing Operations in China

The cost of

increasing

production volumes

is very low and the

ability to scale to

~US$300m p/a of

revenue could occur

in a relatively short

period

Currently EMC has one manufacturing production line in Israel. It is in the process of setting up its first production line in China, with first production expected Q3 CY17. The first line should be capable of producing ~7,200 units pa or US$72m of revenue (almost A$100m). The factory is large enough for a further three production lines.

Chinese staff will be trained in Israel, to assist with a fast ramp up of the production line. Having a scalable manufacturing capability is another key component to success in China. EMC has indicated it takes up to six months to manufacture and install a production line, though more than one can be worked on at any given point in time.

The estimated capex for a new production line is less than US$2m, hence the cost of having too much capacity installed is low. Modules produced in China can also be shipped to other countries.

EMC’s Approach to Manage the Risks of Operating in China

Many companies have gone to China and left disappointed. Whilst this could still be the case with EMC, their approach has been systematic and structured, reducing the chances of this occurring and is as follows:

One of the directors (Ross Haghighat) is the Chairman of FRX polymers, which has plastics manufacturing operations in China. EMC has leveraged his knowledge of operating in the region;

EMC uses a specialist Chinese consulting organisation called Brightfields to help develop relationships in China. Brightfields are also shareholders in EMC (aligned);

To help protect their I.P. and minimise working capital requirements, EMC is using a number of different suppliers for different components;

The MABR production line is being built and tested in Israel before it is shipped to China for re-assembly, with the bugs ironed out;

EMC has taken out patents in China; and

The control system software is difficult to copy.

Whilst everything can be copied in time, replicating EMC’s product and getting them to perform to specification would potentially take 3+ years, by which time they will have scaled up and the roll out of the five year plan would be well under way.


Figure 5: Xizhi River Guangdong South-eastern province, in full algae bloom

Source: Market Watch

Figure 5 shows the extent of water pollution in a major city. Having potable water is a basic need and in our opinion, China is now committed to addressing its water pollution issues.

Figure 6: Yangtze River Running Red

Source: Getty Images

Figure 6 shows the after effects of red dye from textile manufacturers being released into the Yangtze river system, the third longest river in the world.


EMC’s Progress in 2016

Figure: 7 China Progress to date

November 2nd

• Partnership with environmental protection company Jiangsu Jinzi • Focused on design, building and operation of wastewater

treatment • Expected to open access to several key southern provinces • Immediate MABR deployment (test plant) with capacity of 20kl/

day • Jinzi has already installed 1k waste water plants throughout China

Hubei, Hebei & Guangdong

November 25th

• Partnership with China Gezhouba Group Corporation (CGGC) • One of China’s largest construction and engineering

organisations • Deployment of MABR modules in Hubei, Hebei and Guangdong

Provinces


Miyun District Beijing

October 10th

• Distribution & Deployment partnership with Sinorichen

Corp. • Specialist in wastewater treatment consulting &

engineering through Beijing & Northern China • Test plant of 20k//day providing performance data to

expedite provincial certification throughout Beijing • 3-5 year plan to provide 50m+ rural population with

waste water processing • Leading to potential revenues of $75m (Beijing) &

$1.3bn (Adjacent Provinces)

10k MABR

Modules

$2.5bn Estimated Demand

• High volume manufacturing facility due to be completed by Q2 2017

• Phase 1 – support up to A$100m in product sales

• Fully Implemented – support up to A$400m in annual turnover

• Will provide for the global manufacture of EMC’s MABR solution

$1bn Potential Market

22m Rural

Population

Due for Completion

Q3 2017

5 years 100k

MABR Modules

3.5bn L’s Per Day

August 17th

Jiangsu Province Shanghai

August 15th

• Distribution & Deployment partnership with Wuxi

Municipal Design Institute • State-owned provider of environmental protection

services through Jiangsu & Mainland China • Deployment of both MABR and SUBRE product

by Wuxi Guolian • MABR based contracts expected to have

revenues ranging from $50-$300k • Provides performance data to obtain provincial

certification within Jiangsu Province • 5-year plan to support 22m rural population in

Jiangsu Province

$130m First Year

Deployment


Reuse as a Service (RaaS) Opportunity

Client saves 30% of

water bill (likely to

be material), making

the model attractive

to clients. RaaS

generates long term

earnings streams.

