FY19 Portfolio update ASX:LBL, SOP, DEM, 2BE, XRF, BSL, SSG

04/09/2019

Trav Mays
Follow @MaysTrav 

Today I would like to give an update on all the stocks within my portfolio and see how my original thesis has/is playing out. I plan to write another post about other companies that aren’t in my portfolio but I have written about in the past to test my thesis and hopefully learn a bit more. 

I run a very concentrated portfolio because the benefits really resonate with me. I completely understand diversification and its merits, but I struggle to keep up with this many stocks, so adding another 13 or so to get diversified sounds like a nightmare, but each to their own. The figures in the table below are just a snap shot as of end of business day today (04/09/19) and should not be looked at as an indication of performance.

*Weighted average price

LaserBond (ASX:LBL)

I originally made a mistake with LaserBond, to ensure that I learn from it, I have given it its own post, so I won't rewrite that here. You can read all about my mistake here and the original here.

BlueScope Steel (ASX:BSL)

Original thesis can be read here

After going through my analysis I decided to sell BSL today (04/09/19) for $12.33, netting me a return of 11.6% + dividends - brokerage and tax in 9 months, pretty happy with that. The reason I decided to sell is due to increased uncertainty. The trade war continues to drag on, with steel being a key lever both sides are using to hurt the other. BSL has also been spending a lot of money on buybacks, helping to keep the stock price somewhat elevated despite the decrease in profit and predicted large decrease in FY20. If the buyback where to stop before the trade war ends, I would imagine it would hurt the share price in the short term. They have also just started proceedings with the ACCC over alleged steel price fixing. It doesn't sound like they have a very solid case, the ACCC's Chair Mr. Rod Sims stated that due to them only having 6 years to begin civil proceedings and that time is almost up, the "ACCC has determine it is appropriate to commence such proceedings against BlueScope and Mr. Ellis", not the most confident sounding reasoning, but adds to the uncertainty around BlueScope. Whilst I think it is still undervalued, I would rather wait and watch on the sidelines than continue to own a stock whose profits are so heavily tied to the a ongoing disagreement between two of the most powerful people on the planet and get back in if it does happen to go down. 

Synertec (ASX:SOP)

Original thesis can be read here

Synertec looks to be playing out as expected, albeit, slightly postponed, except for their revenue, I didn’t predict anywhere near that big a jump (111.2%). They also recorded decent increases further down the income statement, with EBITDA returning to positive figures that being said, they did produce a loss in FY19 of $85k.

The original thesis revolved around a new accounting standard (IFRS 15, introduced on the 1st January 2018) temporarily disguising earnings, which continues to be the case. We can see this by looking at the disconnect between operating cash and EBIT, EBIT for FY19 was a loss of $40k whilst Operating cash was a positive $0.83m. We can also see that despite SOP recording an EBIT loss in FY18 and FY19, cash and cash equivalents has continued to increase. If you have read my initial post, you would have seen the simple calculation process that reveals SOP's true earnings, which accounts for all but 50k of the 2.4m increase in the cash balance, as calculated at HY19. This hidden profit, I believed, would eventually be put through the income statement, boosting profit and would be the catalyst for a ~40% stock price gain. But despite the deferred income decreasing by $2.4m in FY19, SOP produced a loss, so what is going on? 

I believe the missing profit has been postponed due to some untimely project completion dates; $8.46m worth of projects plus a custody transfer skid were delivered within the first 2 months of FY20. Under IFRS 15, contracts with multiple performance obligations record revenue as each performance obligation is meet, contracts with payments upon completion are recorded "when control of the goods transfer to the customer". Whereas "operating expenses are recognised in profit or loss upon utilisation of the service or at the date of their origin". This means that whilst expenses are recorded as they occur, revenue is recorded only after a milestone is achieved, any cash received before the milestone is recorded as Deferred Income on the balance sheet under Liabilities. As the projects pass their milestones, the deferred income reduces as it is recognised as revenue. The final portion of the revenue both received as cash and recognised on the P&L for the projects finished early FY20, I believe, would have occurred on delivery in FY20, hence the lower deferred income and loss for FY19. While we are not given figures for the custody transfer skid or contract specifics, it's a good bet that they would be settled as cash on delivery, revenue would therefore be recorded in FY20, its costs however, would have all been recorded as they were incurred, the majority of which was in FY19. The same can be said for the performance obligation contracts, the final portion of the payment will be received in FY20, but a large portion of costs would have been expensed in FY19. The 238% increase in the materials and services expense and the 2H19 operating cash loss of $0.42m, I believe, help to validate this point.

Whilst a good portion of the revenue and profit disconnect can be attributed to the accounting standards and untimely completion dates, part is due to the revenue increase coming from the lower margined fixed priced project segments. This segment's revenue increased by 166%, making up 87.3% of total revenue, whilst their other division, rendering of services, decreased by 13%. It would appear that SOP is pricing their projects with a low margin to help win market share, allowing them to show off their skills and talent and to win customers over. Clearly there is a short window in which a strategy like this can be used, but if used correctly, can really help to boost long term shareholder value. 