The first RaaS

contract is expected

in early CY17

The Business Model

EMC intends to use a different business model in more developed countries called Reuse as a Service (RaaS). This model should lead to a material volume of recurring earnings, potentially allowing EMC to carry a high multiple (akin to a water utility). In countries with less established legal systems, EMC is more likely to only attempt to sell their product.

The RaaS model as it is intended to work for EMC is as follows:

EMC drafts a 10-year contract with a client to install a waste water treatment plant, at no cost to the client;

A special purpose vehicle (SPV) is set up to administer the contract;

A financier funds the installation of the plant and associated infrastructure via the SPV. EMC sells the plant to the SPV at full margin;

Responsibility for the operation of the plant is either retained by the client or outsourced to a third party (likely to be the construction company);

The client is charged an agreed rate per cubic metre of water based on the capacity of the plant on a monthly basis (i.e. take or pay basis) for 10 years. EMC is targeting for the solution to offer ~30% water cost savings to the client over their existing water costs (including replacing potable water with irrigation grade water);

The financier receives a monthly payment from the SPV that covers the original cost of the plant, plus an agreed IRR. The balance of the fee (less other operating costs) goes to EMC; and

At the end of the contract, ownership of the plant reverts to EMC. In our opinion, there is a relatively high chance that the client would look to renew the contract after the initial term, potentially providing a higher return if the contract is renewed.

Figure 8: Reuse as a Service Business Model

Source: Henslow’s Estimates

The RaaS model

works particularly

well in regions of

water scarcity and

high energy costs

The attraction of the RaaS model is that it allows for the generation of earnings that is a multiple of that earned via selling the plant alone. EMC has a credit limit (amount not disclosed) with a well-respected financier. As the model is proven via sales, the IRR demanded by the financier (not disclosed) could fall, improving returns to EMC.

EMC was targeting for its first RaaS contract to be in place in CY16. They have previously indicated that interest is high, though with CY16 almost complete, the first client now appears likely in early CY17. The securing of one or more marquee customers as reference points is a key factor that should assist this business model gain traction.

Over time, RaaS is likely to represent the largest portion of shareholder value within EMC. However in the short term, the China opportunity is the major focus, as China won’t wait for EMC. The key factors in forecasting RaaS are:

What rate does the client pay per cubic metre of installed capacity; and

How quickly does the volume of water treated ramp up.

We forecast Bear, Base and Bull case scenarios (with different volume assumptions) and assume an average price of US$2.50/cubic metre of installed capacity being charged to the client.

Emefcy

Provides plant to SPV at full margin Entitled to earning

post operating costs and Financier has

achieved their return.

Financial Partner

Funds Plant Receives payments that provide an agreed target

IRR

Customer

Pays on a ‘Take or Pay’ basis for 10 years

Receives treated water

Integrator, O&M Partner, Asset

Manager

Build, O&M Services Agreed Opex Fees

Special Purpose Vehicle

SPV Owns Plant


Additional Products Under Development

SUBRE focuses upon

the large-scale

wastewater

treatment market

SUBRE

The removal of nitrogen during wastewater treatment is the result of a natural biological process. However, centralised water treatment facilities are increasingly being required to further reduce their nitrogen emissions.

Higher standards of nitrogen emission are being introduced to reduce the creation of algae in water systems. Additional nitrogen removal has traditionally been achieved through the addition of methanol, an expensive, toxic and explosive substance. EMC’s SUBRE module is retrofitted to existing wastewater treatment plants and dispels the nitrogen within the wastewater without the need for treatment by methanol. Essentially SUBRE is a very large MABR not contained by a tank.

Figure 9: Single SUBRE Module & SUBRE Installation Concept


The adoption of SUBRE potentially allows for an existing waste water treatment plant to meet nitrogen removal standards, without the on-going financial cost of using an additional chemical and removes the environmental and safety hazards of using methanol. The attractions of SUBRE are:

Potential market is estimated to be more than US$2bn p/a;

It is a different market segment to the MABR product; and

The product is on target to complete a field pilot study in Israel and be ramped up for commercial distribution by H2 2017.

We do not factor the development or sales of SUBRE into our financial modelling at this stage.

Electronic Bio Reactor (EBR)

A more advanced product under development is EBR. Essentially the waste water treatment module becomes a battery, with a cathode and anode component, resulting in electricity generation as the waste water is treated. Surplus electricity can then be returned to the grid.

This product targets highly loaded industrial wastewater producers, for instance:

Food & Beverage plants;

Pharmaceutical plants;

Agricultural industries with high levels of affluent (i.e. diaries);

Pulp & Paper plants; and

Petrochemical processing.

A water treatment

solution and the

simultaneous

generation of

electricity, a highly

green solution

Figure 10: EBR Module



The benefits of the EBR system are:

The process is energy positive, carbon free and creates zero power costs;

There is a very low level of sludge production which significantly decreases handling/landfill costs;

The process is contained (odourless), results in less NIMBY (not in my backyard) issues and the green footprint is appealing to potential clients; and

The market for this product is estimated at US$2bn+ and due to it treating highly polluted water, it is in adjacent markets to other EMC products.

Field pilots are expected in CY17 and a scale up target is set for CY18. The product still requires further development before it can be field tested, however it offers a material breakthrough in industrial waste water treatment should the technology prove to be commercial.

We do not factor EBR into our financial modelling of EMC at this point in time.

Management Track Record

Figure 11: Key Management

Key Persons Qualifications

Richard Irving

Executive Chairman

Based in Silicon Valley, co-founded Pond Venture Partners in 1997 and brings 30 years of experience in venture capital, business management, marketing and engineering, with over 30 start-ups;

Over $3bn of IPOs, acquisitions and private financings; and

BSc (1st Class Honours) & MSc In Electrical Engineering, Manchester University (UK).

Eytan Levy

Managing Director & CEO

Previously co-founder and CEO of AqWise with over 350 waste water plant installation across 35 countries;

Named as one of Israel’s leading water technology entrepreneurs; and

BSc (cum laude) in Chemical Engineering (Technion) and an MBA.

Ross Haghighat

Non-Executive Director

25+ years experience in Product Venturing with ten start-ups, five exits (two over $1bn) and more than $4bn in shareholder value created;

Based in Boston, director of NASDAQ-listed Aduro Biotech, Managing Partner of Triton Systems Inc., served on the Board of S12 Technologies and FRX Polymers (operations in China); and

BSc and a masters in Material Science in Organometallic Chemistry, Rutgers University (US) & MBA (US).

Peter Marks


30+ years experience in corporate finance, specialising in capital raisings (for listed and unlisted companies), underwriting, IPOs and venture capital transactions;

Has acted as Director and Chairman for a number of listed entities in the ASX and Aim; and

BEc LLB Grad Dip Comm Law, MBA.

Robert Wale


Managing Director of BlueSand Consulting;

30+ years of executive level experience in the global water industry, in roles across the USA, Australia and Asia Pacific region; and

Significant experience managing businesses across the cycle, from early stage start up to maturity including Memtech.

Ronen Shechter

Co-Founder & CTO

Previously co-founder and CTO of AqWise;

One of Israel’s leading water technologists with 20+ years experience in water and wastewater R&D; and

BSc (cum laude) in Chemical Engineering (Technion).