SOP continued to invest in themselves during FY19, they in actual fact accelerated their spend, with business development more than doubling and Employee and Super costs increasing by $1.33m or 21%.

I believe SOP is still good value at current prices, they have no debt, are op cash positive and according to their investor presentation have a medium term target of $40m revenue, with above industry average margins. They seem to be focusing on their custody transfer skids as a large driver of growth, a little more sales info about these units, projected sales volume, a ball park sale price and margin would be appreciated. But nothing stood out as a worry for me, so I'm going to continue to hold. The 1H20 report is the one I am really interested in, within it will hopefully be a return to healthy margins and proof of my thesis playing out, bring with it the ~40% gain I'm predicting. Fingers crossed on this one, I do however believe the risk reward ratio is positively skewed in my favor. 

Shaver Shop (ASX:SSG)

Original thesis can be read here and the half year result here

Shaver Shop along with a number of other large retailers had a pretty good year. Despite the constant retail apocalypse discussions, SSG grew NPAT by 6%, they hit the lower end of their EBITDA guidance, 12.5m and increased their online sales by 30%, which contributed 12.6% to total sales. But more importantly, they grew LFL sales, 1.1% overall and 4.8% when you exclude Daigou sales.

Over the year they have made a number of improvements, they opened 6 new stores and bought back one franchise. They also improved their website, initiated a number of online incentives and completed 8 full store refits. 

Using the PEG ratio, SSG looks priced a little bit higher than it should be, currently sitting on a PEG of 1.5, when using FY19's earnings growth rate of 6% (P/E = 9.14), but is this level of growth justified? So far in FY20, they have increased LFL sales by 9.5% and bought back 2 franchises. Within FY20 they are planning on increasing their marketing spend back up to FY18 levels and refitting 5 - 10 stores with the new design. The franchise buy backs are especially important as they are typically in locations that generate higher sales per store. So they are definitely off to a good start to the year. So it does seem like 6% is a bit low, but it is far too early to tell, as with most retailers, so much of their revenue comes from the holiday season, that any prediction without a little bit of holiday data is pretty much pointless.

During the conference call, Mr. Cameron Fox, current CEO, made an interesting comment. He stated that SSG are using each store as a type of warehouse, whereby as an item is purchased online, the sale order is sent to the store nearest to the customers location, who then, during down periods, package and post the online sales. Clearly this is an excellent idea to try and reduce postage times and costs, keep employees busy during down times and to combat Amazon's 2 day delivery, but one that would need to be managed really well. 

Given all this, I am going to continue to hold and watch, they are paying out a pretty healthy dividend, so assuming everything stays the same or doesn't deteriorate too much and I don't have any other company I want to buy, I'm happy to hold.

De.mem (ASX:DEM)

Original thesis can be read here

DEM on the surface didn't have a very good half, revenue decreased by 37% (HY19 $3.7m) whilst their NPAT loss more than doubled (HY19 -$1.8m). But when we have a look a little further down in the report, at the cash flow statement, a different story emerges. DEM increased their receipts from customers by 9.3% (HY19 $5.08m) and whilst they produced a operating loss of $0.8m the vast majority of it, ~74%, was from the first quarter, showing that they are making progress towards becoming operating cash flow positive. Not only that, but DEM is predicting to surpass CY18's revenue of $10.5m, with $9.5m worth of revenue having already been secured.

Whilst all of this is great, my key take away from the report is that DEM has begun to untether themselves from the mining and infrastructure industries whilst expanding their geographical footprint. DEM states that "while the vast majority of CY 2018 revenues were generated from the mining/resources and infrastructure segments, the revenue mix for CY 2019 includes some contributions from projects in the food & beverage sector". They went on to state that "a key pillar of the expansion strategy for 2019 is to aggressively target the high growth food & beverage and agricultural sectors across Australia". DEM is also expanding their geographical footprint, having set up two new offices in Adelaide and Melbourne, they also acquired PumpTech (07/08/19), Tasmania's equivalent of Akwa-Worx. A recent announcement  really highlights these two points. DEM reported on the 28/08 that they had received two purchase orders for a total of $0.35m, the first order was for a water treatment system in WA, ordered by a WA government organisation, whereas the second order was for a waste water treatment system for a company working in the Food & Beverage industry based in the Pacific Islands region. Whilst the value is not very high, it shows that they are making further progress towards these two goals.

Nothing in the report stood out to me as a worrying sign. I believe DEM is still great value at today's prices and will be able to generate a shareholder return around the 30 - 40% mark in the not to distant future, with the potential for a lot more over the coming years if management performs well and they get a bit of luck on their side. To achieve this, I believe DEM will need to continue to ride the increasing infrastructure spend all the while investing the proceeds back into the business, helping to further expand their customer base industrially and geographically. Signs of DEM departing from this plan is what I will be looking for in the future, but as they currently stand, I am going to happily continue to hold.

TUBI (ASX:2BE)

Original thesis can be read here

Tubi performed really well over the year, they exceeded my revenue prediction by $4.5m, increasing year over year by 82%. They did however fall slightly short on my NPAT prediction, missing it by $0.17m. Their NPAT figure however includes a $0.95m listing expenses, when we adjust for this, EBIT increases to $3m (9.74% margin) and after we remove $0.92m of tax (30% tax rate), NPAT increases to $2.15m (6.8% margin), ~$0.5m higher than I had predicted.

The reason my prediction missed the mark by so much, was due to 2BE generating revenue per month far higher than they have in the past. Over the last 6 months of FY19, Tubi had one plant producing in the Permian Basin which generated $14.4m, or $2.4m per month. My estimate had been the average between the revenue received over the year in NZ and the 2 months in the Permian Basin, $1.65m per month. At the time I was aware that the 2 months in the Permian Basin figure I had used was conservative and would increase as the team became accustom to the factory and site, but I didn't expect that they would be able to increase it by $0.75m.

Along with missing the mark on the rev/month, I was also quite a way off on the sale price of the Iplex unit. Due to me underestimating the amount of revenue per month the plants would generate, I overestimated the cost of the Iplex plant, its actual cost was AUS$9.28m, of which, 40% has already been received with the remaining 60% to be received when the plant is delivered in  FY20.

This report gave us some more valuable information about potential future revenue, so I believe an update of my old projection is warranted. To keep the projection conservative, I won't update the assumptions, despite the fact that the plants are currently ahead of schedule, I will just update the rev/month figure, the Iplex plant sale price and use FY19's adjusted figures. FY20's revenue therefore consists of 18 months (1.5 plants) of production at the new higher rate plus the remaining 60% of the Iplex plant. Whereas FY21's revenue is for 4 plants producing for 12 months, 2 at the new higher rate $2.4/month and 2 at the more conservative lower rate of $1.65m/month. 

The updated information paints 2BE in even better light than my original post. If we look one year out, we have a PEG of 60.7, whereas if we average the next 2 years growth, we have a current PEG of 24.5. Very encouraging figures, especially when we consider that I have not taken into account the Iplex service agreement, the fact that the plants are currently slightly ahead of schedule and my conservative assumptions. I did however make a large amount of assumptions, so this prediction should be looked at with skeptic eyes, you can see how wrong I was last time I tried to predict. Given all this, I believe that the risk reward ratio is currently in my favor and at current prices, continues to offer good value. If you'd like to read more about Tubi, I have referenced and linked Mr. Joshua Baker's report on both XRF and Tubi at the bottom of the XRF section, he goes into more detail about their progress and is an excellent read, highly recommend.

XRF Scientific (ASX:XRF)

Original thesis can be read here

XRF had a bumper of year, having gone through an inflection point, they increased revenue by 20%, NPAT by 109% and Op cash flow by 380%. They also moved closer to turning the German office profitable, recording 2 months in the 2H19 with positive profit.   

Along with this, PBT margins were increased across the board, with the standout being precious metals increasing to 7% and contributing 25% of the total PBT, up from 3% in FY18.

Ricky (twitter:@galumay) has put forth a number of valid arguments against XRF on twitter over the last couple of months. The two that I believe could pose a serious threat are, the fusion machine's ability to process large quantities and their long life span. As a mine site ramps up production, no additional fusion machines are needed to meet the  higher level of output and with the replacement life cycle being so long, without new mines opening up, the sales growth rate within this segment could slow down or reverse. If we look at XRF's geographical revenue breakdown we can see that within Australia there was a large increase in the Capital Equipment segment, but flat in Consumables. We can lightly infer from this (consumables can be purchased from competitors) that a good portion of these purchases are replacements, which is also confirmed by XRF within the report. Higher commodity prices are currently pushing mining profits up, with the ABC reporting a 12.5% increase over FY18, so assuming this continues we should hopefully see capital equipment profit levels hold steady or slightly increase over the next 2 - 3 years (This is really a guess). XRF have also stated that they are focusing on growing the services and parts divisions and are planning to launch new products in FY20, opening up new organic growth opportunities.

Excerpt from XRF Scientific FY19 annual report

The consumables division did well, the continued reduction in Lithium prices helped to push NPAT to record levels, increasing by 35.3%, despite revenue increasing by only 6.16%. Expanding XRF's consumables market share is another area of growth XRF has stated they are targeting. 

As I said earlier, precious metals is the real stand out here, this division appears to be on the cusp of an inflection point and in my opinion is where the future growth will stem from. The German division's progress to becoming profitable has allowed XRF to reduce their precious metal expansion costs by half ($0.3m FY19, $0.743 FY18) and to increase profits to $0.925m, up from $0.556m in FY18.