Yaron Bar-Tal

VP Engineering

Leading Emefcy’s products and project engineering, production and installations;

15+ years experience managing large scale, advanced, multi-disciplinary R&D projects;

Senior operating roles in leading companies: Elbit Systems, Orbotech and Matan digital printers; and

BSc (cum laude) and MSc In mechanical engineering and business Administration from Tel-Aviv University.



The key takeaways from analysing the board and senior management are:

Considerable experience in the water industry;

Several people have a strong track record of commercialising technologies;

The company’s China strategy is well thought out, with strong strategic partners being added;

Several key staff have worked together in the past; and

Performance to date in articulating milestones and achieving them has been very good.

M&A in the water sector is very common

Similar M&A transactions and equity valuations insinuate an industry valued multiple as high as 9 – 18x revenue.

Based on previous

transactions the

industry has a

tendency to pay

considerable sums

for pre-

commercialised

technologies

The EV/EBITDA

multiples in Figure

13 highlights the

huge premium that

successful waste

water treatment

companies trade at

The multiples used below (EV/Revenue) are used as both businesses were loss making at the time of acquisition. This highlights that businesses with attractive technology in this sector are often acquired early.

Figure 12: Previous Takeover Metrics

Company Transaction Details Year EV /

Revenue

Purchased Inge for A$145m with revenues of A$15m 2011 9x

Purchased NanoH20 for A$247m, with less than A$14m in revenues

2014 18x

Source: EMC Announcements & Cap IQ

Figure 13: Current Multiples of Other Listed Waste Water Companies

Company Mkt Cap EV / Revenue EV / EBITDA Exchange

$0.84bn 10.6x 44.5x NYSE:WAAS

$7.13bn 8.9x 16.9x NYSE:WTR

$10.3bn

8.2x 30.5x SZSE:300070

Source: Cap IQ

Since 2005 more

than A$63bn in

water based M&A

transactions have

taken place, with

A$32bn of this

occurring in

products and

services. Generally

the acquiring party

are top tier, blue

chip companies,

with numerous

purchases in the

space

Figure 14: Historical Transactions

Company Mkt. Cap.

No. of Transactions

Company Description

$12.4bn 12 Transactions Design, manufacture and application of engineered technologies for water and wastewater applications.

$3.2bn 9 Transactions Manufactures and sells products and solutions that

manage and conserve the flow of fluids and energy to residential and commercial buildings.

$14.7bn 5 Transactions

Diversified industrial manufacturing company, that operates through valves & controls, technical solutions,

flow & filtration solutions and water quality systems segments

Source: EMC Announcements & Cap IQ


Investment Considerations

As EMC is still in

ramp-up mode, the

key risk is whether it

can deliver the sales

volumes forecast

EMC operates as a calendar year end company and reports in US$. Our model is in US$ and the only figure converted to A$ is the DCF valuation.

EMC has indicated A$130m (US$100m) of revenue in the first year of deployment in China, which we anticipate to be from the beginning of Q4 CY17 (i.e. around October 2017). CY18 of our base case forecasts predicts US$100m of revenue, hence we assume the US$100m run rate occurs later than indicated in our base case.

It is difficult to forecast earnings for EMC with a high degree of certainty due to it transitioning from a technology developer to commercialisation stage. Estimating its future market penetration is difficult. Factors to influence sales volumes are:

The speed of acceptance by customers/construction partners of the technologies lower operating costs and requirement for less pipe infrastructure;

The ability to navigate the large number of approvals required for individual plants; and

The speed at which competition comes.

Our approach has been to separately model:

The China construction only opportunity over a seven-year period, with sales declining post year five. However should EMC penetrate other countries outside of China, our forecasts are likely to be too conservative in the longer term; and

RaaS for the other markets, with very low sales volumes initially and sales ramping as the model gains acceptance and reference sites.

We use a Bear, Base and Bull case scenarios that assume different levels of future sales volumes for both China and RaaS; these are detailed in Figure 16.