So what does this mean for XRF? I believe XRF is well positioned to continue to benefit from the pickup in the mining industry, giving them a couple of years of similar or higher capital equipment revenue, this along with their decrease in precious metals expansion costs, higher margins and organic growth opportunities will help to push earning higher into the future. Hopefully, they will pump a good portion of this back into the company helping to expand their product mix through either acquisitions or product development.  They have stated that they are looking to expand internationally and that they are pursuing M&A opportunities, so this is looking promising. The rest will probably be distributed to share holders, as Mr. Joshua Baker states in his recent article "Results Update: Platinum Gilded Numbers & Close to Light at the End of the Tube", "I believe the company would be able to make a material capital return to investors via a special dividend, which would also allow XRF to distribute the benefit from the $5.7m in franking credits accrued on the balance sheet".

Given all this, I am happy to hold, but I will be watching for any signs of Ricky's fears playing out. I am however going to push my estimate of the share price up to $0.3, with the possibility of more if management perform well and they continue to have luck on their side.

As always, thanks a lot for reading. I am on Twitter Follow @MaysTrav and Linkedin  if you’d like to connect or would like to chat, it’s always great to meet other ASX investors, especially those who have a different view point and don't forget to subscribe to ensure you don't miss out on my new posts. 

Thanks for reading

Just Culture Investor

Trav Mays

Subscribe to Just Culture Investor by Email 

Sources:

1. https://www.livewiremarkets.com/wires/results-update-platinum-gilded-numbers-close-to-light-at-the-end-of-the-tube
2. https://www.abc.net.au/news/2019-09-02/gdp-economic-growth-slow-down-business-indicators-profit-mining/11471034

The author is a current owner of all shares outlined above, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action. Please refer to Disclaimer page for a full list of disclaimers.  

Insane in DE.membrane (ASX:DEM)

30/07/2019

Trav Mays

Follow @MaysTrav 

Today we will be looking at De.mem, a wastewater treatment company that looks set to hit an inflection point. They have a proven and patented technological advantage, which gives them the ability to not only extract more clean water from wastewater, but they can do it whilst operating at a lower cost. Technologies such as these are vital, according to an article on National Geographic titled “Freshwater Crisis”, “Freshwater makes up a very small fraction of all water on the planet. While nearly 70 percent of the world is covered by water, only 2.5 percent of it is fresh. The rest is saline and ocean-based. Even then, just 1 percent of our freshwater is easily accessible, with much of it trapped in glaciers and snowfields. In essence, only 0.007 percent of the planet's water is available to fuel and feed its 6.8 billion people”.

Company

De.mem (ASX:DEM) is a water treatment company that generates their revenue predominately through Build Own Operate (BOO) agreements, but also through the sale of water treatment products (some of which they design and build in-house) and general services. Whilst this has formed the backbone of their revenue to date, the real growth potential comes from their worldwide exclusive licence agreement with NTUitive (Nanyang Technological University), which gives them access to cutting edge membrane technologies, Nanofiltraion, Ultrafiltraion and Forward Osmosis. These membrane technologies are relatively new (especially on the industrial level) and offer several advantages to traditional technologies. These advantages essentially boil down to the system producing very similar results, whilst requiring a lot less hydraulic pressure.

DEM was established in Singapore in 2013 and listed on the ASX on the 7^th April 2017, for $0.20 per share, giving them a market cap of ~$19 million. Having just IPO’d, DEM moved quickly, setting up trials for their membrane technology and the construction of a membrane manufacturing facility. This facility was completed and operational by July 2017, producing membrane modules in both 4 and 8 inch diameters. The perfect size for small scale commercial projects, the size of projects they and the yet to be acquired Akwa-Worx were undertaking.

In an effort to transform DEM into a profitable company, whilst they wait for the development of their Licensed Proprietary Technology, they acquired Akwa-Worx in September 2017 for $1.96m (2.4x Akwa-Worx’s 2017 EBITDA). Akwa-Worx is a leading Australian (based out of Caboolture, Brisbane) water and wastewater treatment systems and solutions provider. Akwa-Worx gave DEM a massive boost in revenue and changed their revenue structure up substantially. They went from generating $0.28m of revenue in 2016 to $10.52m in 2018, that’s a 3657% increase in 2 years. Along with this, their contracting segment went from non-existent to 46.7% of revenue, 0 to $4.9m, in that same 2-year period.

Along with the massive boost to revenue, Akwa-Worx’s founder Mr. Shane Ayre came on board, bringing with him over 17 years of wastewater experience. Mr. Ayre founded Akwa-Worx in May 2002 and whilst it is quite common for the Director of an acquired company to stay on for a year or two as part of the sale agreement, I hope Mr. Ayre will be staying on a for a while longer. Mr. Ayre, along with the CEO, Mr. Andreas Kroell own a combined 4.5% of DEM, not huge but not small either. Positively Mr. Ayre has been adding to his holdings, having purchased 620,120 new shares in 2018.

Along with Mr. Ayre, DEM is being led by the talented Mr. Andreas Kroell, who having working as a Director and Partner of one of DEM’s largest shareholders, New Asia Investments for over 7 years, switched from being an investor to a leader, taking on the role of CEO, in 2016. New Asia Investments as described on Mr. Kroell’s LinkedIn page “is a Singapore-based venture capital fund” “that co-invests with the National Research Foundation (Singapore government) into companies from the water, clean-tech, industrial and med tech sectors”. This experience would have clearly given him the necessary skills to lead DEM into the future. Prior to this, he worked as a Senior Portfolio Manager at Nanostart NG for just over 2.5 years and as a Senior Auditor at Deloitte for just over a year.

Since Mr. Kroell and his team purchased Akwa-Worx, it would appear that they have taken their eye off Singapore somewhat. This can be seen (I might be reading too much in to this) when we look at where geographically DEM generates their revenue from. Whilst both the Singaporean Services and Sales of Goods segments were decreasing between 2017 and 2018 (95% and 60% respectively), all of the Australian segments were improving, increasing from $7m in 2017 to $10m in 2018, a ~43% increase (2017 figure of $7m is the unaudited figure presented in the acquisition announcement). The majority of this increase was in the contracting segment, DEM obtained a total of $2.96m of new contracts in CY2018. Please note that this graph is a bit misleading, the Australian 2017 figures are only for the 3 months after DE.mem purchased Akwa-Worx.

The focus on the Australian Leg has not stopped either, they recently opened 2 new offices, one in Melbourne and another in Adelaide and are still looking to recruit more people. DEM are currently advertising on their website for two new positions, a BDM in Melbourne and a Process Engineer in Caboolture. Whilst still only early days, it appears that the new offices and the continued focus on Australia is having a material effect on CY2019, having to date received $4.17m in new orders. That’s an increase of 40.9% when compare to the whole of 2018 and we are only in July, very impressive.

The increased focus on Akwa-Worx is understandable, not only is there a large market to expand into, estimated by IBIS to be worth $5b p.a., they are currently the only profitable segment of the business, generating $0.37m profit before tax in CY2018, off $10.2m in revenue (PBT margin of 3.1%). Not only that, but they keep getting better, having increased revenue per month by 44% ($0.26m) and increased their return on assets to 15% in CY2018.

 

“That’s all great Trav, but I need more up to date info, how have they gone this year?” That’s a great question, unfortunately, we have only had one quarterly statement released so far and they are yet to publish their half year statement. But as you can see below, receipts from customers in the first quarter are still quite high, not as high as in the past, but not looking too bad.  

A different story plays out once we look a little bit further down the cash flow statement, it would appear that whilst DEM was close to breaking even in Q2 and Q3 last year, they have fallen away this quarter, both from a decrease in receipts and an increase in expenses. Staff costs have increased, but that is expected, especially when you open two more offices. One encouraging thing about the Q1 result was that despite them decreasing the op costs as a percentage of receipts, they stated “that the higher than average burn has been offset by receipt of a customer payment of $715,000 on 8 April 2019, and as a result, “operating performance in Q2 2019 is expected to be substantially improved”.

In other CY2019 encouraging news, DEM just raised $1.9m by offering 13.6m shares at $0.14 each. A portion of this is to continue the Akwa-Worx expansion, another portion is to keep the company afloat and the rest is to fund acquisitions, which I originally thought was going to be a German waste water treatment company (they have been speaking about this for about a year) but a very recent announcement stated that they are looking at a Tasmanian one instead, PumpTech. PumpTech specialises in the design, supply, installation and maintenance of pump sets, pump stations and sewage and water treatment plants; essentially, they do the exact the same things as Akwa-Worx, just that they are situated in Tasmania. This acquisition, if successful, (as of writing, they have only stated that negotiations are currently being undertaken) would allow DEM to essentially bypass the cost and time needed to set up a wing of Akwa-Worx in Tasmania, allowing them to simply walk in, lean it out somewhat, implement their Australian wide systems, use their economies of scale and increase profits (sounds simple, but as we all know, is quite difficult).

Whilst they may have shifted a large portion of their focus onto the Akwa-Worx business, this doesn’t mean that they aren’t still concentrating on their licensed technology. Since the Akwa-Worx acquisition, DEM has been busy validating and expanding the technologies product range, below is a list of some of their achievements

• October 2017: Completed a number of pilot water treatment systems, giving them access to critical data
• November 2017: DEM signed a Memorandum of Understanding with Virtual Curtain China Limited to jointly pursue a number of Chinese opportunities, nothing has come of this as yet
• March 2018: Exclusively licenses hollow fiber forward osmosis membrane technology
• April 2018: The first order of the low pressure hollow fiber nanofiltration membrane modules, 20 8-inch modules in total, giving DEM a total revenue of A$30,000
• May 2018: Took a strategic stake (32%) in Aromatec, a Singaporean company targeting the food and beverage industry, at a cost of $100,000. Aromatec is focused on the commercialisation of an innovative hollow fiber forward osmosis technology
• May 2018: Introduced a Ultrafiltration membrane, expanding their product range considerably
• July 2018: Introduced a “point of use” filtration system using their nano and ultrafiltration technologies, targeting a worldwide market estimated to be worth US$24.5b by 2020
• October 2018: Recorded successes at the deployed pilot programs stated earlier. These sites were to treat wastewater at a car wash, an electronics factory and another to treat river water from the Mekong Delta.
• October 2018: Received AUD$90,000 from three small scale commercial projects using DEM’s filtration technologies, one at a car wash facility, another at an oil and gas factory and the last at a research institution, all in Singapore.
• November 2018: Released a ready for commercial sale Ultrafiltration membrane that was developed in-house.
• February 2019: Recorded their first sale (50 units) of domestic “point of use” water filters.
• June 2019: Recorded first revenues from commercialisation of new hollow fibre Forward Osmosis Technology, ~$150,000.