We make key assumptions around the average size of plants sold, the sale price per module, the cost to operate RaaS and corporate overheads to run the business (which we assume is scalable as revenue grows). Each plant could have a different sale price and cost structure. We are essentially using broad based assumptions that if incorrect, could materially impact our DCF valuation.

Figure 15: Core Assumptions Used in Our Model

Core assumptions modelled Unit Value

Module sell price US$k 10

Gross Margin % 50

Tax Rate % 28

Volume processed per module kl/day 30

Capex per production line US$m 2

US$:A$ exchange rate A$ 0.75


Whilst the ramp of

sales is rapid, it

would appear that

EMC has agreements

in place that could

see sales surpass our

bull case

Building production

capacity could be a

limiting factor and

we have assumed an

orderly roll out of

production capacity

The core driver behind our sales assumptions are:

The Israel manufacturing plant is capable of producing ~2,250 modules p.a. (though the finished modules have a lower waste water treatment capacity is less than what will be produced via the China production line);

The first China production line is scheduled to be operating early within Q3 CY17, with an annual production capability of ~7,200 units (implying up to ~3,000 units capacity in CY17);

Additional production lines are anticipated in China and can be manufactured relatively quickly (in ~6 months and more than one can be worked on at any given time). In theory, the timing of ordering additional production lines is dependent on the demand for modules, which is difficult to predict. Due to the low cost of each line, EMC is likely to order production lines before they have a fully sold order book; and

The agreement announced with CGGC (25th November 2016) indicated that 345 waste water plants were being tendered (~1,500 modules), with deployment expected to commence in 1H CY17. The agreement also indicates that CGGC commits to purchase at least 10,000 modules in the first year after signing the agreement (this is in line with our CY18 base case forecasts).

In our opinion, our CY17 bear case of 750 modules sold assumes that EMC is still largely in the approvals stage and that sales are less than its production capacity. Our bull case of 2,250 modules is below the anticipated production capacity within China in CY17 and incorporates a delayed start-up of the China plant.

Our CY18 bull case (15,000 modules) assumes that Year 2 has two production lines operating for most of the year and a third part plant commences operating towards the end of the year. The volume of modules forecast appears lower than the volumes committed by the current four announced Chinese partners.


Financials

Figure 16: Bear, Base and Bull Scenarios Forecasts


SALES ASSUMPTIONS CY17 CY18 CY19 CY17 CY18 CY19 CY17 CY18 CY19

China Opportunity

No. modules sold (Units) 750 5,000 16,500 1,500 10,000 33,000 2,250 15,000 49,500

Predicted China market share

No. China production lines 1 1 3 1 2 5 1 3 7

Waas Opportunity

No. modules sold 13 19 28 13 22 38 13 25 49

PROFIT & LOSS (US$m)

Operating Revenue 7.2 50.1 165.7 14.7 100.0 330.5 22.1 149.9 495.4

EBITDA (1.7) 5.0 36.8 (3.0) 9.9 73.0 (4.3) 14.8 109.0

EBIT (2.2) 4.1 35.5 (3.5) 8.8 71.2 (4.8) 13.6 106.8

UNPAT pre abnormal (1.6) 2.9 25.6 (2.5) 6.3 51.3 (3.5) 9.7 77.0

Abnormal Items 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Reported NPAT (1.6) 2.9 25.6 (2.5) 6.3 51.3 (3.5) 9.7 77.0

BALANCE SHEET (US$m)

Cash 19.7 13.3 30.9 17.0 10.5 52.2 14.2 7.6 73.3

PP&E 2.6 2.9 7.9 2.7 5.3 13.6 2.8 7.7 19.3

Debtors & Inventory 5.6 12.4 28.5 6.6 18.7 49.4 7.5 24.9 70.3

Total Assets 35.6 44.9 87.8 35.8 54.9 140.8 35.9 64.8 193.7

Borrowings 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Trade Creditors 1.1 7.5 24.9 2.2 15.0 49.6 3.3 22.5 74.3