On the surface this last one doesn’t sound like much and you are right, it is a small drop in 2018’s ~$10m bucket. But it is however, as DEM stated, “validation for the commercial readiness of the technology”, which has led to them “currently preparing an industrial solution for this FO technology in response to strong customer interest”. Which is great to hear, but as we have yet to see this technology generate any real money, a better understanding of it and the other technologies potential is needed before we even think about evaluating DEM.

Competitive Advantage

DEM’s competitive advantage comes from their worldwide Exclusive Licence with NTUitive that gives them access to several cutting-edge filtration technologies, each used at a different stage of the wastewater filtration system. Their original licence gave them “details on the fabrication, characteristics and performance related to the low pressure hollow fibre nanofiltration membrane technology”. This license cost them $35,000 over 2 instalments, with DEM continuing to pay 3% of net sales of licensed products and 25% of all sub licenses. So what does a low pressure hollow fibre nanofiltration membrane do?

Traditionally the filtration of wastewater has been completed through a process called reverse osmosis. Basically, reverse osmosis, when used to treat wastewater, is the process of pushing unclean water through a membrane, which filters out any particles that are of a certain size, producing relatively clean water. The problem with this system is that it not only removes the unwanted particles but all particles, which means needed elements such as magnesium, calcium, potassium etc are often added back into the water after it passes through this system. A relatively new process, called nanofiltration is able to overcome this by operating at lower pressures, which allows the use of more sophisticated membranes that are able to reject solutes not only on size but on charge as well. By doing this, they have created membranes that can reject just the unwanted elements whilst operating at a lower cost.

Nanofiltration up until recently, was mainly used to treat portable drinking water, its usefulness was however expanded when DEM in conjunction with Nanyang Technological University produced the first industrial sized low-pressure hollow fibre nanofiltration membrane module. Their nanofiltration membrane can produce almost as good results (when compared to reverse osmosis), whilst requiring only 20% of the hydraulic pressure, 2 bars of pressure as opposed to the 10-15 bars typically needed in the reverse osmosis process. To put that into context, 2 bars of pressure is equal to 29 PSI, just shy of what you put in your car tyre (32psi) whilst 10 bars of pressure converts to 145 PSI, 4.5 x your tyre pressure. As you can imagine, the large reduction in the pressure required, results in a decrease in the initial CAPEX, (Capital Expenditure; the pump size and in some cases, pump type required are smaller/cheaper), but not only that, these types of systems also have a large impact on OPEX (Operating Expenditure), in some cases reducing the energy required by as much as 80%. This cost saving is extremely important, as the US Department of Energy’s Office of Industrial Technology highlight in their document titled “PumpLife Cycle Costs”, “Energy consumption is often one of the larger cost elements and may dominate the LCC (Life Cycle Cost analysis), especially if pumps run more than 2000 hours per year”. Whilst obviously helping to save newly created plants a large sum of money, due to the standard size of the modules, DEM’s nanofiltration modules can, at times, simply replace existing reverse osmosis modules without the need to change the system in anyway, other than reducing the pressure at the pump. The estimated market size for this technology is ~$570 million p.a.

Along with their nanofiltration modules, DEM has added a number of other technologies to its product list, most notably an Ultrafiltration membrane, which was developed in house and therefore “comes without any royalty obligations” and a domestic water “point of use” filter system. The Ultrafiltration membrane is used in the pre-filtration step for both reverse osmosis and nanofiltration systems, where it removes bacteria and viruses. It has an estimated market size of ~$570 million p.a., whilst the point of use filters market size is estimated to be ~$19.9 billion worldwide, be it an industry with far more competition.

The other exciting technology that DEM has at their disposal is the hollow fibre forward osmosis membrane. As opposed to reverse osmosis that uses hydraulic pressure to push the fluid through the membrane, forward osmosis uses an osmotic pressure differential to draw the fluid through the membrane. For those of you who may not be familiar with this phenomenon, this video gives a great explanation, but essentially it works by two fluids with differing solute levels equalising. For example, if you have a u – tube that has a membrane with pore sizes large enough for just water (Solvent) to flow through, if you were to dissolve salt (Solute) in one side, this would decrease the water concentration on that side whilst simultaneously increasing the solute concentration. As the universe likes to always be in equilibrium, the water molecules will be drawn to the side with a relatively high concentration of solute, this will result in the water level on that side being higher than the lower solute concentration side.