Total Liabilities 3.2 9.6 27.0 4.3 17.1 51.7 5.4 24.6 76.4

Shareholder Equity 32.4 35.3 60.9 31.4 37.8 89.1 30.5 40.2 117.2

CASHFLOW (US$m)

Operating EBITDA (1.7) 5.0 36.8 (3.0) 9.9 73.0 (4.3) 14.8 109.0

Interest & Tax Paid 0.6 (1.2) (9.9) 1.0 (2.5) (19.8) 1.3 (3.9) (29.7)

Working Cap. (4.7) (7.5) (1.2) (5.6) (8.5) 0.9 (6.6) (9.5) 2.8

Operating CF (5.7) (3.7) 25.8 (7.6) (1.1) 54.0 (9.5) 1.4 82.1

Maintenance Capex (0.1) (0.5) (1.7) (0.1) (1.0) (3.3) (0.2) (1.5) (5.0)

Expansion Capex (5.0) (2.2) (6.5) (5.0) (4.3) (9.0) (5.1) (6.4) (11.5)

Free Cashflow (FCF) (10.8) (6.4) 17.6 (12.8) (6.4) 41.7 (14.8) (6.6) 65.7

Ord & Pref Dividends 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Net Other 7.8 0.0 0.0 7.8 0.0 0.0 7.8 0.0 0.0

Net Cashflow (3.1) (6.4) 17.6 (5.0) (6.4) 41.7 (7.1) (6.6) 65.7

VALUATION METRICS

Normalised EPS (c) -0.6 1.1 9.9 -1.0 2.5 20.0 -1.4 3.8 30.0

Normalised PE (x) -129.5 70.5 8.0 -81.6 32.5 4.0 -59.1 21.1 2.7

Enterprise Value ($m) 158 164 147 161 167 126 164 170 104

EV / EBITDA (x) -94.2 33.2 4.0 -54.4 17.0 1.7 -38.3 11.5 1.0

EV / EBITA (x) -85.1 35.2 4.1 -51.3 17.7 1.7 -36.7 12.0 1.0

EV / EBIT (x) -71.3 40.2 4.1 -46.0 18.9 1.8 -34.0 12.5 1.0

DPS (c) 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Dividend Yield (%) 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Net Debt / EBITDA (x) 11.7 (2.7) (0.8) 5.8 (1.1) (0.7) 3.3 (0.5) (0.7)

KEY RATIOS

EBITDA Margin (%) -23.4% 9.9% 22.2% -20.1% 9.9% 22.1% -19.3% 9.8% 22.0%

EBIT Margin (%) -31.0% 8.2% 21.4% -23.9% 8.9% 21.5% -21.8% 9.1% 21.6%

ROE (%) y/e -4.9% 8.3% 42.0% -8.0% 16.7% 57.6% -11.4% 24.2% 65.7%

ROA (%) y/e -13.9% 12.9% 62.3% -18.6% 20.0% 80.4% -22.2% 23.8% 88.7%

Eff Tax Rate (%) 28.0% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0%

EBIT Interest Cover (x) nm 20.4 nm (17.5) 44.2 nm (24.1) 68.0 nm

Gearing ND/ND+E (%) (60.7%) (37.6%) (50.7%) (54.0%) (27.9%) (58.6%) (46.6%) (18.9%) (62.5%)

OPCF / EBITDA (%) 342.1% (75.1%) 69.9% 257.0% (11.5%) 74.0% 223.7% 9.2% 75.3%

DCF Valuation A$ 1.47$ 2.93$ 4.54$

--------- Bear Case --------- -------- Base Case --------- --------- Bull Case ---------


Post a $31.6m capital

raise in August, EMC

appears sufficiently

capitalised to fund

its initial working

capital requirements

needed for growth

Financial Analysis

Our forecasts assume that the 22.5m options exercise upon generating US$2m of sales occurs in CY17 and the dilution effect is incorporated into our multiples and DCF valuation.