Sourced from: http://regularbio.blogspot.com/2018/11/diffusion-and-osmosis.html

Forward osmosis takes advantage of this phenomenon by using a draw fluid (relatively high solute fluid) to draw the unclean water through a membrane. To do this, unclean water is pumped passed a membrane with a draw fluid being pumped passed the other side. The high solute concentration therefore draws the unclean fluid through the membrane and into the draw fluid, cleaning it in the process. This clean water is than separated from the draw fluid, with the draw fluid again being pumped past the membrane, which in turn pulls clean water through the membrane and on and on it goes. 

Sourced from: Jiao, Yanmei & Kang, Yuejun & Yang, Chun. (2015). Osmosis and Its Applications.

The advantage of forward osmosis technology is that it can reduce the amount of concentrated liquid that is needed to be treated at a dedicated water treatment plant. Onsite water treatment technology is currently only able to economically extract a percentage of the potential clean water, the rest is trucked to a dedicated water treatment plant at a cost of ~$400/tonne, where they treat it before putting it back into the environment. DEM’s forward osmosis system is able to reduce the volume of the rejected concentrated liquid by as much as two thirds, giving consumers a considerable cost saving. Even more impressive, is the fact that this “technology can be utilised in place of current ‘Zero Liquid Discharge’ processes and evaporators, which are expensive to purchase and operate, leaving De.mem well positioned to capitalise on the market, which is cited to be worth approximately A$400 million per annum (Source: ForwardOsmosis Tech)”.

DEM is also working with Aromatec (DEM owns 32%), a company that is targeting these technologies, more specifically forward osmosis, on the food and beverage industry. This gives DEM an essential foot in the door to sell not only its forward osmosis technologies, but all of the technologies stated above, which is extremely exciting, as the worldwide food and beverage market for membrane technologies is predicted to be worth US$5.5 billion by 2020 (Sourced from ASX release dated 18 June 2019, DEM cites BCC research).

Evaluation

To Evaluate DEM, due to them not currently generating a profit and the insane level of difficulty in predict anything (earnings in this case), I will simply compare DEM’s Price/Receipts from Customers to a number of companies in a similar albeit different industries.

If we use CY2018’s price to cash receipts, we can see that DEM is trading at a multiple less than half of the next closest.

From this we can calculate what the share price and potential gains we will receive if the market was to assign a more aligned price/cash ratio, the results from which are quite encouraging. If the market assigns just a price/cash ratio of 3, we will see a gain of roughly 30%, keep in mind that that is still only just over half of the next lowest.

‘That’s all well and great Trav, but Q1 saw some massive changes to cash received, especially from PET who received more cash in Q1 2019 than in all of CY2018 and DEM’s decreased by half a mill’. That’s a good point, so to double check our analysis we will run it again using 2019 Q1 figures. As you can see, the results are reassuringly similar.

Risks

This is again my attempt at evaluating a growth company. I therefore would like to take a minute to explain the huge amount of risks associated with this company. I outlined a number of generic risks in my recent article on Tubi (ASX:2BE) so I won’t repeat them here, but that doesn’t mean DEM doesn’t come with its own set of specific risks, some of which I will outline below.

The large potential gain that could come from their licensed technology, whilst it is patented, it isn’t patent around the whole world. Not only that, but the patent only describes a certain type of manufacturing process, this means that other people could potentially produce the membranes using other means, or simply use the same technology in a country where they don’t have patent protection.

This means that they are essentially reliant on the first movers’ advantage, which while it may be extremely powerful, it only gives you a short window in which to prove your product and build brand loyalty. Amazon used this wonderfully to their advantage, everyone knows the brand and they have made their product extremely sticky. Netflix on the other hand is an example of a company that hasn’t used it as well. Their product isn’t especially sticky, I got rid of my subscription ages ago and with a large portion of their good content going to Disney Plus, I think they might be in a bit of trouble in the not too distant future, especially if their recent subscription numbers are anything to go by. Management will need to act quickly and execute well over the coming years for us to receive the payoff that I believe can be generated.

My above analysis is extremely flimsy.

It is currently trading at a 35.7% premium to the price offered to institutional investors just last month.

I learnt a little about process engineering when I completed Mechanical Engineering and a bit more when I did Petroleum Engineering, but I am definitely not a subject matter expert, so my thoughts on the usefulness of this technology could be incorrect.

Whilst not being an ethical investor by any stretch of the meaning, I do however, find myself drawn to companies that are having a positive effect on the environment (who really wants to be part owner of a cigarette company?), which has lead me to purchasing companies when I don’t fully understand them or overlook certain aspects. Windlab is a good example of that, whilst I understand the technology and thinks it’s amazing, I don’t really understand their business model, but I purchased anyway (I have since realised this and sold). Another example is Carnegie Clean Energy, despite some questionable management decisions I purchased a small bundle because again I really liked their technology, I did sell before the price got anywhere near where it is now, but my judgement was clouded due to the ethical bias that I have. This could be the same story playing out again, as Mark Twain is rumoured to have said “History doesn’t repeat itself, but it often rhymes”.