EMC is a capital light business. Even though it owns manufacturing production lines, the capex for each line is guided as less than $2m, allowing it to scale up at a relatively low cost.

EMC plans to secure short payment terms for its accounts receivable and adopt just in time inventory practices, reducing the impact on working capital as it grows. The intention is not to raise further capital to fund growth, and post raising $31.6m in August 2016, it would appear EMC has sufficient balance sheet capacity to fund its working capital requirements. Due to the high gross margin, low capex and likelihood of no dividends in the next few years. EMC should generate high cashflow conversion post the ramp in sales. We estimate that at CY16, EMC is likely to be in a net cash position of ~US$22m.

EMC capitalises R&D and we assume this is written off over 10 years. Due to potential R&D tax concessions and accumulated tax losses, we assume EMC pays tax at 28% of PBT.

As EMC gains scale, its overheads will be spread over a larger base. We assume that overheads as a percentage of revenue falls materially as it grows and note this makes our forecasts highly subjective.

Should EMC be successful in meeting our base case forecasts, it would be currently trading at just 1.7x CY19 EV/EBITDA multiples. This highlights the potential for substantial share price appreciation, should EMC be successful in delivering its rollout strategy (noting peers are trading at > 15x EV/EBITDA, see Figure 13). Further earnings upside exists if the other products currently under development are successfully commercialised.

Our DCF valuation

range using our bear

to bull case

assumptions

assumes a valuation

range of A$2.05 -

$4.84. This is

materially above the

current share price

and is clearly

discounted to cover

the start-up risks

associated with EMC

DCF Analysis

Given that EMC is in start-up mode, we see DCF as the most appropriate valuation methodology for EMC. Our DCF assumptions are as per Figure 17. We use a Beta of 1.5x to capture the start-up risk, which results in a WACC of 13%. This has potential to be lowered over time should EMC continue to hit targets and gain sales momentum.

Figure 17: DCF Assumptions

Beta (x) 1.5 High risk as EMC is not yet profitable

Target D/D+E 10% 10% debt targeted for the medium term

Cost of debt (after tax) 6% Assumed rate for EMC

LT growth rate 2.0% Close to GDP, though likely to be conservative

WACC 13.0% A high WACC is presently appropriate for EMC

Source: Henslow’s estimates

Figure 16 earlier shows our DCF based valuation per share for the Bear, Base and Bull cases. This results in a range of A$1.47 - $4.54/share (between 81% - 460% above the current share price). Whilst the DCF valuation represents a wide range, the Bear Case valuation is materially ahead of the current share price. As there is no other research coverage of EMC in the market and EMC still has to deliver on generating sales, we believe the market has lacked consensus estimates to appropriately value EMC, hence the discount to valuation is high.

There is also a discount being applied to cover the risk that the product may not get accepted in China (i.e. it may not get past the certification stage for example). Their most recent announcement does indicate that the first operating plant in China is producing treated water of the appropriate standard.

Conclusions

For more risk tolerant investors, the risk/reward equation is compelling in our opinion. With EMC likely to continue to secure more construction and engineering integration partners in China and the likely future securing of a Reuse as a Service contract, EMC appears to have near term catalysts. As evidence of sales is produced, EMC is likely to be re-rated.

Risks are high though, with EMC still to prove it will gain the sales momentum forecast. We believe the technology is robust and EMC has first mover advantage. However should EMC be as successful as forecast, new entrants may introduce competition and pricing tension.

We see the management team as a key differentiator, with a solid track record of creating value. EMC has also to date demonstrated an ability to hit its published targets. Whilst many companies are unsuccessful in building a big presence in China, the approach undertaken by EMC appears to be sound and likely to succeed, in our opinion.

There has been a lot of M&A in the waste water sector, particularly of companies with disruptive technology, which we believe EMC has. As a result, once EMC does generate earnings, it is likely to trade on a high multiple and could be subject to a takeover offer.


Research Sales

Heath Andrews

Principal

03 8622 3312

[email protected]

James Emonson

Analyst

03 8622 3315

[email protected]

Peter Ward

Principal

03 8622 3317

[email protected]

Tim Chapman

Principal

03 8622 3310

[email protected]

Aiden Littley

Analyst

03 8622 3323

[email protected]

Disclaimer

Henslow Pty Ltd (Henslow) believes that the information contained in this document has been compiled from sources which are reliable, but no representation or warranty, express or implied, is made by Henslow as to its fairness, accuracy, completeness or correctness. Henslow has not independently verified the facts, assumptions, and estimates contained herein. All estimates, opinions and other information contained in this document constitute Henslow’s judgement as of the date of this document, are subject to change without notice and are provided in good faith but, to a maximum extent possible, without legal responsibility or liability. Henslow accepts no obligation to update or correct information or opinions contained herein.

This document has been prepared by way of general information without taking account of your objectives, financial situation or needs and does not purport to contain all relevant information with respect to the financial products to which it relates. Accordingly, it is not a recommendation that a particular course of action is suitable for you and, therefore, you must not rely on this document. Rather, you should consider its appropriateness having regard to your objectives, financial situation and needs, seek and rely upon your own independent taxation, legal, financial or other professional advice, and make your own independent assessment.

The price, value and income from any financial products referred to in this document can rise as well as fall. Past performance is not necessarily indicative of future performance and no representation is made or warranty, express or implied, is made regarding future performance.

This document is not and should not be considered as a solicitation or an offer or invitation to apply for, purchase or sell any securities or investments or as a recommendation to make an offer or invitation to apply for, purchase or sell any securities or investments. No agreement to subscribe for securities or other financial products will be entered into on the basis of this document.

This document is provided to you on the condition that it not be copied, distributed or disclosed to any other person (in whole or in part). If you are not the intended recipient you should destroy the document and immediately advise Henslow that you received the document in error.

Certain statements in this document may be forward looking statements. You can identify these statements by the fact that they use words such as “anticipate”, “estimate”, “expect”, “project”, “intend”, “plan”, “believe”, “target”, “may”, “assume” and words of similar import. These forward looking statements speak only as at the date of this document. These statements are based on current expectations and beliefs and, by their nature, are subject to a number of known and unknown risks and uncertainties that could cause the actual results, performances and achievements to differ materially from any expected future results, performance or achievements expressed or implied by such forward looking statements. No representation, warranty or assurance (express or implied) is given or made by Henslow or its related bodies corporate, affiliates and each of their respective directors, officers, partners, employees, advisers and agents and any other person involved in the preparation of this document (together referred to as ‘relevant persons’) that any forward looking statements contained in this document are accurate, complete, reliable or adequate or that they will be achieved or prove to be correct.

To the fullest extent permitted by law, each relevant person disclaims any and all liability and responsibility for the accuracy or completeness of this document including any forward looking statements and exclude all liability whatsoever (including without limitation any liability arising from fault or negligence) for any direct, indirect or consequential loss or damage which may arise or be suffered by any person for any reason in connection with this document including but not only as a consequence of use of or reliance on this document, or of any information or error in, or omission from, this document.

Disclosure of Interest

Henslow and its directors, officers and employees or clients may have, or have had, an interest in the financial products referred to in this document and may make purchases or sales in those financial products at any time and therefore may benefit from any increase in the price of those securities. Henslow may earn brokerage, fees and other benefits from financial products referred to in this document.

Henslow and Heath Andrews (or their associated entities) have a beneficial interest in securities issued by EMC at the time of publication of this document. No part of the compensation of Henslow is directly related to inclusion of specific recommendations or views in this document.

Specific Disclosures

Henslow has previously been and may in the future be engaged to provide investment banking, capital markets, corporate advisory and/or other financial services to EMC.

This document is produced by Henslow Pty Ltd (ABN 38 605 393 137) Australian Financial Services Licence No 483168.

equity research report...report, in 2011 55% of china’s groundwater was considered unfit for human...

Documents