Discussion

This filtration system has not only been proven in the laboratory, but in real world applications as well. This is very important milestone for DEM and one that they have only completed relatively recently (October 2018). Along with these pilot projects, DEM has secured a number of orders for both their Nanofilters, Ultrafilters and point of use filters, which is excellent to see. The momentum is something that DEM will need to continue to build on, which leads me to their Australian Acquisitions.

The Australian Acquisitions (one is still currently pending) not only gives DEM an opportunity to generate revenue in the short term, but also gives them the chance to get more of their product out working in the market and therefore more projects to promote and continue the momentum. I see these acquisitions as DEM converting themselves into a company similar to LaserBond, whereby they both have intellectual property that will form the backbone of their growth, but in the mean time operate businesses that are sort of a supporting act, generating a profit, but have limited growth potential. LaserBond’s revenue was stagnant for a number of years following the GFC, it wasn’t until 2 years after they had started to invest in their R&D again, that their revenue started to build, resulting in the large increase in its market cap that we saw in 2018 (If you would like to learn more about LaserBond, please check out my article here). DEM has already spent the money on purchasing and developing their range, they have shown its usefulness both in the lab and out in the real world, so I believe that DEM is similar to LaserBond around the 2017 mark, before the inflection point, but by how much, who knows.

Within the LaserBond article I used the 6 common ingredients of 100 Baggers from Mr. Christopher Mayer’s book “100 Baggers: Stocks that return 100 to 1 and how to find them” in an effort to learn more about inflection point investing. LaserBond around the 2017 mark had five of the six ingredients needed, with the final one just being time for a company to compound its good work. DEM only has 4 of the ingredients, not quite as good as LaserBond, but still quite reassuring. They are as follows:

1. They are small
2. Have a low multiple
3. Owner operators
4. They have been investing in themselves

The additional ingredient that LaserBond had was high returns on capital, which is quite an important one, but something I believe DEM will be able to generate in the future. I’m not trying to say that DEM will be the next LaserBond, I am just highlighting that they both share characteristics with companies that have gone on to become 100 Baggers. LaserBond had several things going for it that DEM doesn’t have, such as the fact that they developed their technology inhouse and were profitable at the time. I view DEM similar to the way I view XRF Scientific, both are currently valued at a 30 – 40% discount from what I believe they are worth and both have a large potential upside, assuming they get some lucky breaks and management executes well.

Conclusion

If you have been reading some of my posts over the past couple of months, you would have noticed that I am currently trying to better predict companies at or just before they reach an inflection point, DEM is in my opinion, just such a company. The market is assigning a market cap of just $25m, which is only 6 million higher than when they IPO’d back in 2017. Since then they have proven and increased their product offering, increased their revenue by 3657%, purchased a 32% stake in Aromatec, expanded into Australia through an acquisition (potentially again) and then further expanded within Australia by opening offices in Adelaide and Melbourne. The Australian revenue since DEM has taken over have increased by $3m (42.8%) and their new contracts to date (July) are 40.2% higher than the whole of CY2018. Whilst they have not yet produced a profit in any quarter, they got extremely close in Q2 and Q3 last year and I believe they are currently sitting just a stone’s throw away from hitting this massive milestone. However, due to this, I would recommend that only those with a considerable risk tolerance begin their own analysis, a lot of things need to come together for this thesis to work out.

As always, thanks a lot for reading, I really appreciate all the feedback I have received so far. I have also just recently found twitter Follow @MaysTrav, give me a follow if you like and/or send me a msg, it’s always great to meet other ASX investors. If you don't have twitter we can connect on Linkedin .

Thanks for reading

Just Culture Investor

Trav Mays

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Sources:

1. https://www1.eere.energy.gov/manufacturing/tech_assistance/pdfs/pumplcc_1001.pdf
2. https://www.nationalgeographic.com/environment/freshwater/freshwater-crisis/
3. Jiao, Yanmei & Kang, Yuejun & Yang, Chun. (2015). Osmosis and Its Applications.
4. http://regularbio.blogspot.com/2018/11/diffusion-and-osmosis.html
5. https://www.youtube.com/watch?v=L-osEc07vMs
6. https://www1.eere.energy.gov/manufacturing/tech_assistance/pdfs/pumplcc_1001.pdf

The author is a current owner of a portion of DE.mem, given this, they may be subject to one or a number of biases, more specifically anchoring and/or confirmation bias. This article is neither general nor personal advice and in no way constitutes specific or individual advice. The website and author do not guarantee, and accept no legal liability whatsoever arising from or connected to, the accuracy, reliability, currency or completeness of any material contained on this website or on any linked site. This website is not a substitute for independent professional advice and users should obtain any appropriate professional advice relevant to their particular circumstances. The material on this website may include the views or recommendations of third parties, which do not necessarily reflect the views of the website or author, or indicate its commitment to a particular course of action. Please refer to Disclaimer page for a full list of disclaimers.